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4.3NONSTATIONARYMODELSFORTIMESERIES
Themodelspresentedsofararebasedonthestationarityassumption,thatis,themeanandthe
varianceoftheunderlyingprocessareconstantandtheautocovariancesdependonlyonthetimelag.
Butmanyeconomicandbusinesstimeseriesarenonstationary.Nonstationarytimeseriescanoccurin
manydifferentways.Inparticular,economictimeseriesusuallyshowtimechanginglevels, ,(see
graph(b)infigure4.1)and/orvariances(seegraph(c)infigure4.1).

4.3.1NonstationaryintheVariance
Whenatimeseriesisnotstationaryinvarianceweneedapropervariancestabilizingtransformation.
Itisverycommonforthevarianceofanonstationaryprocesstochangeasitslevelchanges.Thus,let
usassumethatthevarianceoftheprocessis:

forsomepositiveconstant andsomeknownfunction .Theobjectiveistofindafunction such

thatthetransformedseries
seriesaround

where

hasaconstantvariance.Expanding

inafirstorderTaylor

isthefirstderivativeof

evaluatedat

.Thevarianceof

canbe

approximatedas:

Thus,thetransformation

mustbechosensothat:

Forexample,ifthestandarddeviationofaseries
thetransformation

hastosatisfy

isproportionaltoitslevel,then
.Thisimpliesthat

and
.Hence,a

logarithmictransformationoftheserieswillgiveaconstantvariance.Ifthevarianceofaseriesis
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4.3NonstationaryModelsforTimeSeries

proportionaltoitslevel,sothat

,thenasquareroottransformationoftheseries,

willgiveaconstantvariance.
Moregenerally,tostabilizethevariance,wecanusethepowertransformationintroducedbyBoxand
Cox(1964):

(4.17)

where iscalledthetransformationparameter.Itshouldbenotedthat,frequently,theBoxCox
transformationnotonlystabilizesthevariancebutalsoimprovestheapproximationtonormalityof
process .

4.3.2NonstationarityintheMean
Oneofthedominantfeaturesofmanyeconomicandbusinesstimeseriesisthetrend.Trendisslow,
longrunevolutioninthevariablesthatwewanttomodel.Inbusiness,economics,andfinancetime
series,trendisusuallyproducedbyslowlyevolvingpreferences,technologiesanddemographics.This
trendbehaviorcanbeupwardordownward,steepornot,andexponentialorapproximatelylinear.
Withsuchatrendingpattern,atimeseriesisnonstationary,itdoesnotshowatendencyofmean
reversion.
Nonstationarityinthemean,thatisanonconstantlevel,canbemodelledindifferentways.Themost
commonalternativesaredeterministictrendsandstochastictrends.
4.3.2.0.1DeterministicTrends

LetusconsidertheextensionofWold'sdecompositiontheoremfornonstationaryseriesgivenby
Cramer(1961):

where

isazeromeanstationaryprocess.Thechangingmeanofanonstationaryprocessortrend,

canberepresentedbyadeterministicfunctionoftime.Thesemodelsforthetrendimplythatthe
seriestrendevolvesinaperfectlypredictableway,thereforetheyarecalleddeterministictrend
models.
Forexample,ifthemeanfunction

followsalineartrend,onecanusethedeterministiclineartrend

model:
(4.18)

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Theparameter

4.3NonstationaryModelsforTimeSeries

istheinterceptitisthevalueofthetrendattime

and istheslopeitis

positiveifthetrendisincreasingandnegativeifthetrendisdecreasing.Thelargertheabsolutevalue
of thesteeperthetrend'sslope.
Sometimestrendappearsnonlinear,orcurved,asforexamplewhenavariableincreasesatan
increasingordecreasingrate.Infact,itisnotrequiredthattrendsbelinearonlythattheybesmooth.
Quadratictrendmodelscanpotentiallycapturenonlinearitiessuchasthoseobservedinsomeseries.
Suchtrendsarequadraticasopposedtolinearfunctionsoftime,

Higherorderpolynomialtrendsaresometimesconsidered,butitisimportanttouseloworder
polynomialstomaintainsmoothness.Othertypesofnonlineartrendsthataresometimesappropriate
aretheexponentialtrends.Iftrendischaracterizedbyconstantgrowthatrate ,thenwecanwrite:

