Determining the number of global and country-specific factors in the euro area

Abstract

With the adoption of a single currency and a common monetary policy, the assessment of the existence of common macroeconomic factors driving the euro area as a whole is of key importance. In this paper, we try to contribute to this debate by admitting an approximate factor model with a common component comprising global and country-specific factors. Although it is arguable to allow for common factors shared by all the euro area member countries in the context of the European economic integration, it is also reasonable to admit that there may be country-specific factors. Hence, we end up with a two-level factor model allowing for both global and country-specific factors. We discuss the consistency of the principal components estimator within such framework and propose criteria for determining the number of global and group-specific factors. The consistency of the suggested criteria is established and the small sample properties are assessed through Monte Carlo simulations. Resorting to large datasets for the four major euro area countries, we find evidence of the existence of both global and country-specific factors.