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OXFORD BULLETIN OF ECONOMICS AND STATISTICS, 68, 1 (2006) 0305-9049
Testing for Panel Cointegration with Multiple

Structural Breaks*
Joakim Westerlund
Department of Economics, Lund University, Lund, Sweden
(e-mail: joakim.westerlund@nek.lu.se)
Abstract
This paper proposes a Lagrange multiplier (LM) test for the null hypothesis of
cointegration that allows for the possibility of multiple structural breaks in
both the level and trend of a cointegrated panel regression. The test is general
enough to allow for endogenous regressors, serial correlation and an unknown
number of breaks that may be located at different dates for different
individuals. We derive the limiting distribution of the test and conduct a
small Monte Carlo study to investigate its nite sample properties. In our
empirical application to the solvency of the current account, we nd evidence
of cointegration between saving and investment once a level break is
accommodated.
I.
Introduction
There is a vast literature concerned with extending time-series cointegration

or, rather, non-cointegration tests, to panel data with both a time-series
dimension T and a cross-sectional dimension N. However, there is only a
handful of studies that have attempted to develop panel data tests under the
maintained hypothesis of cointegration. The most noticeable study in this eld
is that of McCoskey and Kao (1998). In their study, the authors extend to
*The author thanks Anindya Banerjee and two anonymous referees for many valuable comments
and suggestions. The author would also like to thank David Edgerton, Johan Lyhagen, Michael
Bergman and seminar participants at Lund University. Financial support from the Jan Wallander and
Tom Hedelius Foundation, research grant number P2005-0117:1, is gratefully acknowledged. The
usual disclaimer applies.
JEL Classication numbers: C12, C32, C33, F21.
101
Blackwell Publishing Ltd, 2006. Published by Blackwell Publishing Ltd, 9600 Garsington Road, Oxford OX4 2DQ, UK
and 350 Main Street, Malden, MA 02148, USA.
102
Bulletin
panel data the univariate LM test for cointegration proposed by Harris and
Inder (1994) and Shin (1994), which is the locally best unbiased invariant test
of the error covariance matrix of a linear regression model. McCoskey and
Kao (1998) show that the proposed test has a limiting normal distribution
under the null hypothesis of cointegration as T tends to innity and then N
sequentially. Because of its good nite sample properties and the attractiveness of the null hypothesis of cointegration rather than the opposite, the test
has become very popular in empirical research (e.g. see, McCoskey and Kao,
2001).
Having been derived using sequential limit arguments whereby T is passed
to innity prior to N, the LM test may be motivated in research situations
involving T which is substantially larger than N. However, researchers need to
be aware that the probability of a structural break in the cointegration relation
increases with the length of the time-series dimension of the panel. As shown
by Hao (1996), this alters the limiting distribution of the test as the
deterministic component of the cointegration regression needs to be modied
to collect for the presence of the structural break. Erroneous omission of
structural breaks is therefore likely to lead to size distortions and deceptive
inference when testing for cointegration. One study that explicitly addresses
this concern when testing the hypothesis of a unit root in panel data is that of
Im, Lee and Tieslau (2005), which generalizes the univariate LM unit root test
of Amsler and Lee (1995). However, to our knowledge there are no such study
that deals with the hypothesis of cointegration in the presence of structural
change in panel data.
In this paper, we propose a simple test for the null hypothesis of
cointegration that accommodate for structural change in the deterministic
component of a cointegrated panel regression. The test is based on the LM
test of McCoskey and Kao (1998) and it is able to accommodate for an
unknown number of breaks in both the constant and trend of the individual
regressions, which may be located at different dates for different individuals.
Test statistics are derived when the locations of the breaks are known
a priori and when they are determined endogenously from the data. Test
statistics are also derived when there is no break but the deterministic
component includes individual-specic constant and trend terms.
Using sequential limit arguments, it is shown that the test has a limiting
normal distribution, i.e. free of nuisance parameters under the null hypothesis.
In particular, it is shown that the limiting distribution is invariant with respect
to both the number and the locations of the breaks and that there is no need to
compute different critical values for all possible patterns of break points as in,
e.g. Bartley, Lee and Strazicich (2001). This invariance property makes the
test computationally very convenient. We also evaluate the small-sample
performance of the test via Monte Carlo simulations. The results suggest that
Blackwell Publishing Ltd 2006
Panel test with multiple structural breaks
103
the test has small size distortions and reasonable power. In our empirical
application, we reexamine the data set employed by Ho (2002) and Taylor
(2002) to assess the solvency of the current account. Contrary to much of the
ndings presented in the earlier literature, we nd evidence suggesting that
saving and investment are cointegrated once a level break in the cointegration
vector is accommodated.
The paper proceeds as follows. In section II, we present the LM test
statistic under the assumption that the locations of the structural breaks are
known. Sections III and IV describes the asymptotic distribution of the test,
while section V relaxes the assumption of known breaks. Section VI is then
devoted to the Monte Carlo study, whereas section VII relates itself with the
empirical application. Section VIII concludes the paper. For notational
convenience, the Bownian motion Bi(r) dened on theR unit interval
1
such as R0 Wi rdr will
r 2 [0, 1] willR be written
as onlyR Bi and integrals
Rr
R1
1
r
1
be written as 0 Wi , 0 Wi sds as 0 Wi and 0 Wi rdWi r as 0 Wi dWi . The
symbol is used to signify weak convergence of the associated probability
measure, [z] is used to denote the largest integer less than z and kzk denotes
the Euclidian norm tr(z0 z)1/2 of z.
II.
The panel LM test with breaks
Consider the multidimensional time-series variable yit, which is observable for

i 1, . . . , N cross-sectional and t 1, . . . , T time-series observations. The
data generating process (DGP) for yit is given by the following system of
equations
yit z0it cij x0it bi eit ;
eit rit uit ;
rit rit1 /i uit ;
where xit xit)1 + vit is a K-dimensional vector of regressors and zit is a

vector of deterministic components. The corresponding vectors of parameters are denoted bi and cij respectively. The index j 1, . . . , Mi + 1 is
used to denote the structural breaks. There can be at most Mi such breaks,
or Mi + 1 regimes, that are located at the dates Ti1, . . . , TiMi, where Ti0 1
and TiMi+1 T. Furthermore, the initial value of rit is assumed to be zero,
which entails no loss of generality as long as zit includes an individualspecic intercept. For convenience in constructing the test and in deriving
its asymptotic distribution, we assume that the vector wit uit ; v0it 0 is
cross-sectionally independent and that it follows a general linear process
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whose parameters satisfy the summability conditions of the following

assumption.
Assumption 1 (Error process). (i) The vectors wij and wkt are independent for
all j, t and i 6 k; (ii)PThe vector P
wit satises wit Ci(L)it, where L is the lag
1
j
0
C
L
;
operator, Ci L 1
ij
j0
j0 kCij Cij k < 1 and it is distributed
independent and identically distributed (i.i.d.) (0, IK+1); (iii) the lower right
K K submatrix of Xi Ci(1)Ci(1)0 is positive denite.
In addition to this, we make the following assumptions regarding the
structural break model.
Assumption 2 (Break model). (i) The locations of the structural breaks are
given as a xed fraction kij 2 (0, 1) of T such that Tij [kijT] and kij)1 < kij
for j 1, . . . , Mi; (ii) Both Mi and kij are assumed to be known.
Assumption 1 (i) states that the members of the panel are independent
of each other. This assumption is convenient as it will allow us to
apply standard central limit theory in a relatively straightforward manner.
For many applications, such as the one considered for this paper, however,
the independence assumption may be quite restrictive and section VII
therefore suggests some possibilities for dealing with the case of crosssectionally correlated data. However, for the present we maintain Assumption 1 (i).
As for the time-series dimension, Assumption 1 (ii) states that the standard
invariance principle is assumed to hold for each individual i as T grows large,
which ensures that the partial sum process constructed
PTr from wit converges to
the vector Brownian motion Bi. Thus, if SiT t1 wit , then T)1/2SiT
Bi Ci(1)Wi as T ! 1 for a xed N, where Bi (Bi1, Bi20 )0 is a vector
Brownian motion and Wi (Wi1, Wi20 )0 is a vector standard Brownian motion
with covariance matrix equal to identity. The covariance matrix of Bi is
dened as
Xi lim T
T !1
1

