Palgrave Handbook of Econometrics Volume 2: Applied Econometrics EditedBy Terence C. Mills and Kerry Patterson Contents NotesonContributors viii Editors’Introduction xi PartI TheMethodologyandPhilosophyofAppliedEconometrics 1 TheMethodologyofEmpiricalEconometricModeling:Applied EconometricsThroughtheLookingGlass 3 DavidF.Hendry,NuffieldCollege,OxfordUniversity 2 HowMuchStructureinEmpiricalModels? 68 FabioCanova,UniversitatPompeuFabra 3 IntroductoryRemarksonMetastatisticsforthePracticallyMinded Non-BayesianRegressionRunner 98 JohnDiNardo,UniversityofMichigan PartII Forecasting 4 ForecastCombinationandEncompassing 169 MichaelP.Clements,WarwickUniversity,andDavidI.Harvey, SchoolofEconomics,UniversityofNottingham 5 RecentDevelopmentsinDensityForecasting 199 StephenG.Hall,UniversityofLeicester,andJamesMitchell, NationalInstituteofEconomicandSocialResearch PartIII TimeSeriesApplications 6 InvestigatingEconomicTrendsandCycles 243 D.S.G.Pollock,UniversityofLeicester 7 EconomicCycles:Asymmetries,Persistence,andSynchronization 308 JoeCardinale,AirProductsandChemicals,Inc.,andLarryW.Taylor, CollegeofBusinessandEconomics,LehighUniversity 8 TheLongSwingsPuzzle:WhattheDataTellWhenAllowedto SpeakFreely 349 KatarinaJuselius,UniversityofCopenhagen 9 StructuralTimeSeriesModelsforBusinessCycleAnalysis 385 TommasoProietti,UniversityofRome‘TorVergata’ 10 FractionalIntegrationandCointegration:AnOverviewandan EmpiricalApplication 434 LuisA.Gil-AlanaandJavierHualde,UniversidaddeNavarra v vi Contents PartIV Cross-sectionandPanelDataApplications 11 DiscreteChoiceModeling 473 WilliamGreene,SternSchoolofBusiness,NewYorkUniversity 12 PanelDataMethodsandApplicationstoHealthEconomics 557 AndrewM.Jones,UniversityofYork 13 PanelMethodstoTestforUnitRootsandCointegration 632 AnindyaBanerjee,UniversityofBirmingham,andMartinWagner, InstituteforAdvancedStudies,Vienna PartV Microeconometrics 14 Microeconometrics:CurrentMethodsandSomeRecentDevelopments 729 A.ColinCameron,UniversityofCalifornia,Davis 15 ComputationalConsiderationsinEmpiricalMicroeconometrics: SelectedExamples 775 DavidT.Jacho-ChávezandPravinK.Trivedi,IndianaUniversity PartVI ApplicationsofEconometricstoEconomicPolicy 16 TheEconometricsofMonetaryPolicy:AnOverview 821 CarloFavero,IGIER-BocconiUniversity 17 MacroeconometricModelingforPolicy 851 GunnarBårdsen,NorwegianUniversityofScienceandTechnology, andRagnarNymoen,UniversityofOslo 18 MonetaryPolicy,Beliefs,UnemploymentandInflation:Evidence fromtheUK 917 S.G.B.Henry,NationalInstituteofEconomicandSocialResearch PartVII ApplicationstoFinancialEconometrics 19 EstimationofContinuous-TimeStochasticVolatilityModels 951 GeorgeDotsis,EssexBusinessSchool,UniversityofEssex, RaphaelN.Markellos,AthensUniversityofEconomicsandBusiness, andTerenceC.Mills,LoughboroughUniversity 20 TestingtheMartingaleHypothesis 972 J.CarlosEscanciano,IndianaUniversity,andIgnacioN.Lobato, InstitutoTecnológicoAutónomodeMexico 21 AutoregressiveConditionalDurationModels 1004 RueyS.Tsay,BoothBusinessSchool,UniversityofChicago 22 TheEconometricsofExchangeRates 1025 EfthymiosG.Pavlidis,IvanPaya,andDavidA.Peel, LancasterUniversityManagementSchool Contents vii PartVIII GrowthDevelopmentEconometrics 23 TheEconometricsofConvergence 1087 StevenN.Durlauf,UniversityofWisconsin-Madison, PaulA.Johnson,VassarCollege,NewYorkState,and JonathanR.W.Temple,BristolUniversity 24 TheMethodsofGrowthEconometrics 1119 StevenN.Durlauf,UniversityofWisconsin-Madison, PaulA.Johnson,VassarCollege,NewYorkState,and