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ECON3350/7350

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 vs Cointegration

What are the implications for empirical economic research of


having I(1) variables?
I

Spurious Regression
I

Spurious Regressions or Cointegration


It is generally true that any combination of two I (1) variables
will also be I (1).
Conclude there is a significant relationship when there is none.

Cointegration
I

Linear combinations of I (1) variables are I (0).

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Spurious Regression
I

Assume xt = xt 1 + x,t and yt = yt


y ,t are independent white noise.

Clearly there is no relationship between xt and yt .

If we do not know the above and wish to test for a


relationship between xt and yt , we would normally estimate

+ y ,t where x,t and

yt =
+ xt + et
I

and use a t

test to test
H0 :

= 0 against H1 :

6= 0

If xt and yt were I (0), would be approximately Normal, t


would
Student t or at least
be approximately

1
T2
! N(0, V ).
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Spurious Regression (cont.)


I

But as xt and yt are I (1), the distribution of is more


disperse than Normal and the distribution of t is more disperse
that Student t.
P(|t| > 1.96) = P(Rejected H0 ) > 0.05

Implications: Tend to reject H0 too often

What happens as T ! 1?
I

Things get worse and there is no well defined asymptotic


distribution to which converges:
1

T 2(

) ! 1 and P(|t| > 1.96) increases

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Spurious Regression (cont.)


I

Indications of a Spurious regression:


Signicant t values; Respectable (sometimes high) R 2 ; low
Durbin-Watson (DW) statistics.

The signicant t - values occur because the random walks tend


to wander, and this wandering looks like a trend.

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

yt = + xt + t ; t I (1) so the regression is meaningless.


This explains why DW is low.

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Cointegration

Recall the concept of the stochastic trend


s t = st

+ t

where t I (0)

Any linear combination of st will be I (1).


I

Thus if
xt = ast + x,t where x,t I (0) then xt I (1)

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Common Stochastic Trend


I

How can two I (1) variables combine to form an I (0) variable?


I

Recall

xt = ast + x,t where x,t I (0) so xt I (1)

Now assume

yt = st + y ,t where y ,t I (0) so yt I (1)

Then

xt

ayt = (ast + x,t )


= ast + x,t
= x,t

I
I

a(st + y ,t )
ast

ay ,t

ay ,t which is I (0)

This is a case of cointegration.


The variables share a common stochastic trend: st .
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Cointegration and Equilibrium


I

The economic interpretation and signicance of cointegration

We may regard the cointegrating relation


z t = xt

ayt

as a stable equilibrium relation.


I

Although xt and yt are themselves unstable as they are I (1),


they are attracted to a stable relationship that exists between
them, zt I (0).

For example, there is strong evidence that interest rates are


I (1). But the spread between two rates of dierent maturities,
within the same market, appear to be I (0).

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Common Stochastic Trend


Example

CWTB3Y: Augmented Dickey-Fuller test statistic -1.253373, p-value (0.6433)


CWTB5Y: Augmented Dickey-Fuller test statistic -1.199108, p-value(0.6673)
SPREAD: Is it I (0)? We return to this question.

The expectations theory of the term structure of interest rates


would suggest that if the interest rates themselves are I (1), the
spread between rates of dierent maturity will be I (0) (Campbell
and Shiller,1991).
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Definition of Cointegration
I

It is possible for a cointegrating relation to involve many


variables. That is, wt may be a (n 1) vector. Also wt may
be integrated of order d.

A more formal definition of cointegration (Engle & Granger,


1987):

Definition

The components of the vector wt are said to be cointegrated of


order d, b, denoted CI (d, b), if
(i) all components of wt are I (d),
(ii) there exists a vector ( 6= 0) so that
zt =
The vector

wt I (d

b), b > 0

is called the cointegrating vector.


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Cointegration Order
I

If wt = (w1,t , w2,t , ..., wn,t )0 I (1) but


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

Then we say that components of the vector wt are


cointegrated of order 1, 1, denoted CI (1, 1).
I In our simple example above,

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

Income = f (Capital, Labour ) with technology/productivity shocks


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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Testing for Cointegration


I

Recall that if a vector of I (1) variables do not cointegrate,


then no combination of them will be I (0). However, if a vector
of I (1) variables DO cointegrate, then there is a combination
of them that will be I (0).

Simple solution: to test for cointegration.

Consider the case of three variables: xt , yt , and zt


I
I

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.

There are a number of ways we could perform this test. We


will look at using the Dickey-Fuller test statistic and the
Durbin-Watson statistic.

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Testing for Cointegration (cont.)

Because the residual et comes from a potential cointegrating


relation, the test statistics will not have the usual distributions
so we cannot use the same critical values.

