Integrated Time Series and

Cointegration

Course: Applied Econometrics

Lecturer: Zhigang Li
Integrated Series and Cointegration
 A series xt is integrated of order d
(we call it I(d) process) if the series
becomes stationary after differencing
d times.
 Two series x and y are cointegrated if
 Both series are of the same order d
 A linear combination of the two series is
integrated to the order b (b<d).
Unit Root Process
 Unit Root Process
 yt=yt-1+ut (ut is a weakly dependent process)
 A random walk (ut is i.i.d. with mean zero) is a
special case of the unit root process.
 No matter how far in the future we look and
how much information we have for the past,
our best prediction of future is today’s value.
 The expected value of a random walk does not
depend on t
 The variance of a random walk increases as a
linear function of time (nonstationary).
 High persistency: Corr(yt, yt+h)=[t/(t+h)]1/2
Spurious Regression
 Spurious regression: X and Y are not related at all but
regressing Y on X shows a significant statistical
correlation between them. This could happen for:
 Omitted variable Z that drives both X and Y
 Trending X and Y
 Even if series Xt and Yt are not trending, the
regression between them may be spurious if X and Y
are independent and are both I(1).
 In this case, the error term of the regression is an I(1)
process, thus strongly dependent, violating consistency
assumptions.
 Solutions
 Include omitted variables
 First difference
 Cointegration
Cointegration and Error Correction
Model
 If β exists such that yt-βxt is an I(0) process, then y and
x are cointegrated.
 yt=α+βxt+e
 A cointegration model between X and Y can be equally
rewritten as
 Δyt=α+γΔxt+δ(yt-1-βxt-1)+u
 While the cointegration model emphasizes the
long-run equilibrium relationship between y and
x, the error correction model characterizes the
short-run adjustment processes towards the
equilibrium relationship.
The Engle-Granger Procedure
 If the series X and Y are integrated to the
same order d, cointegration between X and
Y can be tested through the following two-
stage procedure
 Cointegrating Regression: Regress Y on X (and
other control variables) by OLS
 The residuals from the regression are tested for
the order of integration. If the residuals are
integrated to lower order, then X and Y are
cointegrated.
Rigorous Unit Root Test I
(Dickey-Fuller Test)
 To test whether ρ=1 in yt=α+ρyt-1+e,
rewrite it as Δyt=α+(ρ-1)yt-1+et
 H0: ρ-1=0 H1: ρ-1<0
 The model is assumed to be dynamically
complete (martingale: E(et|yt-1, yt-2,…,y0)=0)
 Because the series yt is I(1) under H0, usual t-
test critical values need to be adjusted (following
Dickey-Fuller) as follows

Significance Level 1% 5% 10%

Critical Value -3.43 -2.86 -2.57
Rigorous Unit Root Test II
(Augmented Dickey-Fuller Test)
 Δyt=α+(ρ-1)yt-1+ Δyt-1+Δyt-2+…+Δyt-p+et
 H0: ρ-1=0 H1: ρ-1<0
 Enough lagged dependent variables are added
so that the model is dynamically complete.
 The lag length is often dictated by the
frequency of the data. For annual data, one or
two lags usually suffice. For monthly data,
twelve lags might be needed.
 The t statistics on the lagged changes have
approximate t distributions, so standard tests
might be used to determine lag lengths.
 The critical values are the same as the Dickey-
Fuller test in last slide.
Rigorous Unit Root Test III
(Dickey-Fuller Test with Time Trend)
 Δyt=α+δt+(ρ-1)yt-1+et
 H0: ρ-1=0 H1: ρ-1<0
 A trend-stationary process can be mistaken for a
unit root process if the time trend is not
controlled for.
 Critical values of the Dickey-Fuller test chanes
when a time trend is included:
Significance Level 1% 5% 10%
Critical Value -3.43 -2.86 -2.57
Critical Value (Trend) -3.96 -3.41 -3.12
Limitations of Cointegration
Analysis
 Pre-test procedures (unit root test of
individual variables) are often
inconclusive.
 There may be substantial small-
sample bias.
 Structural breaks in the time series
can cause difficulties in unit root test
and cointegration analysis.
Aggregated Consumption and the
Demand for Imports (Clarida, 1992)
 Empirical model

m: Import of nonduarable goods

h’: Domestic nondurable goods consumption
p: Relative import prices
v: Stationary disturbance
Pre-test (D-F test) for
Nonstationarity