Inference for Unit Roots in Dynamic Panels in the Presence of Deterministic Trends

Paper number: 97/05

Paper date: March 1997

Year: 1997

Paper Category: Discussion Paper

Authors

Richard D.F. Harris
Elias Tzavalis

University of Exeter

Abstract

This paper proposes a similar unit root testing procedure for heterogeneous dynamic panel data, based on the score principle, assuming that the time dimension of the panel is fixed. It is shown that the limiting distribution of the test is standard normal. The similarity with regard to the initial conditions and the heterogeneity (fixed effects) of the panel is achieved by considering a parameterization of the autoregressive model which allows for a trend under both the null and the alternative hypotheses, without introducing any irrelevant variables under either. Simulation evidence suggests that the proposed tests have empirical size that is very close to the nominal 5% level and considereably more power than other panel unit root tests and the corresponding unit root tests for the single time series case. As an application of our test, we re-examine whether real dividends and stock prices follow drifting random walks. In contrast with many earlier studies, we find that both real dividends and real stock prices are stationary around a deterministic trend.

JEL Classification Nos: C22, C23, F43
Keywords: panel Data, Unit Roots, Fixed Effects, Central Limit Theorem, Score Vector, Market Efficiency Hypothesis

Corresponding Author: Richard Harris, Department of Economics, University of Exeter, Amory Building, Rennes Drive, Exeter, EX4 4RJ, Great Britain, tel:(44) 1392 263215, fax: (44) 1392 263242, email: R.D.F.Harris@exeter.ac.uk