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Working Papers


Archives: WP version of published papers


  • "Identifying Global and National Output and Fiscal Policy Shocks Using a GVAR", by Alexander Chudik, M. Hashem Pesaran and Kamiar Mohaddes, December 2018

    Abstract: The paper contributes to the growing global VAR (GVAR) literature by showing how global and national shocks can be identified within a GVAR framework. The usefulness of the proposed approach is illustrated in an application to the analysis of the interactions between public debt and real output growth in a multicountry setting, and the results are compared to those obtained from standard single country VAR analysis. We find that on average (across countries) global shocks explain about one third of the long-horizon forecast error variance of output growth, and about one fifth of the long run variance of the rate of change of debt-to-GDP. Evidence on the degree of cross-sectional dependence in these variables and their innovations are exploited to identify the global shocks, and priors are used to identify the national shocks within a Bayesian framework. It is found that posterior median debt elasticity with respect to output is much larger when the rise in output is due to a fiscal policy shock, as compared to when the rise in output is due to a positive technology shock. The cross country average of the median debt elasticity is 1.58 when the rise in output is due to a fiscal expansion as compared to 0.75 when the rise in output follows from a favorable output shock.
    JEL Classifications: C30, E62, H6.
    Key Words: Factor-augmented VARs, Global VARs, identi…cation of global and country-specific shocks, Bayesian analysis, public debt and output growth, debt elasticity.
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  • "A Residual-based Threshold Method for Detection of Units that are Too Big to Fail in Large Factor Models", by George Kapetanios, M. Hashem Pesaran and Simon Reese, CESifo Working Papers No. 7401, November 2018

    Abstract: The importance of units with pervasive impacts on a large number of other units in a network has become increasingly recognized in the literature. In this paper we propose a new method to detect such in‡uential or dominant units by basing our analysis on unit-speci…c residual error variances in the context of a standard factor model, subject to suitable adjustments due to multiple testing. Our proposed method allows us to estimate and identify the dominant units without the a priori knowledge of the interconnections amongst the units, or using a short list of potential dominant units. It is applicable even if the cross section dimension exceeds the time dimension, and most importantly it could end up with none of the units selected as dominant when this is in fact the case. The sequential multiple testing procedure proposed exhibits satisfactory small-sample performance in Monte Carlo simulations and compares well relative to existing approaches. We apply the proposed detection method to sectoral indices of US industrial production, US house price changes by states, and the rates of change of real GDP and real equity prices across the world’s largest economies.
    JEL Classifications: C18, C23, C55.
    Key Words: Dominant units, factor models, systemic risk, cross-sectional dependence, networks.
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  • "Short T Dynamic Panel Data Models with Individual and Interactive Time Effects", by Kazuhiko Hayakawa, M. Hashem Pesaran and L. Vanessa Smith, September 2018

    Abstract: This paper proposes a quasi maximum likelihood estimator for short T dynamic fixed effects panel data models allowing for interactive time effects through a multifactor error structure. The proposed estimator is robust to the heterogeneity of the initial values and common unobserved effects, whilst at the same time allowing for standard fixed and time effects. It is applicable to both stationary and unit root cases. Order conditions for identification of the number of interactive effects are established, and conditions are derived under which the parameters are almost surely locally identified. It is shown that global identification is possible only when the model does not contain lagged dependent variables. The QML estimator is proven to be consistent and asymptotically normally distributed. A sequential multiple testing likelihood ratio procedure is also proposed for estimation of the number of factors which is shown to be consistent. Finite sample results obtained from Monte Carlo simulations show that the proposed procedure for determining the number of factors performs very well and the quasi ML estimator has small bias and RMSE, and correct empirical size even when the number of factors is estimated. An empirical application, revisiting the growth convergence literature is also provided.
    JEL Classifications: C12, C13, C23.
    Key Words: short T dynamic panels, unobserved common factors, quasi maximum likelihood, interactive time effects, multiple testing, sequential likelihood ratio tests, output and growth convergence.
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  • "Exponent of Cross-sectional Dependence for Residuals", by Natalia Bailey, George Kapetanios and M. Hashem Pesaran. August 2018

