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Testing for the Cointegrating Rank of a Vector Autoregressive Process with Uncertain Deterministic Trend Term
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1725-6704
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EUI ECO; 2008/24
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DEMETRESCU, Matei, LUETKEPOHL, Helmut, SAIKKONEN, Pentti, Testing for the Cointegrating Rank of a Vector Autoregressive Process with Uncertain Deterministic Trend Term, EUI ECO, 2008/24 - https://hdl.handle.net/1814/8769
Abstract
When applying Johansen's procedure for determining the coin-
tegrating rank to systems of variables with linear deterministic trends, there
are two possible tests to choose from. One test allows for a trend in the
cointegration relations and the other one restricts the trend to be orthogonal
to the cointegration relations. The first test is known to have reduced power
relative to the second one if there is in fact no trend in the cointegration re-
lations, whereas the second one is based on a misspecified model if the linear
trend is not orthogonal to the cointegration relations. Hence, the treatment
of the linear trend term is crucial for the outcome of the rank determination
procedure. We compare two alternative testing strategies which are appli-
cable if there is uncertainty regarding the proper trend specification. In the
first one a specific cointegrating rank is rejected if one of the two tests rejects
and in the second one the trend term is decided upon by a pretest. The first
strategy is shown to be preferable in applied work.