December 2023

Econ 654: Panel Data Econometrics

Exercise: Panel Data Econometrics

1. Consider the following simple panel data model.

yit = xit + i + it , i = 1; : : : ; n; t = 1; : : : ; T; (1.1)

where is one-dimensional, and where it is assumed that

2 2
i = xi + i; with i N ID 0; ; it N ID 0; ;

PT
mutually independent and independent of all xit ’s, where xi = (1=T ) t=1 xit .

The parameter in (1.1) can be estimated by the …xed e¤ects (or within) estimator
given by Pn PT
b i=1 (xit xi ) (yit yi)
FE = Pn t=1PT 2
.
i=1 t=1 (xit xi )
As an alternative, the correlation between the error term i + it and xit can be handled
by an instrumental variables approach.

(a). Give an expression for the IV estimator bIV for in (1.1) using xit xi as an instrument
for xit . Show that bIV and bF E are identical.

Another way to eliminate the individual e¤ects i from the model is obtained by taking
…rst di¤erences. This results in

yit yi;t 1 = (xit xi;t 1 ) + it i;t 1 , i = 1; : : : ; n; t = 1; : : : ; T . (1.2)

(b). Denote the OLS estimator based on (1.2) by bF D . Show that bF D is identical to bIV
and bF E if T = 2. This identity does no longer hold for T > 2. Which of the two
estimators would you prefer in that case? Explain.

(c). Consider the between estimator bB for in (1.1). Give an expression for bB and show
that it is unbiased for + .

1
(d). Finally, suppose we substitute the expression for i into (1.1), giving

yit = xit + xi + i + it , i = 1; : : : ; n; t = 1; : : : ; T (1.3)

The vector ( ; ) can be estimated by GLS (random e¤ects) based on (1.3). It can be
shown that the implied estimator for is identical to bF E . Does this imply that there
is no real distinction between the …xed e¤ects and random e¤ects approaches?

2. Consider the following linear panel data model

yit = x01;it 1 + x02;it 2

0
+ w1;i 1
0
+ w2;i 2 + i + it (1.4)

where wk;i are time-invariant and xk;it are time-varying explanatory variables.

The variables with index 1 (x1;it and w1;i ) are strictly exogenous in the sense that
Efx1;it i g = 0, Efx1;is it g = 0 for all s; t, Efw1;i i g = 0 and Efw1;i it g = 0. It is also
assumed that Efw2;i it g = 0 and that the usual regularity conditions (for consistency
and asymptotic normality) are met.

(a). Under which additional assumptions would OLS applied to (1.4) provide a consistent
0 0 0 0 0 0
estimator for =( 1; 2) and =( 1; 2) ?

(b). Consider the …xed e¤ects (within) estimator. Under which additional assumption(s)
would it provide a consistent estimator for ?

(c). Consider the OLS estimator for based upon a regression in …rst di¤erences. Under
which additional assumption(s) will this provide a consistent estimator for ?

(d). Discuss one or more alternative consistent estimators for and if it can be assumed
that Efx2;is it g = 0 (for all s; t), and Efw2;i it g = 0. What are the restrictions, in
this case, on the number of variables in each of the categories?

(e). Discuss estimation of if x2;it equals yi;t 1 .

(f). Discuss estimation of if x2;it includes yi;t 1 .

(g). Would it be possible to estimate both and consistently if x2;it includes yi;t 1 ? If
so, how? If not, why not? (Make additional assumptions, if necessary.)