ch12 Regressionwith Non Stationary Variables-Modified Cut

Chapter 12
Regression with Time-Series

Data:
Nonstationary Variables
Walter R. Paczkowski
Rutgers University
Principles of Econometrics, 4th
Edition
Chapter 12: Regression with Time-Series Data:

Page 1
12.3
Unit Root Tests for Stationarity

Edition

Page 2
12.3
Unit Root Tests for
Stationarity
There are many tests for determining whether a

series is stationary or nonstationary
The most popular is the DickeyFuller test

Edition

Page 3
12.3
Unit Root Tests for
Stationarity
12.3.1
Dickey-Fuller Test 1
(No constant and No
Trend)
The AR(1) process yt = yt-1 + vt is stationary when

|| < 1
But, when = 1, it becomes the nonstationary
random walk process
We want to test whether is equal to one or
significantly less than one
Tests for this purpose are known as unit root
tests for stationarity

Edition

Page 4
12.3
Unit Root Tests for
Stationarity
12.3.1
(No constant and No
Trend)
Consider again the AR(1) model:

yt yt 1 vt
Eq. 12.4
We can test for nonstationarity by testing the

null hypothesis that = 1 against the alternative
that || < 1
Or simply < 1

Edition

Page 5
12.3
Unit Root Tests for
Stationarity
12.3.1
(No constant and No
Trend)
A more convenient form is:

yt yt 1 yt 1 yt 1 vt
yt 1 yt 1 vt
Eq. 12.5a
yt 1 vt
The hypotheses are:

Edition
H0 : 1
H0 : 0
H1 : 1
H1 : 0

Page 6
12.3
Unit Root Tests for
Stationarity
12.3.2
(With Constant but
No Trend)
The second DickeyFuller test includes a constant

term in the test equation:
yt yt 1 vt
Eq. 12.5b
The null and alternative hypotheses are the

same as before

Edition

Page 7
12.3
Unit Root Tests for
Stationarity
12.3.3
(With Constant and
With Trend)
The third DickeyFuller test includes a constant

and a trend in the test equation:
yt yt 1 t vt
Eq. 12.5c
The null and alternative hypotheses are

H0: = 0 and H1: < 0

Edition

Page 8
12.3
Unit Root Tests for
Stationarity
12.3.4
The Dickey-Fuller
Critical Values
To test the hypothesis in all three cases, we simply

estimate the test equation by least squares and
examine the t-statistic for the hypothesis that
=0
Unfortunately this t-statistic no longer has the
t-distribution
Instead, we use the statistic often called a
(tau) statistic

Edition

Page 9
12.3
Unit Root Tests for
Stationarity
Table 12.2 Critical Values for the DickeyFuller Test
12.3.4
The Dickey-Fuller
Critical Values

Edition

Page 10
12.3
Unit Root Tests for
Stationarity
12.3.4
The Dickey-Fuller
Critical Values
An important extension of the DickeyFuller test

allows for the possibility that the error term is
autocorrelated
Consider the model:
m
Eq. 12.6
where
yt yt 1 as yt s vt
s 1
yt 1 yt 1 yt 2 , yt 2 yt 2 yt 3 , K

Edition

Page 11
12.3
Unit Root Tests for
Stationarity
12.3.4
The Dickey-Fuller
Critical Values
The unit root tests based on Eq. 12.6 and its

variants (intercept excluded or trend included) are
referred to as augmented DickeyFuller tests
When = 0, in addition to saying that the series
is nonstationary, we also say the series has a
unit root
In practice, we always use the augmented
DickeyFuller test

Edition

Page 12
12.3
Unit Root Tests for
Stationarity
Table 12.3 AR processes and the Dickey-Fuller Tests
12.3.5
The Dickey-Fuller
Testing Procedures

Edition

Page 13
12.3
Unit Root Tests for
Stationarity
12.3.5
The Dickey-Fuller
Testing Procedures
The Dickey-Fuller testing procedure:

First plot the time series of the variable and select a
suitable Dickey-Fuller test based on a visual
inspection of the plot
If the series appears to be wandering or fluctuating
around a sample average of zero, use test equation
(12.5a)
around a sample average which is nonzero, use test
equation (12.5b)
around a linear trend, use test equation (12.5c)

