The Effects of Ignoring Level Shifts on Systems Cointegration Tests

Summary: In this paper I analyse the effects of ignoring level shifts in the data generating process on systems cointegration tests that do not accommodate level shifts. I consider two groups of Likelihood Ratio tests based on procedures suggested by Johansen (1988) and Saikkonen and Lütkepohl (2000b). The Monte Carlo analysis reveals that ignoring level shifts reduces the tests’ sizes to zero and causes an important drop in the small sample power for increasing shift magnitudes. This suggests that one should apply test procedures, which take account of level shifts. * This paper is a revised and summarized version of Chapter 3 of my PhD thesis (Trenkler, 2002). I would like to thank two anonymous referees for helpful comments on the submitted paper. Furthermore, I am grateful to Christian Müller, Ralf Brüggemann, and Helmut Lütkepohl for many useful suggestions and comments on an earlier version of the paper and the corresponding chapter of my thesis. The research was supported by the Deutsche Forschungsgemeinschaft (DFG) through the SFB 373 “Quantification and Simulation of Economic Processes” and the SFB 649 “Economic Risk”.