This paper has now been published by Econometrica.

Abstract

We introduce a generalization of the popular local-to-unity model of time series persistence by allowing for p autoregressive roots and p – 1 moving average roots close to unity. This generalized local-to-unity model, GLTU(p), induces convergence of the suitably scaled time series to a continuous time Gaussian ARMA(p, p – 1) process on the unit interval. Our main theoretical result establishes the richness of this model class, in the sense that it can well approximate a large class of processes with stationary Gaussian limits that are not entirely distinct from the unit root benchmark. We show that Campbell and Yogoís (2006) popular inference method for predictive regressions fails to control size in the GLTU(2) model with empirically plausible parameter values, and we propose a limited-information Bayesian framework for inference in the GLTU(p) model and apply it to quantify the uncertainty about the half-life of deviations from Purchasing Power Parity.