Instrumental variable estimation of dynamic linear panel data models with defactored regressors and a multifactor error structure

Milda Norkutė, Vasilis Sarafidis, Takashi Yamagata and Guowei Cui

Journal of Econometrics, 2021, vol. 220, issue 2, 416-446

Abstract: This paper develops two instrumental variable (IV) estimators for dynamic panel data models with exogenous covariates and a multifactor error structure when both the cross-sectional and time series dimensions, N and T respectively, are large. The main idea is to project out the common factors from the exogenous covariates of the model, and to construct instruments based on defactored covariates. For models with homogeneous slope coefficients, we propose a two-step IV estimator. In the first step, the model is estimated consistently by employing defactored covariates as instruments. In the second step, the entire model is defactored based on estimated factors extracted from the residuals of the first-step estimation, after which an IV regression is implemented using the same instruments as in step one. For models with heterogeneous slope coefficients, we propose a mean-group-type estimator, which involves the averaging of first-step IV estimates of cross-section-specific slopes. The proposed estimators do not need to seek for instrumental variables outside the model. Furthermore, these estimators are linear, and therefore computationally robust and inexpensive. Notably, they require no bias correction. We investigate the finite sample performances of the proposed estimators and associated statistical tests, and the results show that the estimators and the tests perform well even for small N and T.

Keywords: Method of moments; Dynamic panel data; Cross-sectional dependence; Factor model (search for similar items in EconPapers)
JEL-codes: C13 C15 C23 (search for similar items in EconPapers)
Date: 2021
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (35)

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Related works:
Working Paper: Instrumental Variable Estimation of Dynamic Linear Panel Data Models with Defactored Regressors and a Multifactor Error Structure (2019)
Working Paper: Instrumental Variable Estimation of Dynamic Linear Panel Data Models with Defactored Regressors and a Multifactor Error Structure (2019)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:econom:v:220:y:2021:i:2:p:416-446

DOI: 10.1016/j.jeconom.2020.04.008

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