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Exploring the Long-Run Relationship between GDP and Private Consumption

of Romania through Cointegration Analysis

Article · May 2014

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Raluca-Maria Bălă
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 Exploring the Long-Run Relationship between GDP and Private
Consumption of Romania through Cointegration Analysis

Raluca-Maria Bălă
Ph.D. student, Faculty of Cybernetics, Statistics and Economic Informatics / Department
of Statistics and Econometrics, Bucharest University of Economic Studies, Romania
ralucamaria.bala@gmail.com

Abstract that address other possible long-term

The Romanian economy has been for a
long time based on household consumption,
as the private consumption accounts for more
than 60% of GDP. The dependence between
GDP and private consumption is of great
importance for macroeconomic policies and
has been extensively analyzed through
econometric methods but the literature lacks
studies of their long-run comovement by
cointegration analysis.
This paper examines the long-run
relationship between GDP and private
(household) consumption of Romania
through cointegration analysis procedure.
Results from the unit root tests reveal
relatively conflicting outcomes and the
Engle-Granger two-step residual-based
cointegration procedure shows that GDP and
household consumption do not share a long-
run equilibrium relationship for the case of
Romania in contrast with the expected results
of the economic theory.
Keywords: Cointegration, GDP, Household
Consumption, Engle-Granger
J.E.L. classification: C22, E21, O11
1. Introduction
The article is exploratory in nature as the
purpose is to identify the existence of a long-
run comovement of GDP and private
consumption of Romania through
cointegration analysis.
The specialized literature regarding this
subject is limited in the case of Romania, a
study concerning specifically cointegration
between GDP and household consumption
being inexistent for this country.
However, there are a couple of articles
relationships in Romania such as the nexus:
GDP-government expenditures [1], GDP-
invesments-exports [2], GDP-electricity
consumption-capital [3] and other macro-
indicators [4].
Regarding the study of a long-run
relationship between GDP and household
consumption Knetsch [5] has identified
cointegration between GDP and private
consumption among other expenditure
components and compared the results in the
case of Germany, France and Italy.
Another case investigated by Gomez-
Zaldivar and Ventosa-Santaularia [6] found
GDP and consumption to be cointegrated in
the case of US but have not found long-term
relationship between the variables in the case
of Mexico.
For India, the results of a study regarding
this subject revealed no cointegration
between GDP and household consumption on
a small sample-size of 30 cases [7].
Also, an interesting research on causality
and cointegration between consumption and
GDP in 25 OECD countries conducted by
Guisan [8] revealed no cointegration among
the two variables in question in the case of
Britain, the author explaining this result as a
possible limitation of cointegration approach.
In this context, the present paper concerns
on how the consumption and GDP of
Romania behave on the long-run.
Considering this, the purpose of this paper is
to explore if GDP shares a common trend
with household consumption by having a
long-term relationship and if it is found such
a relationship, how rapidly this relationship
adjusts to its equilibrium after a shock
reflected by short-run dynamics.
Therefore as many studies show that there
is a strong influence of household
consumption over GDP, we chose to show
whether this dependence exists on the long-
run in the case of Romania and revealing a
possible long-term equilibrium relationship
between the two variables.
2. Data and method
The variables used for the analysis are
Gross Domestic Product (GDP) and
Household Final Consumption Expenditure
(CONS) and the data was retrieved from the
WorldBank Online Database for the available
period 1990-2012 (23 cases), measured in
constant 2005 U.S. $. GDP is the sum of
gross value added by all resident producers in
the economy plus any product taxes and
minus any subsidies not included in the value
of the products. Household final consumption
expenditure is the market value of all goods
and services, including durable products
(such as cars, washing machines, and home
computers), purchased by households. We
test whether the series GDP and CONS share
a long-term relationship through
cointegration analysis.
Two series are cointegrated if they are
integrated of the same order and the linear
combination of them is integrated of an order
at most equal to the order of the considered
series [9]. The general case of cointegrated
series is represented by two series that are
integrated of order one I(1) and the linear
combination of them is stationary or
integrated of order zero I(0). A series is said
to be stationary (in level) if the mean and the
variance are constant. In case the series is
non-stationary, through transformations like
differencing or detrending it will be obtained
a stationary series. Therefore the order of
integration is the number of subsequent
differences necessary to obtain a stationary
series [10].
In general, a regression involving the
levels of non-stationary series will produce
misleading results, with conventional tests
for coefficient significance spuriously
showing a significant relationship between
unrelated series [4], [11].
Considering the economic nature of the
variables GDP and CONS and their evolution
we can assume that the series are non-
stationary, random walks, representing
stochastic processes. This assumption is not
surprising as the variables are measured at
macro level and the macroeconomic
processes are in general stationary at first
difference or I(1).
To demonstrate that, we tested our series
to see if they are non-stationary and if they
are, of what order they are integrated. Main
criticism is that the power of the unit root
tests is low if the process is stationary but
with a root close to the non-stationary
boundary, in other words these tests are
likely to detect a unit root when it does not
exist and vice versa. One way to resolve this
is to use a stationarity test as well as unit root
tests [12].
We used unit root detection tests such as
Augmented Dickey-Fuller (ADF), Phillips-
Perron (PP) and the stationarity test
Kwiatkowski – Phillips – Schmidt – Shin
(KPSS), the most known and used tests in
such a case. The ADF and PP test the null
hyphothesis of a unit root existence and the
KPSS tests the null hyphothesis of a
stationary process.
As we have only two variables to analyze
there may be just one possible cointegration
relationship to find, therefore we chose to
apply the Engle-Granger [13] two-step
residual-based test to verify if the series are
cointegrated.
The first step of this procedure is to
estimate the static regression model (1) with
the dependent variable GDP and the
regressor CONS by Ordinary Least Squares
(OLS) method and to save the residuals u of
the estimated equation.
GDP = α + β*CONS + u (1),
where α represents the constant (drift), β the
parameter of CONS and u the residual
variable assumed to be a white noise error
process.
It is well-known that if the series are
cointegrated, OLS estimation (static OLS) of
the cointegrating β parameter in (1) is
superconsistent, converging at a faster rate
than is standard [14].
The second step is to test the residuals u
to see if they are stationary or not. If the
residual series is stationary I(0) then the
series are said to be cointegrated, the
cointegration relationship being given by the
previously estimated equation known as the
cointegration equation. All procedures were
performed by using Eviews 6.0 software. The
results are discussed in the next section.
3. Results and discussion
The analysis has been performed on the
log-transformations of the variables GDP and
CONS as they are said to be superior and that
provide more consistent empirical findings
[15] than by using the original values. Figure
1. shows the evolution of the log-series of
GDP and CONS that have a general upward
trend over the main period under
consideration 1990-2008 with a drop in 2009
as the consequence of the economic and
financial global crisis. Beginning with 2010
GDP started to grow back reaching in 2012
its value before the crisis (2008) while the
household consumption remained constant,
close to the 2009 value in the last three years.
This means that even though GDP
recovered in real terms after the crisis, the
distrust and economic insecurity of the
population combined with the reduction of
budgetary salaries with 25% in the summer
of 2010, as an anti-crisis measure, have led to
a contraction of household consumption that
continued until 2012.
The Pearson correlation coefficient
reveals a statistically significant strong
positive connection between GDP and
private consumption (CONS) with a value of
0.90.

