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Inappropriate Detrending and Spurious Cointegration

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  • Heejoon Kang

    (Department of Business Economics and Public Policy, Indiana University Kelley School of Business)

Abstract

The empirical literature is abundant with detrended cointegration, where cointegration relationships are tested and estimated with deterministic trend terms. Cointegration is, however, critically dependent on whether time series is detrended or not. A series of Monte Carlo experiments show that inappropriately detrended time series tend to exhibit a spurious cointegration. Although true time series are known not to be cointegrated, inappropriately detrended series tend to be cointegrated. Foreign exchange rates are analyzed to demonstrate the relevance and importance of the inappropriate detrending in the cointegration analysis.

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File URL: http://www.bus.indiana.edu/riharbau/RePEc/iuk/wpaper/bepp2006-14-kang.pdf
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Bibliographic Info

Paper provided by Indiana University, Kelley School of Business, Department of Business Economics and Public Policy in its series Working Papers with number 2006-14.

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Date of creation: 2006
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Handle: RePEc:iuk:wpaper:2006-14

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Keywords: Deterministic trend; Foreign exchange rates; Monte Carlo study; Stochastic trend;

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  1. Granger, Clive W J, 1986. "Developments in the Study of Cointegrated Economic Variables," Oxford Bulletin of Economics and Statistics, Department of Economics, University of Oxford, vol. 48(3), pages 213-28, August.
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  16. PERRON, Pierre & RODRIGUEZ, Gabriel, 1998. "GLS Detrending, Efficient Unit Root Tests and Structural Change," Cahiers de recherche 9809, Universite de Montreal, Departement de sciences economiques.
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