In both tests we assume et = et


H0 : = 1.
I

+ t (t is WN) and test

The Augmented Dickey-Fuller test to test for cointegration.


We proceed as usual but use critical values from Table C in
Enders.
The Durbin-Watson test to test for cointegration (CRDW).
We proceed as usual but use critical values from Table 9.3 in
Verbeek.

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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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Residual Based Dickey Fuller Test (cont.)


I

For now, we will ignore the fact we know and let it be


estimated as = (1, b), so we are only going to test the first
part of the theory, i.e., that the two interest rates cointegrate.

Example
We estimate with T = 48
i5y ,t = 0.798116 + 0.945139i3y ,t + et
et =

0.398300et

+ t

(0.116301)
I
I
I

Augmented Dickey-Fuller test statistic= -3.424726


Critical value from Table C is -3.46 (at the 5% level) and -3.13
(at the 10%)
Therefore, we marginally reject the null hypothesis and
conclude there is some evidence to support the Expectations
theory.
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Residual Based CRDW


I

If the first order autocorrelation is one ( = 1) then the


DW ! 0. Thus, the DW of the cointegrating regression goes
to zero under the null hypothesis

Example
We estimate with T = 48
i5y ,t = 0.798116 + 0.945139i3y ,t + et
DW = CRDW = 1.654472
I

At the 5% the critical value (Table 9.3 in Verbeek) is 0.72 and


thus we reject H0 : et I (1) and conclude there is evidence for
the Expectations theory of the term structure of interest rates.

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Properties of the OLS estimator in the case of cointegration


I
I

The OLS estimator = (


, 1 , 2 )0 .
In the case of cointegration, the OLS estimator of
superconsistent.
I

will be

That is, although normal OLS estimates converge to N(0, V )


1
at the rate T 2 , the OLS estimate of a cointegrating vector
converges at the rate T .

Normally,

! 0 and T 2

With cointegration

! N(0, V )

1
! 0 and T 2
!0

T
! N(0, V )

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Testing the cointegrating space when there is one


cointegrating vector
Recall that the Expectations theory of the term structure of interest
rates implied
i3y ,t I (1) then i5y ,t I (1) and i5y ,t

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

Thus we can test the evidence in support of this theory by


simply calculating zt = i5y ,t i3y ,t and then testing zt I (0)
with a simple ADF.

If we Reject the null hypothesis of a unit root in zt , then if


i5y ,t I (1), then it must hold that i3y ,t I (1) because they
share a common stochastic trend and the cointegrating vector
is = (1, 1)0
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Testing the more explicit economic theories


0

1
ct
consumption
income
Assume wt = @ yt A
at
wealth (assets)
I

If we have a theory that says the cointegrating space is completely


known, e.g., = (1, 1, 1)0 say, then we can test the evidence in
support of this theory by constructing the variable zt = 0 wt and
doing a test for zt I (1) against zt I (0).

Examples
Permanent income hypothesis says
zt = ct -yt = ( 1

1 )

ct
yt

I (0).

To test this we test for stationarity of zt (with a simple ADF test).


If there is evidence of any form of nonstationarity then this can be
taken as evidence against the theory.
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The cointegrating space is partially known


I

Let the income consumption relation respond to levels of


wealth, e.g., = (1, 1, b)0 say, then

We can test the evidence in support of this


theory
by
c
t
constructing the variable z1,t = (1, 1)0
= ct
yt
regressing z1,t on at .

yt and

t + et
z1,t =
+ ba
I

Then test for stationarity of et . If using ADF, use


Cointegrating ADF statistics with, in this case, two variables.
-Table C Enders.

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)

Here = (1, a)0 because this combination cancelled the


stochastic trends.
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Non-Uniqueness of
I

(cont.)

However,
I

if 2 = (2, 2a)0 or = (1, a)0 for any kappa 6= 0 will also


work as 0 wt I (0).

wt = (2, 2a)
= 2(xt
= 2(x,t

Thus we normalise,

ayt )

xt
yt

ay ,t ) which is I (0)

= (1, a)0 to make

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

Thus, there are n = 3 variables, and n r = 1 common


stochastic trends. Therefore, r = 2, cointegrating vectors:
2

3
1 0
=4 0 1 5
b1 b2
I

Although much emphasis is placed upon estimating the


cointegrating vectors, except where r = 1, these vectors are
not interpretable as they are not unique.

What is unique is the cointegrating space. The cointegrating


vectors span (lie in) the cointegrating space.
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Coming Up

ARCH, GARCH, Stochastic Volatility and Realised volatility. Tests


for ARCH-type errors and model identification.

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