Cointegration

Dr. Prabir K Das

Indian Institute of Foreign Trade
 Introduction
• Cointegration is an econometric/statistical
property of more than one time series
variables
• All the series must be integrated of order d
• If the linear combination of these variables is
integrated of order less than d, then the linear
combination is said to be cointegrated
 Introduction…(cont’d.)
• Let X1, X2, and X3 are three time series each
integrated of order d, and for three
parameters α, β, and γ the linear combination
αX1+ β X2+ γ X3 is integrated of order less
than d, then X1, X2 and X3 are cointegrated.
 Cointegration
• PCE: Personal Consumtion Expenditure; I(1)
• PDI: Personal Disposable Income; I(1)
 Cointegating Regression

utis I(0)
Linear combination is stationary
Linear combination cancels out the stochastic trend
 Cointegration
• (Income-Consumption) is I(0).
• Regression of consumption on income is not
spurious.
• Two variables are cointegrated
• Economically speaking, two variables would
be integrated if they have long-run or
equilibrium relationship.
• Fisher’s quantity theory of money, theory of
purchasing parity.
 Cointegration
• A test for cointegration can be thought as a
pre-test to avoid spurious regression.
• Regression is known as cointegration
regression and slope parameter beta 2 is
known as cointegration parameter.
 Testing for Cointegration
• DF or ADF Unit root test on residuals
• Cointegrating regression Durbin Watson test
 Engle Granger Test
• Estimate regression equation
• Obtain residuals
• Carry out DF or ADF test (also known as Engle-
Granger or Augmented Engle-Granger test)
• Use Engle Granger critical values
Example
 Example…(Cont’d.)
• The Engle–Granger 1 percent critical τ value is
−2.5899. Since the computed τ (= t) value is
greater than the critical value, the null
hypothesis is rejected. Therefore, the residuals
from the regression of PCE on PDI are I(0);
that is, they are stationary.
 Example…(Cont’d.)
• Hence, (21.11.3) is a cointegrating regression
and this regression is not spurious, even
though individually the two variables are
nonstationary.
• One can call this equation the static or long
run consumption function and interpret its
parameters as long run parameters. Thus,
0.9672 represents the long-run, or equilibrium,
marginal propensity to consumer (MPC).
 Cointegrating Regression Durbin–Watson (CRDW) Test

• An alternative, and quicker, method of finding out

whether PCE and PDI are cointegrated is the CRDW
test, whose critical values were first provided by
Sargan and Bhargava.
• In CRDW we use the Durbin–Watson d obtained from
the cointegrating regression, such as d = 0.5316 given
in the equation. But now the null hypothesis is that d
= 0 rather than the standard d = 2.
• This is because earlier we observed that d ≈ 2(1− ˆρ),
so if there is to be a unit root, the estimated ρ will be
about 1, which implies that d will be about zero.
 Error Correction Mechanism
• We just showed that PCE and PDI are
cointegrated; that is, there is a longterm, or
equilibrium, relationship between the two. Of
course, in the short run there may be
disequilibrium. Therefore, one can treat the
error term in our PCE–PDI model as the
“equilibrium error.” And we can use this error
term to tie the short-run behavior of PCE to its
long-run value.
 Error Correction Mechanism
• The error correction mechanism (ECM) first
used by Sargan and later popularized by Engle
and Granger corrects for disequilibrium. An
important theorem, known as the Granger
representation theorem, states that if two
variables Y and X are cointegrated, then the
relationship between the two can be
expressed as ECM. To see what this means, let
us revert to our PCE–PDI example.
 Error Correction Mechanism
• ΔPCEt = α0 + α1PDIt + α2ut−1 + εt (21.11.5)
• where Δ denotes the first difference operator,
εt is a random error term, and ut−1 = (PCEt−1 −
β1 − β2PDIt−1), that is, the one-period lagged
value of the error from the cointegrating
regression.
 Error Correction Mechanism
• ECM equation (21.11.5) states that PCE
depends on PDI and also on the equilibrium
error term. If the latter is nonzero, then the
model is out of equilibrium.
 Error Correction Mechanism
• Suppose PDI is zero and ut−1 is positive. This
means PCEt−1 is too high to be in equilibrium,
that is, PCEt−1 is above its equilibrium value of
(α0 + α1PDIt−1). Since α2 is expected to be
negative, the term α2ut−1 is negative and,
therefore,PCEt will be negative to restore the
equilibrium.
 Error Correction Mechanism
• That is, if PCEt is above its equilibrium value, it
will start falling in the next period to correct
the equilibrium error; hence the name ECM.
By the same token, if ut−1 is negative (i.e., PCE
is below its equilibrium value), α2ut−1 will be
positive, which will cause CPEt to be positive,
leading PCEt to rise in period t.
 Error Correction Mechanism
• Thus, the absolute value of α2 decides how quickly
the equilibrium is restored. In practice, we estimate
ut−1 by ˆut−1 = (PCEt −ˆβ1 − ˆ β2PDIt).
 Error Correction Mechanism
• PCEt = 11.6918 + 0.2906PDIt − 0.0867 ˆut−1
• t = (5.3249) (4.1717) (−1.6003) (21.11.6)
• R2 = 0.1717 d = 1.9233
 Error Correction Mechanism
• Statistically, the equilibrium error term is zero,
suggesting that PCE adjusts to changes in PDI in
the same time period. As (21.11.6) shows, short-
run changes in PDI have a positive impact on
short-run changes in personal consumption. One
can interpret 0.2906 as the short-run marginal
propensity to consume (MPC); the long-run MPC
is given by the estimated (static) equilibrium
relation (21.11.3) as 0.9672.
 Applications
• Money supply
• Exchange rate
• Sopt price and future price
• Consumer price index
 Summary
• Dickey-Fuller unit root test is employed to test
whether the process has a unit root or not i.e. the
process is not stationary or stationary.
• Cointegration is a measure of long term dependency
between economic variables generating time series
observations.
• Cointegration analysis tests and models the long
term dynamics in the first step and models the short
term dynamics in the second step in a cointegrated
system.
 Journey Begins…
WISH YOU ALL THE BEST