Edition

Page 14
12.3
Unit Root Tests for
Stationarity
12.3.5
The Dickey-Fuller
Testing Procedures
The Dickey-Fuller testing procedure (Continued):

Second, proceed with one of the unit root tests
described in Sections 12.3.1 to 12.3.3

Edition

Page 15
12.1
Stationary and
Nonstationary
Variables

Edition
FIGURE 12.1 U.S. economic time series

Page 16
12.3
Unit Root Tests for
Stationarity
12.3.6
The Dickey-Fuller
Tests: An Example
As an example, consider the two interest rate

series:
The federal funds rate (Ft)
The three-year bond rate (Bt)
Following procedures described in Sections 9.3
and 9.4, we find that the inclusion of one lagged
difference term is sufficient to eliminate
autocorrelation in the residuals in both cases

Edition

Page 17
12.3
Unit Root Tests for
Stationarity
12.3.6
The Dickey-Fuller
Tests: An Example
The results from estimating the resulting equations

are:
F 0.173 0.045 F 0.561F
t
t 1
t 1
(tau )
( 2.505)
B 0.237 0.056 B 0.237B
t
t 1
t 1
(tau )
( 2.703)
The 5% critical value for tau (c) is -2.86

Since -2.505 > -2.86, we do not reject the null
hypothesis
Edition

Page 18
12.3
Unit Root Tests for
Stationarity
12.3.7
Order of Integration
Recall that if yt follows a random walk, then = 0

and the first difference of yt becomes:
yt yt yt 1 vt
Series like yt, which can be made stationary by

taking the first difference, are said to be
integrated of order one, and denoted as I(1)
Stationary series are said to be integrated of
order zero, I(0)
In general, the order of integration of a series is
the minimum number of times it must be
differenced to make it stationary
Edition

Page 19
12.3
Unit Root Tests for
Stationarity
12.3.7
The results of the DickeyFuller test for a random

walk applied to the first differences are:
F 0.447 F
t
t 1
(tau )
( 5.487)
B 0.701 B
t
t 1
(tau )
Edition
( 7.662)

Page 20
12.3
Unit Root Tests for
Stationarity
12.3.7
Based on the large negative value of the tau

statistic (-5.487 < -1.94), we reject the null
hypothesis that Ft is nonstationary and accept the
alternative that it is stationary
We similarly conclude that Bt is stationary
(-7:662 < -1:94)

Edition

Page 21
12.3
Unit Root Tests for
Stationarity
12.3.4
The Dickey-Fuller
Critical Values
To carry out a one-tail test of significance, if c is

the critical value obtained from Table 12.2, we
reject the null hypothesis of nonstationarity if
c
If > c then we do not reject the null
hypothesis that the series is nonstationary
Ex Nelson Plosser Data

Edition

Page 22
12.2
Spurious Regressions

Edition

Page 23
12.2
Spurious
Regressions
The main reason why it is important to know

whether a time series is stationary or nonstationary
before one embarks on a regression analysis is that
there is a danger of obtaining apparently
significant regression results from unrelated data
when nonstationary series are used in regression
analysis
Such regressions are said to be spurious

Edition

Page 24
12.2
Spurious
Regressions
Consider two independent random walks:

rw1 : yt yt 1 v1t
rw2 : xt xt 1 v2t
These series were generated independently and,

in truth, have no relation to one another
Yet when plotted we see a positive relationship
between them

Edition

Page 25
12.2
Spurious
Regressions
FIGURE 12.3 Time series and scatter plot of two random walk variables

Edition

Page 26
12.2
Spurious
Regressions
FIGURE 12.3 (Continued) Time series and scatter plot of two random
walk variables

Edition

Page 27
12.2
Spurious
Regressions
A simple regression of series one (rw1) on series

two (rw2) yields:
17.818 0.842 rw ,
rw
1t
2t
(t )
R 2 0.70
(40.837)
These results are completely meaningless, or

spurious
The apparent significance of the relationship
is false
Edition

Page 28
12.2
Spurious
Regressions
When nonstationary time series are used in a

regression model, the results may spuriously
indicate a significant relationship when there is
none
In these cases the least squares estimator and
least squares predictor do not have their usual
properties, and t-statistics are not reliable
Since many macroeconomic time series are
nonstationary, it is particularly important to
take care when estimating regressions with
macroeconomic variables
Edition

