J o h a n s en C o I n t e g r a t I o n

Introduction
Cointegration methods have been very popular tools in applied economic work since their introduction about twenty years ago. The phenomenon that non-stationary processes can have linear combinations that are stationary was called cointegration by Granger (1983), who used it for modeling long-run economic relations. The paper by Engle and Granger (1987), which showed the equivalence of the error correction formulation and the phenomenon of cointegration, started a rapid development of the statistical and probabilistic analysis of the ideas. Engle and Granger (1987) formalized this concept of cointegration by introducing a very simple test for the existence of cointegrating relationships for a single equation model.

Drawbacks of the EG approach

One of the best features of the EG approach is that it is both very easy to understand and implement. However there are important shortcomings of the Engle-Granger methodology:
1. One very important issue has to do with the order of the variables. When estimating the

long-run relationship, one has to place one variable in the left hand side and use the others as regressor. The test does not say anything about which of the variables can be used as regressor and why. Consider, for example, the case of just two variables, Xt and Yt. One can either regress Yt on Xt (i.e. Yt = a + Xt + u1t) or choose to reverse the order of the regress Xt on Yt. The problem obviously becomes far more complicated when we have more than two variables to test.
2. A second problem is that when there are more than two variables there may be more than

one cointegrating relationship, and the Engle-Granger procedure using residuals from a single relationship cannot treat this possibility. So, the most important problem is that it does not give us the number of cointegrating vectors. 3. A third and final problem is that it relies on a two-step estimator. The first step is to generate the error series and the second step is to estimate a regression for this series in order to see if the series is stationary or not. Hence, any error introduced in the first step is carried into the second step.
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All these problems are resolved with the use of the Johansen approach.

Cointegration in the Multiple Equations and the Johansen Approach

It is said that if we have more than two variables in the model, then there is a possibility of having more than one cointegrating vector. By this we mean that the variables in the model might form several equilibrium relationships governing the joint evolution of all the variables. In general, for n number of variables we can have only n-1 cointegrating vectors, therefore, when n=2, which is the simplest case, and then if cointegration exists then the cointegrating vector is unique. Having n >2 and assuming that only one cointegrating relationships exists, where there are actually more than one, is a very serious problem that cannot be resolved by the EG singleequation approach. Therefore, an alternative to the EG approach is needed and this is the Johansen approach for multiple equations. Johansens (1988), named after Sren Johansen, multivariate maximum likelihood approach to co-integration is the most popular approach in estimating long-run economic relationships. Studies comparing Johansens approach to other approaches in co-integration analysis have generally concluded favorably for the Johansens approach. This performs better than the other approaches even when the errors are not normally distributed, or the dynamics of the vector error-correction model (VECM) are unknown, and additional lags are included in the VECM.
It is a procedure

for testing cointegration of several I (1) time series. This test permits more than

one cointegrating relationship so is more generally applicable than the EngleGranger test which is based on the DickeyFuller (or the augmented) test for unit roots in the residuals from a single (estimated) cointegrating relationship.

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Vector Error Correction Model

In order to present this approach, it is useful to extend the single-equation error-correction model to a multivariate one. Lets assume that we have three variables, Yt, Xt and Wt which can all be endogenous, i.e. we have that (using matrix notation for Zt = [Yt, Xt, Wt])

Zt = A1 Zt-1 + A2 Zt-2 + . . . . + Ak Zt-k + ut Which is comparable to the single-equation dynamic model for two variables Yt and Xt. Thus, it can be reformulated in a vector Error-Correction Model (VECM) as follows: Zt = 1 Zt-1 + 2 Zt-2 + . . . . + k-1 Z t-k-1 + Zt-1 + ut Where, i = (I A1 A2 - . . . Ak) = - (I A1 A2 - . . . Ak) (i = 1, 2 k-1) and,

Matrix
The most important thing to examine is the 3 x 3 matrix. The matrix is 3 x 3 due to the fact that we assume three variables in Zt = [Yt, Xt, Wt]. The matrix contains information regarding the long-run relationships. In fact, = Where, = include speed of adjustment to equilibrium coefficients = long run matrix of coefficients Therefore the Zt-1 term is equivalent to the error-correction term (Yt-1 o 1 Xt-1) in the single equation case, except that now Zt-1 contains up to (n-1) vectors in a multivariate framework.

