Chapter 2. Dynamic panel data models

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1 Chapter 2. Dynamic panel data models Master of Science in Economics - University of Geneva Christophe Hurlin, Université d Orléans Université d Orléans April 2010

2 Introduction De nition We now consider a dynamic panel data model, in the sense that it contains (at least) a lagged dependent variables. For simplicity, let us consider y it = γy i,t 1 + β 0 x it + α i + λ t + ε it for i = 1,.., N and t = 1,.., T. αi and λ t are the (unobserved) individual and time-speci c e ects, and ε it the error (idiosyncratic) term with E (ε it ) = 0, and E (ε it ε js ) = σ 2 ε if j = i and t = s, and E (ε it ε js ) = 0 otherwise.

3 Introduction Fact It turns out that in this circumstance the choice between a xed-e ects formulation and a random-e ects formulation has implications for estimation that are of a di erent nature than those associated with the static model.

4 Introduction 1 If lagged dependent variables also appear as explanatory variables, strict exogeneity of the regressors no longer holds. The LSDV is no longer consistent when N tends to in nity and T is xed. 2 The initial values of a dynamic process raise another problem. It turns out that with a random-e ects formulation, the interpretation of a model depends on the assumption of initial observation.

5 Introduction 1 The consistency property of the MLE and the generalized leastsquares estimator (GLS) also depends on this assumption and on the way in which the number of time-series observations (T ) and the number of crosssectional units (N) tend to in nity.

6 The dynamic panel bias Section 1. The dynamic panel bias

7 The dynamic panel bias 1 The LSDV (or CV) estimator is consistent for the static model whether the e ects are xed or random. 2 In this section we show that the LSDV (or CV) is inconsistent for a dynamic panel data model with individual e ects, whether the e ects are xed or random.

8 The dynamic panel bias De nition The biais of the LSDV estimator in a dynamix model is generaly known as dynamic panel bias or Nickell s bias (1981). Nickell, S. (1981). Biases in Dynamic Models with Fixed E ects, Econometrica, 49, Anderson, T.W., and C. Hsiao (1982). Formulation and Estimation of Dynamic Models Using Panel Data, Journal of Econometrics, 18,

9 The dynamic panel bias De nition Consider the simple dynamic model y it = γy i,t 1 + α i + ε it for i = 1,.., N and t = 1,.., T. For simplicity, let us assume that α i = α + α i to avoid imposing the restriction that N i=1 α i = 0 (or E (α i ) = 0 in the case of random individual e ects).

10 The dynamic panel bias We also assume that: 1 The autoregressive parameter γ satis es jγj < 1 2 The initial condition y i0 is observable. 3 The error term satis es with E (ε it ) = 0, and E (ε it ε js ) = σ 2 ε if j = i and t = s, and E (ε it ε js ) = 0 otherwise.

11 The dynamic panel bias In this model, the LSDV estimator is de ned by bα i = y i bγ LSDV y i, 1 bγ LSDV = " N T i=1 t=1 " N (y i,t 1 y i, 1 ) 2 # 1 T i=1 t=1 (y i,t 1 y i, 1 ) (y it y i ) # x i = 1 T T t=1 x it y i = 1 T T t=1 y it y i, 1 = 1 T T y i,t 1 t=1

12 The dynamic panel bias De nition The bias of the LSDV estimator is given by: bγ LSDV γ = N i=1 T t=1 N i=1 (y i,t 1 y i, 1 ) (ε it ε i ) / (NT ) T t=1 (y i,t 1 y i, 1 ) 2 / (NT )

13 The dynamic panel bias Let us consider the numerator. Because ε it are uncorrelated with α i are independently and identically distributed, we have 1 plim (NT ) N! 1 = plim NT N! 1 plim NT N! N i=1 T t=1 T t=1 N i=1 T t=1 (y i,t 1 y i, 1 ) (ε it ε i ) 1 y i,t 1 ε it plim NT N i=1 y i, N! 1 1 ε it + plim NT N! T t=1 N i=1 T t=1 y i,t N i=1 y i, 1 ε i 1 ε i

14 The dynamic panel bias By de nition plim (NT ) 1 N! N T i=1 t=1 y i,t 1 ε it = E (y i,t 1 ε it ) = 0 since y i,t 1 only depends on ε i,t 1, ε i,t 2, etc.

