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The perils of aggregating foreign variables in panel data models

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  • Ca' Zorzi, Michele
  • Chudik, Alexander
  • Dieppe, Alistair

Abstract

The curse of dimensionality refers to the difficulty of including all relevant variables in empirical applications due to the lack of sufficient degrees of freedom. A common solution to alleviate the problem in the context of open economy models is to aggregate foreign variables by constructing trade-weighted cross-sectional averages. This paper provides two key contributions in the context of static panel data models. The first is to show under what conditions the aggregation of foreign variables (AFV) leads to consistent estimates (as the time dimension T is fixed and the cross section dimension N -> infinite). The second is to design a formal test to assess the admissibility of the AFV restriction and to evaluate the small sample properties of the test by undertaking Monte Carlo experiments. Finally, we illustrate an application in the context of the current account empirical literature where the AFV restriction is rejected. JEL Classification: C12, C31, C33, F41

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Bibliographic Info

Paper provided by European Central Bank in its series Working Paper Series with number 1444.

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Date of creation: Jun 2012
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Handle: RePEc:ecb:ecbwps:20121444

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Keywords: current account; Curse of dimensionality; panel data models;

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  1. Pesaran, M.H. & Chudik, A., 2010. "Econometric Analysis of High Dimensional VARs Featuring a Dominant Unit," Cambridge Working Papers in Economics 1024, Faculty of Economics, University of Cambridge.
  2. Bussière, Matthieu & Ca' Zorzi, Michele & Chudik, Alexander & Dieppe, Alistair, 2010. "Methodological advances in the assessment of equilibrium exchange rates," Working Paper Series 1151, European Central Bank.
  3. Chudik, Alexander & Dieppe, Alistair & Ca' Zorzi, Michele, 2012. "Thousands of models, one story: current account imbalances in the global economy," Working Paper Series 1441, European Central Bank.
  4. Marco Del Negro & Frank Schorfheide, 2004. "Priors from General Equilibrium Models for VARS," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 45(2), pages 643-673, 05.
  5. Menzie D. Chinn & Eswar S. Prasad, 2000. "Medium-Term Determinants of Current Accounts in Industrial and Developing Countries: An Empirical Exploration," NBER Working Papers 7581, National Bureau of Economic Research, Inc.
  6. Chudik, Alexander & Pesaran, M. Hashem, 2007. "Infinite Dimensional VARs and Factor Models," IZA Discussion Papers 3206, Institute for the Study of Labor (IZA).
  7. Chudik, A. & Pesaran, M.H. & Tosetti, E., 2009. "Weak and Strong Cross Section Dependence and Estimation of Large Panels," Cambridge Working Papers in Economics 0924, Faculty of Economics, University of Cambridge.
  8. Ca' Zorzi, Michele & Chudik, Alexander & Dieppe, Alistair, 2009. "Current account benchmarks for central and eastern Europe: a desperate search?," Working Paper Series 0995, European Central Bank.
  9. Mario Forni & Marc Hallin & Marco Lippi & Lucrezia Reichlin, 2000. "The Generalized Dynamic-Factor Model: Identification And Estimation," The Review of Economics and Statistics, MIT Press, vol. 82(4), pages 540-554, November.
  10. Forni, Mario & Hallin, Marc & Lippi, Marco & Reichlin, Lucrezia, 2004. "The generalized dynamic factor model consistency and rates," Journal of Econometrics, Elsevier, vol. 119(2), pages 231-255, April.
  11. Pesaran, M. Hashem & Smith, Ron, 1995. "Estimating long-run relationships from dynamic heterogeneous panels," Journal of Econometrics, Elsevier, vol. 68(1), pages 79-113, July.
  12. Forni, Mario & Lippi, Marco, 2001. "The Generalized Dynamic Factor Model: Representation Theory," Econometric Theory, Cambridge University Press, vol. 17(06), pages 1113-1141, December.
  13. Jesmin Rahman, 2008. "Current Account Developments in New Member States of the European Union," IMF Working Papers 08/92, International Monetary Fund.
  14. Bussière, Matthieu & Fratzscher, Marcel, 2006. "Current Account Dynamics in OECD Countries and in the New EU Member States: An Intertemporal Approach," Journal of Economic Integration, Center for Economic Integration, Sejong University, vol. 21, pages 593-618.
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