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The analysis of unit roots and cointegration in panel data has been a fruitful
area of study in recent years, with Levin and Lin (1992, 1993) and Quah
(1994) being the seminal contributions in this eld. The investigation of
integrated series in a panel data context is based on two separate but richly
developed elds of econometric investigation, the rst being unit roots and
cointegration in time series and panel data econometrics the other. Both
literatures have been surveyed in rich detail. For unit roots and cointegration
in time series, Banerjee et al. (1993), Hamilton (1994) and Phillips and
Xiao (1998) are useful sources. The book by Baltagi (1995) and the edited
collection by Matyas and Sevestre (1996) are important references for the
literature on panel data econometrics. The several volumes of papers edited
by Maddala (1994) are also relevant in this regard.
The emphasis of the literature on unit roots and cointegration in panel
data has been the attempt to combine information from the time series
dimension with that obtained from the cross-sectional, in the hope that
inference about the existence of unit roots and cointegration can be made
more straightforward and precise by taking account of the cross-section
dimension, especially in environments in which the time series for the data
may not be very long but very similar data may be available across a crosssection of units such as countries, regions, rms or industries.
The empirical motivations have therefore always been important. Furthermore, with increasingly larger quantities of panel data information becoming available, the investing of effort in this area of research has seemed
worthwhile, given the well-known power deciencies of pure time series Paper prepared as editorial introduction for the special issue of the Oxford Bulletin of
Economics and Statistics. I am obliged to the contributors to this volume for their comments and
to Wallace Lo for valuable research assistance. A substantial part of the work for this paper and
for putting together the special issue was undertaken by me during March and April 1999 in the
Department of Economics at the University of Canterbury in Christchurch, New Zealand, under
the auspices of a Visiting Erskine Fellowship. The generosity of the Erskine Foundation and the
Department of Economics in Canterbury is gratefully acknowledged. In particular, I thank Robin
Harrison and Alfred Haug for their hospitality. I also thank the ESRC for funding this research
under grant L116251015.
607
# Blackwell Publishers Ltd, 1999. Published by Blackwell Publishers, 108 Cowley Road, Oxford
OX4 1JF, UK and 350 Main Street, Malden, MA 02148, USA.
608
BULLETIN
based tests for unit roots and cointegration. Panel data techniques have been
used to investigate, for example, wages in unionized and non-unionized
industries (Breitung and Mayer (1994)), purchasing power parity (Bernard
and Jones (1996), Coakley and Fuertes (1997), Frankel and Rose (1996),
MacDonald (1996), O'Connell (1998), Oh (1996), Pedroni (1995, 1997a),
Papell (1997), Wu (1996)) and issues of convergence (Cechetti et al.
(1999), Evans and Karras (1996), Lee, Pesaran and Smith (1997), Pedroni
(1998)). The papers by Suzanne McCoskey and Chihwa Kao and by Chihwa
Kao, Min-Hsien Chiang and Bangtian Chen in this Special Issue look at
urbanization and international R&D spillovers respectively and are described later in the introduction.
The literature that has emerged has liberally drawn many elements from
its parent literatures. The consideration of fully modied estimation techniques, to take account of endogeneity of the regressors and correlation and
heteroscedasticity properties of the residuals, on the one hand, and the use
of methods for xed or random effects estimation, developed in the
literature on panel data with stationary variables, on the other, are two
examples of where the clear links may be identied. Yet, as in other
instances where a new literature comes to be seen to be signicant, the
aggregate has turned out to be greater than the sum of its parts and the
theory and practice of integrated series in panel data have given rise to a set
of interesting and surprising results which are uniquely its own.
A few examples of the distinctive features will sufce to elaborate on the
point made in the previous paragraph. From the early papers which developed the asymptotic theory of unit root processes in time series (Phillips
(1987), Engle and Granger (1987)), many of the estimators and statistics of
interest have been shown to have limiting distributions which are complicated functionals of Wiener processes. In direct contrast, the asymptotics of
non-stationary panels, starting with Levin and Lin, have led to demonstrations of estimators having Gaussian distributions in the limit. These results
have been extended to allow for a wide degree of heterogeneity across the
units comprising the panel.
