Week 4

Topic 3 :
Testing for Trends and
Unit Roots
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Outline
Assumptions of stationary
Why stationary is important
How to characterize time series data
by using univariate models
Impact of shock
Hypothesis testing ==> Unit root test
==> Stationary test
(Extra)
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Assumption of Stationarity
A stationary time series exhibits mean
reversion in that it fluctuates around a
constant long run mean.
Absence of unit root implies that the series
has a finite variance which do not depend
on time (crucial for economic forecasting),
and that the effects of shocks dissipate over
time.
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Assumption of Stationarity
Strict Stationary
Constant mean
Constant variance
Constant covariance
Cov(yt,yt-1) = Cov(yt-1,yt-2) =Cov(yt-i,yt-i-1)
Cov(yt,yt-2) = Cov(yt-1,yt-3) = Cov(yt-I, yt-i-2)
Cov(yt,yt-3) = Cov(yt-1,yt-4) = Cov(yt-I, yt-i-3)
(All Cov (yt,yt-i) are constant)

Assumption of Stationarity
Weak Stationary
Constant mean
Constant variance
Constant covariance
Cov(yt,yt-1) = Cov(yt-1,yt-2) =Cov(yt-i,yt-i-1)
Cov(yt,yt-2) = Cov(yt-1,yt-3) = Cov(yt-I, yt-i-2)
Cov(yt,yt-3) = Cov(yt-1,yt-4) = Cov(yt-I, yt-i-3)
(At least one of Cov (yt,yt-i) is not constant)

Stationarity

This series has non-stationary movement because

its mean and variance are not constant across
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time.

Non-Stationarity
A series can strongly influence its behaviour
and properties - e.g. persistence of shocks will
be infinite for non-stationary series.
Non-stationary series have no tendency to
return to a long-run path. The variance of the
series is time-dependent and goes infinity as
time approaches infinity, which results in series
problem in forecasting.
Presence of trends
Deterministic Trend
Stochastic trend
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Characteristic of Time Series Data

There are two models which have been
frequently used to characterize non-stationarity
(recall stochastic trend & deterministic trend in
Topic 1):
a. the random walk model with drift:
yt = + yt-1 + ut
b. the deterministic trend process:
yt = + t + ut
where ut is IID in both cases.
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Characteristic of Time Series Data

There are FIVE types of univariate models
White Noise (WN)
==> It must be stationary
Moving Average (MA)
==>It can be stationary or non-stationary
Autoregressive (AR)
==> It can be stationary or non-stationary
Autoregressive Moving Average (ARMA)
==> It must be stationary
Autoregressive Integrated Moving Average
(ARIMA)
==> It must be stationary
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Why stationary is important

Spurious regressions
If two variables are trending over time, a
regression of one on the other could have a high
R square even if the two are totally unrelated.
If the variables in the regression model are not
stationary, then it can be proved that the standard
assumptions for asymptotic analysis will not be
valid.
In other words, the usual t-ratios will not follow a
t-distribution, so we cannot validly undertake
hypothesis tests about the regression parameters.
==> R square > Durbin-Watson test statistic
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The Impact of Shocks

The AR (1) could be generalized to three

cases:
yt = + yt-1 + ut
When > 1, yt is an explosive process
When = 1, yt is a unit root process
(non-stationary process)

When < 1, yt is a stationary process

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The Impact of Shocks

Typically, the explosive case is ignored
and we use = 1 to characterize the
non-stationarity because
> 1 does not describe many data series
in economics and finance.
> 1 has an intuitively unappealing
property: shocks to the system are not
only persistent through time, they are
propagated so that a given shock will have
an increasingly large influence.
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Unit Root Test

Dickey-Fuller (1979)
==> Parametric testing
Augmented Dickey-Fuller (1981)
==> Parametric testing
Phillips-Perron (1988)
==> Non-parametric testing
Note: We make sure there is no structural break
in a series across time.
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Dickey-Fuller (DF) Unit Root Test:

- This test was developed by Dickey and Fuller (1979).

