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Dynamic factor extraction of cross-sectional dependence in panel unit root tests

  • George Kapetanios

    (Queen Mary, University of London, London, UK)

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    Recently, considerable emphasis has been placed on the problems arising out of cross-sectional dependence in panel unit root tests. This paper adopts the factor-based cross-sectional dependence paradigm of Bai and Ng (2005) but suggests alternative factor extraction methods. Some theoretical results for these methods are provided. Further, a detailed Monte Carlo study of these methods for multiple and persistent factors is undertaken. It is found that results are radically different from the serially uncorrelated single-factor case. Tests perform much worse and in some cases it is preferable not to correct at all for cross-sectional dependence. Copyright © 2007 John Wiley & Sons, Ltd.

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    Article provided by John Wiley & Sons, Ltd. in its journal Journal of Applied Econometrics.

    Volume (Year): 22 (2007)
    Issue (Month): 2 ()
    Pages: 313-338

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    Handle: RePEc:jae:japmet:v:22:y:2007:i:2:p:313-338
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    1. Phillips, Peter & Sul, Donggyu, 2002. "Dynamic Panel Estimation and Homogenity Testing Under Cross Section Dependence," Working Papers 194, Department of Economics, The University of Auckland.
    2. M. Hashem Pesaran, 2007. "A simple panel unit root test in the presence of cross-section dependence," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 22(2), pages 265-312.
    3. Chang, Yoosoon, 2002. "Nonlinear IV Unit Root Tests in Panels with Cross-Sectional Dependency," Working Papers 2000-08, Rice University, Department of Economics.
    4. Papell, David H., 1997. "Searching for stationarity: Purchasing power parity under the current float," Journal of International Economics, Elsevier, vol. 43(3-4), pages 313-332, November.
    5. O'Connell, Paul G. J., 1998. "The overvaluation of purchasing power parity," Journal of International Economics, Elsevier, vol. 44(1), pages 1-19, February.
    6. Kaddour Hadri, 2000. "Testing for stationarity in heterogeneous panel data," Econometrics Journal, Royal Economic Society, vol. 3(2), pages 148-161.
    7. Samarjit Das & Joerg Breitung, 2004. "Panel Unit Root Tests under Cross- sectional Dependence," Econometric Society 2004 North American Summer Meetings 55, Econometric Society.
    8. MacDonald, Ronald, 1996. "Panel unit root tests and real exchange rates," Economics Letters, Elsevier, vol. 50(1), pages 7-11, January.
    9. Abuaf, Niso & Jorion, Philippe, 1990. " Purchasing Power Parity in the Long Run," Journal of Finance, American Finance Association, vol. 45(1), pages 157-74, March.
    10. Forni, Mario & Reichlin, Lucrezia, 1995. "Let's Get Real: A Dynamic Factor Analytical Approach to Disaggregated Business Cycle," CEPR Discussion Papers 1244, C.E.P.R. Discussion Papers.
    11. Choi, In, 2001. "Unit root tests for panel data," Journal of International Money and Finance, Elsevier, vol. 20(2), pages 249-272, April.
    12. Kapetanios, George, 2004. "A note on modelling core inflation for the UK using a new dynamic factor estimation method and a large disaggregated price index dataset," Economics Letters, Elsevier, vol. 85(1), pages 63-69, October.
    13. George Kapetanios, 2002. "Modelling Core Inflation for the UK Using a New Dynamic Factor Estimation Method and a Large Disaggregated Price Index Dataset," Working Papers 471, Queen Mary University of London, School of Economics and Finance.
    14. 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.
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