Page 29
12.4
Cointegration

Edition

Page 30
12.4
Cointegration
As a general rule, nonstationary time-series

variables should not be used in regression models
to avoid the problem of spurious regression
There is an exception to this rule

Edition

Page 31
12.4
Cointegration
There is an important case when

et = yt - 1 - 2xt is a stationary I(0) process
In this case yt and xt are said to be cointegrated
Cointegration implies that yt and xt share
similar stochastic trends, and, since the
difference et is stationary, they never diverge
too far from each other

Edition

Page 32
12.4
Cointegration
Eq. 12.7
The test for stationarity of the residuals is based on

the test equation:
et et 1 vt
The null hypothesis is that the gamma is zero i.e.
the residual are non stationary i.e. no cointegration. The alternative is cointegration.
The regression has no constant term because the
mean of the regression residuals is zero.
We are basing this test upon estimated values of
the residuals

Edition

Page 33
12.4
Cointegration

Edition
Table 12.4 Critical Values for the Cointegration Test

Page 34
12.4
Cointegration
There are three sets of critical values

Which set we use depends on whether the
residuals are derived from:
Eq. 12.8a
Equation 1: et yt bxt
Eq. 12.8b
Equation 2 : et yt b2 xt b1
Eq. 12.8c
Equation 3 : et yt b2 xt b1 t

Edition

Page 35
Engle-Granger Test of Co-integration

Three Steps Procedure:
(1) Ensure that the two (or more) series to be
tested for co-integration are all I(1)
(2) Estimate the long run (co-integration
regression) in levels, store residuals
(3) Apply ADF test with one of the three sets of
EG critical values determined according to
whether the long run regression in (2) has no
intercept, intercept only or intercept and trend

Edition

Page 36
12.4
Cointegration
12.4.1
An Example of a
Cointegration Test
Consider the estimated model:

Bt 1.140 0.914 Ft , R 2 0.881
Eq. 12.9
(t ) (6.548) (29.421)
The unit root test for stationarity in the

estimated residuals is:
et 0.225et 1 0.254et 1
(tau ) ( 4.196)
As -4.195 <-3.37 (note that the long run relation

includes an intercept) we reject the null
hypothesis of no co-integration. So the short
rate and bond rate are co-integrated.
Edition

Page 37
12.4
Cointegration
12.4.1
An Example of a
Cointegration Test
The null and alternative hypotheses in the test for

cointegration are:
H 0 : the series are not cointegrated residuals are nonstationary
H1 : the series are cointegrated residuals are stationary
Similar to the one-tail unit root tests, we reject

the null hypothesis of no cointegration if c,
and we do not reject the null hypothesis that the
series are not cointegrated if > c
Edition

Page 38
Cointegration and Long-run Equilibrium

Relationship
Although cointegration is a purely statistical
concept, it has important economic
implications.
It represents the existence of a long-run or a
steady state equilibrium relationship between
variables which is a result of economic
forces and behavior rules.
Edition

39
Page 39
Cointegration Relationships in Economic and Finance:
(1) Consumption-Income Relationship

Although both consumption and income exhibit a unit root,
over the long run consumption tends to be a roughly
constant proportion of income so that the difference
between log of consumption and log of income appear to
be a stationary process.
(2) Government Debt and GNP
Kremers (1989) suggested that governments are forced
politically to maintain their debt at a roughly constant
multiple of GNP, so that log(debt)-log(GNP) is stationary
even though each component individually is not stationary.
Edition

40
Page 40
Purchasing Power Parity
(3)
Apart from transaction cost, goods should sell for the same
effective price in two countries.
Let Pt : Price level index in the US (dollar per good)
Pt* : Index of price level in UK (pound per good)
St=Exchange rate between currencies (dollar per pund)
Then PPP states that
Pt=StPt* or taking log
pt=st+pt* (where small letter represent variables in log)
In practice error in measurement, transaction cost, and quality
differences prevent PPP from holding exactly. A weakrer
version of the hypothesis states that the variables defined by
yt pt-st-pt* is stationary even though individual elements
are all I(1).
Edition

