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Table 2
df I 2 3 4 5
o

Percentiles of thef-distribution
/(.eo,df)

/(.esdf)

t(.975,df)

t(.99,df)

r1.WS,ar1 63.657 9.925 5.841 4.604 4.032 3.707 3.499 3.355 3.250 3.169 3.106 3.055 3.012 2.97'7 2.94'7 2.921 2.898 2.878 2.861 2.845 2.831 2.8t9 2.807 2.797 2.787 2.779 2.77r 2.763 2.756 2.750 2.744 2.738
Z.IJJ

7 8 o 10 ll t2 13 t4 15 16 t7 l8 19 20 2l 22 24 25
zo

2'7 28 29 30 31
-)z
JJ

34 35 36 37 38 39 40 50
oo

3.078 1.886 1.638 1.533 1.476 1.440 1.4t5 1.397 r.383 1.372 t.363 1.356 1.350 t.345 1.341 1.337 1.333 1.330 1.328 1.325 1.323 1.321 1.3t9 1.3 8 1 1.3 6 1 1.3 5 1 t.3t4 1.313 1 . 3I 1 1.310 1.309 1.309 1.308 1.307 1.306 1.306 1.305 r.304 t.304 1.303 r.299 t.282

6.314 2.920 2.353 2.132 2.0t5 1.943 1.895 1.860 1.833 1.8t2 r.796 1.182 t.7'71 l.t6r 1.753 1.746 t-740 1.734 1.729 1.725 1.121 t ; 7t 7 1 . 74 t 1 . 7l t 1.708 1;706 t;703 1.701 r.699 1.697 1.696 1.694 r.692 1.691 1.690 1.688 1.687 1.686 1.685 1.684 1.676 1.645

t2.706 4.303 3.182 2.7',76 2.571 2.447 2.365 2.306 2.262 2.228 2.201 2.179 2.160 2.145 2.131 2.120 2.110 2-r01 2.093 2.086 2.080 2.0'74 2.069 2.064 2.060 2.056 2.052 2.048 2.045 2.042 2.O40 2.03'7 2.035 2.032 2.030 2.028 2.026 2.024 2.023 2.021 2.009 1.960

3r.821
6.965 4.541 3.74'7 3.365 3.143 2.998 2.896 2.821 2.764 2.718 2.681 2.650 2.624 2.602 2.583 2.567 2.552 2.539 2.528 2.5t8 2.508 2.500 2.492 2.485 2.479 2.473 2.46'7 2.462 2.457 2.453 2.449 2.445 2.44r 2.438 2.434 2.431 2.429 2.426 2.423 2.403 2.326

2.728 2.724 2.7t9 2.715 2.712 2.708 2.704 2.678 2.576

Source: This table was generatedusing the SAS@ function TINV

The Rules of Summation 2xi:xr+x2+"'+xn la: na

Expectations, Variances & Covariances

cov(x, : El(x- EItDV EIYDI Y) : IIk - E(x)lb n(v))f (x,y) '
-"
n:-

cov(x, r)

s-*.--s..
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i:l

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E(x+Y):E(x)+E(Y)
var(aX t bY + cZ) : a2var(X) + b2va\Y) + c2var(Z)+ 2 a b c o v( X , Y ) + 2 a c c o v ( X , Z ) - t 2 b c c o v ( Y , Z ) If X, Y and Z are independent,or uncorrelated,random variables, then the covariance terms are zero and: var(aX j bY + cZ) : azvar(X) +b2va\v) -l c2var(Z)

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s.. n

x1+x2+ .+xn

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+ 2.2.f(n.y) : I.t,f(ri.yr + f(xi,y2) ,f(ri,y:)l )
t:tl:l

23

2

Normal Probabilities
Y .-

: " f ( . r l, y r ) + f ( u , y z l + f ( x , , y t ) + f(xz,yr) + f (xz,yz) f(xz,yt) + ExpectedValues& Variances E(X) : n f(xr) + x2f(x2)*.. : 2x, f (xi) - Lx f (x) i:l r I x^f(x")

If X-N(p.o2). thenZ: "

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If x-Ni*,r';

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: Ets(x)l Isk).f(") (x) slsr + gr(x)l : Ilg' (') + sz(x)lQ) f
: Isr (x)/("r)+Lgr(x) f (x)
ElcJ : c

Assumptions the SimpleLinear RegressionModel of SRI Thevalue ofy, for each valueof.r, is y: 9' 1 B2x*e SR2 The average value of the randomerror e is : E(e) - 6s1n""*eassumethatE(y) 9r + Bu.r SR3 The variance the randomerrore is var(e): of
SR4 SR5 SR6 o2 : var()) The covariance between any pair of random e l r o r s ,e r a n d e ; i s c o v ( e i , e . y ) : c o v ( ) i , y ; ) : 0 The variable x is not random and must take at least two different values. (optional) The values of e are normally distributedabout their mean a-N(0,o2)

- E[e'(')l E[gz(x)] "

E(cx) :68(Y1 E(a+cX):a+cE(X) E(x)12 : E62) - lE(x)]'? var(a * cX) : E[(a + cX) - E(a + cx)]z -- c2var(X) var(x) : o2 : Elx Marginal and Conditional Distributions f (t) :2 f G,y) for each valueXcan take for each value fcan take 'f('r'Y)

Least Squares Estimation If bl and bz Ne the least squaresestimates,then 9i: bt * bzxi ?i:li-ii:y1-b1-b2x; The Normal Equations

f(y) : L f(r,y)
J \ VI

,/.1.,\ -"rf r. - .lv -.,, -

If X and r are independe", :Yl.variables, then .f(r,y) : f(x) f(y) for each and every pair of values .r and y. The converseis also true. If X and lare independentrandom variables, then the conditional probability density function ofX given that rt"\ I Q , v ) - ' !I , 't\! ' ' : / ( , r ) t I-yrsl\xty): for ^

Nbt +>rib2:}yi lxibl ,'Lf Least Squares Estimators
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tr:2r'r'

,

I('i

J\v)

J\v)

each and every pair of values "r and y. The converseis also true.

- I)(yi - 7) Z(xi - i)'

bt :t

- b2t

Brief Contents
Chapter 1 Chapter 2 Chapter 3 Chapter 4 Chapter 5 Chapter 6 Chapter 7 Chapter 8 Chapter 9 Chapter 10 Chapter l1 Chapter 12 Chapter 13 Chapter 14 Chapter 15 Chapter 16 Chapter 17 Appendix A Appendix B Appendix C Appendix D Appendix E An Introduction to Econometrics The Simple Linear RegressionModel Interval Estimation and Hypothesis Testing Prediction, Goodness-of-Fitand Modeling Issues The Multiple RegressionModel Further Inference in the Multiple RegressionModel Nonlinear Relationships Heteroskedasticity Dynamic Models, Autoconelation and Forecasting Random Regressorsand Moment Based Estimation SimultaneousEquations Models Nonstationary Time-Series Data and Cointegration Vector Error Correction and Vector AutoregressiveModels: An Introduction to Macroeconometrics Time-Varying Volatility and ARCH Models: An Introduction to Financial Econometrics Panel Data Models Qualitative and Limited Dependent Variable Models Writing an Empirical ResearchReport, and Sourcesof Economic Review of Math Essentials Review of Probability Concepts Review of Statistical Inference Answers to SelectedExercises Tables

ltrt

Contents
Preface Chapter I An Introduction to Econometrics
lx

I
I 2
J i

1.1 Why StudyEconometrics? I.2 What is Econometrics About? 1.2.1 SomeExamples Model 1.3 The Econometric 1.4 How Do We ObtainData? 1.4.L Experimental Data 1.4.2 Nonexperimental Data 1.5 Statistical Inference 1.6 A Research Format

5 5
f

6

Chapter 2

The Simple Linear Regression Model

8 8 9 9 t2 15 18 20 22 22 23 24 24 24 26 27 27 28 29 3I 32 33

LearningObjectives Keywords 2.1 An EconomicModel Model 2.2 An Econometric 2.2.1 Introducingthe Error Term Parameters 2.3 Estimating Regression the Principle 2.3.1 The LeastSquares 2.3.2 Estimates the FoodExpenditure for Function the 2.3.3 Interpreting Estimates 2.3.3a Elasticities 2.3.3b Prediction 2.3.3c Computer Output 2.3.4 OtherEconomicModels the Estimators 2.4 Assessing LeastSquares 2.4.I The Estimator b2 Valuesof bl andb2 2.4.2 The Expected 2.4.3 Repeated Sampling and of 2.4.4 The Variances Covariance b1 andb2 2.5 The Gauss-Markov Theorem of Estimators 2.6 The ProbabilityDistributions the LeastSquares 2.7 Estimatingthe Varianceof the Error Term the and of 2.1J Estimating Variances Covariances the LeastSquares Estimators

34

CONTENTS

2.'7.2 Calculations for the Food Expenditure Data 2.8 Exercises 2.8.1 Problems 2.8.2 Computer Exercises Appendix 2,A'Derivation of the Least SquaresEstimates Appendix 28 Deviation from the Mean Form of b2 Appendix 2C bz is a Linear Estimator Appendix 2D Derivation of Theoretical Expression for bz Appendix 2E Deriving the Variance of b2 Appendix 2F Proof of the Gauss-Markov Theorem

35 36 36 39 42 43 44 44 45 46

Ch

Lr K
A

4.

4. Chapter 3 Interval Estimation and Hypothesis Testing

48 48 48 49 49 51 52 53 54 55 55 55 55 56 56 56 57 58 59 59 59 60 6l 62 62 63 64 65 66 66 67 68 68 69 '72
t3

Learning Objectives Keywords 3.1 Interval Estimation 3.1.1 The l-distribution 3.1.2 Obtaining Interval Estimates 3.1.3 An Illustration 3.1.4 The RepeatedSampling Context 3.2 HypothesisTests 3.2.1 The Null Hypothesis 3.2.2 The Alternative Hypothesis 3.2.3 The Test Statistic 3.2.4 The Rejection Region 3.2.5 A Conclusion 3.3 Rejection Regions for Specific Alternatives 3.3.I One-Tail Tests with Alternative "Greater Than" (>) 3.3.2 One-Tail Tests with Alternative "Less Than" (() 3.3.3 Two-Tail Tests with Alternative "Not Equal To" (l) 3.4 Examples of Hypothesis Tests 3.4.1 Right-Tail Tests 3.4.1a One-Tail Test of Significance 3.4.Ib One-Tail Test of an Economic Hypothesis 3.4.2 Left-Tail Tests 3.4.3 Two-Tail Tests 3.4.3a Two-Tail Test of an Economic Hypothesis 3.4.3b Two-Tail Test of Significance 3.5 The p-value 3.5.1 p-value for a Right-Tail Test 3.5.2 p-value for a Left-Tail Test 3.5.3 p-value for a Two-Tail Test 3.5.4 p-value for a Two-Tail Test of Significance 3.6 Exercises 3.6.1 Problems 3.6.2 ComputerExercises Appendix 3,{ Derivation of the r-Distribution Appendix 38 Distribution of the /-Statistic Under FI1

4.

i I

CI

L K 5

CONTENTS

35 36 36 39 42 43 44 44 45 46

Chapter 4 Prediction, Goodness-of-Fit,and Modeling Issues
Learning Objectives Keywords 4.1 Least SquaresPrediction 4.1.1 Prediction in the Food Expenditure Model 4.2 Measuring Goodness-of-Fit 4.2.1 CorrelationAnalysis 4.2.2 Correlation Analysis and R2 4.2.3 The Food Expenditure Example 4.2.4 Reporting the Results 4.3 Modeling Issues 4.3.1 The Effects of Scaling the Data 4.3.2 Choosing a Functional Form 4.3.3 The Food Expenditure Model 4.3.4 Are the RegressionErrors Normally Distributed? 4.3.5 Another Empirical Example 4.4 Log-Linear Models 4.4.1 A Growth Model 4.4.2 A Wage Equation 4.4.3 Prediction in the Log-Linear Model 4.4.4 A Generalized Measure R2 4.4.5 Prediction Intervals in the Loe-Linear Model 4.5 Exercises 4.5.1 Problems 4.5.2 Computer Exercises Appendix 4A Development of a Prediction Interval Appendix 48 The Sum of SquaresDecomposition Appendix 4C The Log-Normal Distribution

75 75 76 76 79 80 81 82 82 83 84 84 86 87 89 90 93 94 94 95 96 96 97 97 98

48 48 48 49 49 51 52 53 54 55 55 55 55 56 56 56
il

10r
103 r03

58 59 59 59 60 61 62 62 63 64 65 66 66 67 68 68 69 72 73

Chapter 5

The Multiple

Regression Model

105
105 105 106 106 l0g 109 110 l 11 111 ll2 ll4 115 115

Learning Objectives Keywords 5.1 Introduction 5.1.1 The Economic Model 5.I.2 The EconometricModel 5.1.2a The GeneralModel 5.1.2b The Assumptionsof the Model 5.2 Estimating the Parametersof the Multiple RegressionModel 5.2.1 Least Squares Estimation Procedure 5.2.2 Least SquaresEstimates Using Hamburger Chain Data 5.2.3 Estimation of the Error Variance o2 5.3 Sampling Properties of the Least SquaresEstimator 5.3.1 The Variancesand Covariances the Least Squares of Estimators 5.3.2 The Properties of the Least SquaresEstimators Assuming Normally Distributed Errors 5.4 Interval Estimation 5.5 Hypothesis Testing for a Single Coefficient 5.5.1 Testing the Significance of a Single Coefficient

rt7
118 120 r20

CONTENTS

5.5.2 One-TailHypothesis Testingfor a SingleCoefficient 5.5.2a TestingFor ElasticDemand 5.5.2b TestingAdvertisingEffectiveness 5.6 Measuring Goodness-of-Fit Results 5.6.1 Reporting Regression the 5.7 Exercises 5.7.1 Problems 5.7.2 Computer Exercises Appendix5,A' Derivationof LeastSquares Estimators Chapter 6 Further Inference in the Multiple Regression Model

122 122

r23
t24 t26 127 127 129 133 134 134 135 135 138 138 140 t42 142 t42 144

7.3

7.4 7.5

LearningObjectives Keywords 6.1 The F-Test 6.I.I The Relationship Betweenr- and F-Tests 6.2 Testingthe Significance a Model of 6.3 An Extended Model 6.4 TestingSomeEconomicHypotheses 6.4.1 The Significance Advertising of 6.4.2 The OptimalLevel of Advertising 6.4.2aA One-TailTestwith More than One Parameter 6.4.3 Using Computer Software 6.5 The Use of Nonsample Information 6.6 Model Specification 6.6.1 OmittedVariables Variables 6.6.2 Irrelevant 6.6.3 Choosing Model the 6.6.3a The RESETTest 6.7 Poor Data,Collinearity, and Insignificance 6.7.L The Consequences Collinearity of 6.7.2 An Example 6.7.3 Identifyingand Mitigating Collinearity 6.8 Prediction 6.9 Exercises 6.9.I Problems 6.9.2 Computer Exercises Appendix6,4'Chi-Square F-Tests: More Details and Appendix68 Omitted-Variable Bias: A Proof Chapter 7 Nonlinear Relationships LearningObjectives Keywords 7.1 Polynomials 7.1.1 CostandProduct Curves 7.1.2 AWage Equation 7.2 Dummy Variables 7.2.1 Intercept Dummy Variables 7.2.1a Choosing Reference the Group

7.6

r45 r46
148 149 150 151 151 153 153 154 155 156 1,57 t57 160

Cha

Lea Ke) 8.1 8.2 8.3

8.4

r63
165 166 t66

8.5

r66 r67 r67
169 170

Cha

t7r
172

Lea Ke) 9.1 9.2

CONTENTS

xix

122 122 123 r24 126 127 127 129 t33 134 134 135 135 138 138 140 t42

r42
142 IM t45 r46 148 149 150 151 151

Slope Dummy Variables An Example: The University Effect on House Prices Dummy Variables InteractionsbetweenQualitativeFactors Qualitative Factors with Several Categories 7.3.3 Testing the Equivalenceof Two Regressions 1.3.4 Controlling for Time Dummies 7.3.4a Seasonal 7.3.4b Annual Dummies 7.3.4c Regime Effects 7.4 Interactions Between Continuous Variables 7.5 Log-Linear Models 7.5.1 Dummy Variables 7.5.1a A Rough Calculation 7.5.1b An Exact Calculation 7.5.2 Interaction and Quadratic Terms 7.6 Exercises 7.6.1 Problems 7.6.2 ComputerExercises Appendix 7A Details of Log-Linear Model Interpretation Chapter 8 Heteroskedasticity

7.2.2 7.2.3 '7.3 Applying 7.3.1 '7.3.2

r72 t74
175

r75 177 r79 181 181 r82 r82 r82 184 185 185 185 186 186 186 190 195

r97
197 197 l9'7 201 202 203 205 208 2tl 2tl 2tl 212 215 215 216 2t6 219 222 224

r53
153 154 155 156 157 157 160 r63 165 166

r66
t66 167 167 r69

Learning Objectives Keywords 8.1 The Nature of Heteroskedasticity 8.2 Using the Least SquaresEstimator 8.3 The Generalized Least SquaresEstimator 8.3.1 Transforming The Model 8.3.2 Estimating the Variance Function 8.3.3 A HeteroskedasticPartition 8.4 Detecting Heteroskedasticity 8.4.1 ResidualPlots 8.4.2 The Goldfeld-Quandt Test 8.4.3 Testing the Variance Function 8.4.3a The White Test 8.4.3b Testing the Food Expenditure Example 8.5 Exercises 8.5.1 Problems 8.5.2 Computer Exercises Appendix 8A Properties of the Least SquaresEstimator Appendix 8B Variance Function Tests for Heteroskedasticity Chapter 9 Dynamic Models, Autocorrelation and Forecasting

226
226 226 227 230 230

r70
tll 172

Learning Objectives Keywords 9.1 Introduction 9.2 Lags in the Error Term: Autocorrelation Model for SugarCane 9.2.1 Area Response

CONTENTS

9.2.2 First Order AutoregressiveErrors Estimating an AR(l) Error Model 9.3.1 Least SquaresEstimation 9.3.2 Nonlinear Least SquaresEstimation 9.3.2a Generalized Least SquaresEstimation 9.3.3 Estimating a More General Model 9.4 Testing for Autocorrelation 9.4.1 Residual Correlogram 9.4.2 A Lagrange Multiplier Test 9.4.3 Recapping and Looking Forward 9.5 An Introduction to Forecasting: AutoregressiveModels 9.6 Finite Distributed Lags 9.7 AutoregressiveDistributed Lag Models 9.8 Exercises 9.8.1 Problems 9.8.2 Computer Exercises Appendix 9A Generalized Least SquaresEstimation Appendix 9B The Durbin-Watson Test 9B.l The Durbin-Watson Bounds Test Appendix 9C Deriving ARDL Lag Weights 9C.1 The Geometric Lag 9C.2Lag Weights for More General ARDL Models Appendix 9D Forecasting:ExponentialSmoothing 9.3 Chapter 10 Random Regressors and Moment Based Estimation

231 235 235 236 237 237 239 239 242 243 244 248 250 253 253 255 259 26r 263 264 264 265 266 268 268 269 270 270 271 272 273 274 274 275 276 276 276

10

10

Learning Objectives Keywords 10.1 Linear Regressionwith Random x's 10.1.1 The Small Sample Properties of the Least SquaresEstimator l0.l.2 Asymptotic Properties of the Least SquaresEstimator: x Not Random 10.1.3 Asymptotic Properties of the Least SquaresEstimator: x Random 10.1.4 Why Least Squares Fails 10.2 Casesin Which x and e are Correlated 10.2.1 MeasurementError 10.2.2 Omitted Variables 10.2.3 SimultaneousEquations Bias 10.2.4 Lagged Dependent Variable Models with Serial Correlation 10.3 Estimators Based on the Method of Moments 10.3.1 Method of Moments Estimation of a Population Mean and Variance 10.3.2 Method of Moments Estimation in the Simple Linear RegressionModel 10.3.3 Instrumental Variables Estimation in the Simple Linear RegressionModel 10.3.3a The Importance of Using Strong Instruments 10.3.3b An Illustration Using Simulated Data 10.3.3c An Illustration Using a Wage Equation

Chs
Lei

Ke ll. I l. 11 11 I l.

I l.

278 278 279 280 281

ll

ll

CONTENTS

xxl

231 235 235 236
z)t zJt

239 239 242 244 248 250 253 253 255 259 261 263 264 264 265 266 268 268 269 270 270

10.3.4 Instrumental Variables Estimation with Surplus Instruments 10.3.4a An Illustration Using SimulatedData 10.3.4b An Illustration Using a Wage Equation 10.3.5 Instrumental Variables Estimation in a General Model 10.3.5a HypothesisTestingwith InstrumentalVariables Estimates 10.3.5b Goodness-of-Fit with Instrumental Variables Estimates 10.4 Specification Tests 10.4.1 The Hausman Test for Endogeneity 10.4.2 Testing for Weak Instruments 10.4.3 Testing Instrument Validity 10.4.4 Numerical ExamplesUsing SimulatedData 10.4.4a The HausmanTest 10.4.4b Test for Weak Instruments 10.4.4c Testing Surplus Moment Conditions 10.4.5 Specification Tests for the Wage Equation 10.5 Exercises 10.5.1 Problems 10.5.2 Computer Exercises Appendix l0A Conditional and Iterated Expectations 10A.1 Conditional Expectations 10,4'.2Iterated Expectations 104,.3Regression Model Applications Appendix 10B The Inconsistency of Least Squares Appendix 10C The Consistency of the 1V Estimator Appendix 10D The Logic of the Hausman Test

282 284 284 285 286 286 286 287 288 289 290 290 290 29r 291 292 292 293 297 297 298 298 299 300 301 303 303 303 304 306 307 307 309 310 311 311

:or ot

EquationsModels Chapter11 Simultaneous
Learning Objectives Keywords l1.l A Supply and Demand Model lI.2 The Reduced Form Equations 11.3 The Failure of Least Squares ll.4 The Identification Problem ll.5 Two-StageLeast Squares Estimation 11.5.1 The GeneralTwo-StageLeast Squares Estimation Procedure 11.5.2 The Properties of the Two-Stage Least SquaresEstimator I1.6 An Example of Two-StageLeast Squares Estimation 11.6.1 Identification II.6.2 The ReducedForm Equations 11.6.3 The Structural Equations ll.7 Supply and Demand at the Fulton Fish Market ll.7.I Identification 11.7.2 The ReducedForm Equations Estimationof Fish Demand 11.7.3 Two-StageLeast Squares 11.8 Exercises 11.8.1 Problems

27r
272
zt3

2',74
a1A Lta

t

275 276 276 276 27',7 278 278 219 280 281

3r2
312 313 314 3r5 315 3r7 318 318

CONTENTS

11.8.2 Computer Exercises Appendix 11A An AlgebraicExplanation the Failureof of LeastSquares

319

Cha

323

Chapter 12 NonstationaryTime-SeriesData and Cointegration
LearningObjectives Keywords I2.l Stationary Nonstationary and Variables l2.l.I The First-Order Autoregressive Model 12.1.2 Random Walk Models Regressions L2.2 Spurious 12.3 Unit Root Testsfor Stationarity 12.3.1 Dickey-Fuller Test I (No Constaat No Trend) and 12.3.2 Dickey-Fuller Test2 (With Constant No Trend) But 12.3.3 Dickey-Fuller Test3 (With Constant With Trend) and 12.3.4 The Dickey-Fuller TestingProcedure 12.3.5 The Dickey-FullerTests: Example An 12.3.6 Orderof Intecration 12.4 Cointegration Test 12.4.1 An Exampleof a Cointegration 12.5 Regression WhenThereis No Cointegration 12.5.1 First DifferenceStationary 12.5.2 TrendStationarv 12.6 Exercises 12.6.I hoblems 12.6.2 Computer Exercises

32s
325 325 326 328

Lea Ke) 14 t4. t4.

33r
333 335 335

t4.

33s
336 336 337 338 339 340 340 14

Cha

34r
342 342 342 344

Lea Ke) 15 15 15

Chapter 13

VEC and VAR Models: An Introduction to Macroeconometrics

15 346 346 346 347 349 349 351 352 352 352 353 355 355 356 357 35'7 357 358 36r

LearningObjectives Keywords 13.1 VEC and VAR Models 13.2 Estimatinga VectorError Correction Model 13.2.1 Example 13.3 Estimatinga VAR Model 13.4 ImpulseResponses Variance and Decompositions 13.4.1 ImpulseResponse Functions 13.4.laThe UnivariateCase l3.4.lb The BivariateCase 13.4.2 Forecast Error Variance Decompositions 13.4.2a Univariate Analysis 13.4.2b BivariateAnalysis 13.4.2c The General Case 13.5 Exercises 13.5.1 Problems 13.5.2 Computer Exercises Appendix 13AThe Identification Problem

15

15

4.3.5.1 Error Term Assumptions 15.2 Testing for Random Effects 15.2 Testing Cross-Equation 15.1 Grunfeld's InvestmentData 15.2 Computer Exercises 375 375 376 Chapter 15 Panel Data Models 382 382 382 384 385 387 389 390 391 391 393 396 398 399 400 401 402 403 403 404 404 406 406 408 4t5 346 346 346 34'l 349 349 351 352 352 352 353 35s 355 356 357 357 3)l Learning Objectives Keywords 15.1 Problems 15.4.3 Fixed Effects Estimation Usins a Microeconomic Panel 15.3 ForecastingVolatility 14.3.5a Endogeneityin the Random Effects Model 15.4 The Fixed Effects Model 15.6.3.6.5 The Random Effects Model 15.2 EstimatingARCH Models 14.l Conditional and UnconditionalForecasts 14.3.l The ARCH Model I4.2 Setsof Regression Equations 15.3 Seemingly Unrelated Regressions or 15.3 Testing.4.4 An Example Using the NLS Data 15.3 GARCH-in-Mean and Time-Varying Risk Premium 14.1 Separate Joint Estimation? Hypotheses 15.5.2 Allowing for an Asymmetric Effect 14.5.1 The GARCH Model-Generalized ARCH 14.3.4.4. Estimating and Forecasting 14.5.I.6 Exercises 15.5 Exercises 14.1 Problems 14.5.2 The Fixed Effects Estimator 15.5c A HausmanTest 15.4 Extensions 14.1 Testing for ARCH Effects 14.5b The Fixed Effects Estimator in a Random Effects Model 15.4.5.2 ComputerExercises Appendix l5A Estimation of Error Components 358 36r .5.5 Comparing Fixed and Random Effects Estimators 15.2 Time-Varying Volatility 14.5.5.1 A Dummy Variable Model 15.5.CONTE NTS 319 3ZJ Chapter 14 Time-Varying Volatility and ARCH Models: An Introduction to Financial Econometrics 363 363 363 364 365 365 369 369 369 370 371 371 3tz Jt+ 32s 325 325 326 328 33r JJJ 335 335 335 336 336 337 338 339 340 340 341 342 342 342 344 Learning Objectives Keywords l4.3 Estimation of the Random Effects Model 15.

