A Simple Approach to Robust Inference in a Cointegrating System

Board of Governors of the Federal Reserve System International Finance Discussion Papers Number 654 December 1999 A SIMPLE APPROACH TO ROBUST INFERENCE IN A COINTEGRATING SYSTEM Jonathan H. Wright NOTE: International Finance Discussion Papers are preliminary materials circulated to stimulate discussion and critical comment. References in publications to International Finance Discussion Papers (other than an acknowledgment that the writer has had access to unpublished material) should be cleared with the author or authors. Recent IFDPs are available on the Web at www.bog.frb.fed.us.

A SIMPLE APPROACH TO ROBUST INFERENCE IN A COINTEGRATING SYSTEM Jonathan H. Wright* Abstract: Cointegration requires all the variables in the system to have exact unit roots; accordingly it is conventional for researchers to test for a unit root in each variable prior to a cointegration analysis. Unfortunately, these unit root tests are not powerful. Meanwhile, conventional cointegration methods are not at all robust to slight violations of the requirement that each variable has a unit root. In this paper I show how this difficulty may be circumvented by instrumenting the regressors in the cointegrating regression by deterministic polynomial time trends, or by artificially generated random walks. KEYWORDS: Cointegration, Local to Unit Roots, Robustness, Instrumental Variables. * Wright is an economist in the International Finance Division of the Federal Reserve Board. I am grateful to David Bowman, Neil Ericsson, Jon Faust, Andrew Levin, Alex Maynard and Jim Stock for their helpful comments. The views in this paper are solely the responsibility of the author and should not be interpreted as reflecting the views of the Board of Governors of the Federal Reserve System or of any person associated with the Federal Reserve System.

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