Econometrics

Chapter 11 Multicollinearity

Multicollinearity

Near-perfect multicollinearity (usually referred to simply as multicollinearity) an approximate linear relationship holds among some or all of the independent variables. While perfect multicollinearity is often the result of model misspecification, near-perfect multicollinearity is a more common phenomenon.

Consequences

Unstable parameter estimates High standard errors for the estimated coefficients on the affected variables

Symptoms

High standard errors (and often low t ratios) on some or all of the independent variables, but high R2 Estimates are very sensitive to changes in data Unexpected signs on parameter estimates and/or unreasonable magnitudes Significant joint effects for the affected variables, but insignificant t tests for the individual variables. High correlations between two or more of the affected variables.

Diagnosis

Examine pairwise correlations among the independent variables Use F tests to examine the joint significance of sets of variables that are individually insignificant

VIF

The VIF is a measure of the effect of multicollinearity on the variance parameter estimates. High VIFs suggest the presence of a multicollinearity problem. VIF > 2 usually indicates multicollinearity problem.

Remedial measures

Acquire more data

Not always possible (especially for time-series analyses) May not make much difference. Results in biased and inconsistent results if the model was correctly specified.

Dropping variables from the model

Reformulate the model

First-differences

May result in the introduction of autocorrelated residuals if the assumptions of the classical regression model were satisfied in the original equation Results in loss of sample information (one less degree of freedom)

Is multicollinearity a problem?

Estimates are unbiased, consistent, and efficient in the presence of multicollinearity. Eliminating variables to solve multicollinearity problems results in estimators that are biased, inconsistent, and inefficient.