2 Post-Estimation Analysis 16.1 Censored Data 16.2 A Monte Carlo Experiment 16.CONTENTS Chapter 1.l Writing an Empirical Research Report.2 MaximumLikelihoodEstimation 16.6a The Econometric Model 16.4 43r 431 432 433 433 434 435 437 437 438 439 440 441 44r M2 444 445 446 447 448 449 450 A -{pp l*a Key B.3 Interpretation the ProbitModel of 16.3 An Example 16.5 Ordered ChoiceModels 16.5 An Example 16.1.6.1 OrdinalProbit ChoiceProbabilities 16.5 An Example 16.6 Sample Selection 16.6.1 Modelswith Binary Dependent Variables 16.3 Sources EconomicData of I7.7.4 An Example 16.1 Links to EconomicData on the Internet 17.3 8.I.2 The ProbitModel 16.7.7.3 MaximumLikelihoodEstimation L6.5 457 457 457 458 458 460 460 461 461 462 8.7.3.3 Interpreting EconomicData 17.3.3 An Example 16.1.7.I MaximumLikelihoodEstimation 16.6.3.3 A.8 Exercises Chapter 17 l7.2 B.4 MaximumLikelihoodEstimation the ProbitModel of 16.6b Heckit Example:Wages Manied Women of 16.4.2 TraditionalSources EconomicData of 17.2 The Logit Model for Binary Choice 16.6 Selecting Topic for an Economics a Project 17.3 Multinomial Logit 16.7.4 Conditional Logit 16.5.2 A.4.4 B.1.7.5.1 Conditional Logit ChoiceProbabilities 16.6 Qualitative and Limited DependentVariable Models LearningObjectives Keywords 16.1 A.6 Modelsfor CountData 16.1.1 Multinomial Logit ChoiceProbabilities 16.l 8.5.3.2 A Format for Writing a Research Report 17.4 Tobit Model Interpretation 16.4 Exercises App l*a Kel .3.3. and Sources of Economic Data 417 417 4t7 418 419 421 422 423 424 425 426 427 427 428 429 App Lea Ke) A.4.7 Limited Dependent Variables 16.1 The Linear ProbabilityModel 16.1.7.3 An Example 16.2 Interpretation the Poisson in Regression Model 16.3.2 Estimationand Interpretation 16.3 Post-Estimation Analysis 16.L2 Writing an Abstract l'7.I Choosing Topic a l7.

4.CONTENTS xxr) 417 477 417 418 419 421 422 423 424 425 426 427 427 428 429 431 431 +32 Appendix A Review of Math Essentials 463 463 463 464 465 465 466 466 466 468 469 470 471 471 472 473 473 +tJ Aaa 433 433 434 435 437 437 438 439 440 441 Learning Objectives Keywords A.4 Properties of Probability Distributions 8.5.2 Exponents A.5 Some Important Probability Distributions 8.2 Probability Distributions 8.1 QuadraticFunction 4.4 Log-Log Function 4.4.4.3 Scientific Notation 4.7 Approximating Logarithms in the Log-Linear Model A.5 Exercises 474 475 476 478 478 479 479 480 483 484 484 486 487 +6 I Appendix B Review of Probability Concepts Learning Objectives Keywords B.2.6 Exercises \ppendix C Review of Statistical Inference 44r 442 444 445 446 447 448 449 450 457 451 457 458 458 460 460 461 461 462 488 490 492 493 493 495 495 496 497 501 s0l 502 Learning Objectives Keywords .1 Random Variables 8.8 Linear-LoeFunction A.2.2 Expected Values of Functions of a Random Variable 8.1 Summation A.4.2 Conditional Probability B.2 The Chi-Square Distribution B.2.1 Mean.4.3 A Simple Experiment 8.4.4.5. Median and Mode 8.4.4.1 Marginal Distributions 8.3 LinearRelationships A.3.3.5.3 The r-Distribution 8.4 The F-Distribution 8.3.3 Expected Values of Several Random Variables 8.4.5 Log-Linear Function 4.4 The Simple Experiment Again B.2 Some Basics 4.4 Logarithms and the Number e A.4.2. Marginal and Conditional Probability Distributions B.3.4 Nonlinear Relationships 4.4.1 Numbers 4.3 Joint.2 Cubic Function 4.3 Reciprocal Function 4.5.6 Approximating Logarithms A.1 The Normal Distribution 8.1 Elasticity 4.

3 Interval Estimation: o2 Unkno*n C.4 The Central Limit Theorem C.5 Example of a One-Tail Test Using the Hip Data C.1 Inference with Maximum Likelihood Estimators C.4.8.3.3 The Sampling Distribution of Y C.5.le A Conclusion C.8.2 Testing the Equality of Two Population Means C.l0 -{ppe Appe Tabl Tabk Tabk Tablt Tabl lnder 5r7 518 518 518 519 519 519 519 520 520 521 522 523 524 525 525 525 526 527 527 528 532 533 534 536 536 538 539 .8.5.1 Componentsof HypothesisTests C.6.7.6.3 The Hip Data C.4 Two-Tail Tests with Alternative "Not Equal To" (l) C.4 Using the Estimates lnterval Estimation C.1 c.7 c.3 One-Tail Tests with Alternative "Less Than" (<) C.lb The Alternative Hypothesis C.2 c.5 Interval Estimation Using the Hip Data Hypothesis Tests About a Population Mean C.6.7.7.2 A Simulation C.9 Type I and Type II Errors C.1 Interval Estimation: o2 Known C.4b The Wald Test C.6 c.6.CONTENTS c.I Estimating the Population Variance C.3 Testing the Ratio of Two Population Variances C.8.5.4.2 The Varianceof Y C.4 Asymptotic Test Procedures C.6.6.5.1 The ExpectedValue of Y C.la The Null Hypothesis C.5 Best Linear UnbiasedEstimation Estimating the Population Variance and Other Moments C.6.3.6.3.5 c.9 c.7 The p-Value C.I Testing the Population Variance C.4.6 Example of a Two-Tail Test Using Hip Data C.4c The Lagrange Multiplier (LI[) Test 502 504 504 506 506 507 508 509 509 510 511 511 5t2 5t2 513 5t4 515 5t7 5r7 5r'1 c.6.8.3 c.10 A Relationship Between Hypothesis Testing and Confidence Intervals Some Other Useful Tests C.4 Testing the Normality of a Population Introduction to Maximum Likelihood Estimation C.8.8 A Sample of Data An Econometric Model Estimating the Mean of a Population C.2 The Variance of the Maximum Likelihood Estimator C.1c The Test Statistic C.6.6.3.ld The Rejection Region C.7.4 A Simulation (Continued) C.8 A Comment on Stating Null and Alternative Hypotheses C.2 Estimating Higher Moments C.6.5.8.4a The Likelihood Ratio (ZR) Test C.6.3.4 c.6.2 One-Tail Tests with Alternative "Greater Than" (>) C.4.6.3 The Distribution of the Sample Proportion C.

CONTENTS xtcuii 502 504 504 506 506 507 508 509 509 510 51i 511 512 512 513 514 515 5t7 511 517 (Optional) Algebraic Supplements C.9.7 527 528 s32 533 534 536 536 538 539 .2 Best Linear UnbiasedEstimation C.1 Derivation of Least Squares Estimator C.9 541 541 543 544 AppendixD Answersto Selected Exercises AppendixE Tables Table I Table 2 Table 3 Table 4 Table 5 lndex Cumulative Probabilities for the Standard Normal Distribution Percentilesfor the r-Distribution Percentilesfor the Chi-square Distribution 95th Percentile for the F-Distribution 99th Percentile for the F-Distribution s48 572 572 573 574 575 576 3t I 5r7 518 518 518 519 519 519 519 520 520 521 522 523 524 525 525 525 526 52'.l0 Exercises C.9.

a wide rangeof opportunities opento is is you upon graduation. are useful to a broad spectrum of individuals. As a student of economics. it is not very specificand may not be very satisfying to an employer to who does not understand economics. and management.specifically researchers in history. and international trade. you become someonewho understands how markets work.you will be able to elaborateon your answerto the employer'squestionabove by saying "I can predict the salesof your product.marketing. engage economicanalysisthat is in part "empirical." "I can estimate effect on your salesif your competitionlowersits price by $l per unit.Through this training you becomea personwho betterunderstands world in which the we live. economichypotheses. and the way in which government policies affect the marketplace." By that. political science.Chapter An Introduction to Econornetrics 7. your employer will want to know the answerto the question. scarcity.You are working with economic models of supply and demand."I can think like an economist.and sociology." "I can the . finance. you are learning to "think like an economist.we meanthat in economicrelationships. and comparative advantage.which include the field of econometrics."With the econometric skills you will learnfrom this book. including how to work with econometricsoftware. Econometrics plays a special role in the training of economists. This breadth of interest in econometricsarises in part becauseeconomicsis the foundation of businessanalysis." You are learning economic conceptssuch as opportunity cost. Thus researchmethods employed by economists.macroeconomicbehavior.7 Why Study Econometrics? The importance of econometricsextendsfar beyond the discipline of economics. Econometrics plays an important role in such diverse fields as forestry and in agricultural economics. Very few economists make their livings by studying economic theory alone. Econometrics is a set of research tools also employedin the business disciplinesof accounting.If you wish to enter the businessworld."What can you do for me?" Students taking a traditional economics curriculumanswer. Most economists. and those who do are usually employed by universities.It is usedby social scientists.whether they work in the businessworld or for the government. or teach in universities. being "a student economics"andbeing "a fills of Studyingeconometrics a gapbetween practicingeconomist. If economics yourmajororminorfield of study. The problem is that a gap existsbetweenwhat you have learnedas an economicsstudent and what economists actually do."While we may view sucha response be powerful. test they useeconomicdatato estimate and predict economicoutcomes.

P'.about how important variablesare related to one another. finance. we may write CoNSUMPTION : f (INCOME) which says that the level of consumption is some function. as The demandfor an individual commodity. For example. That is.INC) Asac the Fe (FRB) mustr so by discou Increa in othr funds autom consu aggre! are su Thr discou answe ratesa and mr and m policie Ecc "Gooc as the conse Eve Bernar a) whichsaysthatthequantityofHondaAccordsdemanded. might be expressed Qd:f(P. and the forest often gets lost in studying the trees. to I a . 7. P .It all begins with a theory from your field of study. you will encounter more econometrics in your future.P. the price of corn) used in the production process. The graduate coursestend to be quite technical and mathematical.because to analyzeeconomic data. Ifyou plan to continueyour educationby enrolling in graduateschool. P' is the price of competitive productsin production (e.g. we must be able to say how much a chanse in one variable affects another. Such pieces of information are keys to good businessdecisions. and the level of income /NC. political science. accounting. I ol t o! ) .1 7.If your goal is to earna master's or Ph. like gasoline. before entering a technically oriented course.sociology. tr.isafunction/(P. along with tools from statistics.F.2 Vhat Is Econornetrics About? At this point we needto describethe nafureof econometrics.P r ) where Q" is the quantity supplied. of income. how we visualize Each of the aboveequationsis a generaleconomicmodel that describes the way in which economic variables are interrelated.you will find that this introduction to econometricsis invaluable.to expressa relationship between income and consumption. of the price of Honda Accords P. say the Honda Accord. P is the price of teef. the price of hogs).l i i ol i and business.or law school.. For most economic decision or choice problems. or forestry. it is not enough to know that certain economic variablesare interrelated.2.whether it is accounting. By taking this introduction to econometricsyou will gain an overview of what econometricsis about and develop some "intuition" about how things work.AN INTRODUCTION TO ECONOMETRICS test whether your new ad campaign is actually increasing your sales. social sciences. the I Econometricsis abouthow we canusetheoryand datafrom economics.INC) P".Economic models of this type guide our economicanalysis.In economicswe expressour ideas about relationships betweeneconomic variablesusing the mathematicalconcept of a function. we must understandthe magnitudes involved.Ec.or eventhe direction of the relationship.D. the price of cars that are substitutes the price of items that are complementsP'.g. and It is the price of factors or inputs (e.. sociology. . answer"how much" type questions. agricultural economics. or economics.In addition. degree in economics. The supply of an agricultural commodity such as beef might be written as a ol \ a : f l p .l . marketing." These answersare they reflect your ability to think like aneconomistand music to an employer's ears./(.). Being able to provide your employer with useful information will make you a valuable employee and increaseyour odds of getting a desirablejob.

and thus must estimate the relationship between advertising and sales.S.this is the FederalReserveSystem. A real estate developer must predict by how much population and income will increaseto the southofBaton Rouge. must decidehow an increase in fares for public transportation(trams. Australia. Louisiana StateUniversity must estimatehow much enrollment will fall if tuition is raisedby $100 per semester.we how much a ress.2 WHAT IS ECONOMETRICS ABOUT? answersare ofuonistand ls decisions. and interest rates over your planning horizon.rics in your rd the forest ics you will " abouthow 1.g. and yet maintain a stable and growing economy?" The answerwill dependon the responsiveness firms and individuals to increases the interest of in ratesand to the effectsof reducedinvestmenton GrossNational Product. 'we visualize istype guide v that certain iaddition. suggestingan increasein the inflation rate.andthe l questions. The values of economic parametersare unknown and must be estimated using a sample of economic data when formulating economic policies.1 SovrE Examprns L theory from rw important relationships : example.such asthose faced by would-be investors. Econometricsis abouthow to bestestimateeconomicparameters given the datawe have. and how much to invest in new plant and equipment. considerthe problem faced by a central bank.-onsequences all of us.. the rate of inflation. The real question facing Chairman Bernanke is "How muchshotld we increase the discount rate to slow inflation.The key elasticities and multipliers are called parameters.Pt. Theserelationships are suggestedby economic theory.the FRB must make a decision about whether to dampenthe rate of growth of the economy.and ifit will be profitable to begin construction of a new strip mall. "Good" econometricsis important. for Every day decisionmakersface "how much" questionssimilar to thosefacing Chairman Bernanke. The owner of a local PizzaHutfranchise must decide how much advertising spaceto purchasein the local newspaper. which has . r a valuable / school.Louisiana.Overall. When prices areobservedto rise. and The CEO of Proctor & Gamble must estimatehow much demandthere will be in 10 years for the detergentTide. PresidentialcandidateClinton questionshow many additional California voters will supporther if she spendsan additional million dollars in advertisingin that state.with Ben Bernankeas Chairman of the FederalReserveBoard (FRB). This has the economic effect of increasing costs.2.you rn a master's economics. U.to as expressed As a casein point. A public transportationcouncil in Melbourne. and buses)will affect the number of .INC) rriceof items IS 'competitive r inputs (e. In the United States.P'.who may be firms seeking tunds for capital expansion or individuals who wish to buy consumer durables like automobiles and refrigerators. . over the next few years. . Increasingtheserates will then senda ripple effect through the economy causing increases in other interestrates. You must decide how much of your savingswill go into a stock fund and how much into the money market.Some examplesmight include the following: A city council pondersthe question of how much violent crime will be reducedif an additional million dollars is spent putting uniformed police on the street. sinceerrorsin the estimatesusedby policy makerssuch a: the FRB may lead to interest rate corrections that are too large or too small. aggregate demandfalls and this is expectedto slow the rate of inflation.It can do so by raising the interest rate it chargesits member banks when they borrow money (the discount rate) or the rate on overnight loans between banks (the federal funds rate). thus whetherits revenuefrom tuition will rise or fall.1. and consumerswould react by reducing the quantity of the durable goods demanded. trains.This requiresyou to make predictionsof the level of economic activity.

.

it is easy to imagine controlledexperiments.a supply equation.and of which we represent using the random variablee. are and These are nonexperimental data.As we analyze datatheform in which Datathat arecollectedmay be of several the they arecollectedaffectswhich methodological issues may encounter.thereis a systematic portion and an unobservable randomcomponent. rart of the Oneway to acquireinformation aboutthe unknown parameters economic relationshipsis of to conduct or observe the outcome of an experiment.in n of price.4. In a telephone survey numbers are selectedrandomly and called.edu/) conducts telephone and mail surveysfor clients. Such controlled experimentsare extremely rare in businessand the social The key aspect sciences. In the physical sciences.4 HOW DO WE OBTAIN DATA? regoing to rovidedby heory and L on these rnderlying rles obtain oard has a & Gamble )u may get onometric lhe source here is an yield the model and In every econometricmodel. iomething rample. we The datamay be collectedin a .We might plant similar plots of land with a particular variety of wheat. Responses questionsare recordedand analyzed.and agriculture. Thus an itted from ivity. as well as currentstoredisplaysand couponusage. Procedures usingsuchdatato answerquestions economicimportance the for of are subjectmatter of this book. and it includes an assumptionabout the functional form. The random component representsa "noise" component. 1.I.7 ExpsRrrurNrar Dere r a general rreyou are tric model . The prices and shoppingenvironmentare controlledby storemanagement.2 NonnxprsrurNTAl DATA variables.This makes the task of leaming about economic parametersall the more difficult. forms. 7.or a productionfunction. at the sametime a datarecord is created. observing at the end of the growing seasonthe bushelsof wheat producedon eachplot.lsu. 1.survey.4 How Do 'We Obtain Data? Where does data come from? Economistsand other social scientistswork in a complex world in which data on variables are "observed" and rarely obtained from a controlled experiment.In such an environmentdata on all to variables collectedsimultaneously the valuesareneitherfixed nor repeatable. ofexperimentaldatais that the valuesofthe explanatory variables can be fixed at specificvaluesin repeatedtrials of the experiment. an item is sold it is passedover a As scanningunit to record the price and the amountthat will appearon your grocery bill. Repeating experimenton Nplots ofland creates sampleofN the a observations.4. The systematic portion is the part we obtain from economic theory. One business examplecomesfrom marketingresearch. The Public Policy Research Lab at Louisiana State University (http://www. Scientistsspecify the valuesof key control variablesand then observethe outcome. and then vary the amounts of fertilizer and pesticide applied to each plot. But.which obscuresour understanding the relationshipamong variables. )mpatible An exampleof nonexperimental data is survey data.and at every point in time the price of the item and the pricesof all its competitorsare known. Suppose areinterested the we in weekly salesof a particularitem at a supermarket. and thus this "experiment" can be repeateda number of days or weeks using the samevaluesof the "control" variables. whetherit is a demandequation. not claim describes g car sales c part and .

macro-data resulting from a pooling or aggregatingover individuals. or electronic media. the annual price ofwheat in the United Statesfrom 1880 to 2007. households. households. In Chapter 17 we list sourcesof economic datathat are availableboth in print. qualitative-outcomes that areof an "either--or" situation. storagetanksonApril1. and of course education. and on the Internet. Ecc thr( cha 1. or the daily price of General Electric stock from 1980 to 2007.or theassetvalueof the Wells Fargo Bank on Jily I. from the time they are in the 8th gradeuntil their mid-twenties. Thesedatabases record not only student characteristicsand performance. such as real prices or per capita income.or flrms. By this we mean we want to "infer" or learn somethingabout the real world by analyzinga sampleof data.or high schoolgraduation rates by state in 2006.income by countiesin California durin920O6. Department of Education has several ongoing surveys. their schools. health economics. Estimating economic parameters. 5 Statistical Inference The phrasestatistical inference will appearoften in this book. or firms at the local. such asthe consumptionof gasoline flow-outcome measures during the last quarter of 2006. The data collected may also representa flow or a stock: over a period of time. or national levels. state. Th reI Gt . stock----oulcome measuredat a particular point in time.Forexample.such as elasticities. The data collected may be quantitative or qualitative: quantitative-outcomes such as prices or income that may be expressed numbers as or some transformation of them.and so on. such as the quantity of crude oilheldbyExxoninitsU. These data may be collected at various levels of aggregation: micro-data collected on individual economic decision-making units such as individuals.The ways in which statistical inference are carried out include .but also the socioeconomiccharacteristicsoftheir families. using econometric methods.AN INTRODUCTION TO ECONOMETRICS time-seriesform-data collected over discrete intervals of time-for example.S. or a personeither is or is not married.in which the samestudentsaretrackedover time. panel data form-data that follow individual microunits over time.2007. economics of the household. aconsumer either did or did not make a purchaseof a particular good. Em thrt 7. For example. Such data are increasingly available. the U.S. Suchdata arerich sourcesofdata for studiesrelated to labor economics.2O06. cross-section form-data collected over sample units in a particular time periodfor example.

1. . and project that developedfrom his shoppingfor a new He relatesa story about a research TV set. Predicting economic outcomes. ProfessorHalVarian("How to Build an EconomicModel in an interesting Your SpareTime. and as we proceed through this book you will learn how to properly estimate. and test. the / price of periodraduation r data are rs several time they y student . in Guidelinesfor writing economicspapersare -eiven Chapter 17. predict.were all of the right-hand-sideexplanatoryvariablesrelevant?Was the correct functional form used? 7. 1. Model diagnosticsareperformed to check the validity of assumptions havemade.What economic resourceallocation and distribution results are implied. h as indi useholds.predictions are made.pp. the end of the work. It all startswith a problemor question. You will find that "inspiration is 99Vo perspiration. and hypothesis tests are performed. e Testingeconomichypotheses.given the initial question. we For example.More questions of will occur during and listing the questions the researchproject.sof their esrelated of course . Sampledata are obtainedand a desirablemethod of statisticalanalysisis chosen.and we will stressthis orderly procedure Empirical economicresearch throughout the book. so on. . given the characteristicsof the data at hand. We must choose a functional form and make some assumptionsabout the nature of the error term. summarizing what you have found and the methods you used.after you dig at a topic long enough. The steps are as follows: 1. Econometrics includes all of these aspects of statistical inference.a new and interesting questionwill occur to you. you may be led by your natural curiosity to question." That means. based on our initial assumotionsand our understandinsof how the data were collected.such as the enrollment in 2-year colleges in the United Statesfor the next l0 years. 2. Fall 1997. Alternatively. suchasthe questionof whethernewspaper advertising is better than storedisplaysfor increasingsales. you look for ideasoutsideacademic magazines. Economic theory gives us a way of thinking about the problem: Which economic variablesareinvolved and what is the possibledirection ofthe relationship(s)?Every project.beginsby building an economicmodel research (hypotheses) interest.6 A RESEARCH FORMAT mple. 3. a paperor report must be written. 6. 5. 3-10) suggests journals-in newspapers. The economic consequences and the implications of the empirical results are analyzedand evaluated.6 A Research Fortnat follows a pattern. Estimates of the unknown parametersare obtained with the help of a statistical software package. The idea may come afterlengthy studyof all that has been written on a particular topic." TheAmerican Economist. The working economic model leads to an econometric model. and what are their policy-choiceimplications?What remainingquestions might be answeredwith further study or new and better data? At This path is one we will follow in the following chapters.lectronic e want to o ways in nethods. 4l (2). but it is good to list those that motivate you at the beginning of the project. gasoline r of crude lue of the numbers )onsumer s or is not 4.

Explain the theoretical decompositionof an observablevariable y into its systematic and random components. 4.x)2. then the least squaresestimator b2 is unbiased. 3.If you are unsureabout the questions answers in or consult your instructor. We to and make sureyou recognizeand can definethe keywords. Explain the meaning of the phrase "sampling variability. Explain how the factors o2. Define the elasticity of y with respecttox and explain its computation in the simple linear regressionmodel when y and x are not transformedin any way. and why the least squaresestimatorsare random variables. andNaffect the precisionwith which we can estimate the unknown parameter B2. and when y and x are transformed by taking the natural logarithm. Explain the meaning of the statement"If regressionmodel assumptionsSR1-SR5 hold. 10. and why least squaresestimatesare not. and sketch the graph of an estimated equation. what exactly does "unbiased" mean?Why is b2biasedif an important variable hasbeenomitted from the model. 6. I(xi .and possiblywrite out answers the questions. Based on the material in this chapter you should be able to l." 9. Discussand explain each of the assumptions the simple linear regressionmodel. Explain how the least squaresprinciple is usedto fit a line through a scatterplot of data. 2.and show this decomposition graphically. of 5.Be able to define the least squares residual and the least squaresfitted value of the dependentvariable and show them on a graph.Chapter 2 The Simple Linear Regression Model Ke) ASSUI: asym BLU biase degre depe devia for econ econ elast Learning Objectives REMARK: Leaming Objectives andKeywords sectionswill appearat the beginning of eachchapter. urgeyou to think about. Econ nomi supp prodr an ir funcl on th leve Ei chap ship price quan varie thes base tions appr 2.When examplesare requested lzarning you shouldthink of examples in the book. State and explain the Gauss-Markov theorem. not Objectivessections. 8. Discuss the interpretation of the slope and intercept parameters of the simple regressionmodel. 7." In particular. Explain the difference between an estimator and an estimate.1 In o imp< betu rand cons supp this inte wee valu ans .

In this chapter we hope to be very clear about these assumptions. Supposethat we are interestedin studying the relationship between household income and expenditure on food. In macroeconomics you specified "investment functions" to explain that the amount of aggregateinvestment in the economy depends on the interestrate and "consumption functions" that related aggregate consumptionto the level of disposable income.1 AN ECONOMIC MODEL Keywords assumptions asymptotic BLUE biasedestimator de-qrees freedom of Jependentvariable Jeviation from the mean tbrm econometric model economic model elasticity Gauss-Markov theorem heteroskedastic homoskedastic independentvariable least squaresestimates least squaresestimators least squaresprinciple least squaresresiduals linear estimator prediction random error term regressionmodel regressionparameters repeatedsampling sampling precision sampling properties scatter diagram simple linear regressionfunction specification error unbiased estimator t"l . is a random variable since the value is unknown to us until a household is selectedand the question is asked and answered.g. 2. state. as they are the conditions under which the analysis in subsequentchapters is appropriate. economic example. given that we know the value of one variable. We ask the question.canweforecast or predict the correspondingvalue of another?We will answer thesequestionsby using a regression model. that is used.r least e not. Consider the "experiment" of randomly selecting households from a particular population. supposethat we are interestedonly in householdswith an income of $1000 per week. Each of these models involves a relationship between economic variables. such as labor. As economistswe are interestedin questionssuch as: If one variable (e. In this chapter we consider how to use a sample of economic data to quantify such relationships. which we denote as y.. the price of a good) changes in a certain way. but important.7 An Econornic Model In order to develop the ideas of regression models we are going to use a simple. imple lematodel. Like all models the regressionmodel is based on assumptions.2. I . by how much will another variable (the quantity demandedor supplied) change?Also. The population might consist of householdswithin a particular city. 'lot of lue of imple hen y -SR5 lactly dtted Economic theory suggestsmany relationships between economic variables. . For the present. You considered "production functions" and "total productcurves" that explainedthe amountofa goodproducedasa function ofthe amountof an input. In microeconomics you considereddemand and supply models in which the quantities demandedand supplied ofa good dependon its price.province. "How much did you spendper person on food last week?" Weekly food expenditure. or country.1 Jor. In this experiment we randomly select a number of households from this population and interview them.

If . That is. will causeweekly expenditureson food to vary from one householdto another.lais actually a conditional probability density function since it is "conditional" upon household income. somewill be vegetarian.including random. All of thesefactors and many others.and somewill eat at restaurants more frequently. impulsive buying. The parametersFy[ and o2. The conditionalvariance of y is var(ylx : $1000) : o2. Probability distributions offood expendituregivenincomes.If you are rusty or uncertain aboutprobability conceptsseeAppendix B at the end of this bookfor a comprehensive review.We will use lowercaseletters.and we will make the interpretationclear in the surroundingtext.whichis the arithmeticaverage of numericalvalues. given $1000 per week income. would give us somevaluable information about the population we are considering. if they were known..The conditionalmean.10 THE SIMPLE LINEAR REGRESSION MODEL REMARK: In AppendicesB and C we distinguishedrandom variablesfrom their values by using uppercase(Y) letters for random variables and lowercase (y) letters for their values.like "y.and if we knew that the conditional distribution fjlx : $1000) was normal.Clearly.which is really a contraction of population mean.or expectedvalue." to denoterandom variablesas well as their values.r: weekly household income : $1000. If we knew these parameters.of y is E(ylx : $1000) : Fy[ and is our population's mean weekly food expenditureper person.1. We will not make this distinction any longer becauseit leads to complicated notation.7 (a) Probability y distribution llx :1000) of foodexpendituregivenincome f (b) y x: $1000. we could compute the proportion ofthe householdpopulation that spendsbetween $50 and $75 per personon food.The pdf f (y) describes how expendituresare "distributed" over the population and might look like Figure 2. then we could calculate probabilities that y falls in specific intervals using properties of the normal distribution.Keepthe distinctionbetween thesetwo usages the term "mean" in of mind. somewill contain senior citizens. the amount spenton food per personwill vary from one householdto anotherfor a variety of reasons:somehouseholdswill be devotedto gourmet food. The continuous random variable y has a probability density function (which we will abbreviate as pdJ) that describesthe probabilities of obtaining various food expenditure values. N(Fyp.This is not the sameas the samplemean. .evenif they all havethe sameincome. fuF = 1000) fup = 2000) At varia and -r good "indt expe Ar impo week How hous valut Fl fup= looo) Fylx \a) [yll000 Fyl2000 heal pred whe plan expe an ir Ir econ quar theo matl wec onf expc pdfl exp( inco l cont the s exp( prcunr 2 . somewill contain teenagers.o2. the center of the probability distribution of the randomvariable.thenthe p conditional df is f Qlx : $ 1000). T\e pdf in Figure 2.r: $1000 and . which measures dispersionof the householdexpendituresy about their mean Fyp.r : $2000. REMARIk The expected value of a randomvariableis called its "mean" value.

