Role of deterministic components in a cointegrated VAR model

The models we discussed so far did not include a constant term or the deterministic time trend
term. Hence we shall next highlight the role and the interpretation of such terms in a cointegrated
V AR model. From our discussion of the unit root analysis of any univariate series, we know that
the presence of deterministic terms such as a constant and/or dummy variables affect the asymptotic
distribution of the unit root statistic. This property extends to the vector case too. We shall highlight
this with the help of the following univariate example. Let us consider a random walk with a drift
term:

Zt = Zt1 + + et or Zt = + et
so that
E(Zt ) = t + Z0 mean of the levels and
E(Zt ) = mean of the equilibrium growth rate

This above example clearly says that if a model in differences has a constant term, it has an
entirely different role to play, when the model is re-written in levels. In the differenced version it
measures the mean of the growth rates assuming that the Zt are logs of the original data but in
the levels it is the coefficient of the trend term.
We can extend this analogy to the vector case too. Recall that a V ECM allows both the
differenced as well as the levels form to be in the same equation. Extending the above univariate
example, We shall show how such terms affect the mean of the differenced process, Zt and the
mean of the equilibrium error process, 0 Zt . Though cointegration is expected to cancel out the
stochastic trends among the variables, it may or may not cancel out any possible deterministic trend
that a finite sample is likely to have. If the cointegrating relation still has a trend, then we may
have to add a linear trend to the cointegrating relation to make it stationary. The presence of a time
trend in the cointegrating relations calls for the inclusion of a constant term in the equation for Zt
too. Such questions are clearly empirical and are best answered by including both the constant and
deterministic trend terms in the V ECM explicitly.
There are several ways in which these two terms enter a V ECM and the basic principle is well
understood by taking the simplest specification.
The specification we are going to use is the simplest V AR(1) model, so that the associated
V ECM is written as

Zt = 0 Zt1 + 0 + et
Note here that a V ECM explains N equations in Zt and r cointegration relations. So 0 can
be considered as the sum two vectors, one contributing to Zt (describing the slope of the linear
trend in levels of Zt ) and one to 0 Zt (which is nothing but the intercept of a long run relation.) We
shall adopt a simple scheme to decompose 0 into two vectors.
The associated M A form is
t
X

X
0
i eti + 0 + Z


Zt = (1) ei + 0 +
i=1 i=0

Mapping with (CT 4) we have

1 = (1)0

X i
i = ( ) 0 1
(I + 0 ) 0
i=0
0 = (1)Z0
Z initial values

1
From the M A form
X
i eti


Zt = (1) et + 0 +
i=0

So,

E Zt = (1)0 (called the mean of the equilibrium growth rate)
Now we have to obtain the mean of the stationary part, that is, E( 0 Zt ). Note that the given V ECM
can be written as
0 Zt = (I + 0 ) 0 Zt1 + 0 0 + 0 et
Since 0 Zt is stationary, we see that E( 0 Zt ) is a constant, so that E( 0 Zt ) = 0 and hence we can
write,
1
E ( 0 Zt ) = ( 0 ) 0 0 (called the mean of the equilibrium error)
We have to show that this mean is zero.
Note that the given V ECM model can be written as
Zt E(Zt ) = 0 Zt1 E( 0 Zt1 ) + et


(CID 1)
Here every term has been written as deviation from the respective mean.
Recall the following:

1 0
(1) = 0 , and the identity
(0 )1 0 + ( 0 )1 0 = I.
Use the identity to write
(0 )1 0 0 + ( 0 )1 0 0 = 0
| {z } | {z }

0 0

0 + 0 = 0
With this expression we can re-write (CID 1) as
Zt (0 )1 0 0 = 0 Zt1 + ( 0 )1 0 0 + et
Zt 0 = 0 Zt1 + 0 + et .

A pertinent point to be noted here is that the way we have decomposed the constant term 0 is
definitely not the only way. But the motivation to choose the identity above to decompose the
the constant term stems from the fact that it satisfies an appealing criterion that an equilibrium
error has mean zero. Note here that the left hand side has zero mean since it is in already
in deviations form and on
the right hand side, et has zero mean by assumption, and hence it
follows that E 0 Zt1 + 0 = 0.
We can also show that equilibrium error has mean zero in a general V ECM where both the
constant with dynamics and/or the trend terms are allowed by using other identity schemes.
Given the tedious nature of the algebra involved, it is not pursued here.
As an illustration we shall explain below five different models arising out of different combinations
of restrictions on a constant term and a trend term in a general V ECM. We shall suppress the
dynamics again for convenience. Hence the given model is,
Zt = 0 Zt1 + 0 + 1 t + et (CID 2)

2
We shall use the following decomposition as before:
0 = 0 + 0
1 = 1 + 1
Substituting the above decompositions in (CID 2), we have
Zt = 0 Zt1 + 0 + 0 + 1 t + 1 t + et
Re-arranging we get,

Zt1
0


Zt = 0 1 1 + 0 + 1 t + et
t
or
Zt = 0 Z
t1 + 0 + 1 t + et (CID 3)
where

0
0 = 0 0 1 and Z t1 = Zt1


1 t
As mentioned before, we list out five different models arising out of restrictions on the constant and
the trend terms in (CID 3).
Case 1: Both 1 and 0 are zero. This case corresponds to a model where there are no
deterministic components either in the cointegrating relations or in the model for Zt . This is
an unlikely case because it is common knowledge that most data set contain at least an intercept
term and many have deterministic trends too. This restriction rules out both possibilities and
hence it is hard to justify this restriction.
Case 2: 1 = 0, 0 = 0 but 0 6= 0. This is a case where the constant term is restricted to be
in the cointegrating relations, implying that the cointegrating relations have a non-zero mean.
Since 0 = 0, there are no linear trends in the data.
Case 3: 1 = 0 but the constant term 0 is unrestricted that is, no linear trends in the model
for Zt but there are linear trends in the levels data. Still the cointegrating relations have no
trend terms but have an intercept; and E(Zt ) = 0 6= 0 The restriction 1 = 0 means linear
trends in the data are canceled in the cointegrating relations, along with stochastic trends.
This is a case of deterministic cointegration.
Case 4: 1 = 0 but ( 0 , 0 , 1 ) 6= 0. These restrictions mean that the trend is restricted to
appear only in the cointegrating relations, but the constant is expected to be present both in
the cointegrating relations and in the model for Zt . This implies that there are linear trends
in the data but such trends are not canceled in the cointegrating relations. Such cointegrating
relations are called trend stationary cointegrating relations.
Case 5: No restrictions on 1 and 0 . This case is not encountered often in practice. Because,
this case allows for linear trends in the differenced variables Zt implying that data in levels
had quadratic trends. Though it is likely that we encounter data sets with quadratic trends,
the development of literature is such, that it is better to detect the factors contributing to the
quadratic trend term and account for them rather than explicitly model such data directly.
These cases clearly highlight the importance of correctly specifying and modeling the deterministic
and the stochastic components correctly in a cointegrated V AR model. One can outline a similar
scenario to show how it is also important to correctly specify and model dummy variables in a
cointegrated V AR model. However, we shall not follow it up here.