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Microeconometrics Lectures Richard Blundell UCL and IFS March 2005

**Dynamic Panel Data Methods
**

Background The standard panel data model is

**yit = β 0 + xit1β 1 + xit 2 β 2 +...+ xitk β k + η i + vit = xit ′ β + η i + vit
**

where the η i are the unobserved constant individual effects. i = 1,..., N ; t = 1,..., T , with N large and T small. Often lagged values of y are included in x.

2

An Example: Company Investment Rates The panel data model is

I it I it −1 =β + ηi + λt + vit K it K it −1

Unbalanced panel Company level data T = 4-10, N = 700.

3

Example OLS Within DIF Levels Groups 2SLS ( I / K )it −1 0.2669 -0.0094 (.0185) (.0181) 0.1626 (.0362) ( I / K )it −2

Instruments

STATA command for GMM: xtabond2 f.windmeijer@ifs.org.uk On the CeMMAP website http://cemmap.ifs.org.uk/ (resources page), the Windmeijer course is available together with the computer exercises and some of the data sets.

4

**Three common specifications to deal with η i : 1. Random effects 2. Fixed effects 3. First Differences In the model
**

yit = xit ′ β + uit uit = η i + vit

we assume that E vit = 0; E vit | xit = 0

a f

a

f

5

The Random Effects specification further assumes that E η i = 0; E η i | xit = 0 i.e. it assumes that the individual effect η i is uncorrelated with the regressors xit . Therefore

E yit | xit = xit ′ β + E η i | xit + E vit | xit = xit ′ β

a f

a

f

a

f

a

f a

f

and therefore the simple OLS estimator on the pooled data is unbiased. However, it is not efficient, and the estimated standard errors are wrong, as it does not take account of the dependence of the error term within individual over time.

6

Let uit = η i + vit and assume independence of vis and vit , s ≠ t , and of η i and the vit , then 2 E uis uit = E η i2 = σ η

a f b g

2 2 v

and therefore the uis and uit are correlated. The within individual variance-covariance matrix is given by, ui′ = ui1 ui 2 ... uiT ,

a

f

LMσ + σ MM σ Ω = Eau u ′f = MN σ

η η

2 i i

2 ση 2 ση +σ2 v

η

2

2 ση

OP PP σ P σ +σ Q

2 ση

η

2

η

2

2 v

β RE

FG ∑ X ′Ω X IJ = H K

N −1 i i i =1

7

−1 N

Xi′Ω −1 yi ∑

i =1

Fixed Effects The more likely and interesting case is when the unobserved individual effects are correlated with the regressors:

E η i | xit ≠ 0.

Clearly, in this case OLS and the Random Effects estimator are biased and inconsistent as

a

f

**E yit | xit = xit ′ β + E η i | xit + E vit | xit
**

it i it it

a

f

a f a f = x ′ β + Eaη | x f ≠ x ′ β

8

A solution is to estimate the model with a separate intercept for every individual by OLS. As

η i = yi − xi ′ β − vi

this happens to be equivalent for the β parameters to estimate the transformed, within group model by OLS

yit − yi = xit − xi ′ β + vit − vi

a

f a

f

Therefore, for the fixed effects, or within group estimator, only the effects of variables that change over time can be estimated. (OLS standard errors in this model are again wrong as it ignores the fact that N intercepts have been estimated).

9

For the fixed effects estimator to be unbiased, one needs that the xit in all periods are uncorrelated with the vis in all periods:

E vis xit = 0; s = 1,..., T , t = 1,..., T

when xit satisfies this condition, we call it to be strictly exogenous. Assuming strict exogeneity, the Hausman test can be used to test whether the unobserved heterogeneity is correlated with the regressors. When they are not correlated the RE estimator is efficient. If they are correlated, the FE estimator is consistent, but the RE estimator is not. −1 ′ H = β FE − β RE Var β FE − Var β RE β FE − β RE

a f

d

i

d i

d i d

i

**If H is large, RE is rejected in favour of FE. For large samples H ~ χ 2 , k with k the number of elements in β .
**

10

First Differencing

**Again consider the model
**

yit = xit ′ β + uit uit = η i + vit

where the unobserved individual effects η i are correlated with xit . Taking first differences eliminates η i :

