Large Panels with Common Factors and Spatial Correlation

This paper considers methods for estimating the slope coe¢ cients in large panel data models that are robust to the presence of various forms of error cross section dependence. It introduces a general framework where error cross section dependence may arise because of unobserved common e¤ects and/or error spillover e¤ects due to spatial or other forms of local dependencies. Initially, this paper focuses on a panel regression model where the idiosyncratic errors are spatially dependent and possibly serially correlated, and derives the asymptotic distributions of the mean group and pooled estimators under heterogeneous and homogeneous slope coe¢ cients, and for these estimators proposes non-parametric variance matrix estimators. The paper then considers the more general case of a panel data model with a multifactor error structure and spatial error correlations. Under this framework, the Common Correlated E¤ects (CCE) estimator, recently advanced by Pesaran (2006), continues to yield estimates of the slope coe¢ cients that are consistent and asymptotically normal. Small sample properties of the estimators under various patterns of cross section dependence, including spatial forms, are investigated by Monte Carlo experiments. Results show that the CCE approach works well in the presence of weak and/or strong cross sectionally correlated errors. Keywords: Panels, Common Factors, Spatial Dependence, Common Correlated E¤ects Estimator. JEL Classi…cation: C10, C31, C33 We are grateful to the Editor (Cheng Hsiao), an Associate Editor and three anonymous referees, Badi Baltagi, Alexander Chudik and George Kapetanios for helpful comments and suggestions.