Co Integration

Cointegration
 When variables are non-stationary to convert

them to stationarity, sometimes we
difference them
 The variables are differenced until they
become stationary.
 OlS is then used at the point at which they
are stationary.
Continuation
 When differencing, the long-term

relationship between variables, which is
given at levels, is lost.
 This is because economic theory gives
equilibrium values in levels not in the form of
differences
 Instead of differencing we first investigate for
presence of cointegration
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Cointegration - Definition
 Is the existence of a long run equilibrium
relationship among time series variables
 Is a property of two or more variables
moving together through time, and
despite following their own individual
trends will not drift too far apart since they
are linked together in some sense
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Cointegration - Definition
Co-integration analysis is done

to investigate long- run
relationship among variables e.g
between income and labour
productivity.
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Example of cointegrated series
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Example: Are Y (disposable income) and X (consumption)
cointegrated?
First be satisfied that the two time series are I(1). E.g. apply unit root
tests to X and Y in turn.
55
X Y
50
45
40
35
30
25
20
15
10
0 10 20 30 40 50 60 70 80 90 100
They are clearly not stationary

But they seem to move together
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Valid condition for Cointegration
 Two time series are cointegrated if:
 They are integrated of the same order,
I(d)
 There exists a linear combination of
the two variables that is stationary
(I(0)).
 Most of the cointegration literature
focuses on the case in which each
variable has a single unit root (I(1)).
Testing for Cointegration
 Firststep must be to use ADF test to

find out whether the series are I(1)
 After which cointegration is tested

 Testing for cointegration tells whether
there is genuine long-run relationship
among variables or a spurious one
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Cont: (implication)
Ifthe cointegration analysis indicates

that there is a cointegrating vector,
we infer that the tested series will not
drift apart in the long-term , and will
revert to equilibrium levels following
any short-term drift that may take
place.
Formal Tests for Cointegration
 I.Augmented Engle-Granger (AEG) Test

 II.Cointegrating Regression Durbin-Watson
(CRDW) Test
 III.Johansen
Multivariate Cointegration Tests
or the Johansen Method
EES 501 LECTURE V 10

Testing for Cointegration using the Engle-
Granger procedure- Residual based
 Testing for co-integration can be done

using the Engle- Granger two-step
procedure.
 The procedure involves testing whether
the regression residuals of a co-
integrated relationship are stationary.


cont
 Thismethod is applicable for simple

regression analysis where the model
contains only two variables
Testing for Co-integration using the Engle-
Granger procedure- Residual based(CONT)
 Assume we have the equation:
 Yt= a0+a1Xt+Ut………….(1)
 Ut should be I(0) if Y and X are
cointegrated
 Note this method applicable only for
model with two variables
Steps in Testing for Cointegration
1) Test all the variables to determine if

they are I(0), I(1) or I(2) using the ADF
test.
2) If both variables are I(1), then carry out
the test for cointegration
3) If there is evidence of cointegration,
use the residual to form the error
correction term in the corresponding
ECM
cont
4. Add in a number of lags of both

explanatory and dependent variables to
the ECM
5. Omit those lags that are insignificant to
form a parsimonious model
6. Use the ECM for dynamic forecasting of
the dependent variable and assess the
accuracy of the forecasts.
Summary of steps
 Step 1: Pre-test the variables of their order of
integration. By definition, cointegration
necessitates that the two variables be
integrated of the same order (Differenced)
 As a prerequisite, it must first be
determined whether Xt and Yt are I(0) or I(1)
processes, that is we check whether Xt and Yt
contain unit roots.

Summary of steps
 Step 2: If the variables are not stationary in level but
are I(1), then they may be cointegrated

 If all are integrated of different order, then they
cannot be cointegrated.
 However, one may want to determine if they are
 multicointegrated.
 If the variables are I(1), then we can estimate the long
 run equilibrium relationship (”cointegrating
regression‘).

Summary of steps
 Step 3: If Yt and Xt are both I (1) and

cointegrated, then they have a long-run
relationship. There exists an error
correction representation.
 Error Correction Model (ECM) is then
conducted to give information on long run
relationship, short run relationship and the
speed of adjustment

Summary: Testing for Cointegration
Estimate equation (1)

Obtain the estimated residuals
(et)
Test for the stationarity of the
residuals


Cointegration
Ifthese error terms are found to be

stationary, thus I(0), it meant that all
the variables in the model are co-
integrated (thus there is a long-
term equilibrium relationship
among the variables).