yit − yit −1 = xit − xit −1 ′ β + uit − uit −1 = xit − xit −1 ′ β + vit − vit −1

a

f a

f a

f a

f

11

and therefore OLS is unbiased if vit − vit −1 and xit − xit −1 are uncorrelated. This is a weaker assumption than the strict exogeneity assumption of the fixed effects estimator. Again OLS estimated standard errors are wrong as it does not take account of the correlation between vit − vit −1 and vit −1 − vit −2

a

f

a

f

a

fa LM 2 −1 Eav v ′f = σ M MM N0

i i 2 v

**E vit − vit −1 vit −1 − vit −2
**

−1 2

a

f a f = −σ

0

f

2 v

−1

OP PP −1 2P Q

(when the vit themselves are not correlated over time).

12

Endogenous Variables

Consider again the model in first differences

**yit − yit −1 = xit − xit −1 ′ β + vit − vit −1
**

And xit is endogenous if it is correlated with vit .

a

f a

f a f

There can also be feedback from vit −1 to xit such that E xit vit −1 ≠ 0. In this case we call xit predetermined or weakly exogenous. In both cases E xit − xit −1 vit − vit −1 ≠ 0 and OLS is biased. If the uit are not correlated over time, lagged values of xit can be used as instruments for the endogenous differences, and the model can be estimated by the Instrumental Variables estimator.

13

ba

fa

fg

If xit is endogenous, E xit vit ≠ 0 and E xit −1vit −1 ≠ 0 . Valid instruments are xis , with s=1,…,t-2, as E xit −2 vit = 0.

a f a

f

a

f

If xit is predetermined, E xit vit−1 ≠ 0 but E xit −1vit −1 = 0 . Valid instruments therefore are xis , with s=1,…,t-1.

a

f

a

f

14

Treatment Effects in Panels

Suppose the model is:

**yit = α i dit + xit′ β + λt + ηi + vit
**

where di = 1 if the program impacts on group i in period t. Typically once the program is in place this dummy is set to unity for all remaining time periods. If the time effects, the group effects and the x are sufficient to render di = 1 exogenous, then within groups (fixed effects) will be consistent for the ATT impact of the treatment. In this case, if the treatment occurs at the same time for all groups that are treated then diff-in-diff and within groups are identical estimators.

15

Dynamic Panel Data Models

A dynamic panel data model is specified as

**yit = αyit −1 + xit ′ β + η i + vit
**

Consider a model without other explanatory variables

yit = αyit −1 + η i + vit

Clearly, yit −1 = αyit −2 + η i + vit −1 is correlated with η i . OLS estimator is biased upwards. Fixed Effects estimator is biased downwards (this bias gets smaller for larger T)

16

a

f

For the first differenced model

yit − yit −1 = α yit −1 − yit −2 + vit − vit −1

a

f a

f

yit −1 is of course correlated with vit −1, ( y is predetermined), and the OLS estimator in the differenced model is severely downward biased.

Valid instruments for yit −1 − yit −2 are the lagged levels yit −2 , yit −3 ,..., yi1, as E yit −2 vit − vit −1 = 0 .

b a

fg

a

f

An Instrumental Variables estimator that uses this information optimally is the Generalised Method of Moments (GMM) estimator.

17

Let ∆vi be the vector of errors for individual i in the first differenced equation: vi 3 − vi 2 ∆yi 3 − α∆yi 2 vi 4 − vi 3 ∆yi 4 − α∆yi 3 ∆vi = =

LM MM MNv

iT

− viT −1

OP PP PQ

LM MM MN∆y

iT

− α∆yiT −1

OP PP PQ

and let Zi be the matrix of instruments for individual i

LM y 0 Z =M MM N0

i

i1

0 yi1 yi 2 …

0 0 0 yi1

0 0 yi 2 … yiT −2

OP PP PQ

18

Then

E Zi ′ ∆vi = 0, a total of (T − 1)(T − 2) / 2 moment conditions. The GMM estimator uses these moment condition to estimate the parameters consistently and efficiently in two steps. The one-step estimator minimises

e

j

JN

FG 1 ∑ Z ′ ∆v IJ ′ W FG 1 ∑ Z ′ ∆v IJ = HN K HN K

N N i i N i i i =1 i =1

where WN is a weight matrix. −1 N 1 Zi ′ Zi results in the Two-Stage Least Squares Choosing WN = ∑ N i =1 estimator.

