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Review 14 - Advanced Panel Data Methods

This document discusses methods for panel data analysis, specifically fixed effects and random effects estimation. Fixed effects estimation removes time-invariant individual characteristics by transforming the data using time demeaning. This controls for potential correlation between unobserved individual characteristics and explanatory variables. Random effects assumes individual characteristics are random and uncorrelated with explanatory variables. The document provides examples of applying each method and notes that fixed effects is generally preferred but random effects is necessary when key explanatory variables do not vary over time.

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Uyen Phan
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60 views6 pages

Review 14 - Advanced Panel Data Methods

This document discusses methods for panel data analysis, specifically fixed effects and random effects estimation. Fixed effects estimation removes time-invariant individual characteristics by transforming the data using time demeaning. This controls for potential correlation between unobserved individual characteristics and explanatory variables. Random effects assumes individual characteristics are random and uncorrelated with explanatory variables. The document provides examples of applying each method and notes that fixed effects is generally preferred but random effects is necessary when key explanatory variables do not vary over time.

Uploaded by

Uyen Phan
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Advanced Panel Data Methods

Chapter 14_Review

Course tutor: Ms. Le Thi Ngoc Mai 1


Fixed effects estimation
Fixed effect, potentially correlated
with explanatory variables

Form time-averages for


each individual

Because (the fixed effect is removed)

• Estimate time-demeaned equation by OLS (the unobserved time-


constant effect in is controlled)
Fixed effects estimation
• Example: Effect of training grants on firm scrap rate

Time-invariant reasons why one firm is more productive than another are controlled for.
The important point is that these may be correlated with the other explanatory variables.

Stars denote
Fixed-effects estimation using the years 1987, 1988, and 1989: time-demeaning

Training grants significantly improve productivity (with a time lag)


Random effects estimation
The individual effect is assumed to be “random” i.e.
completely unrelated to explanatory variables

Random effects assumption:

The composite error term = ai + uit is uncorrelated with the explanatory variables

• Transformed equation:

Quasi-demeaned data
Random effects estimation
• Example: Wage equation using panel data

Random effects is used because


many of the variables are time-
invariant.
Random effects or fixed effects?
• Fixed effects allows arbitrary correlation between and the
explanatory variables, while random effects does not => FE is widely
thought to be a more convincing tool for estimating ceteris paribus
effects.
• Still, random effects is applied in certain situations. Most obviously, if
the key explanatory variable is constant over time, we cannot use FE
to estimate its effect on y.
• It is still fairly common to see researchers apply both random effects
and fixed effects, and then formally test for statistically significant
differences in the coefficients on the time-varying explanatory
variables => Hausman test

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