Spurious Regression and Simple Cointegration

Gloria Gonzlez-Rivera
University of California, Riverside
and
Jess Gonzalo U. Carlos III de Madrid

You are free to use and modify these slides for educational purposes, but please if you improve
this material send us your new version.

Spurious Regression
y t y t 1 u t ; u t iid (0, 2u )
Set-up:
x t x t 1 v t ; vt iid (0, 2v )

Regress

; E(u t , v s ) 0 t, s
E(u t u t k ) E( v t v t k ) 0 k

y t x t t

What do you expect to get?

p

0
p
2
R 0
t t distribution

Spurious Regression (cont)

What does it really happen?

some distribution
2
R some distribution
p
DW 0
T 1 / 2 t some distribution

Spurious Regression (cont)

Spurious Regression Problem (SPR):

Regression of an integrated series on another unrelated integrated
series produces t-ratios on the slope parameter which indicates a
relationship much more often than they should at the nominal test
level. This problem does not dissapear as the sample size is
increased.
The Spurious Regression Problem can appear with I(0) series too
(see Granger, Hyung and Jeon (1998)). This is telling us that the
problem is generated by using WRONG CRITICAL VALUES!!!!

In a Spurious Regression the errors would be correlated and the

standard t-statistic will be wrongly calculated because the variance
of the errors is not consistently estimated. In the I(0) case the
solution is:

t t - distributi on , where (long - run varian ce of )1/2

Maybe the same thing can be done to solve the SPR problem with
I(1) variables.

Spurious Regression (cont)

How do we detect a Spurious Regression (between I(1) series)?
Looking at the correlogram of the residuals and also by testing for a
unit root on them.
How do we convert a Spurious Regression into a valid regression?
By taking differences.
Does this solve the SPR problem?

It solves the statistical problems but not the economic interpretation of

the regression. Think that by taking differences we are loosing
information and also that it is not the same information contained in a
regression involving growth rates than in a regression involved the
levels of the variables.

Spurious Regression (cont)

Does it make sense a regression between two I(1) variables?
Yes if the regression errors are I(0).
Can this be possible?
The same question asked David Hendry to Clive Granger time ago.
Clive answered NO WAY!!!!! but he also said that he would think
about. In the plane trip back home to San Diego, Clive thought about
it and concluded that YES IT IS POSSIBLE. It is possible when both
variables share the same source of the I(1)ness (co-I(1)), when both
variables move together in the long-run (co-move), ... when both
variables are
COINTEGRATED!!!!!!!!!!!!!!!!!!!!!!!

Some Cointegration Examples

Example 1: Theory of Purchasing Power Parity (PPP)
Apart from transportation costs, good should sell for the same
effective price in two countries

*
Pt St Pt
An index of the price level
in the USA

In logs :

A weaker version
of the PPP:

$ per

Price Index for

Spain

*
pt st pt
p t s t p*t z t

If the three variables are I(1) and zt is I(0) then the PPP theory is
implying cointegrating between pt, st and p*t .

Some Cointegrating Examples (cont)

Example 2: Present Value Models (PVM)

Yt (1 )

i E t ( y t i ) c

i 0

Yt: Long-term yields

yt: short-term yields

Stock Prices

dividends

Consumption

labor income

If yt has a unit root and the PVM holds then Yt and yt will be
cointegrated (see Campbell and Shiller (1987)

Z t Yt y t is I(0)

Geometric Interpretation of Cointegration

What is an ATTRACTOR?
Consider the price (over time) of a commodity that is traded in
two different locations i and j.
.
pit p jt
p jt
3
.
.
4
1 : ( pi1 , p j1 )
5
.
2 : ( pi 2 , p j 2 )
.
2
1

t : ( pit , p jt )

45

Suppose that pi1 p j1

pit

Demand will go to location j

pi1 and p j1
The adjustment does not have to be instantaneous but eventually
pit p jt Long-run equilibrium: this is a linear attractor.
Shocks to the economy make us move out of the attractor.

Geometric Interpretation of Cointegration (cont)

The concept of attractor is the concept of long-run equilibrium
between two stochasic processes. We allow the two variables to
diverge in the short-run; but in the long-run they have to converge
to a common region denominated attractor region. In other words,
if from now on there are not any shocks in the system, the two
stochastic processes will converge together to a common attractor
set.

Question 1: Write in intuition terms two two economic examples

where cointegration can be present. Explain why?
Question 2: A drunk man leaving a bar follows a random walk. His
dog also follows a random walk on its own. Then they go into a
park where dogs are not allowed to be untied. Therefore the drunk
man puts a strap on his dog and both enter into the park Will their
paths be cointegrated? Why?

Definition of Cointegration

From an economic point of view we are interested on answering

(1) Can we test for the existence of this attractor?
(2) If it exists, how can be introduced into our econometric modelling?
Some rules on linear combinations of I(0) and I(1) processes
1. X t I (0) a bX t I (0)
X t I (1) a bX t I (1)
2. X t , Yt I (0) aX t bYt I (0)
3. X t I (0),Yt I (1) aX t bYt I (1)
I (1) is dominant
4. X t , Yt I (1) aX t bYt I (1) in general
Definition

If X t and Yt are I(1) but there exists a linear

combination, say
Z t m aX t bYt
such Z t is I(0), then X t , Yt are said to be cointegrated.

Why Two Series Are Cointegrated?

Consider the following construction
~
X t AWt X t I (1) I (1) I (0) (rule 3)
~
Yt Wt Yt
The following linear combination
~
~
Z t X t AYt AWt X t AWt AYt
~
~
Z t X t AYt I(0) (rule 2)
so X t , Yt have a " common I(1) factor".
Result 1.
If two I(1) series have a common I(1) factor and idiosincratic I(0)
components, then they are cointegrated.
It can be proved that Result 1 is an IF and ONLY IF result.