Statistical perspective.9r * pzx (2.Lb we show the probability density functions of food expenditurefor two different levels of weekly income.uld compute )er person on 000) \ \ 00) )n mcome )00 and E(vlx): P. An econometric analysis of the expenditurerelationship can provide answersto some important questions. per person food spending habitsof households dffiring sirys. information.) we must consider long-range plans. In most economics textbooks "consumption" or "expenditure" functions relating consumptionto income are depicted as linear relationships.our facilities to serveour customers.and how much to expand.1. . suchas the elderly. consumerbuying habits. ralue.we recognize that real-world expendituresare random variables.. In econometrics. informationis valuable for assessing patterns. . If economic forecastersare predicting that local income will increase over the next few years. races. . one can determine similarities the Using. The informationmay also be used to developtypical market populationgroups.or From a business health food store. In our food expenditure example. In order to investigatethe relationshipbetweenexpenditureand income we must build an economic model and then a correspondingeconometric model that forms the basis for a quantitative or empirical economic analysis.Department 1997-1998.Or. give an indication of how large the storesin those areasshould be.if we are managersof a supermarket chain (or restaurant. The mathematicalrepresentation our economic model of householdfood expenditure. economic theory suggests that averageweekly perpersonhouseholdexpenditureon food. could weekly food expendituresfall as income rises? How much would we predict the weekly per person expenditure on food to be for a household with an income of $2000 per week? The answers to such questions provide valuable information for decision makers. Consequently we call y the "dependent variable" and x the "independent" or "explanatory" variable.Combinedwith demographic and incomeprojections. in this case the relationship between y : weekly food expenditure per person and r : weekly householdincome. Research Service. we expect the averageexpenditure on food to change. if they were considering.2.this information may be used to anticipate consumption trends. be usedto develop thesepopulation groups. represented mathematicallyby the conditional mean E(ylr) : Fyl' dependson householdincome r. $ 1000and $2000. Economic theory tells us that expenditureon economic goods dependson income.S. Each conditional pdf f (ylx) showsthat expenditureswill be distributed about a meanvalue pr1". ion sinceit is 000.These marketbaskets offood for special baskets pattemsof price indicestailoredto the consumption may.depicted in Figure 2. etc. if we plan to open franchisesin high-income and low-income neighborhoods. and other socioeconomicand demographicfeatures. lBlisard. is dispersionof .June20011 of Agriculture.which rution of the etic average I "mean" in As economists we are usually more interested in studying relationships between variables. then we must decide whether to expand.2.. Noel.such as: If weekly income goes up by $100. how much will average weekly food expendituresrise? Or. Food Spendingin American Households.but the mean with higher income is larger than the mean expenditureby lower expenditureby households income households.in turn. tion /(ylx: .and we will begin by assuming of the samething.1. If we considerhouseholdswith different levels of income. then the rfyisE(ylx: trson.then forecastsof expenditureson food per person. ] AN ECONOMIC MODEL 11 r their values ers for their complicated :s as well as (t. and consumerliving conditions.U. hich we will I expenditure 9 at the end of rson will vary be devotedto somewill be ors and many n food to vary rfv) describes : Figure2.and we want to use data to learn about the relationship.r) . . This product distribution existingmarketconditions. of and disparitiesin the spending geographic areas.along with neighborhooddemographicinformation.incomes. ElectronicReportfrom the Economic BulletinNumber972. In Figure 2.at y falls in .

Algebraically. In order to use data we must now specify an econometric model that describeshow the data on householdincome and expenditure are obtained. we would expect the samplevaluesto be scatteredaround their meanvalue E(ylx) : 9r * lzx.1) is called a simple regression function.E(ylx) dn(ylx) DX AX (2.3 we iurangebell-shaped figures like Figure 2.= o X a oo o E(1tlx)=fu+B2x dE0v) dx ^( -- Frl L FTGURE 2. B1 and 82. and if you are not familiar with the concept. it could be called the marginal propensity to spendon food.:.ationship expenditure income.12 THE SIMPLE LINEAR REGRESSION MODEL Ertlx) g .2 An Econornetric Model The model Ejlx) :9r * Fzx describeseconomic behavior.interpretation. E(yl* satisfy var(yl" We collecl ditures (rando value r Ma theore .1. E(ylr). then the slope B2representsthe changein EfJ.":. and algebra of linear functions seeAppendix A. shownin Figure 2. respectively. and that guides the econometric analysis. along the regression line for each level of income. If you need a review of the geometry.The unknown regression parameters B1and B2are the intercept and slope of the regression function. x : $0. The economic model (2. It is called simple regression because is easy.2) where A denotes "change in" and dEQlx)ldx denotes the "derivative" of E(ylx) with respectto x.3 at the end of the book. If we take a random sample of households with weekly income x : $1000.but because not it thereis only one explanatoryvariableon the right-hand side of the equation.1) summarizes what theory tells us about the relationship betweenweekly householdincome (x) and expectedhouseholdexpendifureon food. In our food expenditure example the intercept 91 representsthe mean per person weekly household expenditure on food by a household with no weekly income.2 The economic modet:a [.1. FIGUR Thir expen assum E(ylx) econo Ino ^ YZ- L. and between ur"rui"per person food The conditional mean E(ylx) in (2. The parametersof the model. we know the actual expenditure values will be scatteredaround the mean value : Sjlx : 1000) : pylx:1000 9r * Bz(1000). you can think of "d" as a "stylized" version of A and go on. If we were to sample as householdexpendituresat other levels of income. If income is measuredin dollars. depicting the pdfs of food expenditure/(ylx).In Figure 2. at eac their n In Figr identic "sprea The we ar! 2. are quantities that help charucteize economic behavior in the population we are considering and are called population parameters. RE rem the ass ofe In Fig var(yl. but it is an abstraction from reality. We will not use derivativesto any great extent in this book.lx) given a $1 changein weekly income.

We have described the sample as random. to be the same. if the we do assumptions not hold. thenthe conclusions draw may not hold.me. as we havedepictedthe "spread" of each of the distributions. abstraction ncome .r : $1000) : o2. It is called y variable on nd B2are the eview of the he end ofthe :l per person . Mathematicians spend their lives (we exaggerate slightly) trying to prove the same theorem with weaker and weaker sets of assumptions. X (ylx) given a end on food.2) E(yl"r)with fyou arenot \ and go on. or average.3. In order to make the econometric model complete we have to make some assumptions. Assumptionsare the "if" part of an "if-then" type statement.tr : mean value re to sample valuesto be bell-shaped e regression In Figure 2. bes how the econometric REMARK: You will hear a great deal about assumptions in this chapter and in the If remainderof the book. the assumptionswe make are true. E(ylx). It also showsthat we expenditure given by the regression is assume valuesof householdexpenditureson food will be distributed around the meanvalue E{glx) : 9r -t lzx at eachlevel of income. (2.2 AN ECONOMETRIC MODEL 13 r Jvr) B1+p2x=E(y6.Ify. so that var(ylr) f oz for all values of income x. The constantvariance assumptionvar$lx) : o2 implies that at each level of income x we are equally uncertain about how far values of y might fall from their mean value.value ofhousehold function Ejlxl :9r * pzx.la we assumed that the dispersion of the values y about their mean is var(yl. This description means that when data are collected they are statistically independent. relationship food. for 2 FTGURE .lb the pdfs for two different incomes have different means.2. The basic assumption is that the dispersion of values y about their mean is the samefor all levels of income -r. This regressionfunction is the foundation of an econometric model for household food expenditure. then certain things follow. then knowing the value of one of these (random) variablestells us nothing about the probability that the other will take a particular value or range of values. E(ll*) :9r * Fzr. In Figure 2. This figure showsthat at each level ofincome the mean. We must make a similar assumptionabout the dispersionof values at each level of income. : $0.r) : o2 for all values of x. and yj denote the per person food expenditures of two randomly selected households.1. zeeconomic parameters. the data are said to be heteroskedastic. That is.3 T\e probabilitydensityfunctions y at two levelsof income. and the uncertainty does not dependon income or anything else. And. as importantly. Data satisfying this condition are said to be homoskedastic. Partof the challenge of econometric analysisis making realistic assumptionsand then checking that they hold. but they have identical variances. var(yl. like Figure 2. This mindset spills over to .This assumptionis also illustrated in Figure 2.) on food r. If this assumptionis violated.

ozf . If all the observationson x within the sample take the same value.4. y .3 for more discussionof this difference. on another. then we will assume that their covarianceis zero. implies it only thatthereis no systematic linear association betweenli andyj. These ideas. o (optional) The values of y are normally distributed about their mean for each value of x. In order to do this r must take at least two values within the sample of data. it is sometimes The usual assumed that the valuesof y arc normally distributed.3 ASSUMPTIONS .Referto AppendixB. : cov(y. var(Ylx) : s2 ASSUI .andnotrandom. define our econometric model.)0 This assumptioncan be made stronger by assumingthat the values of y are all statistically independent.then regression analysisfails. For each value of x. 2. for eachvalue of x. Itisc of -y. This is a weaker assumption than statisticalindependence denceimplieszerocovariance. Finally.t fbr st Th be de syste itisa lts co If we The < indel Ec 9r* alrea (2.lgl(Fr-l Bzx).ranging from IQs to the length of corn stalks to the birth weights of Australian male children.Y.All ourresultswill be conditionalon thegivenx-values. justificationfor this assumption that in naturethe "bell-shaped" curve describes is many phenomena. The samplevalues ofy are all uncorrelatedand have zero covariance.It is reasonable. said desc outc the n the 1 The variable x is not random and must take at least two different values.r. Consequently. assume to that an economicvariableis normally distributed aboutits mean.We will saymoreaboutthis assumption later.. following probability distributions that all have the same variance.) : 0.but for now we will makeit an "optional" assumption. OF THE SIMPLE LINEAR REGRESSION MODEL-I The meanvalue of y.or (sinceindepencov(y. the values of y are distributed about their mean value. is given by the linear regression function E(Ylx):FrfPzx The t Si must ident the e \\ . sincewe do not needto makeit in many cases. say . sometimes.implying that there is no linear associationamong them. More will be said about this assumption soon. .econometric models often make an assumption that is weaker than statisticalindependence. x.we will assumethat the x-valuesare given. Secondly. _yi If and 1y are the expenditures of two randomly selected households. zerocovariance but doesnot imply independence).r: $1000.14 THE SIMPLE LINEAR REGRESSION MODEL econometriciansto some degree.y. it is a and very strong assumptionwhen it is made.. They are a collection of assumptionsthat describe the data.y.2. taken together. In order to carry out a regression analysis we must make two assumptionsabout the valuesofthe variable. The ideaofregression analysis to measure effectofchangesin is the one variable.

) : Br * Bzx. The assumptionthat x is not random meansthat its value is known. Sincey is random.and it is a oollection of 2. is zero." If we could perform controlled experiments. As an example. which in generalis called the dependent variable in the regressionmodel. However. Since y and e differ only by a constant(i.The random componentof y is the difference betweeny and its conditional mean value E(yl*). The systematiccomponentof y is its mean.4) The dependentvariable y is explained by a component that varies systematically with the independent variable x and by the random error term e. The essence ofregressionanalysisis that any observationon the dependentvariabley can be decomposedinto two parts: a systematic component and a random component. given x.E(ylx) : Fr * B2x. The expectedvalue of the error term.2.4. as shown in Figure 2.3). implying ofy areall ilues.4. itimplies pendixB. the samesetofx-values could be usedover and over.e value.3 ns about the rfchangesin :s within the . so is the error tern e. Thus the probability density functions for y and e are identical except for their location. Given what we have already assumedabout y. is zero. suppose the number of Big Macs sold weekly at the local McDonalds. and it is defined as e:j-E(ylx):J-Ft-lzx (2. The DEI.2 AN ECONOMETRIC MODEL 15 )n make an )xpenditures t! is zero. fle). . Equation (2. so that only the that we are interestedin how price affects outcomes) are random. The franchise owner can set the price (x) and then observe the number of Big Macs sold (y) during the week. their variances must be identical and equal to o2. FrcuRE 2 . the properties of the random error e can be derived directly from (2. n for each oF.which itself is not random since it is a mathematicalexpectation.. is E(elx) : E(Ylr) .y-values are said to be "fixed in repeatedsamples. :. as describedin Chapter 1. which is its expectedvalue. a factor that is not random). or lce indepene).3) we obtainthe simple linear regression If we rearrange model /:9r l9zxle (2.2. Note that the centerof thepdffor the error term.3) shows that y and the error term e differ only by the term E(yl. In statisticssuch.4 Fr+ 9zr Probability density functions for e and -r'.which is not random.B1 .B2x : 0 The mean value of the error term. The usual rcribesmany rf Australian : is normally 'nowwewill es. We can now discussa bit more the simplifying assumptionthat -r is not random. This is called a random error term. for statistical purposesit is useful to characterizethe assumptionsanother way.t lNrrooucrNc THE Ennon TBnu It is convenientto describethe assumptionsof the simple linear regressionmodel in terms of y.I onfunction rean value. given x. E(elr) : 0. say x-values are Morewillbe :d.e.3) (2.

.e1): cov(y. It is customaryin econometrics statethe assumptions the regression to of modelin terms of the random error e. The covariance betweenany pair ofrandom errorse.N(0.) : 0 The stronger versionof this assumption that the randomenors e are statistically is independent.their valuesare unknown until they are actually observed. "SR" are denoting "simple regression.instead E(elx): 0 you will seeE(e) :0. . and e. ASSUMPTIONS OF THE SIMPLE LINEAR REGRESSION MODEL-II SRl. making the assumption that x is given. Therearesome of importantsituations which treatingx asfixedis not acceptable. is cov(e. SR4. The valueofy. Thus y and x are both random in this case.since we are treatingx as fixed. The variable"r is not randomand must take at leasttwo different values. and not random. againthedataon sales collected. this case In and x : the price of a Big Mac is not random. SR5. The numberof cases which thex-valuesare fixed is small in the world of business in and economics. When we survey householdswe obtain the data on variables like food expenditureper personand householdincome at the same time. and vice versa..in which case the values of the dependentvariable y are also statisticallyindependent. and not random. Sincer is treatedas a constantnonrandomterm. The expectedvalue of the randomerror e is E(e) : g which is equivalent assuming to that E(Y):Fr*92"t SR3. henceforthwe will not use the "conditioning" notation ylx. is ):Br*Bzxle SR2.but fixed.16 THE SIMPLE LiNEAR REGRESSION \1()I)EL following week thepricecouldbe changed. does not changethe resultswe will discussin the following chapters. So. However. SR6. (optional) The valuesof e arenormally distributedabouttheir mean e . for eachvalueofx. For future referencethe assumptions named SRI-SR6. o2) if the values of y are normally distributed."Remember. these in will be discussed and in Chapter 10.The additional benefit from the assumptionis notational simplicity. Thevariance therandom of errore is var(e):o2:var()) The random variablesy and e havethe samevariancebecause they differ only by a constant. we no longer needthe conditioning notation"l".y.

There is.(Fr + B2x). howeveq one interesting difference between them. The error term capturesany elementsofrandom behaviorthat may be presentin each individual.Unpredictablehumanbehavior is also containedin e.2. Naturally.Bl and B2 are never known.5 The relationship among y. then for any value of y we could calculatee : y . in any economic model. 3 . lf we have omitted some important factor. These factors causeindividual observations). then assumption SR2 E(e) : 0 will be violated.wecouldseparateyintoitsfixedandrandomparts. so the error term e is a "storage bin" for unobservableand/or unimportant factors affecting householdexpenditureson food.5. we want to include all the important and relevant explanatory variables in the model. which will have serious consequences. The random error e and the dependentvariable y are both random variables.2 AN ECONOMETRIC MODEL 17 n this case siness and like food c are both However. . Knowing all the variablesthat influence a household'sfood expenditure might not be enoughto perfectly predict expenditure. x1xZx3x4x FTGURE 2. to differ from the mean value E(y) : Fr * 9zr.This is illustrated in Figure 2.However. it adds noise that masks the relationship between x and y. Knowing the regression functionEO):Ft*lzx. y is "observable" and e is "unobservable." If the regressionparametersB1 and B2 were known. and it is impossible to calculate e. As such. and as we haveshown the propertiesof one can be determinedfrom the propertiesof the other. 2. or made any other serious specification error. e. What comprisesthe error term e? The random error e representsall factors affecting y other than x. In the food expenditureexample. Any other economic factors that affect expenditureson food are "collected" in the error term. :esultswe mption is :r needthe ) arg some discussed 4 Egt)=fu+ p2x e2 ) el in terms R6. and the true regression line. We have included income as the only explanatory variable in this model. E(y)? l . "SR" rt random. what factors can result in a difference betweenhousehold expenditure per person y and its mean. The error term e captures any approximation error that arises becausethe linear functional form we have assumedmay be only an approximation to reality.

73.69 4.22. That is.7652 19.food.3 Estfunating the Regression Parameters The economic and econometric models we developedin the previous section are the basis for using a sampleof data to estimatethe intercept and slopeparameters. is assumedconstant.'or ral . The values of y are weekly food expenditures for a three-person household.dat. We assumethat the expenditure data in Table 2. which is the sameas the variance of the random error e.For B1 illustration we examine typical data on household food expenditure and weekly income from a random sample of 40 households. 1.in dollars.5735 264. the reported income is $369 per week with weekly food expenditure of $115.dta.but a differentextension.95 375.wfl.39 29.4000 3.6600 109. Representative observations and summary statisticsare given in Table 2.1 satisfy the assumptions SRl-SR5. implying that we have not omitted any important factors.implying that we are equally uncertain about the relationship betweeny and x for all observations. and B2.wiley. The variance of y. data files are referenced as *.and so on.6048 20.7100 r12. We control for householdsizeby consideringonly threeperson households. we measureit in units of a in $100.73 Summary statistics 3.def. Consequently.dat.98 : 25't.dat Files in other formatswill havethe samename. The corresponding datadefinition file will befood. REMARIL In the text.food..0300 33.18 THE SIMPLE LINEAR REGRESSION MODEL Table 2 .The values of y for different householdsare assumed un( Th.because $1 increase income hasa numerically small effect on food expenditure.4800 587. The complete data set of observationsis in the file food.22 135. For the 40th household weekly income is $3340 and weekly food expenditure is $375.'hr E\I ral par rnc the Ot \\i it af ar thr ml to Hr of in . we assume that the expected value of household food expenditure is a linear function of income. e.6900 6.suchasfood.40 33. 283. Insteadof measuringincome in dollars. This assumption about the expected value of y is equivalent to assumingthat the random error has expectedvalue zero. Dev.for the first household.40 Sample mean Median Maximum Minimum Std. .8478 2.Thesefiles arelocatedat the book Web site (www.7 Observation (household) Food Expenditure and Incorne Data Food expenditure ($) Weekly ($100) income I 2 39 40 115.com/college/trill).9.

For time-series data with the numberof sampleobservations dataobservations. The valuesof x were actuallyobtainedby randomsampling.we may use one or the other. andplot If ihem. would be betterif we could devisearule that usesall the infbrmationfrom all the data points. the end of the day.8478 0 t TGL:RE 2 .6900 6. .behavior. re the basis rnd B2.39 EO a aa a a a 29. ro theexpenditure largestincome level.and the of rhelack of a formal criterionmakesit difficult to assess accuracy the method.Another at incomelevel. may not be a very good rule because i-gnores it It of the remaining38 observations. s a linear ivalent to ot omitted rerandom lationship : assumed .For <ly income l summary rnly threeree-person in units of .E S T I M A T I N C ] T H E R E ( .. ted at the SR1_SR5. r : -10.6 l0 20 r = weeklyincomein $100 Data for the food expenditure exampie.0300 33.69 4.6.but we will make the analysis .this simplificationdoesnot At change analysis. N : 40. for REMARIC It will be our notationalconventionto use "i" subscripts cross-sectional being N.the problem now is how to use the sampleinformation in Table 2. \\'e would expect this line to be somewherein the middle of all the data points since it represents mean.). .observation : 1.To estimate B1 and B2 we could simply draw the I freehand line throughthe middle of the dataandthen measure slopeand interceptwith .to estimate the unknown regressionparametersB1 and B2. .40 a '" t9. . Our problem is to estimatethe location of the mean expenditureline E(y) : Br * pzx.40 33. i : 1. i methodis to draw a line from the expenditure the smallest This approach doesprovidea formal rule.which follows if we obtainedthe data by random sampling.dta. or average. and.4000 3. at it informationon the exactposition However. we represent 40 datapointsas(y. ith weekly E3340and s is in the uncorrelated with eachother. and Jr.. as observations usethe subscript"t" andlabel the total numberof observations Z In we purely algebraicor genericsituations. we obtain the scatter diagram in Figure 2.x. specific ralues of y.penditure. I { E S S I O N P A R A ] V lE T E R S 19 Weekly come($100) I a :O a 3.onditional on the x valuesin the sample.rruler.6048 20.The problemwith this methodis that differentpeoplewould draw differentlines.1.. the on food model for explainingthe sampleobservations household Given this theoretical erpenditure. These for parameters the represent unknowninterceptand slopecoefficients the food expenditurethe incomerelationship.which allows us to treat them as nonrandom r aluesthat arefixed in repeated samples. in other l.

The interceptand slopeof this line. a thelinethatbestfitsthedatausingtheleastsquaresprinciple. but describe line that runsthroughthe middle of the data. 'l 2. or formula. and the fitted regression line. Many rules are possible.andis simply oneway to distances. (&) The residuals FTGURE2.s) . The fitted line itself is then of lt:brlbzxi i (2.Nl()l)EI Y= b t + b 2 x v3 ? r3 w) y4 x !=bt+bzx ?' I )3 y*=ft+bit ? _r1 x2 x3 (b\ x4 x (a) The relationshipamong ).THE SIMPLE LINEAR REGRESSiON. This rule is arbitrary.7 from another fitted line.theleastsquares estimates B1 and 82.3-l TnE LEesr Squenrs PRrNcrprE To estimateB1and B2we want a rule. areblandb2.but the one that we will use is basedon the least squares principle. 2. This principle asserts that to fit a line to the data values we should make the sum of the squaresof the vertical distancesfrom each point to the line as small as possible. from being canceled The distances squared preventlargepositivedistances are to by largenegative very effective.that tells us how to makeuseof the sample observations.

The problem is to find br andb2in a convenientway.thenwe obtainthe leastsquares .6) 2r:yr-jtt:yi-b1 These residuals are depicted in Figure 2.and very .r)(yi .I is the sum of squaredleast squares residualsfrom (2.rhere y : LyilN and 7 : Lx.7) are zerol If we plug the sample valuesyr and-rr into (2. They are given by -b2x.7) Oc:-=* - of the sample I on the least should make : as small as :ing canceled ly oneway to e of this line.The formulas for the least squares estimatesof B1and B2that give the minimum of the sum of squaredresiduals are THE LEAST SQUARES ESTIMATORS .\rui' : 2r0i .7a. Z(xi .yi.7) anO(2.8) (2. werenot the same r aluefor all observations. : 5.lN are the sample means of the observationson y and x. The least squaresprinciple saysthat the estimatesbl andb2 of B1and B2are the onesto use since the line using them as intercept and slope fits the data best.7b. (2.1zxi)' This is a straightforwardcalculusproblem. That is.for all observations. Denote the new line as yi : bi+b5xt nhere bf and bi are any other intercept and slope values. the details of which aregiven inAppendix2A.It is interesting.6) and :.ii)' SSE* is the sum of squaredresidualsbasedon any other estimates. no matter how the other line might be drawn through the data. -r)' b1 (2.8). then N^N^ ssE<ssE.I. we want to find valuesfor the unknown parametersB1and B2that minimize the "sum of squares"function s(Fr' 9z): he residuals N^ . Now supposewe fit another line. The residuals for this line. The formulafor b2reveals why we hadto assume [SR5]thatthevaluesofx.3 ESTIMATING THE REGRESSION PARAMETERS 21 The vertical distancesfrom eachpoint to the fitted line arethe least squares residuals. for example. The least squaresestimates b1 and b2 have the property that the sum oftheir squaredresidualsis less than the sum of squaredresidualsfor rrn. ilinwtes of the interceptand slopeparametersp 1and B2.9r . If thenb2is mathematically rndefined and doesnot exist since the numeratorand denominatorof (2.I) (2.however. to the data. (1. Given the sampleobservationson y andx..2. if : sse La? r. x.at the end of this chapter. are shown in Figure 2.r' other line.s) '. ii : yt . least squares 2(x. any other line.

b 2 7 : 2 8 3 . Thus.:llu _::le htl Once obtained. This should ring a bell.5'135). We call the numbers obtained when the formulas are used with a particular sample least squares estimates.2lxi . When the formulas for bl and b2aretaken to be rules that are used whateverthe sampledata tum out to be.42.8. Using the least squares estimators(2.3.To distinguish thesetwo cases we call the rules or general formulas for b1 and b2 the least squares estimators.r) : (19. The line's slopeis 10.21andits intercept.The least squaresfitted line passes through the middle of the data in a very precise way.2 Esrrnerrs FoR THE Fooo ExpsNDrruRE FtnrcrroN ."S! :^rg aaol This line is graphed Fi gwe2.3.8). we can obtain the least squaresestimates for the intercept and slope parametersB1and B2in the food expenditureexample using the data in Table 2.8) as t .21is an estimateof B2.( 1 0 . The distinction betweenestimators andestimatesis a fundamentalconceptthat is essential to understandeverything in the rest of this book.3 IwreRpRErrNG THE Esrrtlrerss :. with the estimatesrounded appropriately: li :83.6048.8) h:y .Recall that x. weekly householdincome. : . This follows directly from rewritinC (2. From (2. expected weekly expenditure food will increase approximately$10. 5 7 3 ' 7.1) and(2.21. Least squaresestimatesare numbersthat we obtain by applying the generalformulas to the observeddata.1. is 83. 4 1 6 0 8 i :\F :::e :::\ I rs I A convenient way to report the values for br and b2 is to write out the estimatedor fitted regressionline. 2 0 9 6 ) ( 1 9 . is measured $100 units. that the formulas for D1and b2 are pertectly general and can be used no matter what the samplevaluesturn out to be. Thus the "point of the means" is a useful reference value in regressionanalysis.The value bz : 10. (*.7\ we have :h< lEr \ u. since one of the characteristicsof the fitted line based on the least parameterestimatesis that it passes squares though the point definedby the samplemeans. on by A supermarketexecutivewith information on likely changesin the income and the number . thenbl andb2 arerandom variables. o a Least squaresestimators are general formulas and are random variables.bt I bzi.283. in whereit crosses the vertical axis.:>$ffiC:ffi#:ro2oe6 and from (2. . 6 0 4:8 )3 . 2.-. 2. we estimatethat if weekly householdincome goes by up by $100. The regression in slope B2 is the amount by which expected weekly expenditure on food per household increases when household weekly income increases $100.22 THE SIMPLE LINEAR REGRESSION MODEL important.When actual samplevaluesare substitutedinto the formulas we obtain numbersthat arethe observedvaluesofrandom variables. the least squaresestimatesare interpreted in the context of the economic model under consideration.3.42I l}.::a.