0
E SiT SiT
x2i11
xi21

x0i21
:
Xi22
This matrix can be regarded as the long-run covariance matrix of wit in the
sense that it captures both the contemporaneous variances and covariances
as well as the covariances at all lags and leads. For later discussion, we
also dene the long-run variance of uit conditional on vit as x2i1:2
x2i11 x0i21 X1
i22 xi21 . Assumption 1 (iii) requires Xi22 being a positive denite
matrix, which precludes the possibility of cointegration within xit in the event
that we have multiple regressors. The off-diagonal elements of Xi captures the
dependence between the rst differentiated regressors and the equilibrium
105
error. In keeping with the cointegration literature, these are left unrestricted,
which means that the regressors may be endogenous.
Assumption 2 (i) is a standard requirement to permit the development of the
asymptotic theory and allows existing break points to be asymptotically distinct.
It suggests that each individual may have several breaks that may be located at
different dates for different individuals. Specically, if Mi 0, then individual i
has no break, while, if Mi > 0, then individual i suffers from at least one break. In
addition, as we may have Mi 6 Mj for i 6 j, this suggests that the number of
breaks may vary between the cross-sectional units. Assumption 2 (ii) requires
both the number and the locations of the structural breaks be known. This
assumption is not necessary and will be relaxed later on.
For the deterministic component of the cointegrated regression, we shall
distinguish between ve different cases. The rst three are the panel analogues
of those studied in the univariate context by Shin (1994). These do not involve
any structural break suggesting that Mi 0 for all i. Specically, in Case 1,
we have zit {[}, which corresponds to a cointegrated regression with
no deterministic component. In Case 2, zit 1 implying a cointegrated
regression with an individual-specic intercept as the deterministic component. In Case 3, zit (1, t)0 so both individual-specic intercepts and trends
are permitted. Cases 4 and 5 are the structural break models, which
corresponds to Cases 2 and 3 with Mi > 0 for at least some i. Thus, Case 4
represents a cointegrated regression with at least one shift in the level for at
least one individual, while Case 5 represents a regression with at least one
shift in the level and trend for at least one individual.
In this DGP, the processes driving the unit root and stationary components
of the composite error term in equation (2) are assumed to be perfectly
correlated with the parameter /i reecting their relative weight. No restrictions
are placed on the sign if /i so the direction of a shock may be different for the
unit root and stationary components. Note that if /i 0 then rit vanishes
under the assumption that ri0 0 in which case xit and yit are cointegrated as
uit is assumed to be a stationary process. It follows that the null hypothesis that
all the individuals of the panel are cointegrated can be stated equivalently as
H0 : /i 0 for all i 1; . . . ; N ;
versus
H1 : /i 6 0 for i 1; . . . ; N1 and /i 0 for i N1 1; . . . ; N :
This formulation of the alternative hypothesis allows /i to differ across the
cross-sectional units, and is more general than the homogenous alternative
hypothesis that /i / 6 0 for all i, which is implicit in the testing approach
of McCoskey and Kao (1998) discussed in section I. For consistency of
the test, it is necessary to assume that the fraction of spurious individuals is
106
Bulletin
non-empty. Thus, we require that N1/N ! d as N ! 1, where d 2 (0, 1].

The panel LM test statistic for this hypothesis is given as follows.
^ 1 x
^ 2i11 x
^ 0i21 X
^ 2i1:2 x
DefinitionP
1 (The panel LM test statistic). Let x
i22 ^ i21
t

and Sit kTij1 1 êik ; where êit is any efcient estimate of eit. The panel
LM test statistic is dened as follows
ZM
Tij
N M
i 1
X
X
X
2
^ 2
Tij Tij1 2 x
i1:2 Sit :
i1 j1 tTij1 1
Remark 1. The statistic is written as an explicit function of M

(M1, . . . , MN)0 to denote that it has been constructed for a certain number of
breaks for each cross-section and that its asymptotic distribution depend on it.
Remark 2. To compute the statistic, we need to obtain an efcient estimator
êit of the error term eit. Under Assumption 1 this can be achieved using either
the dynamic ordinary least square (DOLS) estimator of Saikkonen (1991) or
the fully modied OLS (FMOLS) estimator of Phillips and Hansen (1990).
The estimation is carried out separately for each subsample ranging from Tij)1
to Tij time-series observations. For Case 1, the regression is tted without any
deterministic components. For Cases 2 and 4, the regression is tted with an
individual-specic intercept as the deterministic component, while, for Cases
3 and 5, it is tted with both individual-specic intercepts and trends. In
addition, for Cases 13, we have Mi 0 for all i suggesting that the
estimation is carried out using the entire sample.
^ 2i1:2 , we need to obtain a consistent
Remark 3. To be able to construct x
^ i of Xi. To this end, because we are allowing for general forms of
estimator X
serial dependence within the individual regressions over time, consistency
may be achieved using any semiparametrical kernel estimator of the following
form
X
k
T
X
j
1
^
^ it w
^ 0itj :
1
w
Xi T
k
1
tj1
jk
^ i may be
As OLS is consistent even with endogenous regressors, X
0 0
^ it êit ; vit , where êit denotes the OLS estimate of eit.
constructed using w
The weight function 1 ) j/(1 + k) is the Bartlett kernel, which ensures the
^ i . For consistency of the test, it is necessary
positive semideniteness of X
that the bandwidth parameter k satises the property that k ! 1 and k/
T ! 0 as T ! 1. The choice k [T1/3] is sufcient. As the long-run
^ 2i1:2
conditional variance of eit is assumed to be constant, the estimation of x
may be carried out using the full length of the time-series dimension with
107
dummy variables to account for the breaks. However, in practice, it may be

more convenient to estimate not only the parameters but also the variances
separately for each segment, which does not alter the limit distribution of the
test. Besides being easy to implement, this approach has the additional
advantage that it makes the test robust to shifts in the variance if we assume
that they are located at the same dates as the shifts in the deterministic
component.
III.
Asymptotic distribution
In this section, we derive the asymptotic distribution of the test statistic under
the null hypothesis. To this effect, we posit Q and R, respectively, to be the
expected value and the variance of the following vector standard Brownian
motion functional
Z 1
1 Z 1
Z 1
Z r
2
0

i2 dWi1:2 :
Wi2
Wi2 Wi2
W
Vi where Vi Wi1:2
Fi
0
1
0
The process Wi1:2 x1
i1:2 Bi1:2 with Bi1:2 Bi1 xi21 Xi22 Bi2 is a scalar
standard Brownian motion, that is independent of Wi2. The vector standard
i2 z0 ; W 0 0 , where z is the
i2 may be written as W
Brownian motion W
i2
appropriately scaled limit of the deterministic component zit. Specically, z
{[} in Case 1, z 1 in Cases 2 and 4, and z (1, r)0 in Cases 3 and 5. The
functional Fi is referred to as a generalized Cramer-von Mises distribution
with 1 d.f. This functional has the additive property that the sum of Mi + 1
independent generalized Cramer-von Mises distributions with 1 d.f. each is
Cramer-von Mises with Mi + 1 d.f. The expected value of such a sum is equal
and R
as
to (Mi + 1)Q and the variance is equal to (Mi + 1)2R. Let us dene H
the cross-sectional averages of these expectations and variances for each
individual. As the following theorem indicates, when the test statistic is
normalized by the appropriate order of N, then the asymptotic distribution will
and R.

depend only on the known values of H
Theorem 1 (Asymptotic distribution). Under Assumptions 1 and 2, and the

null hypothesis of cointegration, as T ! 1 and then N ! 1
) N 0; R:

N 1=2 ZM N 1=2 H
Remark 4. The proof of Theorem 1 is provided in the Appendix. It uses the

sequential limit theory developed by Phillips and Moon (1999), which means
that in deriving the asymptotic distribution of the test, we rst take the limit as
T ! 1 followed sequentially by the limit as N ! 1. The sequential limit
theory greatly simplies the derivation of the limit distribution of the test but it
108
Bulletin
is not the most general method. In fact, by using the method of joint limits, it
is possible allow for both T and N to approach innity concurrently rather in
sequence. As pointed out by Phillips and Moon (1999), this implies that the
joint limit distribution characterizes the limit distribution for any monotonic
expansion rate of T relative to N. The authors also provide a set of conditions
that are required for sequential convergence to imply joint convergence.
Remark 5. In our case, the sequential limit method substantially simplies the
derivation of the limit distribution for at least two reasons. One reason is that it
allows us to control the effects of the nuisance parameters associated with the
locations of the structural breaks and the serial correlation properties of the
data in the rst step as T ! 1 by virtue of the standard invariance principle.
To
this, note that each of the subsample quantities
PTijget an intuition on
2 2 2
^
T

