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PANEL DATA ECONOMETRICS Theoretical Contributions and Empirical Applications

CONTRIBUTIONS TO ECONOMIC ANALYSIS

274

Honorary Editors:

D. W. JORGENSON J. TINBERGEN

Editors:

B. BALTAGI

E. SADKA

D. WILDASIN

J. TINBERGEN † Editors: B. BALTAGI E. SADKA D. WILDASIN Amsterdam – Boston – Heidelberg –

Amsterdam – Boston – Heidelberg – London – New York – Oxford Paris – San Diego – San Francisco – Singapore – Sydney – Tokyo

PANEL DATA ECONOMETRICS

Theoretical Contributions and Empirical Applications

Edited by

BADI H. BALTAGI Department of Economics and Center for Policy Research Syracuse University, Syracuse, NY 13244-1020 U.S.A.

Research Syracuse University, Syracuse, NY 13244-1020 U.S.A. Amsterdam – Boston – Heidelberg – London – New

Amsterdam – Boston – Heidelberg – London – New York – Oxford Paris – San Diego – San Francisco – Singapore – Sydney – Tokyo

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Introduction to the Series

This series consists of a number of hitherto unpublished studies, which are introduced by the editors in the belief that they represent fresh contribu- tions to economic science. The term ‘economic analysis’ as used in the title of the series has been adopted because it covers both the activities of the theoretical economist and the research worker. Although the analytical method used by the various contributors are not the same, they are nevertheless conditioned by the common origin of their studies, namely theoretical problems encountered in practical research. Since for this reason, business cycle research and national accounting, research work on behalf of economic policy, and problems of planning are the main sources of the subjects dealt with, they necessarily determine the manner of approach adopted by the authors. Their methods tend to be ‘practical’ in the sense of not being too far remote from application to actual economic conditions. In addition, they are quantitative. It is the hope of the editors that the publication of these studies will help to stimulate the exchange of scientific information and to reinforce international cooperation in the field of economics.

The Editors

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Contents

Introduction to the Series

v

Preface

ix

List of Contributors

xv

PART I THEORETICAL CONTRIBUTIONS

1

Chapter 1.

On the Estimation and Inference of a Panel Cointegra- tion Model with Cross-Sectional Dependence 3 Jushan Bai and Chihwa Kao

Chapter 2.

A Full Heteroscedastic One-Way Error Components Model: Pseudo-Maximum Likelihood Estimation and Specification Testing Bernard Lejeune

31

Chapter 3.

Finite Sample Properties of FGLS Estimator for Random- Effects Model under Non-Normality Aman Ullah and Xiao Huang

67

Chapter 4.

Modelling the Initial Conditions in Dynamic Regression Models of Panel Data with Random Effects I. Kazemi and R. Crouchley

91

Chapter 5.

Time Invariant Variables and Panel Data Models: A Generalised Frisch–Waugh Theorem and its Implications 119 Jaya Krishnakumar

PART II EMPIRICAL APPLICATIONS

133

Chapter 6.

An Intertemporal Model of Rational Criminal Choice Robin C. Sickles and Jenny Williams

135

Chapter 7.

Swedish Liquor Consumption: New Evidence on Taste Change Badi H. Baltagi and James M. Griffin

167

Chapter 8. Import Demand Estimation with Country and Prod- uct Effects: Application of Multi-Way Unbalanced Panel Data Models to Lebanese Imports 193 Rachid Boumahdi, Jad Chaaban and Alban Thomas

viii

Contents

Chapter 9.

Can Random Coefficient Cobb–Douglas Production Functions be Aggregated to Similar Macro Functions? 229 Erik Biørn, Terje Skjerpen and Knut R. Wangen

Chapter 10.

Conditional Heteroskedasticity and Cross-Sectional De- pendence in Panel Data: An Empirical Study of Inflation Uncertainty in the G7 Countries 259 Rodolfo Cermeño and Kevin B. Grier

Chapter 11.

The Dynamics of Exports and Productivity at the Plant Level: A Panel Data Error Correction Model (ECM) Ap- proach Mahmut Yasar, Carl H. Nelson and Roderick M. Rejesus

279

Chapter 12.

Learning about the Long-Run Determinants of Real Ex- change Rates for Developing Countries: A Panel Data Investigation Imed Drine and Christophe Rault

307

Chapter 13.

Employee Turnover: Less is Not Necessarily More? Mark N. Harris, Kam Ki Tang and Yi-Ping Tseng

327

Chapter 14.

Dynamic Panel Models with Directors’ and Officers’ Liability Insurance Data George D. Kaltchev

351

Chapter 15. Assessment of the Relationship between Income In- equality and Economic Growth: A Panel Data Analysis of the 32 Federal Entities of Mexico, 1960–2002 361 Araceli Ortega-Díaz