: \ 'o the elasticity of mean expenditurewith respectto income is L E ( y )E . weekly the amount by hen household ld incomegoes m a t e l y$ 1 0 ..{ Lrl* Lx y In the lineareconomicmodel given by (2.60 20 r = weekly income $100 in Frc uRE 2 . nalysis.So..3a Elasticities Incomeelasticity is a useful way to characterize responsiveness consumerexpenthe of Jitureto changes income. 1. rnd the number lEtr ) . bt te S t r i c t l y s p e a k i n g .SeeAppendixA.]./.\ En) - Y: L\y ) (2. carefulwhen interpreting estimated the The problemis that we usuallydo not have .This is an issuethat you shouldconsider each cconomicmodel that you estimate.I ESTIMATING THE REGRESSION PARAMETERS 23 usedno matter rulasfor b1and .\penditure for a household with zero income. then b1 and b2 lulas we obtain ie two cases we rs.thenour estimated in relationship rnaynot be a good approximation reality in that region. t ) l Lrl* -\E r .8.ed on the least samplemeans. 8 Thefittedresression. it to in might be risky to takethis estimate literally. If lr e haveno observations the regionwhereincomeis zero.21more per typical household in perweek for every$100increase income. P. :neralformulas 7=28357 . We call the least squares a + ] = 83.42 10. _Lvlv:Av. . 2 1 .1) we haveshownthat f the economic I thatx.In most economicmodelswe must be very intercept.e) .o a a la t aa Xo o bles.2rx ^.This is a very valuablepieceof informationfor in long-runplanning.inydatapointsnear-{ : 0. s!:brIbzT. 4 2 i s a n e s t i m a t e o f t h e w e e k l y f o o d . a d rl rl I a a a a a 'lI ol' a thatis essential t= 19. which is truefor the food expenditure datashownin Figure2.The elasticity of a variabley with respectto anothervariablex is percentage changein I' percentage changein x ) intated fitted or whereit crosses ddle of the data .42per weekon food. uaresestlmates rmple using the of households an areacould estimatethat it will sell $ 10.3. t h e i n t e r c e p t e s t i m a: 3 3 .3 for a discussion elasticitycalculations a in of in linear relationship.althoughour estimated to model :uggests that a household with zeroincomeis expected spend$83.

2.4 OrHrn EcoNolrrc Moonrs We haveusedthe household expenditure food versusincomerelationship an example on as to introducethe ideasof simple regression. Most commonly the elasticityis calculated the "point of the means" at (x. If we calculate the income elasticity at the point of the means we obtain ".283.24 THE SIMPLE LINEAR REGRESSION MODEL To estimatethis elasticity we replace 9zby bz: 10. The simpleregression model can be appliedto .r and y take their sample mean values. 6 0 ." and the samplemean of y. .The matter is complicated somewhatby the fact that the packagesalso report various numberswhose meaning you may not know.2r :0.SSE >Ai :304505. which you shouldbe able to locate and interpret. a0.the various outputs provide the samebasic information. you will of be able to interpret the remainder of the information. In the EViews output the parameter estimates are in the "Coefficient" column. y ) : ( 1 9 .2.'717o in to increase weekly in household expenditure on food. 5 7 )S i n c e t h e e s t i m a t e d i n c o m e e l a s t i c i t y i s l e s s t .3. 2 8 3 . 2. :LyilN "Mean dependentvar. 4 2 + 1 0 .3.21." The estimatesthat we report in the text are rounded to two significant digits. Suppose that we wanted to predict weekly food expenditure for a household with a weekly income of $2000.3.61per weekon food. lhan "necessity" rather than a "luxury.3c Cornputer Output Many different software packagescan compute least squaresestimates. Software programs typically name the estimateswith the name of the variable as assignedin the computer program (we named our variable INCOME) and an abbreviationfor "constant.60.71 .9. 2 1 ( 2 0:)2 8 7 .5i35.By the end of this book. andINCOME (the estimateb2). 2 l x i : 8 3 .Every software package'sregressionoutput looks different and usesdifferent terminology to describe the output.We must also replace "x" and " EO" by something. 6 1 Wepredict thata household with a weekly incomeof $2000will spend$287. We estimate that a lVo increase weekly householdincomewill lead.on average. using the food expendituredata. ro.3b Prediction The estimated equation canalsobe usedfor predictionor forecasting purposes. which is called "Sum squared :283.This predictionis carriedout by substituting : 20 into our estimated x equationto obtain y i : 8 3 . the output from the software packageEViews is shown in Figure 2. #9 +: This estimated income elasticity takes its usual interpretation.y): (19. 2." We leavediscussion the restof the outputuntil later." for constant term (the estimateb).b. ( x . 4 2 t l } . w e w o u l d .sincein a linear model the elasticityis different on eachpoint upon the regression line. which is called resid.57)becauseit is a representative point on the regression line." which is consistentwith what we classify food as a would expect for an averagehousehold. For example. Despite thesedifferences. with names "C. The other : numbersthat you can recognizeat this time are . when .

nrF-statistic) 83.41600 10.regression regressionmodel is much more flexible than it looks at first glance The simple linear . you will point. 92." The other r is called r is called :.::lple: I 40 . ::r)ther variable. or Blr are not permitted. E.F:).78884 0.gression parameterschange.business. of thebasiceconomicvariables.rdel.i'u.3 ESTIMATING THE REGRESSION PARAMETERS 25 .0622 0. The applicationsof regression r week on risesby 5Vo. what will be the effect on high school graduationrates in 2020?What will be the effect on the crime years? rate by juveniles in2012 and subsequent spanseconomicsand finance. If we -rerendent Variable: FOOD_EXP \{:thod: Least Squares . EViews regression i.093264 1. cubes..irtistic .ted R-squared . must . then the economic interpretations of the ::.ointupon e means" ine.howmuch will new houseprices If the hourly wagerate of electricians increase? in will be generated by Ifthe cigarette increases $1.sial and physical sciences. with Software red in the )onstant. "co.95988 I 1.000019 43. Any time youaskhow mucft a changein one variablewill affect analysisis a potentialtool.385002 0.20964 0.4t016 2. how much additionalrevenue tax the stateof Louisiana? ' software scribe the brmation.T" and .6752 rr.368818 89.5088 23. For is in populartransformation economics the naturallogarithm.and the social analysisare fascinatingand useful. For example i:cnces.iprocals. -.:imate the parametersof many relationshipsin economics.87544 I 1. In a linear regression -::olel the parameter^s not be raised to powers or transformed. If the centralbanking authorityraisesinterestratesby one-half a percentage how much will consumer borrowing fall within 6 months? How much will it fall within I year? What will happento the unemploymentrate in the months following the increase? If we increasefunding on preschooleducationprogramsin 2008. and the calculation of elasticity changesas well. so expressionslike.5735 t12.the simplelinearregression ::. of regression i-:n rquaredresid .D. In Appendix A.ruall! meansthat the parameters not transformedin any way.-'iuded 40 observations: Coefficient Std.r.r can be transformations. dependentvar Akaike info criterion Schwarz criterion Hannan-Quinn criter Durbin-Watson stat pposethat ncome of luation to .2. Error r-Statistic Prob.2 -235.0000 283.92r5't8 4.4 we summarize a variety of nonlinear relationships between variables estimationand the simple linear regression ::rr can be estimatedby using least squares :::.' px 2. 'hat by the know.s 1700 304505.87738r 0.nE hat a lVo in weekly n values. a r example rpplied to . ".893880 Mean dependent var S.or involving logarithms. : likelihood .ed for nonlinear relationshipsbetweenvariables. For EViews is rmn.-quared !. . 9r .::rcethe variables and.The term linear in "linear regression" are :.. we would r what we i.90597 1..squares.as well as most disciplinesin the he rangeof applications .If y and x are transformed in some way. y modelcanbe Thus.Economicmodels :rample.9 outPut.

inthefamiliarandalgebraicallyeasierproblemof estimating themeanofapopulation. This sampling variation is unavoidable.21.and how can we comparealternative estimators?For example. We can investigate the properties of the estimators b1 and b2.7)and(2.42 and b2 : 10.4 Assessingthe Least Squares Estimators Using the food expendituredata we have estimatedthe parametersof the regressionmodel yi: Fr *9zxi *e.2 often. evefl if we had carefully selectedhouseholdswith the same incomes as in the initial sample.covariances.2 in Appendix A.It is natural.Different sampleswill yield different estimatesbecausehouseTheir valuesarenot known hold food expenditures.i until the sampleis collected.You will refer to Table A. we would have obtained dffirent estimates b1 and b2. bz arc alsorandom variables. : l. and deal with the following important questions: l .becausetheir values dependon the random variable y.42 andb2: 10.26 THE SIMPLE LINEAR REGRESSION MODEL like ln(y) : Br * B2ln(x) are common.by choosing anothersetof 40 households to survey. then what are their expected values. .4 for alternative for algebraicfunctional forms.40. estimators the next in REMARK: We will summarize propertiesof the leastsquares the to In severalsections. bt to ask the question "How good are these estimates?" This question is not answerable. variances. the next.but aswe shallarguemisguided. andFigure A. We will never know the true valuesof the population parametersPr or Fz.2 for their geometric shapes.The motivation for this approachis this: If we were to collect anothersampleof data.21 areto the true values. Theleastsquaresprincipleisonly B1 md 92. with the expressions their slopeandelasticity. arerandomvariables. See Table A.and probability distributions? onewayof usingthedatatoobtainestimatesof 2 . when viewed as an estimationprocedure br and . is there another estimatorthat has a higher probability of producing an estimatethat is close to B2? The answersto thesequestionswill dependcritically on whether the assumptions SRI-SRS we are satisfied. In this context we call b1 and b2 the least squaresestimators.AppendixC coversthetopicsin this chapter.The least squares estimatesare numbersthat may or may not be closeto the true parametervalues. Consequentlythe "log-log" model ln(y) : F r * B2ln(x) is also called the constant elasticity model.In later chapterswe will discusshow to check if the assumptions make hold in a specific application. in many ways it is good to seetheseconceptsin the context of a simpler problem before and tacklingthemin theregression model.Weobtainedtheleast squares estimates : 83. How do the least squaresestimatorscomparewith other proceduresthat might be used. consequentlywe cannot say how close b1 : 83.and we will never know. . Ratherthan asking aboutthe quality of the estimateswe will take a stepback and examine the quality of the least squaresestimation procedure. A nice feature of this model.usingtheleastsquaresformulasin(2. . whrch are called their sampling properties. 2. so perhaps put a paper clip on the page for quick access.2 and Figure A. If the least squaresestimators b1 and bz arc random variables.8). if the assumptionsof the regressionmodel hold. . is that the parameterB2ls the elasticity of y with respectto x for all points on the regressionline. . Consequently. and what we might do if one or more assumptionsare shown not to hold. !i."Proofs" of importantresultsappear the appendices this chapter.

This formula is not useful for computations.is there another is close to B2? tions SR1-SR5 s we make hold re shown not to where ei is the random error in the linear regressionmodel y.'s.I ASSESSING THE LEAST SQUARES ESTIMATORS 27 assumptions of respectto. and the formula fot b2 is used to are estimateB2in eachof those samples. 2.iro b2 ors in the next his chapter..becauseit dependson B2. that is.4. The estimator b2is a random variable since its value is unknown until a sampleis collected.12) are the random error terms er.12) is very useful. and on e.10). then that estimator is unbiased. onsequently we re least squares ues. However. We will show that this result is true so that we can illustrate the part played by the assumptions of the linear regression model. is called a linear estimator.x. In (2. as it depends only on the values of .then. Then w.r for 3r f Fz ln(-r)is for alternative .. asin (2. Any estimatorthat is a weighted averageof y. with yet more algebra (Appendix 2D) we can expressb2 in a theoretically convenient way.ckandexamine :his approach is f40 households f we had careThis sampling because houses are not known :ocedure. (2.1 THE Esrnrneron b2 Formulas (2. then E(b) : B2.8) are used to compute the least squaresestimatesb1 and b2. what parts are random? The parameter B2 is not random. What we will show is that if our model assumptionshold.This is an important classification that we will speak more of later. then x. dependsonly on xi that are not random. is not random either. -t)" (2. In (2. for understandingthe sampling properties of the least squaresestimator. It is a population parameter we are trying to estimate. In this section we rewrite the formula for b2 to facilitate its analysis. if our assumptions valid. bz: where Wi:- \wtyi i:l (2.7) and (2. If assumptionSR5 holds.rr) The term w. If many samples of size N are collected.7) b2 is given by bz: -x)(y-i) I('..4. Then. is not random either. we can wite b2 as a linear estimator. andFigureA. is not random. _r)z 'gressionmodel rtainedthe least gue misguided.2.. the expected value of b2 is equal to the true parameter B2.they arenot well suitedfor examining theoreticalpropertiesof the estimators. In this are called their This is called the deviationfrom the mean form of the estimatorbecausethe data have their samplemeanssubtracted.:9r * 9zxi+ e.andwe will . .12). estimator b2is an unbiasedestimatorof B2.The only random factors in (2.10) ' xi-x L(x. the averagevalue of the estimatesb2 obtained from all the samples will be B2. 2(x. so perhaps 2. Using assumptionSR1 and abit of algebra(Appendix2C). so that w.which we do not know.The intuitive SinceE(bz) : B2.r2) r what are their rns? estimates B1 of Juresthat might . bz : 9z +Lwiei (2. and the fapopulation.2 THs Expscrro Varuns on b1 x.the leastsquares meaningof unbiasedness comesfrom the repeatedsampling interpretationof mathematical expectation. When the expected vahte of any estimator of a parameterequals the true parametervalue. rot answerable.2 ten. and b1 riable y.In roblem before rapter.However. which are unobservable.

B2.14 I 1. among other things.29 lJ..This statisticalproperty by itself doesnot mean that property dependson b2is a good estimatorof B2.76 8. Second. and constantscan be factored out ofexpected values. The rules of expectedvalues arefully discussedinAppendix8.28 THE SIMPLE LINEAR REGRESSION MOI)EL We can find the expectedvalue of b2 using the fact that the expectedvalue of a sum is the sum of the expectedvalues: E(br) : E(92+Lwiei) : E(92-f wp1 I wye2+ .and this is one desirableproperty of an estimator. or far from.66 97. factors affecting yi that are omitted from the economic model. If we have omitted anything that is important then we would expectthat E(e)t'O and E(b)*B2.) : wiE(e) becausew. In the last line of (2. 2.21 may be close to 92 or not.63 64. Since B2 is never known we will never know." on average. First.23 26. contains. having an economic model that is correctly specified.whether our estimateis "close" to B2 or not.is a must in order for the least squaresestimators to be unbiased.7'.96 b2 the I 2 J 4 5 6 '7 8 9 t0 6.50 84. If E(e)+0.2least squaresestimatesof the food expenditure model from l0 random samples (table2-2.3 REpEerEo Servrprrxc ho tic diJ (2. is not random.When sampling of repeatedlyfrom a population the least squares estimatoris "correct.lif . Thus the estimateb2 : 10.88 8.in the sense that it includes all relevantexplanatoryvariables.90 9.. The fact that b2is unbiaseddoesnot imply anything about what might happen in just one sample. + wueu) : E(92) -l E(wpv) -t E(w2e2) ' ' ' + E(wpe7s) + : E(92)*LE(w. The unbiasedness the estimatorD2is an important sampling property.48 10.93 9.25 r03.4 at the end of the book.13) we use two assumptions.'h( rat rhe ast To illustrate the concept of unbiasedestimation in a slightly different way.in which caseb2 is a biased estimator of B2. Recall that e.we have relied on the assumptionthat E(e):0.21 79.ei) : Pz * ZwiE(e. The unbiasedness havingmany samplesof datafrom the samepopulation.69 57.4.but it is part of the story.91 46. E(wie.andE(b1): 9t if the model assumptionshold.) : g. given one sample.05 7.30 95. then E(b)l B2.2 Sample tel ret \iu f\t Estirnatesfrorn 10 Sarnples br r31. Thus. we present in Table 2. An individual estimate (a number) b2 ma! be near to.dat) of size N : 40 from the same population with the same incomes as the TabIe 2.ff 10. The leastsquares estimatorD1of B1is also an unbiased estimator.r3) th! sa es lnl pa Iea Ta Un dll pr! lm dis kn Itr po .7 .

and thus we cannot say that an estimateis unbiased.10 aregraphsof two the of possibleprobability distributions of 02. Given a choice.2 shows that the least squaresestimatesof B1 and Fz vary from sampleto sample.4 Trre VenreNCES AND CovenreNcs or b1 nvo b2 Table 2. .the probability is more concentratedaround the true parameter value B2. The varianceof b2is definedas var(b2):Elbz-E(br))' Ir measures spread the probability distributronofb2.1. Remember.In Figure 2. 2. The probability density function fz(b) has a smaller variance than ft(b).r3) book. The variance of the random variable b2 is the averageof the squared distancesbetween the possible values of the random variable and its mean. /e present in lom samples omes as the F: r rcuns 2. and their weekly food expenditure varies randomly. the Understandingthis variability is a key to assessing reliability and sampling precision of an estimator.68. that havethe samemeanvalue but different variances. With the distribution fz(b).let us consider why they are important to know. One estimatoris more precisethan anotherestimator if its sampling varianceis lessthan that of the other estimator.2.Unbiasedness doesnot say that an estimatefrom any one sampleis close to the true parametervalue.Consequently.we often refer to the sampling variance or sampling precision of an estimator.4. andthis is Jt mean that 'depends on seddoesnot estimate(a never know. the greater the sampling precision of that estimator. Note the variability of the least squaresparameterestimates from sample to sample. giving. averagevaltesof byandb2tf many samplesof Thepropertyofunbiasednessisaboutthe population.The average is would approachthe true parametervalues B1 estimatesfrom many samples. is a mustin :n sampling e. which we now know is E(b) : Bz. If we took the averages of samples bt:78. 7 0 Two possibleprobability densitv functionsfor &2. The smaller the variance of an estimator is.Before presentingthe expressionsfor the variancesand covariance. relative to ft(b). . a higher probability of getting an estimate that is close to B2. we are interestedin estimator precision and would prefer that bzhavethepdf f2(b2) ratherthan fi(b). The variance of an estimator measurestheprecision of the estimator in the sensethat it tells us how much the estimatescan vary from sample to sample.74. ft(b) and fz(b). The averagevalue of b1 in these l0 the same size are drawn from the same value of bzisEz:9.getting an estimate close to B2 is our objective.Inthe e lrr is not re relied on is a biased I )j that are ant then we rdel that is .We now obtain the variancesand covarianceof the estimatorsb1andbz.theseaverages and B2.timateb2: ):grifrhe householdsgiven in Table 2.We can say that the least squaresestimation procedure (or the least squaresestimator) is unbiased.+ ASSESSINGTHE LEAST SQUARES ESTIMATORS 29 sum is the (2. This sampling variation is due to the fact that we obtained 40 dffirent householdsin each sample.

I(x.The samplesizeN eachofthe sumsconsistsof uip"urc in eachofthe variancesand covariancebecause .1 . the larger the sum of squares. in each of the variances and in the covariance. The more they are spread out. The sum of squaresof the values of r about their samplemean.You may recognize this sum of they are spreadout.In panel widely spreadout along the -r-axis. the is information we have about B1 and B2 is less precise. the smaller the sum squaresas the numerator of the samplevariance of the x-values.smaller variances affect the variances and better than larger variances.t)2 Also. The larger the sample size N.In panel (a) scatterin which the values of .bz):'2lr-- 'r (2.::zl [NXxr r)"1 o2 I o 14\ var(b-t\ : -.The of squares. Let us consider the factors that covariancein (2. SeeAppendix C'4' The larger the sum of squares.b2) get smaller' since of squaresappearsin their denominator' The sums in the numerator and the sum of denominator var(b1)both getlargerasNgets largerandoffsetoneanother. The variance of the random e11orterm. gets larger as N increasesbecauseeach of the terms in the sum is positive or zero (b"ing .leaving . N gets larger. The sum of squarestetm}(xi N terms.o if . If the regression contains the derivation of the variance of the least squares then the model assumptions SR1-SR5 are correct (assumption sR6 is not required)' variancesand covarianceof bt afid b2arc : var(b1) s-z I "'l:=i:L .f cov(b.rs) Z(xi-x)" . the smaller the variancesand covarianceof the least squaresestimatorsfit is better to have more sampledatathan less.The larger thevariance reflecredin the spreadof the probability distributions f the terrn o2. 1.30 THE SIMPLE LINEAR REGRESSION MODET 2E e we will now presentand discussthe variancesand covarianc of b1 andb2. the data in panel (b) do a better job of determining where the least squaresline must fall.".x)2.iliT are At the beginning of this section we said that for unbiasedestimators. and the larger variances and covariance of the least squaresestimators' .16) l ! .. t :. o2. When o2 is larger.r are .ih. appears 2. becausethey are more Spreadout along the x-axis. the smaller the variances of the least estimatorsand the moteprecisely we can estimatethe unknown parameters' squares (b) is a data in The intuition behind this is demonsffated Figure 2. This expression measureshow spreadout abouttheir mean arethe samplevaluesofthe independentor explanatory less variable x. appearsin each of the expressions.I6). as Consequently.\(*.3 the variance (ylr) . -t)2. The greateris the uncertainty about the varianceo'." Which data scatterwould you prefer given the task of fitting the data are a line by hand? Pretty clearly.greater is that dispersionand the where the values oi y fall relative to their mean E(y). greater It reflectsthe dispersionof the valuesy about their expectedvalue E(y).bunched.r happens to equal its sample mean value for an observation). both var(b2) and cov(b1. (2.''. the griater ls the uncertainty in the statistical model.\ ri a . 3.ll.ID-Q. In Figure 2.Appendix estimator bz. N appearsexplicitly in var(bl ).

definedin (2.2 .The larger this term is. naller. 'ariancesare Lriancesand gxpressions.ll. . of the least r parameters. and the covariancehas a sign opposite to that of 7. the more difficult it is to interpret B1.Since the line must passthrough the point of the means.16) (b\ b\ : : r. (b) is a data In panel (a) :askof fitting determining rut along the : of the least amplesizeN of rs consists n}(x.values. as shown in Figure 2. ensuring that var(b1) also gets smaller as N gets larger.rimation:(a) low.\lrat can we say about the least squaresestimatorsb1 and b2 so far? The estimatorsareperfectly general. 5 T H E G A U S S _ M A R K O VT H E o R E M 31 . x : 0. But if the values of x are large in magnitude. The greater lainty about i larger. imagine the effect of increasing the estimatedslopeb2.high precision. 7 7 The influence of variation in the explanatory variable r on precision of .x variation.rs) (2. (2. t.asin the food expenditureexample. . then the ) i = b 1+ b 2 x . the least squares estimators\ and bz arc random variables. appears sasureshow 'explanatory :es.there is a negative covariance betweenthe leastsquares estimators the slope of and intercept. The absolutemagnitude of the covarianceincreaseswith an increasein magnitudeof the samplemean7.The less : this sum of ppendixC.10). The term Ixf appears var(b1).the term Zx! wlll be large and var(b1) will be larger. the : variance is the variance rc larger the x)2. In panel (b) the leastsquares means.viewed in this way. the largerthe varianceof the in leastsquares estimatorb1.Formulas (2. Thus.r4) (2. Both b1 andb2 as can be written as weighted averagesof the -r'.the effect must be to lower the point where the line hits the vertical axis.ppendix2E I regression l).4. The least squares estimatorsarelinear estimators.5 The Gauss-Markov Theorem . either positive or negative.7) and(2. -t)z . The reasoning here can be seen from fitted line must passthrough the point of the Figure 2. The farther our data are from x : 0. t'ne 2 .low precision:(b) high x variation.and the more difficult it is to accuratelyestimate B1. Consequently.'.itive or zero rbservation). other things being equal. when the sample mean is positive. The samplemean of the r-values appearsin cov(b1. The terml xl measures distanceof the data from the the origin. Given a fitted line through the data. implying a reduced intercept estimate b1.leaving the Nin the denominatoras the dominant term. since rmerator and rther.8) can be usedto estimate the unknown parametersB1 and B2 in the simple linear regressionmodel no matter what the data turn out to be. Why is this so?Recall that the interceptparameterB 1is the expectedvalue ofy given that x : 0. b). If the valuesof r are near zerothen Ixl will be small and this will reduce var(b). 11.

thenbl andb2arcnotthebestlinearunbiased estimators By and 82.6 The Probability Distributions of the Least Squares Estimators The properties ofthe leastsquares estimators that we havedeveloped far do not depend so in any way on the normality assumption SR6. We haveexpressions the variancesof b1 andb2and their covariance.r I .\ -! :r t . and does not.Furthermore.which is proven in Appendix 2F. ..The theorem doesnot say that b1 and b2 are the best of all possible estimators.When comparingtwo linear and unbiasedestimators. the estimatorsb1 and b2 have the smallestvarianceof all linear and unbiased estimators B1and 82. estimator.If we alsomakethis assumption that the random !ffors e. then the probability distributionsof the least squares estimatorsare also normal. always want to we usethe one with the smallervariance. -':\ .i .j GAUSS-MARI(OV THEOREM: Under the assumptions SR1-SR5 of the linear regression model. The estimators and b2arebestwithin their classbecause b1 they havethe minimum variance. rfl 5 .32 THE SIMPLE LINEAR REGRESSION \4OI)EL If assumptions estimatorsare unbiased.The estimatorsb1 and b2 arc the (we would not have onesto use.-E-.: t \:. of The Gauss-Markov theorem does not depend on the assumption of normality (assumption SR6).-f :.--.sincethat estimationrule givesus the higher probability of obtaining an estimatethat is close to the true parametervalue. would we?) and why they are so widely used in research. The Gauss-Markov theorem appliesto the least squares estimators. They are the best linear unbiasedestimators (BLUE) of of B1and B2... 2. Let us clarify what the Gauss-Markov theorem does. assumptions SR1-SR5mustbe true. In orderfor the Gauss-Markovtheoremto hold. '---.:{ :':\r' A -t. In the simple linear regressionmodel.s\: : rle -! :t( . l-{ I. for we have arguedthat for any unbiased having a smallervarianceis better. estimatoq then we have to do no more searching.Itdoes not apply to the least squaresestimatesfrom a single sample..'| 6 . are normally distributed with mean 0 and variance o2.This explainswhy we are studyingtheseestimators you study bad estimation rules. as this implies we have a higher chanceof obtaining an estimateclose to the true parametervalue. The estimatorsb1 and bzare "best" when comparedto similar estimators. This conclusionis obtained : ::te a\l . say. -1.This SRl-SR5 hold then the least squares meansthat E(b) : B1 and E(b) : p. \ . . !. not as ^=a. if we want to use a linear and unbiased . Now we will state and discussthe famous Gauss-Markov theorem.:3 2 . If anyof theseassumptions arenottrue. only in economicsbut in all social and physical sciences well.r.thosethat are linear and unbiased.

is the one unknown parameterof the simple linear regressionmodel that remains to be estimated. Second. like the one discussed in Appendix C. or asymptotic.'onsider estimating o2 as the averageof the squarederrors. . The reason for this vague and unsatisfying answer is that "how large" dependson many factors. this large sample. What if the errors are not normally distributed? Can we say anything about the probability distribution of the least squaresestimators?The answer is.5 linearunbiased n of normality r and unbiased 1 and b2 are the would not have widely used in rces as well. least the squaresestimatorsare linear estimators. for better or worse.*.17) and (2. r is proven in v' " b .The variance of the random error e .r7) bz. \evertheless. ance is better.1.Otherswould saythatN: 50 would be more a reasonablenumber. however. 2.Sincethe "expectation" is an average valuewe might . there is no specific number.-) of the linear ill linear and tors (BLIIE) (2.thosethat : the best of all e the minimum ilways want to :s us the higher value. you may want to review it now. . t does not apply The million dollar questionis "How large is sufficiently large?" The answeris.yes.18). then the least squaresestimatorshave a distribution that approximates normal distributionsshownin (2. Consequently.4.7 Estfunating the Variance of the Error Terrn The varianceof the random error term.N ( u . the .of the form bz:Zwiyi. f we make the normality assumption (assumption SR6 about the error term) then the least squares estimatorsare normally distributed. A CENTRAL LIMIT THEOREM: If assumptions SRI-SR5 hold. sometimes. If you are not familiar with this important theorem. First. The bottom line is. result is frequently invoked in regressionanalysis. o2. . that these are rules of thumb. 1. Leter must be true.: lo not dependin that the random the probability iion is obtained ^) >i . This important result is an application of a central limit theorem. o. . " ' r t-t)') ) i ^ \'" wLe.E(ei)l' : fk?) : rf the assumptionE(e1) 0 is correct.7 ESTIMATING THE VARIANCE OF THE ERROR TERM 33 nbiased.): 02 : Ele.tors. if e.3. t/1\ (2. rse to the true in two steps. basedon assumption SR1. such as what the distributions ofthe random errors look like (are they smooth?symmetric? skewed?)and what the xr valuesare like. is normal then so is y.18) 'great As you will see in Chapter 3. andif the sample size N is sufficiently large. the normality of the least squaresestimators is of importance in many aspectsof statistical inference. and sums of normal random variables are normally distributed themselves.. and that the meaning of "sufficiently large" will change from problem to problem.2.N(ur.i s var(e. This Furthermore. In the simple regression modelsomewould saythatN: 30 is sufficientlylarge.

are unobservablet However.34 THE SIMPLE LINEAR REGRESSION MOI)EL This formula is unfortunately of no use since the random !rrorS e.21) (2. There is a simple modification that produces an unbiasedestimator.23) (2. and that is . while the random errors themselvesare unknown we do have an analog to them.These are quantities usedin hypothesis are testingandconfidence intervals.7. It seems reasonableto replace the random eflors e. They aredenoted se(&1) as and se(b2) se(b1): s e ( b 2 ): (2.ri by From (2..re) parameters (91. the least squaresresiduals.is a biased estimatorof 02.though quite satisfactoryin large samples. The "2" that is subtractedin the denominator is the number of regression makesthe estimator62 unbiased.24) .16) by 62 to obtain (2. Replace the unknown error varianceo2 in (2.1 EsrruerrNc rHr VaRTaNCES AND CovenraxcE oF THE Lpesr SquenEs EsrruanoRs Having an unbiasedestimator of the error variancemeanswe can estimatethe variancesof the least squaresestimators b1 and b2. andthis subtraction 2. by their analogs.14)-\2. and the covariance between them. 2i:yt-ji:yi-b1-b2x. Recall that the random errors are ei:yi-9r-Fz. the least squares residuals. namely.20) (2. so Bz)in the model. that E(62) : 02. .L e i N-2 (2.) (.6) the least squares residualsare obtainedby replacing the unknown parameters their least squares estimates.22) The squareroots of the estimatedvariances the "standarderrors" of b1 and b2.? N This estimator.so that o-: ^) Ler s.

