ABSTRACT
This chapter explains how to select the optimal the number of common factors. It provides a step-by-step procedure for the determination of the optimal factor number. The chapter describes how the step-by-step procedure works in practice. It also provides instructions on how to run STATA, GAUSS, and MATLAB for estimating the number of common factors. In econometric studies on the factor number estimation, theoretical econometricians allow weak cross-sectional dependence among the idiosyncratic component, yito, and allow weak dependence between the common factors and the idiosyncratic components. There are a number of criteria and estimation methods for selecting the factor number. The step-by-step procedure is important to get a reasonable estimate of the factor number and common factors. Alternatively, if the variance heterogeneity comes from the idiosyncratic errors, then the standardization is required for the consistent estimation of the factor number.