Trendhasbeenmodelledasanonlinear(exponential)functionoftimeinlevels,butinlogarithmswe
have

Thus,trendisalinearfunctionoftime.Thissituation,inwhichatrendappearsnonlinearinlevelsbut
linearinlogarithmsiscalledexponentialtrendorloglineartrendandisverycommonineconomics
becauseeconomicvariablesoftendisplaysroughlyconstantgrowthrates.
4.3.2.0.2StochasticTrends

Nonstationarityinthemeancanbedealtwithintheclassofthe

models(4.7).An

modelisnonstationaryifits
polynomialdoesnotsatisfythestationaritycondition,
thatis,ifsomeofitsrootsdonotlieoutsidetheunitcircle.Ifthe
polynomialcontainsatleast
onerootinsidetheunitcircle,thebehaviorofarealizationoftheprocesswillbeexplosive.However,
thisisnotthesortofevolutionthatcanbeobservedineconomicandbusinesstimeseries.Although
manyofthemarenonstationary,theseseriesbehaveverymuchalikeexceptfortheirdifferenceinthe
localmeanlevels.Ifwewanttomodeltheevolutionoftheseriesindependentofitslevelwithinthe
frameworkof
models,the
polynomialmustsatisfy:

thatis:

sothatthe

polynomialcanbefactorisedas:

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Applyingthisdecompositiontothegeneral

model:

or

where

isapolynomialoforder

polynomial,wesaythat

and

.If

isastationary

hasaunitautoregressiveroot.Whenthenonstationary

polynomial

presentsmorethanoneunitroot,forinstance ,itcanbedecomposedas:

Applyingagainthisdecompositiontothegeneral

forsome

where

isastationary

modelweget:

polynomialoforder

Inshort,ifweuse
processesformodellingnonstationarytimeseries,thenonstationarity
leadstothepresenceofunitrootsintheautoregressivepolynomial.Inotherwords,theseries is
nonstationarybutits thdifferencedseries,
stationaryandinvertible

,forsomeinteger
model.Aprocess

anintegratedprocessoforderdanditisdenotedby

,followsa

withthesecharacteristicsiscalled
.Itcanbenotedthattheorderof

integrationofaprocessisthenumberofdifferencesneededtoachievestationarity,i.e.,thenumberof
unitrootspresentintheprocess.Inpractice
and
processesarebyfarthemostimportant
casesforeconomicandbusinesstimeseries,arising

seriesmuchlessfrequently.Boxand

Jenkins(1976)refertothiskindofnonstationarybehaviorashomogeneousnonstationarity,indicating
thatthelocalbehaviorofthissortofseriesisindependentofitslevel(for
processes)andofits
levelandslope(for
Ingeneral,iftheseries

processes).
isintegratedoforder ,itcanberepresentedbythefollowingmodel:

(4.19)

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4.3NonstationaryModelsforTimeSeries

wherethestationary

operator

andtheinvertible

operator

shareno

commonfactors.
Theresultinghomogeneousnonstationarymodel(4.19)hasbeenreferredtoastheAutoregressive
IntegratedMovingAveragemodeloforder
andisdenotedasthe
model.When
order

,the

isalsocalledtheIntegratedMovingAveragemodelof

anditisdenotedasthe

theAutoregressiveIntegratedmodel

model.When

,theresultingmodeliscalled

Inordertogetmoreinsightintothekindofnonstationarybehaviorimpliedbyintegratedprocesses,
letusstudywithsomedetailtwoofthemostsimple
models:randomwalkandrandom
walkwithdriftmodels.
4.3.2.0.3RandomWalkModel.
Therandomwalkmodelissimplyan

withcoefficient

(4.20)

Thatis,intherandomwalkmodelthevalueof attime isequaltoitsvalueattime

randomshock.Therandomwalkmodelisnotcovariancestationarybecausethe

plusa
coefficientis

notlessthanone.Butsincethefirstdifferenceoftheseriesfollowsawhitenoiseprocess,
integratedprocessoforder1,

isan

.Thismodelhasbeenwidelyusedtodescribethebehaviorof

financetimeseriessuchasstockprices,exchangerates,etc.
Graph(a)offigure4.11showsasimulatedrealizationofsize150ofarandomwalkprocess,with
.Itcanbeobservedthattheseriesdoesnotdisplaywhatisknownasameanreversion
behavior:itwandersupanddownrandomlywithnotendencytoreturntoanyparticularpoint.Ifa
shockincreasesthevalueofarandomwalk,thereisnotendencyforittonecessarilyloweragain,itis
expectedtostaypermanentlyhigher.
Takingexpectationsin(4.20)giventhepastinformation