29 38 variancesof Replace the (2.Theentrycalled"S.73 e:y-y -5.98 2t0.96 187.2.21x." It is typical for software not to report the estimated variances and covariance unless ':. E(62): 02. that in of --c ralue 62 is not reported.-r rhefood expenditure covariance matrix of the leastsquares estimators is datathe estimated INCOME C INCOME (2.is the sum of squaredleast squaresresiduals. Error" .90316 -85.?5 6. : 40.20) (2.7.:uested. all software packagesautomatically report the standarderrors." which standsfor "standarderror of the regression.:raredresid" in Figure 2.'rianceto be o-: ^) >a? N -2 304505.69 4.03 12.98 119.304505.br)ii6) I :.1.depending the softwarebeing used.1. Using the residualsfor all N: 40 observations estimatethe error we .7 ESTIMATING THE VARIANCE OF THE ERROR TERM 35 bservablel rg to them.51 -30.. labeled "S.74 -12.reported as "Sum *. N --:nus the numberof estimated parameters.idual ?i : yi . ^-ctus make somecalculationsusing the food expendituredata.91 144.19).23) (2.9 the column labeled "Std.E.'..O9. : ''led the "degrees freedom" for reasons will be explained ChaEQr3.2 :8013.6) and use them to calculate the estimate of r:e error variance in (2. is (2.2r) (2.1) : 112.22) tnd b2. l*r@.9.They are on r::l ed in a rectangular array.-r:mple.or option. The full set ofestimated variancesand covariancesfor a regressionis usually obtained -. thatis r/I(yr -r)'lW of .D.42-t 10.12 -85. Instead.3 L e a s tS q u a r e s e s i d u a l s R v 3. First we will -. For . rtainsse(br):43.InFigure 2. with varianceson the diagonal and covariances . In Table 2. of regression. or matrix.24) 1884. i simplecomputercommand.:he "off-diagonal"positions..47 t15.24 131.re) tmeters(81.4landse(b2):2.9. in the EViews output shown in Figure 2. However. These otedasse(01) l:e numerator.9.09 128.6752.2: 38 is often regression 2.2 CRrcuranroNs Fon rrrp Foon ExprNnrrunE Dera rator of o2.useholds Table2.381752 .2. in Recall that we have estimatedthat for the food expendituredata the fitted least squares ::Sression we line is ! : 83.05 121.68 'ameters by ast squares :.3 are the least squaresresiduals for the first five :.90316 4.The least squaresestimates -: the parametersin the food expenditure model are shown in Figure 2. Table 2. the quantityN .87 7.34 r14.39 4.dependentvar"isthe *:rple standard deviation y.rmpute the least squaresresiduals from (2.02 -23. EViews software reports 6 : t/62 : t/8013ts : r"r -ilJ. The denominatoris the numberof sampleobservations.22 135.For eachobservation computethe least squares :e.!.

8 Exercises Answers to exercisesmarked "*" appearin Appendix D at the end of the book. Put the sums in the last row." which is the estimatedintercept parameterin the regression.1 Consider the following five observations.: -85.Nt' and I(r.Using thesenumericalvaluesshow that I(". the softwarereports the variable nameINCOME for the column or relating to the estimatedslope b2. .442.t)(y' .2 - s*.y) : (a) Complete the entries in the table.7) and (2. h.THE SIMPLE LINEAR R E G R E S S I O N N IC ) I ) E L where C standsfor the "constant term.8) and statetheir interpretation.y) -Lxtyr . (c) ComputeL?:p?. i. .Nxy (d) Use the least squares estimatesfrom part (b) to computethe fitted valuesofy.- 5 2 3 2 -2 s . 2.381752:2.You are to do all the parts of this exercise using only a calculator. What are the samplemeansi and y? (b) Calculateb1 and D2using (2.Ii=rxiyi.l)(yi .90316 Se(rl):\/varlbrl:t/ v l ? t_---^_.- ti. and completethe remainderof the table below.x)2 :Lx! .410 /: se(b2) 1f var(b2): t/4... .8. *@.1 PnosrsNrs 2. Put the sums in the last row.6) "*(11-) The standarderrors are : 4. similarly.- s- _ s.093 These values will be usedextensively Chapter in 3. br. IBUA42 : 43. - . I("i . Thus : 1884. Xi J I' Yi bl xiei 2 -l 0 s*. . 2.381752.

(a) What does the linear regressionmodel look like. using only a hand calculator. if Br : gr (c) If Pt :0 the least squares "sum of squares" function becomes S(Fz) : ILr (y' . where :2i. go back to the drawing board.8 EXERCISES 37 rameter in the for the column 1316 (e) On graph paper.2.lt'l . find the probabilitythat a household with this income spends between$110 and $140 on food in a week. (e) CalculateL-riOi. Obtain the predicted value of y for -x : 7 and plot it on your graph. for a fact. literally. plot the data points and sketch the fitted regression line ji: h t b2xi. The mean weekly expenditure on food for : households with this income is E(yl-r : $1000) : pylr:$1000 S125 and expenditures exhibit variancevar(ylx : $1000) : 49.y). algebraically. locate the point of the means("r. if Bt : gr (b) What does the linear regressionmodel look like.1 A householdhas weekly income $1000. Measure the slope and intercept of the line you have drawn. fthis exercise What are the tation. What do you observeabout this predicted value? (d) Using the leastsquares estimatesfrom (b).)' .8) to compute.9r*. that 9r : 0. Does your fitted line pass through that point? If not.7) and (2. Using the data. We havedefinedthe simple linear regressionmodel to be ] : Br * \zx * e.lN. the least squaresestimatesof the slope and the intercept. (b) Find the probability in part (a) if the variance of weekly expenditures is var(ylx: $1000): olp:sr6s6:81. computethe leastsquares residuals2. Find their sum. (0 On the sketchin part (e). -ix Graph the following observationsof x and y on graph paper. :. What is the significanceof the value of B2 that minimizes S(B2)? (Hint: Your computations will be simplified if you . (g) Show that for these numerical values ! : h -l bzZ. book. () Compute var(b2). Plot this line on your graph. draw a line that fits through the data. 9 i (i) Compute62. 1l (a) Using a ruler.. 1at n lo ll plot the value of the sum of squares function for enoughvaluesof B2for you to locate the approximateminimum. fib:sr*o: (a) Assuming that weekly food expenditures are normally distributed. (b) Use formulas (2. graphically. (h) Show that for thesenumericalvalues : y. (c) Obtain the samplemeansof y :ZyilN and 7 : Lx. Suppose however that we knew. Include a sketch with your solution.

7.bzxt. bz.the vendor estimatesthe relationship betweensodasalesand temperatureto in be! : -240 + 6x.187.Do the estimates Why or make sense? why not? (b) On a day when the temperatureat game time is forecastto be 80'F.) (d)OUsing calculus.(Hint: Use the information in parts (c) and (d).What is the standarderror of b2?What is the value of |.38 THE SIMPLE LINEAR REGRESSION MODEL algebraically expand S(92): L[r0'r _ 9zxi)2by squaring the term in parenthesesand carrying the summation operator through.3. .274and the value of xi : 58. (c) Below what temperatureare the predicted saleszero? (d) Sketch a graph of the estimatedregressionline." I (a) What is the estimated simple regression used by the consultant to make this prediction? (b) Sketcha graphof the estimatedregressionline. the percentage males of 18 years or older who are high school graduates. The consultant writes "Over the past 6 months the averageweekly expenditureon advertising has been $450 and averageweekly saleshave been $7500. 2.).2.6* A sodavendorat LouisianaStateUniversityfootball games are sold the warmer the temperatureat gametime. Based on the results of a simple linear regression. (g) Calculatelx. (d) Suppose 7:69. interpret this If result.(xi . y). What do you observe? (f) Using the estimatesobtained with the formula in (d). The consultant takes a record of how much the firm spent on advertising per week and the corresponding weekly sales over the past 6 months. You have the results of a simple linear regressionbasedon state-leveldata and the District of Columbia. show that the formula for the leastsquaresestimateof B2in this model is bz : 2 x iyi f Zxf . what is the estimateof the intercept parameter? (e) Given the resultsin (b) and (d).Find their sum. plot the fitted (estimated) regressionfunction. (a) Interpret the estimatedslopeand intercept. (e) Using the estimate obtained with the formula in (d).0.18. Use this result to compute b2 and comparethis value to the value you obtained geometrically. Locate the average weekly values on the graph. Computethe leastsquares residualfor Arkansas. (a) The estimated least error variance : 2.00098.7)'? (c) Supposethe dependentvariable )i : the state's mean income (in thousandsof dollars) of males who are I 8 yearsof age or older and x.04672.139 and y:15. observes more sodas that 2. Basedon 32 home gamescovering 5 years. predict how many sodasthe vendor will sell. what is Ixf ? (0 For the Stateof Arkansasthe value of yr : 12. On the graph locate the point (7. wherey: the numberof sodasshesellsandx: temperature degrees Fahrenheit.5 A small businesshires a consultant to predict the value of weekly sales of their product if their weekly advertising is increasedto $600 per week. a total of N : 51 observations. 2. predict saleswill be $8500 if $600 per week is spenton advertising.Whatis the sum of the squared 62 squaresresiduals? (b) The estimatedvarianceof bz is 0..2i : yt . obtain the least squares residuals.

(c) Find the variance of b67. more advancedthan this one. predict how where UNITCOSZ1 equalsthe unit cost ofproduction for the first unit produced.9* Co^npursn ExEncrses An interesting and useful economic concept is the "learning curve.) We have "renamed" Ln(UNITCOS4) and e so that the model looks more familiar. but not including.and e equals the elasticity of unit costs with respectto cumulative production (which we expect to be negative). He provides dataon production and unit costsfrom the DuPont Corporationfor the years i955-1970.8. :!z xz-xl Assuming that all the assumptionsof the simple regressionmodel hold: (a) Show that bs7 is a "linear" estimator.The relationship between the variables is often taken to be UNITCOSTT: UNITCOSTTx CUMPROD\ r sales of their The consultant week and the t writes "Over been $450 and r simple linear . This nonlinear relationship between the variables is transformed to a linear one by taking logarithms of both sides: ln(uN ITC O ST') : ln(U NrcC OSTt) + eln(CU M PROD ) : Fr * $2ln(cuMPROD. s information in . (a) Use your computer software to plot a graph of UNITCOSTagainstCUMPROD. Dr.temperaturein Why or e sense? )'F. No proof is required here.yz). vel data and the he squaredleast rr of b2?What is iin thousandsof )entage males of 8. 1991).Workers learn from experienceand become more efficient in performing their task. (e) Convince ProfessorStuffthattheBZ estimatoris not as good asthe least squares estimator.3. On page 85 of that book Berndt gives the example of learning in the production of a product called titanium dioxide. which is used as a thickener in paint.Z. in the plot from part (a). such as in the automobile industry. or any time a task is performed repeatedly. Ernst Berndt is the author ofan excellentbook.8EXERCISES 39 e term in parrte of B2in this pare this value . calling the slopeof this line the EZ estimatorof B2 in the simple regressionmodel.theEZ estimationrule is . trme t (CUMPROD). (d) Find the probability distribution of b6y. Noting that two points determinea line. 2. interpret this rf the intercept ue of x. (d) Find 62. and In(UNITCOST) against ln(C UM PROD). : 58.entitled The Practice of Econometrics: Classic and Contemporary (Addison and Wesley." The idea is related to a phenomenon that occurs in assembly line production. (c) Find the estimated variancesand covariance of the least squaresestimators. This idea forms the basisfor an economic model relating cost per unit at time I(UNITCOSZT) to the cumulative production of a good up to.ed (estimated) r you observe? e least squares 2. Do these numbers make sense?Make a sketch of the fitted regressionline. if the two points are (x1. y1) and (xz. This meansit takes lesstime and labor coststo producethe final product. Stuff has decidedthat the least squaresestimator is too much trouble.2. Stuffchoosestwo points from a sampleof sizeN and drawsa line betweenthem.dat. The data are given in leam." rt to make this e weekly values that more sodas gamescovering I temperatureto .Yt bu.8o ProfessorE. (b) Obtain the least squares estimatesbl andb2of B 1and B2and give their economic interpretation. by hand or using your software.n advertising. (b) Show that bB2is an unbiasedestimator. Algebraically.2 :.

The 120 observationscoverJanuary 1995 to December2004. pricing model (CAPM) is an importantmodelin the field of finance. That is rj . (a) Plot house price against housesizefor all houses the sample.def. The "econometric model" is obtainedby including an interceptin the model (eventhough theory saysit should be zero) and an error term. respectively.Variable descriptionsare in the file br2.40 THE SIMPLE LINEAR REGRESSION MOI)EL (e) Predict the unit cost of production when cumulative production is CUMPROD\: 2000. plot the fitted regressionline along with the data scatter. Generally the rate of return on any investmentis measuredrelative to its opportunity cost. since it is the reward or punishment for making a risky investment. should be zero. and comment on their estimatedbetavalues. Which firm appears most aggressive? Which firm appears most defensive? (c) Finance theory says that the intercept parameter cr. IBM.lI The file br2./eincluded in the realtor's description. and Mobil-Exxon).rf :\i(r^ ry) where 1 and ryare the returns to securityj and the risk-free rate. the housesize in squarefeet. A stock's betais important to investorssinceit revealsthe stock'svolatility. A beta greater than I indicates an "aggressivestock. Also included is a variable nameds4. and whether it has a pool or fireplace or is on the waterfront.10 The capitalasset It explains variations in the rate of return on a security as a function of the rate of return on a portfolio consisting of all publicly traded stocks.is the return on the market portfolio. valuesof beta less than I indicate that the stock is "defensive" since its variation is less than the market's. (c) Estimatethe regression modelin (b) usingonly traditionalstylehouses.dat aredataon the monthly returnsof six firms (Microsoft. The data include sale price.Draw a sketch of the fitted line. (b) In the datafile capm2." Investors usuallywant an estimate a stock'sbetabeforepurchasing The CAPM of it.dat contains dataon 1080houses sold in BatonRouge. It measures the sensitivity of security j's return to variation in the whole stock market. is thejth security's "beta" value. and B. its age. How do the estimatesseemto compareto those in (bX . Interpret the estimates. The resulting difference is called the risk premium. Estimate the CAPM model for each firm. Disney. and the rate of return on the risk free asset(RKFREE).Louisianaduring mid-2005.which is the return on a risk free asset. model shown above is the "economic model" in this case. which is called the market portfolio. GM. ri-11:a1-lB1Q^-ry)+e (a) Explain why the econometric model above is a simple regressionmodel like those discussedin this chapter.The CAPM saysthat the risk premium on securityTis proportional to the risk premium on the market portfolio. in another Construct plot for housesof traditional style. the rate of return on the market portfolio (MKT). As such. 2. (d) Estimate the model for each firm under the assumptionthat oi :0. (b) Estimatethe regressionmodel PRICE : Fr f gzSQFT * e for all the housesin the sample. GE. Interpret the estimates. Do the estimatesof the beta values change much? 2.r. Does this seem correct given your estimates?For the Microsoft stock.

:tively. (c) Estimatethe regressionmodel in (b) using only housesthat arevacantat the time of sale.predict the number of monthly housing starts. Do the isiana during . (a) Plot house price against house size for all housesin the sample. Variable descriptions are in the file stockton2. variation is sive stock. such as how long the incumbent party has been in power and whether the President is running for reelection. Interpret the estimates. : the rate of s called the rredrelative g difference king a risky tionaltothe (d) For eachof the regressions (b) and (c) computethe least squares in residualsand plot them against SQFT. (a) Plot each of the series against time. econ. Discuss the interpretation of the results as well as any comments you may have about how well the line fits the data.Thel2O IAPMmodel firm appears ro. Interpret the estimates. Plot the fitted regressionline along with the data scatter from (b)..ses. let us ask the question "If mortgage interest rates go tp by l%o. and see in particular his paper entitled "A Vote Equation for the 2004 Election. (b) Plot housing starts (STARfg against the 3O-yearfixed mortgage rate (FIXED_RATD. i " ProfessorRay C.def. they will be lessinclined to build new homes." . .yale. housing starts (thousands).13 One would suspectthat new home constructionand sales depend on mortgage interestrates.Plot the fitted regression line along with the data scatterfrom (d). TheCAPM econometric . . and thus when mortgageinterestratesare high.Fair's data.There are 184 monthly observationsfrom January 1990 to April 2005. presidential elections. Do any of our assumptionsappear violated? l.Repeatthe estimation for housesthat were occupied (not vacant)at time of sale.8 EXERCISES 41 duction is 1offinance. and I is a variable are in the file itruct another the housesin 1e.and houses sold (thousands)are contained in the file house_starts. Does this lot the fitted :0.htm. is re.The dependent variableisVOTE: percentage shareof the popular vote won by the incumbent party. Fair hasfor a number of yearsbuilt and updatedmodelsthat explain and predict the U. during mid2005. Interpret (bx . Consider the explanatory variable . (f) If the 30-year fixed rate mortgage rate is 6Vo. (c) Estimate the simple regression of STARZS on FIXED_MZE.heorysaysit n model like s (Microsoft.How do the estimatesseem to compare to each other? (d) For each of the regressionsin (c) compute the least squaresresiduals and plot them against SQFT.Draw a sketch of the fitted line. (d) Plot housessold (SOID) against FIXED_MTE.datcontainsdataon 880 housessold in Stockton. While this is intuitively reasonable. Discuss the interpretation of the results as well as any comments you may have about how well the line fits the data.2. r the market UE). its age. Builders are aware of this fact.CA. l2* The fiIe stockton2.S.edu/vote2008/index2. A stock's the neasures et. fewer people will be able to afford to borrow the funds necessaryto finance the purchaseof a new home. :.dat.are inthefilefairdat. r. (e) Estimate the simple regression of SOLD on FIXED_RAZE. See his website at http://fairmodel. (b) Estimatethe regressionmodel PRICE : 9r * gzSQFT * e forall thehousesin the sample. Do any of our assumptionsappear violated? (e) Predict the price of a house with 2000 squarefeet of living area. As such. how much does home construction fall?" Data on the 30-year fixed mortgage rate.If interestrates are high.3 I observations the election yearsfrom 1880to for 2000." The basic premise of the model is that the incumbent party's shareof the two-party (Democratic and Republican)popular vote (incumbent means the party in power at the time of the election) is affected by a number of factors relating to the economy and variablesrelating to the politics.

the party in power would havea betterchanceof winning the election.the point (b v b) at which the sum of squaresfunction S is a minimum. on the unknown parameters B1 and 82. and whites. (b) Estimate the linear regressionWAGE: 9t * \2EDUC * e and discussthe results. This minimization problem is a common one in calculus. One would think that if the economy is doing well. .9z): ILr(v. Sketch. Plot VOTE againstINFIATION. Appendix 2A Derivation of the Least Squares Estitnates Given the sample observations on y and .r.15 How much does education affect wage rates?The data fi7ecps-small.Br . and growth is high. out of all the possiblevalues B1and B2. females. the fitted line on the data scatter from (a)' (c) Economy wide inflation may spell doom for the incumbent party in an election.x. Report and discuss the estimation results.1. which is a quadratic in terms of the unknown parametersB1 and B2. and the minimizing point is at the "bottom of the bowl. Compare (d) Estimate separate the results. Discuss the data characteristics.2) z(L x?)Pz 2L xiy + 2(I -rr) i 9r as 092 . our task is to find.andother variablesfrom the 1997 Population Survey (CPS)." Those of you familiar with calculus and "partial differentiation" can verify that the partial derivatives of S with respect to B1 and B2 are dJ E9t 2N9.dat contains on 1000observations hourly wagerates. is a "bowl-shaped surface" like the one depicted in Figure 2A.42 THE SIMPLE LINEAR REGRESSION MODEL growth rate in real per capita GDP in the first three quarters of the GROWH: election year (annual rate). Current (a) Obtain the summary statistics and histograms for the variables WAGE and EDUC.) have been observed. should any patternsbe evident in the least squaresresiduals? regressionsfor males. 2. all the data from 1880 to 2000. (a) Plot a scatter diagram of VOTE against GROWH.education. . The variable INFLATION is the growth in prices over the first 15 quartersof an administration.blacks. Report and discussthe estimation by hand.2Zyi -r 2(}xi)Bz (21'.1) function S dependsonly the sum of squares Since the points (y.gzxi)2 (2A. Are any patternsevident?If assumptionsSRl-SR5 hold. (c) Calculate the least squaresresiduals and plot them against EDUC.. Does there appear to be positive association? using voTE : fu -l 7zGROWH + e by leastsquares (b) Estimatethe regression result. we want to find values for the unknown parametersB1 and 92 that minimize the "sum of squares" function s(Br. This function.

:he mean form of the estimator is derived in Appendix 28. . 0S/dB1 and 0Sl0B2.Oby N.7) is to use sometricks involving 'ummation signs..4) r the unknown Thesetwo equationshave two unknowns bt andbz.) N'. the "bottom of the bowl" occurs where the slope of the bowl. We can find the least squaresestimates rr solving thesetwo linear equationsfor b1 andb2. The first useful fact is that (2A.1) :2*?-2NT2+Nx2:I-i .cross-products.ll.APPENDIX 28 DEVIATION FROM THE MEAN FORM OF b" uarters of the ring well.res. in an election.To solve for b2 multiply (2{. D2: Nlxiyi -Lxilyi (24. quartersof an scussthe esti.(Zt)uz]: o Simplifying these gives equationsusually known as the normal equations.and then isolate D2on Jre left-hand side.3) by N and returange. Appendix 2B Deviation frotn the Mean Fortn of b2 Tlrefirst stepin the conversionof the formula for b2into (2. Are any erns be evident hites. Algebraically.dat contains rfromthe 1997 es WAGE and nd discussthe DUC. appear to be squaresusing result. divide both sides of (2A.Nh . Nh -r (Zxi)bz:}yi ( 2 x .(>)rif (2A. and g the election. rrultiply (2A.2) to zero and replace B1 and B2 by b1 and 12.3) (2A.272xi Nl = :d + .7 function the minimizing and values andb2.2 + Nrz (2B.3)by Zxi.i)z :Lt . respectively. given bz. . b) we set equations(2A.then subtractthe first equationfrom the second. in the directionof each axis.o('*r".s) The deviation from and squares. Compare rtcvnp 2A. b1 The sumof squares Thesederivativesare equationsofthe slope ofthe bowl-like surfacein the directions ofthe a.2) I(xi . This formula for b2is in terms of datasums. is zero.to obtain zf\ri . ) b 1 +( 2 f ) b z : Z x i y i (24.r) S dependsonly ltic in terms of one depicted in &2)at which the common one in Lverify that the N>f. to obtain the point (h. To solve for 01.(bi)bz]: o 2[Lxiyi (Ixr)br.Intuitively. Sketch.

-7)(y.usingtheshortcutformulaL(ri lf l is much easier. the formula for b2 becomes ur:\ffiA t6=. The seconduseful fact is similar to the first. so B2lw.3) we can rewrite b2in deviationfrom the meanform as .as we will useit time and time again in the next few chapters.5) are divided by N..Nry :1xiyi- + QB. or:=Q. then using (28.1 where w.xlxi :Z*? - # ( 28."v.-t)l F 'l-x" Yi: LwiYi t.f | ( x i . that is.x.1)-(28. L(xi-t):0 Then. . and it is L(*. We used two more summationtricks to simplify this.12) replaceyi in (2.Nf :2*? .2) To obtain this result we have usedthe fact that 7:lx. Appendix 2C b2Is a Linear Estirnator In order to derive (2.f N.:9:. is the constantgiven in (2. so lx. :7tg.44 THE SIMPLE LINEAR REGRESSION MODEL -7)' :2*? ShouldyoueverhavetocalculateI(x. :9r bz : Lwiyi: * B2x.Then - I (r. l)2.)0r -Y-) Iftis formula for b2is one that you shouldremember.r ) y i: . The sum of any variable about its averageis zero.10) we make a further simplification using another property of sums.11).. Secondly.10)simplifiesto(2.. this eliminatesthe term B1)w. and (2.12).a -.e._.f (*.I ei and simplify: Iwi(9r * gzxi * et) lLwiet : prlwi llzLwixi : 9z l}w. L(*. If the numerator and denominator of b2 in equation (2A.3) This result is proven in a similar manner.y) :ZxJi . Appendix 2D Derivation of Theoretical Expression for b2 To obtain (2.i )' :2r 7 ..10) by y. Lwi :0. First. Ltt'.: l.

