A Bias-Corrected CD Test for Error Cross-Sectional Dependence in Panel Data Models with Latent Factors

Mohammad Pesaran and Yimeng Xie

No 9234, CESifo Working Paper Series from CESifo

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. It shows that the standard CD test remains valid if the latent factors are weak, and proposes a simple bias-corrected CD test, labelled CD*, which is shown to be asymptotically normal, irrespective of whether the latent factors are weak or strong. This result is shown to hold for pure latent factor models as well as for panel regressions 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 and satisfactory power for both 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. The use of the CD* test is illustrated with two empirical applications from the literature.

Keywords: latent factor models; strong and weak factors; error cross-sectional dependence; 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
New Economics Papers: this item is included in nep-isf and nep-ore
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (7)

Downloads: (external link)
https://www.cesifo.org/DocDL/cesifo1_wp9234.pdf (application/pdf)

Related works:
Working Paper: A Bias-Corrected CD Test for Error Cross-Sectional Dependence in Panel Data Models with Latent Factors (2022)
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:ces:ceswps:_9234

Access Statistics for this paper

More papers in CESifo Working Paper Series from CESifo Contact information at EDIRC.
Bibliographic data for series maintained by Klaus Wohlrabe ().