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Capital adjustment cost and inconsistency in income‐based dynamic panel models with fixed effects

Basu, Parantap; Bhattarai, Keshab; Getachew, Yoseph


Parantap Basu

Yoseph Getachew


After the seminal work of Steve Nickell (1981) [S. Nickel, 1981. Biases in dynamic models with fixed effects. Econometrica 49 (6), 1417--1426], a vast literature demonstrate the inconsistency of "conditional convergence" estimator in income based dynamic panel models with fixed effects when the time horizon (T) is short but the sample of countries (N) is large. Less attention is given to the economic root of inconsistency of the fixed effects estimator when T is also large. Using a variant of the Ramsey growth model with long-run adjustment cost of capital, we demonstrate that the fixed effects estimator of such models could be inconsistent when T is large. This inconsistency arises because of the long-run adjustment cost of capital which gives rise to a negative moving average coefficient in the error term. Income convergence will be thus overestimated. We theoretically characterize the order of this inconsistency. Our Monte Carlo simulation demonstrates that the size of the bias is substantial and it is greater in economies with higher capital adjustment costs.To the best of our knowledge, our paper is the first attempt in the literature to understand the role of capital adjustment cost as an economic fundamental driving the inconsistency of convergence estimator in dynamic panel models with long time horizon.

Journal Article Type Article
Publication Date 2019-11
Journal German Economic Review
Print ISSN 1465-6485
Electronic ISSN 1468-0475
Publisher Wiley
Peer Reviewed Peer Reviewed
Volume 20
Issue 4
Pages e1002-e1018
APA6 Citation Basu, P., Bhattarai, K., & Getachew, Y. (2019). Capital adjustment cost and inconsistency in income‐based dynamic panel models with fixed effects. German Economic Review, 20(4), e1002-e1018.
Keywords Economics and Econometrics; C5; D2; D9; O4; O5; Dynamic panel model; adjustment cost of capital; inconsistency; Ramsey growth model
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