HOMEWORK ECONOMETRICS

CHAPTER 6
Cao Thanh Hng BAFNIU13025

Trng Nguyn Thy Oanh BAFNIU13071

Question 1: Consider the following simultaneous equations system

y1t =0+1y2t +2y3t +3X1t +4X2t +u1t (6.94)

y2t =0+1y3t +2X1t +3X3t +u2t (6.95)

y3t =0+1y1t +2X2t +3X3t +u3t (6.96)

a. Derive the reduced form equations corresponding to (6.94)(6.96).

Renumbering:
y1t 0 1 y 2 t 2 y 3t 3 X 1t 4 X 2 t u1t (1)
y 2 t 0 1 y 3t 2 X 1t 3 X 3t u2 t (2)
y 3t 0 1 y1t 2 X 2 t 3 X 3t u3t (3)

Take equation (1), and substitute in for y3t, to get

y1t 0 1 y 2 t 2 ( 0 1 y1t 2 X 2 t 3 X 3t u3t ) 3 X 1t 4 X 2 t u1t

y1t 0 1 y 2 t 2 0 2 1 y1t 2 2 X 2 t 2 3 X 3t 2 u3t 3 X 1t 4 X 2 t u1t

Gathering terms in y1t on the LHS:

y1t 2 1 y1t 0 1 y 2 t 2 0 2 2 X 2 t 2 3 X 3t 2 u3t 3 X 1t 4 X 2 t u1t

y1t (1 2 1 ) 0 1 y 2 t 2 0 2 2 X 2 t 2 3 X 3t 2 u3t 3 X 1t 4 X 2 t u1t

(4)

Substituting into (2) for y3t from (3).

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)
Substituting into (4) for y2t from (5),

y1t (1 2 1 ) 0 1 ( 0 1 0 1 1 y1t 2 X 2 t 1 3 X 3t 1u3t 2 X 1t

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

Taking the y1t terms to the LHS:

y1t (1 2 1 1 1 1 ) 0 1 0 1 1 0 1 2 X 2 t 1 1 3 X 3t 1 1u3t 1 2 X 1t
1 3 X 3t 1u2 t 2 0 2 2 X 2 t 2 3 X 3t 2 u3t 3 X 1t 4 X 2 t u1t

Gathering like-terms in the other variables together:

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
)

(1 2 1 1 1 1 )
Multiplying all through equation (3) by :

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 )
(7)

y1t (1 2 1 11 1 )
Replacing in (7) with the RHS of (6),

0 1 0 1 1 0 2 0 X 1t (1 2 3 )

y 3t (1 2 1 11 1 ) 0 (1 2 1 11 1 ) 1 X 2 t (1 1 2 2 2 4 ) X 3t (1 1 3 1 3
2 3 ) u3t (1 1 2 ) 1u2 t u1t
2 X 2 t (1 2 1 11 1 ) 3 X 3t (1 2 1 11 1 ) u3t (1 2 1 11 1 )

(8)

Expanding the brackets in equation (8) and cancelling the relevant terms

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)

(1 2 1 1 1 1 )
Multiplying all through equation (2) by :
y 2 t (1 1 1 1 1 2 ) 0 (1 1 1 1 1 2 ) 1 y 3t (1 1 1 1 1 2 )
2 X 1t (1 1 1 1 1 2 ) 3 X 3t (1 1 1 1 1 2 ) u2 t (1 1 1 1 1 2 )
(10)

y 3t (1 2 1 11 1 )
Replacing in (10) with the RHS of (9),

0 1 0 11 0 X 1t (1 2 1 1 3 )

y 2 t (1 1 1 1 1 2 ) 0 (1 1 1 1 1 2 ) 1 X 2 t ( 2 1 4 ) X 3t ( 3 11 3 ) u3t
11u2 t 1u1t
2 X 1t (1 1 1 1 1 2 ) 3 X 3t (1 1 1 1 1 2 ) u2 t (1 1 1 1 1 2 )

(11)

Expanding the brackets in (11) and cancelling the relevant terms

y2t (1 1 1
1 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)

From (6),

0 1 0 1 1 0 2 0 (1 2 3 ) ( 2 2 4 )
y1t 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),

0 02 1 1 01 10 ( 1 1 3 2 22 1 ) ( 1 2 1 14 )
y2 t X 1t X
(1 1 11 12 ) (1 1 11 12 ) (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),
 0 1 0 11 0 (1 2 1 1 3 ) ( 2 1 4 )
y 3t X 1t X
(1 2 1 11 1 ) (1 2 1 11 1 ) (1 2 1 11 1 ) 2 t
( 11 3 3 ) u 11u2 t 1u1t
X 3t 3t
(1 2 1 11 1 ) (1 2 1 11 1 )
(15)

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. What do you understand by the term identification? Describe a rule

for determining whether a system of equations is identified. Apply
this rule to (6.946.96). Does this rule guarantee that estimates of
the structural parameters can be obtained?

