Cointegration and Threshold Adjustment

Abstract

The Engle-Granger test for cointegration is extended by assuming that the error correction terms are asymmetric. Two variants are considered: a simple threshold autoregressive (TAR) model, where the positive and negative disequilibria are the error corrections, and the momentum threshold autoregressive model (M-TAR),where positive and negative changes in the disequilibria are the error corrections. The M-TAR model, in particular, has good power over the Engle-Granger test. We also consider an application where we test for cointegration between long and short US interest rates. Conventional cointegration testing (i.e., Engle-Granger, Johansen) concludes that interest rates are not cointegrated while we do find cointegration in the presence of asymmetric adjustment. We provide an economic rationale for such a finding.

Keywords: asymmetric adjustment, Monte Carlo, nonlinear autoregression, cointegration

JEL Classification: E43, C22, C50