A Panel Unit Root Test with Good Power in Small Samples

University of Cincinnati Economics Working Paper No. 2005-01

34 Pages Posted: 26 Apr 2005  

Claude Lopez

Milken Institute

Date Written: July 2006

Abstract

We propose a new pooled panel unit root test allowing for serial and contemporaneous correlation. The new test combines Elliott, Rothenberg and Stock's (1996) local-to-unity transformation with a pooled panel ADF test. As initially advocated by O'Connell (1998), the new test accounts for contemporaneous correlation by estimating the residual covariance matrix. Monte Carlo simulations demonstrate significantly better finite sample power properties of the new test over a wide range of existing panel unit root tests accounting for cross-sectional correlation. Furthermore, enhanced performances are particularly noticeable when the series are highly persistent and the panels are relatively small. An application to the real exchange rate convergence illustrates the impact of such improvements. Analyzing the post Bretton Woods period, the new test provides strong and reliable rejections of the unit root among the real exchange rates of industrialized countries.

Keywords: Panel Unit Root Test, GLS-detrending

JEL Classification: C32

Suggested Citation

Lopez, Claude, A Panel Unit Root Test with Good Power in Small Samples (July 2006). University of Cincinnati Economics Working Paper No. 2005-01. Available at SSRN: https://ssrn.com/abstract=706562 or http://dx.doi.org/10.2139/ssrn.706562

Claude Lopez (Contact Author)

Milken Institute ( email )

1250 Fourth Street
Santa Monica, CA 90401
United States

HOME PAGE: http://claudelopez.com

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