1

Stationarity, Non Stationarity, Unit

Roots and Spurious Regression
Roger Perman
Applied Econometrics Lecture 11
2
Stationary Time Series
Exhibits mean reversion in that it fluctuates around a constant
long run mean

Has a finite variance that is time invariant

Has a theoretical covariance between values of y
t
that depends
only on the difference apart in time
= ) (
t
y E
| | ) 0 ( ) y ( E ) y ( Var
2
t t
_ =
| | ) ( ) y )( y ( E ) y , y ( Cov
t t t t
t _ =
t t
3

WHITE NOISE PROCESS

X
t
=u
t
u
t
~I I D(0,
2
)









Stationary time series
White Noise
-0.6
-0.4
-0.2
0
0.2
0.4
0.6
4
Stationary time series


X
t
=0.5*X
t-1
+u
t
u
t
~I I D(0,
2
)


Stationary without drift
-0.6
-0.4
-0.2
0
0.2
0.4
0.6
0.8
5
0 50 100 150 200 250 300 350 400 450
.25
.5
.75
1
1.25
1.5
1.75
2
2.25
2.5
Many Economic Series Do not Conform to the
Assumptions of Classical Econometric Theory
Share Prices
0 50 100 150 200 250
.35
.4
.45
.5
.55
.6
.65
.7
Exchange Rate
1960 1965 1970 1975
8.7
8.8
8.9
9
9.1
9.2
9.3
Income
6
Non Stationary Time Series
There is no long-run mean to which the series returns

and/or

The variance is time dependent and goes to infinity
as time approaches to infinity

Theoretical autocorrelations do not decay but, in finite
samples, the sample correlogram dies out slowly
The results of classical econometric theory
are derived under the assumption that variables of concern are stationary.
Standard techniques are largely invalid where data is non-stationary
7

Non-stationary time series

UK GDP (Y
t
)
The level of GDP (Y) is not constant and the mean increases over time. Hence the level of
GDP is an example of a non-stationary time series.
GDP Level
0
20
40
60
80
100
120
1
9
9
2

Q
3
1
9
9
3

Q
2
1
9
9
4

Q
1
1
9
9
4

Q
4
1
9
9
5

Q
3
1
9
9
6

Q
2
1
9
9
7

Q
1
1
9
9
7

Q
4
1
9
9
8

Q
3
1
9
9
9

Q
2
2
0
0
0

Q
1
2
0
0
0

Q
4
2
0
0
1

Q
3
2
0
0
2

Q
2
2
0
0
3

Q
1
8
Non-stationary time series
RANDOM WALK
X
t
=X
t-1
+u
t
u
t
~I I D(0,
2
)

Mean: E(X
t
) = E(X
t-1
) (mean is constant in t)

X
1
= X
0
+u
1
(take initial value X
0
)
X
2
= X
1
+u
2
= (X
0
+u
1
) +u
2


X
t
= X
0
+u
1
+ u
2
++ u
t

E(X
t
) = E(X
0
+u
1
+ u
2
++ u
t
) (take expectations)
= E(X
0
) = constant




9
Non-stationary time series
RANDOM WALK
X
t
=X
t-1
+u
t
u
t
~I I D(0,
2
)

X
t
= X
0
+ u
1
+ u
2
++ u
t

Variance: Var(X
t
) = Var(X
0
) +Var(u
1
) ++ Var(u
t
)
= 0 +
2
++
2

= t
2

(variance is not constant through time)


10
Non-stationary time series: Random Walk


X
t
=X
t-1
+u
t
u
t
~I I D(0,
2
)


Random Walk
0
0.5
1
1.5
2
2.5
11
Constant covariance - use of correlogram

Covariance between two values of X
t
depends only on the
difference apart in time for stationary series.
Cov(X
t
,X
t+k
) = (k)

(covariance is constant in t)

(A) Correlation for 1980 and 1985 is the same as for 1990
and 1995. (i.e. t = 1980 and 1990, k = 5)

(B) Correlation for 1980 and 1987 is the same as for 1990 and
1997. (i.e. t = 1980 and 1990, k = 7)

12

Non-stationary time series

UK GDP (Y
t
) - correlogram



For non-stationary series the Autocorrelation Function (ACF) declines towards zero at a
slow rate as k increases.
0 1 2 3 4 5 6 7
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1.0
ACF-Y
13

First difference of GDP is stationary
Y
t
=Y
t
-

Y
t-1

- Growth rate is reasonably constant through time.
Variance is also reasonably constant through time








Stationary time series
GDP Growth (YBEZ)
0
0.2
0.4
0.6
0.8
1
1.2
1.4
1
9
9
2

Q
3
1
9
9
3

Q
2
1
9
9
4

Q
1
1
9
9
4

Q
4
1
9
9
5

Q
3
1
9
9
6

Q
2
1
9
9
7

Q
1
1
9
9
7

Q
4
1
9
9
8

Q
3
1
9
9
9

Q
2
2
0
0
0

Q
1
2
0
0
0

Q
4
2
0
0
1

Q
3
2
0
0
2

Q
2
2
0
0
3

Q
1
14

Stationary time series

UK GDP Growth ( Y
t
) - correlogram



Sample autocorrelations decline towards zero as k increases. Decline is rapid for stationary
series.
0 1 2 3 4 5 6 7
-0.75
-0.50
-0.25
0.00
0.25
0.50
0.75
1.00
ACF-DY


