How to Detect Network Dependence in Latent Factor Models? A Bias-Corrected CD Testy

Mohammad Pesaran and Yimeng Xie

Cambridge Working Papers in Economics from Faculty of Economics, University of Cambridge

Abstract: In a recent paper Juodis and Reese (2022) (JR) show that the application of the CD test proposed by Pesaran (2004) to residuals from panels with latent factors results in over-rejection. They propose a randomized test statistic to correct for over-rejection, and add a screening component to achieve power. This paper considers the same problem but from a different perspective, and shows that the standard CD test remains valid if the latent factors are weak in the sense the strength is less than half. In the case where latent factors are strong, we propose a bias-corrected version, CD*, which is shown to be asymptotically standard normal under the null of error cross-sectional independence and have power against network type alternatives. This result is shown to hold for pure latent factor models as well as for panel regression models with latent factors. The case where the errors are serially correlated is also considered. Small sample properties of the CD* test are investigated by Monte Carlo experiments and are shown to have the correct size for strong and weak factors as well as for Gaussian and non-Gaussian errors. In contrast, it is found that JR's test tends to over-reject in the case of panels with non-Gaussian errors, and has low power against spatial network alternatives. In an empirical application, using the CD* test, it is shown that there remains spatial error dependence in a panel data model for real house price changes across 377 Metropolitan Statistical Areas in the U.S., even after the effects of latent factors are Filtered out.

Keywords: Latent Factor Models; Strong and Weak Factors; Error Cross-Sectional Independence; Spatial and Network Alternatives; Size and Power (search for similar items in EconPapers)
JEL-codes: C18 C23 C55 (search for similar items in EconPapers)
Date: 2021-08-05
New Economics Papers: this item is included in nep-ecm, nep-isf and nep-ore
Note: mhp1
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (5)

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Related works:
Working Paper: How to Detect Network Dependence in Latent Factor Models? A Bias-Corrected CD Test (2024)
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Persistent link: https://EconPapers.repec.org/RePEc:cam:camdae:2158

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