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Model
For simplicity we assume that k = 2, so that we have only two lagged terms, and the model is then the following: Yt Xt Wt OR = 1 Yt-1 Yt-1

Xt-1 + Xt-1 + et Wt-1 Wt-1

Yt Xt Wt = 1

Yt-1 Xt-1 Wt-1 +

a11 a21 a31

a12 a22 a23 11 21 31 12 22 32

Yt-1 Xt-1 + et Wt-1

Now we analyze only the error correction part of the first equation i.e. for Yt which gives: Yt-1 1 Zt-1 = ([a1111 + a12 12] [a11 21 + a12 22] [a1131 + a12 32] Xt-1 Wt-1 Where 1 is the first row of the matrix. This equation can be rewritten as: 1 Zt-1 = a11 (11 Yt-1 + 21 Xt-1 + 31 Wt-1) + a12 (32 Yt-1 + 12 Xt-1 + 22 Wt-1) Which shows clearly the two cointegrating vectors with their respective speed of adjustment terms a11 and a12

Behavior of Matrix under Different Circumstances

Behavior of matrix can be seen under different circumstances. Given that Zt is a vector of nonstationary I (1) variables, then Zt-1 are I (0) and Zt-1 must also be I (0) in order to have that ut~ I (0) and therefore to have white noise. In general there are three cases for Zt-1 to be I (0):

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Case1: When all the variables in Zt are stationary, it implies that there is no problem of spurious regression and the simple VAR in levels model can e used to model this case.

Case2: When there is no cointegration, therefore the matrix is an n x n matrix of zeros because of no linear relationship among the Zt. In this case the appropriate strategy is to use a VAR model in first differences with no long run elements due to the non-existence of long-run relationships.

Case3: When there exist up to (n-1) cointegrating relationships of the form Zt-1~ I (0). In this particular case, r < (n-1) cointegrating vectors exist in . This simply means that r columns of form r linearly independent combinations of the variables in Zt, each of which is stationary. Of course there will also be (n - r) non-stationary vectors as well.

Only the cointegrating vectors in should be included in the VECM equation, otherwise Zt-1 will not be I (0). This means that the last (n - r) columns, which are non-stationary, of will be statistically insignificant i.e. equal to zero. Therefore, in determining how many r < (n - 1) cointegrating vectors exist in is equivalent to testing which columns of are equal to zero.

Rank of Matrix
Testing for cointegration is also equivalent to determine the rank of matrix , which is given by finding the number of r linearly independent columns in . This methodology was first developed by Johansen (1988). The three different cases regarding rank of matrix are:

Case 1:

When has a full rank i.e. there are r = n linearly independent columns, then the variables in Zt are I (0)

Case2:

When the rank of is zero i.e. there are no linearly independent columns then there are no cointegrating relationships.

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Case 3:

When has a reduced rank i.e. there are r < (n - 1) linearly independent columns and therefore there are r < (n - 1) cointegrating relationships Johansen (1988) developed a methodology that tests for rank of and provides estimates of and through a procedure known as reduced rank regression, but the actual procedure is quit complicated.

The Steps of Johansen Methodology in Practice

Use the following six steps when implementing the Johansen procedure.

STEP 1: Testing the Order of Integration of Variables

It is a good practice to pretest all the variables to assess their order of integration. The most desirable case is when all the variables are integrated of the same order and then to proceed with the cointegration test. But this is not always the case, and that even in cases where a mix of I (0), I (1) and I (2) variables are present in the model, cointegrating relationships might well exist. Johansen approach amounts to testing for the rank of or to find out the number of linearly independent vectors in . So Johansen approach is referred for the inclusion of I (2) variables in the models.

