Macroeconometrics sections

dr Piotr Wjcik
2010/2011

Lab 4. Non-stationarity and its testing, cointegration testing and Error

Correction Model
4.1. Non-stationarity and its testing ADF, KPSS and PP tests
Non-stationarity of time series is an important problem as it tremendously impacts
the way in which data should be treated. Non-stationary data cannot be analyzed with
traditional econometric techniques as in case of non-stationarity some basic model
assumptions are not met and correct reasoning on relationships between non-stationary
time-series is impossible. Thats why it is so important to be able to test stationarity of the
data. The easiest way is to draw a figure of the series and visually inspect it.
Data DHSY.wf1. Lets start with a plot of variable cons.
CONS
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100,000
50,000
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From the above figure it is obvious that consumption series is not stationary since it is
increased upward as time changes. However increasing pattern of the series is not always an
indication of non-stationarity. The process might be stationary around the trend line - it is
called deterministic non-stationarity. How can we transform the time series data from nonstationary to stationary? We need to work on differenced series. But will taking first
differences be enough to obtain stationarity (for economic time series most of the time
taking first differences is enough)? To answer that question we need to run a formal test.
The most popular test of non-stationarity (unit root) is the (Augmented) Dickey-Fuller
test with null hypothesis of non-stationarity. In Eviews You can get results for three different
variants of the test: without constant and trend, with constant only and with constant and
trend the middle variant is the most commonly used one.
Whenever conducting any statistical test remember that what one really needs to
know is the null hypothesis and the p-value (probability) of the test statistic. Tests are always
done at some confidence level and whenever the p-value of the test statistic is lower than
assumed confidence level the null hypothesis is rejected. When the opposite is true - pvalue is higher than , the null cannot be rejected (remember that in statistics one never
accepts statistical hypothesis).
Lets run ADF test for consumption series.
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Macroeconometrics sections
dr Piotr Wjcik
2010/2011

View Unit Root Test

One needs to choose from wide range of tests, select if it will be conducted for
variable in levels, its first or second differences. Then one has to choose whether to include a
constant and/or trend and if the number of lags in test augmentation should be chosen
automatically (based on information criteria) or by user. Lets leave the default settings.
Null Hypothesis: CONS has a unit root
Exogenous: Constant
Lag Length: 8 (Automatic - based on SIC, maxlag=12)

Augmented Dickey-Fuller test statistic

Test critical values:
1% level
5% level
10% level

t-Statistic

Prob.*

0.751908
-3.498439
-2.891234
-2.582678

0.9927

*MacKinnon (1996) one-sided p-values.

We cannot reject the null about non-stationarity. As ADF test does not have strong
power, one can verify the decision by using for example KPSS or PP test. Please note that in
case of KPSS test the null hypothesis is different: it assumes stationarity of the variable of
interest. Philips-Perron test has the same null hypothesis as ADF.
View Unit Root Test

Macroeconometrics sections
dr Piotr Wjcik
2010/2011

Null Hypothesis: CONS is stationary

Exogenous: Constant
Bandwidth: 9 (Newey-West automatic) using Bartlett kernel
LM-Stat.
Kwiatkowski-Phillips-Schmidt-Shin test statistic
Asymptotic critical values*:
1% level
5% level
10% level

1.116440
0.739000
0.463000
0.347000

*Kwiatkowski-Phillips-Schmidt-Shin (1992, Table 1)

The results differ from ADF test as KPSS does not provide a p-value, showing different
critical values instead. In this case we compare the test statistic value with the critical value
on desired significance level. If the test statistic is higher than the critical value, we reject the
null hypothesis and when test statistic is lower than the critical value, we cannot reject the
null hypothesis. Knowing that we can observe that KPSS test results for consumption series
are in line with the above ADF test. We reject the null hypothesis, so consumption is not
stationary.
Philips-Perron test
Null Hypothesis: CONS has a unit root
Exogenous: Constant
Bandwidth: 8 (Newey-West automatic) using Bartlett kernel

Phillips-Perron test statistic

Test critical values:
1% level
5% level
10% level

Adj. t-Stat

Prob.*

0.978450
-3.493129
-2.888932
-2.581453

0.9962

*MacKinnon (1996) one-sided p-values.