T
x
ij
ij1
i1:2 Sit comprised of Z(M) can be treated as a test
tTij1 1
statistic that is not subject to structural change. As shown in the Appendix,
each of these subsample statistics converges to a generalized Cramer-von
Mises distribution with 1 d.f. as T ! 1. Hence, by the additive property of
Fi, the intermediate limit distribution of Z(M) for each individual can be
described entirely in terms of a Cramer-von Mises distribution with Mi + 1
d.f. This means that the limit distribution is invariant not only with respect to
the serial correlation properties of the data but also with respect to the
locations of the structural breaks and that it only depends on Mi, the number of
breaks for each cross-section, which is assumed to be known. Another reason
why sequential limits simplify the derivation is that, as the members of the
panel are assumed to be independent of each other, the statistic may be treated
as a sum of N independent drawings from a set of underlying distributions to
which standard LindbergFeller central limit arguments may be applied to
obtain a limiting normal distribution.
Remark 6. To be able to compute the standardized statistic in equation (5),
we need to obtain numerical values of the moments Q and R. One standard
way in which moments have been obtained in situations where no closed form
expressions exist is to use Monte Carlo simulation of the limiting distribution
of the test. Table 1 presents the simulated values of Q and R using this
method. To obtain the moments, we make 10,000 draws of K + 1 independent
random walks of length T 1,000. By using these random walks as simulated
Brownian motions, we can construct approximations of the functional Fi,
which are then used to compute the moments. The moments apply in general
for any deterministic specication and for any number of regressors when the
slope parameters are estimated separately for each member of the panel.
However, the specic values of Q and R depend on the particular model, such
as whether individual-specic intercepts or trends have been included in the
estimation, and on K, the number of regressors. Accordingly, Table 1 gives the
109
TABLE 1
Simulated asymptotic moments
Moment
Case
K1
K2
K3
K4
K5
1
2/4
3/5
0.35500
0.11601
0.05530
0.26963
0.08464
0.04686
0.20584
0.06539
0.04063
0.16688
0.05295
0.03532
0.13770
0.04442
0.03133
1
2/4
3/5
0.18017
0.01151
0.00115
0.11260
0.00559
0.00078
0.06310
0.00266
0.00056
0.04072
0.00144
0.00036
0.02670
0.00086
0.00027
Notes: Case 1 refers to the regression without any deterministic intercepts or trends, Case 2 refers
to the regression with an individual-specic intercept, Case 3 refers to the regression with individualspecic intercepts and trends, Case 4 refers to the regression with breaks in the intercept and Case 5
refers to the regression with breaks in both intercept and trend. The value K refers to the number of
regressors excluding any tted deterministic intercepts or trends.
moments for each of the ve deterministic specications and for up to ve

based on the simulated expectations in Table 1,
regressors. To obtain H
simply multiply the appropriate expected value by Mi + 1 for each individual
multiply the
and then take the cross-sectional average. Similarly, to obtain R,
appropriate variance by the square of Mi + 1 and then take the cross-sectional
average. Once the standardized test statistic in equation (5) has been
computed, it should be compared with the right tail of the normal distribution.
Thus, large positive values indicate that the null hypothesis should be rejected.
Remark 7. The fact that the moments of Table 1 does not depend on the
locations of the structural breaks is a great advantage. For example, the
univariate cointegration test proposed by Bartley et al. (2001) allows for a single
break to affect the deterministic component of the cointegration vector.
However, this allowance makes the test asymptotically dependent on the
location of the break. To accommodate for this, the authors simulate critical
values for a few equally spaced break points, which can be used to perform the
test. There are at least two problems with this approach. The rst problem is that
assuming equally spaced breaks is not appropriate in general in which case
critical values for a possible continuum of breakpoints may be required. The
second problem is that, even with discrete and equally spaced breaks, one faces
the complication factor of having to consult a table for the critical values for
every break location, which may be a very tedious undertaking in itself. With
multiple breaks, this approach becomes practically infeasible as constructing
tables for every possible pattern of Mi breaks would be extremely cumbersome.
Remark 8. Note that the breaks are allowed under both the null and alternative
hypotheses. This is very convenient as it facilitates a straightforward
interpretation of the test result. To illustrate this, let us consider the univariate
110
Bulletin
unit root test of Zivot and Andrews (1992), which allows for a single unknown
break to affect the level and trend of the series. The problem with this test is that
the break is only permitted under the alternative hypothesis of stationarity. Thus,
a rejection of the null does not necessarily imply a rejection of a unit root per se
but rather a rejection of a unit root without breaks. This outcome calls for a
careful interpretation of the test result in applied work. Particularly, in the
presence of breaks under the null, researchers might incorrectly conclude that a
rejection of the null indicates evidence of stationarity with a break, when in fact
the series non-stationary with breaks.
IV.
Response surface regressions
Preliminary results suggest that the simulated asymptotic moments may not be
borne out fully in realistically small samples and that moments for small
values of T may be required in order to allow for accurate testing. To this end,
in order to present the results more succinctly, we use response surface
regressions. We experimented with a variety of specications and we opted for
the following linear regression model
1=2
yi d1 d2 Ti
d3 Ti1 d4 Ti2 ei ;
where yi is the simulated moment based on a sample of Ti time-series

observations and ei is a heteroskedastic error term that reects the
simulation uncertainty and the approximation of the true regression form
by using the quadratic one in equation (6). The intercept is an estimate of
the asymptotic moment of the test statistic and the remaining parameters determine the shape of the response surface for nite values of T.
1=2
, Ti1 and Ti2 as explanatory variables, we are
Hence, by including Ti
in effect allowing the small-sample moments of the test statistic to differ
from the asymptotic ones. The choice of regressors to include was dictated
by the size of the difference between the estimated intercept and the
appropriate asymptotic moment, by the overall t of the regressions and by
the signicance of the parameters themselves. Adding powers larger than
two of Ti never seemed to be necessary so the same specication applies to
all moments.
The estimation proceeds as follows. For each combination of K and T, we
generate 1,000 test statistics under the null hypothesis with all regression
parameters set equal to one. We use both FMOLS and DOLS estimation. The
FMOLS is performed using the Bartlett kernel with the bandwidth parameter
set equal to [T1/3] and the DOLS is performed using [0.5T1/3] lags and
leads of the rst differences of the regressors. We generate moments
for T 2 {20, 50, 60, 70, 100, 200, 500, 1,000} time-series observations and
111
up to ve regressors. Most samples are relatively small as these seem to

provide more information about the shape of the response surfaces. However,
a few large values of T are also included to ensure that the estimates of
the asymptotic moments are sufciently accurate. Moments for all three
deterministic cases are extracted and stored. We then perform 100 replications
of each experiment, which means that there is a total of 800 observations
available for each of the response surface regressions.
As the regression error is heteroskedastic by construction, we follow
MacKinnon (1996) and apply the generalized method of moments estimator
proposed by Cragg (1983). To this effect, let Z denote the matrix of right-hand
side variables and let Y denote the vector of simulated moments for each
experiment. Also, suppose that ê denotes the residual obtained from the OLS
t of Y on Z, then V^ is the diagonal matrix with the principal diagonal equal to
that of êê0 . The Cragg (1983) estimator may now be written as
d^ Z 0 W W 0 V^ W 1 W 0 Z1 Z 0 W W 0 V^ W 1 W 0 Y ;
where d^ is the vector of estimated response surface parameters and W is a
matrix comprised of one dummy variable for each value of T. The results are
presented in Table 2 for the FMOLS-based test and in Table 3 for the DOLSbased test. These permit a quick computation of the approximate moments for
a particular value of T. As a measure of regression uncertainty, the table
reports the estimated standard error for each regression. These reect both the
simulation uncertainty from estimating the moment rather than knowing it and
the approximation error of using a quadratic regression form rather than the
true one. The standard error is always smaller than 0.03, assuring reasonably
high precision in the estimates and low regression uncertainty. Another
measure of the quality of the estimated response surfaces is the size of the
differences between the estimated intercepts and the moments reported in
Table 1 based on simulating the asymptotic distribution of the test. It was
observed that the intercepts appear to be remarkably precise estimates of the
asymptotic moments.
V.
Unknown break points
In the previous sections, we have assumed that both the number and the
locations of the structural breaks are known. This is not necessary. In fact, if
there is no a priori knowledge about the breaks, one may prefer to treat them
as endogenous variables that need to be estimated from the data. For this
purpose, we suggest using the proposal of Bai and Perron (1998, 2003), which
obtains the location of the breaks by globally minimizing the sum of squared
residuals as follows
112
TABLE 2
FMOLS-based response surface moments
Expected value
Variance
)1/2
Intercept
1
1
1
1
1
2
2
2
2
2
3
3
3
3
3
1
2
3
4
5
1
2
3
4
5
1
2
3
4
5
0.35264
0.26144
0.20695
0.16916
0.13943
0.11708
0.08557
0.06730
0.05391
0.04451
0.05515
0.04749
0.04103
0.03558
0.03073
0.05048
0.03296
)0.12335
)0.26228
)0.24630
)0.05532
)0.06494
)0.11746
)0.09801
)0.09041
0.01680
)0.02300
)0.03676
)0.04270
)0.02145
)0.61249
)0.91888
)0.20455
0.82432
0.75407
0.31233
0.24917
0.60610
0.49008
0.53038
0.21483
0.39897
0.45948
0.53224
0.41501
)2
12.82076
17.62065
15.76128
8.03949
11.69389
3.14865
6.69821
6.52534
11.09135
13.72616
4.98491
6.46768
9.02230
11.23719
15.37253
SE
Intercept
T )1/2
T )1
T )2
SE
0.00407
0.00383
0.00576
0.00679
0.00890
0.00421
0.00571
0.00806
0.01095
0.01394
0.00794
0.00968
0.01186
0.01436
0.01708
0.18995
0.09720
0.06441
0.04111
0.02693
0.01130
0.00581
0.00309
0.00161
0.00095
0.00125
0.00085
0.00057
0.00036
0.00025
)0.42167
0.11888
)0.12325
)0.13058
)0.10471
)0.02838
)0.02252
)0.02008
)0.00995
)0.00646
)0.00527
)0.00385
)0.00232
)0.00087
)0.00023
0.51418
)2.31403
)0.26189
0.15712
0.17162
)0.02232
0.01171
0.05684
0.01394
0.00484
0.00590
0.00168
)0.00541
)0.01211
)0.01607
)0.56690
24.26596
5.93036
0.77613
0.30837
0.55336
0.30932
)0.21322
0.19668
0.31930
0.02762
0.10582
0.22323
0.33811
0.46277
0.01777
0.00990
0.00699
0.00482
0.00342
0.00158
0.00093
0.00050
0.00027
0.00017
0.00020
0.00013
0.00009
0.00009
0.00015
Notes: See Table 1 for an explanation of the different cases. The table gives simulated nite and asymptotic moments for the FMOLS-based test. The
appropriate moment is obtained from the table by calculating the tted value of the corresponding regression.
Bulletin
Case
)1
TABLE 3
DOLS-based response surface moments
Expected value
K
Intercept
1
1
1
1
1
2
2
2
2
2
3
3
3
3
3
1
2
3
4
5
1
2
3
4
5
1
2
3
4
5
0.36132
0.27401
0.22226
0.18901
0.14815
0.11625
0.08775
0.06583
0.05238
0.04255
0.05347
0.04542
0.03855
0.03248
0.02710
)0.22961
)0.31577
)0.63793
)0.82065
)0.40345
0.00344
)0.06769
0.02019
0.03925
0.08621
0.10835
0.10271
0.11087
0.14376
0.19392
1.57112
1.99793
4.13834
5.10891
1.59114
0.25486
0.69281
)0.05966
)0.27469
)0.72910
)0.31741
)0.39739
)0.54675
)0.88995
)1.38020
)2
)16.31658
)15.55645
)30.95020
)33.87714
29.82585
10.42508
9.15342
22.41660
30.42694
41.76848
19.11540
23.86645
30.28444
39.98488
52.16569
SE
Intercept
T )1/2
T )1
T )2
SE
0.00211
0.00149
0.00373
0.00639
0.00997
0.00626
0.00706
0.00804
0.00951
0.01105
0.00821
0.00878
0.00987
0.01128
0.01289
0.19043
0.11030
0.07280
0.05053
0.03162
0.01159
0.00642
0.00301
0.00177
0.00109
0.00124
0.00091
0.00062
0.00044
0.00027
)0.44026
)0.24182
)0.41392
)0.39326
)0.22870
)0.03922
)0.03858
)0.01180
)0.01178
)0.00809
)0.00398
)0.00446
)0.00303
)0.00217
)0.00027
0.68625
0.18178
2.05185
2.01483
1.08659
0.15646
0.20346
0.04324
0.05704
0.03283
0.00988
0.01700
0.00961
0.00279
)0.01137
)10.46369
)0.98334
)18.72711
)17.22861
)7.95727
)2.72168
)2.59177
)0.67325
)0.63751
)0.24776
)0.24893
)0.24814
)0.10056
0.07898
0.34558
0.02274
0.01192
0.00722
0.00562
0.00273
0.00116
0.00062
0.00034
0.00019
0.00014
0.00017
0.00012
0.00008
0.00005
0.00004
Notes: See Table 1 for an explanation of the different cases. The table gives simulated nite and asymptotic moments for the DOLS-based test. The
appropriate moment is obtained from the table by calculating the tted value of the corresponding regression.
113
Case
Variance
)1
)1/2
114
Bulletin
Tî arg min