The limiting distributions have also required the development and use of
multivariate `panel' functional central limit theorems, since the limiting
behaviour has required consideration of processes indexed by not only time
but also by unit. The formal and general treatment of the asymptotic
behaviour of such double indexed integrated processes has begun only
recently (Phillips and Moon (1999a)), although various aspects had been
implicitly employed in the earlier literature. It has become clear that several
approaches are possible and the limit of the processes may depend on the
assumptions made about the manner in which N (the units) and T tend to
innity. For example, one may x N and let the other index pass to innity
and subsequently allow N to tend to innity. This is denoted by Phillips and
Moon (1999a) as (N , T ! 1) seq . Alternatively N and T may be allowed to
pass to innity at a controlled rate of the type T T (N ). A third possibility
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root test proposed in Im et al. (1997). Hall et al. provide an interesting and
important counter-example to the analysis by Pesaran and his co-authors
while at the same time moving the literature on to a more general direction.
The Phillips and Moon long-run relation alluded to above is also another
example of how looking at integrated data in panels led to some widely held
beliefs being modied.
The next section describes testing for unit roots, using the analysis in
Levin and Lin (1992, 1993) as its starting point. Section 2.2 provides an
account of the Im et al. (1997) tests and Section 2.3 introduces the Maddala
and Wu paper in this volume. Section 3 moves on to the discussion of tests
for cointegration, with Section 3.1 presenting Pedroni's tests for cointegration. The construction of these tests is described in detail in Pedroni's paper.
Section 3.2 analyses the LM-test for cointegration developed by McCoskey
and Kao (1998a) and describes an empirical application of the method
contained in the Special-Issue paper by McCoskey and Kao. This section
also introduces the paper by Kao et al. Section 4 discusses new directions
for research. In particular, we discuss Phillips and Moon's formalization of
the asymptotic theory of integrated panel data. The topic of their contribution to the Special Issue is the estimation of local-to-unity parameters in the
presence of homogeneous or heterogeneous deterministic trends, and their
paper provides a new and important example of inconsistent maximumlikelihood-estimation in dynamic panels. Section 5 concludes. The notation
d
used throughout the volume is standard and self-explanatory. ) or )
denotes convergence in distribution while ! p or ! is used for convergence in probability The non-stochastic limit (innite or nite) of a
sequence is also denoted by ! and the context makes the usage clear. In
Wiener integrals of the form W (r)dr, the argument r is often suppressed.
II.
611
under the null also being required about the coefcients relating to the
deterministic components.
The main theorems in Levin and Lin relate to deriving the asymptotic
distributions of the panel estimator of r under different assumptions on the
existence of xed effects or heterogeneous time trends. The simplest cases
to consider are for i, t IID(0, 2 ) for xed i. The errors are also assumed
to be independent across the units of the sample.1 For example, if
i i 0 for all i and there are no common time effects, then the
asymptotic distribution of the ordinary least squares (OLS) pooled panel
^ is given by
estimator r
p
^ ) N (0, 2), T, N ! 1
(2)
T Nr
tr0 ) N (0, 1):
(3)
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For all i and t, i, t has nite non-zero fourth moments, the variance of the
innovation process i, t is bounded from below away from zero and the
variation at frequency zero (long-run variance) of i, t is bounded above.
Levin and Lin (1993) prescribe the use of augmented DickeyFuller
(ADF) test to each individual series as the starting point of their testing
procedure for unit roots. Thus, the regressions (for each i)
pi
X
yi, t r i yi, t1
ij yi, t j i i, t , t 1, 2, . . . , T
(7)
j1
(8)
T
X
^ i, t1 )2
^iV
(^e i, t r
t pi 2
~e i, t ^e i, t =^ e i
~ i, t1 V
^ i, t1 =^ e i
V
^ 2yi (T 1)1
S^ N ,T N 1
T
X
t2
y2i, t 2
K
X
L1
w K L (T 1)1
T
X
!2
yi, t yi, t L
t L2
N
X
(^ yi =^ e i ):
i1
2
This is an estimate of the long-run variance of yi . K is the lag truncation parameter and w K L is
the lag window.