41
Page 41
(4) A variable and its rational future forecast

Campbell and Shiller (1988) argue that if if y 1t is I(1) and y2t is a rational
forecast of future value of y1t , the y1t and y2t will be cointegrated. A
particular example is that stock prices is the present value of discounted
future stream of dividend so stock price and dividend should be
cointegrated.
Also if stock price is a true signal of economic activity, stock market
index should be cointegrated with macro variables e.g output. (direction
of causality from stock price to macro variables).
Spot and Forward market prices should be cointegrated since forward
rate is predictor of future spot rate. Short and Long maturity bonds
should be cointegrated.
Edition

42
Page 42
(5) Real Wages of Two Competing Industries

Intuition suggests that if a random shock disturbs the wage differential
between these industries, economic forces, such as labor migration
should cause real wages in these industries to return to their optimal
relationship over time. In a time series framework, wage differentials
should be a stationary time series process.
(6) Asset prices in two efficient markets cannot be cointegrated

E.g. two spot exchange rates cannot be cointegrated if they are
determined in an efficient market. If a pair of spot rates are
cointegrated, then by the Granger Representation Theorem there exists
an error correction representation, implying that at least one exchange
rate can be used to forecast (i.e. Granger-causes) the other. The ability
of one spot rate to forecast another is inconsistent with a weak form
efficiency. If forex markets are efficient spot rates should embody all
the relevant information so that it is not possible to forecast one as a
function of another.
Edition

43
Page 43
Market forces arising from no arbitrage conditions should ensure an

equilibrium relationship. Variables in a cointegration relationship can
each wander around over time such that they are non-stationary. As
Banerjee et al. (1993) state the divergence from a stable equilibrium
state must be stochastically bounded and, at some point diminishing
over time
But there is some economic/financial force that stops them wandering
too far from each other at any point in time.
In finance, this force holding variables is usually an arbitrage
relationship.
When deviations from the arbitrage relationship exist but are not
profitable to exploit the variables may act approximately
independently
But once they hit the point when arbitrage is profitable, they are forced
to behave in certain ways to remove the profit opportunity.

Edition

44
Page 44
Example: PPP Test between US$ and British

Aggregated over all goods, the law of one price
yields the purchasing power parity: Pt = St.Pt*
It is known that transportation costs, tariffs and
non-tariff barriers will entail market segmentation
and create a wedge among price across countries.
However, if these factors remain constant over
time, PPP can be restated, using a positive
constant A:
Pt = AStPt* which after rearranging in log testable
form
Edition

Page 45
Unit Root Testing of st and (p-p*)t

Step 1: Unit Root Testing
N=603 obs

Edition

Page 46
Unit Root in Residuals rejected (with EG critical values)

at 10%. Some evidence in favour of PPP
Step 2: Run the long run Regression in Levels

Save residuals ut
Step 3: Run ADF Test on Residuals

with EG critical values.
The test is significant at 10% level
h
Principles of Econometrics,
Implying 4tthat
Edition
Chapter
12: Regression
there
is a weak
evidencewith Time-Series Data:
Page 47
12.4
Cointegration
12.4.2
The Error Correction
Model
What is an ECM? Its benefit (Granger

Representation Theorem)
Consider a general model that contains lags of y
and x
yt 1 yt 1 0 xt 1 xt 1 vt
Namely, the autoregressive distributed lag
(ARDL) model, except the variables are
nonstationary:

Edition

Page 48
12.4
Cointegration
12.4.2
Model
If y and x are cointegrated, it means that there is a

long-run relationship between them
To derive this exact relationship, we set
yt = yt-1 = y, xt = xt-1 = x and vt = 0
Imposing this concept in the ARDL, we obtain:
y 1
This can be rewritten in the form:

y 1 2 x

Edition

Page 49
12.4
Cointegration
12.4.2
Model
Add the term -yt-1 to both sides of the equation:

yt yt 1 1 1 yt 1 0 xt 1 xt 1 vt
Add the term 0xt-1+ 0xt-1:

yt 1 1 yt 1 0 xt xt 1 0 1 xt 1 vt
Manipulating this we get:
0 1
yt 1 1
yt 1
xt 1 0 xt vt
1
1
1

