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Unit Roots, Trend Breaks and Transitory Dynamics: A Macroeconomic Perspective

  • Kilian, L.
  • Ohanian, L.E.

There is a widespread tendency in the applied time series literature to interpret rejections of the unit root null hypothesis in favor of a trend stationary process with possible trend breaks as evidence that the data are better characterized as stationary about a broken trend. This interpretation is valid only if the model postulated under the alternative hypothesis is the only plausible alternative to the model postulated under the null. We argue that this implicit assumption is often questionable. There are economically plausible models that are not well captured either under the null hypothesis or under the alternative hypothesis of these tests. We show that applied researchers who ignore this possibility are likely to reject the unit root null with high probability in favor of a trend stationary process with possible breaks. The main contribution of this paper is to provide evidence that this potential pitfall is both economically relevant and quantitatively important. We also explore to what extent applied users may mitigate inferential errors by using finite-sample and bootstrap critical values.

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Paper provided by Michigan - Center for Research on Economic & Social Theory in its series Papers with number 99-02.

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Length: 30 pages
Date of creation: 1999
Date of revision:
Handle: RePEc:fth:michet:99-02
Contact details of provider: Postal: UNIVERSITY OF MICHIGAN, DEPARTMENT OF ECONOMICS CENTER FOR RESEARCH ON ECONOMIC AND SOCIAL THEORY, ANN ARBOR MICHIGAN U.S.A.

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