Modelling Spatial Dependence with Pairwise Correlations

An understanding of the spatial dimension of economic and social activity requires methods that can separate out the relationship between spatial units that is due to the effect of common factors from that which is purely spatial even in an abstract sense. The same applies to the empirical analysis of networks in general. We are able to distinguish between cross-sectional strong dependence and weak dependence. Strong dependence in turn suggests that there are common factors. We use cross unit averages to extract both national and regional factors and contrast this to a principal components approach widely used in the literature. We then use thesholding to determine significant bilateral correlations (signifying neighbours) between spatial units and compare this to an approach that just uses distance to determine units that are neighbours. We apply these methods to real house price changes at the level of the Metropolitan Statistical Area in the USA. JEL Classification: C21, C23