8.DynamicRegressions.PDF

LECTURE 8 Dynamic Regressions Autoregressive Disturbance Processes The interpretation that is given to the disturbance term of a regression model depends upon the context in which the analysis is conducted. Imagine that we are are fitting the regression equation (1) yt = β0 + xt1β1 + · · · + xtk βk + εt to a set of economic variables observed through time. Then, it is usual to assume that the disturbance εt represents the net effect upon the dependent variable yt of a large number of subsidiary variables, which, individually, are of insufficient importance to be included in the systematic part of the model. It may be reasonable to imagine that, instead of accumulating over time, the effects of the subsidiary variables will tend to cancel each other in any period. Then, their overall effect might have a small constant expected value. The inclusion of the intercept term in the regression equation allows us to assume that E (εt ) = 0; for any nonzero net effect of the subsidiary variables will be absorbed by β0 . Economic variables are liable to follow slowly-evolving trends and they are also liable to be strongly correlated with each other. If the disturbance term is indeed compounded from such variables, then we should expect that it too will follow a slowly-evolving trend. The assumptions of the classical regression model regarding the distur- bance term are at variance with these expectations. In the classical model, it is assumed that the disturbances constitute a sequence ε(t) = {εt ;t = 0, ±1, ±2, . . .} of independently and identically distributed random variables such that (2) E (ε ) = 0, for all t and C (ε , ε ) = σ2 , if t = s; t t s 0, if t = s. 1