Scandinavian Working Papers in Economics

HUI Working Papers,
HUI Research

No 37: A New Ridge Regression Causality Test in the Presence of Multicollinearity

Kristofer Månsson, Ghazi Shukur () and Pär Sjölander
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Kristofer Månsson: The Swedish Retail Institute (HUI Research), Postal: Regeringsgatan 60, 103 29 Stockholm, Sweden, and the Department of Economics and Statistics, Jönköping University, Sweden.
Ghazi Shukur: The Swedish Retail Institute (HUI Research), Postal: Regeringsgatan 60, 103 29 Stockholm, Sweden, the Department of Economics and Statistics, Jönköping University, Sweden, and the Department of Economics and Statistics, Linnaeus University, Sweden
Pär Sjölander: The Swedish Retail Institute (HUI Research), Postal: Regeringsgatan 60, 103 29 Stockholm, Sweden,, the Department of Economics and Statistics, Jönköping University, Sweden

Abstract: This paper analyzes and compares the properties of the most commonly applied versions of the Granger causality (GC) test to a new ridge regression GC test (RRGC), in the presence of multicollinearity. The investigation has been carried out using Monte Carlo simulations. A large number of models have been investigated where the number of observations, strength of collinearity, and data generating processes have been varied. For each model we have performed 10000 replications and studied seven different versions of the test. The main conclusion from our study is that the traditional OLS version of the GC test over-rejects the true null hypothesis when there are relatively high (but empirically common levels of) multicollinearity, while it is established that the new RRGC test will remedy or substantially decrease this problem.

Keywords: Granger causality test; multicollinearity; ridge parameters; size and power

JEL-codes: C32

17 pages, February 1, 2010

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