Econometric Reviews, 28(4), 295-313, 2009
We propose a new pooled panel unit root test allowing for serial and contemporaneous correlation. The new test combines Elliott, Rothenberg and Stock’s (1996) local-to-unity transformation with a pooled panel ADF test. As initially advocated by O’Connell (1998), the new test accounts for contemporaneous correlation by estimating the residual covariance matrix. Monte Carlo simulations demonstrate significantly better finite sample power properties of the new test over a wide range of existing panel unit root tests accounting for cross-sectional correlation. Furthermore, enhanced performances are particularly noticeable when the series are highly persistent and the panels are relatively small. An application to the real exchange rate convergence illustrates the impact of such improvements. Analyzing the post Bretton Woods period, the new test provides strong and reliable rejections of the unit root among the real exchange rates of industrialized countries.