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(1)
( 2)
( 3)
The easiest place to start (I think) is to take equation (1), and substitute in for
y3t, to get
y 2 t 0 1 ( 0 1 y1t 2 X 2 t 3 X 3t u3t ) 2 X 1t 3 X 3t u2 t
Removing the brackets
y 2 t 0 1 0 1 1 y1t 1 2 X 2 t 1 3 X 3t 1u3t 2 X 1t 3 X 3t u2 t
(5)
3 X 3t u2 t ) 2 0 2 2 X 2 t 2 3 X 3t 2 u3t 3 X 1t 4 X 2 t u1t
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y1t (1 2 1 1 1 1 ) 0 1 0 1 1 0 2 0 X 1t (1 2 3 ) X 2 t (1 1 2 2 2 4 )
X 3t (1 1 3 1 3 2 3 ) u 3t (1 1 2 ) 1 u2 t u1t
(6)
Multiplying all through equation (3) by (1 2 1 1 1 1 ) :
y 3t (1 2 1 11 1 ) 0 (1 2 1 11 1 ) 1 y1t (1 2 1 11 1 )
2 X 2 t (1 2 1 11 1 ) 3 X 3t (1 2 1 11 1 ) u3t (1 2 1 11 1 )
Replacing
(7)
0 1 0 1 1 0 2 0 X1t (1 2 3)
y 3t (1 2 1 11 1 ) 0 1 0 11 0 X 1t (1 2 1 1 3 ) X 2 t ( 2 1 4 )
X 3t ( 11 3 3 ) u3t 11u2 t 1u1t
(9)
Multiplying all through equation (2) by (1 2 1 1 1 1 ) :
y 2 t (1 1 1 1 12 ) 0 (1 1 1 1 12 ) 1 y 3t (1 1 1 1 12 )
2 X 1t (1 1 1 1 12 ) 3 X 3t (1 1 11 12 ) u2 t (1 1 11 12 )
(10)
Replacing
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0 1 0 1 1 0 X1t (1 2 1 1 3)
y2 t (1 1 11 12 ) 0 02 1 1 0 1 10 X 1t
(
1 1 3 2 22 1 ) X 2 t ( 1 2 1 14 )
X 3t ( 1 3 3 32 1 ) 1u3t u2 t (1 2 1 ) 1 1u1t
(12)
Although it might not look like it (!), equations (6), (12), and (9) respectively
will give the reduced form equations corresponding to (1), (2), and (3), by
doing the necessary division to make y1t, y2t, or y3t the subject of the formula.
From (6),
0 1 0 1 1 0 2 0
(1 2 3 )
( 2 2 4 )
X 1t 1 1 2
X 2t
(1 2 1 1 1 1 )
(1 2 1 1 1 1 )
(1 2 1 1 1 1 )
(1 1 3 1 3 2 3 )
u ( 2 ) 1 u2 t u1t
X 3t 3t 1 1
(1 2 1 1 1 1 )
(1 2 1 1 1 1 )
(13)
From (12),
y1t
y2 t
0 02 1 1 01 10 ( 1 1 3 2 22 1 )
X 1t
(1 1 11 12 )
(1 1 11 12 )
( 1 2 1 14 )
X
(1 1 11 12 ) 2 t
( 1 3 3 32 1 )
u u (1 2 1 ) 1 1u1t
X 3t 1 3t 2 t
(1 1 11 12 )
(1 1 11 12 )
(14)
From (9),
y 3t
0 1 0 11 0
(1 2 1 1 3 )
( 2 1 4 )
X 1t
X
(1 2 1 11 1 ) (1 2 1 11 1 )
(1 2 1 11 1 ) 2 t
( 11 3 3 )
u u u
X 3t 3t 1 1 2 t 1 1t
(1 2 1 11 1 )
(1 2 1 11 1 )
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(15)
Notice that all of the reduced form equations (13)-(15) in this case depend on
all of the exogenous variables, which is not always the case, and that the
equations contain only exogenous variables on the RHS, which must be the
case for these to be reduced forms.
(b) The term identification refers to whether or not it is in fact possible to
obtain the structural form coefficients (the , , and s in equations (1)-(3))
from the reduced form coefficients (the s) by substitution. An equation can
be over-identified, just-identified, or under-identified, and the equations in a
system can have differing orders of identification. If an equation is underidentified (or not identified), then we cannot obtain the structural form
coefficients from the reduced forms using any technique. If it is just
identified, we can obtain unique structural form estimates by backsubstitution, while if it is over-identified, we cannot obtain unique structural
form estimates by substituting from the reduced forms.
There are two rules for determining the degree of identification of an
equation: the rank condition, and the order condition. The rank condition is a
necessary and sufficient condition for identification, so if the rule is satisfied,
it guarantees that the equation is indeed identified. The rule centres around a
restriction on the rank of a sub-matrix containing the reduced form
coefficients, and is rather complex and not particularly illuminating, and was
therefore not covered in this course.
The order condition, can be expressed in a number of ways, one of which is
the following. Let G denote the number of structural equations (equal to the
number of endogenous variables). An equation is just identified if G-1
variables are absent. If more than G-1 are absent, then the equation is overidentified, while if fewer are absent, then it is not identified.
Applying this rule to equations (1)-(3), G=3, so for an equation to be
identified, we require 2 to be absent. The variables in the system are y1, y2, y3,
X1, X2, X3. Is this the case?
