Cointegration for the

Applied Economist
Second Edition

Edited by

B. Bhaskara Rao
Contents

List of Tables x
List of Figures and Screens xiii
Preface to the First Edition xiv
Preface to the Second Edition xvi
Notes on Contributors xviii

1 Introduction 1
B. Bhaskara Rao •
1.1 Introduction 1
1.2 Unit roots and cointegration 1
1.3 Economic implications 3
1.4 An overview of the papers 5
1.5 Concluding observations 8
2 A Primer on Cointegration with an Application
to Money and Income 10
David A. Dickey, Dennis W. Jansen and Daniel L. Thornton
2.1 Introduction 10
2.2 Testing for cointegration: a general framework 11
2.2.1 Locating stationary linear combination
of variables 12
2.2.2 Multiple cointegrating vectors 13
2.2.3 Tests for cointegration and their relation
to unit root tests 15
2.3 Is there an economic interpretation
of cointegration vectors? 16
2.3.1 Cointegration with exogenous variables 16
2.3.2 Should there be many or few
cointegrating vectors? 20
2.4 Alternative tests for cointegration 21
2.4.1 A note about distributions 22
2.4.2 Other approaches to cointegration 23
vi Contents

2.5 An application of cointegration: the

demand for money 24
2.5.1 The velocity of Ml and M2 25
2.5.2 The velocity of the monetary base 28
2.5.3 Empirical results 28
2.5.4 Tests for the order of integration 29
2.5.5 Tests for cointegration using three
methodologies 29
2.5.6 Cointegration using alternative monetary
aggregates 32
2.5.7 Cointegration and the monetary base 34
2.6 Summary and conclusions 35
Appendix to Chapter 2 36

3 Unit Roots and Cointegration for

the Economist 43
Darryl Holden and Roger Perman
3.1 Introduction 43
3.2 Stationarity and unit roots 45
3.2.1 Stationary time series 45
3.2.2 The first order autoregressive process: AR(1) 45
3.2.3 Second order autoregressive case: AR(2) 50
3.3 Testing for unit roots 51
3.3.1 The Dickey-Fuller tests 51
3.3.2 The Augmented Dickey-Fuller regression 55
3.3.3 A suggested sequential procedure for unit
root testing 56
3.3.4 Phillips and Perron tests 59
3.3.5 Unit root tests and structural breaks 61
3.3.6 Trend and difference stationarity 63
3.4 The error correction mechanism (ECM) 64
3.5 Cointegration , 66
3.5.1 The cointegrating regression 70
3.5.2 Testing for cointegration 71
3.5.3 Estimating the ECM 72
3.5.4 Johansen procedure 74
3.6 Cointegration and econometric modelling 80
3.7 Concluding comments 83
Appendix to Chapter 3 84
 Contents vii

The Significance of Unit Roots and the Pitfalls

of Mechanical Statistics 101
Ron Smith
4.1 Introduction 101
4.2 Mechanical statistics 103
4.3 Applied econometrics 104
4.4 Significance 107
4.5 Unit roots 109
4.6 VARs, error correction and cointegration 115
4.7 Weak exogeneity 122
4.8 Identification 124
4.9 Conclusions 127
Unit Roots and Structural Breaks: A Survey
of the Literature 129
Joseph P. Byrne and Roger Perman
5.1 Introduction 129
5.2 Unit roots and ADF tests 130
5.3 Exogenous structural breaks 131
5.4 Endogenous structural breaks 132
5.5 Non-linear breaks and GLS detrending 134
5.6 Multiple structural breaks 135
5.6.1 Two structural breaks 136
5.6.2 Multiple breaks 136
5.7 Unit roots and structural breaks: applied
papers 137
5.8 Other issues 138
5.9 Conclusion 139
5.10 Software 141
New Unit Root Tests Designed for the
Trend-Break Stationary Alternative:
Simulation Evidence and Empirical
Applications 143
Amit Sen
6.1 Introduction 143
6.2 Model and test statistics 145
6.3 Finite sample size and power 159
6.4 Empirical applications 188
6.4.1 Extended Nelson-Plosser data set 188
viii Contents

6.4.2Real per capita GDP for 18

OECD countries 191
6.5 Conclusions 192
Appendix A 192
Appendix B 193
7 How to Deal with Structural Breaks
in Practical Cointegration Analysis? 195
Roselyne Joyeux
7.1 Introduction 195
7.2 Univariate case 196
7.2.1 Shift in intercept model 196
7.2.2 Shift in mean and trend model 198
7.2.3 Generalization to an AR(k) process 199
7.2.4 Generalization to the case of more than
one shift 199
7.3 Multivariate case 200
7.3.1 Shift in intercept model: none of the
p time series have a deterministic trend 202
7.3.2 Some or all of the time series follow a
trending pattern 203
7.3.3 Some or all of the time series follow a trending
pattern in each sub-sample and the
cointegrating relations are stationary
in each sub-sample (with possibly a
broken constant level); trend breaks are
allowed only in the non-stationary series 203
7.3.4 Unit root tests 203
7.4 Empirical illustration: A German
money-demand system 203
7.4.1 Description 203
7.4.2 The analysis 205
7.5 Conclusion 213
Appendix to Chapter 7 213
7A.1 Specification of the model: deterministic components ,
and exogenous variables 215
7A.2 Cointegration tests 215
7A.3 Empirical illustration: a German money-demand
system 216
7A. 4 Other important matters 221
 Contents ix

Panel Cointegration Analysis:

An Empirical Example 222
N.R. Vasudeva Murihy
8.1 Introduction 222
8.2 Model specification, data and cointegration
analysis 224
8.3 Empirical results 228
8.4 Conclusions 233
Appendix to Chapter 8 233

References 245
Index 257