Preface

Panel data econometrics has evolved rapidly over the last decade. Dynamic panel data estimation, non-linear panel data methods and the phenomenal growth in non-stationary panel data econometrics makes this an exciting area of research in econometrics. The 11th international conference on panel data held at Texas A&M University, College Station, Texas, June 2004, witnessed about 150 participants and 100 papers on panel data. This volume includes some of the papers presented at that conference and other solicited papers that made it through the refereeing process. Theoretical econometrics contributions include: Bai and Kao who sug- gest a factor model approach to model cross-section dependence in the panel co-integrated regression setting; Lejeune who proposes new esti- mation methods and some diagnostics tests for a general heteroskedastic error component model with unbalanced panel data; Ullah and Huang who study the finite sample properties of feasible GLS for the random effects model with non-normal errors; Kazemi and Crouchley who suggest a prag- matic approach to the problem of estimating a dynamic panel regression with random effects under various assumptions about the nature of the initial conditions; Krishnakumar who uses a generalized version of the Frisch–Waugh theorem to extend Mundlak’s (1978) results for the error component model. Empirical applications include: Sickles and Williams who estimate a dynamic model of crime using panel data from the 1958 Philadelphia Birth Cohort study; Baltagi and Griffin who find that at least 4 structural breaks in a panel data on liquor consumption for 21 Swedish counties over the period 1956–1999; Boumahdi, Chaaban and Thomas who estimate a flexible AIDS demand model for agricultural imports into Lebanon incorporating a three-way error component model that allows for product, country and time effects as separate unobserved determinants of import demand; Biørn, Skjerpen and Wangen who are concerned with the analysis of heterogeneous log-linear relationships (and specifically Cobb–Douglas production functions) at the firm-level and at the corre- sponding aggregate industry level. They use unbalanced panel data on firms from two Norwegian manufacturing industries over the period 1972– 1993; Cermeño and Grier who apply a model that accounts for conditional heteroskedasticity and cross-sectional dependence to a panel of monthly inflation rates of the G7 over the period 1978.2–2003.9; Yasar, Nelson and Rejesus who use plant level panel data for Turkish manufacturing in- dustries to analyze the relative importance of short-run versus long-run

x

Preface

dynamics of the export-productivity relationship; Drine and Rault who focus on developing countries and analyze the long-run relationship be- tween real exchange rate and some macroeconomic variables, via panel unit root and cointegration tests; Harris, Tang and Tseng who quantify the impact of employee turnover on productivity using an Australian busi- ness longitudinal survey over the period 1994/5 to 1997/8; Kaltchev who uses proprietary and confidential panel data on 113 public U.S. compa- nies over the period 1997–2003 to analyze the demand for Directors’ and Officers’ liability insurance; Ortega-Díaz who assesses how income in- equality influences economic growth across 32 Mexican States over the period 1960–2002.

Theoretical econometrics contributions

Bai and Kao suggest a factor model approach to model cross-section de- pendence in the panel co-integrated regression setting. Factor models are used to study world business cycles as well as common macro shocks like international financial crises or oil price shocks. Factor models offer a significant reduction in the number of sources of cross-sectional depen- dence in panel data and they allow for heterogeneous response to common shocks through heterogeneous factor loadings. Bai and Kao suggest a continuous-updated fully modified estimator for this model and show that it has better finite sample performance than OLS and a two step fully mod- ified estimator. Lejeune proposes new estimation methods for a general heteroskedastic error component model with unbalanced panel data, namely the Gaussian pseudo maximum likelihood of order 2. In addition, Lejeune suggests some diagnostics tests for heteroskedasticity, misspecification testing us- ing m-tests, Hausman type and Information type tests. Lejeune applies these methods to estimate and test a translog production function using an unbalanced panel of 824 French firms observed over the period 1979–

1988.

Ullah and Huang study the finite sample properties of feasible GLS for the random effects model with non-normal errors. They study the effects of skewness and excess kurtosis on the bias and mean squared error of the estimator using asymptotic expansions. This is done for large N and fixed T , under the assumption that the first four moments of the error are finite. Kazemi and Crouchley suggest a pragmatic approach to the problem of estimating a dynamic panel regression with random effects under various assumptions about the nature of the initial conditions. They find that the

Preface

xi

full maximum likelihood improves the consistency results if the relation- ships between random effects, initial conditions and explanatory variables are correctly specified. They illustrate this by testing a variety of different hypothetical models in empirical contexts. They use information criteria to select the best approximating model. Krishnakumar uses a generalized version of the Frisch–Waugh theo- rem to extend Mundlak’s (1978) results for the error component model with individual effects that are correlated with the explanatory variables. In particular, this extension is concerned with the presence of time invari- ant variables and correlated specific effects.

Empirical contributions

The paper by Sickles and Williams estimates a dynamic model of crime using panel data from the 1958 Philadelphia Birth Cohort study. Agents are rational and anticipate the future consequence of their actions. The authors investigate the role of social capital through the influence of social norms on the decision to participate in crime. They find that the initial level of social capital stock is important in determining the pattern of criminal involvement in adulthood. The paper by Baltagi and Griffin uses panel data on liquor consump- tion for 21 Swedish counties over the period 1956–1999. It finds that at least 4 structural breaks are necessary to account for the sharp decline in per-capita liquor consumption over this period. The first structural break coincides with the 1980 advertising ban, but subsequent breaks do not appear linked to particular policy initiatives. Baltagi and Griffin inter- pret these results as taste change accounting for increasing concerns with health issues and changing drinking mores. The paper by Boumahdi, Chaaban and Thomas estimate a flexible AIDS demand model for agricultural imports into Lebanon incorporating a three- way error component model that allows for product, country and time effects as separate unobserved determinants of import demand. In their application to trade in agricultural commodities the authors are primarily concerned with the estimation of import demand elasticities. Convention- ally, such estimates are frequently obtained from time series data that ignore the substitution elasticities across commodities, and thus implicitly ignore the cross-sectional dimension of the data. Exhaustive daily trans- actions (both imports and exports) data are obtained from the Lebanese customs administration for the years 1997–2002. Restricting their atten- tion to major agricultural commodities (meat, dairy products, cereals, ani- mals and vegetable fats and sugar), they estimate an import share equation