STEP 2: Setting the Appropriate Lag Length of the Model

The results of the test are quite sensitive to the lag length, so it is important to be careful. The most common procedure in choosing the optimal lag length is to estimate a VAR model using the non-differenced data. Begin with the longest lag length deemed reasonable and then reducing down by re-estimating the model for one lag less until we reach zero lags. In each of these
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models we inspect the values of AIC and SBC criteria as well as the diagnostic checks. In general a model that passes all diagnostic checks and that minimizes AIC and SBC is selected as the one with the optimal lag length.

STEP 3: Choosing the Appropriate Model Regarding the Deterministic Component in the Multivariate System
The general case of the VECM that can possibly happen is given by the following equation:

Z t = 1 Zt-1 +...+ k-1 Zt-k-1 + 1 (Zt-1 1 t) + 2 + 2t + ut Given this equation five distinct models can be considered:

Model 1 No intercept or trend in CE or VAR (1 =2=1=2=0).In this case there are no

deterministic components in the data. However it is not realistic as the intercept is generally needed in order to account for adjustments in the units of measurements of the variables in (Zt-1 1 t).

Model 2 Intercept (no trend) in CE, no intercept or trend in VAR (1 = 2= 2 = 0). In this case
no linear trend in the data and intercept is restricted to the long run model to account for the unit of measurement of the variables in (Zt-1 1 t).

Model 3 Intercept in CE and VAR, no trends in CE and VAR (1 = 2= 0). In this case no
linear trends in the data but we allow both specifications to drift around an intercept. It is also assumed that intercept in CE is cancelled out by intercept in VAR, leaving just one intercept in short run model.

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Model 4 Intercept in CE and VAR, linear trend in CE, no trend in VAR (2 = 0). Trend in CE
is included to take into account exogenous growth.

Model 5 Intercept and quadratic trend in CE and intercept and linear trend in VAR. In this
last model nothing is restricted; however it is very difficult to interpret because such models would imply an implausible ever-increasing or ever-decreasing rate of change.

STEP 4: Estimating and Determining the Rank of

Two methods are used and both involve the estimation of the matrix which is a k x k matrix with rank r.
(a) In this method the null hypothesis is that Rank () = r with the alternative suggesting

that Rank () = r + 1. The test statistic is based upon characteristic roots (also known as eigen values). Order the largest eigenvalues in descending order and check whether they are significantly different from zero. If the variables are not co integrated then rank of will be zero and all characteristic roots are also zero i.e. (1 - i) = 1. On the other hand if rank of is equal to 1 then 0 < 1< 1 so that (1 - i) < 0, while all rest will be zero. The test statistic used in this method is given by max (r, r + 1) = -T In (1 - r+1) since it is based on maximum eigenvalue so thats why it is called maximal eigenvalue statistic.
(b) This method is based on a likelihood ratio test about the trace of the matrix. The null

hypothesis in this case is that number of cointegrating vectors is less than or equal to r. When all i =0 then the trace statistic is also zero. On the other hand the closer the characteristic roots to unity the more negative the In(1-i) term and larger the trace statistic. This statistic is calculated by trace (r) = -T In (1 - r+1)

STEP 5: Testing for Weak Erogeneity

In a cointegrating system if a variable does not respond to the discrepancy from the long-run equilibrium relationship, it is weakly exogenous.

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Testing for weak exogeneity is equivalent to testing which of the columns of are equal to zero. Assume that we have only one cointegrating vector = (a11 a21 a31). Now assume that a11=0 it means no short run adjustment to equilibrium for yt. If all elements in aij are equal to zero then cointegrating vectors in do not enter in the equation for yt so this variable is weakly exogenous and should be omitted from the left hand side of the model and enter the system on the right hand side only.