15 The dynamic panel bias Besides, we have: 1 plim NT N! N i=1 T t=1 1 y i,t 1 ε i = plim NT N! 1 = plim NT N! N T ε i y i,t 1 i=1 t=1 N ε i T y i, 1 i=1 N 1 = plim N! N ε i y i, 1 i=1

16 The dynamic panel bias In the same way: 1 plim NT N! 1 plim NT N! N i=1 T t=1 T t=1 N i=1 y i, y i, N 1 1 ε it = plim N! N y i, i=1 N 1 1 ε i = plim N! N y i, i=1 1 ε i 1 ε i

17 The dynamic panel bias Fact The numerator of the expression of the LSDV bias can be simpli ed as follows: 1 plim (NT ) N! N i=1 T t=1 1 (y i,t 1 y i, 1 ) (ε it ε i ) = plim N N! N y i, i=1 1 ε i

18 The dynamic panel bias Let us examine this plim. By continous substitution, we have: y it = ε it + γε i,t 1 + γ 2 ε i,t γ t 1 ε i1 + 1 γt 1 γ α i + γ t y i0 For y i,t 1, we have y i,t 1 = ε i,t 1 + γε i,t 2 + γ 2 ε i,t γ t 2 ε i1 + 1 γt 1 1 γ α i + γ t 1 y i0

19 The dynamic panel bias Fact Summing y i,t 1 over t, we have: T y i,t 1 = ε i,t γ2 t=1 1 γ ε i,t γt 1 1 γ ε i1 (T 1) T γ + γt + (1 γ) 2 αi + 1 γt 1 γ y i0 = T y i, 1

20 The dynamic panel bias Example Demonstration: we have (each lign corresponds to a date) T y i,t 1 = y i,t 1 + y i,t y i,1 + y i,0 t=1 = ε i,t 1 + γε i,t γ T 2 ε i1 + 1 γt 1 +ε i,t 2 + γε i,t γ T 3 ε i1 + 1 γt ε i,1 + 1 γ1 1 γ α i + γy i0 +y i0 1 γ α i + γ T 1 y i0 1 γ α i + γ T 2 y i0

21 The dynamic panel bias Example For the individual e ect αi, we have = αi h1 γ + 1 γ γ T 1i 1 γ αi ht 1 γ γ 2.. γ T 1i 1 γ T αi 1 γ = T 1 γ 1 γ = α i T T γ 1 + γ T (1 γ) 2

22 The dynamic panel bias So, we have 1 plim N N! 1 = plim N N! N i=1 N i=1 y i, 1 T 1 ε i ε i,t γ2 1 γ ε i,t γt 1 1 γ ε i1 # (T 1) T γ + γt + (1 γ) 2 αi + 1 γt 1 γ y i0 1 T (ε i ε it )

23 The dynamic panel bias De nition Because ε it are uncorrelated, independently and identically distributed, by a law of large numbers, we have: 1 plim (NT ) N! N i=1 T t=1 N 1 = plim N! N y i, 1 ε i i=1 σ = 2 ε (T 1) T γ + γ T T 2 (1 γ) 2 (y i,t 1 y i, 1 ) (ε it ε i )

24 The dynamic panel bias By similar manipulations we can show that the denominator of bγ LSDV converges to: = 1 plim N! (NT ) " σ 2 ε 1 γ 2 1 N i=1 1 T T t=1 (y i,t 1 y i, 1 ) 2 # 2γ (T 1) T γ + γt 2 (1 γ) T 2

25 The dynamic panel bias Fact If T also tends to in nity, then the numerator converges to zero, and denominator converges to a nonzero constant σ 2 ε / 1 γ 2, hence the LSDV estimator of γ and α i are consistent. Fact If T is xed, then the denominator is a nonzero constant, and bγ LSDV and bα i are inconsistent estimators no matter how large N is.

