[SOUND]. Welcome, the topic of this lecture is time series. And in particular, its motivation. Time series data are a specific type of data that need a somewhat special treatment when using econometric methods. The specific aspect of time series variables is that they are sequentially observed. That is, one observation follows after another. The sequential nature of time series observations has important implications for modeling and especially for forecasting and this is different from the cross-sectional data that we have mostly looked at so far. Think of the shoe size of your next-door neighbor. Now, it is quite unlikely that the very fact that someone lives next to you, implies that this person's shoe size has predictive value for yours. But with time series data, this is different. Yesterday's sales level, likely has predictive value for today's sales level. Just like last month's inflation has for current inflation and your last year's disposable income for this year's. A time series variable is observed at a regular frequency. This can be once per year, once per month, every day and sometimes, like in some areas of finance, even each millisecond. You can imagine that recent observations on a certain time series variable can have predictive value for future observations. If it is winter-like weather today, it will most likely be so tomorrow. When unemployment is high this month, it probably is still going to be high next month. So in terms of regression models, you may want to include the past of a variable in order to predict its future. That is, to predict a new observation of Y, you can use another variable X, but you can also think of using y one period lagged. The inclusion of lagged values of the dependent variable in your regression model can also prevent you from drawing spurious conclusions. That is, you might think that another variable X helps to predict the variable of interest Y, while in reality, Y one period lagged predicts Y and X is irrelevant. To illustrate this point consider two variables, X and Y, for which we know that the true data generating process is such that they depend with a factor 0.9 on their own previous value, whereas the variables X and Y are completely uncorrelated. A scatter of simulated Y and X variables with 100 observations may look like this. Note that there seems to be some positive connection between the two, while we know that they are completely uncorrelated. You could be tempted to fit a simple regression model, as in lecture one to the points in this scatter. Now suppose you would do so. At the left-hand side of this table, you see that we estimate the slope parameter to be equal to 0.4 with a p-value of 0.000. So, this suggests that X has predictive value for Y. Now we know of course, this cannot be true given the way we created the data. The right-hand panel of the table shows what happens if we also include the Y variable one period lagged. The coefficient for this lagged variable is 0.82 and it is significant, whereas the coefficient of X is close to 0 and not statistically significant anymore. You may now wonder whether we should have included not only X, but also X one period lagged. This is the topic of the next test question, which I invite you to consider. Consider the regression model where Y depends on Y one period lagged, X and also X one period lagged. Do X and its lag have any predictive power? Here is the answer, where we use the familiar F-test as in lecture two. The larger model contains two extra variables, so the number of restrictions is two. We have 100 observations and the full model has 4 variables. The two R-squared values were reported in the table. Substituting these values in the familiar expression for the F-test gives a value of 1.8, which is smaller than the 5% critical value of 3.1. So even when we include X and one period lagged X, then these variables do not help to predict Y. Recall that the scatter of Y versus X was very suggestive, but proper analysis shows that pictures can sometimes fool us. Let us now look at how time series in economics and business can look like. Here is an example of passenger revenue data for an airline. The variable of interest is revenue passenger kilometers, which is the sum total over one year of the distance in kilometers traveled by each passenger on each flight of this airline company. The left-hand graph gives the actual total number of kilometers traveled. The middle graph is obtained when taking natural logs and the right-hand graph shows the yearly growth rates. The raw data on the left seems somewhat exponentially increasing, whereas the trend for the log of the time series seems more linear. The yearly growth rates fluctuate between minus 2% and plus 4%. The two leftmost graphs show that the data have a pronounced upward trend. When this occurs, it is not reasonable to assume that the mean of the data is constant over time. In fact, the mean increases with each new observation. In the next lecture, we will deal with this important issue in more detail, as for proper statistical analysis, we need data with constant mean. A constant mean is one aspect of what we call stationarity. For a stationary time series like in the right graph here, we have a straightforward modeling strategy. But for non-stationary time series, we will first need to get rid of this non-stationarity. This issue of trends is even more important when two time series show similar trending behavior. Look at this graph that depicts the revenue passenger kilometers of two airlines. Clearly, they seem to have the same trend, especially when you take logs. This feature can be useful for forecasting in the following way. You may use both time series to estimate the common trend, then you can forecast the trend. And finally, derive the individual forecast for each of the airlines. In case of a single or univariate time series, you can use its own past to make forecasts. When you have several or multivariate time series like in this example, you can try to use the other series to improve your forecasts. Here is another pair of time series that are clearly related over time. These are the monthly industrial production index for the United States of America and the so-called composite leading indicator or CLI. The CLI is constructed by The Conference Board based on a set of ten variables like manufacturers� new orders, stock prices and consumer expectations. All these variables are forward looking. And therefore, they are believed to have predictive value for future macroeconomic developments. And for that reason, it may be useful to consider the CLI in case you want to forecast a variable like industrial production. As with the airlines, the trends in industrial production and the Composite Leading Index seem to follow a similar pattern, which here associates with the business cycle. In our last lecture on time series, you will see if industrial production can indeed be predicted by means of this index. Now I invite you to make the training exercise, where you can train yourself with the topics that were treated in this lecture. As always, you can find this exercise also on the website and this concludes our lecture on the motivation for time series analysis.
