Key words: Unit root hypothesis, structural breaks, Libyan economy

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ECONOMIC DEVELOPMENT AND STRUCTURAL BREAKS: AN APPLICATION OF THE LEE AND STRAZICICH (2003) LAGRANGE MULTIPLIER TEST TO THE LIBYAN ECONOMY, 1970-2007 ALI, Issa^*

VERMA, Reetu Abstract

The aim of the paper is to examine the unit root properties while identifying the timing of the major structural breaks in Libyan economy using annual time series data from 1970 to 2007. The ADF tests results are not able to reject the null of unit root for all of the 14 macroeconomic variables. On the other hand, the results of Lee and Strazicich (2003) test with two endogenously determined structural breaks indicate the non- rejection of unit root null of only eight variables. The structural break dates correspond to the major events in the Libyan economy such as oil shocks in late 70s and early 80s, changing of economic regime in 1977, the UN sanctions in the early 1990s, and lifting of the UN sanctions and USA trade embargo in 2003 and 2004.

Key words: Unit root hypothesis, structural breaks, Libyan economy.

JEL codes: C12; C22; C52;

1. Introduction

The analysis of stationarity of macroeconomic time series data with the presence of structural breaks has attracted remarkable amount of work in recent years. The view of traditional unit root tests (ADF and the Philip Perron’s tests) is that current shocks merely have a temporary effect, and that the long-run movement in the series is unchanged by such shocks. This view was challenged by Nelson and Plosser (1982) who argued, using the ADF technique, that current shocks have a permanent effect on the long-run level of most macroeconomic and financial variables. They found evidence in favour of the unit root hypothesis (non-stationary) for 13 out of 14 macroeconomic and financial aggregates for the United States.¹ However, Perron (1989) questioned this interpretation, suggesting that the observed unit root behaviour may have resulted from failure to account for a structural beak in the Nelson and Plosser data. He pointed out: “Our conclusion is that most macro-economic time series are not characterised by the presence of the unit root and that fluctuations are indeed transitory” (Perron 1989, p.1362). According to Perron, the only two exogenous shocks that have had a permanent effect upon macroeconomic variables were the Great Crash of 1929 and the oil price shock of 1973. As a consequence, ignoring such events or structural changes in the trend function leads to considerable power reduction of traditional unit root tests.

Perron (1989) re-examined the same data used by Nelson and Plosser in their study and showed that the result derived by Nelson and Plosser (1982) could be

* Issa ALI, School of Economics, University of Wollongong, Wollongong, NSW 2522, Australia. Email: [email protected], Reetu VERMA, School of Economics, University of Wollongong, Wollongong, NSW 2522, Austrália. Email: [email protected]

1 The time series considered by Nelson and Plosser (1982) were real GNP, nominal GNP, real per capita GNP, industrial production, unemployment rate, GNP deflator, consumer prices, wages, money stock, velocity, bond yield, and common stock prices.

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reversed for most of the time series variables. Perron allowed for a break in the trend function by simply including dummy variables in the ADF test regression, assuming that the timing of the break point was known a priori, that is that the points selected were uncorrelated with the data.² By doing so Perron (1989) reversed the Nelson and Plosser results in 11 of the 14 macroeconomic variables implying that the series are in fact stationary if a structural break, such as the Great Crash of 1929 or the oil price shock of 1973 is included.

However, Perron’s (1989) assumption of a known exogenous break point was criticized because of its tendency to favour the alternative hypothesis. A subsequent literature, most notably Christiano (1992), Zivot and Andrews (1992), Perron and Vogelsang (1992), Perron (1997) among others incorporated an endogenous single break into the model specification. Zivot and Andrews (1992) who tested for a single endogenous break date found less evidence against the unit root hypothesis than Perron (1989) did using the Nelson and Plosser (1982) data. Zivot and Andrews rejected the unit root at the five percent significance level for only three out of 13 variables using the same data as Nelson and Plosser. However, the results for nominal GNP, real GNP and industrial production were consistent with Perron’s as these variables were rejected even after the break was endogenously determined. A summary of the unit root tests using the Nelson and Plosser data set (1982) is given in Table 1.

Table 1: Unit Root Tests with the Nelson and Plosser’s Data (1982) Set

Empirical Studies by: Model Unit

Root

Stationary

Nelson and Plosser (1982) ADF test with no break 13 1

Perron (1989)** Exogenous with one

break 3 11

Zivot and Andrews (1992)* Endogenous with one

break 10 3

Lumsdaine and Papell (1997)* Endogenous with two

breaks 8 5

Lee and Strazicich (2003)** Endogenous with two

breaks 10 4

* Assume no break(s) under the null hypothesis of unit root.

