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

ThisissameasTrendplusrandomwalk

Examples

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

OptimalForecastsinLevels
RandomWalk

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

RandomWalkwithdrift

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

Sotheforecasterrorfromanhstepforecastis

= yt h + et h +1 + L + et +1 et h +1 + L + et +1
2

Whichhasvariance
2

+L + = h

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

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 Atstaitsitc of18!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