Subject

Business Economics

Paper No and Title

Introduction to time series regression: unit root tests and cointegration

Module No and Title

5 Tests for Stationarity (Part 2): Unit Root Tests and Transformation of
Time Series

Module Tag

BSE_P_M

1. Learning Outcomes
After studying this module, you will be able to understand in detail:
The significance of unit root test in testing the stationarity of a series.
The Augmented Dickey Fuller Test and its significance in analysing the stationarity of
a series.
Phillips-Perron Unit Root Test
The process of transforming the non-stationary time series into a stationary time
series.

2. Unit Root Tests

Unit root test has become one of the most widely used method for testing the stationarity of
the series. Lets first discuss the unit root test briefly, then we will proceed to its applicability
in testing the stationarity of the series.
Any series is generated by random walk if,
Xt = Xt-1 + ut
ut is independently, identically distributed with mean zero and constant variance, that is, the
error term is a white noise.
ut ~ iid(0 , 2)
where:
Xt is the variables values taken over the time t
ut is the error term
In general,
Xt = Xt-1 + ut
If = 1, we consider the model to be a random walk process which has an inherent feature of
non-stationarity in it.

2.1 Random Walk with Drift

On adding the drift variable in the random walk model, we get random walk with drift model
which is represented as below:
Xt = + Xt-1 + ut
where:
is the drift variable

2.2 Random Walk with Drift and Trend

A model which contains both the drift and trend variable in the model, we term it as random
walk with drift and trend.
Xt = + Xt-1 + + ut
where:
is the trend variable
Random walk is a unit root test if the coefficient of Xt-1 is equal to one.

2.3 Unit Root Test/Dickey-Fuller Test

To test the stationarity of a series, we assume our model to be:
Xt = Xt-1 + t
We take a null hypothesis which will further imply whether the model is a random walk
process or not. As a result, our hypothesis will be as under:

H0 :

H1:
We test the model using a t-test and apply the following formula:

1
S .E .
t=

However,
does not follow exactly t-distribution. Rather it follows a Tau distribution.
Therefore, to test the significance we look at the table values of Tau table.
If the calculated value is less than the table tau value, then the null hypothesis is accepted and
the series is a unit root random walk and hence is non-stationary.
If calculated value is greater than the table tau value, then the null hypothesis is rejected
implying that the series is stationary.
However, the process can be tested using another method as well. We take our original model,
that is,
2

Xt = Xt-1 + t
We subtract Xt-1 from both the sides. We, therefore, get:
Xt Xt-1 = Xt-1 Xt-1 + t
On simplifying the above equation, we get,
Xt = (-1)Xt-1 + t
We can write the above equation as:
Xt = Xt-1 + t
where: = 1 = first difference operator
Before we proceed onto the testing procedure, it must be noted that if = 0 or = 1, then this
would imply that our model is a random walk process and hence is non-stationary. Keeping
the above mentioned views into consideration, we make the following hypothesis:
H0: = 1 or 1 = 0 or = 0
H1: 0
We again test the model using the following formula, assuming that our follows a tau
distribution.

t=

S .E.

~ Tau distribution

Summing up,

If calculated value is less than the table value, then we accept the null hypothesis and
reach a conclusion that the series is non-stationary.
If calculated value is more than the table value, then we reject the null hypothesis and
reach a conclusion that the series is stationary.

2.4 Augmented Dickey Fuller Test

Another version of this test is that when t is not a white noise term or they are correlated
with each other. Under these circumstances we use, Augmented Dickey Fuller Test. It is
conducted by augmenting the following equations:

Pure Random
Walk

Yt = Yt-1 + ut

(Random
Walk with
Drift)

Yt = 1 + Yt-1 + ut

Random
Walk with
Drift and
Trend

Yt = 1 + 2t + Yt-1 + ut

Y
Then we add lagged value of the dependent variable (
augmentation. It makes the error term t a white noise term.

i 1

t i

) which in true sense is

So, when the error term is converted into white noise, then our equation becomes:
m

Y
i

Yt = 1 + 2t + Yt-1 +
where: ut is the pure white noise term

i 1

t i

+ ut

Yt = Yt Yt-1
Yt-1 = Yt-1 Yt-2 and so on.
The number of lagged variables are so included that they are enough to make the error term
serially uncorrelated.
Under the Augmented Dickey Fuller Test, we assume the same hypothesis, that is,
H0: = 0
H1: 0
We use the following formula to estimate the calculated value.

t=

S .E.

~ Augmented Dickey Fuller Tau distribution

If the calculated value is less than the table value, we conclude that the error term is autocorrelated and hence the series is non-stationary. On the other hand, if calculated value is
more than the table value, we reject the null hypothesis stating that the series is stationary in
nature.

2.5 The Phillips-Perron Unit Root Test

The test, as the name suggested, was invented by P.C.B. Phillips and P. Perron in their work
Testing for a Unit Root in Time Series Regression.
Phillips-Perron test uses the non-parametric statistical methods to avoid any serial correlation
in the error term without adding the lagged difference terms as in the case of Augmented
Dickey Fuller Test.