    Abstract: In this paper we focus on estimating the degree of cross-sectional dependence in the error terms of a classical panel data regression model. For this purpose we propose an estimator of the exponent of cross-sectional dependence denoted by α, which is based on the number of non-zero pair-wise cross correlations of these errors. We prove that our estimator, [alphatilde], is consistent and derive the rate at which [alphatilde], approaches its true value. We evaluate the finite sample properties of the proposed estimator by use of a Monte Carlo simulation study. The numerical results are encouraging and supportive of the theoretical findings. Finally, we undertake an empirical investigation of α for the errors of the CAPM model and its Fama-French extensions using 10-year rolling samples from S&P 500 securities over the period Sept 1989 - May 2018.
    JEL Classifications: C21, C32
    Key Words: Pair-wise correlations, Cross-sectional dependence, Cross-sectional averages, Weak and strong factor models. CAPM and Fama-French Factors.
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  • "Common Correlated Effects Estimation of Heterogeneous Dynamic Panel Quantile Regression Models", by Matthew Harding, Carlos Lamarche and M. Hashem Pesaran. August 2018

    Abstract: This paper proposes a quantile regression estimator for a heterogeneous panel model with lagged dependent variables and interactive effects. The paper adopts the Common Correlated Effects (CCE) approach proposed by Pesaran (2006) and Chudik and Pesaran (2015) and demonstrates that the extension to the estimation of dynamic quantile regression models is feasible under similar conditions to the ones used in the literature. We establish consistency and derive the asymptotic distribution of the new quantile regression estimator. Monte Carlo studies are carried out to study the small sample behavior of the proposed approach. The evidence shows that the estimator can significantly improve on the performance of existing estimators as long as the time series dimension of the panel is large. We present an application to the evaluation of Time-of-Use pricing using a large randomized control trial.
    JEL Classifications: C21, C31, C33, D12, L94
    Key Words: Common Correlated Effects; Dynamic Panel; Quantile Regression; Smart Meter; Randomized Experiment.
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  • "Land Use Regulations, Migration and Rising House Price Dispersion in the U.S.", by Wukuang Cun and M. Hashem Pesaran. April 2018, revised October 2018

    Abstract: This paper develops and solves a dynamic spatial equilibrium model of regional housing markets in which house prices are jointly determined with location-to-location migration flows. Agents optimize period-by-period and decide whether to remain where they are or migrate to a new location at the start of each period. The agent'’s optimal location choice and the resultant migration process is shown to be Markovian with the transition probabilities across all location pairs given as non-linear functions of wage and housing cost differentials, which are time varying and endogenously determined. On the supply side, in each location the construction …firms build new houses by combining land and residential structures; with housing supplies endogenously responding to migration flows. The model can be viewed as an example of a dynamic network where regional housing markets interact with each other via migration flows that function as a source of spatial spill-overs. It is shown that the deterministic version of the model has a unique equilibrium and a unique balanced growth path. We estimate the state-level supplies of new residential land from the model using housing market and urban land acreage data. These estimates are shown to be significantly negatively correlated with the Wharton Residential Land Use Regulatory Index. The model can simultaneously account for the rise in house price dispersion and the interstate migration in the U.S.. Counterfactual simulations suggest that reducing either land supply differentials or migration costs could significantly lower house price dispersion.
    JEL Classifications: E0, R23, R31
    Key Words: House price dispersion, endogenous location choice, interstate migration, land-use restriction, spatial equilibrium.
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  • "Uncertainty and Economic Activity: A Multi-Country Perspective", by Ambrogio Cesa-Bianchi, M. Hashem Pesaran and Alessandro Rebucci. February 2018

    Abstract: Measures of economic uncertainty are countercyclical, but economic theory does not provide definite guidance on the direction of causation between uncertainty and the business cycle. This paper proposes a new multi-country approach to the analysis of the interaction between uncertainty and economic activity, without a priori restricting the direction of causality. We develop a multi-country version of the Lucas tree model with time-varying volatility and show that in addition to common technology shocks that affect output growth, higherorder moments of technology shocks are also required to explain the cross country variations of realized volatility. Using this theoretical insight, two common factors, a 'real' and a 'financial' one, are identified in the empirical analysis assuming different patterns of crosscountry correlations of country-specific innovations to real GDP growth and realized stock market volatility. We then quantify the absolute and the relative importance of the common factor shocks as well as country-specific volatility and GDP growth shocks. The paper highlights three main empirical findings. First, it is shown that most of the unconditional correlation between volatility and growth can be accounted for by the real common factor, which is proportional to world growth in our empirical model and linked to the risk-free rate. Second, the share of volatility forecast error variance explained by the real common factor and by country-specific growth shocks amounts to less than 5 percent. Third, shocks to the common financial factor explain about 10 percent of the growth forecast error variance, but when such shocks occur, their negative impact on growth is large and persistent. In contrast, country-specific volatility shocks account for less than 1-2 percent of the growth forecast error variance.
    JEL Classifications: E44, F44, G15
    Key Words: Uncertainty, Business Cycle, Common Factors, Real and Financial Global Shocks, Multi-Country, Identification, Realized Volatility.
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  • "A Bias-Corrected Method of Moments Approach to Estimation of Dynamic Short-T Panels", by Alexander Chudik and M. Hashem Pesaran, CESifo WP no. 6688. October 2017