*)ri -72(xr -t) : !(x.-). Consequently 1 V. ' .. : Second. . j I tir. usesthe fact that I ("'-t". il'\ Alternatively.)2 is use that Toshow I wixi :1 weagain )('r. *e have : var(b2) E(92 +7wiei .7"? *222wp1e.e1) : 2w?E (e?)-f 2LL wiw1 (e.9)2 rertyof sums. we can employ the rule for finding the variance of a sum. .r) : o fl. o2 : e) cov(e.) : 0' Another I("..12)andusingtheunbiasednessoftheleastsquaresestimator. then using Lwixi: L(xi .r. .x)(x.E(ej))): E(eie):0' f Then' the very last step The next to last line is obtained by using two assumptions:First..rl L*?:rl. .APPENDIX 2E DERIVING THE VARIANCE OF D2 45 . bz:Fz*Zwiei.02 : n('?) El(ei.I2).e E ) i+i : o'Lwi :oZ term) (square bracketed of (because not random) w.))' : E(et .x)xi >.r)x. and a and b are constants.then vat(aX + bY) : azvat(X) + b2var(Y) r 2ab cov(X'Y) . .r) : I(xi .t) : 0' for expression L(r. If X and I are random variables. -7)" : j9-+:t= Z(xi-t)z _ fiI("..._*: L(x.)tl I('' .t''-. : . : E(Zr..x)2 :\(x. \ 2 _LS i .E(bz)l' Substitutingin(2. 2(x.).n(".p.E(b2):82. : E(2.E(e))(e1. Appendix 2E Deriving the Variance of b2 The least squaresestimatoris a random The starting point is (2.2 _ . IG.^ I The term Lwi :0 because (28.. .-r)' var(e) : Elei . rariable whose variance is defined to be var(b2): Elbz.)'-' wherein the last stepwe usedthe fact that I("t .2) :: Lwi " l!:iLl : ='f---r('.r. .

since for any t..y.3) hold and use them to (2F. If cov(e. I c.t)r' (2F.) :9rIci + Fz* gzLcixi I(w. e1)lO then we cannot drop out all those terms in the double summation. e) (generalizing variance rule) the (using cov(e. + cr)(81't gzxi -l ei) : I(wi + cr)81* I(w. Into this new estimator substitute/. (2F. : wi I ci. Takethe mathematical expectation the last line in (2F. Then. + .)e1 : BrIcr * Fz + 9zLcixi + I(wi -f c. is given in (2. If var(e.. + ci)gzxi* I(wi I c.) : o') : o22r? o2 Z(xi -t)' Carefully note that the derivation ofthe varianceexpressionfor D2dependson assumptions SR3 and SR4. Let bi: fk.3) These conditions must hold in order for b):Zk* to be in the class of linear and unbiased estimators.e.4 reviews all the basic propertiesof random variables. in Appendix 2D b) : lkiyi :|(wi -l ci)yi: I(r.In the secondline below we use this rule extendedto more than two random variables.Our goal is to show that in the classof linear and unbiasedestimatorsthe estimatorb2hasthe smallest variance. :l l : \w! va{e .using the properties of of expectation the assumption E(ei) : Qi and that E(b. * grlci l gz}wixi t FzLcixi+ I(w.1): simplify expression bi : Lkli: 9z * 2(*. is anotherconstantand w. var(b2): var(92+lwiei) : var(}wiei) (sinceB2is a constant) 'A: i '. and simplify. where c. 'r ci)E(ei) + (2F.:1. it is legal.THE SIMPLE LINEAR REGRESSION MODEL Appendix B.11). using the properties of w. (where k.): 0) (using var(e. To make comparisonto the leastsquares estimator b2easier. Appendix 2F Proof of the Gauss-Markov Theorern We will prove the Gauss-Markov theorem for the least squaresestimatorb2 of B2.. : 0 andZw. suppose thatk. mustbe true that Ici : 0 and Lcixi :0 (2F.2) : Brlci f 9z * lz}riri In orderfor the linearestimator b): it lkiyi to be unbiased.The sameis true for the varianceof b1 and the covariance.If either of theseassumptions fails to hold then var(b) is somethingelse andis not given by (2. that someonemight choosewe can find c.15).) + :\w?var(ei) fiw (e iwi cov .4) . While this is tricky.So we will assumethat conditions (2F.1).)e.) f oz for all observations then o2 cannot be factored out of the summation.1) since fw. are constants)be any other linear estimator of B2..x.)e. : BrIw..

: o L-sethe properties of variance to obtain var(b): : varl9z * I(wi * ci)el : L(wi + c..Thus there is no other linear and unbiasedestimator of S2 :iat is better than b2. in which caseb\: Dz.w.r. : var(bz) -t o22c! > var(b2) The last line follows since)cf ) 0 and establishes that for the family of linear and unbiased stimators bi.: 0. To tlr * ci.1) he properties of (2F. (2F.s of linear and nd use them to (2F. since for any k.The only time that var(bj) : var(bz) is when all the -.Our goal hasthe smallest mator of B2.4) .o) . re1rr zof 92.L:&a4l .wherec. and simplify. -x)"- .3) .)zvar(ei) o22(wi + cr)z: o22w! * o22c! on assumptions s in the double lred out of the :hing else andrs iance. )).) -t Lc. which proves the Gauss-Markov theorem.. eachof the alternativeestimatorshas variancethat is greaterthan or equal to 5at of the least squaresestimator b2. .r)'l [I(rr Z(xi .APPENDIX 2F PROOF OF THE GAUSS-MARKOV THEOREM 47 ond line below nt) nce rule) \\'e can now find the variance of the linear unbiased estimator bj following the steps in .x)' -=i zcixi 2(x.\ppendix 2E and using the additional fact that .2) re that (2F.

and rejection region. Explain the terms null hypothesis. 3. Explain how to choosewhat goes in the null hypothesis. Explain the difference between an interval estimator and an interval estimate. 9. Explain the difference betweenone-tail and two-tail tests.including why it is important that a test statistic have a known probability distribution if the null hypothesis is true.and what goes in the alternative hypothesis.Define the level of significanceof a test. Explain the difference between economic and statistical significance. 5. and give an example. how to choosethe rejection region for a one-tail test. Explain the term p-value and how to use a p-value to determine the outcome of a hypothesis test. and exactly what it means in a repeatedsampling context.Explain. Explain Type I error and illustrate it in a sketch. alternative hypothesis. Explain why it is important for statisticalinferencethat the least squares b1 and b2 are normally distributed random variables. Explain how to interpret an interval estimate. giving an example and a sketch of the rejection region. intuitively.Chapter Ir p a Interval Estimation and Hypothesis Testing Learning Objectives Based on the material in this chapter. 6. Explain the "level of confidence" of an interval estimator. 8. Discuss how "repeated sampling theory" relates to interval estimation and hypothesistesting. 4. provide a sketch showing a p-value. 11. Explain the logic of a statisticaltest. you should be able to l. 10. d b n \[ a S b 4 q o l - S estimators 2. 7 . n S h t I S p \ lr e t Kevwords alternative hypothesis confidence intervals critical value degreesof freedom hypotheses hypothesistesting inference 48 interval estimation level of significance null hypothesis one-tail tests point estimates probability value p-value rejection region test of significance test statistic two-tail tests Type I error Type II error .

In developingthe proceduresin this chapterwe will be using the "Student's" r-distribution.Hypothesistestsallow us to say that the data arecompatible. how 'significance ofa ance. 3. not in the intervals the rhemselves..6. . estimatorsbl and byhavenormal distributions. the normal distribution of b2. _ . rejection region.x) | z(-\'. Interval estimation is a procedure for creating ranges of values.The estimate population parameterB2 in the regressionmodel. We prefer to call them interval esfimatesbecause term "confidence" is widely misunderstoodand misused. our confidenceis in the procedurewe use to obtain the intervals.5. For example.Infermeans concludeby reasoningfrom somethingknown or assumed. Such intervals are often called confidence intervals.7 Intewal Estirnation In Chapter 2 we estimatedthat householdfood expenditurewould rise by $10. and h1'pothesis testing in the context of estimating the mean of a normal population. of significance . interval estimation.If assumption SR6 does not hold.1.3. You may want to refresh your memory about this distribution by reviewing helpful to seethe concepts areabouttodiscuss a in AppendixB.1 TnE /-DrsrRrBUTroN :ction region . . vhat goes in the In Chapter 2 we used the least squaresestimators to develop point estimates for the parameters the simple linear regressionmodel. sith a particularconjectureor hypothesis. or are not compatible. and the precision with which we haveestimated rr."This "to dictionary definition describesstatisticalinference as well. then the sample size must be 'ufficiently large so that the distributions of the least squaresestimators areapproximately normal. or read it along with this chapter as we proceed.Nl B : . sometimescalled confidence intervals. In this case the procedureswe develop in this chapter can be used but are also approximate. We have assumeda relationship (SR1-SR5) aboutthe regression betweeneconomicvariablesandmadevariousassumptions given empirical estimatesof regression parameters. it is sometimes we . and * e want to make inferencesabout the population from which the data were obtained.21 given a b2:10. as In this casewe know that the least squares discussedin Section 2.3. In this chapterwe introduce additional tools of statisticalinference: interval estimation and hypothesis testing. the least squares e s t i m a t oo f B z ' i s r .This is consistent with how we assessed properties of the least squares estimators Chapter2. You may $ ant to review this material now. Interval estimation proposesa range of r alues in which the true parameter B2 is likely to fall.21isapoint estimate the unknown of in S100increase weekly income. Hypothesis tests are proceduresfor comparing conjecturesthat we might have aboutthe regressionparameters the parameterestimateswe have obtainedfrom a sample to of data.hata test statistic ue.1 INTERVAL ESTIMATION 49 estimation and luares estimators I exactly what it nterval estimate. the outcome of a . These estimatesrepresentan inference in aboutthe regressionfunction E(y) : 9 t * pzx describinga relationshipbetweeneconomic tariabTes.Basedon theseassumptions. intuitively.As we will the i!e.Also. model. in which the unknown parametersare likely to be located. . In Appendix C we examine statistical inference. The proceduresfor hypothesis testing and interval estimation depend very heavily on usumption SR6 of the simple linear regressionmodel and the resulting normality of the ieast squaresestimators. in 3. \ ( or . statistic ptail tests re I error re II error Let us assumethat assumptionsSR1-SR6 hold for the simple linear regression model.impler setting. Providing a range of values gives a 'enseof what the parametervalue might be. ^ \ b z .

Using a table of normal probabilities (Table 1 at the end of the book) we know that 0 P ( . then 'Ai . When working with the r-distribution rememberthat it is a bell-shapedcurve centeredat zero. with a larger varianceand thicker tails.t bv subtractins its mean and dividing by its standarddeviation: Z_ bz-92 -N(0.tlyv-z) se(br) l-. A similar result holds for bl.95 r(u. 1 ) g >A?l(Ncreatesa random variable we can work with. While we do not know the value of o2 we can estimateit.INTERVAL ESTIMATION AND HYPOTHESIS TESTING A standardizednormal random variable is obtained from b.1) The standardizedrandom variable Z is normally distributed with mean 0 and variance 1.96 ozlL(x. exceptit is more spreadout. It looks like the standardnormal distribution.1) (3.95 of containing the parameter 82. but this substitution changesthe probability distribution from standardnormal to a r-distribution with N . 9 6 < Z < 1 .1) into this expression obtain we Pt-l .tw-z\.95 This defines an interval that has probability 0.*) oz121x.x)2 . to specify a r-distribution with m degreesof freedom.1) to (3..2 degreesof freedom.2 r3 ?) :\t This equation will be the basis for interval estimation and hypothesistesting in the simple linear regression model.{l . < 9z < bz -l1. often abbreviatedas dl We use the notation /1. V var\D2) . r') :0.2) is in Appendix 3A.:uFP -ts-z) ror k:1.2) -'\l Theratiot:(bz-82)lse(b2)hasar-distributionwithN-2degreesoffreedom. R e p l a c i no ' b y 6 2 i n ( 3 .f \ Rearranging gives us I :0. at the end of this chapter.In repeatedsamendpoints (ur+rca1f o2l\(xi -4') pling 95Voof the intervals constructedthis way will contain the true value of the parameter B2. bz-92 : '1 :- o21L1x. The statisticalargumentof how we go from (3.r . so in generalwe can say. In Table 2 at the end of the book (and inside the :i . 9 6:) .which we denoteas t .'t -cl (3. 9 s Substituting(3.. bz-Fz bz-92 .This easy derivation of an interval estimator is basedon both assumption SR6 andthat we know the varianceof the error term o2.e6<-L = . The two -\ | provide an interval estimator.sa o2l\(x.if assumptions SRI-SR6 hold in the simple linear regression model. The least squares residualsare ?i:li-br-bzxtandourestimatorofo2is62: 2 ) .-. The shapeofthe r-distribution is controlled by a single parameter called the degreesof freedom.

For : erample.a (3.crof the probability is .we can make the probability statement P(-t. you can interpolatefor an epproximateanswer. These endpoints define an interval estimator of Be.t. (3.w-zy Table 2. row that -tc i tccns 3.or use your computer software to obtain an exact value. <t<tc):l-(J.ozs. :he propertythat 0.-): | . for degreesoffreedom rn is the percentile value tg-.n).'r)ntainedin the center portion.if the degrees freedomarem:20.2) is in e centeredat with a larger .1 .4) For a95%o confidenceinterval the critical valuesdefine a central region of the r-distribution iontaining probability I .se(b1) are random becausethey vary from -rmple to sample.For nt Jegrees offreedom the 95th percentileofthe r-distribution is denoted/1o. are depictedin Figure 3.. so that I .3.where a is a probability often taken to be cr : 0.) : P t 1 .95.o12. This value has n.tlo. so that el2:0.95 : B2. let us seehow we can put all thesebits together to create a procedurefor interval .rzs.se(br)]: 1 .szs.s) The interval endpoints h . Then the critical value /. tegs.95 z1 \\'e find the percentile values /1o.d]:0.t.leparameter .2 OsrArNrNc IxrEnver Esrrnanrs From Table 2 we car. The .4) becomes : P [. so P[11.3) in the simple to (3. and The -t.In the simple regressionmodel the degreesof freedom are m:N-2. to specify a nd inside the pl -. valuesl. (3.from Table2.05 divided equally ttween the two tails. -<br' < r"l : r .95.1 INTERVAL ESTIMATION 51 its mean and (3.t.w-21) 0.1) d variance 1. = 0. Consequently. then.1.se(bp) 9r < b* -t t.stimation.l L se(rr) Rearrangethis expressionto obtain < Plh . This leaves probability a :0.rv.7 0 Critical values from a r-distribution.4) to obtain edom.cr :0.-ritical value /. (3.025.*1. iront cover) are percentilevaluesof the t-distribution for various degreesof freedom.es. in Now.gt5.725.95 of the probability falls to its left..y< tegs.) : uf2. so erpression(3.ots.tcse(br) andb1 -t t.:t11-o.2) 3. e probability lreedom.P:' ..Should of r ou encountera problem requiring percentilesthat we do not give.01 or a : 0. The probability . which assumptions .The two :peated sam. . Eachshaded"tail" areacontainsef Zofthe probability.3) into (3. Substituter from (3.zo) 1.o .05.find a "critical value" /" from a l-distribution such that P(r ) t.I t < tp.heparameter SR6 and that residualsare by 62in 1:.

suchasbz:10.rea.5 percentile from the r-distribution with 38 degreesof freedom.21.lzs.97. then95%o all the interval estimatesconstructedusing this of procedurewill contain the true parameter.w-21 /1o.and then constructthe interval estimatebp I t.45] That is.21andits :] S relu ::re "la i\P : se(b) : 1fvar(b2) t/4. What we can say about the interval estimate basedon our one sample is that.N : 40 andthe degrees offreedom areN .024 is the 97. Is B2 actually in the interval [5.3 AN IrrusrnerroN 1-rrtt . basedon a given sampleof data.5) are estimated in values(numbers). For B2 the probability statement (3. The critical value /.The propertiesof the interval estimation procedureare basedon the notion of repeatedsampling.5) becomes in I:r T i -Jlll This vJTl :0. What we do know is that when the procedurewe usedis applied to many random samplesof datafrom the samepopulation.01oro :0.2 : 38.and becauseB1is unknown. .The interval estimation procedure"works" 95Vo of the time.95 < P[b.2. However.se(b) is called a 100(l . it is not in any one interval estimate calculated from a sample of data. then 100(l .1 hS . : tg-e1z.45]? We do not know.4sl.05..nc -Por 1. 1s. What is the usefulness an interval estimateof B2?When reporting regression of resultswe alwaysgive a point estimate.5) saysthat the interval bp i t"se(ba) hasprobability I . The interpretationof confidenceintervals requiresa greatdealof care.1. Equivalently it is calleda100(l . we might also report an interval estimate.97. 3.97 and $14. When bpand se(Da) (3. given the reliability of the procedure.a)Vo interval estimate of B7. --rrr '\\'t . we will never know if it does or doesnot.6) we obtaina"95Vo confidence intervalestimate"for B2: b2 t t. then b2 i t.which is a measure of the variability of the least squaresestimator. sothatweobtain a997o confidence interval or a95Vo confidenceinterval.38:2.a)Toconfidenceinterval.rm :. Thus.05.basedon one sampleof data. elu :hatt \iloo \\ rodr :l\ eI 3\ttn .024se(bz)] To constructan interval estimatefor B2 we usethe least squares estimatebz : standarderror (36) 10. we estimate"with957o confidence"that from an additional$100of weekly income households will spendbetween$5.The interval estimateincludes an allowance I .09) : [5. Usuallya : 0.97. When "confidence intervals" are discussed rememberthat our confidenceis in thepro cedureused to construct the interval estimate.thepoint estimate alonegivesno sense its reliability.se(bp) for each sample. compute the least squaresestimate bp and its standarderror se(bp)for each sample.u)Vo of all the intervals constructedwould contain the true parameter Bs Any one interval estimate.45 on food.For a95%o : : confidence intervalct: 0.may or may not contain the true parameterB1. If we were to select many random samples of size N.ct of containing the true but unknown parameter 81. and we will never know. 14.09 Substituting thesevaluesinto (3.:a) 2.52 INTERVAL ESTIMATION AND HYPOTHESIS TESTING statementin (3.024(2.ilO! \ITli For the food expenditure data.21+2.t i:II 14.14.024se(b2) 9z < bz-t 2.we would be "surprised" if B2 is not in the interval t- : T.Interval estimates of incorporateboth the point estimateand the standarderror of the estimate.tin .se(b2): 10.

21is an estimateof how much weekly householdfood expenditurewill rise givena $100increasein weeklyhouseholdincome. the Sampling variability causes centerof eachof the interval estimatesto changewith the valuesof the least squaresestimates.69 57.2 for the same samples.For example.21 1.6) = 10.79 1.If an interval estimateis wide (implying a large standarderror). is larger. But since 957o and of all interval estimatesconstructedthis way contain the true parametervalues.66 97.05 7.63 64.3.it suggeststhat we have learned more about B2.25 103.60 r.23 26.21andits imate" for B2: In Section 2.4r r.22 33.33 41.4sl.given forecastsof income growth in an area.91 46.96 1. When ryocedureused culated from a for the sample size as well.IJ bz se(b2) 62 I 2 J 4 5 6 7 8 9 10 3'7.43 1 4362.7 Sample Least SquaresEstirnatesfrorn 10 Random Samples br 131.96 se(br) 40.1 INTERVAL ESTIMATION 53 containing the .and it causesthe widths of the intervals to changewith the standarderrors.44 t. we would expect perhaps 9 or 10 of these intervals to contain the true but unknown parameters. and the coefficient standard errorsfrom eachsample.75 4722. We have used the least squaresestimatorsto obtain point estimatesof unknown parameters.29 IJ.The estimated veeklyincome ll never know.ionresultswe llone gives no rval estimates h is a measure an allowance Table 3. becausefor lower degreesof freedom the r-distribution critical value /.3 we illustrated the sampling properties of the least squaresestimatorsby showing what would happenif we collected 10 additional samplesof size N : 40 from the same population that gaveus the food expendituredata.79 7002.93 9. If we ask the question "How many of these intervals contain the true parameters. then the CEO may concludethat there is insufficient evidence upon which to make a decision and order a new and larger sampleof data.024is the the probability (3. cm samplesof .91 .However.f) 10. The prudent CEO will cany out a sensitivity analysisby considering values of B2 around 10. What is "wide" and what is "narrow" dependon the problem at hand.The dataare in the file table2-2. The question is "Which values?" Oneanswerisprovidedbythe interval estimate15.14 I 1.1 we presentthe least squaresestimates. Note the difference betweenpoint estimation and interval estimation.18 6.58 7200.12 3793. ACEO of a supermarketchain usethis can estimateto plan future store capacity requirements.iven sampleof luivalently it is ) that we obtain te propertiesof ing.dat.4 THr RrprerED SAMpLTNG CoNTExr =38.16 891 .14 37. If we were nate bp and its e bp * t"se(bp) ontain the true :ontain the true loes not.83 3610.20 5878.30 95.85 4668.61 1.76 8.4.Note the samplingvariation illustratedby theseestimates.71 .While B2may or may not be in this interval.50 84.21 79. In Table 3.8'7 29. which onesare they?" we must answerthat we do not know.If an interval estimateis narrow.1.21.63 589r.The 957oconfidence interval estimates the parameters 1and B2aregiven in Table for B 3. This variation is due to the simple fact that we obtained 40 dffirent householdsin each sample.88 8.15 45.90 9.ted usingthis "works" 95Vo ample is that.For a95Vo : 2. If varying B2within the interval hasdrasticconsequences of on company salesand profits.03 29.58 JJ. it suggests that there is not much information in the sampleabout B2.14. no decision will be basedon this one number alone.78 32. in the interval .in our model b2 : 10.77 r.the estimatesof o2.54 1. 3. the CEO knows that the procedureusedto obtain the interval estimate"works" 95Vo thetime.98 2.48 10.

se(bz) I 2 3 4 5 6 'l 8 9 10 49.t. Given an economic and statistical model.53 119. indicating that a $100 increasein income will increaseexpenditureon food by more than $10. andits square root .40 The t parar as Hr regre the s 3.14 r0.30 18.it may make a good deal of difference for decision purposes whether B2 is greater than 10.52 '7. hypothesesare formed abouteconomic behavior.tase(b2) 3.65 4. to that is containedin a sampleof data. Also.06 t2.for ft : 1 or 2.69 213. basedon economic theory.5 1 13.13 156.54 -9. In each and every hypothesis test five ingredients must be present: COMPONENTS OF FTYPOTHESIS TESTS 17 The .05 140. we believe that$2 should be positive. In the food expenditureexample. implying that the least squaresestimatesare "reliable.2 Sample IntervalEstirnates frorn 10 Randorn Samples bt . When the sampling variability of the least squares estimator is relatively small." a 3. bz -t t. Paire if th iom( alter variance .l3t -'on rul I :1)' li r 1.and its standarderror.96 0.12 11. A test statistic 4. then the interval estimateswill be wide. An alternative hypothesis 1{ 3.93 -66.04 -0.2. A rejection region 5." If the least squaresestimators suffer from large sampling variability. Hypothesis testing procedurescompare a conjecturewe have about a population to the information contained in a sample of data.its leastsquares draw a conclusion about the hypothesis.51 8.97 t6'7. Hypothesistestsusethe information about a parameter point estimate.44 14.Thesehypotheses then represented are as statements about model parameters.68 10. One check of our data and model is whether this theoretical proposition is supportedby the data.89 11.54 INTERVAL ESTIMATION AND HYPOTHESIS TESTING Table 3.2r 4..23 2.29 171.6).32 20.se(br) b2 .26 1t3.30 129.t9 38.85 5.m: se(br) provideinformation about the sampling variability of the least squares'estimator from one sample to another.2. then the interval estimateswill be relatively narrow.81 6.83 28.08 7.2 Thr :as :eg .32 r79.63 t9. Interval estimatorsare a convenientway to report regressionresultsbecausethey combine point estimationwith a measureof samplingvariability to provide a rangeof valuesin which the unknown parametersmight fall.2 Hypothesis Tests Many businessand economic decision problems require a judgment as to whether or not a parameteris a specific value.8s 124. A conclusion _i.02 14.65 5.56 -20. A null hypothesist1s 2.se(bt) br I t.77 1 5 . implying that the least squaresestimatesare "unreliable.27 9.

in the food expenditureexample we might well test economictheory strongly Ho. Rejectingthe null hypothesis ( conclusionthat B7.1 Trc Nurr HYporHrsrs The null hypothesis.3).lz: 0 against : Fz ) 0 because I1r the null hypothesis suggeststhat necessities like food are normal goods.4 Tur RrJrcrroN REGToN The rejection region dependson the form of the alternative. A test statistic has a special characteristic: its probability distribution is jompletely known when the null hypothesisis true.30 18.This point is elaborated Appendix 38.77 15. specifiesa value for a regression :rrameter. basedon md model is lation to the tical model. to 3. implying .2 TrrE ArrrnNATrvE FIyporHESrs Pairedwith everynull hypothesis a logical alternative is hypothesisHlthat we will accept :: the null hypothesis is rejected. :ther or not a good deal of rhat a $100 io. The alternative hypothesis is flexible and dependsto eme extent on economic theory.2.2.7) Se(47.tg-z).2 HYPOTHESIS TESTS 55 bz-t t"se(bz) 10.06 12.02 14. 3. The null hypothesisis stated :r Hs: Br : c.Basedon the valueof a teststatisticwe decideeitherto rejectthe null hypothesis or ror to reject it.f Ii the null hypothesisis not tue. then the t-statistic in (3. and that food expenditurewill rise if income increases.89 11. in which casewe reject the null hypothesis. For the null hypothesis fls: 9t : c the three possible iltemative hypotheses are H y : $p ) c. t : (b* . suffer from that the least -i.40 : information Leto another.and is an important value in the context of a specific :sgressionmodel.2 degrees freedom.It is the range of values of the to a reststatistic thatleadstorejectionof thenull hypothesis. A null hypothesisis the belief we will maintain until we are convincedby :re sample evidence that it is not true. then we can substitutec for Bp and it follows that t: bt-c ^ -trv-z) (3. c. where c is a constant. is It all starts with the key result in (3.. hey combine lues in which least squares rw.2.68 10. that 9r: c in this caseleadsus to acceptthe H1:$p (c.44 r4. Inequality alternativehypothesesare widely usedin economicsbecause economic theory frequently provides information about the signs of relationships betweenvariables.Itispossible construct rejection region only if we have .which is denotedby Hs(H-naugftr). in of 3.p2)lse(bp) .7) doesnot have a r-distribution rr ith N .15 13.3 Trm Tesr Srerrsrrc The sampleinformation about the null hypothesisis embodiedin the samplevalue of a test iratistic.For example. that Br : c in this caseleadsus to acceptthe h:9r * c.12 11.2.3. Rejectingthe null hypothesis conclusion that B1 takes a value either larger or smaller than c.for ft : I or 2. which for generality we denoteas B1. presented as a parameter lard error. and it has someother distribution if the :rull hypothesis not true. If the null hvpothesis Ho:9r: c is true. Rejecting the null hypothesisthat Br : c leadsus to acceptthe conclusion that Bp > c.