In PP test the null hypothesis is analogous to ADF. We cannot reject the null about nonstationarity of consumption.
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Macroeconometrics sections
dr Piotr Wjcik
2010/2011

Next we will check if first differences of consumption are a stationary process. We

can do this simply by checking additional option in Unit Root test window:
View Unit Root Test
Lets select testing for first differences instead of levels.
ADF test
Null Hypothesis: D(CONS) has a unit root
Exogenous: Constant
Lag Length: 7 (Automatic - based on SIC, maxlag=12)

Augmented Dickey-Fuller test statistic

Test critical values:
1% level
5% level
10% level

t-Statistic

Prob.*

-2.753939
-3.498439
-2.891234
-2.582678

0.0688

*MacKinnon (1996) one-sided p-values.

KPSS test
Null Hypothesis: D(CONS) is stationary
Exogenous: Constant
Bandwidth: 8 (Newey-West automatic) using Bartlett kernel
LM-Stat.
Kwiatkowski-Phillips-Schmidt-Shin test statistic
Asymptotic critical values*:
1% level
5% level
10% level

0.255785
0.739000
0.463000
0.347000

*Kwiatkowski-Phillips-Schmidt-Shin (1992, Table 1)

PP test
Null Hypothesis: D(CONS) has a unit root
Exogenous: Constant
Bandwidth: 7 (Newey-West automatic) using Bartlett kernel
Adj. t-Stat

Prob.*

Macroeconometrics sections
dr Piotr Wjcik
2010/2011

Phillips-Perron test statistic

Test critical values:
1% level
5% level
10% level

-11.33818
-3.493747
-2.889200
-2.581596

0.0000

*MacKinnon (1996) one-sided p-values.

The ADF test result shows that first differences of consumption are still nonstationary, but the p-value is close to 5%. The two remaining tests (with higher power)
indicate that first differences of the series are already stationary.
Lets plot these first differences. To do that we need to have differenced values stored
as a new variable. Therefore we generate new series of first differences by writing:
genr dcons = d(cons)
in command window and then plot it.
Differenced CONS
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Exercises 4.1
Exercise 4.1.1
Plot a figure of income (inc) from DHSY.wf1. What conclusions about stationarity can You
draw?

Exercise 4.1.2
Test formally (non)stationarity of income.

Exercise 4.1.3
Test formally (non)stationarity of first differences of income. What is the level of integration
of that series?

Macroeconometrics sections
dr Piotr Wjcik
2010/2011

4.2. modeling long run relationships; cointegration definition and testing

Dane DHSY.wf1
Cointegration means the long run relationship between non-stationary time series. If
there are series (two or more) that are individually non-stationary (have to be integrated of
the same order), but there exists their linear combination which is stationary - we call it
cointegration. Visual inspection of the series expected to be cointegrated is always a good
idea.
Lets start with the plot of consumption and income on one graph.
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CONS

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INC

We will test cointegration by two-step Engle-Granger procedure. Both variables have

to be integrated of the same order. So in the beginning we check the order of integration of
consumption and income (ADF test) we already did it, both are I(1).
Because both series are integrated of the same order, we can test cointegration
between them, so lets start Engle-Granger procedure. First we run a simple regression of
one variable on the other saving the residuals.
Open variables as a group and select Proc Make Equation making a regression of one on
the other (eg. cons on inc).
Dependent Variable: CONS
Method: Least Squares
Date: XX/XX/XX Time: XX:XX
Sample (adjusted): 1980Q1 2006Q2
Included observations: 106 after adjustments
Variable

Coefficient

Std. Error

t-Statistic

Prob.

Macroeconometrics sections
dr Piotr Wjcik
2010/2011

INC
C

0.859174
-4527.759

0.003458
947.5534

248.4531
-4.778368

0.0000
0.0000

The coefficients of the regression are parameters of the potential cointegrating vector.
Lets save model residuals (from regression results window select Proc Make Residual
Series) under a default name resid01.
Second step of testing cointegration is checking the stationarity of saved residuals. If
residuals are stationary, there is a cointegrating relationship between analyzed variables. If
residuals are non-stationary - cointegration does not exist. Lets use ADF and KPSS tests again.
Null Hypothesis: RESID01 has a unit root
Exogenous: Constant
Lag Length: 4 (Automatic - based on SIC, maxlag=12)

Augmented Dickey-Fuller test statistic

Test critical values:
1% level
5% level
10% level

t-Statistic

Prob.*

-2.348439
-3.496346
-2.890327
-2.582196

0.1591

Null Hypothesis: RESID01 is stationary

Exogenous: Constant
Bandwidth: 9 (Newey-West automatic) using Bartlett kernel
LM-Stat.
Kwiatkowski-Phillips-Schmidt-Shin test statistic
Asymptotic critical values*:
1% level
5% level
10% level

0.065520
0.739000
0.463000
0.347000

*Kwiatkowski-Phillips-Schmidt-Shin (1992, Table 1)

The ADF test used here has the null hypothesis of non-stationarity, so lack of
cointegration. The result indicates that we cannot reject the hypothesis, that there is no
cointegration between consumption and income.
However if we conduct KPSS test its test statistic is equal to 0.065520 and is lower
than any of critical values provided, so we cannot reject the null hypothesis about
stationarity of residuals. As KPSS test is more powerful finally we conclude that cointegration
between consumption and income exists.

