Dynamic Panels and GMM

Walter Sosa-Escudero
Econ 507. Econometric Analysis. Spring 2012

April 23, 2012

Walter Sosa-Escudero

Dynamic Panels and GMM

Preliminary issues: the GIVE estimator

Y = X + u,

Z valid instruments, p K, V (u|X) = 2 I

Premultiply by Z 0
Z 0Y

= Z 0 X + Z 0 u

Y = X + u
It is easy to see that E(u |X ) = 0, and that
V (u |X ) = E(u u0 ) = E(Z 0 uu0 Z) = 2 (Z 0 Z) ,
non-spherical.

Walter Sosa-Escudero

Dynamic Panels and GMM

Hence, the BLUE is GLS:

GLS = (X 0 1 X )1 X 0 1 Y
= (X 0 Z(Z 0 Z)1 Z 0 X)1 X 0 Z(Z 0 Z)1 Z 0 Y
= (X 0 PZ X)1 X 0 PZ Y = IV
IV is a GLS of a transformed model.

Walter Sosa-Escudero

Dynamic Panels and GMM

Generalization: V (u|X) =

In this case: V (u |X ) = E(u u0 ) = E(Z 0 uu0 Z) = Z 0 Z

Replacing:
GLS = (X 0 1 X )1 X 0 1 Y
= (X 0 Z(Z 0 Z)1 Z 0 X)1 X 0 Z(Z 0 Z)1 Z 0 Y GIV
This is an efficient IV estimate under heteroskedasticity or serial
correlation. We will label it the generalized IV.
Q? What happens if p = K?

Walter Sosa-Escudero

Dynamic Panels and GMM

A simple dynamic model

The goal is to estimate a dynamic model like:

yit = yi,t1 + x0it + uit
with uit = i + vit
There are two sources of persistence: i y yi,t1 .
Examples:
Unemployment (Galiani, et al. 2003).
Growth convergence (Islam, 1995).

Walter Sosa-Escudero

Dynamic Panels and GMM

Standard estimators are inconsistent

yit = yi,t1 + x0it + uit

with uit = i + vit
By construction yit and yi,t1 depend on i . yi,t1 is correlated
with uit = i + vit .
OLS is inconsistent (v/Hsiao (1986, pp.77)
Random effects is inconsistent

Walter Sosa-Escudero

Dynamic Panels and GMM

The fixed effects estimator is inconsistent as well. FE is based on:

yit
= yi,t1
+ xit + uit

where variables with * are deviations from individual means.

Note:
T

yi,t1

1 X
yi,t1 ,
= yi,t1
T 1
t=2

uit

T
1X
= vit
vit
T
t=1

It is easy to show that yi,t1

y uit are correlated. For example,
both depend on vi,t1

Walter Sosa-Escudero

Dynamic Panels and GMM

If xit is exogenoous, Nickell (1981):

p

Cov(yi,t1
, uit )

v2 (T 1) T + T
T2
(1 )2

when n , for fixed T . Then, FE is inconsistent.

p

, uit ) 0, hence the inconsistency of

If T , Cov(yi,t1
FE is related to T being small.

If > 0 the bias is negative.

How large is the bias?

Walter Sosa-Escudero

Dynamic Panels and GMM

Bias of the FE estimator

= 0.5, 0.8, 0.3

Bias diminishes with T and increases with
Walter Sosa-Escudero

Dynamic Panels and GMM

The Anderson/Hsiao estimator

A transformation that elliminates the individual effect consists in
substracting yi,t1 :
yi,t = yi,t1 + xit + vit
OLS is inconsistent: yi,t1 are trivially correlated with vit .
Both depend on vi,t1 .
Note yi,t2 = yi,t2 yi,t3 though correlated with yi,t1
(both depend on yi,t2 ) it is not correlated with vit .
Anderson and Hsiao (1981): IV using yi,t2 o yi,t2 as
instrument.
Arellano (1989): yi,t2 performs better.
Walter Sosa-Escudero

Dynamic Panels and GMM

The Arrellano/Bond estimator

For simplicity, consider = 0:
yit = yi,t1 + i + vit
Substracting yi,t1 we have:
yi,t = yi,t1 + vit
(i is gone!). The first period for which we observe this
relationship is t = 3
yi,3 = yi,2 + vi3
In this case yi1 is a valid instrument: correlated with
yi,2 yi,2 yi,1 , but not with vi3 vi,3 vi,2 .
Q? How many observations do we have to estimate this?