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 under-identified (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
back-substitution, 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 centers on 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 over-identified, while if fewer are
absent, then it is not identified.

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.

c. Describe a method of obtaining the structural form coefficients

corresponding to an overidentified system

A tempting response to the question might be to describe indirect least squares

(ILS), that is estimating the reduced form equations by OLS and then substituting
back to get the structural forms; however, this response would be WRONG, since
the question tells us that the system is over-identified.

A correct answer would be to describe either two stage least squares (2SLS) or
instrumental variables (IV). Either would be acceptable, although IV requires the
user to determine an appropriate set of instruments and hence 2SLS is simpler in
practice. 2SLS involves estimating the reduced form equations, and obtaining the
fitted values in the first stage. In the second stage, the structural form equations
are estimated, but replacing the endogenous variables on the RHS with their stage
one fitted values. Application of this technique will yield unique and unbiased
structural form coefficients.

Question 2: Consider the following system of two equations

y1t =0+1y2t +2X1t +3X2t +u1t (6.97)

y2t =0+1y1t +2X1t +u2t (6.98)

a. Explain, with reference to these equations, the undesirable

consequences that would arise if (6.97) and (6.98) were estimated
separately using OLS.
A glance at equations (6.97) and (6.98) reveals that the dependent variable
in (6.97) appears as an explanatory variable in (6.98) and that the dependent
variable in (6.98) appears as an explanatory variable in (6.97). The result is
that it would be possible to show that the explanatory variable y2t in (6.97)
will be correlated with the error term in that equation, u1t, and that the
explanatory variable y1t in (6.98) will be correlated with the error term in that
equation, u2t. Thus, there is causality from y1t to y2t and from y2t to y1t, so that
this is a simultaneous equations system. If OLS were applied separately to
each of equations (6.97) and (6.98), the result would be biased and
inconsistent parameter estimates. That is, even with an infinitely large
number of observations, OLS could not be relied upon to deliver the
appropriate parameter estimates.
 b. What would be the effect upon your answer to (a) if the variable y 1t
had not appeared in (6.98)?
If the variable y1t had not appeared on the RHS of equation (6.98), this would
no longer be a simultaneous system, but would instead be an example of a
triangular system (see question 3). Thus it would be valid to apply OLS
separately to each of the equations (6.97) and (6.98).

c. State the order condition for determining whether an equation which

is part of a system is identified. Use this condition to determine
whether (6.97) or (6.98) or both or neither are identified.
The order condition for determining whether an equation from a simultaneous
system is identified was described in question 1, part (b). There are 2
equations in the system of (6.97) and (6.98), so that only 1 variable would
have to be missing from an equation to make it just identified. If no 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.

Question 3: Consider the following vector autoregressive model

Where yt is a p 1vector of variables determined by k lags of all p

variables in the system, ut is a p 1 vector of error terms, 0 is a p 1
vector of constant term coefficients and i are p p matrices of
coefficients on the ith lag of y.

(a)If p=2, and k=3, write out all the equations of the VAR in full,
carefully defining any new notation you use that is not given in the
question.

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 2t 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
0 , yt , ut
20 y2t u2 t
where , and the coefficients on the lags of yt
are defined as follows: ijk refers to the kth lag of the ith variable in the jth equation.
This seems like a natural notation to use, although of course any sensible
alternative would also be correct.

(b)Why have VARs become popular for application in economics and

finance, relative to structural models derived from some underlying
theory?

The most important point is that structural models require the researcher to specify
some variables as being exogenous (if all variables were endogenous, then none of
the equations would be identified, and therefore estimation of the structural
equations would be impossible). This can be viewed as a restriction (a restriction
that the exogenous variables do not have any simultaneous equations feedback),
often called an identifying restriction.. Under a VAR, all the variables have
equations, and so in a sense, every variable is endogenous, which takes the ability
to cheat (either deliberately or inadvertently) or to mis-specify the model in this
way, out of the hands of the researcher. Another possible reason why VARs are
popular in the academic literature is that standard form VARs can be estimated
using OLS since all of the lags on the RHS are counted as pre-determined variables.
Further, a glance at the academic literature which has sought to compare the
forecasting accuracies of structural models with VARs, reveals that VARs seem to be
rather better at forecasting (perhaps because the identifying restrictions are not
valid). Thus, from a purely pragmatic point of view, researchers may prefer VARs if
the purpose of the modelling exercise is to produce precise point forecasts.

(c) Discuss any weaknesses you perceive in the VAR approach to

econometric modelling.

The most important of these criticisms is that VARs are atheoretical which means
they use very little information form economic or financial theory to guide the
model 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.

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