A Principal Components Approach to Cross-Section Dependence in Panels



are averages of RI disturbances, wt = i aiuit where uit = γηit + εit . Hence,
there is correlation between w
t and RII disturbances which also contain εit .
However, the weight of
εit in the former (ai) falls as N increases and so
does the endogeneity bias. Second, since
corr(xit, Xjt) = σ22 + σ2d), if we
let
σd2 0 then the regressors are identical across equations. In this case
plimT,N→∞ b = β + γδ and there are no gains from RII over RI. Third, al-
though the foregoing theoretical results (large T, large N consistency of b
) are
derived for a homogeneous panel with identical
β and γ across units, we con-
jecture that similar results apply to heterogenous panels. This is investigated
via Monte Carlo simulations in §4.

The variance of the POLS estimator of a =[bc]0 in RII is

var(a) E [(^ - α)(^ - a)0] = (X0X)-1E (X0vv0X) (X0X)-1      (15)

where X is an NT × 2 matrix. As shown above ρzw converges in probability
to 1 as T
→∞and N →∞. However, to the extent that wt is not a perfect
measure of the unobserved z
t in finite samples, there will be cross-equation
dependence in the disturbances, E
(vit,vjt) 6=0, and between disturbances
and regressors E
(vit,xjt) 6=0for i 6= j.HenceE(X0vv0X) 6= X0 E (vv0)X.
This suggests estimating
var(a) using an analogous formula to (13).

3.3 Serial dependence and heteroskedasticity

The assumption that dit and zt are iid processes is relaxed by letting

dit = Pddi,t-1 + εd,it, εd,it ~ iid(0, σd)
zt = pzzti + εz,t, εz,t ~ iid(0, σ2)

with -1 ρd, ρz 1. This introduces the serial correlation typical of eco-
nomic variables in the disturbances of RI (and RII). In particular, the matrix
E
(X0 vv0X) in (15) will have also nonzero elements E (xitvitxjsvjs) for t 6= s.
By letting
εd,it ~ iid(0, σdi) the heterogeneous variance of the idiosyncratic
in
fluence in xit introduces groupwise heteroskedasticity in RI and RII errors.
In particular, for RI we have

E(ui2t) = γ2(1 - δ)2σz2 + γ2δ2σ2d,i

By rewriting (6) as yit = βxit + γiwt + γi(zt - wt) + εit it follows that vit =
γ
i (zt - wt) + εit in RII. Hence to the extent that wt 6= zt , letting γi 6= γj will
also introduce heteroskedasticity in RII residuals.

11



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