JonathanR.W.Temple,BristolUniversity 25 TheEconometricsofFinanceandGrowth 1180 ThorstenBeck,EuropeanBankingCenter,TilburgUniversity,andCEPR PartIX SpatialEconometrics 26 SpatialHedonicModels 1213 LucAnselin,SchoolofGeographicalSciencesandUrbanPlanning, andNancyLozano-Gracia,GeoDaCenterforGeospatial AnalysisandComputation,ArizonaStateUniversity 27 SpatialAnalysisofEconomicConvergence 1251 SergioJ.Rey,ArizonaStateUniversity,andJulieLeGallo, UniversitédeFranche-Comté PartX AppliedEconometricsandComputing 28 TestingEconometricSoftware 1293 B.D.McCullough,DrexelUniversity 29 TrendsinAppliedEconometricsSoftwareDevelopment1985–2008: AnAnalysisofJournalofAppliedEconometricsResearchArticles, SoftwareReviews,DataandCode 1321 MariusOoms,VUUniversityAmsterdam AuthorIndex 1349 SubjectIndex 1374 Notes on Contributors Luc Anselin is Foundation Professor of Geographical Sciences and Director of the School of Geographical Sciences and Urban Planning at Arizona State University,USA. Aninyda Banerjee is Professor of Econometrics at the University of Birmingham,UK. GunnarBårdsenisProfessorofEconomicsattheNorwegianUniversityofScience andTechnology,Norway. Thorsten Beck is Professor of Economics and Chair at the European Banking Center,TilburgUniversityandResearchFellow,CEPR. Colin Cameron is Professor of Economics at the University of California, Davis,USA. FabioCanovaisICREAResearchProfessorinSocialScienceatUniversitatPompeu Fabra,Barcelona,Spain. JoeCardinaleisaManager,EconomicsatAirProductsandChemicals,Inc.,USA. MichaelP.ClementsisProfessorofEconomicsatWarwickUniversity,UK. John DiNardo is Professor of Economics and Public Policy at the University of Michigan,AnnArbor,USA. George Dotsis is Lecturer in Finance at the Essex Business School, University of Essex,UK. Steven N. Durlauf is Professor of Economics at the University of Wisconsin- Madison,USA. JuanCarlosEscancianoisAssistantProfessorofEconomicsatIndianaUniversity, Bloomington,USA. CarloA.FaveroisProfessorofEconomicsatIGIER-BocconiUniversity,Italy. Julie Le Gallo is Professor of Economics and Econometrics at the Université de Franche-Comté,France. LuisA.Gil-AlanaisProfessorofEconometricsattheUniversityofNavarra,Spain. William Greene is Professor of Economics at the Stern School of Business, NewYork,USA. StephenG.HallisProfessorofEconomicsatUniversityofLeicester,UK. DavidI.HarveyisReaderinEconometricsattheSchoolofEconomics,University ofNottingham,UK. David F. Hendry is Professor of Economics and Fellow, Nuffield College, Oxford University,UK. viii NotesonContributors ix Brian Henry is Visiting Fellow at the National Institute of Economic and Social Research,NIESR,UK. Javier Hualde is Ramon y Cajal Research Fellow in Economics at the Public UniversityofNavarra,Spain. David Jacho-Chávez is Assistant Professor of Economics at Indiana University, Bloomington,USA. PaulA.JohnsonisProfessorofEconomicsatVassarCollege,NewYorkState,USA. AndrewM.JonesisProfessorofEconomicsattheUniversityofYork,UK. Katarina Juselius is Professor of Empirical Time Series Econometrics at the UniversityofCopenhagen,Denmark. Ignacio N. Lobato is Professor of Econometrics at the Instituto Tecnológico AutónomodeMéxico,Mexico. NancyLozano-GraciaisPostdoctoralResearchAssociateintheGeoDaCenterfor GeospatialAnalysisandComputationatArizonaStateUniversity,USA. RaphaelN.MarkellosisAssistantProfessorofQuantitativeFinanceattheAthens UniversityofEconomicsandBusiness(AUEB),Greece. BruceD.McCulloughisProfessorofDecisionSciencesandEconomicsatDrexel