Enhancing the local power of IVX-based tests in predictive regressions

• Published in: Economics letters 2014-08, Vol.124 (2), p.269-273
• Main Author: Demetrescu, Matei
• Format: Article
• Language: English
• Subjects: Convergence; Economic analysis; Economic models; Economic theory; Estimation; Estimation bias; IV estimation; Lag augmentation; Predictive power; Regression analysis; Studies; Unknown persistence; Variable addition; Variables
• ISSN: 0165-1765; 1873-7374
• DOI: 10.1016/j.econlet.2014.05.032

IVX estimation is used increasingly often in predictive regressions with regressors of unknown persistence. While not exhibiting the second-order bias the OLS estimator has in this setup, IVX estimators have reduced rates of convergence when the regressors are highly persistent. The reduced convergence rates may sometimes lead to power losses in finite samples when testing for no predictability, for instance. The note discusses a simple way of improving the local power of IVX-based tests, consisting of augmenting the predictive regression with the lagged dependent variable. This implies a feed-back loop which strengthens the signal of the IVX instrument without changing its dynamic properties. The proposed augmentation works best when the power loss of IVX would have been maximal compared to the infeasible OLS-based test. •In simple predictive models with persistent regressors, the extended instrumental variable method (IVX) stabilizes size, but loses power.•Augmenting the test regression with the lagged dependent variable may seriously increase local power.•The initial and the augmented IVX methods are equivalent under the null hypothesis of no predictability.•The power gain of the augmented IVX method is maximal when the IVX method has smallest power.