Graphical: Given that Yt has not trend , so we should use model

as below to conduct the unit root test.
Model with constant and
without trend:
t
t 1
t

Y Y

Graphical: Given that Yt has trend , so we should use model as

below to conduct the unit root test.
Model with constant and
with trend:

Yt t Yt 1 t
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DF Unit Root Test

Ho: Yt is non-stationarity (Yt has unit root), 0
H1: Yt is stationarity (Yt has no unit root), 0
Decision rule: We reject Ho is test statistic is less than
critical value. Other-wise, do not reject Ho.

Test statistic:

Critical value:

SE

It can be obtained from the t statistical
table that has been modified by Dickey
and Fuller. Later, the distribution of
modified t is expanded by Mackinnon. 15

Limitations of DF test
DF regression model does not taken
dynamic effect into account.
==> error in the model does not longer to
have normal distribution or white noise
process
==> autocorrelation problem
==> hypothesis results will be invalid

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Augmented Dickey-Fuller (ADF) Unit Root Test:

- This test was further developed by Dickey and Fuller (1981).

Graphical: Given that Yt has not trend , so we should use model

as below to conduct the unit root test.
k
Model with constant and
Yt Yt 1 i Yt i t
without trend:
i 1

Graphical: Given that Yt has trend , so we should use model as

below to conduct the unit root test.
Model with constant and
with trend:

Yt t Yt 1 i Yt i t
i 1

Note:
The optimal lag length for unit root test model is based on the minimum AIC
or SIC, where the autocorrelation problem does not exist in both models. 17

ADF Unit Root Test

Ho: Yt is non-stationarity (Yt has unit root), 0
H1: Yt is stationarity (Yt has no unit root), 0
Decision rule: We reject Ho is test statistic is less than
critical value. Other-wise, do not reject Ho.

Test statistic:

Critical value:

SE

It can be obtained from the t statistical
table that has been modified by Dickey
and Fuller. Later, the distribution of
modified t is expanded by Mackinnon. 18

Phillips-Perron (PP) Unit Root Test:

This test was developed by Phillips and
Perron (1988).
It is deal with the autocorrelation problem in
DF test.
It is a non-parametric test (ranking) with no
assumptions are required (waste some
information) ==> only for small sample size

Yt t Yt 1 t
2

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PP Unit Root Test

Ho: Yt is non-stationarity (Yt has unit root), 0
H1: Yt is stationarity (Yt has no unit root), 0
Decision rule: We reject Ho is test statistic is less than
critical value. Other-wise, do not reject Ho.

Test statistic:

Critical value:

SE

It can be obtained from the t statistical
table that has been modified by Dickey
and Fuller. Later, the distribution of
modified t is expanded by Mackinnon. 20

Stationary Test
- Kwiatkowski, Phillips, Schmidt and Shin (1992)
==> Parametric testing

Note: We make sure there is no structural break

exists in a series across time.

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KwiatkowskiPhillipsSchmidtShin
(KPSS) Stationary Test
- This test was developed by Kwiatkowski, Phillips,
Schmidt and Shin (1992).
- KPSS test is intended to complement unit root
tests, such as the DF, ADF and PP tests.
- By testing both the unit root hypothesis and the
stationarity hypothesis, one can distinguish series
that appear to be stationary, series that appear to
have a unit root, and series for which the data (or
the tests) are not sufficiently informative to be sure
whether they are stationary or integrated.
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KPSS test
Ho: Yt is stationarity
H1: Yt is non- stationarity

- Please refer to reference as follows for

extra information:
Kwiatkowski D., P. C. B. Phillips, P.
Schmidt, and Y. Shin (1992): Testing the
Null Hypothesis of Stationarity against
the Alternative of a Unit Root. Journal of
Econometrics 54, 159178.
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Comparison
Unit Root Test
Ho: Yt has a unit
root

Stationary Test
Ho: Yt is
stationary

Conclusion

Reject Ho

Do not reject Ho

Stationary

Reject Ho

Reject Ho

Inconclusive

Do not reject Ho

Do not reject Ho

Inconclusive

Do not reject Ho

Reject Ho

NonStationary
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Criticism for DF/ADF/KPSS

Small sample size ==> the power of test is
less.

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