613
The nal step is to estimate the panel regression (making use of all i and t)
~ i, t1 ~ i, t
~e i, t r V
(9)
2
RSE(^
r) ^ 4
^
r
,
RSE(^
r)
N
T
X
X
i1 t pi 2
~ 1
^ 2 (N T)
p N 1
31=2
~2 5
V
i, t1
N
T
X
X
N
X
(10)
~ i, t1 )2
^V
(~e i, t r
i1 t pi 2
pi , T~ (T p 1):
i1
tr0 N T~ S^ N ,T ^ 2
r) T~
RSE(^
,
T~
(11)
where T~ and T~ are mean and standard deviation adjustment terms which
are computed by Monte Carlo simulation and tabulated in their paper for
three separate specications of the deterministic terms in (1) above. The
adjustment terms are available for a given regression model, time series
dimension T~ ranging from 25 to 250 and lag truncation parameter K
varying from 9 to 20. N (the cross-section dimension) is set to 250 in all the
adjustment term simulations.3 The central theorem of the Levin and Lin
analysis showed that provided the ADF lag order pmax increased at some
rate T p where 0 , p < 1=4 and the lag truncation parameter K increased at
rate T q where 0 , q , 1, then under the null hypothesis that r 0, the
panel test statistic tr has the property that as T , N ! 1,
tr ) N(0, 1):
(12)
3
An element of the discussion in many of the papers where such corrections are proposed is to
present them for nite T , N and also for so-called asymptotic or large T , N and to see how well
the asymptotic values (since these are most easily usable) approximate the nite sample
corrections. We draw attention to this feature but do not enter into discussion of this important
area.
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(13)
(14)
615
yi, t r i yi, t1
pi
X
ij yi, t j i i, t , t 1, 2, . . . , T
(16)
j1
N
X
LM i,T ( pi , i ),
(17)
i1
i1
s
N
X
1
Var[LM i,T ( pi , 0)jr i 0]
N
(18)
i1
The values of E[LM i,T ( pi , 0)jr i 0] and Var[LM i,T ( pi , 0)jr i 0] are
obtainable by stochastic simulation and are tabulated in their paper using
50,000 replications for different values of T and pi 's. It is shown that under
H 0 : r i 0 for all i,
LM ) N(0, 1)
(19)
i1
s
N
X
N 1
Var[t i,T ( pi , 0)jr i 0]
(20)
i1
where
t N ,T N
N
X
t i,T ( pi , i ),
(21)
i1
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N
X
ln( i )
(22)
i1
617
The literature on testing for cointegration in panels has so far taken two
broad directions. The rst consists of taking as the null hypothesis that of
no cointegration and using residuals derived from the panel analogue of an
Engle and Granger (1987) static regression to construct the test statistics
and tabulate the distributions. The most general statement of this problem
may be taken from Pedroni's paper in this volume, which is based on earlier
work by him (Pedroni (1995, 1997a)). A related paper is by Kao (1999)
which contains very similar and related analysis. The second route is to take
as the null that of cointegration and is the basis of the test proposed by
McCoskey and Kao (1998a).4 This too is a residual-based test and has as its
analogue in the time series literature the tests of Harris and Inder (1994),
Shin (1994), Leybourne and McCabe (1994) and Kwiatowski et al. (1992).
We discuss both approaches in turn. As a preface, it should be noted that the
asymptotic analysis of both approaches involves the use of sequential limit
arguments. This involves allowing the time series dimension T to grow
large rst and then letting N ! 1.
3.1. Pedroni
The details of the Pedroni method are described in some detail in his paper
in this volume. We shall therefore discuss only the key features of the
analysis which are of importance in a more general context. The method
utilizes the residuals from the cointegrating regression given by
yi, t i i t x9i, t i e i, t , t 1, 2, . . . , T ; i 1, . . . , N ;
(23)
where i (1i , 2i , . . . , Mi )9, xi, t (x1i, t , x2i, t , . . . , x Mi, t )9. This formulation therefore allows for considerable heterogeneity in the panel, since
heterogeneous slope coefcients, xed effects and individual specic
deterministic trends are all permitted.
