Factor Models in Panels with Cross-sectional Dependence: An Application to the Extended SIPRI Military Expenditure Data

Elisa Cavatorta*, Ron P. Smith

*Corresponding author for this work

Research output: Contribution to journalArticlepeer-review

17 Citations (Scopus)
161 Downloads (Pure)

Abstract

Strategic interactions between countries, such as arms races, alliances and wider economic and political shocks, can induce strong cross-sectional dependence in panel data models of military expenditure. If the assumption of cross-sectional independence fails, standard panel estimators such as fixed or random effects can lead to misleading inference. This paper shows how to improve estimation of dynamic, heterogenous, panel models of the demand for military expenditure allowing for cross-sectional dependence in errors using two approaches: Principal Components and Common Correlated Effect estimators. Our results show that it is crucial to allow for cross-sectional dependence, that the bulk of the effect is regional and there are large gains in fit by allowing for both dynamics and between country heterogeneity in models of the demand for military expenditures.

Original languageEnglish
Pages (from-to)437-456
Number of pages20
JournalDEFENCE AND PEACE ECONOMICS
Volume28
Issue number4
Early online date16 Jan 2017
DOIs
Publication statusPublished - 4 Jul 2017

Keywords

  • factor models
  • Military expenditures
  • panel data

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