Autocorrelation

Autocorrelation occurs due to the chance correlation of the error term of a particular household with some other household or firm. Autocorrelation is also named chance correlation. Autocorrelation is also applied in the case of time series analysis.

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The process of autocorrelation is defined as the correlation that exists between the members of the series of the observations that are planned with respect to time.

If two types of data are considered – a cross sectional type of data and a time series type of data—then for the cross sectional type of data, if the change in the income of a particular person affects the consumption expenditure of another household other than his, then autocorrelation is present in the data. Similarly, for the time series type of data, if an output is low in one quarter due to a labor strike, and if the data showing low output continues in the next quarter as well, then autocorrelation is supposed to be present in the data.

The process of autocorrelation is defined as the type of lag correlation for a given type of series with itself, which is lagged by several numbers of time units. On the other hand, serial autocorrelation is that type of autocorrelation that is defined as the process of lag correlation between two series in time series data.

There are certain patterns that are exhibited by autocorrelation.

Autocorrelation exhibits patterns among the residual errors. Autocorrelation also occurs in cases when the error shows a cyclical kind of pattern, etc.

The major reason why autocorrelation occurs is because of the inertia or sluggishness that is present in time series data.

The occurrence of the non stationary property in time series data also gives rise to the phenomenon of autocorrelation. Thus, to make the time series almost free of the problem of autocorrelation, the researcher should always make the data stationary.

The researcher should know that autocorrelation can be positive as well as negative. Economic time series generally exhibits positive autocorrelation as the series moves in an upward or downward pattern. If the series moves in a constant upward and downward movement, then autocorrelation is negative.

The major consequence of using ordinary least square (OLS) in the presence of autocorrelation is that it will simply make the estimator inefficient. As a result, the hypothesis testing procedures will give inaccurate results due to the presence of autocorrelation.

There is a popular test called the Durbin Watson test that detects the presence of autocorrelation. This test is conducted under the null hypothesis that there is no autocorrelation in the data. A test statistic called ‘d’ is computed, which is defined as the ratio between the sum of the square of the difference in the residuals with ith and (i-1) time and the square of the residual in ith time. If the upper critical value of the test comes out to be less than the value of ‘d,’ then there is no autocorrelation. If the lower critical value of the test is more than the value of ‘d,’ then there is autocorrelation.

If one detects autocorrelation in the data, then the first thing a researcher should do is that he should try to find whether or not the autocorrelation is pure. If it is pure autocorrelation, then one can transform it into the original model, which is free from pure autocorrelation.