Economics Department of the University of Pennsylvania

Institute of Social and Economic Research -- Osaka University

Threshold Cointegration
Author(s): Nathan S. Balke and Thomas B. Fomby
Source: International Economic Review, Vol. 38, No. 3 (Aug., 1997), pp. 627-645
Published by: Wiley for the Economics Department of the University of Pennsylvania and Institute of Social
and Economic Research -- Osaka University
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INTERNATIONALECONOMIC REVIEW
Vol. 38, No. 3, August 1997

THRESHOLD COINTEGRATION*

BY NATHAN S. BALKE AND THOMAs B. FOMBYti

SouthernMethodist University,and Federal ReserveBank of Dallas, U.S.A.

SouthernMethodist University,and Federal ReserveBank of Dallas, U.S.A.

In this paper, we consider a model in which there is discontinuous adjust-

ment to a long-run equilibrium. Here, the equilibrium error follows a threshold
autoregression that is mean-reverting outside a given range and has a unit root
inside the range. We suggest a two-step approach for examining threshold
cointegration. We find that standard time series methods developed for testing
for cointegration in the linear case work reasonably well when threshold
cointegration is present. We then consider a 'sup-Wald' test of linearity that
takes the double-threshold model as the alternative hypothesis.

1. INTRODUCTION

The concept of cointegration is used to capture the notion that nonstationary

variables may nonetheless possess long-run equilibriumrelationshipsand, thus, have
a tendency to move together in the long-run (see Granger 1986 and Engle and
Granger 1987). Cointegration has been used to examine, among many others, the
relationship between consumption and income (Campbell 1987), stock prices and
dividends (Campbell and Shiller 1987), money demand (Johansen and Juselius
1990), and purchasing power parity (Corbae and Ouliaris 1988). Systems in which
variables are cointegrated can be characterized by an error correction model
(ECM). This ECM describes how the variables respond to deviations from the
equilibrium. One can think of the ECM as the adjustmentprocess through which
the long-run equilibriumis maintained.
Implicit in much of the discussion of cointegration and its correspondingECM is
the assumption that such a tendency to move toward a long-run equilibrium (in
expectation) is present every time period. Yet it is possible that movement toward
the long-run equilibriumneed not occur in every period. For example, the presence
of fixed costs of adjustment may prevent economic agents from adjustingcontinu-
ously. Only when the deviation from the equilibriumexceeds a critical threshold, do
the benefits of adjustmentexceed the costs and, hence, economic agents act to move
* Manuscript received June 1995; revised February 1996.
E-mail: nbalke@post.cis.smu.edu
1A previous draft of this paper was
presented at the Southern Economic Association Meetings,
November 24-26, 1991. We wish to thank the editors and two anonymous referees for detailed
comments on a previous draft of the paper, and Herman Bierens, Margarida Genius, Clive Granger,
Robert Kunst, Essie Maasoumi, Baldev Raj, and seminar participants at Louisiana State University,
Rice, Southern Methodist University, Texas A&M, and the NBER Empirical Methods in Macro
Workshop for helpful comments. This paper in no way represents the views of the Federal Reserve
Bank of Dallas or the Federal Reserve System. Of course, we are responsible for any errors.

627

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628 BALKE AND FOMBY

the system back towards the equilibrium.This type of discrete adjustmentprocess

has been used to describe many economic phenomena including the behavior of
inventories, money balances, consumer durables, prices, and employment.2Even in
efficient financial markets, the presence of transaction costs may create a band in
which asset returns are free to diverge and in which arbitragepossibilities exist.
Discrete adjustment may equally apply to policy interventions. For example,
exchange rate management and commodity price stabilization are often character-
ized by discrete interventions. For exchange rate target zones, exchange rates are
allowed to fluctuate freely within a given band, yet, when exchange rates exceed the
target band, central banks intervene in the foreign exchange market. Similarly,for
commodity price stabilization programs, only when the market price gets too far
from the target price does the governmentintervene by buyingor selling stocks or by
changing the target price. Another case might include a monetary authority that
manipulates two different interest rates in the conduct of monetary policy, for
example, the Federal Reserve's control of the Fed Funds rate and Discount rate. If
the spread between the two rates becomes too large, the monetary authority
intervenes to change one or both interest rates to prevent sending conflicting signals
about monetary policy.
In this paper, we attempt to characterize this discrete adjustment in terms of
threshold cointegration. In particular,we examine the case where the cointegrating
relationship is inactive inside a given range and then becomes active once the system
gets too far from the 'equilibrium.'That is, once the system exceeds a certain
threshold, cointegration becomes active. The concept of threshold cointegration
captures the essence of the nonlinear adjustment process envisioned to hold for
many economic phenomena, yet, as we show below, allows one to use many of the
tools developed for more traditional models of cointegration.
The remainder of this paper is organized as follows. In Section 2 we describe the
threshold cointegration model and discuss some of its properties. In this model, the
equilibrium error will behave like a threshold autoregression. Typically, what is
crucial for determining the stationarity of the threshold autoregression is the
behavior of the time series in the outer regimes. Therefore, although the equilib-
rium error may behave like a randomwalk inside the threshold range, as long as it is
mean-reverting in the outer regimes it is, nonetheless, a stationary stochastic
process.
In Section 3, we evaluate a two-step approach for testing for threshold cointegra-
tion. The first step involves determining whether cointegration is present using the
Engle-Granger approach developed for linear times series models. As it turns out,
standard tests for detecting cointegration in linear time series are also capable of
detecting threshold cointegration. The second step involves determining whether
threshold behavior is present in the time series. Here we examine the abilityof some
well known tests for nonlinearity to detect double-threshold autoregressions. In
addition, we evaluate a 'sup-Wald' test of linearity that specifically casts the
two-threshold model as the alternative hypothesis. In Section 4, we suggest some
extensions to the current analysis and conclude.

2
See, for example, Scarf (1960), Miller and Orr (1966), Bertola and Caballero (1990), Sheshinski
and Weiss (1983), and Bentolila and Bertola (1990).