Macroeconometrics sections
dr Piotr Wjcik
2010/2011

A note: the critical values of ADL test for cointegration (applied to residuals from regression)
are different than those for an ADL test for data series. However often the latter are used as
an approximation of the first.
What is the cointegrating vector and how to interpret it?

Exercise 4.2
Test the existence of cointegration between lcons and linc series. Save the residuals from the
cointegrating equation.

4.3. ECM model (Error Correction Mechanism)

After having found cointegration we can build an Error Correction Model including short
term and long term relationships. For a relationship between consumption and income the
simplest ECM model on quarterly data would take a form:

where 1 will be interpreted as short run reactions of consumption to changes in income and
2 will show the speed of return in direction of the long run relationship in case of shocks.
Therefore 2 is expected to be negative. Parameter is a part of cointegrating vector and in
fact instead of (const41inct4) we will use the residuals saved in the Engle-Granger
cointegration testing procedure.
Lets estimate the model. First we generate new variables using command window:
genr d4cons=cons-cons(-4)
genr d4inc=inc-inc(-4)
And estimate the equation using resid01 (residuals from regression of consumption on
income):
Quick Es8mate equa8on
d4cons d4inc resid01(-4) c
Dependent Variable: D4CONS
Method: Least Squares
Date: XX/XX/XX Time: XX:XX
Sample (adjusted): 1981Q1 2006Q2
Included observations: 102 after adjustments
Variable

Coefficient

Std. Error

t-Statistic

Prob.

D4INC

0.809292

0.014721

54.97558

0.0000

Macroeconometrics sections
dr Piotr Wjcik
2010/2011

RESID01(-4)
C

-0.247943
794.4788

R-squared
Adjusted R-squared
S.E. of regression
Sum squared resid
Log likelihood
F-statistic
Prob(F-statistic)

0.067714
342.9067

0.968726
0.968094
2718.707
7.32E+08
-949.8162
1533.269
0.000000

-3.661614
2.316895

Mean dependent var

S.D. dependent var
Akaike info criterion
Schwarz criterion
Hannan-Quinn criter.
Durbin-Watson stat

0.0004
0.0226
12512.98
15220.38
18.68267
18.75988
18.71393
1.376130

The model seems to be correct as the coefficient at error correction term is negative
and statistically significant. However, the value of Durbin Watson statistic is quite low
(1.376130), suggesting positive first order autocorrelation of residuals. The easiest solution
would be to add autoregression to the model, so include among independent variables the
lagged value(s) of consumption differential or lagged error terms (assuming autoregressive
residual structure). Lets estimate below model:

Quick Es8mate equa8on

d4cons d4inc resid01(-4) ar(1) c
Dependent Variable: D4CONS
Method: Least Squares
Date: XX/XX/XX Time: XX:XX
Sample (adjusted): 1981Q2 2006Q2
Included observations: 101 after adjustments
Convergence achieved after 6 iterations
Variable

Coefficient

Std. Error

t-Statistic

Prob.

D4INC
RESID01(-4)
C
AR(1)

0.799382
-0.159899
964.3709
0.367881

0.019522
0.061641
493.4736
0.099494

40.94716
-2.594017
1.954250
3.697506

0.0000
0.0110
0.0536
0.0004

R-squared
Adjusted R-squared
S.E. of regression
Sum squared resid
Log likelihood
F-statistic
Prob(F-statistic)

0.972255
0.971396
2582.178
6.47E+08
-934.7673
1133.022
0.000000

Mean dependent var

S.D. dependent var
Akaike info criterion
Schwarz criterion
Hannan-Quinn criter.
Durbin-Watson stat

12421.01
15267.78
18.58945
18.69302
18.63138
1.981408

Macroeconometrics sections
dr Piotr Wjcik
2010/2011

Inverted AR Roots

.37

How to interpret the results? Is AR(1) term enough to get rid of autocorrelation in residuals?
Does the error correction mechanism exist?

Exercise 4.3
Estimate ECM model for log consumption and log income and interpret the results.

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