PROBLEMSET2–DUEOCTOBER24-economics.docVIP

Problem Set 2 – Solutions Instructions Part I – Analytical Questions Problem 1: Consider the AR(2) process Show that the AR(2) is stable/stationary and calculate its autocovariance and autocorrelation function. Also, calculate the unconditional mean of the process. Indicate what the ACF and the PACF of this series looks like. Do not calculate this by hand. Rather use your favorite econometric software to find the answer for up to 12 lags. Determine the MA(∞) representation of this AR(2). This will determine the sequence of dynamic multipliers required for the impulse response function. Display these coefficients graphically (up to 12 lags) using your favorite econometric software. Determine the forecasts and forecast error variances for the first 12 period-ahead forecasts. Use your favorite econometric software package to answer this question. Solution Stability: Check the roots of 1 – 1.1z + 0.18z2 = 0. They are: z = 5, and 1.111. Both larger than 1 in absolute value therefore the AR(2) is stable. This is confirmed by the plots of the ACF and PACF below. Given yt and yt-1, the h-periods ahead forecast is easily calculated by generating observations yt+h recursively. The forecast error variance can be easily calculated from the MA(inf) representation since the appropriate sum of squared terms times the variance of the residuals will give you the right FEV. Problem 2: If with with ( and u independent of each other. Then: What is the process for yt? Give conditions to ensure yt is covariance stationary and invertible. Find the long-horizon forecast for yt and its variance. Solution (a) Notice: which is an ARMA(1,2). (b) Stationarity only depends on ( so the usual condition applies here: |(| 1. For invertibility, we need to ensure that the roots are outside the unit circle. Of course, the roots for this problem are trivial since they are . Since stationarity requires that |(| 1 already, we only need . (c) The lon