    Abstract: This paper contributes to the GMM literature by introducing the idea of self-instrumenting target variables instead of searching for instruments that are uncorrelated with the errors, in cases where the correlation between the target variables and the errors can be derived. The advantage of the proposed approach lies in the fact that, by construction, the instruments have maximum correlation with the target variables and the problem of weak instrument is thus avoided. The proposed approach can be applied to estimation of a variety of models such as spatial and dynamic panel data models. In this paper we focus on the latter and consider both univariate and multivariate panel data models with short time dimension. Simple Bias-corrected Methods of Moments (BMM) estimators are proposed and shown to be consistent and asymptotically normal, under very general conditions on the initialization of the processes, individual-speci…c effects, and error variances allowing for heteroscedasticity over time as well as cross-sectionally. Monte Carlo evidence document BMM’s good small sample performance across different experimental designs and sample sizes, including in the case of experiments where the system GMM estimators are inconsistent. We also …nd that the proposed estimator does not suffer size distortions and has satisfactory power performance as compared to other estimators.
    JEL Classifications: C12, C13, C23.
    Key Words: Short-T Dynamic Panels, GMM, Weak Instrument Problem, Quadratic Moment Conditions, Panel VARs, Monte Carlo Evidence.
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  • "Testing for Alpha in Linear Factor Pricing Models with a Large Number of Securities", by M. Hashem Pesaran and Takashi Yamagata, March 2017, revised January 2018

    Abstract: This paper considers tests of zero pricing errors for the linear factor pricing model when the number of securities, N, can be large relative to the time dimension, T, of the return series. We focus on class of tests that are based on Student t tests of individual securities which have a number of advantages over the existing standardised Wald type tests, and propose a test procedure that allows for non-Gaussianity and general forms of weakly cross correlated errors. It does not require estimation of an invertible error covariance matrix, it is much faster to implement, and is valid even if N is much larger than T. Monte Carlo evidence shows that the proposed test performs remarkably well even when T = 60 and N = 5; 000. The test is applied to monthly returns on securities in the S&P 500 at the end of each month in real time, using rolling windows of size 60. Statistically signifi…cant evidence against Sharpe-Lintner CAPM and Fama-French three factor models are found mainly during the recent fi…nancial crisis. Also we fi…nd a signifi…cant negative correlation between a twelve-months moving average p-values of the test and excess returns of long/short equity strategies (relative to the return on S&P 500) over the period November 1994 to June 2015, suggesting that abnormal pro…ts are earned during episodes of market ineffiencies.
    JEL Classifications: C12, C15, C23, G11, G12
    Key Words: CAPM, Testing for alpha, Weak and spatial error cross-sectional dependence, S&P 500 securities, Long/short equity strategy.
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  • "Econometric Analysis of Production Networks with Dominant Units", by M. Hashem Pesarann and Cynthia Fan Yang, October 2016, revised August 2017

    Abstract: This paper considers production and price networks with unobserved common factors, and derives an exact expression for the rate at which aggregate fluctuations vary with the dimension of the network. It introduces the notions of strongly and weakly dominant and non-dominant units, and shows that at most a finite number of units in the network can be strongly dominant. The pervasiveness of a network is measured by the degree of dominance of the most pervasive unit in the network, and is shown to be equivalent to the inverse of the shape parameter of the power law fitted to the network outdegrees. New cross-section and panel extremum estimators for the degree of dominance of individual units in the network are proposed and their asymptotic properties investigated. Using Monte Carlo techniques, the proposed estimator is shown to have satisfactory small sample properties. An empirical application to US input-output tables spanning the period 1972 to 2007 is provided which suggests that no sector in the US economy is strongly dominant. The most dominant sector turns out to be the wholesale trade with an estimated degree of dominance ranging from 0.72 to 0.82 over the years 1972-2007.
    JEL Classifications: C12, C13, C23, C67, E32
    Key Words: Aggregate fluctuations, strongly and weakly dominant units, spatial models, outdegrees, degree of pervasiveness, power law, input-output tables, US economy.
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  • "Quasi Maximum Likelihood Estimation of Spatial Models with Heterogeneous Coefficients", by Michele Aquaro, Natalia Bailey and M. Hashem Pesaran, June 2015

