UNIT ROOTS AND

NON-STATIONARY TIME SERIES

5 November 2021 Dr. Maurice J. Roche, Department of Economics Topic I : 1

 Objectives of the Lecture
• To define the concept of non-stationarity in time series.

• To introduce the random walk.

• To outline the problem of spurious regression.

• To distinguish between trend-stationarity and difference-stationarity.

• To outline tests for unit roots.

5 November 2021 Dr. Maurice J. Roche, Department of Economics Topic I : 2

 Non-stationary processes
• Most economic time series exhibit strong trends in either mean and/or variance.

• For example, real GDP and consumption expenditure appear to be non-stationary.

• For regression analysis to be performed and hypothesis testing to be done the data
has to be stationary or the equation must be in a form that can be rewritten as a
relationship among stationary variables, e.g. an ADL model.

• So how do we proceed?

5 November 2021 Dr. Maurice J. Roche, Department of Economics Topic I : 3

 Conditions for stationarity
• Stationarity refers to the state where the underlying stochastic process that
generates a data series is invariant with respect to time.

• If the characteristics of the stochastic process change over time then we say the
process is non-stationary.

• The characteristics we focus on are mean, variance and covariances.

• If a series is stationary then we can model it via an equation with fixed coefficients
estimated from past data.

• If a series is non-stationary then we have to transform it into a stationary series

before we begin modeling or the equation must be in a form that can be rewritten
as a relationship among stationary variables

5 November 2021 Dr. Maurice J. Roche, Department of Economics Topic I : 4

 Conditions for stationarity (cont.)
• Assume a stochastic time series y1, ... , yT where there are T observations.

• Covariance Stationarity: A stochastic process, yt is weakly stationary if it

satisfies the following requirements:

E  yt  is independent of t

var( yt ) is a constant, independent of t

cov( yt , y s ) is a function of t-s, but not of t or

s.
5 November 2021 Dr. Maurice J. Roche, Department of Economics Topic I : 5
 Conditions for stationarity (cont.)

E  yt  is independent of t
• Thus a stationary series must have a constant mean and a tendency to revert back
to that mean.

• This implies that the expected value will be the same in any period.

• Note this would not be satisfied by real GDP for example.

5 November 2021 Dr. Maurice J. Roche, Department of Economics Topic I : 6

 Conditions for stationarity (cont.)
An example
• Take a simple AR(1) model:

yt  1   2 yt 1   t
E  yt   E  yt 1 
1
E  yt  
Note:
Note:

12 So
Sothe
thestable
stablemean
mean
requires that22isis
requiresthat
less
lessthan
than1.1.

5 November 2021 Dr. Maurice J. Roche, Department of Economics Topic I : 7

 Conditions for stationarity (cont.)

var( yt ) is a constant, independent of t

• This means that the series must have a constant variance.

• A non-stationary series has a non-constant variance tending to infinity.

• Exchange rates and stock prices tend to have non-constant variances.

5 November 2021 Dr. Maurice J. Roche, Department of Economics Topic I : 8

 Conditions for stationarity (cont.)

cov( yt , y s ) is a function of t-s, but not of t or

s.
• This requirement is that the covariance between observations is a function of
only how far apart they are in time, not the time at which they occur.

5 November 2021 Dr. Maurice J. Roche, Department of Economics Topic I : 9

 Some definitions
• A stationary series is said to be integrated of order 0 or I(0).

• A nonstationary series is said to be integrated of order d or I(d).

• This implies you have to difference the series d times to make it stationary.

• It is common to find that macroeconomic and financial series to be integrated of

order 1 or I(1).

• Thus the first-differenced series (a growth rate if measured in logs) is stationary.

5 November 2021 Dr. Maurice J. Roche, Department of Economics Topic I : 10

 Spurious regressions
• In a famous paper Granger and Newbold (1974) introduced the notion of a spurious
regression.

• They warned that researchers had ignored the significance of very high serial
correlation among the residuals in conventional regression models.

• They said that macroeconomic data was in general non-stationary (or integrated)
and that in regressions involving levels of variables, the standard significance tests
were usually misleading.

• The conventional t and F tests would tend to reject the hypothesis of no relationship
even if there was, in fact, none.

5 November 2021 Dr. Maurice J. Roche, Department of Economics Topic I : 11

 Spurious regressions (cont.)
• In general, regressing two integrated or nonstationary processes of the same order,
e.g. I(1), on each other tends to yield significant relationships even when there is no
such relationship.

• Hence the term spurious regression.

• So the term refers to regressions that “look good” - high R2 values, significant t
statistics - but which have no meaning.

• This does not apply in the special case where variables are cointegrated (more later).

