A Transformed System GMM Estimator for Dynamic Panel Data Models ∗

The system GMM estimator developed by Blundell and Bond (1998) for dynamic panel data models has been widely used in empirical work; however, it does not perform well with weak instruments. This paper proposes a variation on the system GMM estimator, based on a simple transformation of the dependent variable. Simulation results indicate that, in finite samples, this transformed system GMM estimator greatly outperforms its conventional counterpart in estimating the coefficient of the lagged dependent variable, especially when the variation in the fixed effects is large relative to that in the idiosyncratic shocks and when the dependent variable is highly persistent. Applying this transformation also substantially strengthens the reliability of inferences on the overall model specification based upon the Sargan/Hansen test. As illustrations, the transformed system GMM estimator is applied to two empirical examples from the literature: a production function and an employment equation.