xii

Preface

for European products as a function of own-price and competitors prices. Competition is taking place between European countries, Arab and re- gional countries, North and South America and the rest of the world. The import share equations are estimated by allowing for parameter hetero- geneity across the 5 commodity groups, and tests for the validity of the multi-way error components specification are performed using unbalanced panel data. Estimation results show that this specification is generally sup- ported by the data. The paper by Biørn, Skjerpen and Wangen is concerned with the analysis of heterogeneous log-linear relationships (and specifically Cobb– Douglas production functions) at the firm-level and at the correspond- ing aggregate industry level. While the presence of aggregation bias in log-linear models is widely recognized, considerable empirical analysis continues to be conducted ignoring the problem. This paper derives a de- composition that highlights the source of biases that arise in aggregate work. It defines some aggregate elasticity measures and illustrates these in an empirical exercise based on firm-level data in two Norwegian manu- facturing industries: The pulp and paper industry (2823 observations, 237 firms) and the basic metals industry (2078 observations, 166 firms) ob- served over the period 1972–1993. The paper by Cermeño and Grier specify a model that accounts for conditional heteroskedasticity and cross-sectional dependence within a typical panel data framework. The paper applies this model to a panel of monthly inflation rates of the G7 over the period 1978.2–2003.9 and finds significant and quite persistent patterns of volatility and cross-sectional dependence. The authors use the model to test two hypotheses about the inter-relationship between inflation and inflation uncertainty, finding no support for the hypothesis that higher inflation uncertainty produces higher average inflation rates and strong support for the hypothesis that higher in- flation is less predictable. The paper by Yasar, Nelson and Rejesus uses plant level panel data for Turkish manufacturing industries to analyze the relative importance of short-run versus long-run dynamics of the export-productivity relation- ship. The adopted econometric approach is a panel data error correction model that is estimated by means of system GMM. The data consists of plants with more than 25 employees from two industries, the textile and apparel industry and the motor vehicles and parts industry, observed over the period 1987–1997. They find that “permanent productivity shocks gen- erate larger long-run export level responses, as compared to long-run pro- ductivity responses from permanent export shocks”. This result suggests that industrial policy should be geared toward permanent improvements in plant-productivity in order to have sustainable long-run export and eco- nomic growth.

Preface

xiii

The paper by Drine and Rault focuses on developing countries and analyzes the long-run relationship between real exchange rate and some macroeconomic variables, via panel unit root and cointegration tests. The results show that the degrees of development and of openness of the econ- omy strongly influence the real exchange rate. The panels considered are relatively small: Asia ( N = 7, T = 21), Africa ( N = 21, T = 16) and Latin America ( N = 17, T = 23). The paper by Harris, Tang and Tseng consider a balanced panel of medium sized firms drawn from the Australian business longitudinal sur- vey over the period 1994/5 to 1997/8. The paper sets out to quantify the impact of employee turnover on productivity and finds that the optimal turnover rate is 0.22. This is higher than the sample median of 0.14 which raises the question about whether there are institutional rigidities hinder- ing resource allocation in the labor market. The paper by Kaltchev uses proprietary and confidential panel data on 113 public U.S. companies over the period 1997–2003 to analyze the de- mand for Directors’ and Officers’ liability insurance. Applying system GMM methods to a dynamic panel data model on this insurance data, Kaltchev rejects that this theory is habit driven but still finds some role for persistence. He also confirms the hypothesis that smaller companies demand more insurance. Other empirical findings include the following:

Returns are significant in determining the amount of insurance and com- panies in financial distress demand higher insurance limits. Indicators of financial health such as leverage and volatility are significant, but not cor- porate governance. The paper by Ortega-Díaz assesses how income inequality influences economic growth across 32 Mexican States over the period 1960–2002. Using dynamic panel data analysis, with both, urban personal income for grouped data and household income from national surveys, Ortega-Díaz finds that inequality and growth are positively related. This relationship is stable across variable definitions and data sets, but varies across regions and trade periods. A negative influence of inequality on growth is found in a period of restrictive trade policies. In contrast, a positive relationship is found in a period of trade openness. I hope the readers enjoy this set of 15 papers on panel data and share my view on the wide spread use of panels in all fields of economics as clear from the applications. I would like to thank the anonymous referees that helped in reviewing these manuscripts. Also, Jennifer Broaddus for her editorial assistance and handling of these manuscripts.

Badi H. Baltagi College Station, Texas and Syracuse, New York

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List of Contributors

Numbers in parenthesis indicate the pages where the authors’ contributions can be found.

Jushan Bai (3) Department of Economics, New York University, New York, NY 10003, USA and Department of Economics, Tsinghua University, Bei- jing 10084, China. E-mail: jushan.bai@nyu.edu

Badi H. Baltagi (167) Department of Economics, and Center for Policy Re- search, Syracuse University, Syracuse, NY 13244-1020, USA. E-mail: bbaltagi@maxwell.syr.edu

Erik Biørn (229) Department of Economics, University of Oslo, 0317 Oslo, Norway and Research Department, Statistics Norway, 0033 Oslo, Norway. E-mail: erik.biorn@econ.uio.no

Rachid

LIHRE,

Boumahdi (193) University

of

Toulouse,

GREMAQ

and

F31000 Toulouse, France. E-mail: rachid.boumahdi@univ-tlse1.fr

Rodolfo Cermeño (259) División de Economía, CIDE, México D.F., México. E-mail: rodolfo.cermeno@cide.edu

Jad Chaaban (193) University of Toulouse, INRA-ESR, F-31000 Toulouse cedex, France. E-mail: chaaban@toulouse.inra.fr

