A Panel Unit Root Test in the Presence of a Multifactor Error Structure

This paper extends the cross sectionally augmented panel unit root test proposed by Pesaran (2007) to the case of a multifactor error structure. The basic idea is to exploit information regarding the m unobserved factors that are shared by k other time series in addition to the variable under consideration. Initially we develop a test assuming that m, the true number of factors is known, and show that the limit distribution of the test does not depend on any nuisance parameters, so long as k m 1. Small sample properties of the test are investigated by Monte Carlo experiments and shown to be satisfactory. Particularly, in contrast to other existing panel unit root tests, our test has correct size and reasonable power for the case with an intercept and a linear trend as well as with an intercept only, for all combinations of cross section and time series dimensions. An illustrative application is also provided where the proposed panel unit root test is applied to Fisher’s in‡ation parity and real equity prices. JEL-Classi…cation: C12, C15, C22, C23