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 THRESHOLD COINTEGRATION 629

2. THRESHOLD COINTEGRATION: MODELS

2.1. A Simple Threshold Model. To be precise about what we mean by

threshold cointegration, consider a simple bivariate system (yt, xt) similar to that in
Engle and Granger (1987) with:

(1) yt + axt =Zt, where zt = t1 +

(2) yt + 3xt =Bt, where Bt =Bt1 +r,.

For simplicity, let et and rmt be i.i.d. mean zero random variables. Equation (1)
represents the equilibriumrelationship between yt and xt, where zt is the deviation
from equilibrium and the cointegratingvector is given by (1, a). Bt, in equation (2),
represents the common stochastic trend of yt and xt.
Rather than a linear autoregression with constant parameters, as in Engle and
Granger (1987), suppose departures from the equilibrium, zt, follow a threshold
autoregression. In particular,

PUi)=1 if Iz1I ?<0

= p, with IPI < 1 if Izt-II > 0.

where 0 represents a critical threshold. As long as )z, -<1) 0, z, acts as if it has a

unit root and, consequently, there is no tendency for the system to drift back
towards the equilibrium relationship. Once )z,-11 > 0, however, z; becomes a
stationary autoregression that has a tendency to revert back to a constant mean (in
the example above, zero). Thus, if the equilibriumerror is less than the threshold
value, then yt and xt do not have a tendency to revert to an equilibrium(i.e., are
not cointegrated); if the equilibriumerror is greater than the threshold then yt and
x1 do tend to move towards some equilibrium(i.e., are cointegrated). While 'locally'
zt may have a unit root (when Izt-1 I < 0), 'globally'this series is stationary.
An alternativeway to represent the threshold cointegration idea is in terms of an
error correction model. We can rewrite the system given by equations (1) and (2) as

(3) =y_-1 z 1 +u1,

(4)(4) A
/\ x= = y(lZ1+2
2i, _ 1 +
x~~~~~~t 1)2t

where y(i) = -(1 - p()),8/( ,8 - a) y(l) - (1 - p(t))/( p - ) [ / / -

-[a/(/3-a)]ht, v2t=[l/(AP-a)](K -et), and zt-1 =Yt-i +axt-1. The error
correction term, zt-1, represents the error in or deviation from the equilibrium
while the parameters y(i) and yi) capture how yt and x, respond to deviations
from the equilibrium relationship. As long as deviations from the equilibrium
condition are not greater than the threshold, the error correction parameters YU})
and y2:i)are zero and yt and x, do not respond to deviations from the equilibrium
condition. Only if the deviations exceed the threshold are y(i) and y4i) nonzero and
yt and xt respond to deviations from the equilibrium.

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630 BALKE AND FOMBY

2.2. A More General Model. We can generalize the dynamics of the equilib-
rium error by allowing nonzero intercepts and asymmetricthresholds. In this case,

,jua) + p(u)(L) zt_ +8 OM) 0(a Z t-d

(5) Zt= A(m) + p(tm)(L)z 1 + e(m) 0(1) <Zt-d ?

<

/P) + p) )( L) zt- + 8 ( ), OM > Zt-

where p('O(L)are lag polynomials and 04i) (i = 1, m, and u) are mean zero random
disturbances with standard deviation a (i).3 Here zt follows a different autoregres-
sion depending on the value of Zt-d. The integer d represents the delay in the error
correction process and reflects the possibility that economic agents or controllers
may react to deviations from the equilibriumwith a lag.
Unfortunately, necessary and sufficient conditions for tPi) and p(i)(L) to guaran-
tee stationarityare still not well understood. Chan and Tong (1985), and Brockwell
et al., (1992) develop a set of sufficient conditions for the general threshold
autoregression, yet they leave open the possibility of a weaker set of sufficient
conditions. For a symmetric threshold autoregression in which the autoregressive
parameters (but not necessarily the intercepts) in the outer regimes are the same,
Tj$stheim (1990) shows a sufficient condition for stationarityis that the roots of the
autoregression in the outer regimes are less than one in absolute value.
Chan et al., (1985) have, however, determined the necessary and sufficient
conditionsfor the case where p(i)(L) = p(') and d = 1. If Jl), au), p(l), and p(u)
satisfy one of the following conditions:
(i) p(l) < 1, p(O)< 1, and p(l)p(U)< 1;
(ii) p(u) < 1, p(l) - 1, and pufl)> 0;
(iii) p(l) < 1, p(u) - 1, and ju) < 0;
(iV) p(l) = p(u) = 1 and /1(u)< 0 < ,u(l);
(v) p(l)p(u)= 1, p(l) < 0, and A(U)+ p(u)A(l)> 0;
then zt is a stationary stochastic process.4 Regardless of the behavior of Z in the
interior regime (m) (zt can display unit root or explosive behavior in the interior)
the nature of zt in the upper and lower regimes determines whether it is stationary.
Note that even if the autoregressivecoefficient, p, is equal one everywhere Zt may
still be stationary. So long as the drift parameters act to push the series back
towardsthe equilibriumband (i.e., N(l) > 0 and 1Au) < 0) the series is stationaryeven

3In addition,this model can be generalizedto multiplethresholds:

Z = ufi + P(i)z,-1 + P), 0(i- 1) < Zt-d < i= 1,. .., K,

where-o = 0(o)< 0(1)< ... < O(K)= 00

4 These resultshold for multiple(more than two) thresholdsas well.

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 THRESHOLDCOINTEGRATION 631

though it has a 'unit root.' This suggests that, in general, just examining the
autoregressiveparameters in the outer regimes is not enough to determine whether
the series is stationary.
Similarly,for the corresponding threshold error correction model the intercepts
as well as the error correction parameters may reflect adjustment towards the
equilibrium.To see this, let /3'X, = B, and a X,=;z where Xt=(ytxt)',ABt=t[B
+ B(L)WABt + mqtmtis a mean zero i.i.d. shock, and z, is the equilibrium error
given by equation (5). The resulting error correction model is given by

(6) AXt = A(') + C(L)(L)AXt + y(i)zt1 + vt('), i = 1, m, u

where y(l) is a vector containing the error correction parameters. The constant
terms in the error correction model, ,L4', are, in part, a function of the constant
parameter in the equilibriumerror.5Thus, along with the error correction parame-
ters, the constant terms in the error correction model can play a role in drivingthe
system back towards the equilibrium.

