Determining the number of primitive shocks in factor models

Abstract

A widely held but untested assumption underlying macroeconomic analysis is that the number of shocks driving economic fluctuations, q, is small. In this article we associate q with the number of dynamic factors in a large panel of data. We propose a methodology to determine q without having to estimate the dynamic factors. We first estimate a VAR in r static factors, where the factors are obtained by applying the method of principal components to a large panel of data, then compute the eigenvalues of the residual covariance or correlation matrix. We then test whether their eigenvalues satisfy an asymptotically shrinking bound that reflects sampling error. We apply the procedure to determine the number of primitive shocks in a large number of macroeconomic time series. An important aspect of the present analysis is to make precise the relationship between the dynamic factors and the static factors, which is a result of independent interest. © 2007 American Statistical Association.