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On the fixed-effects vector decomposition

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  • Breusch, Trevor
  • Ward, Michael B
  • Nguyen, Hoa
  • Kompas, Tom

Abstract

This paper analyses the properties of the fixed-effects vector decomposition estimator, an emerging and popular technique for estimating time-invariant variables in panel data models with unit effects. This estimator was initially motivated on heuristic grounds, and advocated on the strength of favorable Monte Carlo results, but with no formal analysis. We show that the three-stage procedure of this decomposition is equivalent to a standard instrumental variables approach, for a specific set of instruments. The instrumental variables representation facilitates the present formal analysis which finds: (1) The estimator reproduces exactly classical fixed-effects estimates for time-varying variables. (2) The standard errors recommended for this estimator are too small for both time-varying and time-invariant variables. (3) The estimator is inconsistent when the time-invariant variables are endogenous. (4) The reported sampling properties in the original Monte Carlo evidence are incorrect. (5) We recommend an alternative shrinkage estimator that has superior risk properties to the decomposition estimator, unless the endogeneity problem is known to be small or no relevant instruments exist.

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Bibliographic Info

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 21452.

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Date of creation: Mar 2010
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Handle: RePEc:pra:mprapa:21452

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Keywords: panel data models; fixed-effects vector decomposition; instrumental variables; inconsistent estimator; incorrect standard errors; improved shrinkage estimator;

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  1. Hausman, Jerry A. & Taylor, William E., 1981. "Panel data and unobservable individual effects," Journal of Econometrics, Elsevier, Elsevier, vol. 16(1), pages 155-155, May.
  2. Han, Chirok & Schmidt, Peter, 2001. "The asymptotic distribution of the instrumental variable estimators when the instruments are not correlated with the regressors," Economics Letters, Elsevier, vol. 74(1), pages 61-66, December.
  3. Signe Krogstrup & Sébastien Wälti, 2007. "Do fiscal rules cause budgetary outcomes?," IHEID Working Papers 15-2007, Economics Section, The Graduate Institute of International Studies, revised May 2007.
  4. Guglielmo Caporale & Christophe Rault & Robert Sova & Anamaria Sova, 2009. "On the bilateral trade effects of free trade agreements between the EU-15 and the CEEC-4 countries," Review of World Economics (Weltwirtschaftliches Archiv), Springer, vol. 145(3), pages 573-573, October.
  5. Ansgar Belke & Julia Spies, 2008. "Enlarging the EMU to the east: what effects on trade?," Empirica, Springer, vol. 35(4), pages 369-389, September.
  6. Mittelhammer, Ron C. & Judge, George G., 2005. "Combining estimators to improve structural model estimation and inference under quadratic loss," Journal of Econometrics, Elsevier, Elsevier, vol. 128(1), pages 1-29, September.
  7. Timo Mitze, 2009. "Endogeneity in Panel Data Models with Time-Varying and Time-Fixed Regressors: To IV or not IV?," Ruhr Economic Papers, Rheinisch-Westfälisches Institut für Wirtschaftsforschung, Ruhr-Universität Bochum, Universität Dortmund, Universität Duisburg-Essen 0083, Rheinisch-Westfälisches Institut für Wirtschaftsforschung, Ruhr-Universität Bochum, Universität Dortmund, Universität Duisburg-Essen.
  8. Kazimi, Camilla & Brownstone, David, 1999. "Bootstrap confidence bands for shrinkage estimators," Journal of Econometrics, Elsevier, Elsevier, vol. 90(1), pages 99-127, May.
  9. Breusch, Trevor S & Mizon, Grayham E & Schmidt, Peter, 1989. "Efficient Estimation Using Panel Data," Econometrica, Econometric Society, Econometric Society, vol. 57(3), pages 695-700, May.
  10. Mundlak, Yair, 1978. "On the Pooling of Time Series and Cross Section Data," Econometrica, Econometric Society, Econometric Society, vol. 46(1), pages 69-85, January.
  11. Wong, Ka-fu, 1997. "Effects on inference of pretesting the exogeneity of a regressor," Economics Letters, Elsevier, vol. 56(3), pages 267-271, November.
  12. Baltagi, Badi H. & Bresson, Georges & Pirotte, Alain, 2003. "Fixed effects, random effects or Hausman-Taylor?: A pretest estimator," Economics Letters, Elsevier, vol. 79(3), pages 361-369, June.
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