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= + + =
x
y X i e
Random Effects Model
Assumptions
Strict Exogeneity
X includes a constant term, otherwise E(u
i
|X)=u.
Homoschedasticity
Constant Auto-covariance (within panels)
( | ) 0, ( | ) 0 ( | ) 0
it i it
E e E u E c = = = X X X
2 2 '
( | )
i i i
i e T u T T
Var o o = + X I i i
2 2
2 2 2
( | ) , ( | ) , ( , ) 0
( | )
it e i u i it
it e u
Var e Var u Cov u e
Var
c
o o
c o o o
= = =
= = +
X X
X
Random Effects Model
Assumptions
Cross Section Independence
2 2 '
1
2
( | )
0 0
0 0
( | )
0 0
i i i
i i e T u T T
N
Var
Var
o o = O = +
O
(
(
O
(
= =
(
(
O
X I i i
X
Random Effects Model
Extensions
Weak Exogeneity
Heteroscedasticity
1 2
1 2
( | , ,..., ) ( | ) 0
( | , ,..., ) 0
( | ) 0
i
it i i iT it i
it i i it
it it
E E
E
E
c c
c
c
= =
=
=
x x x X
x x x
x
2
2 2
2
( | ) ( | )
it
i i
i
e
it i u it i u
e
Var Var e
o
c o o
o
= + = +
X X
Random Effects Model
Extensions
Serial Correlation
Spatial Correlation
1 '
1
,
it it
it it i it it
i it it
e v
y u e e
e v
= + + =
+
x
'
, ,
it it it it ij jt it it i it
j
y w e e u v c c c = + = + = +
x
Model Estimation: GLS
Model Representation
( )
2 2 '
2 2
2
2
'
,
( | )
( | )
1
i
i i i
i
i i i
i i i i i T i
i i
i i i e T u T T
e i u
e i T i
e
i T T T
i
u
E
Var
T
Q Q
where Q
T
o o
o o
o
o
= + = +
=
= O = +
(
+
= +
(
=
y X i e
X 0
X I i i
I
I i i
Model Estimation: GLS
GLS
( )
( )
1
1 1 1 1 1
1 1
1
1 1 1
1
2
1
2 2 2
2
1/ 2
2 2
( )
( ) ( )
1
1
i
i
N N
GLS i i i i i i
i i
N
GLS i i i
i
e
i i T i
e e i u
e
i i T i
e e i u
Var
where Q Q
T
and Q Q
T
o
o o o
o
o o o
= =
(
= = O O
(
= = O
(
O = +
(
+
(
O = + (
+
(
X X X y X X X y
X X X X
I
I
Model Estimation: RE-OLS
Partial Group Mean Deviations
' '
'
2
2 2
' '
'
( )
( )
1
( ) [(1 ) ( )]
it it it it i it
i i i i
e
i
e i u
it i i it i i i i it i i
it it it
y u e
y u e
T
y y u e e
y
c
o
u
o o
u u u u
c
= + = + +
= + +
=
+
= + +
= +
x x
x
x x
x
Model Estimation: RE-OLS
Model Assumptions
OLS
'
' 2 2 2 2 2
' 2 2 2 2
2
2 2
( | ) 0
( | ) (1 ) (1 2 / / )
( , | ) (1 ) ( 2 / / ) 0,
: 1
it i
it i i u i i i i e e
it is i i u i i i i e
e
i
e i u
E
Var T T
Cov T T t s
Note
T
c
c u o u u o o
c c u o u u o
o
u
o o
=
= + + =
= + + = =
=
+
x
x
x
1
' 1 ' '
1 1
1
2 ' 1 2 '
1
2
( )
( ) ( )
' / ( ),
N N
OLS i i i i
i i
N
OLS e e i i
i
e
Var
NT K
o o
o
= =
=
(
= =
(
= =
= =
XX Xy X X X y
XX X X
y X
Model Estimation: RE-OLS
Need a consistent estimator of u:
Estimate the fixed effects model to obtain
Estimate the between model to obtain
Or, estimate the pooled model to obtain
Based on the estimated large sample variances, it
is safe to obtain
2
2 2
1
e
i
e i u
T
o
u
o o
=
+
2
e
o
2 2
u v
To o +
0 1 u < <
2 2
e u
o o +
Model Estimation: RE-OLS
Panel-Robust Variance-Covariance Matrix
Consistent statistical inference for general
heteroscedasticity, time series and cross section
correlation.
1 1
' ' ' '
1 1 1
1 1
' ' '
1 1 1 1 1 1 1
( ) [( )( ) ']
,
i i i i
N N N
i i i i i i i i
i i i
N T N T T N T
it it it is it is it it
i t i t s i t
i i i it
Var E
c c
c
= = =
= = = = = = =
=
( ( (
=
( ( (
=
=
X X X X X X
x x x x x x
y X
'
it it
y = x
Model Estimation: ML
Log-Likelihood Function
( )
' '
2 2 '
2 2 1
( ) ( 1, 2,..., )
( 1, 2,..., )
~ ( , ),
1 1
( , , | , ) ln 2 ln
2 2 2
i i i
it it i it it it i
i i i
i i i e T u T T
i
i e u i i i i i i
y u e t T
i N
iidn
T
ll
c
o o
o o t
= + + = + =
= + =
O O = +
= O O
x x
y X
0 I i i
y X
Model Estimation: ML
ML Estimator
( )
( )
2 2 2 2
1
2 2 1
2 2
2
2
2
2
' 2 '
2 2 2
1 1
( , , ) arg max ( , , | , )
1 1
( , , | , ) ln 2 ln
2 2 2
1
ln 2 ln
2 2
1
( ) ( )
2
i i
N
e u ML i e u i i
i
i
i e u i i i i i i
i e u
e
e
T T
u
it it it it
t t
e e i u
ll
where
T
ll
T T
y y
T
o o o o
o o t
o o
to
o
o
o o o
=
= =
=
= O O
| |
+
=
|
\ .