Ti
M
i 1
X
Tij
X
yit z0it cîj x0it bî 2 ;
j1 tTij1 1
where Tî Tî1 ; . . . ; TîMi 0 is the vector of estimated break points, cîj and bî are
the estimates of the cointegration parameters based on the partition Ti
(Ti1, . . . , TiMi)0 and s is a trimming parameter such that kij ) kij)1 > s, which
imposes a minimum length for each subsample. Because the minimization is
taken over all possible partitions of permissable length, the break-point
estimators are said to be global minimizers. The estimation is performed in
two separate steps. In the rst step, the global minimizers of the sum of
squared residuals are estimated and stored together with the associated optimal
break partitions for each possible number of breaks Mi 1, . . . , J, where J is
some predetermined upper boundary. In the second step, the number of breaks
are estimated using an information criterion.
The purpose of the rst step is to estimate the unknown regression parameters
together with the unknown break points when T observations are available for
each individual. This can be achieved using the dynamic programming
algorithm developed by Bai and Perron (2003). However, in our case, as the
slope parameters bi are not subject to shift and are estimated using the full length
of the time-series dimension, the algorithm cannot be applied directly. This is so
because the estimate of bi associated with the minimum of the sum of squared
residuals depends on the optimal break partition Ti that we are trying to estimate,
which means that we cannot concentrate out bi from the objective function.
Therefore, the minimization of the sum of squared residuals cannot be performed
with respect to Ti directly but must be carried out iteratively.
The iterative procedure suggested by Bai and Perron (2003) proceeds in the
following fashion. Given a starting value for bi, initiate the procedure by
minimizing the objective function with respect to cij and Ti while keeping bi
xed. This requires an evaluation of the optimal break partition for all
permissable subsamples that admits the possibility of Mi breaks. Because bi is
held xed, this stage amounts to minimize the objective function of a pure
structural change model to which the dynamic programming algorithm apply.
The next stage is to minimize with respect to cij and bi simultaneously while
keeping Ti xed. Then, iterate until the marginal decrease in the objective
function converges or until the number of iterations reaches some predetermined
upper boundary. Each iteration assures a decrease in the objective function.
The rst step yields estimated break partitions and sum of squared
residuals for each number of breaks that lies in the interval [1, J]. The second
step uses these sum of squared residuals to estimate the number of
breaks to include in the cointegrated regression. To this end, we follow the
recommendation of Bai and Perron (2003) and use the Schwarz Bayesian
information criterion. Also, as the case with no breaks is permissable, the sum
115
of squared residuals obtained from the rst step are compared with those
obtained for the corresponding model conguration without any break. The
estimated break vector Tî is then obtained as the partition associated with the
particular number of breaks that minimizes the criterion.
The two steps described above are repeated N times, which produces a vector
of estimated break points for each individual in the sample. The LM statistic can
then be constructed using Tî in place of Ti for each individual. As shown by Bai
and Perron (1998), the above procedure yields consistent estimators of both kij
and Mi for each individual as T grows large. This is very convenient because it
implies that the sequential limit distribution of the statistic derived in section III
will be unaltered even if we treat the locations of the breaks as unknown.
VI.
Monte Carlo simulations
To examine the small-sample properties of the test, we conduct Monte Carlo

