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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