,weget:

Thisimpliesthatthelevelattime ofaseriesgeneratedbyarandomwalkmodelissubjecttothe
stochasticdisturbanceattime
.Thatis,themeanleveloftheprocess changesthrough
timestochastically,andtheprocessischaracterizedashavingastochastictrend.Thisisdifferentfrom
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thedeterministictrendmodel(4.18)oftheprevioussection,wheretheparameter remainsconstant
throughtimeandthemeanleveloftheprocessisapuredeterministicfunctionoftime.

XEGutsm06.xpl
Figure4.11:Realizationsfromnonstationaryprocesses
Assumingthattherandomwalkstartedatsometime

withvalue

,weget:

Therefore,

sothatthevariancegrowscontinuouslyratherthanconvergingtosomefiniteunconditionalvariance.
Thecorrelationbetween and
is:

If

islargecomparedto ,thecorrelationcoefficientswillbeclosetoone.Therefore,the

randomwalkmodelprocesscanbecharacterizedbycoefficientsinthesampleACFoftheoriginal
series thatdecayveryslowly.
4.3.2.0.4RandomWalkwithDriftModel.
Therandomwalkwithdriftmodelresultsofaddinganonzeroconstanttermtotherandomwalk
model:

or
(4.21)
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Sotheprocess

4.3NonstationaryModelsforTimeSeries

isintegratedoforder1,

.Assumingthattheprocessstartedatsometime

bysuccessivesubstitution,wehave:

Itcanbeobservedthat

containsadeterministictrendwithslopeordrift ,aswellasastochastic

trend.Giventhepastinformation

,theleveloftheseriesattime isgivenby:

whichisinfluencedbythestochasticdisturbanceattime

throughtheterm

aswellasby

thedeterministiccomponentthroughtheparameter .
Therandomwalkwithdriftisamodelthatonaveragegrowseachperiodbythedrift, .Thisdrift
parameter playsthesameroleastheslopeparameterinthelineardeterministictrendmodel(4.18).
Justastherandomwalkhasnoparticularleveltowhichitreturns,sotherandomwalkwithdrift
modelhasnoparticulartrendtowhichitreturns.Ifashockmovesthevalueoftheprocessbelowthe
currentlyprojectedtrend,thereisnotendencyforittoreturnanewtrendsimplybeginsfromthenew
positionoftheseries(seegraph(b)infigure4.11).
Ingeneral,ifaprocessisintegrated,thatis,

forsome

,shockshave

completelypermanenteffectsaunitshockmovestheexpectedfuturepathoftheseriesbyoneunit
forever.Moreover,theparameter playsverydifferentrolesfor
and
.When
,
theprocessisstationaryandtheparameter isrelatedtothemeanoftheprocess, :
(4.22)

However,when

,thepresenceoftheconstantterm introducesadeterministiclineartrendin

theprocess(seegraph(b)infigure4.11).Moregenerally,formodelsinvolvingthe thdifferenced
series
,thenonzeroparameter canbeshowntocorrespondtothecoefficient of
inthedeterministictrend,

.Thatiswhy,when

,theparameter is

referredtoasthedeterministictrendterm.Inthiscase,themodelsmaybeinterpretedasincludinga
deterministictrendburiedinanonstationarynoise.

