Deterministic and stochastic trends in the time series models: a guide for the applied economist

Abstract

Applied economists working with time series data face a dilemma in selecting between models with deterministic and stochastic trends. While models with deterministic trends are widely used, models with stochastic trends are not so well known. In an influential paper Harvey (1997) strongly advocates a structural time series approach with stochastic trends in place of the widely used autoregressive models based on unit root tests and cointegration techniques. Therefore, it is important to understand their relative merits. This article suggests that both methodologies are useful and they may perform differently in different models. This article provides a few guidelines to the applied economists to understand these alternative methods.