Finance and Economics Discussion Series (FEDS)
Dynamic Factor Models, Cointegration, and Error Correction Mechanisms
Matteo Barigozzi, Marco Lippi, and Matteo Luciani
The paper studies Non-Stationary Dynamic Factor Models such that: (1) the factors F are I(1) and singular, i.e. F has dimension r and is driven by a q-dimensional white noise, the common shocks, with q < r, and (2) the idiosyncratic components are I(1). We show that F is driven by r-c permanent shocks, where c is the cointegration rank of F, and q-(r-c) < c transitory shocks, thus the same result as in the non-singular case for the permanent shocks but not for the transitory shocks. Our main result is obtained by combining the classic Granger Representation Theorem with recent results by Anderson and Deistler on singular stochastic vectors: if (1-L)F is singular and has rational spectral density then, for generic values of the parameters, F has an autoregressive representation with a finite-degree matrix polynomial fulfilling the restrictions of a Vector Error Correction Mechanism with c error terms. This result is the basis for consistent estimation of Non-Stat ionary Dynamic Factor Models. The relationship between cointegration of the factors and cointegration of the observable variables is also discussed.
Keywords: Cointegration for singular vectors, Dynamic Factor Models for I(1) variables, Granger Representation Theorem for singular vectors
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