Cointegration

Lecture 9: Cointegration and Error-Correction Models
Gumilang Sahadewo
Universitas Gadjah Mada
August 12, 2016
Gumilang Sahadewo (Econ UGM) Econometrics III: Lecture 9 August 12, 2016 1 / 30
1 Introduction
Motivation
2 Cointegration
Equilibrium Error
Granger Representation Theory
Multicointegration
Johansen Procedure
Motivation
Consider national income (Yt ) model:
Yt = β0 + β1 Ct + β2 It
where:
◮ Ct =aggregate consumption
◮ It =aggregate investment
An important assumption is that the sequence {et } is stationary.
However, aggregate output, consumption, and investment are all I (1).
Consequently, there may not be a tendency to return to the long-run
level.
Motivation
The good news is that, there is a linear combination of non-stationary

variables that is stationary.
et = Yt − β0 − β1 Ct − β2 It .
Since the theory posits that et is stationary, then the linear

combination should also be stationary.
Several Co-integrated relations
This is a concept of co-integration: a co-integrated series has a lower

level of integration.
Was introduced by Robert Engle and Clive Granger (1987)
◮ Nobel Price in Economics, 2003.
Equilibrium relationship or cointegration can be:
◮ causal relationship
◮ reduced-form relationship between trending variables
Stock prices and dividends
◮ Campbell and Shiller
Aggregate output, consumption, and investment
◮ King, Plosser, Stock, and Watson
1 Introduction
Motivation
2 Cointegration
Equilibrium Error
Multicointegration
Johansen Procedure
Equilibrium error
In the long run,

 
x1t
h i
 x2t 

β1 β2 . . . βn  ..  = β ′ Xt = 0
.
 
 
xnt
The deviation from the long-run equilibrium is et :

′
et = β Xt = 0
The error process must be stationary.
Remark
There’s an abuse to the word equilibrium as you can see

Economics: a state in that reflects equality between economic forces
such as demand and supply.
Econometrics: any long-run relationship among non-stationary
variables.
Cointegration
Definition
′
The components of the vector Xt = (X1t , X2t , . . . , Xnt ) are said to be
cointegrated of order d, b, or xt ∼ CI (d, b) if:
All components of Xt are integrated of order d

There exists a vector β such that the linear combination βXt is
integrated of order (d − b) where b > 0.
β is the cointegrating vector.
Cointegration
In our example, the linear combination
et = Yt − β0 − β1 Ct − β2 It
is stationary. Then, the variables are CI (1, 1).

The vector of variables is:
(Yt , 1, Ct , It )
The cointegrating vector is:
(1, −β0 , −β1 − β2 )
Remarks
Engle and Granger’s cointegration is limited to a linear relationship

between non-stationary variables.
If there aren non-stationary variables in Xt , there are n − 1 linearly
independent cointegrating vectors.
The number of cointegrating vectors is the cointegrating rank if Xt .
1 Introduction
Motivation
2 Cointegration
Equilibrium Error
Multicointegration
Johansen Procedure
If Y and X are I (1) and cointegrated, then:
∆Yt = µ + γZt−1 + α1 ∆Yt−1 + . . . + αp ∆Yt−p

+ β1 ∆Xt−1 + . . . + βq ∆Xt−1 + et
where Zt−1 = Yt−1 − θXt−1 .

Zt is called the error correction term.
If Y is higher or lower than X , the error correction term pushes Y
towards the long-run equilibrium .
Granger representation theorem state that for any I (1) variables,
error correction and cointegration are equivalent representations.
Engle-Granger methodology
Engle and Granger (1987) proposes a procedure to test whether two

I (1) variables {Yt } and {Xt } are CI (1, 1).
Step 1. Check the order of integration of the two variables.
Step 2a. Estimate the long-run equilibrium relationship:
Yt = β0 + β1 Xt + et
◮ If Yt and Xt are cointegrated, the OLS regression produces a

super-consistent estimator of β0 and β1 (Stock, 1987).
Step 2b. Compute the residuals {êt }, which is the deviations from
the long-run relationship. Test for unit root without drift:
∆êt = ρêt−1 + ǫt
or
n
X
∆êt = ρêt−1 + γi+1 ∆êt−1 + ǫt
i=1
If there is a unit root, then we cannot reject the null of no

cointegration. If e is stationary, we can reject the null of no
cointegration.
Use the critical values using the MacKinnon (1991, 2010) response
surface.
Step 3. Estimate the error-correction model (ECM). If the variables

are cointegrated, the correction term can be used to estimate the
model.
X X
∆Yt = α1 + αY et−1 + α11 (i) ∆Yt−1 + α12 (i) ∆Xt−1 + eYt
i=1 i=1
X X
∆Xt = α2 + αX et−1 + α21 (i) ∆Yt−1 + α22 (i) ∆Xt−1 + eYt
i=1 i=1
◮ αY and αX are called the speed of adjustment coefficients.