Figure 1. The evolution of GDP and CONS over the period 1990-2012

Source: author’s own calculations based on data from WorldBank online Database

The unit root test results were performed
with ADF, PP and KPSS for GDP and
CONS, with the default maximum lag lenght
of 4 based on Schwarz Information Criterion
(SIC) for ADF test and using Bartlett kernel
spectral estimation method based on Newey-
West Bandwidth for PP and KPSS tests. The
results are shown in Table 1.

Table 1. Unit root test results for GDP and CONS

GDP CONS
Test options ADF PP KPSS ADF PP KPSS
Without constant
I(1)* I(1)* NA I(1)* I(1)* NA
or trend
With constant I(1)* I(1)* I(1)* I(1)* I(1)* I(1)*
 With constant
I(2)* I(2)* I(1)* I(1)* I(1)* I(0)*
and trend
Note: *significant at 5% level; NA – Not Applicable. I(0) – integrated of order zero (stationary series in
level), I(1) – integrated of order 1 (stationary series after first differencing), I(2) – integrated of order 2
(stationary series after the second differencing).
Source: author’s own calculations based on data from WorldBank online Database

Following the ADF and PP tests it results
that the logarithmic series GDP and CONS
are I(1) with most of the model option of the
3 existing (without constant, with constant,
with constant and trend). KPSS test identifies
the series GDP as I(1) process in both models
whereas CONS is found to be I(1) only in the
model with constant, whereas in the model
with constant and trend CONS series are
apparently found to be stationary I(0), which
is not the case if we also consider the
evolution in Figure 1.. In general the most
used option for the unit root tests in this case
is “without constant” or “with constant”, the
last option being the most restrictive one.
In what follows we assume that both
series are I(1) in log-transformation. We test
for cointegration using the Engle-Granger
[13] two-step method based on residuals. The
method was applied on the logarithmic series
expecting to find that this model is more
stable than by using the original series.
We estimated a static regression model by
OLS method with the results shown in Figure
2. regarding the logarithmic series.

