A bias-adjusted LM test of error cross-section independence
This paper proposes a bias-adjusted version of Breusch and Pagan (1980) Lagrange multiplier (LM) test statistic of error cross-section independence, in the case of panel models with strictly exogenous regressors and normal errors. The exact mean and variance of the test indicator of the LM test statistic are provided for the purpose of the bias-adjustments. It is shown that the centring of the LM statistic is correct for fixed T and N. Importantly, the proposed bias-adjusted LM test is consistent even when the Pesaran's (2004) CD test is inconsistent. Also an alternative bias-adjusted LM test, which is consistent under local error cross-section dependence of any fixed order p, is proposed. The finite sample behaviour of the proposed tests is investigated and compared to that of the LM and CD tests. It is shown that the bias-adjusted LM tests successfully control the size, maintaining satisfactory power in panel with exogenous regressors and normal errors. However, it is also shown that the bias-adjusted LM test is not as robust as the CD test to non-normal errors and/or in the presence of weakly exogenous regressors. Copyright Royal Economic Society 2007
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Volume (Year): 11 (2008)
Issue (Month): 1 (03)
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- Breusch, T S & Pagan, A R, 1980. "The Lagrange Multiplier Test and Its Applications to Model Specification in Econometrics," Review of Economic Studies, Wiley Blackwell, vol. 47(1), pages 239-53, January.
- M. Hashem Pesaran, 2004.
"General Diagnostic Tests for Cross Section Dependence in Panels,"
CESifo Working Paper Series
1229, CESifo Group Munich.
- Pesaran, M.H., 2004. "‘General Diagnostic Tests for Cross Section Dependence in Panels’," Cambridge Working Papers in Economics 0435, Faculty of Economics, University of Cambridge.
- Pesaran, M. Hashem, 2004. "General Diagnostic Tests for Cross Section Dependence in Panels," IZA Discussion Papers 1240, Institute for the Study of Labor (IZA).
- Frees, Edward W., 1995. "Assessing cross-sectional correlation in panel data," Journal of Econometrics, Elsevier, vol. 69(2), pages 393-414, October.
- Ullah, Aman, 2004. "Finite Sample Econometrics," OUP Catalogue, Oxford University Press, edition 1, number 9780198774488.
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