26 The dynamic panel bias So, we have : plim (bγ LSDV γ) = N! h σ 2 ε γ 2 T σ 2 ε (T 1) T γ+γ T T 2 (1 γ) 2 2γ (T 1) T γ+γt (1 γ) 2 T 2 i plim (bγ LSDV γ) = N! h T 2 T (T 1) T γ + γ T i 2γT 2 ((T 1) T γ + γ T ) (1 γ) 2

27 The dynamic panel bias De nition In a dynamic panel model with individual e ects, the asymptotic bias (with N) of the LSDV estimator on the autoregressive parameter is equal to: plim (bγ LSDV γ) = N! 1 + γ T γ T T 1 γ 2γ (1 γ) (T 1) 1 1 γ T 1 T (1 γ)

28 The dynamic panel bias Fact The bias of bγ LSDV is caused by having to eliminate the unknown individual e ects αi from each observation, which creates a correlation of order (1/T ) between the explanatory variables and the residuals in the transformed model (y it y i ) = γ (y i,t 1 y i, 1 ) + (ε it ε i )

29 The dynamic panel bias 1 When T is large, the right-hand-side variables become asymptotically uncorrelated. 2 For small T, this bias is always negative if γ > 0. 3 Nor does the bias go to zero as γ goes to zero

30 The dynamic panel bias Example For instance, when T = 2, the asymptotic bias is equal to (1 + γ) /2, and when T = 3, it is equal to (2 + γ) (1 + γ) /2. Even with T = 10 and γ = 0.5, the asymptotic bias is

31 The dynamic panel bias Fact The LSDV for dynamic individual-e ects model remains biased with the introduction of exogenous variables if T is small; for details of the derivation, see Nickell (1981); Kiviet (1995). y it = α + γy i,t 1 + β 0 x it + α i + ε it In this case, both estimators bγ LSDV and bβ LSDV are biased.

32 The dynamic panel bias What are the solutions? consistent estimator of γ can be obtained by using: 1 ML or FIML (but additional assumptions on y i0 are necessary) 2 Feasible GLS (but additional assumptions on y i0 are necessary) 3 LSDV bias corrected (Kiviet, 1995) 4 IV approach (Anderson and Hsiao, 1982) 5 GMM approach (Arenallo and Bond, 1985)

33 Section 2. The Instrumental Variable (IV) approach

34 We now consider a dynamic panel data model with random individual e ects: y it = γy i,t 1 + β 0 x it + ρ 0 z i + α i + ε it for i = 1,.., N and t = 1,.., T. αi are the (unobserved) individual e ects, x it is a vector of K 1 time-invariant explanatory variables, z i is a vector of K 2 time-invariant explanatory variables and ε it the error (idiosyncratic) term with E (ε it ) = 0, and E (ε it ε js ) = σ 2 ε if j = i and t = s, and E (ε it ε js ) = 0 otherwise.we assume that : E (α i ) = 0 E (α i x it ) = 0 E (ε it x it ) = 0

35 In a vectorial form, we have: y i = y i, 1 γ + X i β + ez 0 i ρ + eα i + ε it with X i now denoting the T K 1 time-varying explanatory variables, z i being the 1 K 2 time-invariant explanatory variables including the intercept term, and E (α i ) = 0 E α i xit 0 = 0 E αi zi 0 = 0

36 Example Reminder: The standard approach in cases where right-hand side variables are correlated with the residuals is to estimate the equation using instrumental variables regression. 1 The idea behind instrumental variables is to nd a set of variables, termed instruments, that are both (1) correlated with the explanatory variables in the equation, and (2) uncorrelated with the disturbances. 2 These instruments are used to eliminate the correlation between right-hand side variables and the disturbances.

37 Example Two-stage least squares (TSLS) is a special case of instrumental variables regression. As the name suggests, there are two distinct stages in two-stage least squares. 1 In the rst stage, TSLS nds the portions of the endogenous and exogenous variables that can be attributed to the instruments.this stage involves estimating an OLS regression of each variable in the model on the set of instruments. 2 The second stage is a regression of the original equation, with all of the variables replaced by the tted values from the rst-stage regressions. The coe cients of this regression are the TSLS estimates.