2.6 Critique of the Unit Root Test

The significance of the unit root test depends on the size and power of the test. By size, we
mean the strength of the level of significance, or in other terms, the probability of committing
the Type I error. On the other hand, by power of the test we estimate the probability of
rejecting the null hypothesis when it is false.
Before continuing further, lets take a look back at the type of errors committed in the testing
procedures.

Error
Type I
Type II (more harmful)

H0
Rejected
Accepted

When
H0 is true
H0 is false

The power of a test can be calculated by subtracting the probability of Type II error from Type
I. The maximum possible power can be equal to one.
2.6.1 Size of the Test
The Dickey-Fuller test is sensitive to its procedure of conducting it. If for example, our true
model is a random walk model, however, we estimate random walk with drift model. Then
the conclusions derived from it may be wrong at say 5 per cent level of significance. This is
because in the case of the latter, the true level of significance is much larger than 5 per cent.
Moreover, if we also exclude the moving average component from the model, this could
further distort the size.
2.6.2 Power of the Test
It is an inherent characteristic in the Dickey Fuller Test that they have a low power and tend to
accept the null hypothesis more frequently, and thereby increasing the probability of
committing Type II error. The reason can be attributed to the following:
a. The power of a test depends more on the time span of the data as compared to the number
of observations. For example, the power of a test would be more in case of 30
observations over 30 years as compared to 100 observations over 100 days.
b. If in a model, say,
Xt = Xt-1 + ut
1 and not exactly equal to one, then the unit root test would declare the model to be
non-stationary.
5

c. The above mentioned models assume a single unit root, that is, they are integrated of the
order 1. If the model is integrated of order higher than 1, then it may result in more than
one unit root. In the latter case, we use Dickey Pantula Test.
d. The unit root tests are incapable of catching any structural breaks in the model.

3.

Transformation of Non-Stationary Time Series

On regressing the time series which is non-stationary, we may incur a problem of spurious
regression. Therefore, to avoid them, it is important to convert the non-stationary time series
into stationary time series. However, the conversion depends on whether the time series is
difference stationary or trend stationary.

Economic Time
Series

Difference
Stationary
Process
(Has a
stochastic
trend)

Trend Stationary
Process
(Has a
deterministic
trend)

3.1 Difference Stationary Process

If a time series contains a unit root, then the first difference of such time series will be
stationary. Similarly, if the time series is integrated of higher order than 1, say I(2), then
we have to difference it twice. Lets estimate it using the following procedure,
We take a variable Y and observe its values over the period of time. The model will be
represented as:
Yt = Yt-1 + ut
where: Y is the variable taken into consideration
t is the length of time period
ut is the error term
Simplifying the equation, we get
Yt - Yt-1 = ut
Yt = ut

Any series is generated by pure random walk is equal to white noise, if it is a first
difference equation.
Using the Dickey Fuller Test,

t=

S .E.

~ Tau distribution

We conclude saying,
If calculated value is less than the table value, then we accept the null hypothesis and
reach a conclusion that the series is non-stationary.
If calculated value is more than the table value, then we reject the null hypothesis and
reach a conclusion that the series is stationary.

3.2 Trend Stationary Process

The process states that any series which has a trend is a non-stationary series.
We take the following model
Yt = + t + ut
Yt t = ut
The model states that if from a series we subtract the trend, then the series becomes a
stationary series. Here ut is a linearly detrended time series.
It can also be possible that the trend may be non-linear in nature. For example,
Yt = + 1t + 2t2 + ut
Under this, the residuals will now be quadratically detrended time series.
However, it should be noted that if a series is difference stationary process but we treat it
as trend stationary process, then it is called under-differencing. On the other hand, if the
series is a trend stationary process but we treat it as difference stationary process, then it
is called over-differencing.
The consequences of such mis-interpretation can result into specification errors which can
be serious, depending upon how one handles the properties of serial correlation of the
resulting error terms.
In general, most of the macroeconomic time series are difference stationary process rather
than trend stationary process.

4. Summary
The topic can be summarised as follows:

A random walk model has an inherent characteristic of non-stationarity.

A random walk model, random walk with drift model, random walk with drift and
trend model; they all follow Tau distribution.

Stationarity can be checked on the basis of whether the model has a unit root inherent
in it or not. The other methods like Dickey-Fuller Test and Augmented Dickey Fuller
test can also be used for testing the stationarity of the series.

Phillips-Perron test uses the non-parametric statistical methods to avoid any serial
correlation in the error term without adding the lagged difference terms as in the case
of Augmented Dickey Fuller Test.

If the model is integrated of order higher than 1, then it may result to more than one
unit root and in that case we use Dickey Pantula Test.

An economic time series is of two types: Firstly, difference stationary which follows a
stochastic trend, Secondly, trend stationary which follows a deterministic trend.

If a series is difference stationary process but we treat it as trend stationary process,

then it is called under-differencing. On the other hand, if the series is a trend
stationary process but we treat it as difference stationary process, then it is called
over-differencing. Most of the macroeconomic time series are difference stationary
process rather than trend stationary process.