Unit Roots Tests: Methods and Problems

Zahid Asghar, Professor, School of Economics,

QAU
2024-04-20
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 Augmented Dickey-Fuller and Phillips-Perron Unit
Roots Tests using R
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 Unit Roots Tests
H OW DO YOU FIND OUT IF A SERIES IS STATIONARY OR NOT ?
O RDER OF INTEGRATION OF A S ERIES
A series which is stationary after being di!erenced once is said to integrated of order 1
and is being denoted by I(1). In general a series which is stationary after being
di!erenced d times is said to be integrated of order d , denoted I(d). A series, which is
stationary without di!erencing, is said to be I(0)
Yt = b0 + Yt−1 + ϵt –> I(1)
∆Yt = Yt − Yt−1 = b0 + ϵt –> I(0)
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 Informal Procedures to indentify non-stationnary process
Eye ball the data

Constant mean?

Constant variance?
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 Diagnostic test - Correlogram
Correlation between 1980 and 1980+K.
For stationary process correlelogram dies out rapidly. Series has no memory. 1980 is
not related to 1985.

stationary

non-stationary
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 Statistical tests for sationarity: Simple t-test
Set up AR(1) process with drift (b0 )
Yt = b0 + bYt−1 + ϵt where ϵt ∼ iid(0, σ 2 )
Simple approach is to estimate eq(1) using OLS and examine b .
Use a t-test with null H0 : b = 1 (non-stationary)
against alternative Ha : b < 1 (stationary)
Test Statistics : TS=(b − 1)/SE(b) reject null hypothesis when test statistics is large
negative 5% critical value is -1.65
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 Simple t-test based on AR(1) process with drift (b0 )
Yt = b0 + bYt−1 + ϵt –> (1)
ϵt ∼ iid(0, σ 2 )
Problem with simple test approach
1. lagged dependent variables ==> b biased downwards in small samples (i-e dynamic
bias)
2. When b = 1 , we have non-stationary process and standard regression analysis is
invalid (i-e non-standard distribution)
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 Dickey Fuller (DF) Test
Subtract Yt−1 from both sides of eq(1).
Yt − Yt−1 = b0 + bYt−1 − Yt−1 + ϵt
ϵt ∼ iid(0, σ 2 )
∆Yt = b0 + βYt−1 + ϵt
β = b1 − 1
Use a t-test with: null H0 : β = 0 (non-stationary or Unit Root
Root) against alternative
H0 : β < 0
Large negative test statistics reject non-stationary
This is known as unit root test since in eq(1) H0 : b = 0
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 Variants of DF test
The di!erent regression can be used to test the presence of a unit root
∆Y = βYt−1 + ϵt
∆Y = b0 + βYt−1 + ϵt
∆Y = b0 + βYt−1 + b2 t + ϵt
1. For testing if Y is a pure Random Walk
2. For testing if Y is Random Walk with Drift
3. For testing if Y is a Random walk with Drift and Deterministi Trend
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 The simplest model (appropriate only if you think there are no other terms present in
the true regression model)
∆Y = βYt−1 + ϵ
Use the t-statistics and compare it with the table of critical values computed by the DF.
If your t value is outside the confidence interval, the null of unit root is rejected.
τ Statistics
A more general model (allowing for drift)
∆Y = b0 + βYt−1 + ϵ
ϕ1 Statistics- Use F statistics if β = b0 = 0 using the non standard tables
τµ Statistics
- use the t statistics to check if β = 0, against non-standard tables.
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 Examples
Sample size of n=25 at 5% level of significance for eq(2)
τ - critical value=-3.00
t-test critical value=-1.65
∆pt = −0.007 − 0.190pt−1
(−1.05)(−1.49)
β = −0.190 τ = −1.49 > −3.00
hence cannot reject H0 of unit root.
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 Incorporating time trends in DF test for unit root
Some time series clearly display an upward or downward trend (non-stationary mean).
Should therefore incorporate trend in the regression used for the DF test.
∆Y = b0 + βYt−1 + b2 trend + ϵ –>(4) It may be the case that Yt will be stationary
around a trend, although if a trend is not included series is non-stationary.
a. H0 = β = 0 τ
Ha : β < 0 ∆Yt = b0 + βYt−1 + b2 trend + ϵ
b. H0 = β = 0 τµ
Ha : β < 0 ∆Yt = b0 + βYt−1 + ϵ
c. H0 = β = 0 ττ Critical values from Fuller (1976)
Ha : β < 0 ∆Yt = βYt−1 + ϵ
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 Augmented Dickey Fuller (ADF) test for unit root
Dickey Fuller tests assume that the residuals ϵt in the DF regression are non-
autocorrelated.
Solution: incorporated lagged dependent variables
For quarterly data add up to four lags
∆Yt = b0 + βYt−1 + θ1 ∆Yt−1 + θ2 ∆Yt−2 + θ3 ∆Yt−3 + θ4 ∆Yt−4 + ϵ
Problem arises of di!erentiating between models.
Use a general to specific approach to eliminate insiginficant variables Check final
parsimonious model for autocorrelation.
Check F-test for significant variables
Use Information Criteria
Trade-o! parsimony vs. residual variance
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 Conside the following series and its correlogram

