A non-local perspective on the power properties of the CUSUM and CUSUM of squares tests for structural change

Abstract

Abstract We consider the power properties of the CUSUM and CUSUM of squares (CUSQ) tests in the presence of a one-time change in the parameters of a linear regression model. A result due to Ploberger and Kramer [1990. The local power of the cusum and cusum of squares tests. Econometric Theory 6, 335–347.] is that the CUSQ test has only trivial asymptotic local power in this case, while the CUSUM test has non-trivial local asymptotic power unless the change is orthogonal to the mean regressor. The main theme of the paper is that such conclusions obtained from a local asymptotic framework are not reliable guides to what happens in finite samples. The approach we take is to derive expansions of the test statistics that retain terms related to the magnitude of the change under the alternative hypothesis. This enables us to analyze what happens for non-local to zero breaks. Our theoretical results are able to explain how the power function of the tests can be drastically different depending on whether one deals with a static regression with uncorrelated errors, a static regression with correlated errors, a dynamic regression with lagged dependent variables, or whether a correction for non-normality is applied in the case of the CUSQ. We discuss in which cases the tests are subject to a non-monotonic power function that goes to zero as the magnitude of the change increases, and uncover some curious properties. All theoretical results are verified to yield good guides to the finite sample power through simulation experiments. We finally highlight the practical importance of our results.