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  1. CHAPTER 17 PANEL DATA REGRESSION MODELS Damodar Gujarati Econometrics by Example

  2. PANEL DATA REGRESSION MODELS • Panel data regression models are based on panel data, which are observations on the same cross-sectional, or individual, units over several time periods. • A balanced panel has the same number of time observations for each cross-sectional unit • Panel data have several advantages over purely cross-sectional or purely time series data. These include: • (a) Increase in the sample size • (b) Study of dynamic changes in cross-sectional units over time • (c) Study of more complicated behavioral models, including study of time-invariant variables Damodar Gujarati Econometrics by Example

  3. PANEL DATA REGRESSION MODELS • However, panel models pose several estimation and inference problems, such as heteroscedasticity, autocorrelation, and cross-correlation in cross-sectional units at the same point in time. • The fixed effects model (FEM) and the random effects model (REM), also known as the error components model (ECM), are commonly used methods to deal with one or more of these problems. Damodar Gujarati Econometrics by Example

  4. FIXED EFFECTS MODEL (FEM) • In FEM, the intercept in the regression model is allowed to differ among individuals to reflect the unique feature of individual units. • This is done by using dummy variables, provided we take care of the dummy variable trap. • The FEM using dummy variables is known as the least-squares dummy variable model (LSDV). • FEM is appropriate in situations where the individual-specific intercept may be correlated with one or more regressors, but consumes a lot of degrees of freedom when N (the number of cross-sectional units) is very large. Damodar Gujarati Econometrics by Example

  5. WITHIN-GROUP (WG) ESTIMATOR • An alternative to LSDV is to use the within-group (WG) estimator. • Here we subtract the (group) mean values of the regressand and regressor from their individual values and run the regression on the mean-corrected variables. • Although it is economical in terms of the degrees of freedom, the mean-corrected variables wipe out time-invariant variables (such as gender and race) from the model. Damodar Gujarati Econometrics by Example

  6. RANDOM EFFECTS MODEL (REM) • In REM we assume that the intercept value of an individual unit is a random drawing from a much larger population with a constant mean. • The individual intercept is then expressed as a deviation from the constant mean value. • REM is more economical than FEM in terms of the number of parameters estimated. • REM is appropriate in situations where the (random) intercept of each cross-sectional unit is uncorrelated with the regressors. • Unlike in FEM, time-invariant regressors can be used in REM. Damodar Gujarati Econometrics by Example

  7. FIXED EFFECTS OR RANDOM EFFECTS? • If it assumed that εi and the regressors are uncorrelated, REM may be appropriate, but if they are correlated, FEM may be appropriate. • In the former case we also have to estimate fewer parameters. • The Hausman test can be used to decide between FEM and REM: • The null hypothesis underlying the Hausman test is that FEM and REM do not differ substantially. • The test statistic has an asymptotic (i.e., large sample) χ2 distribution with df equal to number of regressors in the model. • If the computed chi-square value exceeds the critical chi-square value for given df and the level of significance, we conclude that REM is not appropriate because the random error term are probably correlated with one or more regressors. • In this case, FEM is preferred to REM. Damodar Gujarati Econometrics by Example

  8. ATTRITION • Some specific problems with panel data model need to be kept in mind: • The most serious problem is the problem of attrition, whereby for one reason or another, members of the panel drop out over time so that in the subsequent surveys (i.e., cross-sections) fewer original subjects remain in the panel. • Also, over time subjects may refuse or be unwilling to answer some questions. Damodar Gujarati Econometrics by Example