Johansen’s VAR-Based

Cointegration Tests
Cointegration in Multivariate Systems
 If there are n > 2 variables in the model, there can be more
than one cointegration vector. The variables in a model
may feature several equilibrium relationship governing the
joint evolution of the variables.
 It is possible for up to (n-1) linearly independent
cointegration vectors to exist, and only when n = 2 is it
possible to show that the cointegration vector is unique.
 Johansen (1992) has shown that estimating a single
equation is potentially inefficient (it does not lead to the
smallest variance against alternative approaches).
 The Johansen Approach Using VAR
Let Zt be a vector of n potentially endogenous variables,

It is possible to specify Zt as an unrestricted vector autoregression

(VAR) involving up to κ lags of Zt,

where Zt is (nx1) and each of the Ai is an (nxn) matrix of

parameters.
The Johansen Approach Using VAR
The system is in reduced form with each variable Zt
regressed only on lagged values of both itself and all other
variables in the system. Thus, ordinary least squares (OLS)
is an efficient way to estimate each equation.

The VAR equation can be reformulated into a Vector

Error Correction Model (VECM) form.
 The Johansen Approach Using VAR

where

i=1,2,…,(k-1) and,

The system above contains information on both the short-run

and long-run adjustment to changes in Zt, via the estimates of
Γi and Π, respectively.
The Johansen Approach Using VAR
Assuming that Zt is a vector of non-stationary
I(1) variables, then all terms in the previous
equation that involve ∆Zt-i are I(0) while ΠZt-k
must be stationary for ut~I(0).

There are three instances when the requirement

that ΠZt-k ~ I(0) is met.
The Johansen Approach Using VAR
Case 1. When all the variables in Zt are in fact stationary.
Case 2. When there is no cointegration at all, implying
that there are no linear combinations of
the Zt that are I (0), and consequently Π is
an (nxn) matrix of zeros. (In this case, the
appropriate model is a VAR in first
differences involving
no long-run elements.)
Case 3. There exists up to (n-1) cointegration
relationships: β’ Zt-k ~ I (0). In this case Π
has reduced rank r < (n-1).
The Johansen Approach Using VAR

 The Johansen procedure will test Case 3.

 The Johansen approach is designed to handle
I(1) (one unit root) and I(0) (stationary)
variables. When there are I(2) (two unit roots)
variables in the model, we must either replace
them with an I(1) alternative through some form
of differencing.
The Johansen Approach in EVIEWS
To carry out the Johansen cointegration test, select
View\Cointegration Test from the VAR window toolbar
(or Quick\Group Statistics\Cointegration Test)
The Johansen Approach in EVIEWS
 The series may have nonzero means and deterministic
trends as well as stochastic trends.
 In order to carry out the test, you need to make an
assumption regarding the trend underlying the data.
 In practice, cases 1 and 5 are rarely used. Use case 1
only if you know that all series have zero mean. Case 5
may provide a good fit in-sample but will produce
implausible forecasts out-of-sample. As a rough guide,
use case 2 if none of the series appear to have a trend.
For trending series, use either case 3 or 4.
The Johansen Approach in EVIEWS

 If you are not certain which trend assumption to use,

you may choose the Summary of all 5 trend
assumptions option (case 6) to help you determine the
choice of the trend assumption. This option indicates
the number of cointegrating relations under each of
the 5 trend assumptions, and you will be able to
assess the sensitivity of the results to the trend
assumption.
Vector Error Correction (VEC) Model
 The VEC model is a restricted VAR designed for use with
nonstationary series that are known to be cointegrated
(check cointegration first using Johansen).
 The VEC has cointegration relations built into the
specification so that it restricts the long-run behavior of the
endogenous variables to converge to their cointegrating
relationship while allowing for short-run adjustment
dynamics.
 As in the single equation, the cointegration term is known as
the “error correction” term since the deviation from long-
run equilibrium is corrected gradually through a series of
partial short-run adjustments.
Vector Error Correction (VEC) Model
Once the long-run cointegration relations has been
achieved, using the Johansen approach, it is now possible
to reformulate the model and estimate the VECM with the
error correction terms explicitly included.
 VEC in EVIEWS
To set up a VEC, click the Estimate button in the VAR
toolbox and choose the Vector Error Correction
specification from the VAR/VEC Specification

Provide the same information as for the VAR, note that the
lag interval specification refers to the “lags of the first
differences”
 VEC in EVIEWS
The constant and the trend specification for the
VEC should be specified in the Cointegration
tab. Select one of the five trend specification in
the Johansen procedure (usually, same as what
was specified in the Johansen procedure).
The number of cointegrating relations should also
be specified (again, from the results of the
Johansen procedure).