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Banerjee-1999-Oxford Bulletin of Economics and Statistics PDF
Banerjee-1999-Oxford Bulletin of Economics and Statistics PDF
0305-9049
Anindya Banerjee
I. INTRODUCTION
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 cross-
section of units such as countries, regions, ®rms or industries.
The empirical motivations have therefore always been important. Further-
more, with increasingly larger quantities of panel data information becom-
ing available, the investing of effort in this area of research has seemed
worthwhile, given the well-known power de®ciencies 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 de-
scribed later in the introduction.
The literature that has emerged has liberally drawn many elements from
its parent literatures. The consideration of fully modi®ed estimation techni-
ques, 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 identi®ed. Yet, as in other
instances where a new literature comes to be seen to be signi®cant, 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 suf®ce to elaborate on the
point made in the previous paragraph. From the early papers which devel-
oped 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 compli-
cated functionals of Wiener processes. In direct contrast, the asymptotics of
non-stationary panels, starting with Levin and Lin, have led to demonstra-
tions 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
in®nity. For example, one may ®x N and let the other index pass to in®nity
and subsequently allow N to tend to in®nity. This is denoted by Phillips and
Moon (1999a) as (N , T ! 1) seq . Alternatively N and T may be allowed to
pass to in®nity at a controlled rate of the type T T (N ). A third possibility
# Blackwell Publishers 1999
PANEL DATA UNIT ROOTS AND COINTEGRATION 609
is for both indexes to pass to in®nity simultaneously without any restrictions
being placed on the divergence denoted by Phillips and Moon as
(N, T ! 1). These are termed sequential, diagonal path and joint limits
respectively. Examples of the use of all three forms of limiting behaviour
are available in the literature and one of the contributions of the new
asymptotics has been to develop wherever possible the equivalences or
relations between the various modes of convergence, possibly under the
speci®cation of restrictions (see Phillips and Moon (1999a)).
Spurious regressions in panels have also been shown to have interesting
properties. Phillips and Moon (1999a) demonstrate how panel methods
allow for the estimation of a long-run relation among variables even in
cases where consideration of the time dimension alone would lead to the
regression being characterized as spurious. Thus in such cases the strong
noise in the time series regression is attenuated by pooling the cross-section
and time series observations. The meaning of this so-called long-run
relation is however open to some interpretation and, as noted in Theorem 1
of Kao (1999), the t-statistic of the estimator is divergent as in pure time
series models.
The case for the importance and distinctiveness of this literature is
therefore well established. The techniques will be developed and put to
many more varied and interesting uses in the future and this Special Issue
brings together contributions from some of the leading researchers in this
®eld. The space available in the introduction does not allow for more than a
selective consideration of the literature. McCoskey and Kao (1998b) and
Phillips and Moon (1999b) are useful overviews. Our aim here is four-fold:
®rst, to provide what might be called a catalogue raisonne of the main
techniques and papers and thereby to take stock of the literature; second, to
present a uni®ed account of the main themes which link the research in this
area; third, to place the papers in this volume within the context of the
literature; and fourth, to put forward new areas for research. The discussion
is divided into two main sections consisting of testing for unit roots and
testing for cointegration. Among papers in the former category are Im,
Pesaran and Shin (1997), Kao (1999), Levin and Lin (1992, 1993), Quah
(1994) and the papers by G. S. Maddala and Shaowen Wu and by Hyungsik
Moon and Peter Phillips in the Special Issue, while in the latter belong Kao
and Chiang (1998), Pedroni (1995, 1996, 1997a), McCoskey and Kao
(1998a), Phillips and Moon (1999a) and the contributions by Peter Pedroni
and Stephen Hall, Stepana Lazarova and Giovanni Urga printed here.
Two further papers are worth mentioning here since they have an
important bearing on this literature and are the motivator of the Hall et al.
analysis in this volume. Robertson and Symons (1992) and Pesaran and
Smith (1995) (extended in Im, Pesaran and Smith (1996)) were very
in¯uential in demonstrating the inconsistency of estimators in dynamic
heterogeneous panels which use pooled or aggregated data and recom-
mended the use of group-mean estimators. The latter is the basis of the unit
# Blackwell Publishers 1999
610 BULLETIN
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 modi®ed.
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 cointegra-
tion. 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 contribu-
tion 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 maximum-
likelihood-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 conver-
gence in probability The non-stochastic limit (in®nite 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.
For all i and t, æ i, t has ®nite non-zero fourth moments, the variance of the
innovation process å i, t is bounded from below away from zero and the
variation at frequency zero (long-run variance) of æ i, t is bounded above.
