The Lag Phenomenon

Abstract

This paper presents a short discussion on the lag phenomenon. Lag-length selection is an important issue since all inferences in VAR models depend on the correct model specification. In contemporary econometric modelling, impulse response functions (IRFs) are used to describe the lagged interactions of financial and economic variables, since they can demonstrate how a dynamic system reacts over time to exogenous shocks (positive or negative). IRFs describe the reaction of an endogenous variable at the time of the shock and over subsequent points in time. They are important in finance and economics because they are consistent to the way our theoretical models are used and to the way outcomes change when an exogenous shock occurs.

Keywords: optimal lag, literature review

JEL Classification: C53, C13, C63, E52, E61, G17