The unit root hypothesis for aggregate output may not hold after all: new evidence from a panel stationarity test with multiple breaks

Southern Economic Journal, Jan, 2007 by Diego Romero-Avila

1. Introduction

Since the seminal work by Nelson and Plosser (1982), researchers have paid considerable attention to the presence of stochastic trends in macroeconomic variables. That work also changed the way macroeconomists think about secular trends and short-run fluctuations in business cycles. Since the existence of a unit root in output purports that shocks are permanent, short-run fluctuations cannot be explained by the traditional view as deviations around a deterministic trend that represents the secular component of the series. Instead, the trend function itself can fluctuate as a result of permanent shocks. King et al. (1991) found that supply factors are important in explaining economic fluctuations, but may not be the lone source of short-run fluctuations. Campbell and Mankiw (1987) stressed that demand shocks may also be the source of permanent shocks to output.

The existence of a high degree of persistence in output has important implications in macroeconomics. For example, the Keynesian view, that most shocks to output are transitory and output fluctuations are temporary deviations from the secular trend, is inconsistent with a unit root in output. On the contrary, the real business cycle view conceives fluctuations as largely the result of real permanent shocks, essentially of a technological nature. This has important implications for economic policy since stabilization policies lose their effectiveness when variations of output are mainly permanent, thus running counter to the Keynesian view.

Much of the empirical literature has focused on the nonstationarity properties of real U.S. gross national product (GNP). To cite a few studies, Perron and Phillips (1987), Schwert (1987), Campbell and Mankiw (1987), and Perron (1988) fail to reject the null hypothesis of a unit root in real U.S. GNP. These results have not gone unchallenged. Christiano and Eichenbaum (1990) and Rudebusch (1993) highlighted the low power of standard unit root tests of the augmented Dickey and Fuller (1979) type to distinguish between the trend stationary and unit root behavior in aggregate output.

The development of cross-country data sets such as the long gross domestic product (GDP) series provided by Maddison (1989) and the Penn World Table (PWT) constructed by Summers and Heston (1990) has allowed researchers to provide international evidence on the unit root behavior in aggregate output. For instance, Wasserfallen (1986) found a unit root in GNP series for some Organization for Economic Co-operation and Development (OECD) countries over the postwar era. Kormendi and Meguire (1990) confirmed the existence of a unit root in output for twelve OECD countries over the period 1870-1985. (1) However, the seminal work of Perron (1989) uncovered the fact that nonstationarity may conceal the existence of stationarity with structural change, showing that standard unit root tests tend to misinterpret trend stationarity with a structural break as a unit root. By exogenously imposing a structural break in real U.S. GNP, Perron (1989) was able to strongly reject the unit root hypothesis. However, Zivot and Andrews (1992) provided slightly less evidence of a unit root in real U.S. GNP using a test that allowed for a structural break that was endogenously determined from the data.

In an international context, Zelhorst and De Haan (1994, 1995) found evidence for OECD countries that over long-time periods, where the presence of structural change becomes more likely, the null of a unit root in output tends to be rejected in favor of regime-wise stationarity. Ben-David and Papell (1995) employed the Zivot and Andrews (1992) test to investigate the unit root behavior in output for 16 OECD countries over the period 1870-1989 and rejected the null of a unit root for one-third of the countries. Ben-David, Lumsdaine, and Papell (2003) revisited their previous work by employing the univariate unit root test developed by Lumsdaine and Papell (1997), which allows for two changes in level and slope. Their evidence points to the rejection of the unit root hypothesis for three-quarters of the countries.

More recently, researchers have turned to a panel methodology with the aim of increasing statistical power in testing for a unit root in output. Fleissig and Strauss (1999) employed the panel unit root tests by Levin, Lin, and Chu (2002); Im, Pesaran, and Shin (2003); Maddala and Wu (1999); and the seemingly unrelated procedure developed by Abuaf and Jorion (1990) to analyze the unit root behavior in output for 15 OECD countries over the period 1900-1987. (2) They reported overwhelming evidence that OECD output is trend stationary even after controlling for cross-correlation through bootstrap methods. Along similar lines, Rapach (2002) extended the analysis of the nonstationarity properties of OECD output data using four different data sets of real GDP and real GDP per capita. As opposed to Fleissig and Strauss (1999), he provided overwhelming evidence of a unit root in aggregate output using the tests by Levin, Lin, and Chu (2002); Im, Pesaran, and Shin (2003); Abuaf and Jorion (1990); and the less restrictive seemingly unrelated approach by Taylor and Sarno (1998). The reason for the discordant results from these studies using apparently similar panel unit root tests may be the misspecification of the trend function governing the time series behavior in the output series. Rapach (2002), indeed, found it surprising that panel unit root tests fail to reject the unit root hypothesis for output series, but not for other variables, such as inflation rates, unemployment rates, and nominal interest rates. He called for future research to examine the robustness of his results along two dimensions. First, he suggested including structural breaks so as to avoid misinterpretation of trend stationarity with breaks as difference stationarity. Second, he suggested employing a panel stationarity test of the KPSS-type (Kwiatkowski et al. 1992), which takes stationarity as the null hypothesis.