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Factor models in panels with cross-sectional dependence: an application to the extended SIPRI military expenditure data

Listed author(s):
  • Ron Smith

    (Department of Economics, Mathematics & Statistics, Birkbeck)

  • Elisa Cavatorta

    (King’s College London)

Strategic interactions between countries, such as arms races, alliances and wider economic and political shocks, can induce strong cross-sectional dependence in models of military expenditures using panel data. 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-section dependence and there are large gains in it by allowing for both dynamics and between country heterogeneity in demand models of military expenditures. Our estimates show that mean group estimation of error correction models using the Common Correlated Effect approach provides an effective modelling framework.

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File URL: http://www.bbk.ac.uk/ems/research/wp/2016/PDFs/BWPEF1602.pdf
File Function: First version, 2016
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Paper provided by Birkbeck, Department of Economics, Mathematics & Statistics in its series Birkbeck Working Papers in Economics and Finance with number 1602.

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Date of creation: Apr 2016
Handle: RePEc:bbk:bbkefp:1602
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  1. Kapetanios, G. & Pesaran, M. Hashem & Yamagata, T., 2011. "Panels with non-stationary multifactor error structures," Journal of Econometrics, Elsevier, vol. 160(2), pages 326-348, February.
  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.
  3. 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.
  4. Jushan Bai, 2009. "Panel Data Models With Interactive Fixed Effects," Econometrica, Econometric Society, vol. 77(4), pages 1229-1279, July.
  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. 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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