The Cross Sectional Dependence Puzzle

Abstract

The analysis of unit roots and cointegration in panel data is becoming a growing research area. A number of issues have been raised in the literature (see Phillips and Moon 1999 and 2000, Banerjee 2000, Maddala and Wu 1999). The aim of the present paper is to contribute to the issue of cross sectional dependence in non-stationary panel data. We review some of the most recent econometric techniques proposed by the literature to dealing with cross sectional dependence and notice a sort of puzzle. We extend the bootstrap methodology proposed by Maddala and Wu (1999) and apply the resulting test to test for PPP. We find no evidence favouring PPP. Finally, we use Monte Carlo simulation to analyse the size distortion of the bootstrap test presented in this paper. The proposed test presents size distortion only when T = 100.