This paper proposes a factor model with infinite dynamics and nonorthogonal
idiosyncratic components. The model, which we call the generalized dynamic
-factor model, is novel to the literature and generalizes the static approx
imate factor model of Chamberlain and Rothschild (1983), as well as the exa
ct factor model a' la Sargent and Sims (1977). We provide identification co
nditions, propose an estimator of the common components, prove convergence
as both time and cross-sectional size go to infinity at appropriate rates,
and present simulation results. We use our model to construct a coincident
index for the European Union. Such index is defined as the common component
of real GDP within a model including several macroeconomic variables for e
ach European country.