Explain how unit root tests can be adapted or adjusted to allow for structural breaks

 

US Current Account Balance

Introduction

In this blog, we examine the issue of identifying unit roots in the presence of structural breaks.

We will use the quarterly US current account to GDP ratio to compare results from a number of unit root test found in the GAUSS tspdlib library including the:

  • Zivot-Andrews (1992) unit root test with a single structural break.
  • Narayan and Popp (2010) unit root test with two structural breaks
  • Lee and Strazicich (2013, 2003) LM tests with one and two structural breaks
  • Enders and Lee Fourier (2012) ADF and LM tests

What is stationarity?

Stationary series have a mean and covariance that do not change over time. This implies that a series is mean-reverting and any shock to the series will have a temporary effect.

comparing stationary and non-stationary series

In the graph above we compare a stationary, non-stationary, and trend stationary AR(1) series. Looking at the blue stationary series we can see that despite the random shocks, the series fluctuates around its zero mean.

The green line is the same series as the stationary series with an added constant time trend. Though this time-series grows over time, it fluctuates around its constant time trend.

Finally, the orange line is a non-stationary series and has a unit root. It does not revert to a mean or trend line and its stochastic shocks have permanent impacts on the series.

structural breaks and stationarity

The graph above helps demonstrate the impact of structural breaks on stationarity. The series plotted above shows a structural break in the level and clearly does not revert around the same mean across all time.

Though the series is stationary within each section, most standard unit roots will bias towards non-rejection of the unit root for this series.

This is problematic because different modeling techniques should be used for the unit-root series than the series with a structural break.

Testing for unit roots with structural breaks

A number of different unit root tests have emerged from the research surrounding structural breaks and unit roots. These tests vary depending on the number of breaks in the data, whether a trend is present or not, and the null hypothesis that is being tested.

Today we will compare the results from six different tests, all of which can be found in the GAUSS tspdlib.

Preparing for testing

Before running the tests in the GAUSS tspdlib library, we must set-up a number of input parameters. All of the tests, with the exception of the fourier expansion test, require the same inputs:


y_test
Vector, the time-series to tested.
model
Scalar, indicates the type of model to be tested.
1 = break in level.
2 = break in level and mean.
pmax
Scalar, Maximum number of lags for Dy. 0 = no lags.
ic
Scalar, the information criterion used to select lags.
1 = Akaike.
2 = Schwarz.
3 = t-stat significance.
trimm
Scalar, data trimming rate. Not required for the fourier expansion tests.
fmax
Scalar, maximum number of single Fourier frequency. Required only for the fourier expansion tests.

The COVID-19 outbreak that has occurred has caused governments throughout the world

to give orders that have “closed” their economies to one degree or another. This raise the

possibility of a structural break in economic data. Write a short research essay on the

effffects of structural breaks on testing for unit roots. I am envisioning no more than one

page, using a 12-point font. Your essay should cover the following points:

• Provide a defifinition of “structural break”;

• Explain why a structural break creates a problem in testing for unit roots;

• Explain how unit root tests can be adapted or adjusted to allow for structural breaks.

Do structural breaks require entirely difffferent unit root tests? Make sure you show

what the unit root test looks like in the presence of a structural break.

You must include references, but I am not requiring footnotes. You must include links to

documents you have consulted. make sure that the links work before submitting

your essay!

Long Island University Effects of Structural Breaks on Testing for Unit Roots HW
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