experiments similar to the design of McCoskey and Kao (1998). The DGP can
be summarized using the following system of equations
yit z0it cij xit bi rit uit ;
xit xit1 vit ;
rit rit1 /uit :
The error vector wit (uit, vit)0 is generated as an MA(1) process satisfying
wit eit + heit)1, where h is the moving average parameter, eit N(0, V) and
V is a positive denite matrix with V11 V22 1.1 For the initiation of xit, rit
and eit, we use the value zero. The data were generated for 1,000 panels with
N cross-sectional and T + 50 time-series observations. The rst 50 observations for each cross-section is then disregarded in order to reduce the effect of
the initial condition.
The parametrization of the DGP is as follows. For simplicity, make the
assumption that there is a single break such that ki1 k1 for all i and k1
(0.3, 0.5, 0.7).2 We also assume that there is a single regressor with slope
bi N(1, 1). For the deterministic component, we have ve different
congurations, each of which correspond to one of our ve model specications. For Cases 13, we have M 0 so cij ci1 is constant for all i.
Specically, ci1 0 in Case 1, ci1 N(1, 1) in Case 2 and ci1 N(1, I2) in
Case 3. For Case 4, we have cij N(lj, 1), while cij N(lj, I2) for Case 5. In
both cases, the break parameters are generated with l1 1 and d l2 ) l1,
where the parameter d (1, 2, 3) is used to control the size of the break.
1
For some simulation results for the panel LM test with autoregressive errors, see Westerlund
(2005).
2
Some simulations results for the case with two structural breaks are available from the author
upon request.
116
Bulletin
The parameter / determines whether the null hypothesis is true or not. For
brevity, we make the assumption that this parameter takes on a common value
for all individuals. Therefore, under the null hypothesis, we have / 0,
while / (0.05, 0.1) under the alternative hypothesis. The parameters h and
V introduces nuisance in the DGP. The effect of the MA(1) component is
governed by h ()0.5, 0, 0.5), while the degree of endogeneity is captured
by the off-diagonal elements V12 and V21 of V. For brevity, we only present the
results for the case when V12 V21 0.4.
Simulations have been carried out using both DOLS and FMOLS estimation.
However, the results were very similar and we therefore only present the results
for the FMOLS estimator, which employs a semiparametric correction to
account for the presence of endogenous regressors. To this end, we use the
Bartlett kernel with the bandwidth parameter chosen as a xed function of Tsuch
that [T1/3]. In estimating the unknown break points, we follow the recommendation of Bai and Perron (2003) and use the trimming parameter s 0.15. The
convergence criterion in the iterative procedure is set to 0.0001 and the
maximum number of iterations allowed is 50. The maximum number of breaks
considered is J 5. The test results are based on the moments obtained using
the estimated response surfaces in Table 2. For brevity, we only report the size
and size-adjusted power of a nominal 5% level test.
We begin by considering the performance of the test for the case with no
structural breaks. The results are presented in Table 4. Turning rst to the
results on the empirical size we see that the test generally maintains the
nominal level well when h 0 but it is distorted when h 6 0. For positive
values of h, the test has a size above the nominal level. Conversely, for
negative values of h, the test has a size below the nominal level. The larger the
absolute value of h, the larger the distortion. Yet, negative values of h in
general led to more severe distortions than positive. In addition, while
decreasing in T, we see that the distortions have a tendency of accumulating
and to become more serious as N increases.
The results on the size-adjusted power suggest that the test performs well
with rejection frequencies that are close to one in most experiments. The test
of Case 1 has the highest power and the test of Case 3 has the lowest power.
Thus, the introduction of deterministic intercept and trend terms that need to
be estimated affects the test by reducing its power. Moreover, the power
increases as both N and T grows, which is presumably a reection of
consistency of the test. As expected, the rate at which this happens depend
strongly on the inuence of the unit root component in the errors as indicated
by the value taken by /.
For Cases 4 and 5 with known breaks, the simulations were carried out
using d 1 for the size of the shifts. The results are reported in Table 5. In
agreement with the results for the models with no break, we see that the test is
TABLE 4
N 10, T 100
N 20, T 100
N 10, T 200
N 20, T 200
Case
h0
h )0.5
h 0.5
h0
h )0.5
h 0.5
h0
h )0.5
h 0.5
h0
h )0.5
h 0.5
1
1
1
2
2
2
3
3
3
0.00
0.05
0.10
0.00
0.05
0.10
0.00
0.05
0.10
0.078
0.836
0.980
0.074
0.598
0.952
0.058
0.244
0.716
0.108
0.870
0.978
0.120
0.602
0.946
0.148
0.218
0.694
0.002
0.910
0.998
0.002
0.556
0.946
0.000
0.258
0.768
0.050
0.988
1.000
0.066
0.804
0.998
0.066
0.334
0.920
0.124
0.982
1.000
0.118
0.786
0.994
0.138
0.388
0.934
0.000
0.992
1.000
0.000
0.814
1.000
0.000
0.414
0.950
0.070
0.994
1.000
0.076
0.962
1.000
0.080
0.782
0.996
0.094
0.992
1.000
0.108
0.978
1.000
0.146
0.814
0.998
0.000
0.994
1.000
0.002
0.982
1.000
0.000
0.784
0.996
0.064
1.000
1.000
0.048
1.000
1.000
0.082
0.962
1.000
0.102
1.000
1.000
0.128
1.000
1.000
0.138
0.976
1.000
0.000
1.000
1.000
0.000
1.000
1.000
0.000
0.980
1.000
117
Notes: The value / refers to the weight being attached to the unit root component in the regression errors and h refers to the moving average parameter. See
Table 1 for an explanation of the different cases.
Size and size-adjusted power for Cases 13
118
Bulletin
correctly sized when h 0 but there is a problem with size distortions when
h 6 0. As expected from the asymptotic theory, we see that the performance
under the null is unaffected by the location of the structural break. One notable
exception is for Case 5 where the results suggest that the test can be severely
distorted unless the time-series dimension of the individual subsamples before
and after each break is sufciently large. In fact, based on the results obtained
from the simulations, we recommend not using the test in this case unless the
size of each subsample is T 100 or greater.
As for the power of the test, the results indicate that the performance is good
in general. Notably, the loss of power caused by estimating the parameters of the
model for each subsample separately rather than over the entire length of the
time-series dimension as in Cases 2 and 3 need not be large and is effectively
non-existing in some experiments. These results appear to be rather robust and
applies regardless of the location of the structural break. As in the no break case,
we also observe large gains in power as N, T and / increases.
The results on the size and power for the DGP with unknown breaks are
presented in Table 6. In this case, the data were generated with k1 0.5 xed
and we instead vary the magnitude of the breaks. The results under the null
hypothesis indicate that the test maintain the nominal size well and that there are
no large differences in the performance depending on whether the breaks are
treated as known or not. As for the performance under the alternative
hypothesis, we nd that the power of the test decreases considerably in some
experiments when compared with the case with known breaks, which accords
with the results reported by Kurozumi (2002) in the context of stationarity
testing in time-series data. One reason for this might be that the estimated
number of breaks tend to lie above its true value, which means that the
alternative model becomes close to the null hypothesis, as is the case when more
breaks are being estimated, thus causing a loss of power. However, given the
smallness of the weight attached to the random walk component in the errors,
the power still appears to be reasonable in most experiments. In addition, it was
observed that the power increases as the size of the break becomes larger. As
will be argued momentarily, a larger break is easier to detect, which suggests
that the power increases as the precision of the estimated breaks improves.
By treating the locations of the breaks as unknown, the test results can also
be analysed in terms of the accuracy of the break estimates. To this end, Bai
and Perron (1998) show that, although consistent as T increases, the rate at
which the estimated break fractions converge to their true values depend on
the magnitude of the breaks, which seems reasonable as a smaller break is
more difcult to discern. Bartley et al. (2001) analyses this issue in small
samples and found that Ti can be estimated fairly well when the size of the
break is larger than two in absolute value. To examine the accuracy of the
estimated breaks in our case, Table 7 presents the correct selection frequencies
TABLE 5
Size and size-adjusted power for Cases 4 and 5 with known breaks
N 10, T 100
N 20, T 100
N 10, T 200
N 20, T 200
k1
h0
h )0.5
h 0.5
h0
h )0.5
h 0.5
h0
h )0.5
h 0.5
h0
h )0.5
h 0.5
4
4
4
4
4
4
4
4
4
5
5
5
5
5
5
5
5
5
0.3
0.3
0.3
0.5
0.5
0.5
0.7
0.7
0.7
0.3
0.3
0.3
0.5
0.5
0.5
0.7
0.7
0.7
0.00
0.05
0.10
0.00
0.05
0.10
0.00
0.05
0.10
0.00
0.05
0.10
0.00
0.05
0.10
0.00
0.05
0.10
0.022
0.246
0.720
0.016
0.244
0.716
0.012
0.276
0.768
0.200
0.090
0.256
0.042
0.240
0.718
0.154
0.298
0.752
0.044
0.246
0.758
0.054
0.258
0.706
0.044
0.262
0.730
0.230
0.170
0.388
0.124
0.234
0.702
0.222
0.304
0.706
0.002
0.256
0.710
0.000
0.234
0.706
0.000
0.230
0.704
0.042
0.098
0.286
0.000
0.210
0.668
0.044
0.234
0.752
0.018
0.356
0.926
0.018
0.340
0.922
0.020
0.438
0.930
0.454
0.132
0.510
0.072
0.364
0.920
0.430
0.460
0.940
0.066
0.316
0.904
0.060
0.354
0.910
0.056
0.442
0.936
0.534
0.144
0.504
0.186
0.340
0.910
0.510
0.428
0.932
0.000
0.344
0.934
0.000
0.334
0.896
0.000
0.462
0.952
0.110
0.110
0.408
0.000
0.338
0.920
0.130
0.456
0.936
0.020
0.784
0.994
0.030
0.760
0.996
0.010
0.858
0.996
0.026
0.372
0.946
0.012
0.776
1.000
0.030
0.816
0.996
0.066
0.766
0.994
0.052
0.796
0.994
0.042
0.818
1.000
0.074
0.410
0.944
0.074
0.772
1.000
0.088
0.792
0.996
0.000
0.822
0.998
0.000
0.826
0.998
0.000
0.854
1.000
0.000
0.480
0.954
0.000
0.798
0.998
0.000
0.846
1.000
0.016
0.964
1.000
0.012
0.956
1.000
0.012
0.962
1.000
0.036
0.648
1.000
0.024
0.974
1.000
0.038
0.976
1.000
0.056
0.986
1.000
0.060
0.974
1.000
0.060
0.958
1.000
0.126
0.542
0.998
0.130
0.954
1.000
0.110
0.958
1.000
0.000
0.976
1.000
0.000
0.966
1.000
0.000
0.982
1.000
0.000
0.640
1.000
0.000
0.960
1.000
0.000
0.984
1.000
Notes: The value k1 refers to the location of the structural break, the value / refers to the weight being attached to the unit root component in the regression
errors and h refers to the moving average parameter. See Table 1 for an explanation of the different cases.
119
Case
120
TABLE 6
Size and size-adjusted power for Cases 4 and 5 with unknown breaks
N 10, T 100
N 20, T 100
N 10, T 200
N 20, T 200
h0
h )0.5
h 0.5
h0
h )0.5
h 0.5
h0
h )0.5
h 0.5
h0
h )0.5
h 0.5
4
4
4
4
4
4
4
4
4
5
5
5
5
5
5
5
5
5
1
1
1
2
2
2
3
3
3
1
1
1
2
2
2
3
3
3
0.00
0.05
0.10
0.00
0.05
0.10
0.00
0.05
0.10
0.00
0.05
0.10
0.00
0.05
0.10
0.00
0.05
0.10
0.018
0.083
0.127
0.007
0.093
0.197
0.013
0.173
0.310
0.040
0.120
0.267
0.037
0.120
0.260
0.057
0.087
0.167
0.000
0.073
0.157
0.003
0.087
0.173
0.003
0.117
0.233
0.070
0.083
0.140
0.047
0.120
0.207
0.080
0.083
0.153
0.146
0.147
0.153
0.030
0.110
0.330
0.007
0.150
0.427
0.000
0.093
0.210
0.000
0.087
0.250
0.000
0.107
0.307
0.012
0.173
0.253
0.007
0.133
0.390
0.010
0.207
0.533
0.070
0.097
0.387
0.080
0.103
0.310
0.070
0.107
0.353
0.006
0.103
0.163
0.007
0.073
0.207
0.007
0.127
0.383
0.140
0.160
0.327
0.133
0.163
0.263
0.153
0.100
0.297
0.142
0.153
0.220
0.015
0.110
0.437
0.010
0.100
0.550
0.000
0.110
0.380
0.000
0.107
0.353
0.000
0.100
0.390
0.020
0.280
0.507
0.018
0.273
0.643
0.013
0.427
0.747
0.017
0.300
0.750
0.020
0.263
0.763
0.007
0.293
0.713
0.000
0.187
0.600
0.010
0.267
0.700
0.007
0.297
0.780
0.020
0.207
0.523
0.007
0.210
0.533
0.017
0.200
0.660
0.150
0.170
0.560
0.037
0.320
0.880
0.013
0.493
0.943
0.000
0.347
0.943
0.000
0.303
0.900
0.000
0.383
0.960
0.016
0.413
0.777
0.005
0.627
0.913
0.013
0.537
0.910
0.027
0.390
0.937
0.017
0.487
0.957
0.017
0.407
0.953
0.000
0.260
0.803
0.000
0.437
0.963
0.003
0.387
0.923
0.033
0.243
0.777
0.030
0.317
0.830
0.030
0.260
0.750
0.197
0.227
0.790
0.018
0.543
0.987
0.010
0.687
1.000
0.000
0.633
1.000
0.000
0.477
0.993
0.000
0.600
1.000
Notes: See Table 1 for an explanation of the different cases and Table 5 for an explanation of the various parameters. The value d refers to the size of the
structural break.
Bulletin
Case
121
for both the number and the locations of the estimated break fractions obtained
under the null hypothesis with k1 0.5 held xed. The results indicate that
the breaks can be estimated with high accuracy in most cases and that the
precision of the estimates increase as both T and d increases, which is
consistent with the asymptotic results presented by Bai and Perron (1998).
Overall, the simulations leads us to the conclusion that the test performs
well in general with reasonable power and small size distortions in most
experiments. The results also suggest that the performance of the test in Cases
4 and 5 is unaffected by the locations of the breaks but the performance of the
test with shifts in both intercept and trend can be poor unless the time series of
each subsample is sufciently long. We have also examined the effects of a
misspecied model where the true DGP includes a structural break that is not
considered by the researcher. In this case, the rejection frequencies are
effectively one in all experiments and the results are therefore not presented.
Thus, serious size distortions are likely to arise when an existing structural
breaks are omitted.
VII.
An application to the current account
In this section, we make an attempt to demonstrate empirically the usefulness

