(a) What do you understand by the term autocorrelation? (b) An econometrician suspects that the residuals of...

Question:

(a) What do you understand by the term ‘autocorrelation’?

(b) An econometrician suspects that the residuals of her model might be autocorrelated. Explain the steps involved in testing this theory using the Durbin–Watson (DW) test.

(c) The econometrician follows your guidance (!!!) in part (b)

and calculates a value for the Durbin–Watson statistic of 0.95. The regression has sixty quarterly observations and three explanatory variables (plus a constant term). Perform the test. What is your conclusion?

(d) In order to allow for autocorrelation, the econometrician decides to use a model in first differences with a constant

(5.82)

By attempting to calculate the long-run solution to this model, explain what might be a problem with estimating models entirely in first differences.

(e) The econometrician finally settles on a model with both first differences and lagged levels terms of the variables

(5.83)

Can the Durbin–Watson test still validly be used in this case?

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