HOW TO DEAL WITH STRUCTURAL BREAKS IN APPLIED COINTEGRATION ANALYSIS

Roselyne JOYEUX (Macquarie University)

The empirical literature making use of unit root and cointegration tests has been growing over the last two decades. The application of those tests is challenging for many reasons including the treatment of deterministic terms (constant and trend) and structural breaks. Franses (2001) addresses the problem of how to deal with intercept and trend in practical cointegration analysis. In this paper we use Franses (2001) approach to consider the treatment of structural breaks in VAR models used to tests for unit roots and cointegration.

Johansen, Mosconi and Nielsen (2000) generalize the likelihood-based cointegration analysis developed by Johansen (1988, 1996) to the case where structural breaks exist at known points in time. In this paper we provide a simple explanation of the specification of intervention dummies in VAR models used to test for cointegration, which is not present in the later paper. A survey of the applied literature using Johansen's test for cointegration in a VAR setting would reveal that intervention dummies are usually inappropriately specified. It is the aim of this note to show how to specify and include intervention dummies and to make accessible to applied economists the latest developments in the use of intervention dummies when testing for cointegration.