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Panels with nonstationary multifactor error structures

  • G. Kapetanios
  • M. Hashem Pesaran

    (CAM - University of Cambridge (UK) - University of Cambridge (UK))

  • T. Yamagata

    ()

    (University of York [York] - University of York)

The presence of cross-sectionally correlated error terms invalidates much inferential theory of panel data models. Recently, work by Pesaran (2006) has suggested a method which makes use of cross-sectional averages to provide valid inference in the case of stationary panel regressions with a multifactor error structure. This paper extends this work and examines the important case where the unobservable common factors follow unit root processes. The extension to processes is remarkable on two counts. Firstly, it is of great interest to note that while intermediate results needed for deriving the asymptotic distribution of the panel estimators differ between the and cases, the final results are surprisingly similar. This is in direct contrast to the standard distributional results for processes that radically differ from those for processes. Secondly, it is worth noting the significant extra technical demands required to prove the new results. The theoretical findings are further supported for small samples via an extensive Monte Carlo study. In particular, the results of the Monte Carlo study suggest that the cross-sectional average based method is robust to a wide variety of data generation processes and has lower biases than the alternative estimation methods considered in the paper.

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Paper provided by HAL in its series Post-Print with number hal-00768190.

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Date of creation: 21 Dec 2010
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Publication status: Published, Journal of Econometrics, 2010, 160, 2, 326
Handle: RePEc:hal:journl:hal-00768190
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  1. M. Hashem Pesaran & Til Schuermann & Scott M. Weiner, 2002. "Modeling Regional Interdependencies Using a Global Error-Correcting Macroeconometric Model," Center for Financial Institutions Working Papers 01-38, Wharton School Center for Financial Institutions, University of Pennsylvania.
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