University,Philadelphia,USA. Terence C. Mills is Professor of Applied Statistics and Econometrics at LoughboroughUniversity,UK. JamesMitchellisResearchFellowattheNationalInstituteofEconomicandSocial Research,UK. RagnarNymoenisProfessorofEconomicsatUniversityofOslo,Norway. Marius Ooms is Associate Professor of Econometrics at the VU University, Amsterdam,TheNetherlands. KerryPattersonisProfessorofEconometricsattheUniversityofReading,UK. Efthymios G. Pavlidis is Lecturer in Economics at the Lancaster University ManagementSchool,LancasterUniversity,UK. IvanPayaisSeniorLecturerinEconomicsattheLancasterUniversityManagement School,LancasterUniversity,UK. DavidA.PeelisProfessorinEconomicsattheLancasterUniversityManagement School,LancasterUniversity,UK. D.StephenG.PollockisProfessorofEconomicsattheUniversityofLeicester,UK. Tommaso Proietti is Professor of Economic Statistics at the University of Rome ‘TorVergata’,Italy. SergioReyisProfessorofGeographicalSciencesatArizonaStateUniversity,USA. Larry W. Taylor is Professor of Economics at the College of Business and Economics,LehighUniversity,Pennsylvania,USA. x NotesonContributors JonathanR.W.TempleisProfessorofEconomicsatBristolUniversity,UK. PravinTrivediisProfessorofEconomicsatIndianaUniversity,Bloomington,USA. RueyS.TsayisProfessorofEconometricsandStatisticsattheUniversityofChicago BoothSchoolofBusiness,USA. Martin Wagner is Senior Economist at the Institute for Advanced Studies in Vienna,Austria. Editors’ Introduction Terence C. Mills and Kerry Patterson The Palgrave Handbook of Econometrics was conceived to provide an understand- ing of major developments in econometrics, both in theory and in application. Over the last twenty-five years or so, econometrics has grown in a way that few could have contemplated, and it became clear to us, as to others, that no sin- gle person could have command either of the range of technical knowledge that underpinstheoreticaleconometricdevelopmentsortheextentoftheapplication ofeconometrics.Inshort,econometricsisnot,asitusedtobeconsidered,asetof techniquesthatisappliedtoapreviouslywell-definedproblemineconomics;itis not a matter of finding the “best” estimator from a field of candidates, applying that estimator and reporting the results. The development of economics is now inextricablyentwinedwiththedevelopmentofeconometrics. ThefirstNobelPrizeinEconomicswasawardedtoRagnarFrischandJanTinber- gen, both of whom made significant contributions to what we now recognize as appliedeconometrics.Morerecently,NobelPrizesinEconomicshavebeenawarded toCliveGranger,RobertEngle,JamesHeckmanandDanielMcFadden,whohave allmademajorcontributionstoappliedeconometrics.Itisthusclearthatthedis- cipline has recognized the influential role of econometrics, both theoretical and applied,inadvancingeconomicknowledge. The aim of this volume is to make major developments in applied economet- ricsaccessibletothoseoutsidetheirparticularfieldofspecialization.Theresponse to Volume 1 was universally encouraging and it has become clear that we were fortunate to be able to provide a source of reference for others for many years to come.Wehopethatthishighstandardiscontinuedandachievedhere.Typically, applied econometrics, unlike theoretical econometrics, has always been rather poorlyservedfortextbooks, makingitdifficultforbothundergraduateandpost- graduate students to get a real “feel” for how econometrics is actually done. To some degree, the econometric