Rob Crouchley (91) Centre for e-Science, Fylde College, Lancaster University, Lancaster LA1 4YF, UK. E-mail: r.crouchley@lancaster.ac.uk

Imed Drine (307) Paris I, Masion des Sciences de l’Economie, 75647 Paris cedex 13, France. E-mail: drine@univ-paris1.fr

Kevin B. Grier (259) Department of Economics, University of Oklahoma, OK 73019, USA. E-mail: angus@ou.edu

James M. Griffin (167) Bush School of Government and Public Service, Texas A&M University, College Station, TX 77843-4220, USA. E-mail: jgriffin@bushschool.tamu.edu

Mark N. Harris (327) Department of Econometrics and Business Statistics, Monash University, Melbourne, Vic 3800, Australia. E-mail: mark.harris@buseco.monash.edu.au

Xiao Huang (67) Department of Economics University of California, Riverside, CA 92521-0427, USA. E-mail: xiao.huang@email.ucr.edu

George D. Kaltchev (351) Department of Economics, Southern Methodist Uni- versity, Dallas, TX 75275-0496, USA. E-mail: gkaltche@mail.smu.edu

Chihwa Kao (3) Center for Policy Research and Department of Economics, Syracuse University Syracuse, NY 13244-1020, USA. E-mail: cdkao@maxwell.syr.edu

xv

xvi

List of Contributors

Iraj Kazemi (91) Centre for Applied Statistics, Lancaster University, Lancaster LA1 4YF, UK. E-mail: i.kazemi@lancaster.ac.uk

Jaya Krishnakumar (119) Department of Econometrics, University of Geneva, UNI-MAIL, CH-1211 Geneva 4, Switzerland. E-mail: jaya.krishnakumar@metri.unige.ch

Bernard Lejeune (31) HEC-University of Liège, CORE and ERUDITE, 4000 Liège, Belgium. E-mail: b.lejeune@ulg.ac.be

Carl H. Nelson (279) Department of Agricultural & Consumer Economics, University of Illinois at Urbana-Champaign, Urbana, IL 61801, USA. E-mail: chnelson@uiuc.edu

Araceli Ortega-Díaz (361) Tecnológico de Monterrey, 14380 Tlalpan, México. E-mail: araceli.ortega@itesm.mx;aortega@sedesal.gob.mx

Chrisophe

Department

Rault (307) University

of

Evry-Val

d’Essonne,

d’économie, 91025 Evry cedex, France. E-mail: chrault@hotmail.com

Roderick M. Rejesus (279) Department of Agricultural & Applied Economics, Texas Tech University, Lubbock, TX 79409-2132, USA. E-mail: roderick.rejesus@ttu.edu

Robin C. Sickles (135) Department of Economics, Rice University, Houston, TX 77005-1892, USA. E-mail: rsickles@rice.edu

Terje Skjerpen (229) Research Department, Statistics Norway, 0033 Oslo, Nor- way. E-mail: terje.skjerpen@ssb.no

Kam-Ki Tang (327) School of Economics, University of Queensland, St. Lucia, Qld 4072, Australia. E-mail: kk.tang@uq.edu.au

Alban

F-31000

Thomas (193) University

of

Toulouse,

INRA-LERNA,

Toulouse cedex, France. E-mail: thomas@toulouse.inra.fr

Yi-Ping Tseng (327) Melbourne Institute of Applied Economic and Social Re- search, University of Melbourne, Parkville, Vic 3010, Australia. E-mail: y.tseng@unimelb.edu.au

Aman Ullah (67) Department of Economics, University of California, River- side, CA 92521-0427, USA. E-mail: aman.ullah@ucr.edu

Knut R. Wangen (229) Research Department, Statistics Norway, 0033 Oslo, Norway. E-mail: knut.reidar.wangen@ssb.no

Jenny Williams (135) Department of Economics, University of Melbourne, Melbourne, Vic 3010, Australia. E-mail: jenny.williams@unimelb.edu.au

Mahmut Yasar (279) Department of Economics, Emory University, Atlanta, GA 30322, USA. E-mail: myasar@emory.edu

PART I

Theoretical Contributions

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Panel Data Econometrics B.H. Baltagi (Editor) © 2006 Published by Elsevier B.V. DOI: 10.1016/S0573-8555(06)74001-9

CHAPTER 1

On the Estimation and Inference of a Panel Cointegration Model with Cross-Sectional Dependence

Jushan Bai a and Chihwa Kao b

a Department of Economics, New York University, New York, NY 10003, USA and Department of Economics, Tsinghua University, Beijing 10084, China E-mail address: Jushan.Bai@nyu.edu b Center for Policy Research and Department of Economics, Syracuse University, Syracuse, NY 13244-1020, USA E-mail address: cdkao@maxwell.syr.edu

Abstract

Most of the existing literature on panel data cointegration assumes cross- sectional independence, an assumption that is difficult to satisfy. This pa- per studies panel cointegration under cross-sectional dependence, which is characterized by a factor structure. We derive the limiting distribution of a fully modified estimator for the panel cointegrating coefficients. We also propose a continuous-updated fully modified (CUP-FM) estimator. Monte Carlo results show that the CUP-FM estimator has better small sample properties than the two-step FM (2S-FM) and OLS estimators.

