I was estimating a long-run relationship of exchange rate and purchasing power parity. The residual of the long-run relation which should be $I(0)$, but it is only $I(0)$ when I introduce trend in the long-run relationship. Can someone provide the logic or study material that shows introducing trend is not a problem and how to justify it?

  • $\begingroup$ this should answer your question: repub.eur.nl/res/pub/1559/feweco19990414090913.pdf $\endgroup$ – Matthias Wolf Aug 2 '13 at 2:43
  • $\begingroup$ @MattWolf That is useful, but I think his problem is more basic, related to the choices he is making in variables. For instance, if you are using the relative inflation rates versus the price levels, then you may or may not have needed to use include the trend term. $\endgroup$ – John Aug 2 '13 at 21:09

The critical values of the unit root test you are using depends if there is a trend or not. For example, the quantiles of the Dickey-Fuller distribution is different when a trend is included from when a trend is not included, hence the critical values for your unit root test are different. The critical values of unit root tests are generated by simulation, with different kinds of deterministic terms to match the series you are considering.

| improve this answer | |

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.