In: Economics
Answer. Time series that diverge
away from their mean over time are said to be non-stationary.
Therefore, the classical estimation of variables with this
relationship most times gives misleading inferences or spurious
regression.
A non-stationary time series is a stochastic process with unit
roots or structural breaks. However, unit roots are major sources
of non-stationarity. The presence of a unit root implies that a
time series under consideration is non-stationary while the absence
of it entails that a time series is stationary. This depicts that
unit root is one of the sources of non-stationarity. A
non-stationary stochastic process could be Trend Stationary
(deterministic) Process (TSP) or Difference Stationary Process
(DSP).
It should be made clear that if a time series is TSP, but treated
as DSP, this is called over-differencing. On the other hand, if a
time series is DSP, but treated as TSP; this is referred to as
under-differencing. The implications of these types of
specification error can be serious, depending on how the serial
correlation properties of the resulting error terms are handled.
However, it has been observed that most time series are DSP rather
than TSP. Therefore, when such non-stationary time series (DSP) are
used in estimation of an econometric model, the Ordinary Least
Square (OLS) traditional diagnostic statistics for evaluation of
the validity of the model estimates such as, coefficient of
determination (R2), Fisher’s Ratio(F Statistic),
Durbin-Watson(DW-Stat), t-statistic etc. become highly misleading
and unreliable in terms of forecast and policy. In such series, the
mean, variance, covariance and autocorrelation functions change
overtime and affect the long run development of the series. The
presence of unit root in these series leads to the violation of
assumptions of constant means and variances of OLS.