FUNCTIONAL FORM MISSPECIFICATION IN REGRESSIONS WITH A UNIT ROOT

We examine the limit properties of the nonlinear least squares (NLS) estimator under functional form misspecification in regression models with a unit root. Our theoretical framework is the same as that of Park and Phillips (2001, <italic>Econometrica</italic> 69, 117–161). We show that the limit behavior of the NLS estimator is largely determined by the relative orders of magnitude of the true and fitted models. If the estimated model is of different order of magnitude than the true model, the estimator converges to boundary points. When the pseudo-true value is on a boundary, standard methods for obtaining rates of convergence and limit distribution results are not applicable. We provide convergence rates and limit theory when the pseudo-true value is an interior point. If functional form misspecification is committed in the presence of stochastic trends, the convergence rates can be slower and the limit distribution different than that obtained under correct specification.