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an AR(1) error term
Let’s consider a dynamic model with an unobserved fixed effect f
i
and serial correlation
of the error term u
it
as in question 2 of the problem set:
1
where u (1).
it it i it
it it it
it
y x f u
u u
AR
ρ ε
−
= + +
= +
∼
Assumptions are that x
it
may be correlated with f
i
, x
it
is uncorrelated with ε
it
and x
it
is not
strictly exogenous.
CochraneOrcutt transformation:
1 1 1
1 1 1
1 1 1
1. take lags:
y
2. multiply by :
3. substract from the original model:
y y (1 )
it it i it
it it i it
it it it it i it it
x f u
y x f u
x x f u u
β
ρ
ρ ρβ ρ ρ
ρ β ρβ ρ ρ
− − −
− − −
− − −
= + +
= + +
− = − + − + −
1
1 1 1 1
1 1
4. substitute :
y y (1 )
so that we obtain
y y (1 )
5. now we can take first differences to get
it it it
it it it it i it it it
it it it it i it
u u
x x f u u
x x f
ρ ε
ρ β ρβ ρ ρ ε ρ
ρ β ρβ ρ ε
−
− − − −
− −
= +
− = − + − + + −
= + − + − +
1 1
rid of the fixed effect,
y y
it it it it it
x x ρ β ρβ ε
− −
∆ = ∆ + ∆ − ∆ + ∆
Now the problem is the common problem in dynamic panel data: ∆ε
it
is correlated with
∆y
it1
because ε
it1
is correlated with y
it1
, but ∆ε
it
is not with further back lags of ∆y.
Moreover, x
it
is not strictly exogenous but it is uncorrelated with the present innovation
ε
it
. Let’s assume x
it
is related with past values of ε, eg. ε
it1
, ε
it2
,… Then ∆x
it
is correlated
with ∆ε
it
in the above transformed model in first differences, because x
it
is correlated with
ε
it1
. ∆x
it1
is however uncorrelated with the residual ∆ε
it
.
Hence, we need to find instruments, as outlined in question 2.3 c) for ∆y
it1
and ∆x
it
. We
can for example use y
it2
and x
it1
.
Form the matrices X and Z,
( 1) ( 1)
( 2) 1 ( 1)
1
1
[ ]
[ ]
The GMM estimator is:
( ' ' ) ' '
where,
'
[
X Y X X
Z Y X X
X ZGZ X X ZGZ Y
Z Z
G
N
E
ρ
β
ρβ
− −
− − −
−
−
= ∆ ∆ ∆
= ∆
=
Ω  
=

\ ¹
Ω = '] ε ε ∆ ∆
Method of estimating: use Z’Z in a first stage estimation to replace G, estimate the model
and obtain
ε ∆ . Use the predicted errors to obtain
G and use it to estimate the parameters
by GMM in a second regression.
Form the matrices X and Z. Z ' ΩZ G = N Ω = E[∆ε∆ε '] Method of estimating: use Z’Z in a first stage estimation to replace G.3 c) for ∆yit1 and ∆xit. X = [∆Y( −1) Z = [Y( −2) ∆X ∆X ( −1) ] X −1 ∆X ( −1) ] The GMM estimator is: ρ β = ( X ' ZGZ ' X )−1 X ' ZGZ ' Y ρβ where. Use the predicted errors to obtain G and use it to estimate the parameters by GMM in a second regression. xit is not strictly exogenous but it is uncorrelated with the present innovation εit. because xit is correlated with εit1. ∆xit1 is however uncorrelated with the residual ∆εit. Hence. Let’s assume xit is related with past values of ε. we need to find instruments. eg. We can for example use yit2 and xit1. as outlined in question 2. εit2. estimate the model and obtain ∆ε . −1 .… Then ∆xit is correlated with ∆εit in the above transformed model in first differences. εit1.Moreover.
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