5 November 2021 Dr. Maurice J. Roche, Department of Economics Topic I : 12

 Spurious regressions (cont.)
• A spurious regression is likely when the model looks like:

yt  1   2 xt   t

• And the y and x variables are integrated or non-stationary random processes.

• As a result the x2/T (the denominator in the OLS estimator of 2 ) does not
converge on any limiting value and the OLS estimator is not consistent and the
usual inference procedures are not valid.

5 November 2021 Dr. Maurice J. Roche, Department of Economics Topic I : 13

 Spurious regressions (cont.)

• In a Monte-Carlo study Granger and Newbold (1974) created two non-stationary

random walks y and x that were uncorrelated with each other.

• They regressed y on x and found that in 75 per cent of cases, the t test on the2
rejected the null that it was zero.

• So in 75 per cent of the cases, a spurious significant relationship was found.

5 November 2021 Dr. Maurice J. Roche, Department of Economics Topic I : 14

 Spurious regressions (cont.)

• Granger and Newbold (1974) concluded that when regressions of this sort were
performed:
– the R2 tended to be high,
– low DW statistics were observed,
– the t tests were very misleading.

• Phillips (1986) has provided the theoretical proof of the Granger and Newbold
(1974) findings.

• The initial solution was to use first-differences.

• Now researchers first test for cointegration between y and x, see Topic II.

5 November 2021 Dr. Maurice J. Roche, Department of Economics Topic I : 15

 First differences
• So in first-difference form the regression would be:

yt  1   2 xt  vt
vt   t   t 1
• If the original error is not serially correlated then the differenced error is a MA(1)
process which is autocorrelated.

• In this case the OLS estimates are still consistent although inefficient.

• Granger and Newbold (1974) showed that estimation of this equation does not distort
the hypothesis testing.

5 November 2021 Dr. Maurice J. Roche, Department of Economics Topic I : 16

 First differences (cont.)

• The strong message is that when using non-stationary series in levels you should
take great care.

• This led to work being done in differences.

• But the real message is that we cannot conduct inference unless we detrend the
data.

5 November 2021 Dr. Maurice J. Roche, Department of Economics Topic I : 17

 Detrending data
• The usual statistical properties of OLS only hold when the data is stationary.

• Non-stationary data must have the trend removed before you can use it.

• There are two common approaches to this:

– detrending using a time trend (or some deterministic function of time)
– using differences.

• Which approach is the best?

5 November 2021 Dr. Maurice J. Roche, Department of Economics Topic I : 18

 Detrending data (cont.)

• It depends on the source of the non-stationarity.

• We have to examine two types of non-stationarity:

– deterministic trend behaviour
– stochastic or random trend behaviour.

5 November 2021 Dr. Maurice J. Roche, Department of Economics Topic I : 19

 Deterministic trends
• We assume that the process is driven by a deterministic or secular trend component
and a random component:
yt  f (t )   t
 t ~ iid  0,  2

• We might write this as a linear time trend process:

yt    t   t
• The least squares residuals from this model form a detrended, stationary time series that
can be used in regression analysis:

ˆt  yt  ˆ  ˆt

5 November 2021 Dr. Maurice J. Roche, Department of Economics Topic I : 20

 Deterministic trends (cont.)
• Time series that can be detrended in this way are called trend-stationary (TSP)
processes.

• This was the common approach.

• But there is another source of non-stationarity that is possible and detrending as if

the processes are TSP provides us with the sort of problems identified by Granger
and Newbold (1974).
• The second source of non-stationarity in time series has been called stochastic
trending behaviour.

• Integrated processes like the one’s Granger and Newbold (1974) were dealing with
follow stochastic trends.

5 November 2021 Dr. Maurice J. Roche, Department of Economics Topic I : 21

 Stochastic Trends
• A common model is the random walk:

yt    yt 1   t This
Thisisisan
anexample
example
of
ofaarandom
randomwalk
walk
et ~ iid  0,  drift
2 with
withfixed
fixeddrift

• By direct substitution:


yt   (    t i )
i 0
• The random walk is thus a simple sum of an infinite number of random variables,
possibly with a non-zero mean.

5 November 2021 Dr. Maurice J. Roche, Department of Economics Topic I : 22

 Stochastic trends (cont.)
• To make this sort of process stationary we have to take first-differences:

yt    yt 1   t
The
Thedifferenced
differencedseries
seriesisisnow
yt  yt 1     t
now
aafunction
functionof
ofaaconstant
constantandandaa
random
randomerror.
error.
yt     t
• A series which can be rendered stationary by taking differences is called a difference-stationary
(DSP) process or I(1).

