Time Series Econometrics

Literature Review

Rukunuddin Aslam & Amna Akbar

Oil Prices and the Macroeconomy

Changes in macroeconomic variables have been attempted to be hypothesized only to be limited by econometric and data related limitations. However, over the years economists have studied possible avenues to explain the changes in these variables using naturally occurring changes and their relationships with any resulting changes in macroeconomic variables. Such a field was thought of by Sims with impacts on macroeconomic variables in general and pursued by Hamilton and others who studied oil prices in particular and how they affected macroeconomic variables.

Sims, in his paper ‘Macroeconomics and Reality’ (1980), uses six variables : i) Money Supply ii) Real GNP iii) Unemployment iv) Wages v) Price Level vi) Import Prices. He treats all the variables as endogenous because he believes that all variables move simultaneously and that the economy is dynamic. Sims discusses a general strategy for estimating profligately parameterized macromodels, and presents results for a relatively small scale application. In order to pursue such an approach, Sims first step was to develop a class of multivariate time series models which will serve as the unstructured first-stage models. What Sim actually did was to fit to quarterly an unconstrained vector autoregression the postwar time series for the US. And West Germany on money, GNP, unemployment rate, price level, and import price index. Since the model being estimated by Sim is an autoregression, the distributed theory on which the tests are based is asymptotic. It follows chi-squared distribution for the likelihood ratio test statistics. Out of the six data series used in the model for each country, each series except unemployment was logged, and the regressions all included time trends. Sims uses the impulse response functions to describe the movements of an economy overtime given a shock to the system. He says that analysis of the system’s response to typical random shocks appears to be the best descriptive device. The ‘typical shocks’ whose effects are discussed in the paper are positive residuals of one standard deviation unit in each equation of the system. In the paper, the residuals are also referred to as the ‘innovations’. In order to be bale to see the distinct patterns of movement the system may display, it was useful for Sim to transform them to orthogonal form.

Hamilton (1983) discusses the causes of the recessions in the US after world war 11. His study focused on the correlation between the dramatic increases in the prices of crude petroleum and the recession that followed just about every time the prices would increase. He took this starkly evident coincidence under his study in order to see if its merely a coincidence the increases in the prices of the petroleum truly is a contributing factor to the recession of the US economy. The poor performance of the US economy has been very well documented. Poor economic performance always coincided with the period of rapidly rising energy prices. The energy prices and the recession were not only secularly correlated, but their correlation was cyclical. Hamilton in his paper also discusses three possible hypotheses that could explain this coincidence.