textbook market has responded, so that now the leading textbooks include many examples; even so, these examples typically are ofanillustrativenature,focusingonsimplepoints,simplyexposited,ratherthan on the complexity that is revealed in practice. Thus our hope is that this vol- umewillprovideagenuineentryintothedetailedconsiderationsthathavetobe xi xii Editors’Introduction madewhencombiningeconomicsandeconometricsinordertocarryoutserious empiricalresearch. AsinthecaseofVolume1,thechaptersherehavebeenspeciallycommissioned fromacknowledgedexpertsintheirfields; further, eachofthechaptershasbeen reviewedbytheeditors, oneormoreoftheassociateeditorsandareferee. Thus, theprocessisakintosubmissiontoajournal;however,whilstensuringthehighest standards in the evaluation process, the chapters have been conceived of as part of a whole rather than as a set of unrelated contributions. It has not, however, beenourintentiontoprovidejustaseriesofsurveysoroverviewsofsomeareasof appliedeconometrics,althoughthesurveyelementisdirectlyorindirectlyserved inparthere.Byitsverynature,thisvolumeisabouteconometricsasitisapplied and,tosucceedinitsaim,thecontributions,conceivedasawhole,havetomeet thisgoal. WehaveorganizedthechaptersofthisvolumeoftheHandbook intotenparts. Thepartsarecertainlynotwatertight,butserveasausefulinitialorganizationof the central themes. Part I contains three chapters under the general heading of “TheMethodologyandPhilosophyofAppliedEconometrics.”Theleadchapteris byDavidHendry,whohasbeenmakingpath-breakingcontributionsintheoretical andappliedeconometricsforsomefortyyearsorso.Itisdifficulttoconceivehow econometrics would have developed without David’s many contributions. This chapter first places the role of applied econometrics in an historical context and then develops a theory of applied econometrics. As might be expected, the key issuesareconfrontedhead-on. Inintroducingthefirstvolumewenotedthatthe“growthineconometricsisto be welcomed, for it indicates the vitality and importance of the subject. Indeed, this growth and, arguably, the dominance over the last ten or twenty years of econometricdevelopmentsintakingeconomicsforward,isanotablechangefrom thesituationfacedbythesubjectsometwenty-fiveyearsorsoago.”YetinChapter 1,Hendrynotesthat,nexttodatameasurement,collectionandpreparation,onthe onehand,andteaching,ontheother,“AppliedEconometrics”doesnothaveahigh credibilityintheprofession.Indeed,whilstcoursesintheoreticaleconometricsor econometrictechniquesarederigueurforagoodundergraduateorMastersdegree, coursesinappliedeconometricshavenosuchgeneralstatus. Theintricacies,possiblyevenalchemy(Hendry,1980),surroundingthemixof techniques and data seem to defy systematization; perhaps they should be kept outofthegazeofquerulousstudents,whomay–indeedshould–besatisfiedwith illustrativeexamples!OftentoanundergraduateorMastersstudentundertakinga project,appliedeconometricsistheapplicationofeconometricstodata,nomore, noless,withsomereliefiftheresultsareatallplausible.Yet,incontrast,leading journals, forexample, theJournalofEconometrics, theJournalofAppliedEconomet- ricsandtheJournalofBusinessandEconomicStatistics, andleadingtopicjournals, suchastheJournalofMonetaryEconomics,allpublishappliedeconometricarticles having substance and longevity in their impact and which serve to change the direction of the development of econometric theory (for a famous example, see Nelson and Plosser, 1982). To some, applying econometrics seems unsystematic