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Unit Root Test

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yt = T Dt + T St + Ct = T Dt + Zt

The basic issue in unit root testing is to determine if

T St = 0. Two classes of tests, called unit root tests,

have been developed to answer this question:

I(0))

I(1))

1.1

yt = yt1 + ut, ut I(0)

The null and alternative hypothesis are

H0 : = 1 ((z) = 0 has a unit root)

H1 : || < 1 ((z) = 0 has root outside unit circle)

The most popular of these tests are the Dickey-Fuller

(ADF) test and the Phillips-Perron (PP) test. The

ADF and PP tests dier mainly in how they treat

serial correlation in the test regressions.

1. ADF tests use a parametric autoregressive structure to capture serial correlation

(L)ut = t

(L) = 1 1L k Lk

2. PP tests use non-parametric corrections based on

estimates of the long-run variance of yt.

1.2

Stationarity Tests

The first is based on the Wold representation

yt = (L)t, t iid(0, 2)

The null and alternative hypotheses are

H0 : (1) = 0 ( (z) = 0 has a unit root)

H1 : (1) > 0 ( (z) = 0 has roots outside unit circle)

The second is based on the UC-ARIMA model

yt

t

(L)Ct

cov(t, t)

=

=

=

=

t + Ct

t1 + t, t iid(0, 2 )

(L) t, t iid(0, 2 )

0

H0 : 2 = 0 (t = 0)

H1 : 2 > 0 (t = 0 +

t

X

j=1

j )

(L) is equivalent to testing 2 = 0.

Intuition: Recall the random walk plus noise model.

The reduced form is an MA(1) model with moving

average root given by

=

(q + 2) +

2

q = 2

q 2 + 4q

MA(1) model has a unit moving average root.

The most popular stationarity tests are the KitawoskiPhillips-Schmidt-Shin (KPSS) test and the LeyborneMcCabe test. As with the ADF and PP tests the

KPSS and Leyborne-McCabe tests dier main in how

they treat serial correlation in the test regressions.

1.3

In practice, however, there are a number of diculties:

non-normal asymptotic distributions.

These distributions are functions of standard Brownian motions, and do not have convenient closed

form expressions. Consequently, critical values

must be calculated using simulation methods.

deterministic terms, e.g. constant, time trend,

dummy variables, and so dierent sets of critical values must be used for test regressions with

dierent deterministic terms.

1.4

yt = yt1 + t, where t WN(0, 2)

The hypotheses of interest are

H0 : = 1 (unit root in (z) = 0) yt I(1)

H1 : || < 1 yt I(0)

The test statistic is

t=1 =

SE()

= least squares estimate

d

)

T (

N (0, (1 2))

1

A

N , (1 2)

T

A

t=0 N (0, 1)

the above result gives

A

N (1, 0)

Problem: under the unit root null, {yt} is not stationary and ergodic, and the usual sample moments do not

converge to fixed constants. Instead, Phillips (1987)

showed that the sample moments of {yt} converge to

random functions of Brownian motion:

T 3/2

T

X

yt1

Z 1

W (r)dr

0

t=1

Z 1

T

X

d

2

T 2

yt1

2

W (r)2dr

0

t=1

Z 1

T

X

d

T 1

yt1t 2

W (r)dW (r)

0

t=1

process) defined on the unit interval.

A Wiener process W () is a continuous-time stochastic process, associating each date r [0, 1] a scalar

random variable W (r) that satisfies:

1. W (0) = 0

W (t2)W (t1), W (t3)W (t2), . . . , W (tk )W (tk1)

are independent normal with

W (s) W (t) N (0, (s t))

3. W (s) is continuous in s.

unit root null H0 : = 1

R1

d 0 W (r)dW (r)

1)

T (

R1

2

0 W (r) dr

R1

W (r)dW (r)

d

t=1 R0

1 W (r)2dr 1/2

0

For example,

1

T

X

2

1 =

yt1

yt1t

t=1

t=1

1

T

T

X

X

2

1) = T 2

T (

yt1

T 1

yt1t

t=1

t=1

Z

!1 Z

1

1

d

2

W (r) dr

W (r)dW (r)

0

0

T

X

p

is super-consistent; that is,

at rate T

instead of the usual rate T 1/2.

t=1 is not asymptotically standard normal.

The limiting distribution of t=1 is called the DickeyFuller (DF) distribution and does not have a closed

form representation. Consequently, quantiles of

the distribution must be computed by numerical

approximation or by simulation.

1) has a well

Since the normalized bias T (

defined limiting distribution that does not depend

on nuisance parameters it can also be used as a

test statistic for the null hypothesis H0 : = 1.

> qnorm(c(0.01,0.05,0.10))

[1] -2.326 -1.645 -1.282

> qunitroot(c(0.01,0.05,0.10), trend="nc")

[1] -2.565 -1.941 -1.617

The usual one-sided 5% critical value for standard normal is 1.645

The one-sided 5% critical value for the DF distribution

is 1.941

Note: 1.645 is the 9.45% quantile of the DF distribution

1.5

Trend Cases

the null and alternative hypotheses appropriately to

characterize the trend properties of the data at hand.

or decreasing trend, then the appropriate null and

alternative hypotheses should reflect this.

