Fully modified estimation of cointegrating vectors via var prewhitening: A simulation study

Summary In this paper we investigate, by simulation methods, the finite samples properties of the Fully Modified Least Squares (FMLS) estimator of cointegrating vectors when the long run covariance matrix is estimated via VAR prewhitening. We compare this estimator to the FMLS estimator based on an automatic or a fixed bandwidth kernel estimator of the long run covariance matrix. By and large, FMLS estimator based on VAR prewhitening perform better than FMLS based on fixed bandwidth or automatic bandwidth, with the latter behaving almost in the same way in finite samples. More importantly, the empirical distribution of a Wald test statistic built from VAR prewhitened FMLS is closer to the asymptoticχ ² distribution than those obtained from alternative kernel estimators. Thus, our findings strongly favor the use of VAR prewhitening in the FM correction of the OLS estimator. We would like to thank P. C. B. Phillips for his suggestions, two anonymous referees for detailed comments, and the participants of the IGIER (Milan), the University of Padova and the CIDE (Bologna) seminars for comments. This paper has been presented at the Econometric Society European Meeting 1984 held at Maastricht, Netherlands. We acknowledge financial support from MURST-Funds 40%. The usual disclaimers apply.