38 Example More formally, let be Z the matrix of instruments, and let y and X be the dependent and explanatory variables. Then the coe cients computed in two-stage least squares are given by bβ TLS = X 0 Z Z 0 Z 1 Z 0 X 1 X 0 Z Z 0 Z 1 Z 0 y

39 In the dynamic panel data models context, the Instrumental Variable (IV) approach was rst proposed by Anderson and Hsiao (1982). Anderson, T.W., and C. Hsiao (1982). Formulation and Estimation of Dynamic Models Using Panel Data, Journal of Econometrics, 18,

40 This estimation method consists of the following procedure. 1 First step: Taking the rst di erence of the model, we obtain (y it y i,t 1 ) = γ (y i,t 1 y i,t 2 ) + β 0 (x it x i,t 1 ) + ε it ε i,t 1 for t = 2,.., T. 2 Second step: Because y i,t 2 or (y i,t 2 y i,t 3 ) are correlated with (y i,t 1 y i,t 2 ) but are uncorrelated with ε it ε i,t 1 they can be used as an instrument for (y i,t 1 y i,t 2 )and estimate γ and by the instrumental-variable method.

41 Then, the following estimator is consistent. bγiv bβ IV = T i=1 t=3 " N T i=1 t=3 (yi,t 1 y i,t 2 ) (y i,t 2 y i,t 3 ) (y i,t 2 y i,t 3 ) (x it x i,t 1 ) (x it x i,t 1 ) (y i,t 2 y i,t 3 ) (x it x i,t 1 ) (x it x i,t 1 ) 0 " N # yi,t 2 y i,t 3 (y i,t y i,t 1 ) x it x i,t 1

42 Another consistent estimator is:. " bγiv N = bβ IV T i=1 t=2 T i=1 t=2 (yi,t 1 y i,t 2 ) y i,t 2 y i,t 2 (x it x i,t 1 ) 0 (x it x i,t 1 ) y i,t 2 (x it x i,t 1 ) (x it x i,t 1 ) 0 " N # y i,t 2 (y x it x i,t y i,t 1 ) i,t 1 1

43 1 The second estimator has an advantage over the rst one, in that the minimum number of time periods required is two, whereas the rst one requires T 3. 2 In practice, if T 3, the choice between both depends on the correlations between (y i,t 1 y i,t 2 ) and y i,t 2 or (y i,t 2 y i,t 3 ).

44 1 Third step: given the estimates bγ IV and bβ IV, we can deduce an estimate of ρ (the vector of parameters for the time invariant variables) for i = 1,.., N. Let us consider, the following equation y i bγ IV y i, 1 bβ 0 IV x i = ρ 0 z i + v i with v i = α i + ε i The parameters vector ρ can simply be estimated by OLS.

45 1 Step four: given bγ IV, bβ IV, and bρ, we can estimate the variances as follows: bσ 2 ε = 1 N (T 1) T t=2 N i=1 bβ 0 IV (x i,t x i,t 1 ) [(y i,t y i,t 1 ) bγ IV (y i,t 1 y i,t 2 ) 2 bσ 2 α = 1 N N 2 y i bγ IV y i, 1 bβ 0 IV x i bρ 0 1 z i i=1 T bσ2 ε

46 Theorem The instrumental-variable estimators of γ, β, and σ 2 ε are consistent when N or T or both tend to in nity. The estimators of ρ and σ 2 α are consistent only when N goes to in nity. They are inconsistent if N is xed and T tends to in nity.

