Econometrics

J. Ortega Garcia

Deterministic and stochastic trend: an introduction1

1
This presentation is based on Hamilton(1994), Time series analysis
J. Ortega Garcia Econometrics 2016 1 / 15
1 ARMA model

2 Modeling nonstationary time series

General Form
Deterministic trend
Stochastic trend

3 Comparisons of trend-stationary and unit root processes

Forecast
Dynamic multipliers
Transformations to achieve stationarity

J. Ortega Garcia Econometrics 2016 2 / 15

 ARMA model

1 ARMA model

2 Modeling nonstationary time series

General Form
Deterministic trend
Stochastic trend

3 Comparisons of trend-stationary and unit root processes

Forecast
Dynamic multipliers
Transformations to achieve stationarity

J. Ortega Garcia Econometrics 2016 3 / 15

 ARMA model

ARMA model
A univariate time series model can be written in the form
yt = + t + 1 t1 + 2 t2 +
= + (L)t
2


where: t i.i.d N 0,
P
j=0 |j | <
roots of (L) = 0 are outside the unit circle

Two important characteristics:

E (yt ) = 0
lm yt+s|t =
s

Many of the economic and financial time series encountered in practice are
nonstationary.
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 Modeling

1 ARMA model

2 Modeling nonstationary time series

General Form
Deterministic trend
Stochastic trend

3 Comparisons of trend-stationary and unit root processes

Forecast
Dynamic multipliers
Transformations to achieve stationarity

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 Modeling General Form

Modeling nonstationary time series

General form

yt = + t + t
1 1 L 2 L p Lp t = 1 + 1 L + 2 L2 + + q Lq t
2

Suppose that autoregressive operator is factored:

1 1 L 2 L2 p Lp = (1 1 ) (1 2 ) 1 p

If the eigenvalues are inside the unit circle

yt = + t + (L)t (1)
1 + 1 L + 2 L2 + + q Lq t


t =
= (L)t
(1 1 L) (1 2 L) 1 p L
P
with j=0 |j | < 0 and roots of (L) outside the unit circle.
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 Modeling Deterministic trend

Modeling nonstationary time series

Deterministic trend

In (1), when |i | < 1 for i = 1, 2, , p the process is known as deterministic trend or

stationary in trend.

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 Modeling Stochastic trend

Modeling nonstationary time series

Stochastic trend

Suppose instead that 1 = 1 and |i | < 1 for i = 2, 3, , p, then (1) would state that

1 + 1 L + 2 L2 + + q Lq


t =
= (1 L)1 (L)t
(1 L) (1 2 L) 1 p L

yt = + t + (1 L)1 (L)t (2)

P
where j=0 |j | <

If (2) is first-differenced, the result is:

(1 L)yt = + (L)t

wich is the form of the unit root process.

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 Comparisons of trend-stationary and unit root processes

1 ARMA model

2 Modeling nonstationary time series

General Form
Deterministic trend
Stochastic trend

3 Comparisons of trend-stationary and unit root processes

Forecast
Dynamic multipliers
Transformations to achieve stationarity

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 Comparisons of trend-stationary and unit root processes Forecast

Comparisons of trend-stationary and unit root processes

Forecast
Note that (1) implies
yt+s = + (t + s) + 0 t+s + 1 t+s1 + 2 t+s2 +
The optimal linear forescast, error associated with this forecast and mean squared error
(MSE) associated, respectively.
Et [yt+s ] = + (t + s) + s t + s+1 t1 + s+2 t2 +
yt+s Et [yt+s ] = 0 t+s + 1 t+s1 + 2 t+s2 + + s1 t+1
 
E (yt+s Et (yt+s ))2 = 02 + 12 + 22 + + s1
2
2
Where Et denotes the expectative operator conditioned on t , t1 , t1 ,
The MSE increases
P with the forecasting
 horizon s though given the assumption of absolute

summability j=0 |j | < the added uncertainty, when s is large, becomes negligible

lm E (yt+s Et (yy+s ))2 = 02 + 12 + 22 + 2

s
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 Comparisons of trend-stationary and unit root processes Forecast

Comparisons of trend-stationary and unit root processes

Forecast

Solving unit root

By contrast, for a unit root process (2) the s-period-ahead forecast, error associated with
this forecast and mean squared error (MSE) associated, respectively .


Et (yt+s ) = s + yt + (1 + 2 + + s ) t + 2 + 3 + + s+1 t1 +



yt+s Et yt+s = 0 t+s + (0 + 1 ) t+s1 + + 0 + 1 + + s1 t+1


2 h 2
2 i 2
E yt+s Et yt+s = 0 + (0 + 1 )2 + + 0 + 1 + + s1

The MSE of a unit root process does not converge to any fixed value when s goes to infinity.

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 Comparisons of trend-stationary and unit root processes Dynamic multipliers

Comparisons of trend-stationary and unit root processes

Dynamic multipliers
Deterministic trend
yt = + t + 0 t + 1 t1 +
yt+s = + (t + s) + 0 t+s + 1 t+s1 +
yt+s
= s
t

yt+s X
lm = 0, given |j | <
s t
j=0
Stochastic trend
yt+s yt
= + 1 + 2 + + s
t t
= 1 + 1 + 2 + + s
= (1)
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 Comparisons of trend-stationary and unit root processes Transformations to achieve stationarity

Comparisons of trend-stationary and unit root processes

Transformations to achieve stationarity

Deterministic trend
Substract + t from yt to produce a stationary representation.

Stochastic trend
Difference the series

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 Comparisons of trend-stationary and unit root processes Transformations to achieve stationarity

Appendix
Why logs?
Deterministic trend

yt = e+t+t , t N 0, 2

log (yt ) = + t + t

Stochastic trend
 
yt
(1 L) log(yt ) = log
yt1
 
yt yt1
= log +1
yt1
yt yt1
= Taylors expansion of first order
yt1

The asumption is that the rate of growth of the series is a stationary stochastic process.
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 Comparisons of trend-stationary and unit root processes Transformations to achieve stationarity

Appendix
Solving unit root

yt+1 = yt + + 0 t+1 + 1 t +
yt+2 = yt+1 + + 0 t+2 + 1 t+1 +
.. ..
. .
yt+s = yt+s1 + + 0 t+s + 1 t+s1 +

yt+s = yt + s + 0 t+s + (0 + 1 ) t+s1 + (0 + 1 + 2 ) t+s2 + +

0 + 1 + + s1 t+1 + (1 + 2 + + s ) t + 2 + 3 + + s+1 t1 +

Return

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