Panel Unit Root Tests in the Presence of a Multifactor Error Structure

59 Pages Posted: 23 Jan 2008

See all articles by M. Hashem Pesaran

M. Hashem Pesaran

University of Southern California - Department of Economics

L. Vanessa Smith

University of York - Department of Economics and Related Studies

Takashi Yamagata

University of Cambridge - Faculty of Economics and Politics

Multiple version iconThere are 2 versions of this paper

Date Written: January 2008

Abstract

This paper extends the cross sectionally augmented panel unit root test proposed by Pesaran (2007) to the case of a multifactor error structure. The basic idea is to exploit information regarding the unobserved factors that are shared by other time series in addition to the variable under consideration. Importantly, our test procedure only requires specification of the maximum number of factors, in contrast to other panel unit root tests based on principal components that require in addition the estimation of the number of factors as well as the factors themselves. Small sample properties of the proposed test are investigated by Monte Carlo experiments, which suggest that it controls well for size in almost all cases, especially in the presence of serial correlation in the error term, contrary to alternative test statistics. Empirical applications to Fisher's inflation parity and real equity prices across different markets illustrate how the proposed test works in practice.

Keywords: panel unit root tests, cross section dependence, multi-factor residual structure, Fisher inflation parity, real equity prices

JEL Classification: C12, C15, C22, C23

Suggested Citation

Pesaran, M. Hashem and Smith, L. Vanessa and Yamagata, Takashi, Panel Unit Root Tests in the Presence of a Multifactor Error Structure (January 2008). CESifo Working Paper No. 2193, Available at SSRN: https://ssrn.com/abstract=1086555

M. Hashem Pesaran (Contact Author)

University of Southern California - Department of Economics ( email )

3620 South Vermont Ave. Kaprielian (KAP) Hall 300
Los Angeles, CA 90089
United States

L. Vanessa Smith

University of York - Department of Economics and Related Studies ( email )

Heslington
University of York
York, YO10 5DD
United Kingdom

Takashi Yamagata

University of Cambridge - Faculty of Economics and Politics ( email )

Austin Robinson Building
Sidgwick Avenue
Cambridge, CB3 9DD
United Kingdom

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