Figure 2. Estimated equations results by OLS using the logarithmic series

Source: author’s own calculations based on data from WorldBank online Database

The estimated model coefficient for and 23 cases dlower=1,26.

CONS is significant at 1% level (Prob. of t-
Statistic < 0.01) with an R-squared of 0.82
and with the F-statistic validating the overall
performance of the model being significant
also at 1% level. The Durbin-Watson (DW)
statistic reveals a positive autocorrelation of
the residuals (Figure 2.), the test value of
0.29 being below the lower critical value for
DW with 2 parameters (including intercept)
However, we cannot draw any
conclusions regarding cointegration based
only on this estimated model. We saved the
residuals from the estimated equation
(RESID) and tested with the usual tests to see
if they are stationary or not with results
shown in Table 2.
 Table 2. Unit root test results for RESID
Test options
Without constant or trend
With constant
With constant and trend
Note: *significant at 5% level; NA – Not Applicable. I(0) – integrated of order zero (stationary series in
level), I(1) – integrated of order 1 (stationary series after first differencing).
Source: author’s own calculations based on data from WorldBank online Database
Based on the results obtained after
applying the Engle-Granger residual-based
test for cointegration, it appears that the
series are not cointegrated, the residuals of
the estimated model being in most of the test
cases non-stationary in level and stationary in
first differences I(1). As Engle-Granger
suggest to test the residuals for unit root only
in the case “without constant and trend”, we
conclude that GDP and household
consumption (CONS) of Romania do not
have a long-term equilibrium relationship.
Although the results of the estimated model
in Figure 2. are not validating the overall
performance it is known that in most cases
the distribution of the estimated regression
parameter, though superconsistent in the case
of cointegration, does not have a t-statistic
standard distribution and inferences cannot
be made from the models. Only if the
regressor is strictly exogenous and the errors
are homoskedastic, serially uncorrelated, and
normally distributed, then the OLS estimator
is also normally distributed (conditional on
the explanatory variables) and the t-statistic
has an exact t-distribution [16].
4. Conclusions
The main purpose of this study was to
analyze the possible existence of a long-run
relationship between the GDP and household
consumption (CONS) of Romania as they
have registered consistent growth since 1990,
household consumption accounting for over a
half of GDP being well-known that the
Romanian economy has been based generally
on private expenditures.
For the analysis we preffered the Engle-
Granger method for cointegration testing as
we had only two variables to test and just one
possible relation of cointegration. We found
that both variables are non-stationary in their
level form but stationary in first difference
RESID
ADF PP KPSS
I(1)* I(1)* NA
I(1)* I(1)* I(0)*
I(1)* I(1)* I(1)*
form. The Engle-Granger residual-based test
for cointegration revealed that the residuals
of the static model are non-stationary
processes meaning that the variables are not
moving together in the long-run. This finding
is in contrast with the common sense of the
macroeconomic theory and especially with
the structure of Romanian economy,
indicating that on the long-run GDP and
private consumption will follow different
paths.
The results of the study must be carefully
interpreted as it may have the following
limits:
 the size of the series is rather small, only
23 observations, the ADF test results
specifying that is using 20 observations
for computing the critical test values and
the test associated probabilities and may
not be accurate for a sample size of 19
cases remaining after adjustments in unit
root testing for residuals, based on
MacKinnon computed values [17];
 the conventional unit root tests such as
ADF and PP tests are widely reported to
have low power performance when time-
series sample size is small [18], [19].
 the drop in values of both variables in
2009 as a consequence of the economic
and financial world crisis may represent a
change on long-term in the future
structure of Romania’s economy.
Further analysis is needed in order to
obtain more stable and consistent results
regarding cointegration between GDP and
household consumption by using an
increased time series for the variables when
the data will be available.
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