( (
y X
y X
x x
`
)
Hypothesis Testing
To Pool or Not To Pool, Continued
Test for Var(u
i
) = 0, that is
If T
i
=T for all i, the Lagrange-multiplier test statistic
(Breusch-Pagan, 1980) is:
, , ,
( ) ( ) ( )
it is i it i is it is
Cov Cov u e u e Cov e e c c = + + =
( ) ( )
( )
2
2
2
'
1 1
2
'
2
1 1
' '
( )
1 1 ~ (1)
2 1 2 1
1 ,
N T
it
i t
N T
N T
it
i t
it it it T T T
Pooled
e
I J NT NT
LM
T T
e
where e y J
u
_
= =
= =
(
(
(
= =
(
(
(
(
( = =
(
e e
ee
x i i
Hypothesis Testing
To Pool or Not To Pool, Continued
For unbalanced panels, the modified Breusch-
Pagan LM test for random effects (Baltagi-Li, 1990)
is:
Alternative one-side test:
( )
( )
( )
2
2 2
1 1 1
2
2
1 1
1
1 ~ (1)
2 ( 1)
i
i
N N T
i it
i i t
N T
N
it
i i
i t
i
T e
LM
e
T T
_
= = =
= =
=
(
(
=
(
0
~ (0,1)
: Pr ( )
n
LM N under H
P Value z LM >
Hypothesis Testing
To Pool or Not To Pool, Continued
References
Baltagi, B. H., and Q. Li, A Langrange Multiplier Test for the Error
Components Model with Incomplete Panels, Econometric Review, 9,
1990, 103-107.
Breusch, T. and A. Pagan, The LM Test and Its Applications to Model
Specification in Econometrics, Review of Economic Studies, 47, 1980,
239-254.
Hypothesis Testing
Fixed Effects vs. Random Effects
'
0
'
1
: ( , ) 0 ( )
: ( , ) 0 ( )
i it
i it
H Cov u randomeffects
H Cov u fixed effects
=
=
x
x
Estimator Random Effects
E(u
i
|X
i
) = 0
Fixed Effects
E(u
i
|X
i
) =/= 0
GLS or RE-OLS
(Random Effects)
Consistent and
Efficient
Inconsistent
LSDV or FE-OLS
(Fixed Effects)
Consistent
Inefficient
Consistent
Possibly Efficient
Hypothesis Testing
Fixed Effects vs. Random Effects
Fixed effects estimator is consistent under H
0
and H
1
; Random effects estimator is efficient
under H
0
, but it is inconsistent under H
1
.
Hausman Test Statistic
( ) ( )
' 1
2
( ) ( )
~ (# ), # # ( )
RE FE RE FE RE FE
FE FE RE
H Var Var
provided no intercept _
(
=
=
Hypothesis Testing
Fixed Effects vs. Random Effects
Alternative (Asym. Eq.) Hausman Test
Estimate any of the random effects models
F Test that = 0
' ' ' '
' ' '
' ' '
' ' '
( ) ( ) ( )
( , random effects model : ( ) )
( ) ( )
( ) ( )
it i it i it i it
it it it i it
it i it i i it
it i it i it it
y y e
or y e
y y e
y y e
u u
u u
u u
= + +
= + +
= + +
= + +
x x x x
x x x
x x x
x x x
0 0
: 0 : ( , ) 0
i it
H H Cov u = = x
Hypothesis Testing
Fixed Effects vs. Random Effects
Ahn-Low Test (1996)
Based on the estimated errors (GLS residuals) of
the random effects model, estimate the following
regression:
2 2
( )
~ (# )
it it i i it
X X X e
NTR
c o u
_
= + + +
Hypothesis Testing
Fixed Effects vs. Random Effects
References
Ahn, S.C., and S. Low, A Reformulation of the Hausman Test for
Regression Models with Pooled Cross-Section Time-Series Data,
Journal of Econometrics, 71, 1996, 309-319.
Baltagi, B.H., and L. Liu, Alternative Ways of Obtaining Hausmans Test
Using Artificial Regressions, Statistics and Probability Letters, 77, 2007,
1413-1417.
Hausman, J.A., Specification Tests in Econometrics, Econometrica, 46,
1978, 1251-1271.
Hausman, J.A. and W.E. Taylor, Panel Data and Unobservable Individual
Effects, Econometrics, 49, 1981, 1377-1398.
Mundlak, Y., On the Pooling of Time Series and Cross-Section Data,
Econometrica, 46, 1978, 69-85.
Example: Investment Demand
Grunfeld and Griliches [1960]
i = 10 firms: GM, CH, GE, WE, US, AF, DM, GY, UN,
IBM; t = 20 years: 1935-1954
I
it
= Gross investment
F
it
= Market value
C
it
= Value of the stock of plant and equipment
it i it it it
I F C o | c = + + +