5 November 2021 Dr. Maurice J. Roche, Department of Economics Topic I : 23

 Trend and Difference
stationary processes
• So we can have two types of trending, non-stationary series:
– A series which can be rendered stationary by taking differences is called a
difference-stationary (DSP) process
– A series which can be rendered stationary by detrending using a deterministic
time trend is called a trend-stationary (TSP) process

• We need to compare TSPs to DSPs to understand what the issues are.

• The problem is that the two processes can behave in similar ways but over the
longer term will yield totally different outcomes.

• It is sometimes difficult to tell from visual examination what is the source of non-
stationarity is.

5 November 2021 Dr. Maurice J. Roche, Department of Economics Topic I : 24

 Tracing the DSP history
• We can see this by starting both processes off at time t = 0 with yt = y0.
• The successive values of the DSP are:

y1  y0    1
y2  y1     2  y0   (2)   1   2 

yt  y0  t  vt
vt  i 1 ei
t

5 November 2021 Dr. Maurice J. Roche, Department of Economics Topic I : 25

 Comparing the TSP and DSP
• The TSP is:

y t  y 0  t   t
• The DSP is:

yt  y0  t  vt
vt  i 1 ei
t

• The two processes look alike except that the error term vt is clearly not stationary
because the variance of vt is equal to 2t.

5 November 2021 Dr. Maurice J. Roche, Department of Economics Topic I : 26

 Implications
• If we estimate the DSP as if it is a TSP we are likely to run spurious regressions
because yt and t are non-stationary.

• The residuals from that regression will not be stationary.

5 November 2021 Dr. Maurice J. Roche, Department of Economics Topic I : 27

 Unit root testing
• Two statisticians David Dickey and Wayne Fuller (1979) developed a test to
determine whether the process is DSP or TSP.

• The tests have become known as unit root tests.

• To see why they are called unit root tests we have to briefly review the concept of a
root in a polynomial.

5 November 2021 Dr. Maurice J. Roche, Department of Economics Topic I : 28

 Unit roots
• Take a simple AR(1) process:

yt  yt 1   t
• We can write this in lag operator form as:

(1  L) yt   t

5 November 2021 Dr. Maurice J. Roche, Department of Economics Topic I : 29

 Unit roots (cont.)
• Under what conditions will this process be stationary?
• If the root of:

(1  L)  0
is greater than one in absolute value.
• The root is:

L  1/ 

5 November 2021 Dr. Maurice J. Roche, Department of Economics Topic I : 30

 Unit roots (cont.)
• So for L > 1 we require:

1    1
• If L = 1, for example, then the process is non-stationary.
• This is a unit root process and would imply that:

 1

5 November 2021 Dr. Maurice J. Roche, Department of Economics Topic I : 31

 Testing for a unit root
• So an obvious test in

yt  yt 1   t
• Is to test whether:

H0 :  1
H1 : 1    1
• using a t-test. Under H0 the series y is a DSP or I(1).

• Appropriate critical values are given in Fuller (1976) and Enders (1995) Table 4.1.

5 November 2021 Dr. Maurice J. Roche, Department of Economics Topic I : 32

 Testing for a unit root (cont.)
• We can re-parameterise the AR(1) process:

yt  yt 1   t

• As:

yt  yt 1  yt 1  yt 1   t
yt  (  1) yt 1   t
yt   yt 1   t *

5 November 2021 Dr. Maurice J. Roche, Department of Economics Topic I : 33

 Testing for a unit root (cont.)
• So a test of the null that:

H0 :  1
H1 : 1    1
• Becomes a test that:

H0 :   0 *

H1 :   0 *

5 November 2021 Dr. Maurice J. Roche, Department of Economics Topic I : 34

 Augmented Dickey-Fuller tests
for a unit root
• There are a few variants to the Dickey-Fuller (1979) test.

• The test is valid only if the errors in the test regression are white noise.

• It is common to augment the test regression with enough lagged differences in y so

as to ensure that the residuals are serially uncorrelated.

• If the series has a non zero mean then a constant is added to the test regression.
• If the series displays a trend then a trend dummy is added to the test regression.

• The general expression for the test regression is given by

p
y t  a 0  y t 1  a 2 t   i y t i 1   t
*

i2
5 November 2021 Dr. Maurice J. Roche, Department of Economics Topic I : 35
 Augmented Dickey-Fuller tests
for a unit root (cont.)

• Appropriate critical values differ for each variant of the test.

• They are given in Fuller (1976) and Enders (1995) Table 4.1.

• Zivot and Andrews (1992) suggest tests that allow for breaking trends.

• It is similar to a sequential Chow test using dummy variables.

p
y  a  y
t 0
*
t 1  a t    y
2 i t i 1  t
i2
5 November 2021 Dr. Maurice J. Roche, Department of Economics Topic I : 36