Under H 0, dening z i, t ( yi, t , x9i, t )9, 9i, t ( i,y t , x9
i, t ),
z i, t z i, t1 i, t ,
(24)
4
In a similar vein, Hadri (1998) develops a test of the null of trend versus difference
stationarity.
618
BULLETIN
(25)
(26)
The analogy with the Levin and Lin (1993) and Im et al. (1997) papers is
evident, in terms of the heterogeneity permitted under the alternative
hypothesis, in the former case for the root of the raw time series, the
autoregressive coefcient in the estimated residuals for the latter.
We next describe the construction and use of the second of the withindimension tests, called the Panel r-Statistic, referring the reader to Pedroni's
paper for the remaining tests. The non-parametric tests require estimating
i and the long-run variance of ^u i, t , where
^ i ^e i, t1 ^u i, t
^e i, t
(27)
and ^e i, t are the residuals from the panel cointegrating regression (23). The
parametric tests estimate
^ i ^e i, t1
^e i, t
ki
X
k1
^ ik ^e i, t k ^ui, t
(28)
and use the residuals ^ui, t to estimate their (simple) variance since the ADF
procedure in (28) whitens the ^ui, t .
5
The interesting consequences of relaxing this assumption are an important part of the Hall et
al. paper.
619
The following steps are implemented for the construction of the Panel rStatistic. The panel cointegrating regression (23) is estimated and the
residuals extracted. Next, the differenced regression given by
yi, t 9i xi, t i, t , t 1, 2, . . . , T ; i 1, . . . , N
(29)
(30)
i1 t1
11i i, t1
i1 t1
11i
(31)
In order to dene the statistic suitable for making inference, a standardization based on the moments of the vector of Brownian motion functionals is
again required. Letting V and W to be mutually independent standard
Brownian motion processes of dimension 1 and M respectively, dene
1
~
WW 9
WV ;
(32)
~ :
Q V 9W
(33)
2
~
~
9
Q , Q dQ, 9 :
(34)
(35)
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Levin and Lin estimators, generalizes to all seven of the Pedroni estimators,
so that
p
N ,T N
p
) N (0, 1)
(37)
for the appropriately standardized statistic and corrections for mean and
variance. The correction factors and depend on (a) the statistic considered; (b) the dimension of M; and (c) whether or not unit-specic constants
and/or trends are included in the regression. They are computed by Monte
Carlo simulation and are tabulated in easily readable form by Pedroni in
Table 2 of his paper.
We turn now to considering the LM-test for the null of cointegration, due
to McCoskey and Kao (1998a).
t
X
u i, j u i, t :
(38)
j1
(39)
1 X
p
w i, t ) B():
T t1
[Tr]
As noted by McCoskey and Kao (1998a) the analysis can be generalized to allow for this specic form
of heterogeneity also but, allied to the assumption of independence across i, the relaxation of this
restriction will imply that the method will be equivalent to equation-by-equation estimation of the
system.
# Blackwell Publishers 1999
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$21
$12
:
22
621
(40)
LM
N
X
i1
1
T2
T
X
t1
S y2
i, t
(41)
$
^ 21:2
where $
^ 21:2 is a consistent estimator of
y
^ 1 i, k
$21:2 $21 $12 1
^ 12
22 $21 , y i,k yi,k $
22
and
S
i, t
t
X
y 9x ):
( yy i,k i c
i i,k
k1
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p
N (LM v )
LM
:
v
(42)
LM y ) N (0, 1)
(43)
Under H 0 : 0,
and since the statistic diverges under the alternative hypothesis, large values
of LM y imply rejections of the null hypothesis. The correction factors v
and 2v are the mean and variance of a complex functional of a Brownian
motion process dened in Harris and Inder (1994) but depend only on the
dimension of M and on whether or not unit-specic constants or trends are
included in (23).
All this is of course very much in line with the general principles for
constructing such tests that we have tried to describe in this paper. For
example, the McCoskey and Kao (1998a) test is in the spirit of the Im et al.
(1997) analysis, since it involves the averaging of the individual LMstatistics across the cross-sections. They also involve the use of nonparametric corrections (common to the spirit of the Pedroni tests) and mean
and variance correction factors (common to all the testing and estimation
procedures described here, except for the Maddala and Wu tests). Thus it is
possible to see many unifying strategic features in this already quite diverse
literature and this is helpful for an understanding of the issues resolved and
where the important extensions may lie.