47 GMM: a general presentation Application to dynamic panel data models Section 3.

48 GMM: a general presentation Application to dynamic panel data models Fact We note that y i,t 2 or (y i,t 2 y i,t 3 ) is not the only instrument for (y i,t 1 y i,t 2 ). In fact, it is noted by Arellano and Bond (1991) that all y i,t 2 j, j = 0, 1,.., satisfy the conditions E [y i,t 2 j (y i,t 1 y i,t 2 )] 6= 0 E [y i,t 2 j (ε i,t ε i,t 1 )] = 0 Therefore, they all are legitimate instruments for (y i,t 1 y i,t 2 ). Arellano, M., and S. Bond (1991). Some Tests of Speci cation for Panel Data: Monte Carlo Evidence and an Application to Employment Equations, Review of Economic Studies, 58,

49 GMM: a general presentation Application to dynamic panel data models Let us consider the same dynamic panel data model as before y it = γy i,t 1 + β 0 x it + ρ 0 z i + α i + ε it for i = 1,.., N and t = 1,.., T. αi are the (unobserved) individual e ects, x it is a vector of K 1 time-invariant explanatory variables, z i is a vector of K 2 time-invariant explanatory variables and ε it the error (idiosyncratic) term with E (ε it ) = 0, and E (ε it ε js ) = σ 2 ε if j = i and t = s, and E (ε it ε js ) = 0 otherwise.we assume that : E (α i ) = 0 E (α i x it ) = 0

50 GMM: a general presentation Application to dynamic panel data models De nition The GMM estimation method is also based on the rst di erence of the model (to swip ou the individual e ects α i and the time unvariant variables z i ): (y it y i,t 1 ) = γ (y i,t 1 y i,t 2 ) + β 0 (x it x i,t 1 ) + ε it ε i,t 1 for t = 2,.., T.

51 GMM: a general presentation Application to dynamic panel data models Fact We assume that the time varying explanatory variables x it are strictly exogeneous in the sense that: E x 0 it ε is = 0 8 (t, s)

52 GMM: a general presentation Application to dynamic panel data models De nition Letting = (1 L) where L denotes the lag operator and q it (t 1+TK 1,1) = y i0, y i1,.., y i,t 2, xi 0 0 where xi 0 = (xi1 0,.., x it 0 ), for each périod we have the following orthogonal conditions E (q it ε it ) = 0, t = 2,.., T

53 GMM: a general presentation Application to dynamic panel data models Stacking the (T 1) rst-di erenced equations in matrix form, we have y i = y i, 1 γ + X i β + ε i i = 1,.., N where : 0 y i = (T 1,1) y i2 y i3.. y i1 y i2 y it y i,t C A y i, 1 = (T 1,1) y i1 y i2.. y i0 y i1 y it 1 y i,t 2 1 C A

54 GMM: a general presentation Application to dynamic panel data models 0 X i = (T 1,K 1 ) x i2 x i3.. x i1 x i2 x it x i,t 1 1 C A 0 ε i = (T 1,1) ε i2 ε i3 ε i1 ε i2.. ε it ε i,t 1 1 C A

55 GMM: a general presentation Application to dynamic panel data models De nition The T (T 1) (K 1 + 1/2) orthogonality (or moment) conditions can be represented as 0 W i = q i2 (1+TK 1,1) E (W i ε i ) = 0 0 q i3 (2+TK 1,1) q it (T 1+TK 1,1) is of dimension [T (T 1) (K 1 + 1/2)] (T 1)... 1 C A

56 GMM: a general presentation Application to dynamic panel data models Proof. The total number of ligns of the matrix W i (equal to the number of orthognal conditions) is equal to: 1 + TK TK TK 1 + (T 1) = T (T 1) K (T 1) T (T 1) = T (T 1) K = T (T 1) (K 1 + 1/2)

57 GMM: a general presentation Application to dynamic panel data models De nition The number of othogonal conditions (moments), e.g. T (T 1) (K 1 + 1/2), is much larger than the number of parameters,e.g. K Thus, Arellano and Bond (1991) suggest a generalized method of moments (GMM) estimator.