The trend properties of the data under the alternative hypothesis will determine the form of the

test regression used.

The type of deterministic terms in the test regression will influence the asymptotic distributions of

the unit root test statistics.

1.5.1

yt = c + yt1 + t

and includes a constant to capture the nonzero mean

under the alternative. The hypotheses to be tested

are

H0 : = 1, c = 0 yt I(1) without drift

This formulation is appropriate for non-trending economic and financial series like interest rates, exchange

rates, and spreads.

1) are computed

The test statistics t=1 and T (

from the above regression. Under H0 : = 1, c =

0 the asymptotic distributions of these test statistics

are influenced by the presence, but not the coecient

value, of the constant in the test regression:

where

R1

(r)dW (r)

W

0

1)

T (

R1

2

0 W (r) dr

R1

W (r)dW (r)

0

t=1 R

1 W (r)2dr 1/2

0

W (r) = W (r)

Z 1

0

W (r)dr

Z 1

0

W (r) = 0

and Watson (1989) ECTA.

Note: inclusion of a constant pushes the distributions

1) to the left:

of t=1 and T (

> qunitroot(c(0.01,0.05,0.10), trend="c")

[1] -3.430 -2.861 -2.567

> qunitroot(c(0.01,0.05,0.10), trend="c",

+

statistic="n")

[1] -20.62 -14.09 -11.25

Note: 1.645 is the 45.94% quantile of the DF distribution!

1.5.2

yt = c + t + yt1 + t

and includes a constant and deterministic time trend

to capture the deterministic trend under the alternative. The hypotheses to be tested are

H0 : = 1, = 0 yt I(1) with drift

This formulation is appropriate for trending time series like asset prices or the levels of macroeconomic

aggregates like real GDP. The test statistics t=1 and

1) are computed from the above regression.

T (

of these test statistics are influenced by the presence

but not the coecient values of the constant and time

trend in the test regression.

where

R1

(r)dW (r)

W

0

1)

T (

R1

2

0 W (r) dr

R1

W (r)dW (r)

0

t=1 R

1 W (r)2dr 1/2

0

Z

1

1

1

2 0

2

is a de-meaned and de-trended Wiener process.

The inclusion of a constant and trend in the test regression further shifts the distributions of t=1 and

1) to the left.

T (

> qunitroot(c(0.01,0.05,0.10), trend="ct")

[1] -3.958 -3.410 -3.127

> qunitroot(c(0.01,0.05,0.10), trend="ct",

+

statistic="n")

[1] -29.35 -21.70 -18.24

Note: 1.645 is the 77.52% quantile of the DF distribution!

1.6

time series yt is well characterized by an AR(1)

with white noise errors.

more complicated dynamic structure than is captured by a simple AR(1) model.

Said and Dickey (1984) augment the basic autoregressive unit root test to accommodate general ARMA(p, q) models with unknown orders and

their test is referred to as the augmented DickeyFuller (ADF) test

Basic model

yt = 0Dt + yt1 + ut

(L)ut = (L)t, t WN(0, 2)

The ADF test tests the null hypothesis that a time series yt is I(1) against the alternative that it is I(0), assuming that the dynamics in the data have an ARMA

structure. The ADF test is based on estimating the

test regression

yt = 0Dt + yt1 +

p

X

j ytj + t

j=1

Dt = deterministic terms

ytj captures serial correlation

The ADF t-statistic and normalized bias statistic are

1

ADFt = t=1 =

SE()

1)

T (

ADFn =

1

p

1

Result: ADFt,ADFn have same asymptotic distribu 1) under white noise errors

tions as t=1 and T (

provided p is selected appropriately.

yt = 1yt1 + 2yt2 + t

= 1yt1 + (2yt1 2yt1) + 2yt2 + t

= (1 + 2)yt1 2yt1 + t

= yt1 + yt1 + t

where

= (1 + 2)

= 2

Remarks:

has non-normal distribution

yt1 I(1)

has normal distribution!

yt1 I(0)

Derivation requires trick from Sims, Stock and

Watson (1989) ECTA

Important results:

yt = 1yt1 + 2yt2 + t

the model may be reparameterized such that 2

is the coecient on an I(0) variable

yt = (1 + 2)yt1 2yt1 + t

The

that

2 has an asymptotic normal distribution.

= 1 + 2 is the coecient on an I(0) variable.

It is the coecient on an I(1) variable. Therefore,

has an asymptotic unit root distribution.

yt = 0Dt + yt1 +

p

X

j ytj + t

j=1

= 1

Under the null hypothesis,

yt I(0) = 0.

The ADF t-statistic and normalized bias statistics are

ADFt = t=0 =

SE()

T

ADFn =

1

p

1

and these are equivalent to the previous statistics.

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