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UnitRoots

Anautoregressiveprocess

a ( L) yt = et
hasaunitrootif

a (1) = 0
ThesimplestcaseistheAR(1)model

(1 L) yt = et
or

yt = yt 1 + et

ExamplesofRandomWalks

RandomWalkwithDrift
AR(1)withnonzerointerceptandunitroot

yt = + yt 1 + et

ThisissameasTrendplusrandomwalk

yt = Tt + C t
Tt = t
C t = Ct 1 + et

Examples

yt = 0.1 + yt 1 + et
et ~ N (0,1)

OptimalForecastsinLevels
RandomWalk

yt +1|t = yt
yt + h|t = yt

RandomWalkwithdrift

yt + h|t = + yt
yt + h|t = h + yt

OptimalForecastsinChanges
Takedifferences(growthratesify inlogs)

z t = yt = yt yt 1
Optimalforecast:Randomwalk

z t + h|t = 0
Optimalforecast:Randomwalkwithdrift

z t + h|t = h

ForecastErrors
Bybacksubstitution

yt = yt 1 + et

= yt h + et h +1 + L + et +1

Sotheforecasterrorfromanhstepforecastis

et h +1 + L + et +1

Whichhasvariance

+L + = h
2

Thustheforecastvarianceislinearinh

Forecastintervals
Theforecastintervalsareproportionaltothe
forecaststandarddeviation

h 2 = h
Thustheforecastintervalsfanoutwiththe
squarerootoftheforecasthorizonh

Example:RandomWalk

GeneralCase
Ify hasaunitroot,transformbydifferencing

z t = yt = yt yt 1
Thiseliminatestheunitroot,soz isstationary.

a ( L) yt = et
a ( L) = b( L)(1 L)
b ( L) z t = et
Makeforecastsofz
Forecastgrowthratesinsteadoflevels

Forecastinglevelsfromgrowthrates
Ifyouhaveaforecastforagrowthrate,you
alsohaveaforecastforthelevel
Ifthecurrentlevelis253,andtheforecasted
growthis2.3%,theforecastedlevelis259
Ifa90%forecastintervalforthegrowthis
[1%,4%],the90%intervalforthelevelis
[256,263]

EstimationwithUnitRoots
Ifaserieshasaunitroot,itisnonstationary,
sothemeanandvariancearechangingover
time.
Classicalestimationtheorydoesnotapply
However,leastsquaresestimationisstill
consistent

ConsistentEstimation
Ifthetrueprocessis

yt = yt 1 + et
AndyouestimateanAR(1)

yt = + yt 1 + et
Thenthecoefficientestimateswillconvergein
probabilitytothetruevalues(0and1)asT
getslarge

Exampleonsimulateddata
N=50

N=200

N=400

Modelwithdrift
Ifthetruthis

yt = + yt 1 + et
AndyouestimateanAR(1)withtrend

yt = + t + yt 1 + et
Thenthecoefficientestimatesconvergein
probabilitytothetruevalues(,0,1)
Itisimportanttoincludethetimetrendinthis
case.

Examplewithsimulateddatawithdrift
N=50

N=200

NonStandardDistribution
Aproblemisthatthesamplingdistributionof
theleastsquaresestimatesandtratiosare
notnormalwhenthereisaunitroot
Criticalvaluesquitedifferentthan
conventional

Densityoftratio

NonNormal
Negativebias

TestingforaUnitRoot
Nullhypothesis:
Thereisaunitroot

InAR(1)
Coefficientonlaggedvariableis1

InAR(k)
Sumofcoefficientsis1

AR(1)Model
Estimate

yt = + yt 1 + et
Orequivalently

yt = + yt 1 + et
= 1

Testfor=1sameastestfor=0.
Teststatisticistratioonlaggedy

AR(k+1)model
Estimate

yt = + yt 1 + 1yt 1 + L + k yt k + et
Testfor=0
CalledADFtest
AugmentedDickeyFuller
(TestwithoutextralagsiscalledDickeyFuller,test
withextralagscalledAugmentedDickeyFuller)

TheoryofUnitRootTesting
WayneFuller(IowaState)
DavidDickey(NCSU)
DevelopedDFandADFtest

PeterPhillips(Yale)
Extendedthedistribution
theory

STATAADFtest
dfuller t3,lags(12)
ThisimplementsaADFtestwith12lagsof
differenceddata
EquivalenttoanAR(13)
Alternatively
reg d.t3L.t3L(1/12).d.t3

Example:3monthTbill

Example:3monthTbill

Thepvalueisnotsignificant
Equivalently,thestatisticof2isnotsmaller
thanthe10%criticalvalue
Donotrejectaunitrootfor3monthTBill

JamesMacKinnon
QueensUniversity
Computedpvaluefunction

Alternatively

ThetforL1.t3is2
Ignorereportedpvalue,comparewithtable

InterestRateSpread

ADFtestforSpread

Thetestof4.8issmallerthanthecriticalvalue
Thepvalueof.0001ismuchsmallerthan0.05
Werejectthehypothesisofaunitroot
Wefindevidencethatthespreadisstationary

TestingforaunitRootwithTrend
Iftheserieshasatrend

yt = + yt 1 + t + 1yt 1 + L + k yt k + et
Againtestfor=0.
dfuller y,trendlags(2)

Example:Log(RGDP)
ADFwith2lags

Thepvalueisnotsignificant.
Wedonotrejectthehypothesisofaunitroot
Consistentwithforecastinggrowthrates,notlevels.

UnitRootTestsinPractice
Examineyourdata.
Isittrended?
Doesitappearstationary?

Ifitmaybenonstationary,applyADFtest
Includetimetrendiftrended

Iftestrejectshypothesisofaunitroot
Theevidenceisthattheseriesisstationary

Ifthetestfailstoreject
Theevidenceisnotconclusive
Manyusersthentreattheseriesasifithasaunitroot
Differencethedata,forecastchangesorgrowthrates

SpuriousRegression
Oneproblemcausedbyunitrootsisthatit
caninducespuriouscorrelationamongtime
series
CliveGrangerandPaulNewbold (1974)
Observedthephenomenon
PaulNewbold aUWPhD(1970)

PeterPhillips(1987)
Inventedthetheory

SpuriousRegression
Supposeyouhavetwoindependenttime
seriesyt andxt
Supposeyouregressyt onxt
Sincetheyareindependent,youshould
expectazerocoefficientonxt andan
insignificanttstatistics,right?

Example
TwoindependentRandomWalks

Regressionofyonx

Xhasanestimatedcoefficientof.6
Atstatisticof18!Highlysignificant!
Butxandyareindependent!

SpuriousRegression
Thisisnotanaccident
Ithappenswheneveryouregressarandom
walkonanother.
Traditionalimplication:
Dontregresslevelsonlevels
Firstdifferenceyourdata

Evenbetter
Makesureyourdynamicspecificationiscorrect
Includelagsofyourdependentvariable

DynamicRegression
Regressyonlaggedy,plusx

Nowxhasinsignificanttstatistic,andmuch
smallercoefficientestimate
Coefficientestimateonlaggedyiscloseto1.

Message
Ifyourdatamighthaveaunitroot
TryanADFtest
Considerforecastingdifferencesorgrowthrates
Alwaysincludelaggeddependentvariablewhen
seriesishighlycorrelated