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Large Panels with Common Factors and Spatial Correlations

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Author Info
M. Hashem Pesaran () (Cambridge University, USC and IZA)
Elisa Tosetti () (Cambridge University)

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Abstract

This paper considers the statistical analysis of large panel data sets where even after conditioning on common observed effects the cross section units might remain dependently distributed. This could arise when the cross section units are subject to unobserved common effects and/or if there are spill over effects due to spatial or other forms of local dependencies. The paper provides an overview of the literature on cross section dependence, introduces the concepts of time-specific weak and strong cross section dependence and shows that the commonly used spatial models are examples of weak cross section dependence. It is then established that the Common Correlated Effects (CCE) estimator of panel data model with a multifactor error structure, recently advanced by Pesaran (2006), continues to provide consistent estimates of the slope coefficient, even in the presence of spatial error processes. Small sample properties of the CCE estimator under various patterns of cross section dependence, including spatial forms, are investigated by Monte Carlo experiments. Results show that the CCE approach works well in the presence of weak and/or strong cross sectionally correlated errors. We also explore the role of certain characteristics of spatial processes in determining the performance of CCE estimators, such as the form and intensity of spatial dependence, and the sparseness of the spatial weight matrix.

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Paper provided by Institute for the Study of Labor (IZA) in its series IZA Discussion Papers with number 3032.

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Length: 47 pages
Date of creation: Sep 2007
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Handle: RePEc:iza:izadps:dp3032

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Related research
Keywords: panels; common correlated effects; strong and weak cross section dependence;

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Find related papers by JEL classification:
C14 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods: General - - - Semiparametric and Nonparametric Methods
D13 - Microeconomics - - Household Behavior - - - Household Production and Intrahouse Allocation
D91 - Microeconomics - - Intertemporal Choice and Growth - - - Intertemporal Consumer Choice; Life Cycle Models and Saving
L14 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - Transactional Relationships; Contracts and Reputation
O12 - Economic Development, Technological Change, and Growth - - Economic Development - - - Microeconomic Analyses of Economic Development

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
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  3. Forni, Mario & Reichlin, Lucrezia, 1998. "Let's Get Real: A Factor Analytical Approach to Disaggregated Business Cycle Dynamics," Review of Economic Studies, Blackwell Publishing, vol. 65(3), pages 453-73, July. [Downloadable!] (restricted)
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  14. Kapetanios, G. & Pesaran, M.H. & Yamagata, T., 2006. "Panels with Nonstationary Multifactor Error Structures," Cambridge Working Papers in Economics 0651, Faculty of Economics, University of Cambridge. [Downloadable!]
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  18. Stock, James H & Watson, Mark W, 2002. "Macroeconomic Forecasting Using Diffusion Indexes," Journal of Business & Economic Statistics, American Statistical Association, vol. 20(2), pages 147-62, April.
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  20. Coakley, Jerry & Fuertes, Ana-Maria & Smith, Ron, 2006. "Unobserved heterogeneity in panel time series models," Computational Statistics & Data Analysis, Elsevier, vol. 50(9), pages 2361-2380, May. [Downloadable!] (restricted)
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Alexander Chudik & M. Hashem Pesaran, 2009. "Infinite-dimensional VARs and factor models," Working Paper Series 998, European Central Bank. [Downloadable!]
    Other versions:
  2. Pesaran, M.H. & Zaffaroni, P., 2008. "Optimal Asset Allocation with Factor Models for Large Portfolios," Cambridge Working Papers in Economics 0813, Faculty of Economics, University of Cambridge. [Downloadable!]
    Other versions:
  3. Mario Cerrato & Christian de Peretti & Rolf Larsson & Nick Sarantis, 2009. "A Nonlinear Panel Unit Root Test under Cross Section Dependence," Working Papers 2009_28, Department of Economics, University of Glasgow. [Downloadable!]
    Other versions:
  4. Holly, Sean & Petrella, Ivan, 2009. "Factor Demand Linkages, Technology Shocks and the Business Cycle," MPRA Paper 18120, University Library of Munich, Germany. [Downloadable!]
  5. Holly, S. & Petrella, I., 2008. "Factor demand linkages and the business cycle: Interpreting aggregate fluctuations as sectoral fluctuations," Cambridge Working Papers in Economics 0827, Faculty of Economics, University of Cambridge. [Downloadable!]
    Other versions:
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