2.3. Some Specific Examples. As suggested above, the 'local' or short-term

dynamics can be quite rich and still yield a stationaryequilibriumerror. In order to
better illustrate this richness and to determine how the local dynamics affects the
tests of cointegration and of nonlinearity examined below, we consider three
alternative threshold autoregressive (TAR) models for the equilibrium error, zt.
These models are:
Equilibrium-TAR, zt =zt-1 +t, if Izt_1I ?
= PZt- 1+ et if Izt_1I > 0;
Band-TAR, zt =0(1-p)+pz_1+et if Zt- >0

=Zt-1 + et if Jzt_1I < 0

=-0(1 -P) +PZt-1 + et if Zt-1 < -0;
RD-TAR, Zt=- 1 + et
+ Zt- if Zt-1 > 0

= Zt_1+ if Izt_1I<0

=+Zt-1 +Et if ZI_1 <-6.

5The errorcorrectionparametersare:

AW 1 a ( )
a:( a(i) (i)(i) )

and

re
C(he(L) ((L - ( (L - L) BL)

where p*W(X(L)
=(p(i )(L) -p(i )(1))1(1-L).

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632 BALKE AND FOMBY

The Equilibrium-TAR (EQ-TAR) model is where the process tends towards an

equilibriumvalue (here zero) when outside the region [ - 0, 0 ]. The associated error
correction model responds to the deviations from the equilibriumrelationship; the
strength of the error correction effect depends, in part, on how far the variable is
away from the equilibriumrelationship. In a control context, it is as if the controller
is trying to return the controlled variable back to a particular equilibrium value.
However, one can conceive of situations where the controller is satisfied if the
process is within a 'target' band. In this case, the controller tries to return the
variable to within the equilibriumband and not necessarily back to an equilibrium
point. The Band-TAR model represents the case where the process returns to an
equilibriumband (here [ - 0, 0 1) rather than to an equilibriumpoint. The RD-TAR
(or 'returning drift' threshold) model is where a unit root is present in every regime
but the drift parameters move the process back towards the equilibriumband when
the process is outside the thresholds. The 'returning drift' model also has this
property of drifting back towards an equilibrium band rather than an equilibrium
point.
While all three of the above models of the equilibriumerror are stationary and,
hence, xt and yt are cointegrated, they do imply different short-term dynamics.
Unlike linear autoregressions, the constants in the threshold autoregression con-
tribute to persistence as well as the autoregressive parameters; the Band-TAR
model, even though it is identical to the EQ-TAR with respect to autoregressive
parameters, is substantiallymore persistent. Not surprisingly,the larger the autore-
gressive parametersin the outer regimes the more persistent the time series. Finally,
the further apart the thresholds are, as measured by the ratio 6 2/a(iii)2 the more
persistent is the time series. For all three of the above models, this ratio is the
expected hitting time of reaching the thresholds starting from zero. The longer it
takes to reach the outer regimes, the more often unit root behavior is observed.

3. TESTING FOR THRESHOLD COINTEGRATION

How would one determine whether time series are threshold cointegrated?As we
suggested above, threshold cointegration has implications for 'local' as well as
'global'behavior of a time series. Cointegrationis a global characteristicof the time
series while the threshold regimes are local characteristics. The combination of
global and local behavior suggest four possible hypotheses summarized by the
following:

Hypotheses LinearityVersus Threshold Behavior

no cointegration no
linearity, cointegration thresholds,no cointegration
versus ,, _, ..

cointegration. linear cointegration threshold cointegration

Take as the null hypothesis no cointegration and linearity (upper left cell). There
are three alternative hypotheses: no cointegration and nonlinearity, cointegration

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 THRESHOLD COINTEGRATION 633

and linearity, and cointegration and nonlinearity. Our particular focus is on this
third alternative hypothesis: threshold cointegration.6
Ideally, one would like to test the no cointegration/linearity null hypothesis
directly against the threshold cointegration alternative.7However, this poses several
difficulties. First, there is a nonstandard inference problem. Not only do we have
unit roots present under the null but there are nuisance parameters present under
the alternativehypothesis that are not present under the null, namely the thresholds
(0(u) and 0(l)). While there is a growing literature on testing when parameters are
not present under the null (see, for example, Davies 1977 and 1987, Andrews and
Ploberger 1994, and Hansen 1996), the theory has been developed for a stationary
null hypothesis. Second, and perhaps more importantly, the class of stationary
threshold models may be too large to permit testing parametricallythe no cointegra-
tion/linear null against the general threshold cointegration alternative. For exam-
ple, for the simple TAR(1) models described above, there are five separate condi-
tions involvingmultiple one-sided tests that must be examined in order to determine
whether the threshold model is stationary,and for a more general threshold model
we may not even know all the conditions that guarantee stationarity.As a conse-
quence, one is likely going to have to resort to setting a particular (and probably
simple) threshold model as the alternativehypothesis in order to test parametrically
the no cointegration/linear null directly;setting up general threshold cointegration
as an alternative is problematic.
As a result, we suggest breaking up the analysis into, first, an examination of the
global behavior of the time series-testing for no cointegration/cointegration-and,
second, an examination of the local behavior of the time series-testing for
nonlinear or threshold behavior. This approach rests on the fact that many of the
existing tools for testing for cointegration are likely to be of use even in the case of
threshold cointegration. If cointegration is found, then testing for nonlinearity and
threshold behavior can help determine the local behavior. In all the analysis below,
we essentially take the Engle-Granger single equation approachto cointegrationby
examining the equilibriumerror; first for stationarityand then for threshold behav-
ior.

3.1. Determining Global Behavior: Testing for Cointegration. Because the

cointegratingrelationship between yt and x, is assumed to be linear, standard time
series analyses used for linear cointegration will be valid asymptoticallyfor the
threshold cointegration case. The reason is that the threshold nonlinearity of z;
does not affect the order of integration of y,, xt, and zt. Indeed if the equilibrium
error zt satisfies certain 'a mixing' conditions (Assumption 2.1 in Phillips 1987),
then the asymptotic results of Phillips (1987) hold for unit root tests of x, and yt,
and the superconsistency of least squares estimates of the cointegratingvector, a,

6There may be other interesting stationary nonlinear alternatives to the linear no cointegration
null hypothesis and the methodology discussed below may have power against those alternatives.
7Or, alternatively, one may want to set up threshold cointegration as the null model.