An Example of a Cointegration Test
The null and alternative hypotheses in the test for cointegration are:
H 0 : the series are not cointegrated  residuals are nonstationary
H1 : the series are cointegrated  residuals are stationary

12.4.1 An Example of a Cointegration Test
Bˆt  1.644  0.832 Ft , R 2  0.881

(t ) (8.437) (24.147)
eˆt  0.314eˆt 1  0.315eˆt 1

(tau ) ( 4.543)
continuation
 Alternatively,if the variables are I(d),

thus differenced of order `d` in order to
be stationary, both the dependent and
independent are co-integrated even
though they are individually non-
stationary.

Cointegration
Thus they are integrated of same

order= I(d)
If this is the case you have to test
whether the series are cointegrated
in the next stage

Example
 
 ut  0.435 u t 1
(3.723)

Decision
 Critical values for 1%, 5%, and 10% = -

2.54, -1.9439,-1.617
 Decision: In absolute terms the t value
exceeds the critical value so we reject
the null hypothesis and conclude that
the estimated residuals are stationary
hence the variables included in the
model are cointegrated
DURBIN WATSON TEST
 Assumes that the disequilibrium errors can

can be modelled by a first order AR process
 Regress the cointegrating relationship
 Obtain the estimated D.W value
 H0: DWc=0 ( no cointegration)
 H1: DWc >0 ( there is cointegration)

CONT
 DECISION: If DWc < critical value

accept the H0 that there s no
cointegration
 Large values are taken as evidence of
rejection of the null hypothesis of no
cointegration

JOHANSEN METHOD
 The Johansen’s Method is preferred due to

reasons mainly relating to the shortfalls of
Engle-Grangers Two Step Estimation Method.
 The Two Step Estimation Method is very easy
to run, however it needs a larger sample size
to avoid possible estimation errors and
 can only be run on a maximum of two variables
(Brooks 2008).
THE JOHANSEN TEST
 Definition: is a test for cointegration that

allows for more than one cointegrating
relationship unlike Engle- Granger method
 Is a multivariate form method based on a
VAR representation of the stochastic process
 i.e applied when we have more than two
variables in the model

THE JOHANSEN TEST
 Example
Yt=a0+a1X1t+a2X2t+a3X3t+……..
+akXkt+ut
Note: no assumption that the Xs
are exogenous

THE JOHANSEN TEST
 In this case there may be up to r linearly

independent cointegrating relationships where
r≤k-1
 This makes the OLS based approach
above inappropriate
 In this case there are multiple
cointegrating relationships
 This calls for a different approach
cont
The answer is to use a system

approach that allows
determination of all r
cointegrating relationships
One such approach is Johansen
method
The Johansen test
Once the VAR is formulated one can

find the number of significant
eigenvalues ( number of
cointegrating vectors) in the system
It is possible to have more than one
cointegrating relationship

Differences with ADF test
 (i).The test produces a number of statistics

which can be used to determine the number
of cointegrating vectors present
 (ii).There are two separate tests for the
number of cointegrating relationships and
they do not always agree to the number
present ( they may give different decisions)

THE JOHANSEN TEST
 (iii).It is more difficult to interpret especially if there are
more than a single cointegrating relationship present
 iv).A decision must be made which cointegrating

vector is appropriate.
 (iv).It is a maximum likelihood based test hence

needs a large sample
 (v). ADF is OLS based
 (vi).Based on a VAR not a single OLS estimation
To Note!!
 Find the optimal lag structure
 Make sure the residuals are normally distributed white
noise
 The method requires normal distribution in the residuals
which often necessitates the use of dummies.
 To obtain the optimal lag structure we can start from the
general one with many lags and later reduce the VAR by
eliminating the insignificant lags downwards as far s
possible without destroying the assumption of white noise
variables ( or use AIC or any method to determine lag
length)
 You must test for normality of the residual
Procedure
 Test the variables for stationarity using

ADF
 if all variables are I(1), then include them
in the cointegrating relationship
 Use AIC and SBIC to determine lag
length
 Use Trace and Maximal eigenvalue to
determine the number of cointegrating
vectors present
The Johansen ML Procedure
 This is based on a VAR approach to

cointegration
 All the variables are assumed to be
endogenous (although it is possible to
include exogenous variables)
 The test relies on the relationship
between the rank of a matrix and its
eigenvalues or characteristic roots.

