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COINTEGRATION
Alicia N. Rambaldi
Week 6
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In this lecture
Readings
Introduction
Spurious Regression vs Cointegration
Spurious Regression
Cointegration
Introduction to Cointegration
Definition of Cointegration
Cointegration Order
Example
Testing for Cointegration
Properties of the OLS estimator in the case of cointegration.
Testing the cointegration space
Non-Uniqueness of
Coming Up
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Reference Materials
Author
Title
Chapter
Call No
Enders, W
Applied
Econometric
Time Series,
3e
A Guide to
Modern
Econometrics
6.16.2
HB139 .E55
2015
9.2,9.3
HB139
.V465 2012
Verbeek, M
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Spurious Regression
I
Cointegration
I
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Spurious Regression
I
yt =
+ xt + et
I
and use a t
test to test
H0 :
= 0 against H1 :
6= 0
1
T2
! N(0, V ).
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What happens as T ! 1?
I
T 2(
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If they wander in the same direction for a while (say for the
time of the observed sample), there appears to be a
relationship.
In:
I
I
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Cointegration
+ t
where t I (0)
Thus if
xt = ast + x,t where x,t I (0) then xt I (1)
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Recall
Now assume
Then
xt
I
I
a(st + y ,t )
ast
ay ,t
ay ,t which is I (0)
ayt
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Definition of Cointegration
I
Definition
wt I (d
b), b > 0
Cointegration Order
I
wt0 I (0)
where
0
wt = w1,t
+ ...wn,t n
0
1
w1,t
B w2,t C
B
C
= ( 1 , 2 , ..., n )0 B . C
@ .. A
1
+ w2,t
wn,t
xt
1
wt =
and =
yt
a
I
because xt
ayt I (0).
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Example
King, R.G., C.I. Plosser, J.H. Stock, and M.W. Watson (1991).
"Stochastic trends and economic fluctuations." The American
Economic Review, 81,819-840.
Yt =
1
t Kt L t
yt = ln( t ) + kt + (1
ln( t ) = ln(
t 1)
)lt
+ t
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Example
(cont.)
The economys resource constraint implies that output is either
consumed or invested, Yt = Ct + It , and with common stochastic
Ct
It
trends ( t ) the ratios
and
(the Great Ratios) are stable.
Yt
Yt
Therefore, in logs, ct yt and it yt must be I (0) and ct , yt , and
it are I (1) but cointegrate.
That is
0
1
ct
1
0
b
c t + b 1 yt
1
0
@
A
it
wt =
=
I (0)
0 1 b2
i t + b 2 yt
yt
We also know from the theory that we can restrict b1 =
b2 = 1.
1 and
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Estimate: xt =
+ 1 yt + 2 zt + et (by OLS)
Test the residual, et , for a unit root. If et I (0), then
xt , yt , and zt cointegrate.
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Example
Expectations theory of the term structure of interest rates implies
the following empirically testable feature
If i3y ,t I (1) then i5y ,t I (1) and i5y ,t
i3y ,t I (0)
That is, the long and short interest rates will cointegrate
We had computed:
i3y ,t : Augmented Dickey-Fuller test statistic -1.253373, p-value (0.6433)
i5y ,t : Augmented Dickey-Fuller test statistic -1.199108, p-value(0.6673)
Thus, they are I (1)
i5y ,t
I
I
i3y ,t
H0 : et = i5y ,t i3y ,t I (1) ,
That is, the long and short interest rates will cointegrate and
we know the cointegrating relation is = (1, 1).
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Example
We estimate with T = 48
i5y ,t = 0.798116 + 0.945139i3y ,t + et
et =
0.398300et
+ t
(0.116301)
I
I
I
Example
We estimate with T = 48
i5y ,t = 0.798116 + 0.945139i3y ,t + et
DW = CRDW = 1.654472
I
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will be
Normally,
! 0 and T 2
With cointegration
! N(0, V )
1
! 0 and T 2
!0
T
! N(0, V )
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i3y ,t I (0)
Put another way, if i3y ,t I (1) then i5y ,t I (1) because they
share a common stochastic trend AND the cointegrating vector for
the cointegrating relation is = (1, 1)0 .
I
1
ct
consumption
income
Assume wt = @ yt A
at
wealth (assets)
I
Examples
Permanent income hypothesis says
zt = ct -yt = ( 1
1 )
ct
yt
I (0).
yt and
t + et
z1,t =
+ ba
I
Note that
can be interpreted as the mean of the error
correction term zt .
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Non-Uniqueness of
Recall cointegration with stochastic trend st where wt = (xt , yt )0
xt = ast + x,t where x,t I (0) so xt I (1) and
yt = st + y ,t where y ,t I (0) so yt I (1)
Then,
wt = (1, a)
= xt
= x,t
ayt
xt
yt
ay ,t which is I (0)
Non-Uniqueness of
I
(cont.)
However,
I
wt = (2, 2a)
= 2(xt
= 2(x,t
Thus we normalise,
ayt )
xt
yt
ay ,t ) which is I (0)
unique.
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Example
in the Real Business Cycle model with Balanced Growth Hypthesis
(King et al.,1991) we had three variables (ct , it , yt ) and one
common stochastic trend - productivity shocks.
I
3
1 0
=4 0 1 5
b1 b2
I
Coming Up
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