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Factor Models in Panels with Cross-sectional Dependence: An Application to the Extended SIPRI Military Expenditure Data

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  • Elisa Cavatorta
  • Ron P. Smith

Abstract

Strategic interactions between countries, such as arms races, alliances and wider economic and political shocks, can induce strong cross-sectional dependence in panel data models of military expenditure. If the assumption of cross-sectional independence fails, standard panel estimators such as fixed or random effects can lead to misleading inference. This paper shows how to improve estimation of dynamic, heterogenous, panel models of the demand for military expenditure allowing for cross-sectional dependence in errors using two approaches: Principal Components and Common Correlated Effect estimators. Our results show that it is crucial to allow for cross-sectional dependence, that the bulk of the effect is regional and there are large gains in fit by allowing for both dynamics and between country heterogeneity in models of the demand for military expenditures.

Suggested Citation

  • Elisa Cavatorta & Ron P. Smith, 2017. "Factor Models in Panels with Cross-sectional Dependence: An Application to the Extended SIPRI Military Expenditure Data," Defence and Peace Economics, Taylor & Francis Journals, vol. 28(4), pages 437-456, July.
  • Handle: RePEc:taf:defpea:v:28:y:2017:i:4:p:437-456
    DOI: 10.1080/10242694.2016.1261428
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    References listed on IDEAS

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    1. Pesaran, M. Hashem, 2015. "Time Series and Panel Data Econometrics," OUP Catalogue, Oxford University Press, number 9780198759980.
    2. M. Hashem Pesaran, 2006. "Estimation and Inference in Large Heterogeneous Panels with a Multifactor Error Structure," Econometrica, Econometric Society, vol. 74(4), pages 967-1012, July.
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    4. Elisa Cavatorta, 2010. "Unobserved Common Factors In Military Expenditure Interactions Across Mena Countries," Defence and Peace Economics, Taylor & Francis Journals, vol. 21(4), pages 301-316.
    5. J. Paul Dunne & Sam Perlo-Freeman & Ron Smith, 2008. "The Demand For Military Expenditure In Developing Countries: Hostility Versus Capability," Defence and Peace Economics, Taylor & Francis Journals, vol. 19(4), pages 293-302.
    6. 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.
    7. 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.
    8. Chudik, Alexander & Pesaran, M. Hashem, 2015. "Common correlated effects estimation of heterogeneous dynamic panel data models with weakly exogenous regressors," Journal of Econometrics, Elsevier, vol. 188(2), pages 393-420.
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    11. Brauner Jennifer, 2012. "Military Spending and Democratisation," Peace Economics, Peace Science, and Public Policy, De Gruyter, vol. 18(3), pages 1-16, December.
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    1. repec:spr:laecrv:v:27:y:2018:i:1:d:10.1186_s40503-018-0059-8 is not listed on IDEAS
    2. repec:spr:empeco:v:56:y:2019:i:3:d:10.1007_s00181-017-1379-2 is not listed on IDEAS

    More about this item

    JEL classification:

    • C33 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Models with Panel Data; Spatio-temporal Models
    • C82 - Mathematical and Quantitative Methods - - Data Collection and Data Estimation Methodology; Computer Programs - - - Methodology for Collecting, Estimating, and Organizing Macroeconomic Data; Data Access
    • H56 - Public Economics - - National Government Expenditures and Related Policies - - - National Security and War

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