of our test by revisiting the data set used by Taylor (2002) and Ho (2002) to
assess the solvency of the current account. To this end, let Iit be the ratio of
investment to gross domestic product (GDP) at current local prices and let Sit
be the corresponding saving rate. The starting point of our investigation is the
following regression
Iit ai bi Sit eit :
Recent theoretical and empirical work suggests that saving and investment as a
fraction of GDP are non-stationary variables (e.g. see Coakley, Kulasi and
Smith, 1996; Levy, 2000). The implication being that the current account must
be stationary as debt cannot explode. Because the current account is identically
the difference between saving and investment, this suggests that saving and
investment as a fraction of GDP should be cointegrated. Yet, for a theory so
straightforward and widely accepted, the solvency of the current account has
proven extremely difcult to establish empirically (e.g. see Leachman, 1991;
de Haan and Siermann 1994; Lemmen and Eijfnger, 1995; Ho, 2002).
Although there are many explanations for these empirical ndings, this
section focuses on two explanations that has attracted much attention recently.
The rst explanation is that conventional time-series cointegration tests may
have low power against persistent alternatives because of the short-sample
periods usually employed (e.g. see de Haan and Siermann, 1994; Ho, 2002).
The second explanation is that the empirical relationship between saving and
122
TABLE 7
Correct selection frequencies for Cases 4 and 5 with unknown breaks
N 10, T 100
N 20, T 100
N 10, T 200
N 20, T 200
Frequency
h0
h )0.5
h 0.5
h0
h )0.5
h 0.5
h0
h )0.5
h 0.5
h0
h )0.5
h 0.5
1
1
2
2
3
3
1
1
2
2
3
3
Number
Location
Number
Location
Number
Location
Number
Location
Number
Location
Number
Location
0.647
0.292
0.786
0.549
0.846
0.669
0.954
0.944
0.956
0.949
0.961
0.957
0.567
0.177
0.669
0.380
0.733
0.522
0.762
0.749
0.730
0.724
0.747
0.742
0.613
0.327
0.810
0.579
0.874
0.716
0.987
0.979
0.996
0.990
0.997
0.994
0.641
0.281
0.791
0.541
0.856
0.672
0.960
0.950
0.961
0.956
0.963
0.959
0.578
0.171
0.663
0.382
0.706
0.511
0.741
0.729
0.747
0.740
0.745
0.741
0.609
0.324
0.798
0.580
0.868
0.710
0.987
0.979
0.996
0.990
0.997
0.993
0.725
0.305
0.856
0.570
0.901
0.709
0.979
0.974
0.987
0.981
0.987
0.981
0.658
0.197
0.734
0.424
0.757
0.534
0.828
0.823
0.822
0.818
0.818
0.817
0.686
0.363
0.845
0.605
0.893
0.726
0.993
0.989
0.999
0.994
0.999
0.998
0.730
0.306
0.857
0.565
0.893
0.695
0.985
0.980
0.984
0.981
0.984
0.981
0.644
0.197
0.742
0.423
0.767
0.534
0.819
0.812
0.823
0.820
0.821
0.819
0.678
0.347
0.842
0.590
0.889
0.709
0.996
0.992
0.999
0.996
0.999
0.997
Notes: The number frequency species the frequency count of correctly chosen number of breaks. The location frequency species the frequency count of
correctly chosen break locations when the estimated number of breaks is equal to its true value. See Table 1 for an explanation of the different cases and Table 5
for an explanation of the various parameters. The value d refers to the size of the structural break.
Bulletin
Case
4
4
4
4
4
4
5
5
5
5
5
5
123
investment that is being estimated need not be invariant to policy regime

changes, which may lead to structural shifts in both saving and investment and
hence in the relationship between them (e.g. see Alexakis and Apergis, 1994;
zmen and Parmaksiz, 2004).
Sarno and Taylor, 1998; Corbin, 2004; O
However, while very reasonable and potentially appealing, these explanations have been found to be empirically inadequate and far from convincing,
and this section therefore offers an alternative route. The idea is that, to
provide any robust evidence on the cointegration between saving and
investment, one needs to consider not the low power and the presence of
structural change separately but simultaneously. The intuition is simple. First,
while increasing the length of the sample may be justied from a power point
of view, it also increases the probability of a break occurring somewhere in the
sample. On the other hand, modifying existing tests so as to accommodate for
structural change is typically very costly in terms of power. Therefore, it is the
joint consideration of both these aspects that is likely to be key when testing
the solvency of the current account. One way to accomplish this is to use the
panel LM test developed in the previous sections.
The data that we use consists of cross-sectional observations on saving and
investment as fractions of GDP sampled at annual frequency between 1883
and 1992 for 15 Organization for Economic Co-operation and Development
(OECD) countries plus Argentina.3 Before applying our test, we examine
whether the variables are stationary or not and whether there exist any structural
breaks or not. To test if the variables are non-stationary, we employ the panel data
unit root test recently proposed by Im et al. (2005), which allows for the
possibility of a single heterogeneous shift in the level of the series.4 The
calculated values of the statistic for the saving and investment variables are
)0.560 and )1.330 respectively. Thus, as the critical region of the test is given by
the left tail of the normal distribution, the null hypothesis of a unit root test cannot
be rejected. This conclusion is supported by the individual Schmidt and Phillips
(1992) and Amsler and Lee (1995) unit root test statistics presented in Table 8.
The rst does not allow for any break, while the second allows for a single break
to affect the level of each series. The results suggest that we cannot reject the null
of a unit root at the 10% level of signicance for any of the countries.
To test the presence of structural change in the estimated regressions, we
employ for each individual the B(s) statistic of Hao and Inder (1996), and
the MeanF and SupF statistics of Hansen (1992). The results presented in
Table 8 suggest that at least six of the individual cointegration regressions
3
For a detailed description of the data, see Taylor (2002).