FG H

IJ K

19

**The one-step GMM estimator uses as the weight matrix
**

WN 1

AN

FG 1 ∑ Z ′ A Z IJ = HN K LM 2 −1 0 0 OP 0 −1 2 PP =M −1 MM 0 N 0 0 −1 2 PQ

N −1 i N i i =1

and is efficient when the errors are homoscedastic and not correlated over time. This is often too restrictive. However, the one-step results are consistent, and robust standard errors that adjust for heteroscedasticity and autocorrelation are easily obtained.

20

The two-step estimator is efficient under more general conditions, like heteroscedasticity. The efficient weight matrix is computed as

WN 2

FG 1 ∑ Z ′ ∆v ∆v ′ Z IJ = HN K

N i i i i i =1

−1

∆vi = ∆yi − α 1∆yi , −1

where α 1 is the one-step GMM estimator. A problem is that in small samples (small number of individuals) the estimated standard errors of the two-step GMM estimator tend to be too small.

21

Sargan test for overidentifying restrictions:

The null hypothesis for this test is that the instruments are valid in the sense that they are not correlated with the errors in the first-differenced equation. It is computed as

FG 1 ∑ Z ′ ∆v IJ ′ W FG 1 ∑ Z ′ ∆v IJ . S = NJ aα f = N HN K HN K

N N N 2 i i2 N2 i i2 i =1 i =1

Under the null, this test statistic has a χ 2 distribution, with q equal to the q total number of instruments minus the number of parameters in the model. Only use the two-step result for the Sargan test.

Note also test for serial correlation in the errors.

22

An Example: Investment Rates across Firms

The estimated model is

FG I IJ = λ + α FG I IJ + η + v HK K HK K

it it −1 t i it it −1

it

and results are presented in Table 1 for OLS, within groups, just identified Two-Stage Least Squares for a differenced model, with ( I / K )it −2 as an instrument for ∆( I / K )it −1, and two GMM estimates for α in the differenced model, one using ( I / K )it −2 and ( I / K )it −3, the other using ( I / K )it −2 ,..., ( I / K )i1 as instruments.

23

OLS Within 2SLS DIF GMM1 DIF GMM1 DIF Levels Groups ( I / K )it −1 0.2669 -0.0094 (.0185) (.0181) -4.71 2.52 -11.36 -2.02 0.1626 (.0362) -10.56 0.61 0.1593 (.0327) -10.91 0.52 0.36 ( I / K )it −2 ( I / K )it −2 ( I / K )it −3 0.1560 (.0318) -11.12 0.46 0.43 ( I / K )it −2 ( I / K ) i1

m1 m2 Sargan (p) Instruments

24

Exogeneity/Endogeneity of additional regressors and instrument set

Consider again the dynamic model with one other explanatory variable: yit = αyit −1 + βxit + η i + vit and the model in first differences: ∆yit = α∆yit −1 + β∆xit + ∆vit . Consider the case with T = 4. When x is strictly exogenous w.r.t. v , the instruments are

LM y , x ,..., x Z = N 0

i1 i1 i

i4

0 . yi1 , yi 2 , xi1 ,..., xi 4

OP Q

25

When x is predetermined

LM y , x , x Z = N 0

i1 i1 i

i2

0 . yi1 , yi 2 , xi1 , xi 2 , xi 3

OP Q

And when x is endogenous

LM y , x Z = N 0

i1 i

i1

0 . yi1 , yi 2 , xi1 , xi 2

OP Q

26

An example and finite sample inference

Arellano and Bond (1991) estimate dynamic employment equations using a sample of 140 UK quoted firms over the years 1976-1984. One model was specified as nit = α 1nit −1 + α 2 nit −2 + βwit + β 1wit −1 + γkit + δysit + δ 1 ysit −1 + λ t + η i + uit where nit is the logarithm of UK employment in company i at the end of the period t , wit is the log of the real product wage, kit is the log of gross capital and ysit is the log of industry output. The table presents estimation results for the one- and two-step GMM estimators.