equation used
 ∆Xt=∏Xt-k+Ґ1 ∆Xt-1+ Ґ2∆Xt-2….. Ґk-1 ∆Xt-(k-1)+ut

 The above is called Vector error correction model
( VECM)
 The (VECM) contains g variables in first differenced
form on the LHS and k-1 lags of the dependent
variables ( differences ) on the RHS each with a Ґ
coefficient matrix attached to it
 The Johansen test centers around an examination

of the matrix ∏
THE JOHANSEN TEST
 ∏ can be interpreted as a long-run

coefficient matrix , since in equilibrium all
∆Xt-I will be zero

Johansen ML Approach
The rank ‘r’ of π equals the number
of cointegrating vectors
If π consists of all zeros, as with the
ADF test, the rank of the matrix
equals zero, all of the xs are unit root
processes, implying the variables are
not cointegrated.

cont
As with the ADF test, the equation can

also include lagged dependent variables,
although the number of lags included is
important and can affect the result.
This requires the use of the Akaike or
Schwarz-Bayesian criteria to ensure an
optimal lag length.
The π Matrix
 As mentioned, r is the rank of π and determines
the number of cointegrating vectors.
 When r = 0 there are no cointegrating vectors
 If there are g variables in the system of equations,
there can be a maximum of g-1 cointegrating
vectors.
 If r=1 this means there is one cointegrating
vector
 If 1<r<n there is multiple cointegrating vectors

JOHANSEN TEST STATISTICS
We use 2 statistics:

(i) the trace statistics
(ii) the maximum eigenvalue
statistic
It is possible both can give
different results

THE JOHANSEN TEST
Both can be used to determine the

number of cointegrating vectors
present, but may give different
results

THE TRACE TEST
 The Trace test is a joint test,

 Ho: the number of cointegrating
vectors is≤ r,
 H1: that there are more then r.
 The distribution of both test statistics is
non-standard.

The trace method
 To determine the number of co-integration

vectors, Johansen (1988, 1989) and Johansen and
Juselius (1990)
 suggested two statistic test, the first one is the
trace test (λtrace).
 It tests the null hypothesis that the number of
distinct cointegrating vector is less than or equal
to q against a general unrestricted alternatives q =
r.
 the test calculated as follows:
trace
g 
trace (r )  T  In (1  i )
i  r 1
cont
 T is the number of observations, and the

 λ 1,s are the estimated eigenvalue from the
matrix.
EIGEN TEST
 The Maximal Eigenvalue test conducts

separate tests on each eigenvalue.
 Ho: that there are r cointegrating vectors
present
 H1: that there are (r + 1) present.

Eigenvalue method
the maximum eigenvalue test

(λmax) that is calculated according
to the following
formula
 λmax (r, r + 1) = -T In (1 – λr + 1)
CONT
 Johansen and Jeselius (1990) provide critical

values for the two statistics
 The distribution of the test statistics is non-
standard and the critical values depend on:
1. g-r
2. The number of non-stationary components
3. Whether constants are included in each
equation

DECISION
 Decision rule: If the test statistic is≥ the

critical value from Johansen`s tables
reject the null hypothesis that there are
r cointegrating vectors in favour of the
alternative that there are r+1 ( for trace)
or more than r ( for max)

Procedure
 Testing is done in a sequence and under the null

hypothesis r= ,1,2,…..g-1 so that the hypothesis
for max are:
 H0: r=0 vs H1: 0<r ≤g
 H0: r=1 vs H1: 1<r ≤g
 H0: r=2 vs H1: 2<r ≤g
 H0: r=3 vs H1: 3<r ≤g
.
.
 H0: r=g-1 vs H1: r =g
Explanation
 The first test involves a H0 of no cointegrating

vectors ( the matrix has zero rank)
 If null is not rejected it would be concluded
that there are no cointegrating vectors and
the testing would be completed
 if the H0:r=0 is rejected the H0:r=1 would be
tested and so on
 Thus the value or r is continually increased
until the H0 is no longer rejected
Johansen ML Results
(Trace Test)
Null Alternative
Trace 5% Value
40.3 20.2
r  0 r 1
7.6 9.16
r 1 r  2

Maximum Eigenvalue Tests
Null Alternative
Max 5% Value
34.7 15.9
r  0 r 1
8.6 9.2
r 1 r  2

Interpretation of Results
 Given that for both tests, the test statistic

exceeds its critical value (5%) when the null
is r = 0, we can conclude that at least one
cointegrating vector is present.
 For more than one cointegrating vector, the
test statistic is less than the critical value so
we conclude only a single cointegrating
vector is present.

