Time series analysis

The concept of stationarity

Autoregressive processes and stationarity
• Stationarity is a desirable property of an estimated AR
model for several reasons.

• One important reason is that a non-stationary AR

process exhibits the property that previous values of a
time series will have a non-declining effect on the
current value of the series as time progresses.

• In contrast, the autocorrelations of a stationary AR

process will decline eventually as the lag length is
increased (the autocorrelation function (ACF) will decay
geometrically to zero).
Characteristic equation
Integrated processes and differencing
Unit root tests
Illustration
Augmented Dickey-Fuller (ADF) test in
EViews
Double click on sesame:
You will see a spreadsheet containing the price series.
Click on View and then select Unit Root Test…
In the pop-up window (titled ‘Unit Root Test’), select Trend
and intercept. Leave the other options as they are.
Since the series is non-stationary (has unit root), we need to
check if first differencing induces a stationary series. Click on
View, select Unit Root Test… and then 1st difference.
Non-stationarity and spurious regression
• There are several reasons why the concept of stationarity is
important.

• One of reasons is that the use of non-stationary data can lead

to spurious regressions.

• If two stationary variables are generated as independent

random series and when one of those variables is regressed
on the other:

– the t-ratio on the slope coefficient would be expected not

to be significantly different from zero,

– and the value of R-squared would be expected to be very

low.
• However, if two variables are trending over time, a regression
of one on the other could have a high R-squared even if the
two are totally unrelated.

• So, if standard regression techniques are applied to non-

stationary data, the end result could be:

– a regression that ‘looks’ good under standard measures

(significant coefficient estimates and a high value of R-squared),

– but which is really valueless or has no meaningful economic

interpretation.

• Such a model would be termed a ‘spurious regression’.

Illustration
• We can see that R-squared is large (73%) and the model is
adequate as judged by the F-test (p-value < 0.001).

• Moreover, the t-test indicates that the total reserves of

Ethiopia is significant at the 1% level, that is, total reserves
of Ethiopia has a significant influence on US GDP.

• But we know that the total reserves of Ethiopia (a small

economy) can never affect the US economy (as measured
by US GDP).

• This is clearly a spurious regression.

• Since both series are non-stationary (have unit roots),
we need to take first differences.

• Then we have to check if first differencing removes the

unit root problem.

• If this is so, US GDP and the total reserves of Ethiopia

are integrated of order one (I(1)).
• We can see that:
• R-squared is zero
• The F-statistic is insignificant (p-value > 0.05).
• The t-ratio is insignificant (p-value > 0.05).

• Thus, there is no relationship between US GDP and

the total reserves of Ethiopia.

• The significant relationship that we obtained earlier was

simply a consequence of the underlying trend in both
series.