Testing for Structural Breaks in Dynamic Factor Models

68 Pages Posted: 8 Jun 2016

See all articles by Jörg Breitung

Jörg Breitung

University of Bonn; Deutsche Bundesbank

Sandra Eickmeier

Deutsche Bundesbank; Australian National University (ANU) - Centre for Applied Macroeconomic Analysis (CAMA)

Date Written: 2009

Abstract

From time to time, economies undergo far-reaching structural changes. In this paper we investigate the consequences of structural breaks in the factor loadings for the specification and estimation of factor models based on principal components and suggest test procedures for structural breaks. It is shown that structural breaks severely inflate the number of factors identified by the usual information criteria. Based on the strict factor model the hypothesis of a structural break is tested by using Likelihood-Ratio, Lagrange-Multiplier and Wald statistics. The LM test which is shown to perform best in our Monte Carlo simulations, is generalized to factor models where the common factors and idiosyncratic components are serially correlated. We also apply the suggested test procedure to a US dataset used in Stock and Watson (2005) and a euro-area dataset described in Altissimo et al. (2007). We find evidence that the beginning of the so-called Great Moderation in the US as well as the Maastricht treaty and the handover of monetary policy from the European national central banks to the ECB coincide with structural breaks in the factor loadings. Ignoring these breaks may yield misleading results if the empirical analysis focuses on the interpretation of common factors or on the transmission of common shocks to the variables of interest.

Keywords: Dynamic factor models, structural breaks, number of factors, Great Moderation, EMU

JEL Classification: C3, C12, C01

Suggested Citation

Breitung, Jörg and Eickmeier, Sandra, Testing for Structural Breaks in Dynamic Factor Models (2009). Bundesbank Series 1 Discussion Paper No. 2009,05, Available at SSRN: https://ssrn.com/abstract=2785334 or http://dx.doi.org/10.2139/ssrn.2785334

Jörg Breitung (Contact Author)

University of Bonn ( email )

Postfach 2220
Bonn, D-53012
Germany

Deutsche Bundesbank

Wilhelm-Epstein-Strasse 14
Frankfurt/Main D-60431
Germany

Sandra Eickmeier

Deutsche Bundesbank ( email )

Wilhelm-Epstein-Strasse 14
Frankfurt/Main D-60431
Germany

Australian National University (ANU) - Centre for Applied Macroeconomic Analysis (CAMA) ( email )

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