Abstract
In this article, we consider the properties of the Pesaran CD test for cross-section correlation when applied to residuals obtained from panel data models with many estimated parameters. We show that the presence of period-specific parameters leads the CD test statistic to diverge as the time dimension of the sample grows. This result holds even if cross-section dependence is correctly accounted for and hence constitutes an example of the incidental parameters problem. The relevance of this problem is investigated for both the classical two-way fixed-effects estimator and the Common Correlated Effects estimator of Pesaran. We suggest a weighted CD test statistic which re-establishes standard normal inference under the null hypothesis. Given the widespread use of the CD test statistic to test for remaining cross-section correlation, our results have far reaching implications for empirical researchers.
Original language | English |
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Pages (from-to) | 1191-1203 |
Journal | Journal of Business and Economic Statistics |
Volume | 40 |
Issue number | 3 |
Early online date | 2021 May 4 |
DOIs | |
Publication status | Published - 2022 |
Subject classification (UKÄ)
- Probability Theory and Statistics
Free keywords
- Cross-section dependence
- Factor model
- Panel data
- Time fixed effects
- U-statistic