4.3.3TestingforUnitRootsandStationarity
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Aswehaveseenthepropertiesofatimeseriesdependonitsorderofintegration, ,thatisonthe
presenceofunitroots.Itisimportanttohavetechniquesavailabletodeterminetheactualformof
nonstationarityandtodistinguishbetweenstochasticanddeterministictrendsifpossible.Thereare
twokindsofstatisticaltests:onegroupisbasedontheunitroothypothesiswhiletheotherisonthe
stationarynullhypothesis.
4.3.3.0.1UnitRootTests

Thereisalargeliteratureontestingforunitrootstheory.AgoodsurveymaybefoundinDickeyand
BellandMiller(1986),amongothers.Letusconsiderthesimple
model:
(4.23)

where

andtheinnovations

regress

on

areawhitenoisesequencewithconstantvariance.Wecan

andthenusethestandardtstatisticfortestingthenullhypothesis

Theproblemarisesbecausewedonotknowaprioriwhetherthemodelisstationary.If
modelisstationaryandtheleastsquares(LS)estimatorof ,

,the

,equalstheMaximum

Likelihoodestimatorundernormalityandfollowsanormalasymptoticdistribution.Furthermore,the
statisticgivenby:

where

istheestimatedstandarddeviationof

,followsanasymptoticdistribution

Forsmallsamples,thisstatisticisdistributedapproximatelyasaStudent's with
offreedom.Nevertheless,when

.
degrees

,thisresultdoesnothold.ItcanbeshownthattheLS

estimatorof isbiaseddownwardsandthatthetstatisticundertheunitrootnullhypothesis,does
nothaveaStudent's distributioneveninthelimitasthesamplesizebecomesinfinite.
The

model(4.23)canbewrittenasfollowsbysubstracting

tobothsidesofthe

equation:

(4.24)

where

.Therelevantunitrootnullhypothesisis

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4.3NonstationaryModelsforTimeSeries

,since

correspondstoexplosivetimeseriesmodels.Dickey(1976)tabulatedthe

percentilesofthisstatisticundertheunitrootnullhypothesis.The

ofaunitrootisrejectedwhen

thevalueofthestatisticislowerthanthecriticalvalue.Thisstatistic,denotedby ,iscalledthe
DickeyFullerstatisticandtheircriticalvaluesarepublishedinFuller(1976).
Uptonowithasbeenshownhowtotestthenullhypothesisofarandomwalk(oneunitroot)against
thealternativeofazeromean,stationary
.Foreconomictimeseries,itcouldbeofinterestto
consideralternativehypothesisincludingstationarityaroundaconstantand/oralineartrend.This
couldbeachievedbyintroducingthesetermsinmodel(4.24):
(4.25)
(4.26)

Theunitrootnullhypothesisissimply

inbothmodels(4.25)(4.26).DickeyFuller

tabulatedthecriticalvaluesforthecorrespondingstatistics,denotedby

and

respectively.It

shouldbenotedthatmodel(4.26)underthenullhypothesisbecomesarandomwalkplusdriftmodel,
whichisahypothesisthatfrequentlyarisesineconomicapplications.
Thetestspresentedsofarhavethedisadvantagethattheyassumethatthethreemodelsconsidered
(4.24),(4.25)and(4.26)coverallthepossibilitiesunderthenullhypothesis.However,many
seriesdonotbehaveinthatway.Inparticular,theirDataGeneratingProcessmayincludenuisance
parameters,likeanautocorrelatedprocessfortheerrorterm,forexample.Onemethodtoallowa
moreflexibledynamicbehaviorintheseriesofinterestistoconsiderthattheseries followsan
model:

Thisassumptionisnotparticularlyrestrictivesinceevery
modelalwayshavean
representationifitsmovingaveragepolynomialisinvertible.The
modelcanberewrittenas
thefollowingregressionmodel:

(4.27)

where

and

haveaunitrootif
hypothesis

.Sincetheautoregressivepolynomialwill
,thepresenceofsucharootisformallyequivalenttothenull

.Inthiscase,theunitroottest,denotedastheAugmentedDickeyFuller(Dickey

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andFuller1979),isbasedontheLSestimationofthe coefficientandthecorrespondingtstatistic.
Thedistributionofthisstatisticisthesamethatthedistributionof ,sowemayusethesamecritical
values.Thismodelmayincludeaconstantand/oralineartrend:
(4.28)

(4.29)

andthetstatisticsfortheunitrootnullhypothesisfollowthesamedistributionas

and

respectively.
Themostcommonvaluesfor arezeroand1ineconomicandbusinesstimeseries.Thatiswhywe
haveconcentratedsofarintestingthenullhypothesisofoneunitrootagainstthealternativeof
stationarity(possiblyindeviationsfromameanoralineartrend).Butitispossiblethattheseries
presentmorethanoneunitroot.Ifwewanttotest,ingeneral,thehypothesisthataseriesis
againstthealternativethatitis