58 GMM: a general presentation Application to dynamic panel data models Now we relax the assumption of exogeneity, and we assume only that explanatory variables are pre-determined, that is: E x 0 it ε is = 0 if t s

59 GMM: a general presentation Application to dynamic panel data models In this case, we have E (q it ε it ) = 0, t = 2,.., T q it = y i0, y i1,.., y i,t 2, xi1, 0.., x 0 0 it (t 1+tK 1,1)

60 GMM: a general presentation Application to dynamic panel data models De nition If the explanatory variables are pre-determined, there are T (T 1) (K 1 + 1) /2 orthogonality (or moment) conditions that can be represented as 0 W i = q i2 (1+K 1,1) E (W i ε i ) = 0 0 q i3 (2+2K 1,1) q it (T 1+(T 1)K 1,1) is of dimension [T (T 1) (K 1 + 1) /2] (T 1). 1 C A

61 GMM: a general presentation Application to dynamic panel data models Proof. The total number of ligns of the matrix W i (equal to the number of orthognal conditions) is equal to: 1 + K K (T 1) K 1 + (T 1) = (1 + K 1 ) [ (T 1)] T (T 1) = (1 + K 1 ) 2

62 GMM: a general presentation Application to dynamic panel data models De nition Whatever the assumption made on the explanatory variable, we have largely more orthogonal conditions than parameters to estimate: E (W i ε i ) = 0 and we can use GMM to estimate θ = γ, β 0 in y i = y i, 1 γ + X i β + ε i i = 1,.., N

63 GMM: a general presentation Application to dynamic panel data models 3.1. GMM: a general presentation

64 GMM: a general presentation Application to dynamic panel data models De nition The standard method of moments estimator consists of solving the unknown parameter vector θ by equating the theoretical moments with their empirical counterparts or estimates.

65 GMM: a general presentation Application to dynamic panel data models 1 Suppose that there exist relations m (y; θ) such that E [m (y; θ 0 )] = 0 where θ 0 is the true value of θ, where m (y; θ 0 ) is a r 1 vector. 2 Let bm (y, θ) be the sample estimates m (y, θ) of based on N independent samples of y i bm (y, θ) = (1/N) N i=1 m (y i ; θ) 3 Then the method of moments estimator of θ is to nd bθ, such that bm y, bθ = 0

66 GMM: a general presentation Application to dynamic panel data models Fact If the number r of equations (moment) is equal to the dimension a of θ, it is in general possible to solve for bθ uniquely. The system is just identi ed.

67 GMM: a general presentation Application to dynamic panel data models Example Let us assume that y have a t-distrubtion with v degree of freedom. We want to estimate v from a sample fy 1,..y N g where the y i are i.i.d. and have the same distribution as y. We know that the two rst uncentered moments are: µ 1 = E (y) = 0 µ 2 = E y 2 = var (y) = v v 2 If µ 2 is known, then v can be derived from : v = 2E y 2 E (y 2 ) 1

68 GMM: a general presentation Application to dynamic panel data models Example Now let us consider the sample estimate bµ 2,T bµ 2,T = 1 T T yt 2 i=1 we know that bµ 2,T p! T! µ 2

69 GMM: a general presentation Application to dynamic panel data models Example So, a consistent estimate (classical method of moment) of v is de ned by: bv = 2bµ 2,T bµ 2,T 1

70 GMM: a general presentation Application to dynamic panel data models Example Another way to write the problem. Let us de ne By de nition, we have: m (y; v) = y 2 E [m (y; v)] = E y 2 v v 2 v = 0 v 2

71 GMM: a general presentation Application to dynamic panel data models Example Let us de ne bm (y; v) = 1 N N i=1 m (y i ; v) = 1 N N i=1 y 2 i v v 2 So the estimator bv of the classical method of moment is de ned by: bm (y; bv) = 0

72 GMM: a general presentation Application to dynamic panel data models De nition If the number r of equations (moments) is greater than the dimension a of θ, the system of non linear equation bm (y; bv) = 0, in general has no solution. It is then necessary to minimize some norm (or distance measure) of bm y; bθ, say 0 bm y; bθ A bm y; bθ where A is is some positive de nite matrix. The system is sur-identi ed.

