Panels with Nonstationary Multifactor Error Structures

34 Pages Posted: 17 Aug 2006

See all articles by George Kapetanios

George Kapetanios

King's College, London

M. Hashem Pesaran

University of Southern California - Department of Economics; University of Cambridge - Trinity College (Cambridge)

Takashi Yamagata

University of Cambridge - Faculty of Economics and Politics

Date Written: August 2006

Abstract

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 for stationary panel regressions with multifactor error structure. This paper extends this work and examines the important case where the unobserved common factors follow unit root processes and could be cointegrated. It is found that the presence of unit roots does not affect most theoretical results, which continue to hold irrespective of the integration and the cointegration properties of the unobserved factors. This finding is 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 all of the alternative estimation methods considered in the paper.

Keywords: cross section dependence, large panels, unit roots, principal components

JEL Classification: C12, C13, C33

Suggested Citation

Kapetanios, George and Pesaran, M. Hashem and Yamagata, Takashi, Panels with Nonstationary Multifactor Error Structures (August 2006). IZA Discussion Paper No. 2243, CESifo Working Paper Series No. 1788, IEPR Working Paper No. 06.62, Available at SSRN: https://ssrn.com/abstract=924583

George Kapetanios

King's College, London ( email )

30 Aldwych
London, WC2B 4BG
United Kingdom
+44 20 78484951 (Phone)

M. Hashem Pesaran (Contact Author)

University of Southern California - Department of Economics

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

University of Cambridge - Trinity College (Cambridge) ( email )

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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