I'm pretty sure that I'm missing something obvious here, but I'm rather confused with different terms in the time series field. If I understand it correctly, serially autocorrelated errors are a problem in regression models (see for example here). My question is now what exactly defines an autocorrelated error? I know the definition of autocorrelation and I can apply the formulas, but this is more a problem of comprehension with time series in regressions.
For example, let's take the time series of daily temperatures: If it is a hot day today (summer time!), it's probably hot tomorrow as well, and vice versa. I guess I have a problem to call this phenomenon a phenomenon of "serially autocorrelated errors" because it just doesn't strike me as an error, but as something expected.
More formally, let's assume a regression set-up with one dependent variable $y_t$ and one independent variable $x_t$ and the model.
$$
y_t = \alpha + \beta x_t + \epsilon_t
$$
Is it possible that $x_t$ is autocorrelated, while $\epsilon_t$ is i.i.d? If so, what does that mean for all that methods that adjust standard errors for autocorrelation? Do you still have to do that or do they only apply to autocorrelated errors? Or would you always model the autocorrelation in such a setting in the error term, so it basically doesn't make a difference if $x_t$ is autocorrelated or $e_t$?
This is my first question here. I hope it's not too confusing and I hope I didn't miss anything obvious…I also tried to google it and found some interesting links (for instance, here on SA), but nothing really helped me.
Best Answer
Is seems to me that you are getting hung up on the difference between autoregression (temperature today is influenced by temperature yesterday, or my consumption of heroin today depends on my previous drug use) and autocorrelated errors (which have to do with the off-diagonal terms in variance-covariance terms for $\epsilon$ being non-zero. Sticking with your weather example, suppose you model temperature as a function of time, but it is also influenced by things like volcanic eruptions, which you left out of your model. The volcano sends up clouds of dust, which block out the sun, lowering the temperature. This random disturbance will persist over more than one period. This will make your time trend appear less steep than it should be. To be fair, it is probably the case that both autoregression and autocorrelated errors are an issue with temperature.
Autocorrelated errors can also arise in cross-sectional spatial data, where a random shock that affects economic activity in one region will spill over to other areas because they have economic ties. A shock that kills grapes in California will also lower sales of beef from Montana. You can also induce autocorrelated disturbances if you omit a relevant and autocorrelated independent variable from your time-series model.