Walter Sosa-Escudero

Dynamic Panels and GMM

Consider now period, t = 4:

yi,4 = yi,3 + vi4
but in this case yi2 and yi1 are valid instruments.
Using this logic, the valid instruments for period T are
yi1 , yi2 , . . . , yi,T 2 .
In general, the previous argument implies the following
(T 2)(T 1)/2 moment conditions:

E[vit yi,tj ] = 0,

j = 2, . . . , T 1; t = 3, 4, . . . , T

From here, we will construct a GMM estimator.

Walter Sosa-Escudero

Dynamic Panels and GMM

Instruments in Anderson-Hsiao and Arellano-Bond

i
1
1
1
1
1
2
2
2
2
2

t
1
2
3
4
5
1
2
3
4
5

yit
a
b
c
d
e
f
g
h
i
j

yi,t1

Dy

Dyi,t1

AH
yi,t2

AB
1

a
b
c
d

c-b
d-c
e-d

c-b
d-c

a
b
c

a
0
0

0
a
0

0
b
0

0
0
a

0
0
b

0
0
c

f
g
h
i

h-g
i-h
j-i

h-g
i-h

f
g
h

f
0
0

0
f
0

0
g
0

0
0
f

0
0
g

0
0
h

Walter Sosa-Escudero

Dynamic Panels and GMM

For each individual, define Wi as follows:

[yi1 ]
0

[y
,
y
]
i1
i2

Wi =
..

.
0
[yi1 , . . . , yi,T 2 ]

is (T 2) (T 2)(T 1)/2 matrix. Moment conditions can be

expressed in vector form as:
E(Wi0 vi ) = 0,

i = 1, . . . , N
PN

The sample counterpart is(1/N ) i=1 Wi0 vi = (1/N )W 0 v,

with W a matrix that stacks Wi vertically, for all individuals, vi
is defined similarly.

Walter Sosa-Escudero

Dynamic Panels and GMM

The GMM estimator of will be:

= argmin (W 0 v)0 AN (W 0 v)
where AN is any sequence of symmetric pd matrices. The optimal
GMM estimator can be based on:
AN = (1/N )

i v
i0 Wi
Wi0 v

i are residuals based on any preliminary consistent

where v
estimation of . Note that, based on Hansens result, we are using
a consistent estimate of the variance of Wi0 vi .
Now the problem is to find a preliminary estimator for .

Walter Sosa-Escudero

Dynamic Panels and GMM

Preliminary estimation: In matrix terms:

y = y1 + v
W is a matrix of valid instruments for this model. It is easy to
check:
V (v) = E(vv 0 ) = v2 (IN G) = v2
(See Baltagi (2001, pp. 132) for a definition of G).

Arellano and Bond (91): use the GIV estimator. Premultiply to get
W 0 y = W 0 y1 + W 0 v
and replacing in the formula for the GIV estimator V IG :
0
0
1 = (y1
W (W 0 W )1 W 0 y1 )1 y1
W (W 0 W )1 W 0 y

is the Arellano-Bond preliminary estimator.

Walter Sosa-Escudero

Dynamic Panels and GMM

Consistency depends crucially on E[vit yi,tj ] = 0, implying

no serial correlation. It is important to check this hypothesis.
6= 0. Depends on the exogeneity status of x.
Finite samples: preliminary estimator works fine.

Walter Sosa-Escudero

Dynamic Panels and GMM

Small sample performance

Judson and Owen (1999): empirical comparisson.

OLS, LSDV(FE), GMM1(AB preliminary), AH (Anderson-Hsiao),
LSDVC (Kiviet)
OLS and LSDV tend to be very biased, even when T = 20 (12%
and when = 0.8).
When T = 30 the bias is small.
In terms of performance, LSDVC seems to be best.
LSDVC no avabilable for unbalanded panels, not easy to compute.
T 10: GMM1, T 20 GMM1 o AH, T 30: FE

Walter Sosa-Escudero

Dynamic Panels and GMM

Empirical Illustration

Walter Sosa-Escudero

Dynamic Panels and GMM