    Abstract: This paper considers spatial autoregressive panel data models and extends their analysis to the case where the spatial coefficients differ across the spatial units. It derives conditions under which the spatial coefficients are identied and develops a quasi maximum likelihood (QML) estimation procedure. Under certain regularity conditions, it is shown that the QML estimators of individual spatial coefficients are consistent and asymptotically normally distributed when both the time and cross section dimensions of the panel are large. It derives the asymptotic covariance matrix of the QML estimators allowing for the possibility of non-Gaussian error processes. Small sample properties of the proposed estimators are investigated by Monte Carlo simulations for Gaussian and non-Gaussian errors, and with spatial weight matrices of differing degree of sparseness. The simulation results are in line with the paper's key theoretical findings and show that the QML estimators have satisfactory small sample properties for panels with moderate time dimensions and irrespective of the number of cross section units in the panel, under certain sparsity conditions on the spatial weight matrix.
    JEL Classifications: C21, C23
    Key Words: Spatial panel data models, heterogeneous spatial lag coefficients, identification, quasi maximum likelihood (QML) estimators, non-Gaussian errors.
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  • "Business Cycle Effects of Credit Shocks in a DSGE Model with Firm Defaults", by M. Hashem Pesaran and TengTeng Xu, CWPE Working paper. No. 1159, CESifo Working Paper No. 3609, IZA Discussion Paper No. 6027, October 2011, revised April 2016

    Abstract: This paper proposes a new theoretical framework for the analysis of the relationship between credit shocks, firm defaults and volatility. The key feature of the modelling approach is to allow for the possibility of default in equilibrium. The model is then used to study the impact of credit shocks on business cycle dynamics. It is assumed that firms are identical ex ante but differ ex post due to different realizations of firm-specific technology shocks, possibly leading to default by some firms. The implications of firm defaults for the balance sheets of households and banks and their subsequent impacts on business uctuations are investigated within a dynamic stochastic general equilibrium framework. Results from a calibrated version of the model suggest that, in the steady state, a firm's default probability rises with its leverage ratio and the level of uncertainty in the economy. A positive credit shock, defined as a rise in the loan-to-deposit ratio, increases output, consumption, hours and productivity, and reduces the spread between loan and deposit rates. Interestingly, the effects of the credit shock tend to be highly persistent, even without price rigidities and habit persistence in consumption behavior.
    JEL Classifications: E32, E44, E50, G21.
    Key Words: Firm Defaults; Credit Shocks; Financial Intermediation; Interest Rate Spread; Uncertainty.
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    Supplement: 5Oct2011_Supplement.pdf


  • "Optimality and Diversifiability of Mean Variance and Arbitrage Pricing Portfolios", by M. Hashem Pesaran, and Paolo Zaffaroni, CESifo Working Papers No. 2857, October, 2009

    Abstract: This paper investigates the limit properties of mean-variance (mv) and arbitrage pricing (ap) trading strategies using a general dynamic factor model, as the number of assets diverge to infinity. It extends the results obtained in the literature for the exact pricing case to two other cases of asymptotic no-arbitrage and the unconstrained pricing scenarios. The paper characterizes the asymptotic behaviour of the portfolio weights and establishes that in the non-exact pricing cases the ap and mv portfolio weights are asymptotically equivalent and, moreover, functionally independent of the factors conditional moments. By implication, the paper sheds light on a number of issues of interest such as the prevalence of short-selling, the number of dominant factors and the granularity property of the portfolio weight.
    JEL Classifications: Large Portfolios, Factor Models, Mean-Variance Portfolio, Arbitrage Pricing, Market (Beta) Neutrality, Well Diversification.
    Key Words: C32, C52, C53, G11.
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