6.1 ONE-TnrrTssrs wrrH ArrEnNATrvE "GR-EnrEnTnaN" (>) -: rh \ac . 9r 1c. we need to specify the level of significanceof the test. o.\tt . The good news is that we can specify the amount of Type I error we will tolerate by setting the level of significancecr. Third. If such an error is costly. -:!)\l . to have a rejection region for a null hypothesis we need a test statistic.01.u ::i is . if the alternative hypothesisFI1:Bp ) c is true. called the level of significance of the test. which you should be able to explain. then the value of the r-statistic (3.we needa specificalternative. The critical value that leavesprobability a in the right I .7). then we have committed a Tlpe II error. and thus it is unlikely that the null hypothesis is true. The level of significanceof a test is the probability of committing a Type I error. . If we do not reject a null hypothesis that is false. I When testing the null hypothesisHs:$k : c. thenvaluesof the test statisticwill tendto be unusually large or unusually small. we urge you to make it standardpracticeto saywhat the conclusionmeans in the economic contextof the problem you areworking on and the economic significanceof the finding..tu: If 1. The level of significanceof a test. t: :.5 A CoNcrusroN a. an alternative hypothesis a level of significance The rejection region consists of values that are unlikely and have low probability of occurring when the null hypothesisis true. th' -:. 3.which can be very misleading.9.-JLl 3l\' \ . Statistical proceduresare not ends in themselves.Do you When you have completedtestinga hypothesis reject the null hypothesis. which we have.56 INTERVAL ESTIMATION AND HYPOTHESIS TESTING o a test statistic whose distribution is known when the null hypothesis is true . The terms "large" and "small" are determinedby choosing a probability cr. then we commit what is called a lYpe I error.7) tends to become larger than usual for the t-distribution.:.2.\ \l 3. 0. 3. so P(Type I enor) : cr. In this sectionwe hope to be very clear aboutthe nature of the rejection rules for eachof the three possible alternatives the null hypothesisHs:Bp: c.Also. or $pl c.." The level of significanceof the test a is usually chosento be 0. _ i ^ .| r lw I re lle t . which is calledaTypelerror. or do you not reject the null hypothesis? As we will argue below you should avoid saying that you "accept" the null hypothesis. For more about Type I and Type II errors see Appendix C.10.. then we make cr small.J Rejection Regions for Specific Alternatives _ r.05 or 0.-ul ::c c you shouldstateyour conclusion. then it is unlikely that the test statistichas the assumeddistribution. The chain of logic is "If a value of the test statistic is obtainedthat falls in a region of low probability. If we reject the null hypothesiswhen it is true. . As noted in the previous to section. In a real-world situation we cannot control or calculate the probability of this type of error becauseit dependson the unknown true parameterFr.9r> c. which provides a meaning for "an unlikely event. is the probability that we reject the null hypothesiswhen it is actually true. it is given in (3.3." If the alternativehypothesisis true.Any time we reject a null hypothesisit is possible that we have made such an esel-1[e1g is no avoiding it.. Second. We will reject the null hypothesisif the test statistic is larger than the critical value for the level of significancea.In '-:c n !-r id .J .They are carried out for a reason and have meaning.

The critical value that leavesprobability cr in the left tail is the a-percentile to. shown in Figure 3.ed out for a r eachofthe he previous . r-o.r.ls.ion.leading us to conclude that the null hypothesisis unlikely to be true. as shown in Figure 3.2.691 ' The rejection rule is hypothesis H1:Bp) c.1-21..thenthe valueof the /-statistic(3. to the left of The level of significance is a the critical value. then the probability that the /-statistic value falls in the extreme right tail of the distribution is small.3 REJECTION REGIONS FOR SPECIFIC ALTERNATIVES rs true . u-2\ c a g a i n s t F 1 r : B 1) c .Forexample. Evidence against the null hypothesis is evidence in support of the alternative hypothesis.10. H1 ' I Wtrentestingthe null hypothesis : Be : c againstthe alternative tf and acceptthe alternativehypothesis t 1 t6. If t l tg a.. We reject the null hypothesis if the test statisticis smallerthan the critical value forthe level of significancea. then the test statistic(3. z o ) : I .and we do not reject it.7) hasa r-distributionand its valuesfall in the nonrejectionregion with probability I .2 ONE-TelTssrs wrrH ALTERNATTvT "LEss THaN" (() .05andN .Fl6 9r : c is true. ) a o f t h e l ..robability of e test statistic . 7 2 5 n d t h e 5 t h p e r c e n t i l e v a l u e i s / ( o .3.7) has a r-distribution.05or 0.e have made 5e amount of nor is costly.wheremost of the probability is contained.l-z\.i-21 the negative of the (l-a)-percentile if I.3. Do you e will argue can be very usionmeans gnificanceof . and its value would tend to fall in the center of the distribution.if a : 0.then from Table2the 95thpercentile : . we take it asevi denceagainst the null hypothesis.2 tr= t6 -o..2 :20. lled a Tlpe I 'pe I error.v-2).2:30. I reject the null hypothesis I .t statistichas true.u-z). Rejection region for a one-tail test of Hs:9t : as tail is the (l.z.which is If the alternative hypothesis : B1 ( c is true. then thereis no statisticallysignificant evidenceagainstthe null hypothesis. ct : 0... o s. hen we have calculate the neter B. an event that is unlikely to occur by chance.Ifwe obtain a teststatisticvalue in the rejection region.*-r1. For example. Thus if we reject the null hypothesis then we conclude that the alternative is true. so that the cr-percentile/1o. When using Table 2 to locate critical values.1. Wfrentestingthe null hypothesis B6 : c againstthe alternative f/e: I and acceptthe altemativehypothesis t 2tg-o. | If the null hypothesis. thenthe test statistic(3. so . ficance of a ue.3.or Bplc. if I reject the null hypothesis The testis called a "one-tail" test because unlikely valuesofthe /-statisticfall only in one tail of the probability distribution.1y-21.. If the null hypothesisis true." If the ually large or a probability "an unlikely 0.:o. The rejection rule is: l:Bp>cis ual for the the critical in the right ^FIe hypothesis :Bp 1c. chosenso that ifthe null hypothesisis true.1 o7 2 5 .ct)-percentile /11-o.05 and N . 3. which we :. 1.recall that the r-distribution is symmetric is about zero..7) tendsto F11 become smaller than usual for the t-distribution. then from Table 2 the critical value is the 95th percentile value : /1o. For 0 prcune 3 .d i s t r i b u t i o n i s t p g s .a.

a. /1o.N-2.5-percentile :2.042.3 Two-Terr (l) leg . then the value of the /-statistic(3.:o.58 INTERVAL ESTIMATION AND HYPOTHESIS TESTING Reject //6: B1 = c laik .When the null hypothesis true. For example. if the alternativehypothesisF1l: Bpf c istrue.N-2).If the alternativeis ">". If the altemative "(". the right-tail critical valueis the 97. _z) t't FIGURE 3. and We rejectthe null hypothesis thatI/s : 9r : c in favor of the alternative thatHy :81.w-z)or t ) tg-o1z.N 2) rci .F16: : c a g a i n s t 1 : B p l c .N-z) then do not rejectHs:$k : g.:o.ritl ran -c\t tr= t(a.-l Us . then reject in the right tail.the probability of obtainingsucha /-valueis I .Thus if t > t@. r-z) '( -'l]Jl.al prcunx 3 .iet iol J5t _ l sig rc = Ira:. which is chosento be is large.042.5-percentile value : -2.rbt rrol '.pe Do not rejecl Hs:Pp=s Reject 116:B1= c Accept H1 : B1+ r '\t J) Reject Hs: B1= c Accept 111 p1 * c : .qr rtbt .025 andthe lefrtail critical valueis the 2.1 c if the test statistict 1 t61z. Therejection region a one-tail of H6:9r.4 Rejectionregion for a test of . To have a test with level of significanceo we define the critical values so that the probability ofthe t-statistic falling in either tail is u 12.7i-21 the right-tail critical value is the percentile tg-o1z.{ -r. Remembering wheretherejectionregionis locatedmay be facilitatedby thefollowing trick: MEMORY TRICK: The rejection region for a one-tail test is in the direction of the arrow in the altemative.2 : 3}.if a : 0. \\'e l'\O 'is 3. and the left-tail critical value is found using the svmmetrv of the t-distribution.7) tendsto becomeeitherlargeror smallerthan usualfor the r-distribution.4.ozs. rejectin the left tail.rzs..then af 2 : 0. The lefrtail critical value is the percentile t61z.: c against for test 11r:B1 The nonrejectionregion consistsof /-statisticvaluesgreaterthan /(a. 3.3.The /1o.ltU When testing the null hypothesisIIs :9r : c.05 as andN .3 :he 0 (c. is '(Nor Equer To" Trsrs wrrH ALTERNATTvE i \\'e J. shownin Figure 3. H B1- .N-21. right-tail critical value is found in Table 2.

Fls 9r : c is true. and the test is called a test of significance.ht tail.Conversely.05 . Thus the rejection rule is 3p{c.1 Rrcnr-Ten Tpsrs i.rectionof the . 1t 3.bservingthat the estimatehasthe right sign doesnot constitutescientific proof. On the other hand.1a One-Tail Test of Signficance L-suallyour first concernis whether there is a relationshipbetweenthe variables.u-zy or if t ) t6_o1z. We want to ietermine if there is convincing. Calculate the sample value of the test statistic. Samplevaluesof the test statistic in the central nonrejection area are compatible with the null hypothesis and are not taken as evidenceagainst the null hypothesis being true. statistical evidence that would lead us to :onclude that B2 ) 0. Economic theory suggeststhat food is a normal good.{.4. When testingthe null hypothesis B1 : c againstthe alternative Hs: reject the null hypothesisand accept the altemative hypothesisif t I tp1z.which is certainly greaterthan zero.N-z).4 Exarnples of Hypothesis Tests \\'e illustrate the mechanicsof hypothesistesting using the food expendituremodel. hypothesis H1:$p t' c.a statistical test can lead k=c t . this test is called a two-tail test. then the probability of obtaining a value of the : test statistic r in the central nonrejection region is high.2." The sumof the tail probabilitiesis cr.The ound using the Determine the null and alternative hypotheses.4 EXAMPLES OF HYPOTHESIS TESTS 59 Sincethe rejection region is composedof portions of the t-distribution in the left and right tails.and thus that B2 > 0.closely following the list of requiredcomponentsfor all hypothesistestslisted at the beginning of Section 3. 4. f r thanusualfor itical values so :ritical valueis r-d/z.Ineachcase will follow aprescribed we of set nisteps.21.N-21' ( tg_t1z. If 92 :0 then there is no linear relationship between food :rpenditure and income. andtwo-tailtests.3.We i1 I c if the test rle. Select a and determine the rejection region. If the \\-e do not reject the null hypothesisif t61z.. all the hypothesis test can establish is that the information in a -rmple of data is compatible with the null hypothesis.if cr : 0.left-tail.042. When testing the null hypothesis that a parameter is zero.w_z). The least yluaresestimateof B2is bz : 10.u_z). A standardprocedure for all hypothesis testing problems and . c is true.ercentilevalue l:2. J. When the null is chosento be followingtrick: .as we have . We give eramples right-tail. However.precified in our model. A statistical test procedurecannot prove the truth of a null hypothesis. simply . and that rr income increasesfood expenditure will also increase. When the null hypothesisis true. State vour conclusion. or significant. the probability of obtaininga value of the test statisticthat fallsin eithertail areais "small. Specify the test statistic and its distribution if the null hypothesis is true. 5 .Samplevaluesof the test statisticthat are in the tail areasareincompatible *'ith the null hypothesisand areevidenceagainstthe null hypothesisbeing true.if the null hypothesis.ituations is STEP-BY-STEP PROCEDURE FOR TESTING HYPOTHESES :) : B7. we are rsking ifthe estimate b2 is significantly different from zero.When we fail to :eject a null hypothesis.

you will want to describe the outcome of the test in the context of the problem you are investigating. When you report your resultsto an audience. our example. Hr:92 > 0.21 5.4. The stepsof this hypothesistest are as follows: The null hypothesisis F1s: : 0. we reject the hypothesisthat there is no relationship between income and food expenditure. by . 4. not What if we had not beenable to reject the null hypothesisin this example?Would we have concludedthat economictheory is wrong and that thereis no relationship betweenincome and food expenditure?No.21 with standarderror r: : -. we found that b2: se(b2):2. and conclude that there is a statistically significant positiverelationshipbetweenhouseholdincome and food expenditure..60 INTERVAL ESTIMATION AND HYPOTHESIS TESTING us to reject the null hypothesis.05.t(u-z) if the null hypothesisis true. The least squares whichis greaterthan What estimateof 5.ss.(br) 2.that 9z > 5.then we will reject the null hypothesis.686.we will not reject the null hypothesis. The test statisticis (3.99. so t : bzlse(bz) .:s):1. The last part of the conclusionis important. The value of the test statisticis 10. For this reason null hypothesis usuallystated sucha way that is the In if our theory is correct. we want to determineis if there is convincing statisticalevidencethat would lead us to conclude.If t < 1.7).With this goal we set up the null hypothesis that thereis no relation between the variables.1b One-Tail Test of an Economic Hypothesis Suppose that the economic profitability of a new supermarket depends on households spendingat least $5.50 out of each additional $100 weekly income on food and that construction will not proceedunlessthereis strongevidenceto this effect.5. just in terms of Greek letters and symbols. Ho:92:0.686.with only a small probability cr of rejecting the null is conclusion hypothesis when it is actuallytrue.21. In this casec : 0. The critical value for the right-tail rejection region is the 95th percentile of the r-distribution with N . then the supermarket wanttobuildit. one that will go in the alternativehypothesis.5. 1 3. S2tsb2=10. Let us selecta :0.S. B2 2. concluding that B2 is positive. If we then rejectthe null hypothesis we can make a direct statement. That is. with only a small (ct) probability that we are in error.Thus rejectinga null hypothesis a stronger in thanfailing to rejectit.This judgment is basednot only on the estimateb2. Using the food expendituredata.4'uu .88 > 1. We would like to establish that there is statistical evidence to support this theoryusing a hypothesis test. In the alternative hypothesis we put the conjecture that we would like to establish.basedon the availabledata.blutalso on its precisionas measured se(b:). In this casethe conjecturewe want to establish.S.686. Sincel:4.686. The alternativehypothesisis I11:B2 > 0.we rejectthe null hypothesis that B2 : 0 and acceptthe alternativethat B2 > 0.economic theory implies that there should be a positive relationshipbetween income and food expenditure.og b't 10. Rememberthat failing to reject a null hypothesisdoesnot mean that the null hypothesis true. Thus we will reject the null hypothesis the calculated if of t > 1.If Fr < 5.2 :38 degrees of freedom. value /ro. that is the will be unprofitableand the ownerswould not 9z > 5. is 3.

The alternativehypothesisis 11r: B2 < 15.tJO a . t> 2.omes of great importance.5) lse(b2).A construction project worth millions of dollars dependson --ting convincing evidencethat householdswill spendat least $5.3.429 we will not reject the null hypothesis.If t < 2.2r 5.economic )me and food .:ilding the supermarket will be unprofitable.is that :rs would not ran5. The alternativehypothesisis 111 B2> 5.the choice of cr --ust madeon an assessment nsftand the consequences making be of of an incorrectdecision. bz : 10.01because seeka testthathasa low chance we ofrejectingthenull hypothesis ".we havechosen conservative ! . :Pz 0' > -21 if the null r region is the of freedom. then r.5.4 EXAMPLES OF HYPOTHESIS TESTS 61 )cting the null ger conclusion iuch a way that rple. audience.429. A CEO unwilling to make a decisionbasedon the aboveevidence may well ordera new i:d largersampleof datato be analyzed.01.That tells us that the rejection ::gion is in the left tail of the r-distribution.5.5.5 againstthe alternative :-:rcction regionareexactlythe same.429 we do not reject the null hypothesis rhat B2 ( 5. In this example. ofct : 0.21 with standardenor se(b2):2. The stepsof this hypothesis test are as follows: 1.25 <2. In eachreal-world situation. Recallthat as the samplesizeincreases.The rejectionregionis in ':e direction of the arrow " ( " in the alternativehypothesis.er. The test statisticand 9z : 5.2 Lsnr-TArL TEsrs n households ood and that Lthis casethe thesis.5 is exactly the same as ':. The null hypothesisis F1e: > 15.a^-\\ "Z 10. :2.:ently hypothesistestsbecomemore powerful tools for statisticalinference.:ll hypothesiswhen it is true to be very small.:s. '-^- .ue o hen it is actually true.5.1.5. and thereforewe want the probability of rejecting the . We are not ableto conclude that the new supernarket will be profitable and will not besin construction.05.429.tandard error i.5. \. nd accept the o relationship a statistically I expenditure. Let us select cr: . Using the food expendituredata.ting Ilo : hypothesis Ht:92 > 5.\u_zt if the null hypothesisis true. This null hypothesis too limited because is theoretically is it possiblethat r: < 5.' . lculated value . as '-:. if the null hypothesisis true. The valueof the test statistic is .5 againstthe alternativehypothesisHt:92>5. least the \:uares estimator becomesmore precise (as measuredby estimator variance) and conse:. The test statistict : (bz .5. We want the probability of building an -::profitablemarket to be very small. We will reject the null hypothesisif the calculated value of /1o.o support this hatthere is no Ls we put the iull hypothesis y a small (cr) What will the null hypothesisbe? We have been statingnull hypotheses equalities.50 out of eachadditional incomeon food. While the "usual" choiceis cr : 0.2 :38 degrees of freedom.r completeness will illustrate a test with the rejection region in the left tail.5. : t . B2 . The steps of this hypothesis test are as follows: l .-has Fz : 5. What :ld lead us to rt only on the l .5.09. you rlem you are /ould we have ween income oes not mean -. For a right-tail testyou canform the null hypothesis in :. 2. It tums out that the hypothesistestingprocedurefor testingthe null hypothesis ::et Hs:B2 < 5.:her of theseways dependingupon the problem at hand.this examplewe have poseda situationwhere the choice of the level of significance cr -r. Consider we ::e null hypothesis that 9z ) 15 and the alternative hypothesis < 15.09 1< se\b2) Since r : 2.Recall our memory 9z '::ck for determining locationofthe rejectionregionfor a the /-test. Recall that the level of significanceof a testdefineswhat we meanby :-: unlikely value of the test statistic. The null hypothesisis I1s: B2 < 5. The critical value for the righrtail rejection region is the 99th percentile of the l-distribution with N .

INTERVAL ESTIMATION

AND HYPOIHESIS

TESTING

2. The test statistict : (bz - 15)lse(b2)-/1,r, r) if the null hypothesisis true. 3. Let us selecta : 0.05. The critical value for the left-tail rejectionregion is the 5th : percentile of the t-distribution with N - 2 :38 degreesof freedom, l1o os,:s) -1.686. -1.686. We witl reject the null hypothesisif the calculatedvalue of t < A If t> - 1.686we will not reject the null hypothesis. left-tail rejectionregion is illustratedin Figure 3.3. error se(b2): 2.09.The data,bz : 10.21with standard 4. Using the food expenditure value of the test statisticis I: b z- l 5 t4b): 10.21 15 :-:'tv Log

5. Sincet : -2.29 < - l.686werejectthenullhypothesisthat > 15andacceptthe B2 spendlessthan$ l5 from each alternative at 9z < 15.We concludethathouseholds th additional$100 income on food. 3.4.3 Tvo-Ten Tpsrs

3.4.3a Two-Tail Test of an Econornic Hypothesis the A consultantvoicesthe opinion that basedon other similar neighborhoods households near the proposedmarket will spendan additional $7.50 per additional $100 income. In as termsof our economicmodel we can statethis conjecture the null hypothesis :7 .5.|f 9z is we wantto testwhetherthis is trueor not,thenthealternative that B2 l1 .5.This alternative than7.5 or lessthan7.5, simply that it is not 7.5. makesno claim aboutwhetherB2is greater In such caseswe use a two-tail test, as follows: is hypothesis H1 :82 17.5. The null hypothesis Hs : B2 : 7.5. The alternative is - 7 .5) lse(b2)- t6-z) if the null hypothesisis true. 2. The test statistict : (bz 3. Let us selectcr : 0.05.The critical valuesfor this two-tail testarethe 2.5-percentile :2'024. Thus we will reject : /1o.ers,:s) /ie.ozs,:a) -2.024 and the 97.5-percentile the null hypothesis if the calculated value of t>2.024 or if r < -2.024. lf -2.024 <t <2.024 we will not reject the null hypothesis. enor se(b2):2.09. The 4. For the food expendituredata bz : 10.21with standard l. value of the test statisticis h-_-7\
, -: " t ""

lnrl_7.5 2.09

se(bz)

that 9z : I .5. 5. Since-2.204 < t : 1.29< 2.204we do not rejectthe null hypothesis The sample data are consistentwith the conjecture householdswill spend an additional$7.50 per additional$100 income on food. We must avoid reading into this conclusion more than it means.We do not conclude from value. this test that B2 : 7.5, only that the data arenot incompatiblewith this parameter 116: : 8.5 (/ : 0.82), Hs:$2 The data are also compatiblewith the null hypotheses B2 test A 6.5 (t : 1.77),andHo:92 : 12.5(r : - 1.09). hypothesis cannot be usedto prove that a null hypothesisis true. useful. intervalsthat is sometimes There is a trick relatingtwo-tail testsand confidence then interval,so that if t, : t,r-o,r.7,r-2;, Let c be a valuewithin a 100(1 - a)% confidence bp - t,se(bp)I c I br + t.se(b1)

3.4 EXAMPLES OF HYPOTHESIS TESTS

63

;is is true. 'egion is the 5th : lom, /1o.os,:a) ofr<-1.686. ection region is bz) :2.09.The

li we testthe null hypothesis Hs:Bk : c against :9r I c, when c is insidethe confidence I11 :nterval,then we wlll not reject the null hypothesisat the level of significancect. If c is outsidethe confidenceinterval, then the two-tail test will reject the null hypothesis.We do rot advocateusing confidenceintervals to test hypotheses,they serve a different purpose, rut if you are given a confidence interval this trick is handy. i.{.3b Two-Tail Test of Significance \\-hile we are confident that a relationship exists between food expenditure and income, nodels areoften proposedthat aremore speculative,and the purposeofhypothesis testing is :o ascertainwhether a relationship between variables exists or not. In this case the null :li pothesisis B2: 0; that is, no linear relationship existsbetweenx and y. The alternativeis j: + 0, which would meanthat a relationshipexists,but that there may be either a positive or :r'sative association between the variables. This is the most common form of a test of rignificance. The test steps are as follows: l . The null hypothesisis I/s : B2 : 0. The alternativehypothesisis $:8210. is t . The test statistict : bzI se(bz)- t(N-z\ if the null hypothesis true.

5 and acceptthe n $15 from each

the households i100income.In rsisB2 : 7.5.11 This alternative that it is not 7.5.

Let us selecta : 0.05.The critical valuesfor this two-tail testarethe 2.5-percentile :2.024. We will reject the : /1erzs,:s) /1o.ozs,:a)-2.024 and the 97.5-percentile null hypothesis if the calculated value of t>2.024 or if t < -2.024. If -2.024 < t < 2.024 we will not reject the null hypothesis.

+.

Using the food expendituredata, bz : 10.21 with standarderror se(b2):2.09. : The value of the test statisticts t : bzlse(bz) : 10.2112.09 4.88. that F2 = 0 and concludethat Sincel:4.88 >2.024 we reject the null hypothesis thereis a statistically significant relationshipbetweenincome and food expenditure.

fu:5217.5.
,sisis true. e 2.5-percentile s we will reject t < -2.024. If 5z) : 2.09. The

:'.\o points should be made about this result. First, the value of the t-statistic we - .mputed in this two-tail test is the same as the value computed in the one-tail test of .: :nificancein Section3.4.1a.The differencebetweenthe two testsis the rejectionregion ::J the critical values. Second, the two-tail test of significance is something that .:.ould be done each time a regressionmodel is estimated,and consequentlycomputer .. it*are automatically calculates the /-values for null hypothesesthat the regression ::rameters are zero. Refer back to Figure 2.9. Consider the portion that reports the -'.:imates:

s that 92 : 7.5. will spend an

',rable

Coefficient

Std.Error 43.41016 2.093264

f-Statistic

Prob

I conclude from arametervalue. J.82), s:82: H re used to prove metimes useful. I a/z,N-21,then

"( oME

83.41600 1.0.20964

t.921578 4.877381

0.0622 0.0000

'.'re that there is a column labeled r-Statistic.This is the r-statisticvalue for the null : ^rothesis parameter zero. It is calculatedas t :brlse(br). is that the corresponding -''',iding the least squaresestimates(Coefficient) by their standarderrors (Std. Error) that the parameter zero. is ::: r'sthe t-statisticvalues(r-Statistic)for testingthe hypothesis l:r'r-statistic value forthe variableINCOME is 1.817381,which is relevantfortesting the :0. :,-i hypothesis,Fl6:B2 We have roundedthis valueto 4.88 in our discussions.

INTERVAL ESTIMATION

AND HYPOTHESIS TESTING

that the interceptis zeroequalsl-92.The ct : 0'05 The r-valuefor testingthe hypothesis : critical valuesfor thesetwo-tail testsare/1o.ozs.:s -2.024 and /1o.ezs.:t) 2'024 whether ): we are testing a hypothesis about the slope or intercept, so we fail to reject the null H1:$110' thatH():9r : 0 giventhe alternative hypothesis The final column, labeled "Prob." is the subjectof the next section'

'.:1

.

S

-:a:t

imply "economically sigREMARK: "statistically significant" does not necessarily chain plansa certaincourseof the nificant." For example,suppose CEO of a supermarket a suppose large sampleis collectedfrom which we obtain actionif B2l 0. Furthermore, the estimatebz:0.0001 with se(b2):0.00001, yielding the t-statistict : 10'0' We that B2 : 0 and acceptthe altemativethat B2 f0'Herc would reject the null hypothesis bz : 0.0001is statisticallydifferent from zero.However,0.0001may not be "economically" different from 0, and the CEO may decide not to proceedwith the plans. The of hereis that one mustthink carefully aboutthe importance a statisticalanalysis message beforereportingor using the results.

::'l

:

_t.