** Assume break(s) under both the null and the alternative hypothesis.

Source: Glynn, J; Perera, N; and Verma, R. (2007)

2 The exogeneity assumption is utilized by Perron as a device to remove the influence of the shocks from the noise function.

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The debate regarding the relationship between the unit root hypothesis and structural breaks was resumed by several studies including Lumsdaine and Papell (1997) and Lee and Strazicich (2003) among others. Once again, the assumption of an unknown or endogenous break point was criticized because of a loss of information from ignoring two breaks in the one break test. In the words of Lee and Strazicich (2003, p.1082) “…given a loss of power from ignoring one break, it is logical to accept a similar loss of power from ignoring two, or more, breaks in the one-break test”.

Lumsdaine and Papell (1997) extended the Zivot and Andrews (1992) model, allowing for two breaks under the alternative hypothesis of the unit root. They also re- examined the Nelson and Plosser (1982) data finding more evidence against unit root than Zivot and Andrews but less than Perron (1989).³ Using finite-sample critical values, they rejected the unit root null for five series at the five percent significance level, the three series found by Zivot and Andrews plus employment and per-capita real GNP.

These endogenous break tests that allow for the possibility of one or two breaks;

Zivot and Andrews (1992), Perron (1997) and, Lumsdaine and Papell (1997) do not allow for break(s) under the null hypothesis of unit root and thus derive their critical values accordingly. This may potentially bias these tests. Nunes et al., (1997) showed that this assumption leads to size distortions in the presence of a unit root with a break and Perron (2005, pp.55) suggested that there may be some loss of power.

Furthermore, given the breaks are absent under the null hypothesis of unit root, there may be tendency for these tests to suggest evidence of stationary with breaks (Lee and Strazicich 2003).

Lee and Strazicich (2003) also applied their two-break minimum LM unit root test to Nelson and Plosser’s (1982) data. They found stronger rejections of the unit root null using the Lumsdaine and Papell test than the LM test. Only the null of industrial production and the unemployment rate are rejected by both the Lumsdaine and Papell and LM tests. Furthermore, Lee and Strazicich point out that the null is rejected at the five percent significance level for real GNP, nominal GNP, per capita real GNP and employment using the Lumsdaine and Papell test, but the null for these variables is only rejected at the higher significance level with the LM test.

The minimum LM unit root test proposed by Lee and Strazicich (2003) not only endogenously determines structural breaks but also avoids the problems of bias and spurious rejections. As the test allows for breaks in both the null and alternative hypothesis, it is also the only test which is consistent with Perron’s (1989) original study.

The main purpose of this paper is to apply the LM unit root test with two endogenously determined breaks by Lee and Strazicich (2003) to investigate the time series properties for 14 macroeconomic variables of the Libyan economy. The time series properties of macroeconomic data have important implications for theories in macroeconomics. Empirically, the order of integration of macroeconomic variables is important for appropriate econometric modelling of time-series data. On the economic side, if macroeconomic series contains a unit root, business cycle theories describing output fluctuations as temporary deviations from long-run growth trends lose their empirical support.

3 See Table 1

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Figure 1: Plots of macroeconomic data for the Libyan economy

Sources: (1) The International Financial Statistics Yearbook (IFS), IMF, various issues. (2) The Central Bank of Libya, Economic Bulletin, various issues. (3) National Authority for Information and Documentation, Libya, various issues.

5.8 6.0 6.2 6.4 6.6 6.8 7.0 7.2

1970 1975 1980 1985 1990 1995 2000 2005 Oil Production

7.6 7.8 8.0 8.2 8.4 8.6 8.8 9.0

1970 1975 1980 1985 1990 1995 2000 2005 Oil GDP

6.5 7.0 7.5 8.0 8.5 9.0 9.5 10.0

1970 1975 1980 1985 1990 1995 2000 2005 Non-Oil GDP

7.0 7.5 8.0 8.5 9.0 9.5 10.0

1970 1975 1980 1985 1990 1995 2000 2005 Money Supply

5.6 6.0 6.4 6.8 7.2 7.6 8.0 8.4

1970 1975 1980 1985 1990 1995 2000 2005 Government Investment

8.0 8.4 8.8 9.2 9.6 10.0

1970 1975 1980 1985 1990 1995 2000 2005 Gross Domestic Product

6.6 6.8 7.0 7.2 7.4 7.6 7.8 8.0 8.2 8.4

1970 1975 1980 1985 1990 1995 2000 2005 Government Consumption

0.2 0.4 0.6 0.8 1.0 1.2 1.4 1.6 1.8

1970 1975 1980 1985 1990 1995 2000 2005 Consumer Price Index

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Furthermore, applying the procedure for testing the unit root hypothesis, which allows for the possible presence of the structural break, has at least two advantages.

