Potential Pitfalls in Determining Multiple Structural Changes.pdfVIP

Potential Pitfalls in Determining Multiple Structural Changes with an Application to Purchasing Power Parity Ruxandra Prodan University of Houston Revised August 2006 We investigate the empirical performance of the Bai and Perron (1998) multiple structural change tests and show that the use of their critical values may cause severe size distortions in persistent series. To correct these size distortions while maintaining a good power, we implement the Bai (1999) structural change test and extend it in two directions: develop a new procedure to choose the number of breaks and a restricted version that specifically models breaks that imply mean or trend reversion. Using our newly proposed methodologies, we reconcile the results of unit root tests with those of tests for structural change when testing for long-run purchasing power parity. Keywords: Structural change, Size distortions, Purchasing Power Parity I am grateful to Bruce Hansen, Tim Hopper, Lutz Kilian, Ulrich Mueller, Chris Murray, Bent Sorensen, and especially David Papell, as well as to participants in seminars at the University of Alabama, Bates College, University of Connecticut, University of Houston, Kansas State University, University of Mississippi, University of Texas at Arlington, Texas Camp Econometrics IX and the 2003 Southern Economics Meetings for helpful comments and discussions. I would also like to thank Pierre Perron for providing me with his Gauss program. Correspondence to: Ruxandra Prodan, tel. (713) 743 3836, email: rprodan@uh.edu, Department of Economics, University of Houston, Houston, TX, 77004. Introduction Structural change i