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634 BALKE AND FOMBY

(Stock 1987) holds as well.8 This suggests that standardtests for unit roots should be
able to detect the unit roots present in x, and yt and the cointegratingvector a can
be treated as known in the second stage of two stage procedures such as Engle and
Granger (1987).
Furthermore, standard tests for unit roots or of stationarity should be able to
detect the stationarityof zt. As we pointed out above, there are several alternative
parameter settings in which z; is stationary;a unit root could be present in the outer
regimes and z, could still be stationary(cases (ii), (iii), and (iv), above). Nonetheless,
standard linear unit root tests such as the augmented Dickey-Fuller test and the
Phillips-Perron (1988) test should still have power against these nonlinear alterna-
tives. Alternatively, if one takes the null hypothesis as stationarityas is the case in
Bierens and Guo (1993) and Kwiatkowskiet al., (1992) (KPSS), then as long as
certain mixing conditions hold for z; these tests apply to threshold as well as a linear
stationarytime series. Thus, techniques designed to detect unit roots and cointegra-
tion in the linear case should work for the threshold case.
To evaluate the performance of standard tests for unit roots/stationarity, we
conduct a Monte Carlo experiment in which data is generated by a model similar to
that described in equations (1) and (2). The cointegrating relationship is given by:
yt + axt =Zt, where zt follows one of the three threshold models described above.
The common stochastic trend is determined by: yt + ,8xt = Bt, where Bt is a random
walk without drift. In this experiment, a = -2, and ,3 = -3 while the innovationsin
zt and Bt have unit variance and are uncorrelatedwith one another. To be sure that
initial conditions did not unduly affect the nonlinear time series, we allowed a start
up period of 1,000 observationswhen generating the time series. In addition to the
three threshold models, we also generated linear first-order autoregressive series
that have the same first-orderautocorrelationas the related threshold model.9 This
allows us to generate a linear model with (roughly) the same persistence as the
nonlinear model. By comparing the results for the threshold model with that of its
associated linear model, we can better assess the effect of threshold nonlinearityon
the performance of the tests.10
Tables 1 and 2 apply the augmented Dickey-Fuller (ADF) and the Phillips-
Perron (PP) tests for unit roots to the null of no cointegration.1"In Table 1 the
cointegrating vector is assumed to be known, while in Table 2 the cointegrating

8 Whether stationary threshold autoregressions in general satisfy a-mixing is an

open question.
For the examples considered below, the EQ-TAR and Band-TAR models are geometrically ergodic
(Chan and Tong 1985) and will satisfy a-mixing (Athreya and Pantula 1986). It is not clear that the
RD-TAR model, in general, satisfies a-mixing. However, for the numerical values considered here,
RD-TAR seems to have about the same memory as the Band-TAR models.
9 The unconditional first order
autocorrelations for EQ-TAR ( p = 0.4) with 0 = 3, 5, or 10 are
0.78, 0.89, and 0.97, respectively. For the Band-TAR ( p = 0.4) with 0 = 3, 5, or 10, they are 0.90,
0.96, and 0.99, respectively. For RD-TAR (I I = 1.0) with 0 = 3, 5, or 10, they are 0.87, 0.95, and
0.99, respectively.
10After several drafts of this paper, we became aware of the work of Pippenger and Goering
(1993) who examine the power of the Dickey-Fuller test against stationary EQ-TAR alternatives
and found similar results.
11
In a previous draft, we also examined variance-ratio tests and found that they typically had less
power than the Dickey-Fuller test against the threshold alternatives examined here.

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 THRESHOLD COINTEGRATION 635

TABLE 1. APPROACH:
ENGLE-GRANGERSINGLE-EQUATION COINTEGRATING
VECTORKNOWN*;
NULLHYPOTHESISOF NO COINTEGRATION
(1) Power of ADF Test at 5% Nominal SignificanceLevel
6 EQ-TAR EQ-AR (1) Band-TAR Band-AR (1) RD-TAR RD-AR (1)
T 3 5 10 3 5 10 3 5 10 3 5 10 3 5 10 3 5 10
100 49 16 8 67 30 8 16 11 8 19 10 6 27 13 8 34 11 6
250 98 64 15 99 91 17 61 19 12 75 27 7 89 28 12 94 39 8
500 100 99 54 100 100 54 99 66 16 100 78 17 100 87 18 100 91 20
1000 100 100 97 100 100 97 100 99 29 100 100 46 100 100 38 100 100 55

(2) Power of Phillips -Perron Test at 5% Nominal Significance Level

0 EQ-TAR EQ-AR (1) Band-TAR Band-AR (1) RD-TAR RD-AR (1)

T 3 5 10 3 5 10 3 5 10 3 5 10 3 5 10 3 5 10
100 95 33 16 94 53 10 25 18 12 32 12 6 50 20 13 55 14 7
250 100 98 22 100 99 23 95 28 15 93 36 9 100 47 16 99 51 10
500 100 100 55 100 100 63 100 91 19 100 88 20 100 99 20 100 97 24
1000 100 100 99 100 100 99 100 100 36 100 100 50 100 100 50 100 100 63

*Entries represent percentiles of 1000 replications. For EQ-TAR and Band-TAR, p = 0.4. For the
RD-TAR, I i I = 1.0. The EQ-AR (1), Band-AR (1), RD-AR (1) are linear AR(1) models that have the same
first order autocorrelations as the corresponding threshold autoregressive models. The number of lags in
the Augmented Dickey -Fuller and Phillips -Perron test =integer [4(T/100 )25] .Both tests also include a
constant term.