Equation (1): X3t only is missing, so the equation is not identified.
Equation (2): y1t and X2t are missing, so the equation is just identified.
Equation (3): y2t and X1t are missing, so the equation is just identified.
However, the order condition is only a necessary (and not a sufficient)
condition for identification, so there will exist cases where a given equation
satisfies the order condition, but we still cannot obtain the structural form
coefficients. Fortunately, for small systems this is rarely the case. Also, in
practice, most systems are designed to contain equations that are overidentified.
(c). It was stated in Chapter 4 that omitting a relevant variable from a
regression equation would lead to an omitted variable bias (in fact an
inconsistency as well), while including an irrelevant variable would lead to
unbiased but inefficient coefficient estimates. There is a direct analogy with
the simultaneous variable case. Treating a variable as exogenous when it really
should be endogenous because there is some feedback, will result in biased
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variables are absent, the equation would not be identified, while if more than
one were missing, the equation would be over-identified. Considering
equation (6.97), no variables are missing so that this equation is not
identified, while equation (6.98) excludes only variable X2t, so that it is just
identified.
(d) Since equation (6.97) is not identified, no method could be used to obtain
estimates of the parameters of this equation, while either ILS or 2SLS could be
used to obtain estimates of the parameters of (6.98), since it is just identified.
ILS operates by obtaining and estimating the reduced form equations and
then obtaining the structural parameters of (6.98) by algebraic backsubstitution. 2SLS involves again obtaining and estimating the reduced form
equations, and then estimating the structural equations but replacing the
endogenous variables on the RHS of (6.97) and (6.98) with their reduced form
fitted values.
Comparing between ILS and 2SLS, the former method only requires one set of
estimations rather than two, but this is about its only advantage, and
conducting a second stage OLS estimation is usually a computationally trivial
exercise. The primary disadvantage of ILS is that it is only applicable to just
identified equations, whereas many sets of equations that we may wish to
estimate are over-identified. Second, obtaining the structural form coefficients
via algebraic substitution can be a very tedious exercise in the context of large
systems (as the solution to question 1, part (a) shows!).
(e) The Hausman procedure works by first obtaining and estimating the
reduced form equations, and then estimating the structural form equations
separately using OLS, but also adding the fitted values from the reduced form
estimations as additional explanatory variables in the equations where those
variables appear as endogenous RHS variables. Thus, if the reduced form
fitted values corresponding to equations (6.97) and (6.98) are given by y1t and
y2t respectively, the Hausmann test equations would be
y1t 0 1 y 2t 2 X 1t 3 X 2t 4 y 2t 'u1t
y 2t 0 1 y1t 2 X 1t 3 y1t ' u1t
Separate tests of the significance of the y1t and y2t terms would then be
performed. If it were concluded that they were both significant, this would
imply that additional explanatory power can be obtained by treating the
variables as endogenous.
3. An example of a triangular system was given in Section 6.7. Consider a
scenario where there are only two endogenous variables. The key distinction
between this and a fully simultaneous system is that in the case of a triangular
system, causality runs only in one direction, whereas for a simultaneous
equation, it would run in both directions. Thus, to give an example, for the
system to be triangular, y1 could appear in the equation for y2 and not vice
versa. For the simultaneous system, y1 would appear in the equation for y2,
and y2 would appear in the equation for y1.
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4. (a) p=2 and k=3 implies that there are two variables in the system, and that
both equations have three lags of the two variables. The VAR can be written in
long-hand form as:
y1t 10 111 y1t 1 211 y 2t 1 112 y1t 2 212 y 2t 2 113 y1t 3 213 y 2 t 3 u1t
y 2t 20 121 y1t 1 221 y 2t 1 122 y1t 2 222 y 2t 2 123 y1t 3 223 y 2t 3 u 2t
10
y1t
u1t
where 0
, yt
, ut
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specification process. The result is that the models often have little or no
theoretical interpretation, so that they are of limited use for testing and
evaluating theories.
Second, VARs can often contain a lot of parameters. The resulting loss in
degrees of freedom if the VAR is unrestricted and contains a lot of lags, could
lead to a loss of efficiency and the inclusion of lots of irrelevant or marginally
relevant terms. Third, it is not clear how the VAR lag lengths should be
chosen. Different methods are available (see part (d) of this question), but
they could lead to widely differing answers.
Finally, the very tools that have been proposed to help to obtain useful
information from VARs, i.e. impulse responses and variance decompositions,
are themselves difficult to interpret! See Runkle (1987).
(d) The two methods that we have examined are model restrictions and
information criteria. Details on how these work are contained in Sections
6.12.4 and 6.12.5. But briefly, the model restrictions approach involves
starting with the larger of the two models and testing whether it can be
restricted down to the smaller one using the likelihood ratio test based on the
determinants of the variance-covariance matrices of residuals in each case.
The alternative approach would be to examine the value of various
information criteria and to select the model that minimises the criteria. Since
there are only two models to compare, either technique could be used. The
restriction approach assumes normality for the VAR error terms, while use of
the information criteria does not. On the other hand, the information criteria
can lead to quite different answers depending on which criterion is used and
the severity of its penalty term. A completely different approach would be to
put the VARs in the situation that they were intended for (e.g. forecasting,
making trading profits, determining a hedge ratio etc.), and see which one
does best in practice!
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