◮ If αX is zero and α21 (i) = 0, then {∆Yt } does not Granger cause
{∆Xt }.
Step 4. Perform a diagnostic check:
◮ Are the residuals white noise?
◮ Hypothesis testing of the speed of adjustment coefficients.
STATA
Developed by Schaffer (2010)

Command: egranger varlist, ecm lags()
Cointegration test:
◮ egranger varlist, lags()
You can also include a linear or a quadratic trend:
◮ egranger varlist, lags() trend
◮ egranger varlist, lags() qtrend
Two-step procedures:
◮ egranger varlist, ecm lags()
The critical values obtained from the MacKinnon (1991, 2010)
response surface.
Remarks
The long-run regression requires one variable on the left-hand side

and the other on the right-hand side.
◮ It is possible that the residuals are cointegrated using one variable on
the left-hand side but not cointegrated using the other variable.
The EG methodology requires two-step procedures and the last
procedures requires the results from the first procedure.
◮ Any error made in the first procedure affects the second procedure.
Further developments: Johansen (1988) and Stock and Watson
(1988)
◮ We will discuss Johansen’s procedure in two sub-sections.
1 Introduction
Motivation
2 Cointegration
Equilibrium Error
Multicointegration
Johansen Procedure
Multicointegration
In many cases, the variables of interest are of different integration

orders.
Despite this difference, we can still obtain an equilibrium relationship.
For example, if Yt and Xt are both I (2), and other variables that are
I (1).
We can find a long-run relationship between a linear combination
between Yt and Xt and the I (1) variables.
This is referred to as multicointegration (Lee and Granger, 1990).
Multicointegration
Suppose that Yt and Xt are both I (2) and Wt is I (1).

The long-run equilibrium relationship of the form:
Yt = βXt + γWt
or
Yt = βXt + α∆Xt + γWt .
The linear combination Yt − βXt is I (1) can be cointegrated with
∆Xt and Wt .
Testing for multicointegration
Estimate the equation:
Yt = α0 + α1 t + α2 t 2 + β2 Xt + β3 ∆Xt + γZt + et .
Estimate:
p
X
∆êt = ρêt−1 + δi ∆êt−i + vt .
i=1
Rejection of the null hypothesis indicates multicointegration.

The critical values are provided by Haldrup (1994) and Engsted,
Gonzalo, and Haldrup (1997).
◮ The values depend on the number of I (1) regressors and the
deterministic regressors.
1 Introduction
Motivation
2 Cointegration
Equilibrium Error
Multicointegration
Johansen Procedure
Johansen Procedure
Due to Soren Johansen.

◮ Many extensions with Katerina Julius
Johansen procedure is an answer to EG’s drawbacks:
◮ It uses just one-step procedure
◮ allow estimation of multiple cointegrating vectors
Consider a vector of n variables Yt :
Yt = AYt−1 + et
∆Yt = (A − I) Yt−1 + et
∆Yt = πYt−1 + et
where:
◮ Yt , et are (n × 1)
◮ A is (n × n)
Johansen Procedure
Consider the system:
∆Yt = πYt−1 + et
The rank of π = (A − I) equals the number of cointegrating vectors.

If rank(π) = 0, {Yit } are unit root processes and the variables are not
cointegrated
If rank(π) = n, {Yit } are stationary and the system of difference
equation is convergent.
The error correction term is πYt−1 .
Johansen Procedure
We can extend the model to include constants in the model:
∆Yt = A0 + πYt−1 + et
We can rewrite this as:
∆Yt = π ∗ Yt−1
∗
+ et
where:
′
∗
Yt−1 = (Y1,t−1 , Y2,t−1 , . . . , Yn,t−1 , 1)
 
π11 . . . π1n a10

 π21 . . . π2n a20 

π= .. .. .. .. 
. . . . 
 

