Bank of Lithuania
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No 91

The Factor Analytical Approach in Trending Near Unit Root Panels

  • Abstract

    In this study, we re-visit the factor analytical (FA) approach for (near unit root) dynamic panel data models, whose asymptotic distribution has been shown to be normal and well centered at zero without the need for valid instruments or correction for bias. It is therefore very appealing. The question is: Does the appeal of FA, which so far has only been documented for fixed effects panels, extends to panels with incidental trends? This is an important question, because many persistent variables are trending. The answer turns out to be negative. In particular, while consistent, the asymptotic normality of FA breaks down when there is an exact unit root present, which limits its applicability.

    Keywords: Dynamic panel data models, Unit root, Factor analytical method

    JEL codes: C12, C13, C33

    The views expressed are those of the author(s) and do not necessarily represent those of the Bank of Lithuania.