TABLE 2. ENGLE-GRANGERSINGLE-EQUATION
APPROACH: COINTEGRATING
VECTORUNKNOWN*;
NULLHYPOTHESIS OF NO COINTEGRATION
(1) Power of ADF Test at 5% Nominal Significance Level
0 EQ-TAR EQ-AR (1) Band-TAR Band-AR (1) RD-TAR RD-AR (1)
T 3 5 10 3 5 10 3 5 10 3 5 10 3 5 10 3 5 10
100 28 13 9 42 18 6 12 11 8 13 9 6 15 11 7 19 10 6
250 90 37 10 98 65 9 34 13 8 46 15 7 61 17 9 73 24 7
500 100 96 17 100 100 26 96 31 10 98 43 9 100 54 11 100 70 10
1000 100 100 64 100 100 82 100 94 15 100 95 21 100 99 18 100 99 27

(2) Power of Phillips -Perron Test at 5 % Nominal Significance Level

0 EQ-TAR EQ-AR (1) Band-TAR Band-AR (1) RD-TAR RD-AR (1)

T 3 5 10 3 5 10 3 5 10 3 5 10 3 5 10 3 5 10
100 72 25 14 77 28 9 21 15 12 19 11 9 29 18 12 35 13 10
250 100 80 19 100 89 14 67 22 13 71 21 8 97 29 14 96 36 8
500 100 100 27 100 100 33 100 52 14 99 55 11 100 82 15 100 85 12
1000 100 100 88 100 100 90 100 100 20 100 98 25 100 100 25 100 100 33

*Entries represent percentiles of 1000 replications. For EQ-TAR and Band-TAR, p = 0.4. For the
RD-TAR, I I = 1.0. The EQ-AR (1), Band-AR (1), RD-AR (1) are linear AR(1) models that have the same
first order autocorrelations as the corresponding threshold autoregressive models. The cointegrating vector
was estimated by DOLS. The lags in Augmented Dickey-Fuller and Phillips-Perron test
integer [4(T/100 )25]. Both tests include a constant term. Critical values are from MacKinnon (1991).

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636 BALKE AND FOMBY

vector is estimated by the Dynamic OLS (DOLS) method proposed by Stock and
Watson (1993).12 Because the threshold models considered in this simulation are
relatively persistent, the power of the tests in small samples are relatively low. In
larger samples the power of the tests approaches 1.0, which suggests that the tests
are consistent against the threshold alternative. For larger samples and/or smaller
threshold values, both the ADF and the PP tests have more power against the
associated stationarylinear alternativethan against the stationarythreshold alterna-
tive. However, for large threshold values relative to the sample size, the tests
actually have more power against the threshold series than against the linear
autoregression. The reason is that over the course of the Monte Carlo experiment
there will be instances in which the sample fortuitously starts near the threshold
values which, in turn, allows the mean-revertingnature of the nonlinear model to
show up better in small samples.
Interestingly,for the examples considered in Tables 1 and 2, the PP test has more
power than the ADF test. While this is also true for the linear models considered, it
is particularlytrue for the threshold models. Apparently, the nonparametricnature
of the PP test gives it more power against threshold cointegration than the ADF
test. Finally, estimating the cointegratingvector results in a loss of power for both
the ADF and the PP versions of unit root tests. However, the power loss due to
estimating the cointegrating vector is not substantially different for the threshold
models compared with the linear autoregressions.
Table 3 shows results when cointegration is taken to be the null hypothesis and
the cointegratingvector is known. Here the nonlinear models tend to have a larger
size distortion than the correspondinglinear autoregressivemodels except for large
threshold values and small samples. This is similar to the power results for the no
cointegration null discussed above. While there is a substantial size distortion for
the KPSS test, this is true for both linear and nonlinear models and probably has
more to do with the need to increase the window width to account for the
persistence in these time series than it does with nonlinearity. The Bierens-Guo
Cauchy #3 (BG3) test has little size distortion except at large threshold values for
the Band-TAR and RD-TAR and their associated linear ARs.
An alternative to testing for cointegration using the Engle-Granger approach is
the Johansen (1991) full information, maximumlikelihood approach. The problem
with the Johansen method is that it is based on a Gaussian,linear vector autoregres-
sion (VAR) and, like the Dickey-Fuller regression,would be misspecified under the
threshold alternative; the estimates of the linear VAR would reflect the average
across the three regimes. Nonetheless, it may still yield the correct average rank of
Johansen'slong-run matrixand, hence, could detect threshold cointegration.Table 4
presents results for the Johansen trace test for one or more cointegratingvectors.
The implied VAR for the test is one in which an intercept is present in the
cointegratingvector but in which there is no drift in the stochastic trend(s). To the

12
We also calculated the average bias and mean squared error of OLS and DOLS estimates of
the cointegrating vector. For both OLS and DOLS, the bias is typically larger for threshold
cointegration compared with linear cointegration, but not substantially so. These results are
available upon request.

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 THRESHOLD COINTEGRATION 637

TABLE 3. APPROACH:COINTEGRATING
ENGLE-GRANGERSINGLE-EQUATION VECTORKNOWN*;
NULLHYPOTHESISOF COINTEGRATION
(1) Size of KPSS Test at 5% Nominal SignificanceLevel
0 EQ-TAR EQ-AR(1) Band-TAR Band-AR(1) RD-TAR RD-AR(1)
T 3 5 10 3 5 10 3 5 10 3 5 10 3 5 10 3 5 10
100 21 37 56 17 26 53 38 51 60 34 50 63 30 48 58 26 46 63
250 16 33 65 12 21 55 33 55 73 27 50 73 24 48 72 19 44 71
500 14 31 73 11 20 61 30 59 86 26 54 82 21 51 84 19 47 80
1000 13 27 67 11 17 58 28 55 90 25 47 85 20 45 87 16 39 81
(2) Size of Bierens -Guo Cauchy Test (#3) at 5% Nominal Significance Level

0 EQ-TAR EQ-AR (1) Band-TAR Band-AR (1) RD-TAR RD-AR (1)

T 3 5 10 3 5 10 3 5 10 3 5 10 3 5 10 3 5 10
100 5 3 6 5 3 7 4 3 14 3 4 13 5 3 12 4 4 12
250 6 5 4 6 6 7 6 5 18 6 5 18 5 4 15 6 5 16
500 5 5 5 7 6 5 5 5 18 6 5 16 6 6 16 6 5 14
1000 5 6 5 5 6 6 6 5 14 5 6 14 4 5 12 5 6 11