Firstly, it prevents yielding a test result which is biased towards non-rejection, as suspected by Perron (1989). Secondly, since this procedure identifies the presence of structural breaks, it can provide valuable information for analysing whether a structural break on a certain variable is associated with a particular government policy, economic crises, war, regime shifts or other factors. As can be seen by Figure 1, the Libyan economy has been subjected to numerous structural changes during the sample period of the study. The volatility of the Libyan data demonstrates the need of subjecting these fluctuations to a rigorous econometric investigation. Therefore, this paper applies both the traditional ADF test and the Lee and Strazicich unit root test with two endogenously determined structural breaks. No known Libyan studies have undertaken this.

The annual time series data for the period 1970 to 2007 is used in the study.

Data is collected from the various issues of the International Financial Statistics Yearbook (IMF), the Central Bank of Libya Economic Bulletin, and National Authority for Information and Documentation, Libya. The macroeconomic time series examined are private consumption (RPC), real private investment (RPI), real government consumption (RGC), real government investment (RGI), real gross domestic product (RGDP), real non-oil GDP (RNOGDP), real oil GDP (ROGDP), real exchange rate (RER), real money supply (RMS), real oil price (ROP), oil production (OP), consumer price index (CPI), real imports (RIM), and real exports (REX).

The rest of this paper is structured as follows: Section 2 discusses the theoretical model of Lee and Strazicich (2003) minimum LM unit root test with two endogenous determined structural breaks. Section 3 provides the empirical results of both the ADF and LM unit root tests, while Section 4 concludes.

2. Minimum Lagrange Multiplier (LM) Unit Root Test with Two Endogenous Structural Breaks

Lee and Strazicich (2003) consider the data-generating process (DGP) as follows:

y_t 



^Z_te_t_,

e

_t

  e

_t_₁

 

_t (1) where

Z

_t consists of exogenous variables and



_t is an error term with mean zero and variance



². Two structural breaks models are considered by Lee and Strazicich.

Model A allows for two shifts in level and is given by

Z

_t

 [1, , 1 , 2 ] t D

_t

D

_t , where

jt 1

D  if

1, 1, 2

Bj

t  T  j 

, and 0 otherwise. The term D_jt represents a dummy variable for a mean shift accruing at

T

_B.

T

_B denotes the time period when the break occurs.

CPI

.

The other eight variables of RPI RGI RNOGDP ROGDP RMS ROP RIM, , , , , , and REX are non-stationary

4 The inclusion of the trend can be justified as the graphs in Figure 1 indicate that most of the time series considered in the study have a trend.

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Table 2: ADF test for stationarity (includes an intercept and a linear trend)

Notes: 1 All variables are in log form and are constant 1990 prices. 2 Critical t values at the 1%, 5%

and 10% levels are -4.2268, -3.5366 and -3.2003, respectively. 3 Represents optimum lags, selecting automatically by Schwarz Bayesian Criterion (SBC).

.

Variables description¹ ADF t-statistic² k³ Result

Real private consumption (RPC) -3.085918 0 Unit Root

Real private investment(RPI) -3.474963 0 Unit Root

Real Government consumption (RGC) -2.661063 0 Unit Root

Real Government investment (RGI) -1.635928 0 Unit Root

Real GDP (RGDP) -2.737358 3 Unit Root

Real non-oil GDP (RNOGDP) -2.818355 1 Unit Root

Real oil GDP (ROGDP) -2.136234 0 Unit Root

Real exchange rate (RER) -2.071300 0 Unit Root

Real money supply (RMS) -2.455769 0 Unit Root

Real oil price (ROP) -2.083468 0 Unit Root

Oil production (OP) -2.532940 0 Unit Root

Consumer price index (CPI) -2.797346 2 Unit Root

Real imports (RIM) -2.428256 0 Unit Root

Real exports (REX) -2.428753 0 Unit Root

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Table 3: Results of Two-Break Minimum LM Unit Root Test, MC: Breaks in Intercept and Slope.