27

nit −1 nit −2 wit wit −1 kit ysit ysit −1 m1 m2 Wald

One-Step coeff std err .535 .166 -.075 .068 -.592 .168 .292 .142 .359 .054 .597 .172 -.612 .212 -2.493 -0.359 219.6

coeff .474 -.052 -.513 .225 .293 .610 -.446

Two-Step std err std errc .085 .185 .027 .052 .049 .146 .080 .142 .040 .063 .109 .156 .125 .217 -2.826 -1.999 -0.327 -0.316 372.0 142.0

28

Another test statistic with reasonable finite sample properties is the difference between the Sargan test statistics in the models with and without the restriction imposed. Imposing α 2 = 0 (keeping time periods and instruments the same) results in a Sargan test of 30.58. The difference between the Sargan tests is therefore 0.47, which is much smaller that the 5% critical value of the chi-squared distribution with one degree of freedom. H0 : α 2 = 0 is therefore not rejected.

29

Weak Instruments and Dynamic Panels

Remember that instruments have to satisfy that 1.They are not correlated with the error term in the equation of interest. 2.They are correlated with the endogenous explanatory variable. Whether the instruments are correlated with the error term is tested by means of the Sargan test. If the Sargan test rejects the null of no correlation, the IV estimator is biased and inconsistent. However, even if the instruments are not correlated with the error term, a serious small sample bias can occur if they are only weakly correlated with the endogenous explanatory variable.

30

**For the dynamic panel data model in first differences
**

∆yit = α∆yit −1 + ∆vit

lagged levels yit −2 ,..., yi1 as instruments for ∆yit −1 become less informative as α increases. (For the extreme unit root case, yit = yit −1 + vit , α is not identified in the first differenced GMM model). The weak instrument bias tend to go in the direction of the within groups bias (i.e. downward). This occurs for any highly persistent endogenous r.h.s. variable – capital etc.

31

There are T − 2 additional moment conditions (additional to the moment conditions for the model in first differences) for this case are

**E uit ∆yit −1 = E η i + vit ∆yit −1
**

it

a

f ba = Eba y

f

− αyit −1 ∆yit −1 = 0

f

g

g

These additional moment conditions are available if the initial conditions satisfy E η i ∆yi 2 = 0 , which holds when the process is mean stationary:

yi1 = E ε i1

a

f

a f a f

32

ηi + ε i1 1−α . = E η i ε i1 = 0

The GMM estimator that combines the moment conditions for the differenced model with those for the levels model is call the SYSTEM estimator (Blundell and Bond (1998)) and has been shown to perform much better (less bias and more precision), especially when α is large, i.e. when the series are persistent. This is due to the fact that ∆yit −1 is a good instrument for yit −1, it explains yit −1 well, irrespective of the value of α . Whether the additional moment conditions are valid has of course to be tested, using the Sargan test.

33

The model is yit = αyit −1 + βxit + η i + vit xit = ρxit −1 + τη i + θvit + eit

2 2 T = 8, N = 500, β = 1, τ = 0.25, θ = −0.1, σ η = 1, σ 2 = 1, σ e = 0.16 v (Normal), 10,000 replications

34

ρ = 0.5 α = 0.5

OLS Mean St D

WG Mean St D 0.265 0.311 0.490 0.662 0.388 .018 .017 .045 .016 .044

DIF SYS Mean St D Mean St D 0.494 0.480 0.930 0.548 0.226 .034 0.501 .024 .040 0.511 .027 .136 0.997 .124 .177 0.979 .011 .356 0.983 .101

ρ 0.762

.012 .007 .034 .001 .035

α 0.820

β 0.775

α = 0.95 α 0.990 β 0.581

35

ρ = 0.95 α = 0.5

OLS Mean St D

WG Mean St D 0.591 0.396 0.796 0.882 0.745 .017 .015 .040 .009 .040

DIF SYS Mean St D Mean St D 0.676 0.480 0.800 0.927 0.615 .222 0.958 .031 .033 0.518 .021 .290 1.075 .059 .025 0.957 .003 .400 1.019 .031

ρ 0.997

.001 .009 .022 .001 .017

α 0.650

β 0.830

α = 0.95 α 0.962 β 0.902

36

An Example: Company Capital Stock

The estimated model is

kit = λ t + αkit −1 + η i + vit Within Groups 0.733 (.027) -6.82 -1.73 GMM1 DIF (t − 3) 0.768 (.070) -5.80 -1.73 .563 GMM1 SYS (t − 3) 0.925 (.021) -6.51 -1.81 0.627 0.562

