Untangling Fixed Effects and Constant Regressors

Franc Klaassen and Rutger Teulings
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Rutger Teulings: University of Amsterdam, the Netherlands

No 15-137/VI, Tinbergen Institute Discussion Papers from Tinbergen Institute

Abstract: Fixed effects (FE) in panel data models overlap each other and prohibit the identification of the impact of ''constant'' regressors. Think of regressors that are constant across countries in a country-time panel with time FE. The traditional approach is to drop some FE and constant regressors by normalizing their impact to zero. We introduce ''untangling normalization'', meaning that we orthogonalize the FE and, if present, the constant regressors. The untangled FE are much easier to interpret. Moreover, the impact of constant regressors can now be estimated, and the untangled FE indicate to what extent the estimates reflect the true value. Our untangled estimates are a linear transformation of the traditional, zero-normalized estimates; no new estimation is needed. We apply the approach to a gravity model for OECD countries' exports to the US. The constant regressors US GDP, world GDP and the US effective exchange rate explain 90% of the time FE, making the latter redundant, so the estimated impacts indeed reflect the true value.

Keywords: gravity model; fixed effects; multicollinearity; normalization; orthogonalization (search for similar items in EconPapers)
JEL-codes: C18 C23 F14 (search for similar items in EconPapers)
Date: 2015-12-24
New Economics Papers: this item is included in nep-ecm
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Citations: View citations in EconPapers (5)

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Related works:
Working Paper: Untangling Fixed Effects and Constant Regressors (2016)
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Persistent link: https://EconPapers.repec.org/RePEc:tin:wpaper:20150137

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