The generalized dynamic-factor model: Identification and estimation

This paper proposes a factor model with infinite dynamics and non-orthogonal idiosyncratic components. The model, which we call the generalized dynamic factor model, is novel to the literature, and generalizes the static approximate factor model of Chamberlain and Rothschild (1983), as well as the exact factor model `a la Sargent and Sims (1977). We provide identification conditions, propose an estimator of the common components, prove convergence as both time and cross-sectional size go to infinity at appropriate rates and present simulation results. We use our model to construct a coincident index for the European Union. Such index is defined as the common component of real GDP within a model including several macroeconomic variables for each European country.