Note: The critical values at the five percent significant level are as follows: for

, , , , ,

RPI ROP OP CPI RIM REX is



= (0.4,0.8) =-5.56; for

, ,

R G I R G D P R N O G D P is



= (0.2, 0.6) = -5.67; for RPC ROGDP, is



= (0.2, 0.4) = -5.59; and for RER is



= (0.2, 0.8) = -5.71.

Two-Break Minimum LS Unit Root Test

Variable description

t-Statistic TB1 TB2 k Result Real private consumption (RPC) -7.3365 1979 1986 4 Statio

nary

Real private investment(RPI) -5.2772 1985 1999 2 Unit

Root Real Government consumption (RGC) -6.1739 1981 1991 2 Statio nary Real Government investment (RGI) -4.5654 1980 1991 4 Unit Root

Real GDP (RGDP) -4.4568 1979 1993 2 Unit

Root

Real non-oil GDP (RNOGDP) -3.8579 1976 1989 2 Unit

Root

Real oil GDP (ROGDP) -5.6750 1979 1983 3 Statio

nary

Real exchange rate (RER) -8.9725 1980 1998 3 Statio

nary

Real money supply (RMS) -4.9629 1981 1995 3 Unit

Root

Real oil price (ROP) -7.1631 1984 1997 3 Unit

Root

Oil production (OP) -8.0948 1988 1997 4 Statio

nary

Consumer price index (CPI) -5.8910 1981 1999 3 Statio

nary

Real imports (RIM) -5.1697 1981 2003 3 Unit

Root

Real exports (REX) -5.1704 1981 2003 3 Unit

Root

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On the whole, while the traditional ADF unit root test suggests that all variables of interest are non-stationary, results from the LM method suggests that only eight of of the 14 variables are non-stationary after taking into account two endogenously determined structural breaks under both the null and alternative hypotheses. The two-break points in the level and trend are significant for a most of the variables. The exceptions are first break for

RNOGDP

and RER, and both breaks for

ROGDP

and

RMS

. As can be seen from Table 3, the first significant break date for the majority of the macroeconomic variables in the Libyan economy took place in the late 1970 and early 1980s. These breaks are consistent with the changing of economic regime in 1977; the oil crash of 1979; and the subsequent increase of oil prices during late 1970s and early 1980s. The early 1980s also saw an embargo imposed by the USA where parts of foreign assets were frozen.

The second breaks date of 1991 (RGC and RGI) and 1993 (RGDP) are in line with UN sanctions imposed in the early 1990s. Other second break dates of 1997-1999 and 2003 for RPI, ROP, CPI, RIM and REX correspond to economic reforms in the Libyan economy during the late 1990s and the beginning of this century. These reforms saw the restrictions upon the private sector alleviated and also the lifting of sanctions imposed by the United Nations took place. The breaks also correspond to the depreciation of the official exchange rate in 1999; the unification of the exchange rate in 2002; and the lifting of the UN sanctions and USA trade embargo in 2003 and 2004, respectively.

4. Concluding Remarks

The objective of the study was to investigate the time series properties of the Libyan economy from 1970-2007 while identifying the time of the structural break dates. This paper applies the traditional ADF unit root test and LM unit root test of Lee and Strazicich (2003) with two unknown structural breaks for 14 major macroeconomic variables of the Libyan economy. The results indicate the non-rejection of the unit root null hypothesis of all 14 variables of interest using the traditional ADF unit root test.

However, after accounting for two endogenous structural breaks in the data, the results of the LM model are not able to reject the null of unit root for only eight variables at the five percent significance level. This is consistent with Perron’s (1989) findings that a failure to allow for an existing break leads to a bias, which reduces the ability to reject a false unit root null hypothesis.

The endogenously determined breaks points are consistent with the oil related shocks of the late of 1970s, early 1980s and after 2000; the collapsing of oil prices during the mid of 1980s and 1990s; the changing of economic regime in1977; the USA embargo of the early 1980s; the UN sanctions in the early 1990s; the lifting of sanction and the change of the official exchange rate in 1999; the unification of exchange rate in 2002. The study has shed some light upon the matter of structural breaks in Libyan data and hence provides an indication for future studies utilising the macroeconomic data in Libya.

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