GC 11/02: Unit root testing under a local break in trend

Abstract

Recent approaches to testing for a unit root when uncertainty exists over the presence and timing of a trend break employ break detection methods, so that a with-break unit root test is used only if a break is detected by some auxiliary statistic. While these methods achieve near asymptotic efficiency in both fixed trend break and no trend break environments, in finite samples pronounced valleys in the power functions of the tests (when mapped as functions of the break magnitude) are observed, with power initially high for very small breaks, then decreasing as the break magnitude increases, before increasing again. In response to this problem we propose two practical solutions, based either on the use of a with-break unit root test but with adaptive critical values, or on a union of rejections principle taken across with-break and without break unit root tests. These new procedures are shown to offer improved reliability in terms of finite sample power. We also develop local limiting distribution theory for both the extant and the newly proposed unit root statistics, treating the trend break magnitude as local-to-zero. We show that this framework allows the asymptotic analysis to closely approximate the finite sample power valley phenomenon, thereby providing useful analytical insights.

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Authors

David I. Harvey, Stephen J. Leybourne and A. M. Robert Taylor

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