Edition

Page 50
12.4
Cointegration
12.4.2
Model
Or:
yt yt 1 1 2 xt 1 0 xt vt
Eq. 12.10
This is called an error correction equation

This is a very popular model because:
It allows for an underlying or fundamental link
between variables (the long-run relationship)
It allows for short-run adjustments (i.e.
changes) between variables, including
adjustments to achieve the cointegrating
relationship
Edition

Page 51
12.4
Cointegration
12.4.2
Model
For the bond and federal funds rates example, we have:
Bt 0.142 Bt 1 1.429 0.777 Ft 1 0.842Ft 0.327Ft 1
2.857
9.387 3.855
The estimated residuals are
et 1 Bt 1 1.429 0.777 Ft 1
Interpretation of the error correction term: 14.2% of the short run deviation
from the long run equilibrium is corrected in one time period (here one
quarter). The t-statistic of the associated coefficient is significantly different
from zero. So the convergence towards equilibrium is statistically significant
providing further evidence in support of co-integration. Data File usa.wf
(See Iqbal and Najma Uddin (2013) for a forecast comparison of different
error correction models).
Edition

Page 52
12.5
Regression When
There is No
Cointegration
FIGURE 12.4 Regression with time-series data: nonstationary variables
12.5.3
Summary

Edition

Page 53

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Chapter 12

Regression with Time-Series

Chapter 12: Regression with Time-Series Data:

Principles of Econometrics, 4th

Chapter 12: Regression with Time-Series Data:

There are many tests for determining whether a

Principles of Econometrics, 4th

Chapter 12: Regression with Time-Series Data:

The AR(1) process yt = yt-1 + vt is stationary when

Principles of Econometrics, 4th

Chapter 12: Regression with Time-Series Data:

Consider again the AR(1) model:

We can test for nonstationarity by testing the

Principles of Econometrics, 4th

Chapter 12: Regression with Time-Series Data:

A more convenient form is:

The hypotheses are:

Principles of Econometrics, 4th

Chapter 12: Regression with Time-Series Data:

The second DickeyFuller test includes a constant

The null and alternative hypotheses are the

Principles of Econometrics, 4th

Chapter 12: Regression with Time-Series Data:

The third DickeyFuller test includes a constant

The null and alternative hypotheses are

Principles of Econometrics, 4th

Chapter 12: Regression with Time-Series Data:

To test the hypothesis in all three cases, we simply

Principles of Econometrics, 4th

Chapter 12: Regression with Time-Series Data:

Table 12.2 Critical Values for the DickeyFuller Test

Principles of Econometrics, 4th

Chapter 12: Regression with Time-Series Data:

An important extension of the DickeyFuller test

Principles of Econometrics, 4th

Chapter 12: Regression with Time-Series Data:

The unit root tests based on Eq. 12.6 and its

Principles of Econometrics, 4th

Chapter 12: Regression with Time-Series Data:

Table 12.3 AR processes and the Dickey-Fuller Tests

Principles of Econometrics, 4th

Chapter 12: Regression with Time-Series Data:

The Dickey-Fuller testing procedure:

Principles of Econometrics, 4th

Chapter 12: Regression with Time-Series Data:

The Dickey-Fuller testing procedure (Continued):

Principles of Econometrics, 4th

Chapter 12: Regression with Time-Series Data:

Principles of Econometrics, 4th

FIGURE 12.1 U.S. economic time series

Chapter 12: Regression with Time-Series Data:

As an example, consider the two interest rate

Principles of Econometrics, 4th

Chapter 12: Regression with Time-Series Data:

The results from estimating the resulting equations

B 0.237 0.056 B 0.237B

The 5% critical value for tau (c) is -2.86

Chapter 12: Regression with Time-Series Data:

Recall that if yt follows a random walk, then = 0

Series like yt, which can be made stationary by

Chapter 12: Regression with Time-Series Data:

The results of the DickeyFuller test for a random