MEcon 514 Applied Econometrics 2014

Master of Economics Program for Professionals

Rabeya Khatoon

Department of Economics, University of Dhaka

09 November, 2014

Rabeya Khatoon MEcon 514 Applied Econometrics 2014 09 November, 2014 1 / 11

 Time series Econometrics Stationarity, Unit roots, Cointegration and ECM models

Stationarity, Unit roots, Cointegration

and ECM models

Rabeya Khatoon MEcon 514 Applied Econometrics 2014 09 November, 2014 2 / 11

 Time series Econometrics Stationarity, Unit roots, Cointegration and ECM models

Random Walks

A random walk is an AR(1) model where ρ = 1, meaning the series is

not weakly dependent

yt = ρyt−1 + et , t = 1, 2, . . .

With a random walk, the expected value of yt is always y0 - it doesn’t

depend on t
Var (yt ) = σe2 t, so it increases with t
A random walk is a special case of what is known as a unit root
process
Note that trending and persistence are different things - a series can
be trending but weakly dependent, or a series can be highly persistent
without any trend
A random walk with drift is an example of a highly persistent series
that is trending
Rabeya Khatoon MEcon 514 Applied Econometrics 2014 09 November, 2014 3 / 11
 Time series Econometrics Stationarity, Unit roots, Cointegration and ECM models

Transforming Persistent Series

In order to use a highly persistent series and get meaningful estimates

and make correct inferences, we want to transform it into a weakly
dependent process
We refer to a weakly dependent process as being integrated of order
zero, I (0)
A random walk is integrated of order one, I (1), meaning a first
difference will be I (0)

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 Time series Econometrics Stationarity, Unit roots, Cointegration and ECM models

Testing for Unit Roots

Consider an AR(1): yt = α + ρyt−1 + et

Let H0 : ρ = 1, (assume there is a unit root)
Subtract yt−1 from both sides to obtain ∆yt = α + (ρ − 1)yt−1 + et
Unfortunately, a simple t-test is inappropriate, since this is an I(1)
process
A Dickey-Fuller (DF) Test uses the t-statistic, but different critical
values

Rabeya Khatoon MEcon 514 Applied Econometrics 2014 09 November, 2014 5 / 11

 Time series Econometrics Stationarity, Unit roots, Cointegration and ECM models

Testing for Unit Roots (Cont...)

We can add p lags of ∆yt to allow for more dynamics in the process
e.g., for p = 1, ∆yt = α + (ρ − 1)yt−1 + δ∆yt−1 + et
Still want to calculate the t-statistic for ρ − 1
Now it’s called an augmented Dickey-Fuller (ADF) test, but still the
same critical values
The lags are intended to clear up any serial correlation, if too few,
test won’t be right

Rabeya Khatoon MEcon 514 Applied Econometrics 2014 09 November, 2014 6 / 11

 Time series Econometrics Stationarity, Unit roots, Cointegration and ECM models

Testing for Unit Roots (Cont...)

If a series is clearly trending, then we need to adjust for that or might

mistake a trend stationary series for one with a unit root
Can just add a trend to the model :
∆yt = α + (ρ − 1)yt−1 + δ∆yt−1 + χT + et
Still looking at the t-statistic for ρ − 1, but the critical values for the
DF test change

Rabeya Khatoon MEcon 514 Applied Econometrics 2014 09 November, 2014 7 / 11

 Time series Econometrics Stationarity, Unit roots, Cointegration and ECM models

Correlogram

In case of small samples, the inspection of the autocorrelation

function and correlogram is an important tool in determining whether
the variables are stationary or not
The sample autocorrelation function for any variable at any lag k is
defined by the ratio of covariance at lag k to variance
Sample correlogram: estimated autocorrlation coefficients at different
lags are plotted against k
For non-stationary variables correlograms die down slowly giving rise
to either a secular declining or a constant trend in the graph of
autocorrelation coefficients
In case of stationary variables they damp down almost instantly and
then show random movement

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 Time series Econometrics Stationarity, Unit roots, Cointegration and ECM models

Spurious Regression

Consider running a simple regression of yt on xt where yt and xt are

independent I (1) series
The usual OLS t-statistic will often be statistically significant,
indicating a relationship where there is none
Called the spurious regression problem

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 Time series Econometrics Stationarity, Unit roots, Cointegration and ECM models

Cointegration

Say for two I(1) processes, yt and xt , there is a β such that yt − βxt
is an I(0) process
If so, we say that y and x are cointegrated, and call β the
cointegration parameter
If we know β, testing for cointegration is straightforward if we define
st = yt − βxt
Do Dickey-Fuller test and if we reject a unit root, then they are
cointegrated
If β is unknown, then we first have to estimate β , which adds a
complication
After estimating β we run a regression of ∆ût on ût−1 and compare
t-statistic on ût−1 with the special critical values
If there are trends, need to add it to the initial regression that
estimates β and use different critical values for t-statistic on ût−1
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 Time series Econometrics Stationarity, Unit roots, Cointegration and ECM models

Testing for Cointegration: The Engle-Granger Procedure

The linear combination of two I (d) variables is more likely to be I (d)

Engle and Granger showed that in an exceptional case the linear
combination of two I (d) variables can found to be integrated of a
lower order than d
OLS estimates will give valid long run relationships removing the
spurious regression possibility and the variables are said to be
cointegrated
Run OLS regression using I (d) variables and get residuals
Estimate ∆ût = (ρ − 1)ût−1 + δ∆ût−1 + et
Test the t-ratio for the coefficient (ρ − 1) with critical values provided
by McKinnon (1991)

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