Keywords: panel data, cross-sectional dependence, factor analysis, CUP- FM, 2S-FM

JEL classifications: C13, C33

1.1 Introduction

A convenient but difficult to justify assumption in panel cointegration analysis is cross-sectional independence. Left untreated, cross-sectional dependence causes bias and inconsistency estimation, as argued by Andrews (2005). In this paper, we use a factor structure to characterize cross-sectional dependence. Factors models are especially suited for this purpose. One major source of cross-section correlation in macroeconomic data is common shocks, e.g., oil price shocks and international financial

4

J. Bai and C. Kao

crises. Common shocks drive the underlying comovement of economic variables. Factor models provide an effective way to extract the comove- ment and have been used in various studies. 1 Cross-sectional correlation exists even in micro level data because of herd behavior (fashions, fads, and imitation cascades) either at firm level or household level. The general state of an economy (recessions or booms) also affects household decision making. Factor models accommodate individual’s different responses to common shocks through heterogeneous factor loadings. Panel data models with correlated cross-sectional units are important due to increasing availability of large panel data sets and increasing inter- connectedness of the economies. Despite the immense interest in testing for panel unit roots and cointegration, 2 not much attention has been paid to the issues of cross-sectional dependence. Studies using factor models for nonstationary data include Bai and Ng (2004), Bai (2004), Phillips and Sul (2003), and Moon and Perron (2004). Chang (2002) proposed to use a nonlinear IV estimation to construct a new panel unit root test. Hall et al. (1999) considered a problem of determining the number of common trends. Baltagi et al. (2004) derived several Lagrange Multiplier tests for the panel data regression model with spatial error correlation. Robertson and Symon (2000), Coakley et al. (2002) and Pesaran (2004) proposed to use common factors to capture the cross-sectional dependence in station- ary panel models. All these studies focus on either stationary data or panel unit root studies rather than panel cointegration. This paper makes three contributions. First, it adds to the literature by suggesting a factor model for panel cointegrations. Second, it proposes a continuous-updated fully modified (CUP-FM) estimator. Third, it provides a comparison for the finite sample properties of the OLS, two-step fully modified (2S-FM), CUP-FM estimators. The rest of the paper is organized as follows. Section 1.2 introduces the model. Section 1.3 presents assumptions. Sections 1.4 and 1.5 develop the asymptotic theory for the OLS and fully modified (FM) estimators. Section 1.6 discusses a feasible FM estimator and suggests a CUP-FM estimator. Section 1.7 makes some remarks on hypothesis testing. Sec- tion 1.8 presents Monte Carlo results to illustrate the finite sample proper- ties of the OLS and FM estimators. Section 1.9 summarizes the findings. Appendix A1 contains the proofs of lemmas and theorems. The following notations are used in the paper. We write the integral

1 W (s) ds as W when there is no ambiguity over limits. We define

0

1 For example, Stock and Watson (2002), Gregory and Head (1999), Forni and Reichlin (1998) and Forni et al. (2000) to name a few.

2 See Baltagi and Kao (2000) for a recent survey.

On the Estimation and Inference of a Panel Cointegration Model

5

Ω 1/2 to be any matrix such that Ω = 1/2 )(Ω 1/2 ) . We use A to de- note {tr (A A)} 1/2 , | A| to denote the determinant of A, to denote weak

convergence,

largest integer x , I (0) and I (1) to signify a time-series that is integrated

of order zero and one, respectively, and BM (Ω) to denote Brownian mo- tion with the covariance matrix Ω . We let M < be a generic positive number, not depending on T or n .

p to denote convergence in probability, [x ] to denote the

1.2 The model

Consider the following fixed effect panel regression:

(1.1)

where y it

intercept, and e it is the stationary regression error. We assume that x it is a

k × 1 integrated processes of order one for all i , where

is 1 × 1, β is a 1 × k vector of the slope parameters, α i is the

y it = α i + βx it + e it ,

i = 1,

, n, t = 1,

,T,

x it = x it 1 + ε it .

Under these specifications, (1.1) describes a system of cointegrated re-

gressions, i.e., y it is cointegrated with x it . The initialization of this system is y i 0 = x i 0 = O p ( 1) as T → ∞ for all i . The individual constant term α i can be extended into general deterministic time trends such as

other deterministic component. To model the

cross-sectional dependence we assume the error term, e it , follows a factor

model (e.g., Bai and Ng, 2002, 2004):

(1.2)

α 0i + α 1i t +···+ α pi t or

e it = λ

i F t + u it ,

where F t is a r × 1 vector of common factors, λ i is a r × 1 vector of factor loadings and u it is the idiosyncratic component of e it , which means

E(e it e jt ) = λ i E(F t F )λ j ,

t

i.e., e it and e jt are correlated due to the common factors F t .

R EMARK 1.1. We could also allow ε it to have a factor structure such that

ε it = γ

i

F t + η it .

Then we can use Δx it to estimate F t and γ i . Or we can use e it together with Δx it to estimate F t , λ i and γ i . In general, ε it can be of the form

ε it = γ

i

F t + τ G t + η it ,

i

where F t and G t are zero mean processes, and η it are usually independent over i and t .

6

J. Bai and C. Kao

1.3 Assumptions

Our analysis is based on the following assumptions.

ASSUMPTION 1.1. As n → ∞ , definite matrix.

1

n

i n = 1 λ i λ

i

Σ λ , a r × r

positive

ASSUMPTION 1.2. Let w it = (F , u it , ε it ) . For each i , w it = Π i (L)v it

> 1,

where v it is i.i.d. over t . In addition, Ev it = 0, E(v it v it ) = Σ v > 0, and E v it 8 M < .