Levin and Lin (1993) prescribe the use of augmented Dickey±Fuller
(ADF) test to each individual series as the starting point of their testing
procedure for unit roots. Thus, the regressions (for each i)
X
pi
Ä yi, t r i yi, tÿ1 èij Ä yi, tÿ j á i å i, t , t 1, 2, . . . , T (7)
j1
is estimated by regressing ®rst Ä yi, t and then yi, tÿ1 on the remaining
^ i, tÿ1 respectively. The
variables in (7), providing the residuals ^e i, t and V
^
regression of ^e i, t on V i, tÿ1
^ i, tÿ1 å i, t
^e i, t r i V (8)
is then estimated to derive r ^ i from the ith cross-section. The following
expressions are next required:
X
T
ó^ 2e i (T ÿ pi ÿ 1)ÿ1 ^ i, tÿ1 )2
^iV
(^e i, t ÿ r
t pi 2
~e i, t ^e i, t =ó^ e i
~ i, tÿ1 V
V ^ i, tÿ1 =ó^ e i
!2
X
T X
K X
T
ó^ 2yi (T ÿ 1)ÿ1 Ä y2i, t 2 w K L (T ÿ 1)ÿ1 Ä yi, t Ä yi, tÿ L
t2 L1 t L2
X
N
S^ N ,T N ÿ1 (ó^ yi =ó^ 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.
X
N X
T
~ ÿ1
ó^ 2å (N T) ^V
(~e i, t ÿ r ~ i, tÿ1 )2
i1 t pi 2
X
N
p N ÿ1 pi , T~ (T ÿ p ÿ 1):
i1
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.
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,
Ø LM ) N(0, 1) (19)
as T, N ! 1 and N=T ! k where k is a ®nite positive constant. For the
test to be consistent under the alternative, it is also required that
lim N !1 (N1 =N ) ë1 , 0 , ë1 < 1. p Under
this further assumption, Ø LM
diverges to positive in®nity at rate T N under the alternative.
Im et al. (1997) also propose the use of a group-mean t-bar statistic given
by
( )
p X
N
ÿ1
N t N ,T ÿ N E[t i,T ( pi , 0)jr i 0]
i1
Øt s , (20)
X N
N ÿ1 Var[t i,T ( pi , 0)jr i 0]
i1
where
X
N
ÿ1
t N ,T N t i,T ( pi , è i ), (21)
i1
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 á i ä i t x9i, t â i e i, t , t 1, 2, . . . , T ; i 1, . . . , N ; (23)
where â i (â1i , â2i , . . . , â Mi )9, xi, t (x1i, t , x2i, t , . . . , x Mi, t )9. This formu-
lation therefore allows for considerable heterogeneity in the panel, since
heterogeneous slope coef®cients, ®xed effects and individual speci®c
deterministic trends are all permitted.
Under H 0, de®ning z i, t ( yi, t , x9i, t )9, î9i, t (î i,y t , î x9
i, t ),
z i, t z i, tÿ1 î i, t , (24)
where the process î9i, t satis®es
1 X
[Tr]
p î i, t ) Bi (Ù i ) for each i as T ! 1:
T t1
4
In a similar vein, Hadri (1998) develops a test of the null of trend versus difference
stationarity.
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.
~ :
Q V ÿ â9W (33)
The vector of Brownian motion functionals is then given by
9 2 ~
Q , Q dQ, â9â : ~ (34)
Levin and Lin estimators, generalizes to all seven of the Pedroni estimators,
so that
p
ê N ,T ÿ ì N
p ) N (0, 1) (37)
í
for the appropriately standardized statistic and corrections for mean and
variance. The correction factors ì and í depend on (a) the statistic consid-
ered; (b) the dimension of M; and (c) whether or not unit-speci®c 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).
X
N X
T
1
N
1
T2 S y2
i, t
i1 t1
LM (41)
^ 21:2
$
and
X
t
S y
i, t ( yy i,k ÿ á i ÿ âc
y 9x ):
i i,k
k1
V. CONCLUSION
This volume contains descriptions and the use of all the major testing and
estimation procedures for unit roots and cointegration in heterogeneous
# Blackwell Publishers 1999
626 BULLETIN
REFERENCES
Baltagi, B. H. (1995). Econometric Analysis of Panel Data, Wiley, Chichester.
Banerjee, A., Dolado, J., Galbraith, J. W. and Hendry, D. F. (1993). Co-integration,
Error Correction and the Econometric Analysis of Non-Stationary Data, Oxford
University Press, Oxford.
Bernard, A. and Jones, C. (1996). `Productivity Across Industries and Countries:
Time Series Theory and Evidence', Review of Economics and Statistics, 78,
135±146.
Breitung, J. and Mayer, W. (1994). `Testing for Unit Roots in Panel Data: Are
Wages on Different Bargaining Levels Cointegrated?', Applied Economics, 26,
353±361.
Cechetti, S. G., Mark, N. C. and Sonora, R. (1999). `Price Level Convergence
Among United States Cities: Lessons for the European Central Bank', Mimeo.
Coakley, J. and Fuertes, A. (1997). `New Panel Unit Root Tests of PPP', Economics
Letters, 57, 17±22.
9
The only class of tests not discussed here is due to Harris and Tzavalis (1999) who derive
asymptotic unit root tests for ®rst-order autoregressive panel data models, assuming that the time
dimension of the panel is ®xed. They show that when ®xed effects or individual trends are
included in the regressors, the least squares estimator is inconsistent and the test statistic must be
adjusted appropriately.