*
Entries represent percentiles of 1000 replications. For EQ-TAR and Band-TAR, p = 0.4. For the
RD-TAR, Ij.t = 1.0. The EQ-AR (1), Band-AR (1), RD-AR (1) are linear AR(1) models that have the same
first order autocorrelations as the corresponding threshold autoregressive models. Null hypothesis is
stationarity around a constant mean. The number of lags used in the KPSS test = integer [4(T/100)25].

extent they can be directly compared (they have slightly different alternative
hypotheses), the power of the Johansen test is greater than the Engle-Granger
approach that uses the ADF test, but has less power than the Engle-Granger
approach with the PP unit root test. Like the Engle-Granger ADF approach, the
power loss is relatively larger when going from linear to threshold models than was
the case for the nonparametric PP test. This leaves open the possibility that more
nonparametric methods like Bierens (1997; this assumes only a linear infinite
moving average representation) may be more effective at detecting cointegration in
the threshold case than the Johansen approach.

TABLE4. JOHANSEN
TRACE
TESTFORCOINTEGRATION*;
NULLHYPOTHESIS
OFNOCOINTEGRATION
(1) Percent rejections at the 5% significance level
6 EQ-TAR EQ-AR(1) Band-TAR Band-AR(1) RD-TAR RD-AR(1)
T 3 5 10 3 5 10 3 5 10 3 5 10 3 5 10 3 5 10
100 29 12 8 38 13 6 11 7 6 10 6 6 14 10 7 16 7 5
250 91 41 10 99 63 11 35 12 7 48 14 7 63 17 7 71 21 8
500 100 99 19 100 99 22 98 32 10 98 36 7 100 52 10 100 62 8
1000 100 100 60 100 100 67 100 92 13 100 94 14 100 99 16 100 99 20
* Entries represent percentiles of 500 replications. For EQ-TAR and Band-TAR, p = 0.4. For the
RD-TAR, I tLI = 1.0. The EQ-AR(1), Band-AR(1), RD-AR(1) are corresponding linear AR(1)
models that have same first order autocorrelations as the threshold autoregressive models. The
VAR includes a constant but with the restriction of no drift in the stochastic trend(s). The number
of lags in the VAR = integer[2*(T/100).25].

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638 BALKE AND FOMBY

The bottom line is that standardlinear methods for examiningcointegrationseem

to work reasonably well for threshold cointegration. While for most of the Monte
Carlo experiments considered here the threshold behavior of the equilibriumerror
does result in a slight loss of power (or increase in size distortion) relative to linear
models, in a few cases nonlinearity actually helps the performance of tests for
cointegration. The presence of thresholds seems to affect the performance of the
standard tests most when the time series displaysgreater persistence on average (or
unconditionally)than what is implied by the outer regimes alone.13

3.2. Determining Local Behavior: Testing for Nonlinearity. In determining

whether threshold behavior is present, we focus on the equilibriumerror, z, = y +
axt. That is, if yt and xt are characterized by threshold cointegration then zt will
follow a threshold autoregression. Thus, we test for nonlinearity and, in particular,
threshold nonlinearityin zt. In this subsection, we examine how effective some tests
for nonlinearity are at detecting two-break threshold autoregressions. Of special
interest is how well these tests perform for the linear unit root null hypothesis and
the effect of estimating the cointegratingvector on the power and size of the tests.
The basic tool in determining the local behavior of the time series is an arranged
autoregression. An arranged autoregression orders the data according to the value
of the potential threshold variable (say Zt-d), rather than by time. Note that for any
given observation in the arranged sample the actual dynamic relationship between
Zt and its lags is retained, only the ordering of observations is different. The
arranged autoregressionis useful for detecting threshold-typebehavior because the
threshold model changes structure accordingto the value Zt-d-
As a result, Petrucelli and Davies (1986) have used recursive residuals from an
arranged autoregression to develop a CUSUM test for a threshold autoregression
and Tsay (1989) has developed a test for threshold nonlinearity that also employs
the recursive residuals from an arranged autoregression. Rolling or sequential
Chow-typetests for structuralchange can also be applied in the arrangedregression
context. Thus, the maximumWald statistic for a one-time structuralchange over a
set of possible break points could be used to test nonlinearity.While none of these
approaches tests linearity directly against the two-thresholdmodel that is of interest
here, they are commonly used tests for nonlinearity that, nonetheless, may have
power against the two-threshold alternative.
To test for the two-threshold model directly, we simply look for two structural
breaks in the arranged autoregression. For a given set of threshold values, we
estimate the threshold autoregression by least squares and calculate the sum of
squared errors. In addition, we calculate the Wald-statisticfor the hypothesis of no
structuralchange versus the alternative of two structuralchanges. This is done for
all combinations of possible threshold values. The estimated thresholds are those
13
In a previous version of the paper, we examined a unit root test in which only observations in
the outer regimes are used to test for a unit root. Unfortunately, the power of the outer-regimes-only
test was only occasionally better than the ADF test and in most cases worse than the Phillips-
Perron test. The fact that the thresholds must be estimated and the relatively small samples in the
outer regimes probably limits the power of the outer-regimes-only test. The results of our small
Monte Carlo study are available upon request.

