A Monte Carlo study on the pitfalls in determining deterministic components in cointegrating models

Abstract

Recently the use of the so-called 'Pantula principle' has been suggested as a means of determining deterministic components in cointegrating models (see Ahking in Journal of Macroeconomics 24, 2002, and Hatemi-J in Economic Modelling 19, 2002). Moreover, the procedure is suggested in the widely used CATS in RATS program (see [Hansen, H., Juselius, K., 1995. CATS in RATS. Estima, United States]). In this paper, we examine, by means of Monte Carlo simulation, the properties of the 'Pantula principle'. We investigate the five models contained within the Johansen methodology and find that the 'Pantula principle' is heavily biased towards choosing the model with an unrestricted constant when the model with a restricted trend is the true one. We suggest a modification that reduces this bias to an important extent.