πn1 . . . πnn an0
Include drift terms or not?
Johansen Procedure
We can also consider a higher-order AR process:
Yt = A1 Yt−1 + A2 Yt−2 + . . . + Ap Yt−p + et
so that:
p−1
X
∆Yt = πYt−1 + Γi ∆Yt−i + et
i=1
where:
Pp
◮ π=− P I − i=1 Ai
p
◮ πi = − j=i+1 Aj
Note that this is the general version of the ADF.
If rank(π) = 0, {Yit } are unit root processes and the variables are not
cointegrated
If rank(π) = n, {Yit } are stationary and the system of difference
equation is convergent.
If 1 <rank(π) < n, there are several cointegrating vectors.
Test Statistics
There are two test statistics that we can use:

n
X
λtrace (k) = −T ln 1 − λ̂i
i=k+1

λmax (k, k + 1) = −T ln 1 − λ̂k+1
where λ̂i are the estimated eigenvalues.

Null hypothesis:
◮ λtrace . H0 : the number of distinct cointegration vectors is less than or
equal to k (against general alternative).
◮ λmax . H0 : the number of cointegrating vectors is r (against r + 1).
Critical values from Johansen (1995) or Osterwald-Lenum (1992).
Johansen (1995)
The VECM is:

p−1
X
∆Yt = α (πYt−1 + µ + ρt) + Γi ∆Yt−i + γ + τ t + et
i=1
There are five different trend specifications:

◮ no trend or a constant: µ = 0, ρ = 0, γ = 0, τ = 0.
◮ restricted constant (stationary around non-zero means): ρ = 0, γ = 0,
τ = 0.
◮ unrestricted constant (linear trend in the level data, stationary around
non-zero means): ρ = 0, τ = 0.
◮ restricted trend (trend in the cointegrating equations): τ = 0.
◮ linear trend in the cointegrating equations and quadratic trend in the
undifferenced data.
STATA
VECM: vec varlist, rank() lag() trend()

◮ to estimate cointegrating rank: vecrank
◮ lag selection (we’ve seen this): varsoc
Post estimation:
◮ test for autocorrelation: veclmar
◮ test for normality: vecnorm
◮ stability of estimates: vecstable
◮ forecast: fcast compute
◮ forecast graph: fcast graph
IRF: irf

Cointegration

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Lecture 9: Cointegration and Error-Correction Models

Universitas Gadjah Mada

August 12, 2016

Consider national income (Yt ) model:

The good news is that, there is a linear combination of non-stationary

Since the theory posits that et is stationary, then the linear

This is a concept of co-integration: a co-integrated series has a lower

In the long run,

The deviation from the long-run equilibrium is et :

The error process must be stationary.

There’s an abuse to the word equilibrium as you can see

All components of Xt are integrated of order d

In our example, the linear combination

is stationary. Then, the variables are CI (1, 1).

The cointegrating vector is:

(1, −β0 , −β1 − β2 )

Engle and Granger’s cointegration is limited to a linear relationship

If Y and X are I (1) and cointegrated, then:

∆Yt = µ + γZt−1 + α1 ∆Yt−1 + . . . + αp ∆Yt−p

where Zt−1 = Yt−1 − θXt−1 .

Engle and Granger (1987) proposes a procedure to test whether two

◮ If Yt and Xt are cointegrated, the OLS regression produces a

If there is a unit root, then we cannot reject the null of no

Step 3. Estimate the error-correction model (ECM). If the variables

◮ αY and αX are called the speed of adjustment coefficients.

Developed by Schaffer (2010)

The long-run regression requires one variable on the left-hand side

In many cases, the variables of interest are of different integration

Suppose that Yt and Xt are both I (2) and Wt is I (1).

Estimate the equation:

Rejection of the null hypothesis indicates multicointegration.

Due to Soren Johansen.

Consider the system:

The rank of π = (A − I) equals the number of cointegrating vectors.

We can extend the model to include constants in the model:

We can rewrite this as:

Yt = A1 Yt−1 + A2 Yt−2 + . . . + Ap Yt−p + et

There are two test statistics that we can use:

where λ̂i are the estimated eigenvalues.

The VECM is:

There are five different trend specifications:

VECM: vec varlist, rank() lag() trend()

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