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Testing Linearity in Cointegrating Relations With an Application to Purchasing Power Parity

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  • Hong, Seung Hyun
  • Phillips, Peter C. B.

Abstract

This paper develops a linearity test that can be applied to cointegrating relations. We consider the widely used RESET specification test and show that when this test is applied to nonstationary time series its asymptotic distribution involves a mixture of noncentral chi^2 distributions, which leads to severe size distortions in conventional testing based on the central chi^2. Nonstationarity is shown to introduce two bias terms in the limit distribution, which are the source of the size distortion in testing. Appropriate corrections for this asymptotic bias leads to a modified version of the RESET test which has a central chi^2 limit distribution under linearity. The modified test has power not only against nonlinear cointegration but also against the absence of cointegration. Simulation results reveal that the modified test has good size infinite samples and reasonable power against many nonlinear models as well as models with no cointegration, confirming the analytic results. In an empirical illustration, the linear purchasing power parity (PPP) specification is tested using US, Japan, and Canada monthly data after Bretton Woods. While commonly used ADF and PP cointegration tests give mixed results on the presence of linear cointegration in the series, the modified test rejects the null of linear PPP cointegration.

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File URL: http://pubs.amstat.org/doi/abs/10.1198/jbes.2009.07182
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Bibliographic Info

Article provided by American Statistical Association in its journal Journal of Business and Economic Statistics.

Volume (Year): 28 (2010)
Issue (Month): 1 ()
Pages: 96-114

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Handle: RePEc:bes:jnlbes:v:28:i:1:y:2010:p:96-114

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Citations

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Cited by:
  1. Marmer, Vadim, 2009. "Nonlinearity, Nonstationarity, and Spurious Forecasts," Micro Theory Working Papers vadim_marmer-2009-60, Microeconomics.ca Website, revised 03 Nov 2009.
  2. Wang, Qiying & Phillips, Peter C.B., 2009. "Asymptotic Theory For Local Time Density Estimation And Nonparametric Cointegrating Regression," Econometric Theory, Cambridge University Press, vol. 25(03), pages 710-738, June.
  3. Derek Bond & Michael J. Harrison & Edward J. O'Brien, 2006. "Purchasing Power Parity: The Irish Experience Re-visited," Trinity Economics Papers tep200615, Trinity College Dublin, Department of Economics.

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