recap

Many economic and financial time series exhibit trends

Determination of the form of trend is important (deterministic

or stochastic)

Two common trend removal procedures are first differencing

and time-trend regression. (Trend need to be removed for
ARMA modeling)

First differencing is appropriate for I(1) time series and

time-trend regression is appropriate for trend stationary I(0)
time series.

Unit root tests can be used to determine the form of trends

Sunil Paul

Lecture Notes

recap

Dicky -Fuller tests has a null of unit root

Three different specification (none, with drift, with trend and

drift).

If DGP is a higher order AR process ADF can be used

Under the null hypothees the DF test statistics have

nonstandard and non-normal asymptotic distributions.

The distributions are affected by the inclusion of deterministic

terms, e.g. constant, time trend, dummy variables, and so
different sets of critical values must be used for test
regressions with different deterministic terms

Sunil Paul

Lecture Notes

Summary of DF tests

Model
Yt = c + t + Yt1 + t

Yt = c + Yt1 + t
Yt = Yt1 + t

Sunil Paul

Hypotheses (H0 )
=0
==0
==c =0
=0
=c =0
=0

Lecture Notes

test statistics
t
3
2

Multiple roots

If you suspect two unit root take first difference and conduct
DF test
2 Yt = D + 1 Yt1 + t
where Dt is the deterministic terms like drift, trend etc.

H0 : 1 = 0, testing can be done using , ort based on the

form of DF equation.

Yt I (2) ,if we fail to reject the null

Sunil Paul

Lecture Notes

Multiple roots

If the null is rejected the null of single unit root can be done
in the usual DF test (You can find an alternative procedure in
Enders)

it is very rare to find higher order integrated economic series

with more than two unit roots.

Sunil Paul

Lecture Notes

Power of the test

Unit root test have low power

Not good at distinguishing a unit root and a near unit root

process

Power=1-Type II error( Probability of rejecting a false null)

Power of the test decreases if we incorrectly specifies the

model.

Sunil Paul

Lecture Notes

Other practical issues

We have already discussed the procedure to choose the

appropriate specification earlier

Choosing an appropriate lag length is also important in the

ADF test

Use AIC or SBC

If the lag is too small, then the remaining serial correlation in

the errors will bias the test.

If lag is too large, then the power of the test will suffer

Make sure residuals are free from autocorrelation using ACF

and Q statistics

Sunil Paul

Lecture Notes

Treating seasonality in unit root tests

If seasonal pattern is deterministic we can use dummy variable

to capture the seasonality

For example: Quarterly seasonal dummies, Di = 1 for season i

and zero otherwise where i = 1, 2, 3

Given Yt =
P
0 + 1 D1 + 2 D2 + 3 D3 + Yt1 + pi=2 i Yti+1 + t

DF test can be done by testing the null of unit root (i.e.

= 0))

There can be unit roots in seasonal lags also

Sunil Paul

Lecture Notes

Phillips-Perron (PP) unit root tests

An alternative test to ADF

The PP unit root tests differ from the ADF tests mainly in
how they deal with serial correlation and heteroskedasticity in
the errors.

The ADF tests use a parametric autoregression to approximate

the ARMA structure of the errors in the test regression.

The PP method estimates the non-augmented DF test

equation and modifies the test statistics so that serial
correlation does not affect the asymptotic distribution of the
test statistic.

The tests usually give the same conclusions as the ADF tests

Sunil Paul

Lecture Notes

Phillips-Perron (PP) unit root tests

Consider a model Yt = c + Yt1 + t

I
I

DF:t iid
PP:t serially correlated

Yt = c + Yt1 + t

ADF adds lagged values of Yt to whiten the residuals;

The PP tests correct for any serial correlation and

heteroskedasticity in the errors by directly modifying the test
statistics t=0

Sunil Paul

Lecture Notes

Phillips-Perron (PP) unit root tests

I
I
I

The modified statistics are given by

q
 2 2

2
b
T .SE (b
)
Zt = bb2 21 bb
2

b2

b2 and
The terms
b2 are the estimates of variance parameters
2 = lim T 1
T
PT
andST = t=1

PT

t=1

E (2t ) , 2 = lim

PT

t=1

E (T 1 ST2 )

Under the null hypothesis PP Zt statistics have the same

asymptotic distributions as the ADF t-statistic

Sunil Paul

Lecture Notes

The power and size of PP and ADF tests

Power The ADF and PP tests are known to have low power
against the alternative hypothesis that the series is stationary
(or TS) with a large autoregressive root

Size The ADF and PP tests are known to have severe size
distortion (in the direction of over-rejecting the null) when the
series has a large negative moving average root.

PP tests are more size distorted than the ADF tests.

Sunil Paul

Lecture Notes

KPSS test
I

ADF and PP has a H0 : Yt I (1)

Kwiatkowski, Phillips, Schmidt and Shin (1992) (KPSS) test

has a H0 : Yt I (0) stationarity tests

KPSS assume time series as a sum of deterministic trend, a

random walk(Stochastic trend) and a stationary error

Consider Yt = t + rt + t ,
where
t is the deterministic trend,
rt = rt1 + t , t WN(0, 2 ) is random walk and
t is stationary error.

If 2 = 0 and the rt = r0 and Yt become an I (0) around a

deterministic trend and intercept

Under null Yt is a trend stationary series;

H0 : Yt I (0) = 2 = 0 and H1 : 2 > 0
Sunil Paul

Lecture Notes

KPSS test
I

KPSS test statistics is given as follows

KPSS =

T 2

T
X

!
Sbt2

be2

t=1

Pt

where Sbt = j=1 ebj , ebt is the residual of a regression of

Yt = + t + et and
be2 is a consistent estimate of long run
variance et using ebt
I

We can have a null of trend stationary or a null of level

stationary

If the null is level stationary the residuals should be obtained

from Yt = + et to compute the test statistics

Sunil Paul

Lecture Notes