73 GMM: a general presentation Application to dynamic panel data models What is the optimal weigthing matrix? The property of the estimator thus obtained depends on A. The optimal choice (if there is no autocorrelation of m (y; θ 0 )) of A turns out to be A = E [m (y; θ 0 ) m (y; θ 0 )] 0 1 De nition The GMM estimation of is to choose bθ such that it minimizes the criteria bm y; ˆθ 0 A bm y; bθ bθ = ArgMin fθ2r a g q (y, θ) = ArgMin fθ2r a g

74 GMM: a general presentation Application to dynamic panel data models De nition Remark: if we assume that thre is autocorrelation in m (y; θ 0 ), the optimal weighting matrix is given by by the inverse of the long run variance covariance matrix of m (y; θ 0 ): A (r,r ) = " E # 1 h (θ 0, w t ) h (θ 0, w t v ) 0 j=

75 GMM: a general presentation Application to dynamic panel data models 3.2. Application to dynamic panel data models

76 GMM: a general presentation Application to dynamic panel data models Fact Let us consider the model y i = y i, 1 γ + X i β + ε i i = 1,.., N We want to estimate the K parameters of the θ = γ, β 0 0 vector. For that, we have T (T 1) (K 1 + 1/2) moment conditions (if x it are strictly exogeneous) that can be represented as E (W i ε i ) = E [W i ( y i y i, 1 γ X i β)] = 0

77 GMM: a general presentation Application to dynamic panel data models Let us denote m (y i, x i ; θ) = W i ( y i y i, 1 γ X i β) with E [m (y i, x i ; θ)] = 0

78 GMM: a general presentation Application to dynamic panel data models De nition The Arellano and Bond GMM estimator of θ = γ, β 0 0 is bθ = ArgMin fθ2r K 1 +1 g 1 N! 0 N m (y i, x i ; θ) A 1 i=1 N! N m (y i, x i ; θ) i=1 or equivalently bθ = ArgMin fθ2r K 1 +1 g 1 N! N εi 0 Wi 0 A 1 i=1 N! N W i ε i i=1 with A = E [m (y; θ 0 ) m (y; θ 0 )] 0 1

79 GMM: a general presentation Application to dynamic panel data models De nition The optimal weighting matrix can be estimated by ba = " E!# 1 N 1 N 2 W i ε i εi 0 Wi 0 i=1

80 GMM: a general presentation Application to dynamic panel data models In addition to the previous moment conditions, Arellano and Bover (1995) also note that E (ε i ) = 0, where v i = y i y i, 1 γ x 0 i β ρ 0 z i Therefore, if instruments eq i exist (for instance, the constant 1 is a valid instrument) such that E (eq i v i ) = 0 then a more e cient GMM estimator can be derived by incorporating this additional moment condition. Arellano, M., and O. Bover (1995). Another Look at the Instrumental Variable Estimation of Error-Components Models, Journal of Econometrics, 68,

81 GMM: a general presentation Application to dynamic panel data models Apart from the previous linear moment conditions, Ahn and Schmidt (1995) note that the homoscedasticity condition on E v 2 it implies the following T 2 linear conditions E (y it ε i,t+1 y i,t+1 ε i,t+1 ) = 0 t = 1,.., T 2 Combining these restrictions to the previous ones leads to a more e cient GMM estimator. Ahn, S.C., and P. Schmidt (1995). E cient Estimation of Models for Dynamic Panel Data, Journal of Econometrics, 68, 5 27.

82 GMM: a general presentation Application to dynamic panel data models 1 While theoretically it is possible to add additional moment conditions to improve the asymptotic e ciency of GMM, it is doubtful how much e ciency gain one can achieve by using a huge number of moment conditions in a nite sample. 2 Moreover, if higher-moment conditions are used, the estimator can be very sensitive to outlying observations.

83 GMM: a general presentation Application to dynamic panel data models 1 Through a simulation study, Ziliak (1997) has found that the downward bias in GMM is quite severe as the number of moment conditions expands, outweighing the gains in e ciency. 2 The strategy of exploiting all the moment conditions for estimation is actually not recommended for panel data applications. For further discussions, see Judson and Owen (1999), Kiviet (1995), and Wansbeek and Bekker (1996).

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