A Simple Test for Cointegration

This test is due to Engle and Granger (1987)
Estimate the following regression model in levels

y t x t z t ; y t , x t I(1)
Perform an ADF test on the residuals:

t z
t 1
z

t i error
i z

i 1

The null hypothesis

Ho : 0

This means that the residuals have a unit root and therefore yt and xt are not cointegrated.
If the residuals are I(0) then yt and xt are cointegrated

Error Correction Model

Vector Error Correction Model(VECM)

X t , Yt are I(1) and cointegrated,

X t c1 1Zt 1 1X t 1 ..... 1Yt 1 .... xt
Yt c2 2 Zt 1 1X t 1 ..... 1Yt 1 .... yt

For a bivariate VAR, where

where ( xt , yt )' is a bivariate white noise and

Z t X t AYt I (0), and
at least one i 0
If X t , Yt are not cointegrated Zt I (1) (rule 4)
In the ECM, I(1) cannot explain I(0), i.e. X t , Yt 1 2 0

Result 2.
If X t , Yt are cointegrated, then exists an ECM representation.
Cointegration is a necessary condition for ECM and viceversa
(Granger Representation Theorem).

Geometric intuition of the Error Correction Model

Intuition on ECM
Z t Yt AX t : disequilib rium error

Yt
Zt 0

Yt AX t

Xt

Wherever the system goes at time t+1 , depends on the magnitude

and sign of the disequilibrium error of the previous period t, at least.
Short-run dynamics: movements in the short run, modeled in the
ECM, that guide the economy towards the
Long-run equilibrium Yt AX t

Cointegration and Econometric Modelling

1. Check the integration of X t , Yt I (1) : use the Dickey-Fuller tests
2. Testing for cointegration between X t and Yt . Find the cointegrating
relation. OLS regression (minimize the variance of residuals).
Yt c X t Z t
H 0 : non - cointegration Zt I (1)
H1 : cointegration Z t I (0)

If H 0 is rejected X t , Yt are cointegrated

Warning: we will be tempted to use the Dickey-Fuller tests but the
test is based in residuals . We need a different set of critical values,
as in Engle-Granger (89) or McKinnon (90).
P( w 1.65) 5% Normal distribution

P( w 2.86) 5% Dickey - Fuller distribution

P( w 3.34) 5% Engle - Granger/McKinnon

Cointegration and Economic Modelling (cont)

(1, ) is the cointegrating vector

is super - consistent (T( ) some distributi on)
3. Short-run dynamics: ECM

X t c1 1 (Yt 1 X t 1 ) x1X t 1 ..... y1Yt 1 .... xt

Yt c2 2 (Yt 1 X t 1 ) x1X t 1 ..... y1Yt 1 .... yt
Engle-Granger two-step estimation method:
(i) Estimate Zt
(ii) Plug Z t in the ECM (SURE estimation): estimators in the ECM
are consistent and efficient.

Cointegration with more than two variables

Example 1.

N 3, h 2
Yt Wt ut

X t Wt vt Wt I (1) ut , vt , st I (0)
Z t Wt st
1 commonstochastic trend Wt
2 cointegrating vectors: (1 1 0)' (0 1 1)'

Example 2.

N 3, h 1
Yt Wt ut

X t Wt Rt vt Wt , Rt I (1) ut , vt , st I (0)

Z t Rt st

2 commonstochastic trends Wt , Rt

1 cointegrating vector : (1 1 1)'

Cointegration with more than two variables (cont)

Example 3.

N 2, h 1
Yt AWt ut
Wt I (1) ut , vt , st I (0)
X t Wt vt
1 commonstochastic trend Wt

Example 4.

1 cointegrating vector: (1 A)'

N 2, h 2; Yt and X t are stationary
2 cointegrating vectors: (1 0)' (0 1)'

Cointegration: Testing and Estimation with more than two variables

Johansens method:
Two major advantages with respect to Engle-Granger procedure:
(1) Testing for number of cointegrating vectors when N>2
(2) Joint procedure: testing and maximum likelihood estimation of
the vector error correction model and long run equilibrium relations.

Framework
Consider a VAR(p)

Yt 1Yt 1 2Yt 2 .... pYt p t

We construct the vector error correction model transforming the VAR:

where 0 I [ I 1 2 .... p ]
Yt 1Yt 1 2 Yt 2 .... p 1Yt p 1 0Yt 1 t
subtracting Yt 1 from both sides :

[1 2 .... p ]
where i [ i 1 i 2 .... p ] i 1,...p 1
Yt 1Yt 1 2 Yt 2 .... p 1Yt p 1 Yt 1 t

Vector error correction model:

Yt 1Yt 1 2 Yt 2 .... p 1Yt p 1 0Yt 1 t

If Yt is cointegrated with cointegrating rank h,

then 0 B A' (the matrix is of reduced rank) and
nxh hxn

0Yt 1 B A' Yt 1 BZt 1

nxh hxn

A contains the cointegrating vectors

B contains the coefficients of adjustment
Example 5: 2 variables, 1 cointegrating vector
Z t X t Z t
X t 1
1
0Yt 1 1

Z
2
t 1

H 0 : h cointegrating vectorsat most (restrictions on 0 )

H1 : n cointegrating vectors(no restrictions on 0 )
Objective:
Construct the likelihood function under the null and under
the alternative, and construct a likelihood ratio-type test.
max
s.t. 0 BA'

Johansens algorithm to maximize the constrained likelihood is

based on canonical correlation analysis.
Likelihood ratio test has a non-standard distribution due to the
non-stationarity of the variables.
H 0 : h n
Trace test

H1 : h n
2(1 0 )
H 0 : h
H : h 1 maximum eigenvalue test
1