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Published online by Cambridge University Press: 01 October 2004
A concise derivation of the Wallace and Hussain fixed effects transformation.
In vector form the disturbances can be written as
where Zμ = IN [otimes ] ιT, IN is an identity of dimension T, and ιN is a vector of ones dimension N, Zλ = ιN [otimes ] IT, μ is of dimension N × 1, λ is of dimension T × 1, and ν is of dimension NT × 1. In general, if Δ = [X1,X2] then PΔ = PX1 + P[QX1 X2], where PΔ = Δ(Δ′Δ)−1Δ′ denotes the projection matrix on Δ and QΔ = I − PΔ. Applying this result to Δ = [Zμ,Zλ] , one gets
where P = IN [otimes ] JT with JT = ιTιT′/T and Q = IN [otimes ] ET with ET = IT − JT. Using the fact that QZλ = ιN [otimes ] ET, Zλ′QZλ = NET, (Zλ′QZλ)− = (1/N)ET, one gets PQZλ = JN [otimes ] ET. Hence
which means that
as required. Here QΔ is the fixed effects transformation derived by Wallace and Hussain (1969). Note that the order does not matter; i.e., one could have orthogonalized on Zλ.