Before proceeding to a discussion of these extensions, it is necessary to
note briey the results of McCoskey and Kao and by Kao et al. in this
volume since both papers make extensive use of the techniques discussed in
this section. McCoskey and Kao use their LM-test to investigate the
relationship between urbanization, output per worker and capital per worker
in a sample of 30 developing countries and 22 developed countries. They
nd that the existence of a long-run relationship can be sustained, although
the sign and magnitude of the impact of urbanization varies widely across
countries. Their results are sensitive to whether or not a trend is included in
the cointegrating regressions, to proxy for the growth rate in gross domestic
product per worker caused by factors other than urbanization and capital per
worker. An interesting interpretation of the signicant interaction between
urbanization and time trend is suggested. Under this interpretation, there
appears to be some evidence for urbanization acting as a potential leveller
of growth rates across countries. For example, the results show that
urbanization acts as a draining inuence on otherwise positive growth while
propping up growth rates in struggling economies.
Kao et al. return to a proposition put forward by Coe and Helpman
(1995), using a sample of 21 OECD countries and Israel, to show that both
domestic and foreign R&D capital stocks have important effects on the total
factor productivity (TFP) of countries. Using FM and DOLS methods, Kao
et al. conclude that while evidence of the linkage between domestic capital
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stock and TFP is strong, the link between international capital stock and
TFP appears to be considerably weaker. They therefore reject an important
conclusion of the Coe and Helpman analysis, namely that international
R&D spillovers are trade related.
IV. NEW DIRECTIONS
The most comprehensive formalization of the asymptotic theory of nonstationary panel data is due to Phillips and Moon (1999a). The signicant
aspects of this research are rst summarized below. We then move on to
discuss some issues which remain largely unresolved.
4.1. Phillips and Moon
Several important areas have been covered by Phillips and Moon in their
recent papers to which reference should be made for the details. The rst set
of signicant results is their formalization of the multi-indexed asymptotic
theory relevant to panel data. This is based upon distinguishing among three
kinds of limiting behaviour of N and T, as described in the introduction
above, and upon deriving conditions where sequential limits are equivalent
to joint limits, both for convergence in probability and convergence in
distribution. The essential condition is one of uniform convergence (that is
convergence of the random variable is uniform in the N dimension as
T ! 1) for which Phillips and Moon (1999a) present generalized conditions applicable to multi-indexed asymptotics.
The second set of important ndings relates to looking at the asymptotic
behaviour of estimators in (a) panel-spurious regressions where there is no
time series cointegration; (b) heterogeneous panel cointegration, where each
unit has its own cointegrating relation (as in (23) above); (c) homogeneous
panel cointegration ( i for all i); and (d) near homogeneous panel
cointegration, where the divergence from homogeneity across units is small
and is caused by the value of a so-called localizing parameter. They show
in
p
particular that both for cases (a) and (b) above, it is possible to obtain N
consistent estimates for the long-run average coefcient using pooled data.8
The limit distributions are demonstrated to be Gaussian. This is a very
notable departure from the analysis of Pesaran and Smith (1995) who
established that average effects would not be consistently estimated from
pooled data if the panel were characterized by heterogeneous cointegrating
relationships across the different units. This departure arises from a somewhat different and `robust' denition of the long-run average coefcient in
terms of the long-run average variance of the panel which can exist even in
the absence of any cointegration.
For cases (c) and (d), Phillips and Moon derive pooled fully-modied
8
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p
estimators which are T N consistent and also have Gaussian limiting
distributions. Use can be made of these results to formulate hypothesis tests
about the long-run average parameters between subsets of the sample.
In their contribution to this volume, Moon and Phillips develop some
local-to-unity asymptotics for maximum likelihood estimation in dynamic
panels. While the local-to-unity parameter can be estimated consistently in
the absence of deterministic trends or in their presence but in homogeneous
form, heterogeneous deterministic trends lead to the maximum likelihood
estimator being inconsistent. The inconsistency arises from the number of
incidental parameters (namely the deterministic trends) going to innity as
N ! 1. In a range of panel data contexts, such as in the estimation of
dynamic models with xed effects, the inconsistency disappears as T ! 1.