In calculating the value of the test statistic, we use a lag augmentation of three to account for the
effects of serial correlation. The location of the break is determined endogenously via grid search at
the minimum of the statistics. To this end, we use a trimming parameter of 0.15 to eliminate the
endpoints.
4
124
TABLE 8
Country specic tests
Unit root saving
Unit root investment
Cointegration tests
Z(s)
s~
Z(s)
s~
Argentina
Australia
Canada
Finland
Spain
Sweden
UK
USA
)1.942
)2.806
)2.374
)2.266
)1.957
)1.671
)2.178
)2.157
)1.935
)2.854
)2.408
)2.959
)2.353
)1.855
)2.238
)2.895
)3.349
)2.511
)2.144
)2.117
)2.143
)2.487
)2.446
)2.462
)3.320
)2.068
)2.093
)2.166
)2.682
)2.588
)2.942
)3.273
)4.657
)6.877
)3.991
)5.576
)5.386
)5.462
)4.457
)3.971
Stability tests
Estimated breaks
Z^t
B(s)
MeanF
SupF
No.
Location
)3.900
)6.397
)3.041
)4.580
)4.838
)4.393
)2.261
)3.364
0.748
0.667
1.363
1.033
1.091
0.920
1.990
0.798
10.349
1.741
3.434
7.939
2.298
7.622
12.636
3.266
13.795
4.570
14.226
14.886
11.152
15.795
17.872
6.483
2
2
3
2
2
3
4
3
1913,
1930,
1914,
1951,
1919,
1934,
1906,
1914,
50
49
32,
69
47
57,
23,
47,
49
75
46, 63
75
Notes: In constructing the test statistics, we use three lags, a bandwidth of [T1/3] and a trimming parameter of 0.15. The last two columns to the right present
the estimated break points used in computing the panel LM statistic. The maximum number of breaks allowed is ve. The 10% critical values are given as
follows: )3.72 for the s~ statistic of Amsler and Lee (1995) and the Z(s) statistic of Schmidt and Phillips (1992); )3.0657 for the Z^t statistic of Phillips and
Ouliaris (1990); )4.34 for the Zt statistic of Gregory and Hansen (1996); 1.0477 for the B(s) statistic of Hao and Inder (1996); 5.20 and 13.4 for the MeanF and
SupF statistics of Hansen (1992) respectively.
Bulletin
Country
Zt
125
cannot be regarded as stable and there is a need to allow for structural change. To
this effect, we now employ the panel LM statistic. The calculated value for Case
2 with only an individual-specic constant term is 9.025 for the FMOLS-based
test and 8.173 for the DOLS-based test. Thus, if we ignore the possibility of
structural change, then we nd no evidence of cointegration. By contrast, if
we allow for a level shift in each regression, then the calculated values of
the statistics are 2.138 and 1.414 for the FMOLS- and DOLS-based test
respectively. Thus, in this case we cannot reject the null hypothesis on the 1%
level, which suggests that the variables are cointegrated around a broken
intercept. To reinforce this assertion, Table 8 presents some conrmatory
evidence for each country. The Z^t statistic of Phillips and Ouliaris (1990) do not
allow for any break, while the Zt statistic of Gregory and Hansen (1996) is able
to accommodate for a single break in the intercept of each regression. As seen
from the table, the null of no cointegration is rejected on six occasions at the 10%
level for both statistics.
Table 8 also reports the estimated break points obtained by using the
procedure described in section V. At least two breaks are found for each
country with all breaks occurring during the period 190675. From an
historical point of view, this seems very reasonable. First, there are essentially
no breaks prior to the advent of the First World War, which agrees with
the stability of the classical gold standard regime. Secondly, there is a
preponderance of breaks occurring between 1913 and 1949. This accords
approximately with the interwar period and seems consistent with the ndings
of Levy (2000), Hoffmann (2004) and Corbin (2004). The break in 1913 for
Argentina is also expected given the Bearing Crisis. Thirdly, there are several
breaks occurring between the years 1957 and 1975. This coincides with the oil
price shocks of that period, the breakdown of the Bretton Woods system and
the establishment of the Exchange Rate Mechanism.
An important caveat worth noting is that so far all forms of cross-sectional
dependency has been ignored. If this assumption is violated, then the panel
LM test depends on various nuisance parameters associated with the crosssectional correlation properties of the data, which means that the test no longer
has a limiting normal distribution. A limited form of cross-sectional
dependence can be permitted by using data that has been demeaned with
respect to a common time effects, which does not affect the distribution of the
test. Therefore, to accommodate some form of cross-sectional dependency, we
applied the test to the cross-sectionally demeaned data. Using this approach
the calculated values of the FMOLS- and DOLS-based test statistics are 1.783
and 1.632 respectively. Thus, in agreement with the earlier results, we cannot
reject the null on the 1% level of signicance.
However, in general, with dynamic feedback effects that runs from one
cross-section to another, and which are not common across the members of the
126
Bulletin
panel, then a common time effects will not account for all dependencies. One
possible solution to this problem is to employ the bootstrap approach, which
makes inference possible even under very general forms of cross-sectional
dependence. The bootstrap opted for this section proceeds as follows.
1 Obtain Tî for each i using the procedure outlined in section V.
2 Estimate cij and bi for each i by FMOLS or DOLS using T observations and dummy variables to account for the breaks. Obtain
êt ê1t ; . . . ; êNt 0 .
3 Compute the centred residual
~et êt T 1
T
X
êt :
t1
^ t ~e0t ; v0t 0 , where vt

Let w
0 0
innovations wt ~e0
t ; vt by
5
v01t ; . . . ; v0Nt 0 .
Generate the bootstrap

^ t with replaceresampling the vector w
ment.
5 Generate the bootstrap sample yit and xit with xi0 0 recursively as
xit xit1 vit ;

^
yit z0it cîj x0
it bi eit :
6 Compute the standardized panel LM test statistic for each bootstrap

sample while treating Tî as known.
We apply the bootstrap approach to the saving and investment data using
5,000 bootstrap replications. The 1% critical value obtained from the
bootstrap distribution is 2.218 for the FMOLS-based test and 1.647 for the
DOLS-based test. Hence, the null is not rejected on the 1% level.
Nevertheless, it is tempting, particularly given the results from the more
straightforward setting of the previous sections, to conclude that the effects of
cross-sectional correlation are small and that the critical value from the normal
distribution in fact apply. To check whether this is indeed the case, we
performed a small set of Monte Carlo simulations based on the DGP of
section VI but now with the error uit having the factor specication uit
pft + eit, where (eit, vit, ft)0 N(0, I3). With this modication, the correlation
between uit and ukt for i 6 k is given by p2/(1 + p2). Thus, a non-zero value
on the parameter p induces correlation between the members of the panel.
Table 9 presents some results on the size of a nominal 5% level test for this
DGP using both the bootstrapped critical value and the critical value obtained
from the normal distribution. It is observed that the bootstrap test performs
5
^ t rather than ~et , we can preserve not only the cross-sectional correlation structure
By resampling w
of eit but also any endogenous effects that may run across the individual regressions of the system.
127
TABLE 9
Size for Case 4 with cross-sectional dependence
FMOLS
DOLS
ZB(M)
Z(M)
ZB(M)
Z(M)
1
2
6
1
2
6
1
2
6
1
2
6
10
10
10
20
20
20
10
10
10
20
20
20
100
100
100
100
100
100
200
200
200
200
200
200
0.024
0.036
0.024
0.038
0.026
0.028
0.024
0.034
0.026
0.038
0.032
0.024
0.028
0.074
0.076
0.062
0.120
0.146
0.030
0.072
0.080
0.064
0.108
0.116
0.038
0.040
0.046
0.044
0.046
0.036
0.032
0.032
0.036
0.036
0.040
0.024
0.030
0.040
0.068
0.046
0.082
0.090
0.030
0.050
0.080
0.048
0.118
0.122
Notes: FMOLS, fully modied ordinary least square; DOLS, dynamic ordinary least square.
The value p refers to the loading parameter in the common time effects specication. We use Z(M)
and ZB(M) to refer to the test based on the normal and bootstrapped 5% critical value.
well and the test based on the normal distribution appears to be remarkable robust to moderate degrees of cross-sectional correlation. To get an
appreciation of the size of the problem in the saving and investment data, we
estimate the correlation matrix of the equilibrium errors. The largest
correlation is 0.402, suggesting that the simulation results for the DGP with
p 1 should be relevant in which case Table 9 indicates that the effects of
cross-sectional dependence on the test should be small and that inference
based on the normal distribution should not be misleading.
The bootstrap approach can accommodate for all types of cross-sectional
dependencies that are absorbed in the long-run covariance matrix of the
equilibrium errors and the rst differences of the regressors. Another source of
cross-sectional dependence is cointegration that runs between the members
of the panel. Banerjee, Marcellino and Osbat (2004) uses Monte Carlo
simulations to study this issue in small samples and found that the
consequences of cross-sectional cointegration on existing panel cointegration
tests can be quite severe. The authors suggest testing for the presence of crosssectional cointegration by using the procedure developed by Gonzalo and
Granger (1995), which involves rst extracting the common trends from each
cross-section and then testing for cointegration among these trends. When we
employ this approach to the saving and investment data, we end up marginally
rejecting the null of no cointegration on the 1% level on one occasion. Hence,
there appears to be no severe violation of the assumption of no cross-sectional
cointegration.
128
VIII.
Bulletin
Conclusions
In this paper, we extend the panel LM cointegration test proposed by

