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Markov regime-switching and unit root tests

  • Charles R. Nelson
  • Jeremy M. Piger
  • Eric Zivot

We investigate the power and size performance of unit root tests when the true data generating process undergoes Markov regime-switching. All tests, including those robust to a single break in trend growth rate, have very low power against a process with a Markov-switching trend growth rate as in Lam (1990). However, for the case of business cycle non-linearities, unit root tests are very powerful against models used as alternatives to Lam (1990) that specify regime-switching in the transitory component of output. Under the null hypothesis, the received literature documents size distortions in Dickey-Fuller type tests caused by a single break in trend growth rate or variance. We find these results do not generalize to most parameterizations of Markov-switching in trend or variance. However, Markov-switching in variance can lead to over-rejection in tests robust to a single break in the level of trend.

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Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series International Finance Discussion Papers with number 683.

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Date of creation: 2000
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Handle: RePEc:fip:fedgif:683
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