Panel Data Models and Transitory Fluctuations in the Explanatory Variable

This paper demonstrates that fixed-effects and first-differences models often understate the effect of interest because of the variation used to identify the model. In particular, the within-unit time-series variation often reflects transitory fluctuations that have little effect on behavioral outcomes. The data in effect suffer from measurement error, as a portion of the variation in the independent variable has no effect on the dependent variable. Two empirical examples are presented: one on the relationship between AFDC and fertility and the other on the relationship between local economic conditions and AFDC expenditures. Coefficient estimates from first-differences, long-differences, and fixed-effects models are compared. These estimates differ in ways that are consistent with the presence of measurement error. Results from the analysis of AFDC expenditures, a dependent variable likely to respond to long-term changes in economic conditions, are compared to an analysis of UI Expenditures, a dependent variable likely to respond to short-term changes in economic conditions. Further analysis considers instrumental variables approaches and the use of lagged effects models.