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Introduction
Many economic time series are trending.
Important to distinguish between two important cases:
(1) A stationary process with a deterministic trend:
Shocks have transitory eects.
(2) A process with a stochastic trend or a unit root:
Shocks have permanent eects.
Why are unit roots important?
(1) Interesting to know if shocks have permanent or transitory eects.
(2) It is important for forecasting to know if the process has an attractor.
(3) Stationarity was required to get a LLN and a CLT to hold.
For unit root processes, many asymptotic distributions change!
Later we look at regressions involving unit root processes: spurious regression
and cointegration.
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Trend Stationarity
Consider a stationary AR(1) model with a deterministic linear trend term:
Yt = Yt1 + + t + t,
t = 1, 2, ..., T,
()
t1
+ 2
t2
+ 3
t3
+ ...
2
V [Yt] = V [ t + t1 + t2 + ...] = + + + ... =
.
1 2
2
2 2
4 2
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The stochastic part of the process is stationary and shocks have transitory eects
We say that the process is mean reverting.
Also, we say that the process has an attractor, namely the mean, + 1t.
We can analyze deviations from the mean, yt.
From the Frisch-Waugh theorem this is the same as a regression including a trend.
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15.0
Y t = y t + 0.1 t
12.5
10.0
7.5
5.0
2.5
0.0
0
10
20
30
40
50
60
70
80
90
100
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t = 1, 2, ..., T,
()
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t
X
i=1
with moments
Yi = Y0 +
t
X
( + i) = Y0 + t +
i=1
t
X
i,
i=1
-2
-4
-6
-8
0
10
20
30
40
50
60
70
80
90
100
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H0 : = 1 against HA : < 1.
= yt1 + t,
H0 : = 0 against HA : < 0.
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b
1
.
=
)
se(b
) se(b
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=
=
=
=
where
= 1 + 2 + 3 1 = (1)
c1 = (2 + 3)
c2 = 3.
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To
If the variable has a deterministic trend, consider a regression model of the form
Yt = Yt1 + c1yt1 + c2yt2 + + t + t.
The ADF test is the ttest, b
t =
b/se(b
).
The critical value at a 5% level is 3.41.
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The DF Distributions
DF with a linear trend, t
DF with a constant, c
0.5
DF,
0.4
N(0,1)
0.3
0.2
0.1
-5
-4
-3
-2
-1
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0.125
0.100
0.075
0.050
First difference, r t
0.025
0.000
-0.025
1970
1975
1980
1985
1990
1995
2000
2005
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(4.49)
(0.199)
(0.817)
(0.406)
(0.911)
(0.647)
The 5% critical value (T = 100) is 2.89, so we do not reject the null of a unit root.
(0.534)
Here we safely reject the null hypothesis of a unit root (7.49 2.89).
(Yt ) = (Yt1 ) + t
Yt = Yt1 + (1 ) +
Yt = Yt1 + + t
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H0 : = 1 against HA : < 1,
imply
HA : Yt = + stationary process
H0 : Yt = Y0 + t + stochastic trend.
We compare a model with a linear trend against a model with a non-zero level!
Potentially dicult to interpret.
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RSS0
LR = T log
= 2 (loglik0 loglikA) ,
RSSA
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Since we do not impose the restriction under the null, the trend will accumulate.
A quadratic trend is allowed under H0, but only a linear trend under HA.
A solution is to impose the combined hypothesis
H0 : = = 0.
This is done by running the two regressions
HA : Yt = Yt1 + + t +
H0 : Yt = + t,
and perform a likelihood ratio test. The 5% critical value for this test is 12.39.
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Special Events
Unit root tests assess whether shocks have transitory or permanent eects.
The conclusions are sensitive to a few large shocks.
Consider a one-time change in the mean of the series, a so-called break.
This is one large shock with a permanent eect.
Even if the series is stationary, such that normal shocks have transitory eects, the
presence of a break will make it look like the shocks have permanent eects.
That may bias the conclusion towards a unit root.
Consider a few large outliers, i.e. a single strange observations.
The series may look more mean reverting than it actually is.
That may bias the results towards stationarity.
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t = t1 + vt,
vt IID(0, 2v ).
Yt =
b + ebt,
()
to find the estimated stochastic component. Under the null, ebt is stationary.
H0 : 2v = 0 against HA : 2v > 0.
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PT
2
t=1 St
,
b2
P
where St = ts=1 ebs is a partial sum;
b2 is a HAC estimator of the variance of ebt.
(This is an LM test for constant parameters against a RW parameter).
The regression in () can be augmented with a linear trend. Critical values:
Deterministic terms
in regression ()
Constant
Constant and trend
Critical values
0.10 0.05 0.01
0.347 0.463 0.739
0.119 0.146 0.216
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