3.2.3.

1 Variable Process Identification (Unit Root Tests)

The variable process identification is accomplish by testing all the variables

for unit roots (or non-stationarity): Augmented Dickey-Fuller (ADF), Phillips-Perron

(PP), Elliott-Rothenberg-and-Stock (ERS), and Ng and Perron (NP). To illustrate how

the tests work, the ADF procedure is explained because the majority of test include

similar set of steps. ADF tests are carried out with the estimation of three models

(steps) that differ from the presence of a constant and a trend terms (see Enders

2004). Step one starts by estimating the most general equation using OLS:

Δyt = α0 + α2 t + γyt−1 + ∑m
s−1 βi Δyt−i + εt (3.39)

Where Δyt is the variable of interest in differences, α0 is a constant term, a2t is

a linear trend, γyt-1 are one period lagged levels, and (∑𝑚
𝑠−1 βi Δ𝑦𝑡−𝑖 ) are dependent

variable lagged differences to capture the whole dynamic nature of the process and

fix residuals autocorrelation. The optimal lag length is based on the lowest estimate of

the Akaike’s information criterion (AIC). The null hypothesis is non-stationarity or

unit-root process (Ho: γ=0) and is tested using the ττ statistic. Alternatively, it is

possible to carry out a joint test for the presence of a trend and a unit-root (Ho:

a2=γ=0) using the φ3 statistic. If the restriction is not binding, the second step is to

estimate a model with a constant term without a trend:

Δ𝑦𝑡 = 𝛼0 + 𝛾𝑦𝑡−1 + ∑𝑚
𝑠−1 βi Δ𝑦𝑡−𝑖 + 𝜀𝑡
(3.40)

Then test for the significance of the constant term and a unit-root (Ho:

a0=γ=0) using the φ1 statistic.

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