McCoskey and Kao (1998) to allow for multiple structural breaks in both level
and trend of the cointegration regression. Test statistics are derived when both
the number and the locations of the breaks are known and when they are
determined endogenously from the data. Test statistics are also derived when
the cointegration regression is not subject to structural change but the
deterministic component includes individual-specic intercepts and trends.
Using sequential limit theory, we are able to show that the test has a limiting
normal distribution that is free of nuisance parameters under the null
hypothesis. In particular, we show that the limiting distribution is invariant
with respect to both the number and the locations of the breaks and that there
is no need to compute different critical values for all possible patterns of break
points, which makes the test computationally very convenient. Results form
Monte Carlo experiments suggest that the test has small size distortions and
reasonable power. To demonstrate the practical usefulness of the new test, we
reexamine the data set employed by Ho (2002) and Taylor (2002) to assess the
solvency of the current account. Contrary to most of the ndings presented in
the earlier literature, we nd evidence suggesting that saving and investment
are cointegrated once a level break in the cointegration regression is
accommodated.
Final Manuscript Received: May 2005
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Appendix
Mathematical proofs
In this appendix, we prove the asymptotic distribution for the DOLS estimator.
The proof uses the methods of Shin (1994) so only essential details will be
given.
Proof of Theorem 1. Under the null hypothesis, the DGP for the most general
case with endogenous regressors and breaks in both the level and trend may be
written as the following truncated regression
H
X
0
v0itk /ik uit ;
A1
yit Xit dij
kH
P
where Xit
dij (cij, bi)0 and uit jkj>H v0itk /ik uit is a
stationary error term comprised of the projection of uit onto all the lags and
leads above the truncation point H and an orthogonal term uit . The DOLS
estimator is obtained by performing OLS on (A1). Consider the DOLS
estimator of segment j using the subsample t Tij)1, . . . , Tij and let dî denote
the OLS estimate of dij based on this subsample. The tted regression may be
written in the following fashion
H
X
yit Xit0 dî
v0itk /îk ûit :
A2
z0it ; x0it 0 ,
kH
Assumption 2 (i) ensures that each subsample approaches to innity when

T ! 1. Hence, there will be no loss of generality by analysing each subsample
as a sample of length T that is not subject to structural change. To this end,
131
PTr
consider the partial sum process SiT t1 ûit obtained from equation (A2).
If we let D1 diag(T)1/2, T)3/2, T)1IK) and D2 diag(T)1, T)2, T)3/2IK),
then this sum may be written as
T 1=2 SiT T 1=2
T 1=2
Tr
X
yit T 1=2
Tr
X
t1
t1
Tr
X
Tr
X
uit T 1=2
t1
T 1=2
Xit0 dî T 1=2
Tr X
H
X
v0itk /îk
t1 kH
Xit0 dî di
t1
Tr
X
H
X
v0itk /îk /ik
t1 kH
1=2
Tr
X
uit
Tr X
X
1=2
t1
D1
2
v0itk /ij
t1 jkj>H
Tr
X
^
Xit0 D1
1 di
di T
1=2
t1
Tr X
H
X
v0itk /îk /ik :
t1 kH
Under the regulatory conditions of Saikkonen (1991), the second and

fourth terms are op(1) and can be disregarded. Moreover,
byR the multiPTr
r 0
X
)
and
variateP invariance principle, we have D1
2
t1 it
0 Bi2
Tr
1=2
u
)
B
.
Also,
by
Theorem
3.3
of
Park
and
Phillips
(1988),
T
i1:2
t1 it
as T ! 1
Z 1
1 Z 1
î di )
i2 B
0
i2 dBi1:2 :
B
B
D1
d
1
i2
0
Using these weak convergence results, and as Wi1:2 x1

i1:2 Bi1:2 and Wi2
1=2
Xi22 Bi2 , the limit of T )1/2SiT as T ! 1 may now be readily obtained as
follows
T
1=2
SiT ) Bi1:2
Z
0
0
B
i2
Z
xi1:2 Wi1:2 xi1:2
1
0
r
0
xi1:2 Vi :
i2 B
0
B
i2
0
W
i2
1 Z
i2 dBi1:2
B
0
Z
1
0
i2 W
0
W
i2
1 Z
i2 dWi1:2
W
0
A3
Given that the restriction placed on the bandwidth expansion rate is satised,
^ 2i1:2 is consistent for x2i1:2 as T ! 1. Hence, we obtain
then x
132
Bulletin
2
^ 2
x
i1:2
T
X
2
SiT
) Fi
1
0
t1
Vi2 :
A4
PTij
2
^ 2
Consequently, if we dene Rij tT
Tij Tij1 2 x
i1:2 Sit , then
ij1 1
it follows that Rij Fij, where Fi1, . . . , FiMi+1 are Mi + 1 independent
generalized Cramer-von Mises distributions. Using this result, we can prove
the intermediate limit of Z(M) as follows
ZM
Tij
N M
i 1
X
X
X
2
^ 2
Tij Tij1 2 x
i1:2 Sit
i1 j1 tTij1 1
N M
i 1
X
X
Rij
i1 j1
N M
i 1
X
X
A5
Fij :
i1 j1
Thus, as the limiting distribution passing T ! 1 is i.i.d. over the cross-section,

it follows
that E(Fij) Q and EFij2 R for all i and j. Consequently, if we let
PMi 1
and
Fi j1 Fij , then E(Fi) (Mi + 1)Q and EFi2 Mi 12 R. Let H

R be the cross-sectional averages of the expected value and the variance of Fi
respectively.
Z(M), rst dene
Plimiting distribution of
PMi 1 To derive the sequential
in probability as
Rij and note that N 1 Ni1 Ri converges to H
Ri j1
T ! 1 and then N ! 1 sequentially by the law of large numbers. Next,
expand the statistic in the following manner
!
N
X
1=2
1=2
1=2
1
:
ZM N H N
N
Ri H
A6
N
i1
Assume that the Lindeberg condition is satised, then N 1=2 ZM

) N 0; R
as T ! 1 prior to N by direct application of the
N 1=2 H
Lindeberg-Feller central limit theorem. This establishes the limit distribution
n
of the panel LM statistic as required for the proof.

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OXFORD BULLETIN OF ECONOMICS AND STATISTICS, 68, 1 (2006) 0305-9049

Testing for Panel Cointegration with Multiple

There is a vast literature concerned with extending time-series cointegration

Panel test with multiple structural breaks

The panel LM test with breaks

Consider the multidimensional time-series variable yit, which is observable for

eit rit uit ;

rit rit1 /i uit ;

where xit xit)1 + vit is a K-dimensional vector of regressors and zit is a

whose parameters satisfy the summability conditions of the following

Panel test with multiple structural breaks

non-empty. Thus, we require that N1/N ! d as N ! 1, where d 2 (0, 1].

Remark 1. The statistic is written as an explicit function of M

Panel test with multiple structural breaks

dummy variables to account for the breaks. However, in practice, it may be

Theorem 1 (Asymptotic distribution). Under Assumptions 1 and 2, and the

Remark 4. The proof of Theorem 1 is provided in the Appendix. It uses the

Panel test with multiple structural breaks

moments for each of the ve deterministic specications and for up to ve

Response surface regressions

where yi is the simulated moment based on a sample of Ti time-series

Panel test with multiple structural breaks

up to ve regressors. Most samples are relatively small as these seem to

Unknown break points

Blackwell Publishing Ltd 2006

Blackwell Publishing Ltd 2006

Panel test with multiple structural breaks

T^i arg min

yit z0it c^ij x0it b^i 2 ;

Panel test with multiple structural breaks

Monte Carlo simulations

To examine the small-sample properties of the test, we conduct Monte Carlo

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Blackwell Publishing Ltd 2006

Panel test with multiple structural breaks

Size and size-adjusted power for Cases 13

Panel test with multiple structural breaks

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Panel test with multiple structural breaks

An application to the current account

In this section, we make an attempt to demonstrate empirically the usefulness

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Panel test with multiple structural breaks

investment that is being estimated need not be invariant to policy regime

For a detailed description of the data, see Taylor (2002).

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Unit root investment

Panel test with multiple structural breaks

^ t ~e0t ; v0t 0 , where vt

Generate the bootstrap

6 Compute the standardized panel LM test statistic for each bootstrap

Blackwell Publishing Ltd 2006

Panel test with multiple structural breaks

In this paper, we extend the panel LM cointegration test proposed by

Panel test with multiple structural breaks

Cragg, J. G. (1983). More efcient estimation in the presence of heteroskedasticity of

Blackwell Publishing Ltd 2006

Assumption 2 (i) ensures that each subsample approaches to innity when

Panel test with multiple structural breaks

Xit0 d^i T 1=2