15

Relationship between stationary and non-stationary process
AutoRegressive AR(1) process

X
t
= + X
t-1
+u
t
u
t
~I I D(0,
2
)

< 1 stationary process
- process forgets past
= 1 non-stationary process
- process does not forget past


= 0 without drift
= 0 with drift



Non-stationary Time Series: summary
16
Stationary time series with drift

X
t
= + 0.5*X
t-1
+u
t
u
t
~I I D(0,
2
)


Stationary with Drift
-0.2
0
0.2
0.4
0.6
0.8
1
1.2
17
Non-stationary time series: Random Walk with Drift

X
t
= + X
t-1
+u
t
u
t
~I I D(0,
2
)


Random Walk with Drift
0
2
4
6
8
10
12
18

General Models

AutoRegressive AR(1) process without drift

X
t
= X
t-1
+u
t


< 1 stationary process
- process forgets past
= 1 non-stationary process
- process does not forget past

AutoRegressive AR(k) process without drift

X
t
=
1
X
t-1
+
2
X
t-2
+
3
X
t-3
+
4
X
t-4
++
k
X
t-k
+u
t



Time Series Models: summary
19
Spurious Regression Problem

y
t
= y
t-1
+u
t
u
t
~ iid(0,
2
)

x
t
= x
t-1
+v
t
v
t
~ iid(0,
2
)


u
t
and

v
t
are serially and mutually uncorrelated

y
t
=
0
+
1
x
t
+
t


since y
t
and x
t
are uncorrelated random walks we should expect R
2
to tend to zero. However this is not the case.

Yule (1926): spurious correlation can persist in large samples with
non-stationary time series.
- if two series are growing over time, they can be correlated
even if the increments in each series are uncorrelated

20
Spurious Regression Problem
Two random walks generated from Excel using RAND() command
hence independent

y
t
= y
t-1
+u
t
u
t
~ iid(0,
2
)

x
t
= x
t-1
+v
t
v
t
~ iid(0,
2
)





Two Random Walks
-4
-2
0
2
4
6
8
10
12
14
1 40 79 118 157 196 235 274 313 352 391 430 469
RW1 RW2
21
Spurious Regression Problem
Plot Correlogram using PcGive
(Tools, Graphics, choose graph, Time series ACF, Autocorrelation
Function)
y
t
= y
t-1
+u
t
u
t
~ iid(0,
2
)

x
t
= x
t-1
+v
t
v
t
~ iid(0,
2
)





0 5 10
0.25
0.50
0.75
1.00
ACF-RW1
0 5 10
0.25
0.50
0.75
1.00 ACF-RW2
22
Spurious Regression Problem
Estimate regression using OLS in PcGive
y
t
=
0
+
1
x
t
+
t

based on two random walks
y
t
= y
t-1
+u
t
u
t
~ iid(0,
2
)

x
t
= x
t-1
+v
t
v
t
~ iid(0,
2
)



EQ( 1) Modelling RW1 by OLS (using lecture 2a.in7)
The estimation sample is: 1 to 498
Coefficient t-value
Constant 3.147 25.8
RW2 -0.302 -15.5

sigma 1.522 RSS 1148.534
R^2 0.325 F(1,496) = 239.3 [0.000]**
log-likelihood -914.706 DW 0.0411
no. of observations 498 no. of parameters 2

23
Trend: Deterministic or Stochastic?
0 50 100 150 200 250 300 350 400 450 500
100
200
0 50 100 150 200 250 300 350 400 450 500
100
200
0 5 10 15 20 25
.25
.5
.75
1
0 5 10 15 20 25
.25
.5
.75
1
The First
The Second
Y a Y
t t t
= + +
1 1
c
Y a a Y a t
t t
= + + +
1 2 1 3
c
(with a
2
<1 and a
3
>0)
24
Y a a Y a t
t t
= + + +
1 2 1 3
c
This series has a deterministic trend (if a
3
> 0)

Classical inference is valid
(provided that a
2
is less than 1).

The series is transformed to a stationary series by
subtracting the deterministic trend from the left side
(and so the right side).
Y a t a a Y
t t
= + +
3 1 2 1
c
25
Y a Y
t t t
= + +
1 1
c
This series is non-stationary - the trend is stochastic

Classical inference is not valid

The series is called difference stationary
Y Y a
t t t
= +
1 1
c
Random Walk With Drift
26
Parameter Set Description Properties
1 | | = < =
0 1 0
1
, ,
Deterministic Trend With
Stationary AR(1) components
2
| | = = =
0 1 0
1
, ,
Random Walk with Drift and
Deterministic Trend
I (1)
3
| | = = =
0 1 0
1
, ,
Random Walk with Drift
I (1)
4
| | = = =
0 0 0
1
, ,
Deterministic Trend
I (0)
5
| | = = =
0 1 0
1
, ,
Pure Random Walk
I (1)
Y Y t
t t
= + + +

| | c
1 1
Types of Model from the General Formulation
I (0)