Example (JOHANSEN TRACE
approach)
Null hypo Test stat 10% critical 5% critical 1%critical
r<=2 8.07 7.52 9.24 12.97
r<=1 19.84 17.85 19.96 24.60
r=0 57.17 32.00 34.91 41.07
Example (Johansen Max eigen
value)
Null hypo Test stat 10% critical 5% critical 1%critical
r<=2 8.07 7.52 9.24 12.97
r<=1 19.84 17.85 19.96 24.60
r=0 57.17 32.00 34.91 41.07
interpretation
 From the above two table we can see that the null
hypothesis that there is no cointegration relationship
among the variables is rejected even at 1% level of
significance and we fail to reject the null hypothesis
that there is at most one contegration relationship
among the variable
 Though we also fail to reject the null hypothesis about
two such relationship inside the system, we ultimately
come to the decision that the three variables of our
concern has one cointegration relationship.
Cointegration Tests using Johansen:
Examples
Example 1: Hamilton(1994, pp.647 )
 Does the PPP relationship hold for the US / Italian exchange rate -
price system?

 A VAR was estimated with 12 lags on 189 observations. The Johansen
test statistics were
r max critical value
0 22.12 20.8
1 10.19 14.0

 Conclusion: there is one cointegrating relationship.
63
The Approach to Multivariate
Cointegration and VECMs
1) Test the variables for stationarity using the usual ADF tests.
2) If all the variables are I(1) include in the cointegrating
relationship.
3) Use the AIC or SBIC to determine the number of lags in the
cointegration test (order of VAR)
4) Use the trace and maximal eigenvalue tests to determine
the number of cointegrating vectors present.
5) Assess the long-run β coefficients and the adjustment α
coefficients.
6) Produce the VECM for all the endogenous variables in the
model and use it to carry out Granger causality tests over
the short and long run.

Criticisms of the Johansen Approach
The result can be sensitive to the

number of lags included in the test and
the presence of autocorrelation
If there are more than two cointegrating
vectors present, how do we find the
most appropriate vector for the
subsequent tests.
If the two test statistics differ, which one
gives the correct result?
This is a large sample test.

Co Integration

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Cointegration

 When variables are non-stationary to convert

 When differencing, the long-term

EES 501 LECTURE V 2

EES 501 LECTURE V 3

Co-integration analysis is done

EES 501 LECTURE V 4

EES 501 LECTURE V 5

They are clearly not stationary

 Firststep must be to use ADF test to

 After which cointegration is tested

EES 501 LECTURE V 8

Ifthe cointegration analysis indicates

 I.Augmented Engle-Granger (AEG) Test

EES 501 LECTURE V 10

 Testing for co-integration can be done

EES 501 LECTURE V 11

 Thismethod is applicable for simple

 Assume we have the equation:

1) Test all the variables to determine if

4. Add in a number of lags of both

EES 501 LECTURE V 16

EES 501 LECTURE V 17

 Step 3: If Yt and Xt are both I (1) and

EES 501 LECTURE V 18

Estimate equation (1)

EES 501 LECTURE V 19

Ifthese error terms are found to be

EES 501 LECTURE V 20

H 0 : the series are not cointegrated  residuals are nonstationary

H1 : the series are cointegrated  residuals are stationary

Bˆt  1.644  0.832 Ft , R 2  0.881

eˆt  0.314eˆt 1  0.315eˆt 1

 Alternatively,if the variables are I(d),

EES 501 LECTURE V 23

Thus they are integrated of same

EES 501 LECTURE V 24

EES 501 LECTURE V 25

 Critical values for 1%, 5%, and 10% = -

 Assumes that the disequilibrium errors can

EES 501 LECTURE V 27

 DECISION: If DWc < critical value

EES 501 LECTURE V 28

 The Johansen’s Method is preferred due to

 Definition: is a test for cointegration that

EES 501 LECTURE V 30

EES 501 LECTURE V 31

 In this case there may be up to r linearly

The answer is to use a system

Once the VAR is formulated one can

EES 501 LECTURE V 34

 (i).The test produces a number of statistics

EES 501 LECTURE V 35

 iv).A decision must be made which cointegrating

 (iv).It is a maximum likelihood based test hence

 Test the variables for stationarity using

 This is based on a VAR approach to

EES 501 LECTURE V 39

 ∆Xt=∏Xt-k+Ґ1 ∆Xt-1+ Ґ2∆Xt-2….. Ґk-1 ∆Xt-(k-1)+ut

 The Johansen test centers around an examination

 ∏ can be interpreted as a long-run

EES 501 LECTURE V 41

EES 501 LECTURE V 42

As with the ADF test, the equation can