Starting from the dynamic factor model for nonstationary data we derive the factor-augmented error correction model (FECM) and its moving-average representation. The latter is used for the identification of structural shocks and their propagation mechanisms. We show how to implement classical identification schemes based on long-run restrictions in the case of large panels. The importance of the error correction mechanism for impulse response analysis is analyzed by means of both empirical examples and simulation experiments. Our results show that the bias in estimated impulse responses in a factor-augmented vector autoregressive (FAVAR) model is positively related to the strength of the error correction mechanism and the cross-section dimension of the panel. We observe empirically in a large panel of US data that these features have a substantial effect on the responses of several variables to the identified permanent real (productivity) and monetary policy shocks.
