Unobserved Heterogeneity in Panel Time Series Models

Birkbeck College Working Paper in Economics & Finance No. 0403

Cass Business School Research Paper

25 Pages Posted: 3 Nov 2004

See all articles by Ana-Maria Fuertes

Ana-Maria Fuertes

Cass Business School, City University of London

Jerry Coakley

University of Essex - Essex Business School

Ron Smith

Birkbeck College

Date Written: October 2004

Abstract

Recently, the large T panel literature has emphasized unobserved, time-varying heterogeneity that may stem from omitted common variables or global shocks that affect each individual unit differently. These latent common factors induce cross-section dependence and may lead to inconsistent regression coefficient estimates if they are correlated with the explanatory variables. Moreover, if the process underlying these factors is nonstationary, the individual regressions will be spurious but pooling or averaging across individual estimates still permits consistent estimation of a long-run coefficient. The need to tackle both error cross-section dependence and persistent autocorrelation is motivated by the evidence of their pervasiveness found in three well-known, international finance and macroeconomic examples. A range of estimators is surveyed and their finite-sample properties are examined by means of Monte Carlo experiments. These reveal that a mean group version of the common-correlated-effects estimator stands out as the most robust since it is the preferred choice in rather general (non) stationary settings where regressors and errors share common factors and their factor loadings are possibly dependent. Other approaches which perform reasonably well include the two-way fixed effects, demeaned mean group and between estimators but they are less efficient than the common-correlated-effects estimator.

Keywords: Factor analysis, global shocks, latent variables, Feldstein-Horioka, PPP

JEL Classification: C32, F31

Suggested Citation

Fuertes, Ana-Maria and Coakley, Jerry and Smith, Ron P., Unobserved Heterogeneity in Panel Time Series Models (October 2004). Birkbeck College Working Paper in Economics & Finance No. 0403; Cass Business School Research Paper. Available at SSRN: https://ssrn.com/abstract=612783 or http://dx.doi.org/10.2139/ssrn.612783

Ana-Maria Fuertes

Cass Business School, City University of London ( email )

Faculty of Finance
106 Bunhill Row
London, EC1Y 8TZ
United Kingdom
+44 207 477 0186 (Phone)
+44 207 477 8881 (Fax)

HOME PAGE: http://www.city.ac.uk/people/academics/ana-maria-fuertes

Jerry Coakley (Contact Author)

University of Essex - Essex Business School ( email )

Wivenhoe Park
Colchester, CO4 3SQ
United Kingdom
+44 1206 872455 (Phone)
+44 1206 873429 (Fax)

HOME PAGE: http://www.essex.ac.uk/afm/staff/coakley.shtm

Ron P. Smith

Birkbeck College ( email )

Malet Street
London WC1E 7HX
United Kingdom
+44 207 631 6413 (Phone)
+44 207 631 6416 (Fax)

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