,DickeyandPantula(1987)suggesttofollowasequential

procedure.First,weshouldtestthenullhypothesisof unitrootsagainstthealternativeof
unitroots.Ifwerejectthis
againstthealternativeof

,thenthenullhypothesisof

unitrootsshouldbetested

unitroots.Last,thenullofoneunitrootistestedagainstthe

alternativeofstationarity.
4.3.3.0.2Example.
TheXEGutsm07.xplcodecomputestheADFstatistictotesttheunitroothypothesisforasimulated
randomwalkseriesofsize1000.Thevalueofthe is0.93178,whichrejectsthenullhypothesisat
the5%significancelevel.Thisoutputprovidesaswellwiththecriticalvalues1%,5%,10%,90%,
95%and99%.Itcanbeobservedthatthedifferencesbetweenthedistributionsoftheconventionalt
statisticand areimportant.Forexample,usinga0.05significancelevelthecritical valueis
2.86whilethatofthenormalapproximationtoStudent's is1.96forlargesamples.

XEGutsm07.xpl
4.3.3.0.3TestingforStationarity

Ifwewanttocheckthestationarityofatimeseriesoralinearcombinationoftimeseries,itwouldbe
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interestingtotestthenullhypothesisofstationaritydirectly.Bearinginmindthattheclassical
hypothesistestingmethodologyensuresthatthenullhypothesisisacceptedunlessthereisstrong
evidenceagainstit,itisnotsurprisingthatagoodnumberofempiricalworkshowthatstandardunit
roottestsfailtorejectthenullhypothesisformanyeconomictimeseries.Therefore,intryingto
decidewethereconomicdataarestationaryorintegrated,itwouldbeusefultoperformtestsofthe
nullhypothesisofstationarityaswellastestsoftheunitrootnullhypothesis.
Kwiatkowski,Phillips,SchmidtandShin(1992)(KPSS)havedevelopedatestforthenullhypothesis
ofstationarityagainstthealternativeofunitroot.LetusconsiderthefollowingDataGenerating
Process:
(4.30)

Theterm

isarandomwalk:

wheretheinitialvalue
and
randomwalktheseries

istreatedasfixedandplaystheroleofintercept,theerrorterm
isassumedtobeastationaryprocessindependentof

.If

isnota

wouldbetrendstationary.Therefore,thestationarityhypothesisissimply

.
Let

,betheLSresidualsoftheauxiliaryregression:

andletusdefinethepartialsumoftheresidualsas:

TheteststatisticdevelopedbyKPSSisbasedontheideathatforatrendstationaryprocess,the
varianceofthesumseries shouldberelativesmall,whileitshouldbeimportantinthepresenceof
oneunitroot.Then,theteststatisticforthenullhypothesisoftrendstationarityversusastochastic
trendrepresentationis:

(4.31)

where

standsforaconsistentestimationofthe'longterm'varianceoftheerrorterm

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4.3NonstationaryModelsforTimeSeries

derivedtheasymptoticdistributionofthisteststatisticunderthestrongerassumptionsthat
normaland

is

,andtabulatedthecorrespondingcriticalvalues.Since only

takespositivevalues,thistestprocedureisanuppertailtest.Thenullhypothesisoftrendstationarity
isrejectedwhen exceedsthecriticalvalue.
Thedistributionofthisteststatistichasbeentabulatedaswellforthespecialcaseinwhichtheslope
parameterofmodel(4.30)is
.Insuchacase,theprocess isstationaryaroundalevel( )
ratherthanaroundatrendunderthenullhypothesis.Therefore,theresidual
auxiliaryregressionof

onaninterceptonly,thatis

,isobtainedfromthe

4.3.3.0.4Example.
TheXEGutsm08.xplcodeteststhestationarityhypothesisforasimulated
and

serieswith

.Theresultsdonotrejectthenullhypothesisofstationarity.

[1,]OrderTestStatisticCrit.Value
[2,]0.10.050.01
[3,]_______________________________________________________
[4,]2const0.1050.3470.4630.739
[5,]2trend0.1030.1190.1460.216

XEGutsm08.xpl

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