OLS Levels

kit −1

0.987 (.002) 7.72 2.29

m1 m2 Sargan (p) Dif-Sar

37

Count Data Models

Often the dependent variable is an integer valued non-negative count variable, like the number of visits to the doctor, the number of patents granted or the average daily number of cigarettes smoked. A standard model for analysing such data is the Poisson regression model. The Poisson density for a count variable yi given xi e− µi µ i y f yi | xi = yi !

a f

where

µ i = E yi | xi = exp xi ′ β

a f

e j

**is the conditional mean of yi given xi , which is positive.
**

38

As ln µ i = xi ′ β , the model is often called a log-linear model. The Poisson distribution has the property that the conditional variance is equal to the conditional mean (equidispersion): Var yi | xi = E yi | xi = exp xi ′ β . Consider the regression model yi = exp xi ′ β + ui with E ui | xi = 0 from which it follows that E xi ui = 0. As long as these conditions are valid in the population, the Poisson estimator for β is consistent, even if the true distribution is not Poisson.

a f

a f a f

e j

e j

a f

a f

39

Parameter Interpretation

The partial effects are given by ∂E y| x = β j exp x ′ β . ∂x j

a f

e j

Further,

∂E y| x 1 βj = ∂x j E y| x

a f

a f a f

and so β j is a semi-elasticity, it equals the proportionate change in the conditional mean if the j th regressor changes by one unit. If x j is replaced by ln x j , β j is the elasticity of E y| x with respect to x j .

c h

40

Overdispersion

In many applications there is overdispersion, i.e. the conditional variance is larger than the conditional mean (and sometimes there is underdispersion). The Poisson maximum likelihood estimated standard errors are then wrong, but they can easily be corrected by using robust standard errors that allow for general heteroskedasticity.

41

Overdispersion can be introduced directly into the model by introducing an unobserved heterogeneity term, η i . Conditional on xi and η i , the yi are Poisson distributed with E yi | xi , η i = exp xi ′ β + η i = exp xi ′ β ε i

a

f

e

j

e j

If ε i is independent of xi and has a gamma distribution with E ε i = 1 and Var ε i = δ 2 , then the conditional distribution of yi given xi is negative binomial with

a f

a f

a f e j Var a y | x f = expe x ′ β j + δ

E yi | xi = exp xi ′ β

i i i

2

exp xi ′ β

e j

2

Note again, that as the conditional mean has not changed, the Poisson ML estimator is consistent in this case, but not efficient.

42

Panel Data

To allow for general correlation between xit and η i the fixed effects Poisson estimator is obtained by including N individual specific dummies in the model. This is similar to the within groups estimator in the linear model, and therefore the Poisson model does not suffer from the incidental parameter problem. This fixed effects, within groups mean scaling estimator is obtained from the regression

yit = µ it

µi

yi

+ wit

′ β and µ = 1 T µ . where µ it = exp xit ∑ it i T t =1

e j

43

#cigs age age2 lrhi hsownd unemp dkid04 female

Pooled Poisson coeff se .789 .052 -.102 .006 -.112 .020 -.586 .028 .218 .030 -.115 .028 -.202 .028

Fixed Effects Poisson coeff se .725 .078 -.095 .002 .019 .004 -.132 .008 -.016 .008 -.041 .006

# obs # indiv

89844 19070

32043 5657

44

Weak exogeneity

For both the random and fixed effects estimators, the xit have to be strictly exogenous. This assumption can be relaxed and quasidifferencing techniques can be used to allow for endogenous and/or predetermined explanatory variables. Write the panel data model with unobserved heterogeneity as

yit = exp xit ′ β uit uit = ε i vit

e j

and ε i is not correlated with vit .

45

Then

µ it

yit

−

µ it −1

yit −1

= uit − uit −1 = ε i vit − vit −1

a

f a

f

If for example xit is endogenous, E xit vit ≠ 0, valid moment conditions are yit yit −1 E xit − s − = 0, for s ≥ 2.

LM FG N Hµ

it

µ it −1

a f IJ OP KQ

Alternative moment conditions that are only valid when xit is predetermined are

LM x FG y E N H

it − s

µ it −1 − yit −1 it µ it

IJ OP = E L x F y expF −a x K Q MN H H

it − s it

46

it

− xit −1 ′ β − yit −1

f IK

I OP = 0, KQ

for s ≥ 1.

These moment conditions can be used for estimation by GMM.

**Dynamic Panel Data Methods Lecture II
**

Microeconometrics Lectures Richard Blundell UCL and IFS March 2005

47

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