Panel Data Models

Dynamic panels and unit roots

 Introduction
• To describe the dynamic panel and
motivate its use (This is mostly a practical
guide to its use).
• To differentiate between the Arellano-
Bond and Arellano-Bovver approaches.
• To discuss the problems of unit roots in
panel data.
• To introduce the concept of cointegration
in panel data.
 Dynamic Panel Data Models
• This approach to panel data models involves the
use of a dynamic effect, in this case adding a
lagged dependent variable to the explanatory
variables.
• In addition the model is estimated using
Generalised Method of Moments (GMM), which
works in a similar way to Two Stage least
squares, overcoming problems of endogeneity.
• This approach requires that N>T, i.e. the cross
section observations exceed the time series.
 Theoretical Reason for the
Dynamic Panel
• The main theoretical reason for the dynamic
panel is that it is modelling a partial adjustment
based approach.
• If it is a partial adjustment process, the
coefficient on the lagged dependent variable
measures the speed of adjustment (i.e. 1 –
coefficient is speed of adjustment)
• In addition the lagged dependent variable can
remove any autocorrelation.
 Individual Effects
• The dynamic panel approach accounts for the
individual effects, as with other panel data
models. In the main approach of Arellano-Bond,
this entails differencing the data.
• This means it is difficult to include dummy
variables in these models.
• Although the individual effects applies to the
cross section, two way individual effects can
also be included, using time dummy variables.
 Generalised Method of Moments
• This technique is basically a method that chooses
parameter estimates, such that the theoretical model is
satisfied as ‘closely’ as possible. The estimates are
chosen to minimise the weighted distance between the
theoretical and actual values.
• This method requires that the theoretical relations
between the parameters satisfies so called ‘orthogonality
conditions’, which mean that the sample correlations
between the explanatory variables and instruments is as
close to zero as possible.
• OLS is a special case of GMM, where we assume no
correlation between the explanatory variables and error
term. (GMM is similar to 2SLS, in that we need to specify
the instrument list)
 Dynamic Panel Approaches
• There are basically 2 approaches, the Arellano-
Bond and Arellano-Bovver approach.
• They differ in terms of the way that the individual
effects are included in the model, with the
Arellano-Bond method using differencing and
the Arellano-Bovver approach using orthogonal
deviations.
• Although the Arellano-Bond approach has
proven most popular, the Arellano-Bovver
approach has better small sample properties
and also is better at modelling non-stationary
data.
 Dynamic Panel Models
• Criticisms of both approaches centre around the
basic dynamic model, as dynamics are usually
more complicated than a single lagged
dependent variable.
• Also when accounting for unobserved
heterogeneity, the methods for modelling this
are limited.
• The stationarity of the variables tends to be
ignored, although given that these models are
restricted to short time series, this may not be
too much of a problem.
 Example
• The most well known example is the
modelling of dividends (div) and earnings
(earn):

diˆvt  0.7  0.5divt 1  0.8earnt

(0.5) (0.1) (0.2)
 Steps for estimating a dynamic
panel data model
1) Specify model.
2) Choose whether to use differencing or orthogonal
deviations to account for fixed effects.
3) Specify instruments (often lagged values of all
variables in model)
4) Choose method for adjusting standard errors, to
overcome heteroskedasticity. This is usually Whites
adjustment.
5) Use the Sargan test to determine if the instruments are
suitable (Test for overidentifying restrictions)
 Panel Unit Root Tests
• Panel unit root tests can have the usual
benefits of using a panel, in so far as
increasing the number of observations
• In addition Levin and Lin (1992) have
shown that the panel approach
substantially increases the power of the
test relative to the time series ADF tests.
 Levin and Lin approach (LL)
• In the 1993 test, they adopt a similar approach
to the ADF test for a unit root, where the null
hypothesis is that there is a unit root.
• In effect ADF tests are carried out for each
individual in the panel, then adjusted to account
for any heteroskedasticity, a pooled t-test is then
produced to test the null, which are
asymptotically distributed under the normal
distribution.
• Different lags are allowed across different cross
sections.
 Levin and Lin
• The 1993 model takes the following form
(to remove autocorrelation lagged
dependent variables included):

pi
yit  yi ,t 1   iL yi ,t  L  zit   uit
L 1
zit  fixed / random effect
 Levin Lin
• The error terms across the cross sections
are assumed to be independent.
• It is assumed the ρ is the same across all
the cross sections.
• The lag length for the lagged dependent
variables is chosen in the usual way.
• As with ADF tests, a trend can also be
included in the test.
Im Pesaran and Shin Test (IPS)
• The IPS test is an example of an alternative to
the LL test, as instead of assuming a common
unit root process, where all the ρ are identical, it
tests for individual unit root processes.
• This in effect tests for all i cross sections to be
stationary.
• The IPS test averages all the individual ADF
test statistics.
• The null hypothesis in this case is that each
series contains a unit root for all i cross sections.
 IPS Test
• The IPS test in effect follows the model below:

pi
yit  i yi ,t 1   iL yi,t  L  zit   uit
L 1
zit  fixed / random effect
 IPS and LL tests Compared
• The main difference between the tests, is that one
assumes a common unit root, the other individual unit
root, also the IPS has an alternative hypothesis stating
that at least one of the I cross section series is
stationary, so LL requires all to be stationary, IPS only
some.
• Both suffer from the assumption that the error terms
across the cross sections are independent, which rules
out any cointegration between them. This may not
always be the case, particularly where the cross sections
are financial markets or banks.
• Depending on different values of the N and T
components, the two test statistics can give different
results
 Panel Unit Root Test
• There are a variety of different tests with
panel data, which differ in terms of the
assumptions regarding the null hypothesis
and how the autocorrrelation is removed.
• For instance the Fisher PP test removes
the autocorrelation using an adjustment to
the standard errors, as with the usual
Phillips-Perron (PP) test.
 Panel Cointegration
• The main approaches to cointegration have the same
advantages as the panel unit root tests, in that they
increase the power of the test.
• There are essentially two approaches, one based on the
Engle-Granger approach and the other using a
Johansen ML type methodology.
• There are in turn variations of both approaches, for
example in the Engle –Granger approach, there is the
Kao test, which assumes the same values across all
cross sections, whereas Pedroni assumes they can vary
across the cross sections, in effect allowing considerable
differences in the dynamics across the cross sections.
 Conclusion
• The dynamic panel allows dynamic effects
to be introduced into the model.
• There are basically two different methods,
which differ in how the fixed effects are
measured.
• Both unit root tests and tests for
cointegration can be conducted with panel
data, which increases the power of the
tests.