CHAPTER 8

THE PROBLEM OF CORRELATED ERRORS

8.1 INTRODUCTION: AUTOCORRELATION

One of the standard assumptions in the regression model is that the error terms εi and εj, associated with the ith and jth observations, are uncorrelated. Correlation in the error terms suggests that there is additional information in the data that has not been exploited in the current model. When the observations have a natural sequential order, the correlation is referred to as autocorrelation.

Autocorrelation may occur for several reasons. Adjacent residuals tend to be similar in both temporal and spatial dimensions. Successive residuals in economic time series tend to be positively correlated. Large positive errors are followed by other positive errors, and large negative errors are followed by other negative errors. Observations sampled from adjacent experimental plots or areas tend to have residuals that are correlated since they are affected by similar external conditions.

The symptoms of autocorrelation may also appear as the result of a variable having been omitted from the right-hand side of the regression equation. If successive values of the omitted variable are correlated, the errors from the estimated model will appear to be correlated. When the variable is added to the equation, the apparent problem of autocorrelation disappears. The presence of autocorrelation has several effects on the analysis. These are summarized as follows:

  1. Least squares estimates of the regression coefficients are ...

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