VAR MODEL

https://www.aptech.com/blog/introduction-to-the-fundamentals-of-vector-autoregressive-models/

https://www.youtube.com/watch?v=SbE8ns0oOTs

https://studfile.net/preview/4375525/page:72/

The vector autoregressive (VAR) model is a workhouse multivariate time series model that relates current
observations of a variable with past observations of itself and past observations of other variables in the system.

VAR models differ from univariate autoregressive models because they allow feedback to occur between the
variables in the model. For example, we could use a VAR model to show how real GDP is a function of policy rate
and how policy rate is, in turn, a function of real GDP.

Advantages of VAR models

✔ A systematic but flexible approach for capturing complex real-world behavior.

✔ Better forecasting performance.

✔ Ability to capture the intertwined dynamics of time series data.

VAR modeling is a multi-step process and a complete VAR analysis involves:

 Specifying and estimating a VAR model.

 Using inferences to check and revise the model (as needed).
 Forecasting.
 Structural analysis.

Who uses VAR models?

VAR models are traditionally widely used in finance and econometrics because they offer a framework for
accomplishing important modeling goals, including (Stock and Watson 2001):

 Data description.
 Forecasting.
 Structural inference.
 Policy analysis.

However, more recently VAR models have been gaining traction in other fields like epidemiology, medicine, and
biology.

Example question Field Description

A VAR system is used to model the past and current
How are vital signs in cardiorespiratory
Medicine relationships between heart rate, respiratory rate,
patients dynamically related?
blood pressure and SpO2.
Count data of past infections across different age
How do risks of COVID-19 infections
Epidemiology groups was used to model the relationships between
interact across age groups?
infection rates across those age groups.

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 Example question Field Description
Is there a bi-directional relationship A two-equation VAR system is used to model the
between personal income and personal Economics relationship between income and consumption over
consumption spending? time.
How can we model the gene expression The relationships across large networks of genes are
Biology
networks? modeled using a sparse structural VAR model.
A structural VAR model is used to compute variance
What is driving inflation more --
decomposition and impulse response functions
monetary policy shocks or external Macroeconomics
following monetary shocks and external system
shocks?
shocks.

The reduced form, recursive, and structural VAR

There are three broad types of VAR models, the reduced form, the recursive form, and the structural VAR model.

Reduced form VAR models consider each variable to be a function of:

 Its own past values.

 The past values of other variables in the model.

While reduced form models are the simplest of the VAR models, they do come with disadvantages:

 Contemporaneous variables are not related to one another.

 The error terms will be correlated across equations. This means we cannot consider what impacts
individual shocks will have on the system.

Recursive VAR models contain all the components of the reduced form model, but also allow some variables to be
functions of other concurrent variables. By imposing these short-run relationships, the recursive model allows us
to model structural shocks.

Structural VAR models include restrictions that allow us to identify causal relationships beyond those that can be
identified with reduced form or recursive models. These causal relationships can be used to model and forecast
impacts of individual shocks, such as policy decisions.

A simple example

As an example, let's consider a VAR with three endogenous variables, the unemployment rate, the inflation rate,
and interest rates.

A reduced form VAR(2) model of the system includes the following equations:

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A recursive form VAR(2) model of the system might include the following equations:

To estimate the structural VAR model of the system, we have to put restrictions on our model. For example, we
may assume that the Fed follows the inflation targeting rule for setting interest rates. This assumption would be
built into our system as the equation for interest rates.

Specifying a VAR model

What makes up a VAR model?
A VAR model is made up of a system of equations that represents the relationships between multiple variables.
When referring to VAR models, we often use special language to specify:
 How many endogenous variables there are included.
 How many autoregressive terms are included.

For example, if we have two endogenous variables and autoregressive terms, we say the model is a Bivariate
VAR(2) model. If we have three endogenous variables and four autoregressive terms, we say the model is a
Trivariate VAR(4) model.
In general, a VAR model is composed of n-equations (representing n endogenous variables) and includes p-lags of
the variables.

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How do we choose the number of lags in a VAR model?

Lag selection is one of the important aspects of VAR model specification. In practical
applications, we generally choose a maximum number of lags,

and evaluate the performance of the model including

The optimal model is then the model VAR(p) which minimizes some lag selection criteria. The most commonly used
lag selection criteria are:

 Akaike (AIC)
 Schwarz-Bayesian (BIC)
 Hannan-Quinn (HQ).

How do we decide what endogenous variables to include in our VAR model?

From an estimation standpoint, it is important to be deliberate about how many variables we include in our VAR
model. Adding additional variables:

Increases the number of coefficients to be estimated for each equation and each number of lags.
Introduce additional estimation error.

Deciding what variables to include in a VAR model should be founded in theory, as much as possible. We can use
additional tools, like Granger causality or Sims causality, to test the forecasting relevance of variables.

Granger causality tests whether a variable is “helpful” for forecasting the behavior of another variable. It’s
important to note that Granger causality only allows us to make inferences about forecasting capabilities -- not
about true causality.

Estimating and inference in VAR models

Despite their seeming complexities, VAR models are quite easy to estimate. The equation can be estimated using
ordinary least squares given a few assumptions:
 The error term has a conditional mean of zero.
 The variables in the model are stationary.
 Large outliers are unlikely.
 No perfect multicollinearity.

Under these assumptions, the ordinary least squares estimates:

 Will be consistent.
 Can be evaluated using traditional t-statistics and p-values.
 Can be used to jointly test restrictions across multiple equations.

Forecasting
One of the most important functions of VAR models is to generate forecasts. Forecasts are generated for VAR
models using an iterative forecasting algorithm:

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  Estimate the VAR model using OLS for each equation.
 Compute the one-period-ahead forecast for all variables.
 Compute the two-period-ahead forecasts, using the one-period-ahead forecast.
 Iterate until the h-step ahead forecasts are computed.

Reporting and evaluating VAR models

Often we are more interested in the dynamics that are predicted by our VAR models than the actual coefficients
that are estimated. For this reason, it is most common that VAR studies report:
 Granger-causality statistics.
 Impulse response functions.
 Forecast error decompositions

Granger-causality statistics

As we previously discussed, Granger-causality statistics test whether one variable is statistically significant when
predicting another variable.

The Granger-causality statistics are F-statistics that test if the coefficients of all lags of a variable are jointly equal to
zero in the equation for another variable. As the p-value of the F-statistic decreases, evidence that a variable is
relevant for predict another variable increases.

The impulse response function traces the dynamic path of variables in the system to shocks to other variables in
the system. This is done by:

 Estimating the VAR model.

 Implementing a one-unit increase in the error of one of the variables in the model, while holding the
other errors equal to zero.
 Predicting the impacts h-period ahead of the error shock.
 Plotting the forecasted impacts, along with the one-standard-deviation confidence intervals.

Forecast error decomposition

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Forecast error decomposition separates the forecast error variance into proportions attributed to each variable in
the model.

Intuitively, this measure helps us judge how much of an impact one variable has on another variable in the VAR
model and how intertwined our variables' dynamics are.