Moon and Phillips show that the incidental parameter problem persists in
their framework even when both N ! 1 and T ! 1.
4.2. Unresolved Issues and Extensions
Several issues remain which are worthy of further investigation. A substantial part of both the theory and the practice in this area has been based on
considering and using the asymptotic properties of estimators and tests. It is
clear that a substantial amount of simulation work is necessary to establish
systemtatically the role of asymptotic theory in estimates and tests derived
from nite samples.
More signicantly, a formal study of the relaxation of the pervasive
cross-sectional independence assumption is necessary in order to make
the asymptotic theory relevant to empirical examples. This is because in
many multi-country contexts, with dependence on common global
shocks, the independence assumption is very likely to be violated. In the
conclusion to their paper, Phillips and Moon (1999a) discuss the considerable difculties involved not only in incorporating dependence into the
analysis but also of characterizing it appropriately. However, the authors
of three of the papers published in this volume have made an important
start in this direction, and two of these papers appear here. Maddala and
Wu use bootstrapping methods to allow for cross-section dependence.
Pedroni (1997b), in his study of purchasing power parity, proposes the
use of GLS-based corrections to allow for feedback across individual
members of the panels. In his study of violations of purchasing power
parity relations, the corrections for cross-sectional dependence do not
appear to play a signicant role but this should not be to deny the
potential of this strand of the research agenda. Finally, the paper by Hall
et al. introduces a range of ideas which should lead to interesting new
research.
Building on earlier work by Hall and Urga (1998), the Hall et al. paper
provides another counter-example to the Pesaran and Smith (1995) analysis.
Focusing on the structure of the regressors in the panel cointegrating
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625
regressions, Hall et al. demonstrate that if the regressors in each unit of the
panel are driven by common stochastic trends, and each unit cointegrates,
then a standard panel data estimator which imposes homogeneous parameters across the panel will provide consistent estimates of the average
long-run effects even if the true model has heterogeneous parameters. The
paper then goes on to develop a new principal-components-based test for
common stochastic trends and presents size and power properties of these
tests in nite samples. The testing methods are consistent even in the
presence of a mixture of I(0) and I(1) variables, thereby obviating the need
to pre-test the panel for unit roots.
Two signicant features of this work should be noted, particularly
because they throw light on the tensions in the literature and the developments required. First, by working with common driving trends across the
units of the panel, cross-sectional dependence is introduced explicitly.
However, except for proving consistency, the asymptotic theory of the
principal-component estimators is not developed and the analysis of the
properties relies heavily on the simulations conducted. This may prove to
be a difcult task, but the analysis represents an important step in the right
direction.
The second feature is to allow for multiple cointegrating vectors, albeit
only in the regressor set. This too is a necessary extension of the
estimation and inference framework which nevertheless remains very
incomplete in this respect. The cointegrating vector (in each unit of the
panel) is usually taken to be unique and issues of normalization (i.e. to do
with the choice of the regressand) are not addressed. Only Larsson,
Lyhagen and Lothgren (1998), by proposing the panel data analogue of the
Johansen maximum likelihood method, study the case of multiple cointegrating vectors in panels. The price they pay is their need to maintain the
assumption of cross-sectional independence. Their suggested statistic,
inspired by the Im et al. (1997) test for unit roots, is the average (across
units) of the Johansen likelihood ratio statistic. This is asserted to have a
standard normal density once the mean and variance corrections have been
implemented, where these moments are derived as usual by stochastic
simulations.
The status of the results in Larsson et al. (1998) is unclear since the main
theorem is asserted and not proved. Nevertheless, if correct, it would mark
important progress. An overarching analysis which combines the relaxation
of the independence condition by Hall et al. with a consideration of multiple
cointegrating vectors due to Larsson et al. (1998) would denote a huge step
forward in the study of integrated dynamic panels.
V.
CONCLUSION
This volume contains descriptions and the use of all the major testing and
estimation procedures for unit roots and cointegration in heterogeneous
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REFERENCES
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