Thursday, July 28, 2011

Moving Average Errors

"God made X (the data), man made all the rest (especially ε, the error term)."
Emanuel Parzen

A while back I was asked if I could provide some examples of situations where the errors of a regression model would be expected to follow a moving average process. 

Introductory courses in econometrics always discuss the situation where the errors in a model are correlated, implying that the associated covariance matrix is non-scalar. Specifically, at least some of the off-diagonal elements of this matrix are non-zero. Examples that are usually mentioned include: (a) the errors follow a stationary first-order autoregressive (i.e., AR(1)) process; and (b) the errors follow a first-order moving average (i.e., MA(1)) process. Typically, the discussion then deals with tests for independence against a specific alternative process; and estimators that take account of the non-scalar covariance matrix - e.g., the GLS (Aitken) estimator.

It's often easier to motivate AR errors than to think of reasons why MA errors may arise in a regression model in practice. For example, if we're using economic time-series data and if the error term reflects omitted effects, then the latter are likely to be trended and/or cyclical. In each case, this gives rise to an autoregressive process. The omission of a seasonal variable will general imply errors that follow an AR(4) process; and so on.

However, let's think of some situations where the MA regression errors might be expected to arise.