The variable Y is clealry trended and question is whether trend : Deterministic or

Stochastic
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 Choose between alternative models - The model-progress
results
∆Yt = b0 + βYt−1 + θ1 ∆Yt−1 + θ2 ∆Yt−2 + θ3 ∆Yt−3 + θ4 ∆Yt−4 + ϵ
∆Yt = b0 + βYt−1 + θ1 ∆Yt−1 + θ2 ∆Yt−2 + θ3 ∆Yt−3 + ϵ
∆Yt = b0 + βYt−1 + θ1 ∆Yt−1 + θ2 ∆Yt−2 + ϵ
∆Yt = b0 + βYt−1 + θ1 ∆Yt−1 + ϵ
∆Yt = b0 + βYt−1 + ϵ
AIC, SBC, HQC or some other criteria maybe used beside having judgement for
appropriate lag selection.
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 ADF vs PP

Comparison of ADF Test and PP Test Features

Feature ADF.Test PP.Test
Underlying No serial correlation in error No assumptions about serial
Assumption terms correlation
Applicability Data with no significant serial Data with potential serial
correlation correlation
Implementation Requires lag selection No lag selection required
Advantages Common, well-established More robust to serial
test correlation
Disadvantages Requires attention to serial Less common, may be
correlation computationally expensive
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 Choosing ADF or PP
If you’re confident there’s no serial correlation in your data, ADF can be a good choice.
If you suspect serial correlation or are unsure, the PP test is generally recommended
for its robustness.
In practice, it’s often recommended to run both tests and compare the results. If they
agree on the presence or absence of a unit root, you can be more confident in the
conclusion.
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 Three
Three main
main aspects
aspects of
of Unit
Unit root
root testing
testing
Determining components (constant , time trend).
ADF test- lag length , use F-test or Schwarz Information Criteria
In what sequence should we test?
Phi and tau tests
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 Three
Three Strategy
Strategy for
for Unit
Unit Roots
Roots
Formal Strategy
1. Use informal tests- eye ball data and correlogram
2. Incorporate Time trend if data is upwards trending
3. Specification of ADF test - how many lags should we incorporate to avoid serial
correlation?
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 Example
Example
Real GDP (2000 Prices) Seasonally Adjusted

1. Plot Time Series- Non-Stationary (i-e. time varying mean and correlogram non-zero)
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 Unit
Unit Root
Root Testing
Testing
1) Plot first di!erence of time series- Stationary
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 General
General to
to Specific
Specific or
or Specific
Specific to
to General
General Techinque
Techinque
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 Multiple
Multiple Roots
Roots
∆2 yt = b0 + β1 ∆yt−1 + ϵt
If β1 does di!er from zero, estimate
∆2 yt = b0 + β1 ∆yt−1 + β2 yt−1 + ϵt
If you reject the null hypothesis β2 =0, conclude yt is stationary.
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 Panel
Panel Unit
Unit Root
Root Tests
Tests
∆yit = bio + γ i yit−1 + ∑ni=1 pi ∆yit−j + ϵit

One way to obtain a more powerful test is to pool the estimates from a number
separate series and then test the pooled value. The theory underlying the test is
very simple: if you have n independent and unbiased estimates of a parameter,
the mean of the estimates is also unbiased. More importantly, so long as the
estimates are independent, the central limit theory suggests that the sample mean
will be normally distributed around the true mean.

The difficult issue is to correct for cross equation correlation

Because the lag lengths can di!er across equations, you should perform separate lag
length tests for each equation. Moreover, you may choose to exclude the deterministic
time trend. However, if the trend is included in one equation, it should be included in
all
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 Limitations
Limitations
The null hypothesis for the IPSE test γ 1 = γ 2 =. . . = γ 1 = 0. Reject of the null
hypothesis means that at least one of the γ i′ s di!ers from zero.
At this point, there is substantial disagreement about the asymptotic theory
underlying the test. Sample size can approach infinity by increasing n for a given T,
increasing T for a given n, or by simultaneously increasing n and T.
For small T and large n, the critical values are dependent on the magnitudes of the
various βij . The test requires that that the error terms be serially uncorrelated and
contemporaneously uncorrelated. You can determine the values of pi to ensure that
the autocorrelations of ϵit are zero. Nevertheless, the errors may be
contemporaneously correlated in that E(ϵit ϵjt ) ≠ 0 The example above illustrates a
common technique to correct for correlation across equations. As in the example, you
can subtract a common time e!ect from each observation. However, there is no
assurance that this correction will completely eliminate the correlation. Moreover, it
is quite possible that is nonstationary. Subtracting a nonstationary component from
each sequence is clearly at odds with the notion that the variables are stationary.
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