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 THRESHOLD COINTEGRATION 639

that minimize the sum of squared errors. The test statistic is simply the maximum
Wald (sup-Wald) statistic over the possible threshold values.14 For the case of
homoskedasticity,the break points that minimize the sum of squared errorswill also
yield the maximum Wald statistic. For the heteroskedastic case, general het-
eroskedasticity can be accounted for by using White's consistent covariance matrix
estimate for the Wald-statisticwhile the possibility of grouped heteroskedasticityin
which the variance of innovations differs across regimes can be accounted for by
weighted least squares.
Testing linearity against the two-threshold alternativeinvolves nonstandardinfer-
ence in that the threshold values are not identified under the null. Hansen (1996)
has developed asymptotic theory for cases such as this and proposes a simulation
method which can approximatethe asymptoticdistributionof the sup-Wald statistic.
Alternatively, the sampling distribution of the sup-Wald statistic can be calculated
by bootstrap methods.15Taking a linear autoregression as the null model, one can
resample the residuals from this model to create a bootstrap sample from which one
can calculate a sup-Wald statistic. This resamplingis repeated yielding a distribution
of sup-Wald statistics under the null of a linear autoregression.For the bootstrap,
we considered two null models: a linear autoregression in levels and a linear
autoregression with a unit root imposed. Finally, both the Hansen and Bootstrap
methods have the additional advantage over the other tests of permitting inference
when the delay parameter, d, is unknown.
All the tests share a common modelling strategy. First, a tentative AR model of
order p and a set of possible threshold variables (zt-d for various values of d) is
selected. In the Monte Carlo experiment presented below, we take the order of the
autoregression, p, and the delay as known at p = d = 1. The sample is then
arranged according to the value of Zt-d; here we arrangedthe sample from low to
high values of Zt-d. The start-up for the Tsay and CUSUM tests is taken to be 10%
of the sample. For the one-break sup-Wald test, we take the interior 80% of the
arrangedsample to be the set of possible break points. For the two-breaksup-Wald
test, we search from the 5th to 30th percentile of the arranged sample to find the
lower threshold and from the 70th to 95th percentile to find the upper threshold, so
that, at minimum, 40 percent of the sample is in the middle regime.
One complication present in our application is that an interesting null hypothesis
is one in which zt is a linear autoregression with a unit root. All the tests of
nonlinearity discussed above, with the exception of the difference stationary boot-
strap, assume the null hypothesis is a stationarylinear autoregression.To determine
whether there are significant size distortionspresent when the null model contains a
unit root, we conducted a Monte Carlo experiment in which the tests are applied to
a random walk as well as a stationary autoregression.Furthermore,in practice, the

14
In addition to the sup-Wald, Andrews and Ploberger (1994) have proposed averaging Wald
statistics over possible break points (their avg-Wald and exp-Wald statistics). Those could also be
applied to the double-threshold case.
15
Christiano (1992) has applied bootstraps for testing the trend-break hypothesis and Diebold
and Chen (1996) have shown that bootstrap methods can be quite useful for finite sample inference
in structural change problems.

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640 BALKE AND FOMBY

cointegrating vector has to be estimated, so we also examine the size and power
consequences of having to estimate the cointegratingvector.
Table 5 presents the size and power properties of the various tests of nonlinearity,
both for the case where the cointegratingvector is known and the case where it is
estimated. With the possible exception of the one-break sup-Waldtest, there is little
size distortion for a linear unit root model relative to the linear stationary autore-

TABLE 5. MONTE CARLO EXAMINATION OF TESTS FOR NONLINEARITY*

Percent Rejections at 5% Significance Level, Cointegrating Vector Known

EQ-TAR Band-TAR RD-TAR
0= 0= 0=
AR RW 3 5 10 3 5 10 3 5 10
T= 100
Tsay 4 6 79 69 43 25 20 14 24 22 15
CUSUM 4 5 73 56 30 23 17 11 20 16 10
sup-Wald 4 8 81 77 57 28 24 17 36 27 18
(1-break)

T = 250
Tsay 4 5 99 95 69 64 52 30 54 56 30
CUSUM 4 4 99 86 54 63 48 28 61 52 28
sup-Wald 6 7 99 99 81 70 59 39 76 65 43
(1-break)

T= 500
Tsay 5 5 100 100 92 92 84 52 76 87 56
CUSUM 4 6 100 99 76 92 75 44 89 81 48
sup-Wald 6 8 100 100 96 96 90 66 97 91 68
(1-break)

Percent Rejections at 5% Significance Level, Cointegrating Vector Unknown .

Basic-TAR Band-TAR RD-TAR
0= 0= 0=
AR RW 3 5 10 3 5 10 3 5 10
T= 100
Tsay 3 4 54 38 22 11 8 6 13 9 7
CUSUM 3 4 48 29 17 10 8 6 11 7 6
sup-Wald 4 5 54 40 26 12 9 8 18 10 9
(1-break)

T= 250
Tsay 5 6 97 80 43 38 25 13 39 25 15
CUSUM 4 5 95 69 33 39 22 13 42 24 13
sup-Wald 6 6 98 82 46 43 26 16 51 31 17
(1-break)

T = 500
Tsay 4 5 100 97 64 71 43 17 65 53 17
CUSUM 4 6 99 95 53 72 42 16 76 50 16
sup-Wald 4 8 100 99 67 77 48 22 84 58 24
(1-break)
* Based on 1000 replications. For EQ-TAR and Band-TAR, p = 0.4. For RD-TAR,
AI = 1. For
AR, zt = .8zt_ 1 + et. For RW, zt = zt -1 + Et. For all models, Et - N(0, 1).

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 THRESHOLD COINTEGRATION 641

gression (see the AR and RW columns, respectively). This is very different from
testing for structural change over time where a unit root process can give the
appearance of a structural change in a stationary autoregression and vice versa.
Because the structural change here occurs in the arranged regression or across
threshold values, the linear unit root model is less likely to be confused with
structuralchange.16
Not surprisingly,estimating the cointegratingvector lowers the power of the tests,
but it does not dramaticallyalter the size properties of the tests. In addition, the
power of the tests diminishes substantiallyfor larger threshold values. The reason is
that for a given sample size, the larger the threshold values the smaller the number
of observations in the outer regimes.
Table 6 presents the results of a small Monte Carlo experiment to evaluate the
alternative methods of testing for the two-threshold model. Because the bootstrap
method involves numerous replications for each Monte Carlo replication, the
computational demands of an unconditional search for the two thresholds in the
Monte Carlo experiment was excessive, particularlyin larger samples.17As a result,
for the bootstrap experiment, we iteratively estimate the two thresholds conditional
on the other.18That is, we search for one threshold at a time taking the value of the
other threshold as given. Having found the location of the first threshold, we
searched for the second threshold conditional on the estimated location of the first.
We iterated back and forth until the same two thresholds were continually chosen.
While in general the iterative search will not alwaysyield the same thresholds as an
unconditional search, it appears to be quite cost effective in practice.19The iterative
search was applied both to the pseudo-data in the Monte Carlo experiment and to
the bootstrap replications. For the Hansen procedure, a standard grid search was
conducted.
On the basis of this small Monte Carlo study, it appears that the size and power
of the Hansen and Bootstrap methods are fairly similar. Not surprisingly,both the
Hansen and Bootstrap tests based on the two-threshold alternative have more
power against the threshold models considered here than the Tsay, CUSUM, and
sup-Wald tests based on a single threshold. However, they also seem to have slightly
larger measured size distortion although this may reflect the relativelysmall number
of Monte-Carlo replications. Once again having to estimate the cointegratingvectors
lowers the power of the tests, although it does not appear to dramaticallyaffect the
size of the tests. Finally, the size and the power of the bootstrap test is not markedly
different when the null model is specified as a linear randomwalk as compared to a
linear stationary autoregression.