=

t

= 0 Π ij v it j ,

j

j

= 0 j a Π ij < , |Π i ( 1)|

= 0, for some a

ASSUMPTION 1.3. F t

across i .

and u it

are independent; u it

are independent

Under Assumption 1.2, a multivariate invariance principle for w it holds,

i.e., the partial sum process

1

T

[T

t = 1

r ]

w it satisfies:

[T r ]

1

T

t =1

where

w it B(Ω i ) as T → ∞ for all i,

B i =

B

B

B

F

ui

εi

.

(1.3)

The long-run covariance matrix of { w it } is given by

Ω i =

j =−∞

E(w i 0 w

ij )

= Π i ( 1v Π i ( 1)

= Σ i + Γ i + Γ


=

i

Ω F i

Ω uF i

Ω εF i

Ω F ui

Ω ui

Ω εui

where

Ω Fεi

Ω uεi

Ω εi

,

Γ i =

j = 1

E(w i 0 w

ij ) =

Γ F i Γ uF i Γ εF i

Γ F ui Γ Fεi

Γ uεi

Γ ui

Γ εui

Γ εi

(1.4)

On the Estimation and Inference of a Panel Cointegration Model

7

and

Σ i = E(w i 0 w 0 ) =

i

Σ F i

Σ uF i

Σ εF i

Σ F ui

Σ ui

Σ

εui

Σ Fεi

Σ uεi

Σ εi

are partitioned conformably with w it . We denote

Ω =

Γ =

and

Σ =

lim

n→∞

lim

n→∞

lim

n→∞

1

n

1

n

1

n

n

i = 1

n

i = 1

n

i = 1

Ω i ,

Γ i ,

Σ i .

ASSUMPTION 1.4. Ω εi is nonsingular, i.e., {x it }, are not cointegrated.

Define

Ω bi =

and

Ω F i

Ω uF i

Ω F ui

Ω ui

Ω b.εi = Ω bi Ω bεi Ω

,

1

εi

Ω εbi .

Ω bεi = Ω Fεi

uεi

Ω

Then, B i can be rewritten as

B

i

where

B bi

= B bi

B

εi

= Ω

=

F ui ,

B

B

V bi =

and

V F V ui ,

V bi

W

i

= BM (I )

1/2

b.εi

0

εi

1/2

Ω bεi Ω

Ω

εi

1/2

V bi

W

i

,

(1.5)

8

J. Bai and C. Kao

is a standardized Brownian motion. Define the one-sided long-run covari- ance

Δ i = Σ i + Γ i

with


=

j =0

E(w i 0 w

ij )

Δ i =

Δ bi

Δ εbi

Δ bεi

Δ εi

.

REMARK 1.2. (1) Assumption 1.1 is a standard assumption in factor models (e.g., Bai and Ng, 2002, 2004) to ensure the factor structure is identifiable. We only consider nonrandom factor loadings for simplicity. Our results still hold when the λ i s are random, provided they are indepen- dent of the factors and idiosyncratic errors, and E λ i 4 M . (2) Assumption 1.2 assumes that the random factors, F t , and idiosyn- cratic shocks (u it , ε it ) are stationary linear processes. Note that F t and ε it are allowed to be correlated. In particular, ε it may have a factor structure as in Remark 1.1. (3) Assumption of independence made in Assumption 1.3 between F t and u it can be relaxed following Bai and Ng (2002). Nevertheless, inde- pendence is not a restricted assumption since cross-sectional correlations in the regression errors e it are taken into account by the common factors.

1.4 OLS

Let us first study the limiting distribution of the OLS estimator for Equa- tion (1.1). The OLS estimator of β is

ˆ

β

OLS =

n

T

i = 1

t = 1

y it (x it x¯ i )

n

T

i =1 t =1

(x it x¯ i )(x it x¯ i ) 1 .

(1.6)

THEOREM 1.1. Under Assumptions 1.1–1.4, we have

nT ( β OLS β) nT

1

ˆ

lim

n→∞

n

N 0, 6Ω

ε

1

n

i =1

i Ω F.εi λ i Ω εi + Ω u.εi Ω εi ) Ω

1

ε

,

On the Estimation and Inference of a Panel Cointegration Model

9

n

as (n, T → ∞ ) with T 0 where

δ nT =

n

1

n

i = 1

i Ω Fεi Ω

λ

1/2

εi

1 T

1

T

T

t = 1

x it (x it x¯ i ) Ω

1/2

εi

+ Ω uεi Ω

1/2

εi

1 T

1

T

T

t = 1

x it (x it x¯ i ) Ω

1/2

εi

+ Δ uεi

×

×

1

n

n

i = 1

1

T 2

T

t = 1

(x it x it )(x it x¯ i ) 1 ,

W i = W i W i and Ω ε = lim n

1

n

i n = 1 Ω εi .

+ Δ Fεi

REMARK 1.3. It is also possible to construct the bias-corrected OLS by using the averages of the long run covariances. Note

E [ δ nT ]

=

n

1

n

1

n

= 1

i

n

i

= 1

λ

i

1

2 Ω Fεi + Δ Fεi 2 Ω uεi + Δ uεi

1

6 Ω ε 1

1

2

1

i Ω Fεi + Ω uεi ) + λ i Δ Fεi + Δ uεi

6 Ω ε 1

1

=

1

n

n

i = 1

1

2 λ

i Ω Fεi + 1

n

+ 1

n

n

i = 1

Δ uεi 1 6 Ω ε 1

.

n

i = 1

Ω uεi + 1

n

n

i = 1

λ

i Δ Fεi

It can be shown by a central limit theorem that

n δ nT E [ δ nT ] N (0,B)

for some B . Therefore,

nT ( β OLS β) nE [ δ nT ]

ˆ

ˆ

= nT ( β OLS β) nT + n δ nT E [ δ nT ]

N (0, A)

for some A.

