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Applied Econometrics

Stationary and Non-stationary Time series


During regression, we assume that the time series is stationary.

A time series is stationary if its mean and variance are constant overtime
A time series is an example of stochastic process- sequence of random
variables ordered in time.

(Log of exchange rate)

LnEx is generally drifting upwards, though with great variation, suggesting that
neither mean nor variance of this time series is constant, thus LnEX is nonstationary or unit root.
Example: Inflation rates
Henry and shields found that standard unit root tests such as dickey fuller and Elliot
et al, and the KPSS tests of the null hypothesis of stationary may provide misleading
evidence as to the degree of persistence of shocks to inflation.
If a time series is unit root, we can study its behavior only for the period under
consideration. As a result it is not possible to generate for future time periods.
Tests of stationary:

Graphical analysis (visually)

Autocorrelation function ( correlation against itself)
Dickey fuller test
Augmented Fuller test
Phillips Perron test

Autocorrelation function :- ACF at lag k is defined as:

pk = Yk/Y0 = covariance at lag k/variance

Akaike/Schwarz information criterion to determine the lag length.

Rule of thumb is to find ACF up to to1/3 the length of the time series
Test the stat. significance of each AC coefficient in the correlogram by
calculating its standard error
Alternatively, find out if the sum of autpcorrelation coefficient is stat.
significant. Using the Q statistic where n is the sample size, and the m is the
number of lags








2350.9 0.0000
4695.7 0.0000
7034.2 0.0000
9366.6 0.0000
11693 0.0000

Dickey Fuller (DF) test

The unit root test for the variable is

Y t =B1+ B2 t +B3 Y t 1 +ut

Regress the differences of the log of exchange rate on the trend variable and
the on-period lagged balue of the exchange rate.

The null hypothesis is that

In the unit root context, the null hypothesis is Y contains a unit root
The alternative hypothesis is Y is stationary.
Use the DF test, whose critical values are calculated by simulations and
modern stat packages, such as EVIEWS and STATA.
DF test requires a comparison of the Z(t) stat to the critical values, it must be
lower the DF critical values.
If absolute test statistic of 3 (Z(t)) is less than absolute DF critical value,
indicates nonrejection of the unit root null.
Absolute test stat on 3 (Z(t)) is 0.17, which is less than absolute DF critical
value (1%) 3.43. Hence, we can accept the null hypothesis that LEX does
contain a unit root.
DF test can be performed in three different forms:

B 3 , the coefficient of

Y t1 , is zero.

Y t =B3 Y t 1+ ut

Random Walk:

Random Walk with a drift :

Random walk with drift and a deterministic trend :

Y t =B1+ B3 Y t 1 +ut

Y t =B1+ B2 t+ B3 Y t 1 +ut

The simple DF test is only valid if the series is an AR(1) process. If the series
is correlated at higher order lags, the assumption disturbances



ADF (augmented dickey-fuller) tests constructs a parametric correction for
higher-order correlation by assuming that the series follows an AR (p) process

and adding p lagged differences terms of the dependent variable (Y) to the
right hand side of the test regression.
If the error term ut is correlated, use ADF.
Add the lagged values of the dependent variables aka

Y t =B1+ B2 t+ B3 Y t 1 + ai Y ti +e t

Null and alternative hypotheses are same as DF test.

Phillips Perron test an alternative method of controlling for serial correlation
when testing for a unit root.
The PP method estimates the non-augmented DF test equation, and modifies
the t-ratio of the a coefficient so that serial correlation does not affect the
asymptotic distribution of the test statistic.
The PP test is based on the statistic:

~t =t 0

Where the

1/ 2

( )


T ( f 0 0 ) ( se ( a^ ) )
2f 0

1 /2

is the estimate and the ta is the t-ratio of a, se(a) is

coefficient standard error, and the s is the standard error of the test
regression, In addition, 0 is consistent estimate of the error variance, f0 is
an estimator of the residual spectrum at frequency zero.
There are two choices you will have make when performing the PP test:
First, you must choose whether to include a constant, a constant a linear line
trend, or neither in the test regression.
Second, you will have to choose a method for estimating f0. Stata and Eviews
has estimators to estimate this.
PP test with trend. Null and alternative hypotheses are same as ADF test. PP
test shows Y is a unit root variable.
If there is a general trend you can make it stationary by removing the trend
from it.
Yt = A1+A2t+et, where t is trend variable and e is error term with the usual

e^ =Y t A1 A 2 t

After running the regression,

The estimated error term in the above equation now represents the
detrended Y time series i.e. Y without the trend.
This procedure is valid if the original Y has a deterministic trend. If the time
series becomes stationary after detrending then it is called trend stationary.
Taking the first difference Y is a better way to make it stationary.