STEP 6: Testing for Linear Restrictions in the Cointegrating Vectors

Estimating the coefficients of matrices and and then test for possible linear restrictions regarding those matrices Especially for matrix , the matrix that contains the long run parameters because it allows us to test specific hypothesis about theoretical predictions from economic theory point of view

Hypothesis Testing in the Johansen Model

This is just a very short introduction. Here is just an example. Assume that your system consists of 3 variables (y1t; y2t; y3t) and that you have found that there are 2 co integrating vectors. In other words you have an estimate of B where 11 21 31 12 22 32

Assume then that you have a long-run hypothesis of the form y1t - y3t = 0 (e.g. the PPP-model has this form). This would be the case if for example 11 = -13 and 12 = 0. Note that the model only identifies the parameters up to scale. But even worse the matrix is only identified up to rotations so it is not obvious how one can do a Wald test. However a Likelihood Ratio test will give you a standard 2-test (if you condition on cointegration of order 2). Under the alternative you have to parameterize as (H; ), where is a 3 x 1 vector of parameters, and 1
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H=

0 -1

Johansen and Juselius explain how one can estimate models with restrictions of this and similar forms (and also how to impose linear restrictions on ). (It is actually surprisingly easy to modify the program that does the \standard" Johansen ML-estimator to impose these restrictions). Notice that the hypotheses have to formulate in the form of linear relationships rather than as explicit null-restrictions. I need to explain how to find the degrees of freedom (df) for such a hypothesis. Theoretically we can normalize the Vector to 0

0 1 32

21 31

so there are 3 df in the matrix. The reason to use the word theoretically" is that you may have to re-order the rows since we have not imposed the restriction that any particular ij is equal to zero in the restricted model (but again you may not know which one a priori) to be 1. So the \PPP" hypothesis that one of the cointegration vectors is (1, 0, -1) can then be tested against the 2 (1) distribution. The null hypothesis is estimated by modifying the ML-algorithm for the unrestricted model. There are 2 df (since one of the coefficients can be normalized).

Advantages
From the multiple equation approach we can obtain estimates for both cointegrating vectors, while with the simple equation we have only a linear combination of the two long run relationships.

Also even if there is only one co integrating relationship (for example the first only) rather than two, with the multiple equation approach we can calculate all three differing speeds of adjustment coefficients (a11, a21, a31).

Only when a21 = a31 = 0, and only one co integrating relationship exists, can we then say that the multiple equation method is same (reduces to ) as the single equation approach,
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and therefore there is no loss from not modeling the determinants of Xt and Wt being weekly exogenous. So, summarizing, only when all right-hand variables in a single equation are weekly exogenous does the single equation approach provide the same result as a multivariate equation approach.

Drawbacks
There are two drawbacks of the Johansen method.

One is that it takes a little getting used to interpreting the results and formulating hypotheses in this setting. In the VAR system all variables are treated symmetrically, as opposed to the standard univariate models that usually have a clear interpretation in terms of exogenous and endogenous variables.

The other drawback of the VAR system is one has to model all the variables at the same time, which will be a problem if the relation for some variable is flawed. This may give bias in the whole system and one may have been better of conditioning on that variable. Further, the multidimensional VAR model uses many degrees of freedom.

Conclusion
Overall, the results of many empirical studies show that there is a substantial probability, much larger than the nominal size of the test, of falsely concluding that completely unrelated series are co integrated. We find that a systematic check of additional tests on the co integrating vector(s)based on Johansens claim that there is little need to pre-test variables for unit roots helps reduce the spurious rejection frequency. However, the spurious rejection frequency remains large and appears to increase with the number of variables in the system, even after applying such specification tests. The results are obtained in a Monte Carlo simulation under perfect circumstances. That is, the data are normally distributed and the lag-length in the VAR in levels is known and equal to one. In practice, we do not have the benefit of being given the correct modelneither in terms of the variables in the system nor the lag length.
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The findings in this paper further illustrate the sensitivity of cointegration methods to deviations from the pure unit-root assumption, as originally noted by Elliott (1998) in regards to inference on the cointegrating vectors. Since unit-root tests cannot easily distinguish between a unit root and close alternatives, this raises a precautionary note to the interpretation of results from cointegration studies. In particular, it raises questions regarding the conclusions drawn in previous studies that have relied on cointegrating methods despite having found evidence of stationary of the included variables. One way of making the Johansen procedure more robust to near-unit-roots may be through a Bonferroni type bounds procedure as proposed by Cavanagh et al. (1995) for inference on the cointegrating vector and by Hjalmarsson and sterholm (2007) for residual-based tests of cointegration.

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