10

J. Bai and C. Kao

1.5 FM estimator

ˆ

Next we examine the limiting distribution of the FM estimator, β FM . The

FM estimator was suggested by Phillips and Hansen (1990) in a different

context (nonpanel data). The FM estimator is constructed by making cor-

rections for endogeneity and serial correlation to the OLS estimator

in (1.6). The endogeneity correction is achieved by modifying the variable

y it , in (1.1) with the transformation

ˆ

β

OLS

y

+

it

= y it

i Ω Fεi + Ω uεi

1

εi

Δx it .

The serial correlation correction term has the form

Δ

+

bεi = Δ bεi Ω bεi Ω

= Δ + .

Fεi

Δ

+

uεi

εi

1

Δ

εi

Therefore, the infeasible FM estimator is

FM =

˜

β

n

i = 1

T

t

= 1

y

×

n

T

i = 1

t = 1

+

it

(x it x¯ i ) T λ

i Δ Fεi + + Δ

(x it x¯ i )(x it x¯ i ) 1 .

Now, we state the limiting distribution of

˜

β FM .

uεi

+

(1.7)

THEOREM 1.2. Let Assumptions 1.1–1.4 hold. Then as (n, T → ∞ ) with

n 0

T

nT ( β FM β)

˜

N 0, 6Ω


ε

1

lim

n→∞

1

n

n

i =1

i Ω F.εi λ i Ω εi + Ω u.εi Ω εi ) Ω

1

ε

.

REMARK 1.4. The asymptotic distribution in Theorem 1.2 is reduced to

nT ( β FM β) N 0, 6Ω

˜


ε

1

lim

n →∞

1

n

n

i = 1

2

λ

i

Ω F.ε + Ω u.ε

if the long-run covariances are the same across the cross-sectional unit i and r = 1.

On the Estimation and Inference of a Panel Cointegration Model

11

1.6 Feasible FM

In this section we investigate the limiting distribution of the feasible FM. We will show that the limiting distribution of the feasible FM is not af- fected when λ i , Ω εi , Ω εbi , Ω εi , and Δ εbi are estimated. To estimate λ i , we use the method of principal components used in Stock and Watson (2002).

Let λ = 1 , λ 2 ,

T ) . The method of

principal components of λ and F minimizes

n ) and F = (F 1 , F 2 ,

,F

V (r) = 1 nT

n T

where

eˆ it =

i = 1

y it αˆ i

t = 1

ˆ

βx

(eˆ it λ i F t ) 2 ,

it

ˆ

= (y it y¯ i ) β(x it x¯ i ),

ˆ

with a consistent estimator

malization that F F/T

× n with

F , a

T × r matrix, is T times eigenvectors corresponding to the r largest eigenvalues of the T × T matrix ZZ , and

β . Concentrating out λ and using the nor-

= I r , the optimization problem is identical to

maximizing tr (F (ZZ )F ) , where Z = (eˆ 1 , eˆ 2 , eˆ i = (eˆ i 1 , eˆ i 2 , eˆ iT ) . The estimated factor

eˆ n ) is T

, matrix, denoted by

,

ˆ

λ = ( F F

)

F Z

=

T

1

F Z

is the corresponding matrix of the estimated factor loadings. It is known that the solution to the above minimization problem is not unique, i.e., λ i and F t are not directly identifiable but they are identifiable up to a trans- formation H . For our setup, knowing H λ i is as good as knowing λ i . For

example in (1.7) using λ

λ

λ

Fεi will give the same information as using

Fεi is also identifiable up to a transformation, i.e.,

i Δ +

i H H ′−1 Δ +

Fεi since Δ +

i H H ′−1 Δ +

Fεi = λ i Δ +

Fεi . Therefore, when assessing the properties of the

estimates we only need to consider the differences in the space spanned by,

ˆ

say, between λ i and λ i .

ˆ

Define the feasible FM, β FM , with λ i , F t , Σ i , and Ω i in place of λ i , F t ,

ˆ

Σ i , and Ω i ,

ˆ

β

FM =

n

i = 1

T

t =1

yˆ (x it x¯ i ) T Δ

it

λ

i

+

ˆ

+

Fεi +

×

n

T

i =1

t = 1

(x it x¯ i )(x it x¯ i ) 1 ,

uεi

Δ

+

12

J. Bai and C. Kao

where

yˆ

and Δ

it

= y it ( λ

Fεi and

+

+

ˆ

i

+

Ω Fεi + Ω uεi )

Ω

1

εi

Δx it

Δ uεi are defined similarly.

Assume that Ω i = Ω for all i . Let

+

e it

= e it i Ω F ε + Ω uε

1

ε Δx it ,

Δ

+

bεn =

and

Δ

+

bεn =

Then

1

n

1

n

n

i

= 1

n

i

= 1

Δ

+

bεi ,

Δ

+

bεi .

nT (

=

1

ˆ

˜

β FM β FM )

n

i = 1

nT

T

t =1

+

bεn

eˆ (x it x¯ i ) T Δ

it

+

×

T

e

t = 1

1

nT 2

+

it

(x it x¯ i ) T Δ

+

bεn

n

T

i = 1 t = 1

(x it x¯ i )(x it x¯ i ) 1

=

1

nT

n

i =1

T

t

= 1

eˆ − e (x it x¯ i ) T Δ

it

it

+

+

+

bεn Δ

×

1

nT 2

n

T

i = 1 t = 1

(x it x¯ i )(x it x¯ i ) 1 .

bεn

+

Before we prove Theorem 1.3 we need the following lemmas.

