Bayesian Unobserved Component Models

Abstract. We present the basics of Bayesian estimation and inference for unobserved component models on the example of a local-level model. The range of topics includes the conjugate prior analysis using normal-inverted-gamma 2 distribution and its extensions focusing on hierarchical modelling, conditional heteroskedasticity, and Student-t error terms. We scrutinise Bayesian forecasting and sampling from the predictive density.

Keywords. Unobserved Component Models, Local-Level Model, State-Space Bayesian Inference, Forecasting, Heteroskedasticity, Hierarchical Modelling, Gibbs Sampler, Simulation Smoother, Precision Sampling

Unobserved component models

Unobserved Component (UC) models are a popular class of models in macroeconometrics that use the state-space representation for unit-root nonstationary time series. The simple formulation of the model equations decomposing the series into a non-stationary and stationary component facilitates economic interpretations and good forecasting performance.

A simple local-level model

The model is set for a univariate time series whose observation at time \(t\) is denoted by \(y_t\). It decomposes the variable into a stochastic trend component, \(\tau_t\), and a stationary error component, \(\epsilon_t\). The former follows a Gaussian random walk process with the conditional variance \(\sigma_\eta^2\), and the latter is zero-mean normally distributed with the variance \(\sigma^2\). These are expressed as the model equations: \[\begin{align} y_t &= \tau_t + \epsilon_t,\\ \tau_t &= \tau_{t-1} + \eta_t,\\ \epsilon_t &\sim\mathcal{N}\left(0, \sigma^2\right),\\ \eta_t &\sim\mathcal{N}\left(0, \sigma_\eta^2\right), \end{align}\] where the initial condition \(\tau_0\) is a parameter of the model.

Matrix notation for the model

To simplify the notation and the derivations introduce matrix notation for the model. Let \(T\) be the available sample size for the variable \(y\). Define a \(T\)-vector of zeros, \(\mathbf{0}_T\), and of ones, \(\boldsymbol\imath_T\), the identity matrix of order \(T\), \(\mathbf{I}_T\), as well as \(T\times1\) vectors: \[\begin{align} \mathbf{y} = \begin{bmatrix} y_1\\ \vdots\\ y_T \end{bmatrix},\quad \boldsymbol\tau = \begin{bmatrix} \tau_1\\ \vdots\\ \tau_T \end{bmatrix},\quad \boldsymbol\epsilon = \begin{bmatrix} \epsilon_1\\ \vdots\\ \epsilon_T \end{bmatrix},\quad \boldsymbol\eta = \begin{bmatrix} \eta_1\\ \vdots\\ \eta_T \end{bmatrix},\qquad \mathbf{i} = \begin{bmatrix} 1\\0\\ \vdots\\ 0 \end{bmatrix}, \end{align}\] and a \(T\times T\) matrix \(\mathbf{H}\) with the elements: \[\begin{align} \mathbf{H} = \begin{bmatrix} 1 & 0 & \cdots & 0 & 0\\ -1 & 1 & \cdots & 0 & 0\\ 0 & -1 & \cdots & 0 & 0\\ \vdots & \vdots & \ddots & \vdots & \vdots\\ 0 & 0 & \cdots & 1 & 0\\ 0 & 0 & \cdots & -1 & 1 \end{bmatrix}. \end{align}\]

Then the model can be written in a concise notation as: \[\begin{align} \mathbf{y} &= \mathbf{\tau} + \boldsymbol\epsilon,\\ \mathbf{H}\boldsymbol\tau &= \mathbf{i} \tau_0 + \boldsymbol\eta,\\ \boldsymbol\epsilon &\sim\mathcal{N}\left(\mathbf{0}_T, \sigma^2\mathbf{I}_T\right),\\ \boldsymbol\eta &\sim\mathcal{N}\left(\mathbf{0}_T, \sigma_\eta^2\mathbf{I}_T\right). \end{align}\]

Likelihood function

The model equations imply the predictive density of the data vector \(\mathbf{y}\). To see this, consider the model equation as a linear transformation of a normal vector \(\boldsymbol\epsilon\). Therefore, the data vector follows a multivariate normal distribution given by: \[\begin{align} \mathbf{y}\mid \boldsymbol\tau, \sigma^2 &\sim\mathcal{N}_T\left(\boldsymbol\tau, \sigma^2\mathbf{I}_T\right). \end{align}\]

This distribution determines the shape of the likelihood function that is defined as the sampling data density: \[\begin{align} L(\boldsymbol\tau,\sigma^2|\mathbf{y})\equiv p\left(\mathbf{y}\mid\boldsymbol\tau, \sigma^2 \right). \end{align}\]

The likelihood function that for the sake of the estimation of the parameters, and after plugging in data in place of \(\mathbf{y}\), is considered a function of parameters \(\boldsymbol\tau\) and \(\sigma^2\) is given by: \[\begin{align} L(\boldsymbol\tau,\sigma^2|\mathbf{y}) = (2\pi)^{-\frac{T}{2}}\left(\sigma^2\right)^{-\frac{T}{2}}\exp\left\{-\frac{1}{2}\frac{1}{\sigma^2}(\mathbf{y} - \boldsymbol\tau)'(\mathbf{y} - \boldsymbol\tau)\right\}. \end{align}\]

Prior distributions

Bayesian estimation

Gibbs sampler

Simulation smoother and precision sampler

Analytical solution for a joint posterior

Hierarchical modeling

Estimating gamma error term variance prior scale

Estimating inverted-gamma 2 error term variance prior scale

Estimating the initial condition prior scale

Student-t prior for the trend component

Estimating Student-t degrees of freedom parameter

Laplace prior for the trend component

Model extensions

Autoregressive cycle component

Random walk with time-varying drift parameter

Student-t error terms

Conditional heteroskedasticity

Bayesian forecasting

Predictive density

Sampling from the predictive density

Missing observations

References

Citation

BibTeX citation:
@online{woźniak2024,
  author = {Woźniak, Tomasz},
  title = {Bayesian {Unobserved} {Component} {Models}},
  date = {2024-05-01},
  url = {https://donotdespair.github.io/Bayesian-Unobserved-Component-Models/},
  doi = {10.26188/25814617},
  langid = {en}
}
For attribution, please cite this work as:
Woźniak, Tomasz. 2024. “Bayesian Unobserved Component Models.” May 1, 2024. https://doi.org/10.26188/25814617.