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International Finance Discussion Papers
The International Finance Discussion Papers logo links to the International Finance Discussion Papers home page Markov Regime-Switching and Unit Root Tests
Charles R. Nelson; Jeremy Piger; Eric Zivot
2000-683  (September 2000)

Abstract:  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.

Full paper (91 KB PDF)

stochastic trends, deterministic trends, structural change, heteroskedasticity

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