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Tests for Parameter Instability in Dynamic Factor Models

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  • Xu Han
  • Atsushi Inoue

Abstract

We develop tests for structural breaks of factor loadings in dynamic factor models. We focus on the joint null hypothesis that all factor loadings are constant over time. Because the number of factor loading parameters goes to infinity as the sample size grows, conventional tests cannot be used. Based on the fact that the presence of a structural change in factor loadings yields a structural change in second moments of factors obtained from the full sample principal component estimation, we reduce the infinite-dimensional problem into a finite-dimensional one and our statistic compares the pre- and post-break subsample second moments of estimated factors. Our test is consistent under the alternative hypothesis in which a fraction of or all factor loadings have structural changes. The Monte Carlo results show that our test has good finite-sample size and power.

Suggested Citation

  • Xu Han & Atsushi Inoue, 2011. "Tests for Parameter Instability in Dynamic Factor Models," TERG Discussion Papers 306, Graduate School of Economics and Management, Tohoku University, revised May 2013.
    • Handle: RePEc:toh:tergaa:306
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