LEMMA 1.1. Under Assumptions 1.1–1.4 n( Δ

+

bεn Δ

+

bεn ) = o p ( 1).

Lemma 1.1 can be proved similarly by following Phillips and Moon (1999) and Moon and Perron (2004).

LEMMA 1.2. Suppose Assumptions 1.1–1.4 hold. There exists an H with rank r such that as (n, T → ∞ )

On the Estimation and Inference of a Panel Cointegration Model

13

(i)

1

n

n

i

= 1

λ i H λ i 2 = O p

ˆ

nT .

1

δ

2

(ii) Let c i (i = 1, 2, c i = O p (1) and

, n) be a sequence of random matrices such that

1 n i n

= 1 c i 2 = O p ( 1) then

1

n

n

i

=1

( λ i H λ i ) c i = O p

ˆ

where δ nT = min { n, T }.

nT ,

1

δ

2

Bai and Ng (2002) showed that for a known eˆ it that the average squared

ˆ

deviations between λ i and H λ i vanish as n and T both tend to infinity and

the rate of convergence is the minimum of n and T . Lemma 1.2 can be

proved similarly by following Bai and Ng (2002) that parameter estimation

uncertainty for β has no impact on the null limit distribution of

ˆ

λ i .

LEMMA 1.3. Under Assumptions 1.1–1.4

1

nT

n T

i

= 1

t =1

eˆ − e (x it x¯ i ) = o p (1)

it

it

+

+

as (n, T → ∞ ) and n 0.

T

Then we have the following theorem:

THEOREM 1.3. Under Assumptions 1.1–1.4 and (n, T

n

T

0

nT (

ˆ

β FM

˜

β FM ) = o p (1).

) and

In the literature, the FM-type estimators usually were computed with a

two-step procedure, by assuming an initial consistent estimate of β , say

ˆ

β OLS . Then, one constructs estimates of the long-run covariance matrix,

Ω ( 1) , and loading, λ

ˆ

(

i

1)

. The 2S-FM, denoted β

2S

ˆ

(

1)

is obtained using Ω

( 1)

ˆ

and λ

(

i

1)

:

ˆ

β

(

1)

2S

=

n

i = 1

T

yˆ

t =1

×

n

T

i = 1

t = 1

+

it

( 1)

(x it x¯ i ) T

ˆ

λ

( 1)

i

( 1)

Δ

+

Fεi

(x it x¯ i )(x it x¯ i ) 1 .

( 1)

+ Δ

+

uεi

(1.8)

14

J. Bai and C. Kao

In this paper, we propose a CUP-FM estimator. The CUP-FM is con-

structed by estimating parameters and long-run covariance matrix and

Ω and λ i are estimated repeatedly, until

loading recursively. Thus

convergence is reached. In Section 1.8, we find the CUP-FM has a supe- rior small sample properties as compared with the 2S-FM, i.e., CUP-FM

has smaller bias than the common 2S-FM estimator. The CUP-FM is de- fined as

ˆ

β FM ,

ˆ

ˆ

β

CUP

=

n

i

= 1

T

t

=1

yˆ ( β CUP )(x it x¯ i )

it

+

ˆ

ˆ

T λ

i (

ˆ

β CUP )

Δ

+

Fεi (

ˆ

β CUP ) +

Δ

+

uεi (

ˆ

β

×

n

T

i = 1 t =1

(x it x¯ i )(x it x¯ i ) 1 .

CUP )

(1.9)

REMARK 1.5. (1) In this paper, we assume the number of factors, r , is known. Bai and Ng (2002) showed that the number of factors can be found by minimizing the following:

IC(k) = log V (k) + k n + T log nT

nT n + T .

(2) Once the estimates of w it , w it = ( F , uˆ it , Δx it ) , were estimated, we used

t

Σ = 1 nT

n T

i = 1 t = 1

w it w

it

to estimate Σ , where

uˆ it = eˆ it

λ

ˆ F t .

i

Ω was estimated by

(1.10)

Ω = 1

n

+

N

i =1

1

T

1

T

l

τ = 1

T

t

= 1

̟

τl

w it w

it

T

t = τ + 1

it ) ,

( w it w

it τ + w it τ w

(1.11)

where ̟ τl is a weight function or a kernel. Using Phillips and Moon (1999), Σ i and Ω i can be shown to be consistent for Σ i and Ω i .

On the Estimation and Inference of a Panel Cointegration Model

15

1.7 Hypothesis testing

We now consider a linear hypothesis that involves the elements of the co- efficient vector β . We show that hypothesis tests constructed using the FM estimator have asymptotic chi-squared distributions. The null hypothesis has the form:

(1.12)

where r is a m × 1 known vector and R is a known m × k matrix describing

the restrictions. A natural test statistic of the Wald test using

0 : = r,

H

ˆ

β FM is

W

= 6 nT 2 (R β FM r) 6 Ω

1

ˆ

ε

1

lim

n→∞

1

n

n

i =1

+

Ω

u.εi

εi )

Ω

Ω

1

ε

1

ˆ

(R β FM r).

(

ˆ

Ω

λ

i

F.εi

ˆ

λ i

Ω εi

(1.13)

It is clear that W converges in distribution to a chi-squared random

→ ∞ ) under the null

variable with k degrees of freedom, χ