16 If there is drift in the unit root series, however,size distortionsmay be more likely; the
arrangedsamplemaybe verymuchlike the time orderedsamplebecauseof the trendpresentin the
time series.
17 A singleBootstrapMonte Carloexperimentof 200 replicationswith 100 bootstrapreplications
and a samplesize of 100 involvescalculating1.35x 107 Waldstatistics.
18 We thankMarkWoharfor suggestingthis iterativeprocedure.
19In a limited Monte Carlo experiment,the iterative procedure picked exactly the same
thresholdsas the unconditionalgrid searchbut with substantiallyfewer calculations.

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642 BALKEAND FOMBY

TABLE 6. MONTE CARLO EXAMINATION OF TESTS FOR TWO-THRESHOLD TAR*

Percent Rejections at Stated 5% Significance Levels
Cointegrating Vector Known
EQ-TAR Band-TAR RD-TAR
AR RW 0=3 0=5 0=3 0=5 0=3 0=5
T= 100
Hansen 5 10 91 76 36 32 52 35
Boot-AR 8 6 90 89 30 26 43 34
Boot-RW 6 5 87 80 19 15 31 25

T= 250
Hansen 6 7 100 98 72 58 83 70
Boot-AR 8 6 100 99 69 66 86 79
Boot-RW 5 6 100 100 76 50 84 62

Cointegrating Vector Unknown

EQ-TAR Band-TAR RD-TAR
AR RW 0=3 0=5 0=3 0=5 0=3 0=5
T= 100
Hansen 10 8 66 34 19 17 22 15
Boot-AR 4 7 64 54 14 10 19 12
Boot-RW 3 3 54 44 12 10 10 9

T= 250
Hansen 4 7 95 74 41 25 48 26
Boot-AR 5 5 99 87 44 23 53 35
Boot-RW 1 3 95 77 36 15 40 25
* Based on 200 Monte Carlo replications. For Boot-AR, the null model is a stationary linear AR.
For Boot-RW, the null model is a linear AR with unit root imposed. P-values for bootstrap and
Hansen methods are based on 100 simulations. For EQ-TAR and Band-TAR, p = 0.4. For
RD-TAR, IAI = 1. For AR, zt = .8zt-1 + et. For RW, zt =zt- + et. For all models, et N(0,1).

Given that the null hypothesis of linearity is rejected, we can estimate the
threshold and parameters of the respective autoregression by conditional least
squares. That is, estimate the threshold autoregression for given threshold values
(and delays) and then find the threshold values (and delays) by minimizingthe sum
of squared errors. Chan (1993) shows that for the case of a single threshold, the
estimated threshold value is (super)consistentin that it converges in distribution at
rate T where T represents the sample size. Chan also shows that the asymptotic
distributionof the estimates of the autoregressiveparametersis independent of the
estimated threshold values. Thus, having rejected linearity, asymptotic inference
about the threshold autoregressive parameters can proceed as if the threshold
values were known. These results are likely to hold for multiple threshold case as
well. How inference about the estimated thresholds themselves might be conducted
in practice is still an open question.20

20
Hansen(1995)developsthe asymptoticinferencefor a single-thresholdmodel.

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 THRESHOLD COINTEGRATION 643

4. SUMMARY AND DIRECTIONS FOR FURTHER RESEARCH

In this paper, we have presented a model in which the cointegratingrelationship

between variables turns on and off. We modelled this on and off behavior explicitly
as a threshold model in which the series are cointegrated if they move too far away
from the equilibrium relationship but are not cointegrated as long as they are
relatively close to the equilibrium. Because of the difficulty of parametrically
characterizing stationarity for the threshold model, we suggested a two-step ap-
proach in which cointegration and threshold behavior are tested separately.
The basic insight of this paper will also hold for smooth transition threshold
models. In these models, the change in regimes does not occur abruptly and,
instead, occurs only gradually.Nonetheless, the further the time series is away from
the equilibrium the stronger is the reversion back to the equilibrium.Balke (1992)
used a smooth transition error correction mechanism to model the dynamics of
aggregate income and consumer durables, and Anderson (1994) estimated a smooth
transition error correction model of the term structure.
The approach taken in this paper to testing for threshold cointegration is
essentially the single equation Engle-Granger approach. One could also take a
systems approach in that threshold cointegration implies a threshold vector error
correction model. Ideally, the testing for cointegration and thresholds and the
estimation of the cointegrating vector and the threshold vector error correction
model all would be done in the same framework-something like the FIML
approach of Johansen, except now we have a threshold VECM. Perhaps, some kind
of recursive, reduced rank regression (Phillips 1996) could be employed except that
the sample is ordered according to the value of a threshold variable instead of time.
The problem is that the threshold variable itself is determined by the cointegrating
vector which in turn must be estimated. A halfway measure might be a two-step
procedure in which the rank of the long-run matrix is determined first. Then given
the cointegratingvector (or cointegratingrank of the long run matrix),one can test
for threshold cointegration by determiningwhether a threshold vector error correc-
tion model is present. A multivariate version of the sup-Wald test could be
employed with inference determined either by bootstrap methods or a multivariate
version of Hansen's simulation method.

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