3 .5 The p-Value
When reporting the outcome of statisticalhypothesistests,it hasbecome standardpractice to report the p-value (an abbreviation for probability value) of the test. If we have the p-value of a test,p, we candetermine the outcome of the test by comparing the p-value to a, ihe chosenlevel of significance, without looking up or calculatingthe critical values. The rule is when thep-value is lessthan, or equal p-VALUE RULE: Rejectthe null hypothesis pi ( a t h e n r e j e c t . F l 6 I. f p > c I t h e n d o n o t t o , t h e l e v e l o fs i g n i f i c a n c e c r . T h a t i s , f reject Hs. to If you havechosenthe level of significance be e : 0.01, 0.05, 0.10, or any other value, p-value of a test and then reject, or not reject, without checking the you can compareit to the critical value.In written works reporting thep-value of a test allows the readerto apply his or her own judgment about the appropriate level of significance. How thep-value is computeddependson the alternative.If r is the calculatedvalue of the /-statistic, then
o a a

if ft:Bp) c, p: ifIl1:Bp 1c, p:

probabilityto the right of / probabilityto the left of/

-ltl if I/r : Br l r, p : sum of probabilitiesto the right of ltl and to the left of

TRICK: The direction of the alternativeindicatesthe tail(s) of the disI MEMORY falls. in tribution whichthep-value I

3.5 THE p-VALUE

65

) 2 . T h ec t : 0 . 0 5 = 2.024 whether r reject the null

3.5.1 p-Verun FoR A Rrcnr-Ten

Trsr

In Section 3.4.1b we tested the null hypothesis I1s:B2 < 5.5 against the one-sided alternative Hr:92 >5.5. The calculatedvalue of the r-statisticwas

bo- 5.5 .-^se\D2)

t0.2r- 5.5- ' ) ) \
2.09

rnomically sig:rtain courseof 'hich we obtain t : 10.0. We at 8210. Here be "economicthe plans. The listical analysis

In this case, since the alternative is "greater than" (>), the p-value of this test is the probability that a r-random variable with N - 2 :38 degreesof freedom is greater than

1.25, U: Pltps)>2.251:0.0152. or
This probability value cannot be found in the usual r-table of critical values,but it is such easily found using the computer. Statistical software packages,and spreadsheets e. Excel, have simple commands to evaluate the cumulative distribution function cdl) (see Appendix B.2) for a variety of probability distributions. If Fa(r) is the cdf ior a random variable X, then for any value x: c the cumulative probability is PIX < cl : FxG).Given such a function for the r-distribution, we compute the desired r-\.alue

u - P l t p z ) > 2 . 2 5 1 t - P h : s l < 2 . 2 5 1 :I - 0 . 9 8 4 8 : 0 . 0 1 5 2 :
tandardpractice If we have the g the p-value to , critical values. Following the p-value rule we conclude that at cl : 0.01 we do not reject the null hypo:hesis.If we had chosenct :0.05 we would reject the null hypothesisin favor of the rlternative. The logic of thep-value rule is showninFigure 3.5. The probability of obtaining a r-value /1o.or,:a;, :teater than 2.25 is 0.0152,O: Plfuat>2.25J :0.0152. The 99th percentile : 0.01, must fall * hich is the critical value for a right-tail test with level of significancaof cr :o rheright of 2.25.This meansthat / : 2.25 doesnot fall in therejectionregionif ct : 0.01 :-'rdwe will not reject the null hypothesisat this level of significance.This is consistentwith :nep-value rule:Whenthep-value (0.0152)is greaterthan the chosenlevel of significance ,t.01)we do not reject the null hypothesis.

than, or equal octhen do not

any other value, rut checking the rr to apply his or rted value of the

lefrof -lll

--nnr<t

'/

2

= = I , o q s . r s r 1 ' 6 8 6 tlo.ss,tty 2'429
:.-{; L'RE 3 . 5 The p-value for a right-tail test.

l',t

66

INTERVAL ESTIMATION

AND HYPOI'HESIS TESTING

-rl-, \-1
FTGURE ,6 3

0

I

2

3

t

-2.429 t10.0s,3s; = -l'686 tro.or.tu= Thep-value a left-tailtest. for

On the otherhand,the 95th percentile/(o.qs,:s),which the critical value for a right-tail is : testwith cr. 0.05, mustbe to the left of 2.25.This meansthat t : 2.25 falls in the rejection region and we reject the null hypothesisat the level of significancecr :0.05. This is consistentwith the p-value rule'.When thep-value (0.0152)is less than or equal to the chosenlevel of significance(0.05) we will reject the null hypothesis. 3.5.2 p-Varua FoR A LErr-Tan TEsr

,l

.-U

'.f,

In Section 3.4.2 we carried out a test with the rejection region in the left tail of the ) t-distribution.The null hypothesiswas -F1s:B2 15 and the alternativehypothesiswas Ht:92 < 15.The calculated value of the /-statisticwas / : -2.29. To computethep-value for this left-tail test we calculatethe probability of obtaining a t-statistic to th eleft of -2.29. Using your computersoftwareyou will find this value to Ue P [(:s; < -2.29]: 0.0139. Following thep-valuerule we conclude that at cr : 0.01we do not rejectthe null hypothesis. If we choose cr : 0.05 we will reject the null hypothesis in favor of the alternative. See Figure3.6 to seethis graphically. Locatethe I st and5th percentiles. Thesewill be thecritical valuesfor left-tail testswith a : 0.01anda : 0.05 levelsof significance. When thep-value (0.0139)is greaterthanthe level of significance : 0.01) thenthe /-value-2.29 is notin (a the test rejection region. When the p-value (0.0139)is less than or equal to the level of significance(a : 0.05) then the t-value -2.29 is in the test rejection region. 3.5.3 p-Verur FoR A Two-Tnrr Tnsr

<l

, rtl

:.:!I

For a two-tail test,the rejectionregionis in the two tails of the r-distribution, andthep-value is similarly calculated the two tails of the distribution.In Section3.4.3awetestedthe null in hypothesis thatgz :7.5 againstthe valueof alternative hypothesis l7 .5.The calculated 9z the /-statisticwas / : | .29. For this two-tail testthep-value is the combinedprobability to the right of 1.29 and to the left of -1.29:

"Cr

P[(:a;< -r.29]:0.2033 , : Pltpt)>r.291+
This calculationis depictedin Figure3.7. Oncethep-valueis obtained useis unchanged. its If wechoosect:0.05.o :0.10,orevenct:0.20wewillfailtorejectthenullhypothesis becausep > cr.

) : \'i,
-_-i(

' .itl

:n

3.5 THE p-VALUE

67

-t/-,

-1

0

1

,\

3

t

FIGuRE 3 .7 or a right-tail r the rejection 0.05. This is : equal to the

2.024 \ogts.t)t= The p-value a two-tail testof significance. for

= -2'024 Iro.o:'s.:s,

At the beginning of this section we statedthe following rule for computingp-values for two-tailtests:ifl11:9rlc, p:sumofprobabilitiestotherightof ltlandtotheleftof-lrl. The reasonfor the use of absolutevalues in this rule is that it will apply equally well if the value of the /-statistic turns out to be nositive or nesative.

3.5.4 ft tail of the pothesiswas le thep-value leftof -2.29.

p-Venn

FoR A Two-Tnn

Trsr or SrcNrrrcRNcE

9] : o'01:9.
ll hypothesis. ernative. See be the critical :n thep-value 2.29 isnotin r the level of

All statistical software computes the p-value for the two-tail test of significance for each ;oefficient when a regressionanalysisis performed. In Section 3.4.3b we discussedtesting the null hypothesisHo:92:0 against the alternative hypothesisHt:9zl 0. For the --alculatedvalue of the /-statistic / : 4.88 the p-value is

+Pl(:sl < -4.88]: 0.0000 o : Pltpt)>4.88]
\bur software will automatically compute and report this p-value for a two-tail test of ,.ignificance. Refer back to Figure 2.9 ar.d consider just the portion reporting the estimates:

\ ariable

Coefficient

Std. Error

f-Statistic

Prob.

Ld thep-value estedthe null latedvalue of rrobability to

{ :\.COME

83.41600 10.20964

43.41016 2.093264

1.92rs78 4.8'77381

0.0622 0.0000

s unchanged. ll hypothesis

Next to each /-statistic value is the two-tail p-value, which is labeled "Prob" by the EViews software. Other software packageswill use similar names.When inspecting comoutput we canimmediately decideif an estimateis statistically significant (statistically -3uter Jifferent from zero using a two-tail test) by comparing the p-value to whatever level of lignificance we care to use. The estimated intercept has p-value 0.0622 so it is not 'tatistically different from zero at the level of si,snificancea : 0.05, but it is statistically .rgnificantifa:0.10.

68

INTERVAL ESTIMATION

AND HYPOTI]ESIS TESTING

The estimatedcoefficient for income has a p-value that is zero to four places.Thus p I a :0.01 or even ct : 0.0001,and thus we rejectthe null hypothesis that income has no effecton food expenditure these levelsofsignificance. Thep-valueforthis two-tail test at of significance is not actually zero. lf more places are used then p:0.00001946. in Regression softwareusually doesnot print out more than four placesbecause practice levels of significance less than cr :0.001 are rare.

3,6 Exercises
Answers to exercisesmarked * appear in Appendix D at the end of the book.

3.6.1

Pnonrmrs

model shown in Figure 2.9: output for the food expenditure 3.1 Using the regression (a) Constructa957o interval estimatefor B1 and interpret. (b) Testthe null hypothesis that Br is zero,against alternative the that it is not, at the 5Vo level of significancewithout using the reportedp-value. What is your conclusion? (c) Draw a sketch showing the p-value 0.0622 shown in Figure 2.9, the critical value from the r-distribution used in (b) and how the p-value could have been usedto answer(b). (d) Testthe null hypothesis that B I is zero,against alternative the thatit is positive.at the 5Volevel of significance.Draw a sketchof the rejection region and compute the p-value. What is your conclusion? (e) Explain the differences and similaritiesbetweenthe "level of significance"and the "level of confidence." (f) The resultsin (d) showthatwe are957oconfident that B 1is positive.Trueor false? If false,explain. 3.2 The generalmanagerof an engineeringfirm wants to know if a technical artist's experience influences the quality of their work. A random sample of 24 artists is selectedand their years of work experienceand quality rating (as assessed by' their supervisors) recorded.Work experience(EXPER) is measuredin years and quality rating (RAZNG) takes a value of 1 through 7, with 7 : excellentandI poor. The simple regressionmodel RAZNG: 9r f \2EXPER f e is proposed. The least squaresestimatesof the model, and the standarderrors of the estimates. are RATING : 3.204 + 0.0'76EXPER ('") (0.70e) (0.044) (a) Sketch the estimated regressionfunction. Interpret the coefficient of EXPER. (b) Constructa95VoconfidenceintervalforB2,theslopeoftherelationshipbetween quality rating and experience.In what are you 95Vo confident'! (c) Testthe null hypothesis the that B2is zeroagainst alternative that it is not usinga two-tail test and the e : 0.05 level of significance. What do you conclude? (d) Testthe null hypothesis that B2 is zero againstthe one-tail alternativethat it is What do you conclude? positive at the ct : 0.05 level of significance.

3.6 EXERCISES

69

places.Thus rt income has s two-tail test

(e) For the test in part (c), the p-value is 0.0982. If we choosethe probability of a Type I error to be q : 0.05, do we reject the null hypothesisor not, just basedon an inspection of the p-value? Show,in a diagram, how this p-value is computed. In an estimated simple regressionmodel, based on 24 observations,the estimated slope parameteris 0.310 and the estimated standarderror is 0.082. (a) Testthe hypothesisthat the slopeis zero,againstthe alternativethat it is not, at the lVo level of significance. (b) Testthe hypothesisthat the slope is zero, againstthe alternativethat it is positive at the l%olevel of significance. (c) Test the hypothesisthat the slope is zero againstthe alternativethat it is negative atthe 5Volevel of significance. Draw a sketch showing the rejection region. (d) Testthe hypothesisthat the estimatedslope is 0.5, againstthe alternativethat it is not, at the 570 level of significance. (e) Obtain a 99Vaintewal estimate of the slope.
:-l

0.00001946.
se in practice

k.

r Figure 2.9: t is not, at the Mhat is your ), the critical Lldhave been is positive,at and compute ificance" and Trueor false? mical artist's of 24 artists ; assessed by in years and :llentand 1 : is proposed. he estimates, (a) What is the estimated equation intercept? Show your calculation. Sketch the estimated regressionfunction. (b) What is the standarderror of the estimated slope? Show your calculation. (c) What is the p-value for the two-tail test of the hypothesis that the equation intercept is zero? Draw a sketch to illustrate. (d) State the economic interpretation of the estimated slope. Is the sign of the coefficient what you would expect from economic theory? (e) Construct a 99Voconfidence interval estimate of the slope of this relationship. (0 Test the hypothesisthat the slopeofthe relationship is 0.2, againstthe alternative that it is not. State in words the meaning of the null hypothesisin the context of this problem. 3.6.2 ConpurrR ExrRcrsEs Consider a simple regressionin which the dependentvariable MIM : mean income of males who are 18 years of age or older, in thousandsof dollars. The explanatory variable PMHS - percent of males 18 or older who are high school graduates.The data consist of 51 observationson the 50 statesplus the District of Columbia. Thus MIM and,PMHSare "state averages."The estimatedregression, along with standard errors and t-statistics,is

(a) +O.[80PMHS MIM: ('") (2.174) (b)

(r)

(r.2s7)(s.7s4)

. of EXPER. ship between is not using a conclude? Ltivethat it is ude?

.:.5 A life insurancecompany wishes to examine the relationshipbetweenthe amount of life insurance held by a family and family income. From a random sample of 20 households,the company collected the data in the file insundat. The data are in units of thousandsof dollars. (a) Estimate the linear regressionwith dependentvariable INSURANCE and independentvariableINCOME. Write down the fitted model and draw a sketchof the fitted function. Identify the estimated slope and intercept on the sketch.Locate the point of the means on the plot.

70

INTERVAL ESTIMATION

AND HYPOTHESIS TESTING

(b) Discuss the relationship you estimated in (a). In particular (i) What is your estimate of the resulting change in the amount of life insurancewhen income increases $1000? by (ii) What is the standarderror of the estimate in (i) and how do you use this standarderror for interval estimation and hypothesis testing? (c) One member of the managementboard claims that, for every $1000 increasein income, the amount of life insurance held will go up by $5000. Choose an alternativehypothesisand explain your choice.Does your estimatedrelationship support this claim? Use a 5Vosignificance level. (d) Test the hypothesis that as income increases the amount of life insurance increasesby the same amount. That is, test the hypothesis that the slope of the relationship is 1. (e) Write a short report (200-250 words) summarizing your findings about the relationship between income and the amount of life insuranceheld. 3.6* Consider the learning curve example introduced in Exercise 2.9. (a) Construct a 95Vointerval estimate for B2 and interpret. (b) Test at the 5Vo level of significance whether there is no learning against the alternative that there is learning. Formulate the null and alternativehypotheses and discussyour reasoning.Explain your conclusion. 3.7 Considerthe capital assetpricing model (CAPM) in Exercise2.10. (a) Testatthe5%levelof significancethehypothesisthateachstock's "beta" value is I against the alternative that it is not equal to 1. What is the economic interpretation of a beta equal to 1? (b) Test at the 5Vo level of significance the null hypothesis that Mobil-Exxon's " beta" value is greaterthan or equal to 1 againstthe alternativethat it is lessthan than 1? 1. What is the economicinterpretationof a betaTess (c) Test at the 57o level of significance the null hypothesis that Microsoft's "beta" value is less than or equal to I against the alternative that it is greater than 1. What is the economic interpretation of a beta more than 1? (d) Construct a 95Vointerval estimateof Microsoft's "beta." Assume that you are a stockbroker.Explain this result to an investor who has come to you for advice. (e) Test (at a 5Vo significance level) the hypothesis that the intercept term in the CAPM model for eachstock is zero, againstthe alternativethat it is not. What do you conclude? 3.8 Consider the housing starts data (house_starts.dat)introdtced in Exercise 2.13. (a) Estimate the simple regressionof housing starts(STARIS) on the 30-year fixed rate (FIXED_RAIE). Using a 5Vosigniflcancelevel, test the null hypothesisthat there is no linear relationshipbetweenthesevariablesagainstthe alternativethat there is an inverse relationship. (b) It is conjecturedthat if the 3O-year fixed interestrate increases 17othen house by starts will fall by 150,000.Test this hypothesis at the 5Volevel of significance using a two-tail test. (c) Construct a 95Eointerval estimateof the slope from the regressionestimated in part (a). State the meaning of this interval estimate.In part (b) you tested that the slope of the relationship was B2 : - 150.Is the value - 150 inside the 95Vointewal estimate?How does this findine relate to the hypothesis test in (b)?

3.6 EXERCISES

71

mount of life ) you usethis
0'l

00 increasein 0. Choose an d relationship life insurance I the slope of rgs about the td.

-j.9* Reconsiderthe presidential voting data (faindat) introduced in Exercise 2.14. (a) Using the regression model VOTE : 9r -t \zGROWTH + e, test (at a 57o significance level) the null hypothesis that economic growth has no effect on the percentage vote earned by the incumbent party. Select an alternative hypothesisand a rejectionregion. Explain your choice. (b) Using the regressionmodel in part (a), construct a95%ointewal estimate for 82, and interpret. (c) Using the regressionmodel VOTE:fu *\zINFLATION + e, test the null hypothesis that inflation has no effect on the percentagevote earned by the incumbent party. Select an alternative hypothesis, a rejection region, and a significancelevel. Explain your choice. (d) Using the regressionmodel in part (c), construct a95%ointewal estimate for 82, and interpret. i l0 The file brdat containsdata on 1080 housessold in Baton Rouge, Louisiana during mid-2005. (a) Estimatethe regressionmodel PRICE : Br * \1SQFT * e for (i) all the houses in the sample,(ii) town houses,and (iii) French style homes.Constructa 957o interval estimate for $2 in each case and discussthe differences. (b) Test the hypothesisthat an additional squarefoot of living areaincreaseshouse price by $80 for eachof the casesin part (a). Use a two-tail testusing the a : 0.05 level of significance.

g against the re hypotheses

value he economic obil-Exxon's : it is lessthan Microsoft's t it is greater

'beta"

t?
me that you te to you for I term in the not.Whatdo

:cise2.73. iO-yearfixed pothesisthat ernativethat 6 then house significance n estimated ) you tested 0 inside the othesis test

: I I + The file stockton2.datcontainsdata on 880 housessold in Stockton, CA during mid2005. This data was considered Exercise2.12. in (a) Estimatethe regressionmodel PRICE : Br * PISQFT * e for all the housesin the sample. Test the hypothesis that an additional square foot of living area increases houseprice by $80. Use a two-tail test using the ct :0.05 level of significance. (b) Repeatpart (a) using housesthat were vacant at the time of sale. (c) Repeatpart (a) using housesthat were occupied (not vacant) at time of sale. (d) Using the housesthat were occupied at the time of sale,test the null hypothesis that the value ofan additional squarefoot ofliving area is less than or equal to $80, against the alternative that the value of an additional squarefoot is worth more than $80. (e) Using the housesthat were vacant at the time of sale, test the null hypothesis that the value of an additional squarefoot of living area is more than or equal to $80, against the altemative that the value of an additional square foot is worth less than $80. (fl Construct a 95Vo intewal estimate for B2 using (i) the full sample, (ii) houses vacant at the time of sale, and (iii) occupied at the time of sale. ll How much does experienceaffect wage rates?The data file cps_small.dat contains 1000 observationson hourly wage rates, experience,and other variables from the 1997 Current PopulationSurvey (CPS). (a) Estimate the linear regression WAGE: Br * P2EXPER* e and discuss the results. Using your software plot a scatterdiagram with WAGE on the vertical axis and EXPER on the horizontal axis. Sketch in by hand, or using your software, the fitted regressionline. (b) Test the statistical significance of the estimated slope of the relationship at the 5Volevel. Use a one-tail test.

72

INTERVAL ESTIMATION

AND HYPOTHESIS TESTING

(c) Repeatpart (a) for the subsamples consisringof (i) females, (ii) males, (iii) blacks,and (iv) white males.What differences, any, do you notice? if (d) For each of the estimatedregression models in (a) and (c), calculatethe least squaresresiduals and plot them against EX?ER. Are any patterns evident? 3.13i) Qspenl Exercise 3.12 using the data file cps.dar,which contains 4?33 observations. This exercise may not work with "student" versions of software.

Appendix 3A Derivation of the /-Distribution
Interval estimationand hypothesistestingprocedures this chapterinvolve the r-distribution. in Here we develop the key result. The first result that is neededis the normal distribution of the least squaresestimator. Consider,for example,the normal distribution of b2theleastsquares estimatorof p2, which we denote as /, l'\ o" b't-Nl 8,. =l

- ) >(*, x)'

A standardizednormal random variable is obtained from b2 by subtracting its mean and dividing by its standarddeviation:

-N(0,l)

(3A.1)

That is, the standardized random variable Z is normally distributed with mean 0 and variance 1. The second pieceofthe puzzleinvolvesa chi-square randomvariable. IfassumptionSR6 holds,thentherandomerrorterme;hasanormaldistribution, e;-N(0,o2).Again,wecan standardizetherandomvariablebydividingbyitsstandarddeviationsothateilo-N(0,1). The square of a standard normal random variable is a chi-square random variable (see Appendix B.5.2) with one degree freedom,so (e;f o)2 - xf,,. trm the randomeffors are of independentthen

,(?)': (7)'*O'** (3)'-*'r,
,r- >a? (N - 4oz v:
a

(3A.2)

Since the true randomerrorsareunobservable replacethem by their samplecounterparts, we the least squaresresiduals Ai : yi - b1 - bzxi to obtain

(3A.3)

The randomvariableVin (3A.3) doesnot havea X2r, distributionbecause leastsquares the residuals arenot independent random variables.All N residuars?; - y; - b1 - b2xi depend on the leastsquares estimators andb2.Itcanbe shownthat only N - 2 of the leastsquares by residuals independent the simplelinear regression are in model.Consequently, random the variablein (3A.3) hasa chi-square distributionwith N - 2 degrees offreedom.That is, when

APPENDIX

38 DISTRIBUTION

OF THE I-STATISTIC UNDER

I11

73

s, (ii) males, (iii) ru notice? ;alculate the least .tternsevident? '733 observations.

multiplied by the constant(N - 2) I oz ,the random variable 62 hasa chi-squaredistribution t'.ith N - 2 degrees of freedom,

,:t

(N - 2\62

-Xir-zr

(3A.4)

: the r-distribution. iquaresestimator. mtorof B2,which

\\-e have nal established the fact that the chi-square random variable V is statistically b1andb2,but it is. The proof is beyondthe scope :ndependent theleastsquares estimators of oi this book. Consequently, V and the standardnormal random variable Z in (3A.1) are :ndependent. From the two random variables V and Z we can form a /-random variable. A r-random rariable is formed by dividing a standardnormal random variable, Z-N(0,1), by the lquare root of an independent cli-square random variable, V -X?^t, that has been divided rr its degreesof freedom, la. That is,

t:

Z

tr*-tt^t

ting its mean and

of Thet-distribution's shapeis completely determinedby the degrees freedomparameter,m, ind the distributionis symbolizedby 4^t. SeeAppendix B.5.3.Using ZandVfrom (3A.1) :nd (3A.4), respectively, have we

Z (3A.1) vith mean0 and f assumption SR6 2).Again,wecan *e;fo - N(O,l). om variable(see :andom errorsare

\/vl(N -2)
(bz

-u,ttrtxr-X I -aqa nN
Y N1
bz-92
l1/ var\oz)

(3A.s)

bz-Fz

bz-92
se(br)

-.t

' \ t -\ - ._ 1

(34.2) tplecounterparts,

in The last line is the key result that we statein (3.2), with its generalization (3.3).

Appendix 38 Distribution

of the /-Statistic Under F11

(3A.3) the least squares b1- b2x;depend 'the least squares :ntly, the random rm.Thatis, when

frr examinethe distribution of the /-statisticin (3.7) when the null hypothesisis not true, .rpposethat the true B2 : l Following the stepsin (3A.5) in Appendix 3,{we would find
::l3t

bz-I t:r.ib;

-ttN-21

:: P' : 1 and c I I thenthe test statisticin (3.7) doesnot havea r-distributionsince,in its : rrmation, the numeratorof (3A.5) is ,?otstandardnormal. It is not standardnormal because ':e incorrect value B2 : c is subtractedfrom b2.

1t Jiat@.74 INTERVAL ESTIMATION AND HYPOTHESIS TESTING : If Bz : l andwe incorrectlyhypothesizethatFzc.. where var(b.\z Since its meanis not zero.1) is not standardnormal.) o2 S/.thenthenumeratorin(3A. as reouired in the formation of a /-random variable..5)thatis (3.7) has the distribution used in forming bz-c (3B. . L\^I -. the distribution of the variable in (3B.

as Learning Objectives Basedon the material in this chapter. Explain the relationship between correlation analysis and R2. and a goodness-of-fit measurein a log-linear model. and Modeling Issues 'd normal. 2. why predictions forr valuesfurther fromx are less reliable. Goodness-of:Fit. Why would you want to scale the variables? 8. Report the results of a fitted regressionequation in such a way that confldence intervals and hypothesis tests for the unknown coefficients can be constructed quickly and easily. a prediction interval. Explain how to test whether the equation "errors" are normally distributed? 13.5)thatis Chapter (38. Explain how to usethe simple linear regressionmodel to predict the value of y for a given valueofx. intuitively and technically. Explain how to compute a prediction. 6. you should be able to 1. Explain the differencebetweenthe slopeof a functional form and the elasticity from a functional form. Explain the meaning of SS?i SSR. 5. and linear-log functional forms.1) Prediction. 11. 4. Appreciate the wide range of nonlinear functions that can be estimated using a model that is linear in the parameters. and how they are related to R2. Explain how you would go about choosing a functional form and deciding that a functional form is adequate? 12. 10.(3A. . 7 . Explain.and SSE. Write down the equations for the log-log. logJinear. 9. Describehow estimatedcoefficientsandother quantitiesfrom a regressionequation will change when the variables are scaled. 3. Define and explain the meaning of the coefficient of determination.

7 Least Squares Prediction In Section2. as Given the simplelinear regression model and assumptions SR1-SR6.3. so that.We want to predictthe conesponding valueof H which we call ys. and it is important to local businesses havepredictionsof growth in neighborhood populationsand income so that to they may expand. COODNESS_OF_FIT. var(es): o2. 4. A\D MODELING ISSUES Keywords coefficient of determination correlation data scale forecast error forecast standarderror functional form goodness-of-fit growth model Jarque-Beratest kurtosis predictor least squares linear model linear relationship linear-logmodel log-linear model log-log model log-normal distribution prediction prediction interval R2 residual skewness In Chapter 3 we focused on making statistical inferences. saving. it is important to governmentpolicy makers who attempt to predict the rates of growth in national income. The ability to predict is important to businesseconomistsand financial analystswho attempt to forecast the salesand revenuesof specific firms.tsand E(eg):0. and testing hypotheses about regression parameters. inflation. A prediction is a forecast of an unknown value of the dependentvariable y given a particular value ofx.In this sectionwe explore the use of linear regression a tool for prediction. and tax revenues. Accuratepredictionsprovide a basisfor better decision making in every type of planning context.3bwe briefly introducedthe idea that the leastsquares of estimates the linear regressionmodel provide a way to predict the value of y for any value of x.is prediction.or contract. We also assumethat es has the same varianceas the regressionerrors.{0be a valueof the explanatory variable. and e6 is . In orderto useregression analysis a basisfor prediction. investment.Another purpose of the regressionmodel. A prediction interval. much like a confidence interval. For each observation in the sample the difference between the predicted value ofy and the actual value is a residual.let.their provision of services. in particulaq SR1 holds for theseobservations )o : 9r I }zxo I eo (4. Diagnostic measuresconstructed from the residuals allow us to check the adequacy of the functional form used in the regressionanalysis and give us some indication of the validity of the regression assumptions. We assumethat E0i0): 9t * B2. is a range of values in which the unknown value of y is likely to be located. social insurance program expenditures.76 PREDICTI ON. Examining the correlation between sample values of y and their predicted values provides a goodness-of-fit measure called R2 that describes how well our model fits the data. constructing confidence intervals.we mustassume ys andxs are as that related to one another by the same regressionmodel that describesour sample of data. and the one we focus on first in this chapter. will examineeachof theseideasand concepts We in turn.1) where es is a random error.

2) That is.4.7 A pointprediction.we can show (seeAppendix 44. f : vo -.:r. implying that our forecastis close to the value ae are predicting. Using (4. This result is reasonablegiven that the least squares stimators b1 and b2 are best linear unbiasedestimators. Note that the variance of the forecast error is smaller when . .on average.We would prefer that the varianceof the forecasterror be 'mall.1) We also rd e6 is \otice that someof the elementsof this expressionappearin the formulas for the variances . .***#=rA var(/) (4. equacy of ion of the I concepts j. so that cov(es.It :'-rllows predictor io: br * b2xsmust also be random.lo : (9r * 9zxoa no). The probability ofa small forecasterror also dependson the varianceofthe :orecasterror.retrying to predict.'r199351 errOr iS the linear ability to r forecast kers who :. How good is this prediction procedure?The least squares .t'nt 4.o:h*b2xs (4.e) :0 = | . While we will not prove it. residual.as shown in Figure 4. which is analogousto the -<astsquaresresidual.3) and what we know about the variancesand covarianceof the least squares 3:timators.ln(bt) + E(b2)xgl :9r*1zxo+0-[9rfFzro] -0 r hich means.so :"[. . and !6 is an unbiased predictor ofys.2. To evaluate that the least squares :ou well this predictor performs we define the forecast error.1.4) (4. The least squares predictor of ye comes from the fitted regressionline confidence ose of the ediction is valueofx. N.1 LEAST SQUARES PREDICTION b2 xi listribution terval . Taking the expectedvalue of/we find E(f) : Fr * Fzxo+ E(es) .unbiasedness doesnot necessarilyimply that a particular forecastwill be close to jre actualvalue. which would increasethe probability that the prediction j's is close to the value ys we r. saving. .(h * bzxo) (4. in which r between I measure ion in the . -ncorrelatedwith the random errors that are part ofthe sampledata.the forecasterror is zero. at the end of this chapter)that the varianceof the i. the predicted value !e is given by the point on the least squaresfitted line where : = -r0.3) 1\'ewould like the forecasterror to be small. to local re so that lrovide a : explore value of e call ye.itimators bl andb2 are random variables-their valuesvary from one sampleto another. nd-16 are data. !s is the best linear unbiased predictor (BLIIP) rf re if assumptionsSR1-SR5 hold. However.rfthe leastsquares estimatorsand affect the precisionof prediction in the sameway that they rffect the precision of estimation. .

+7 its estimator62 to obtain by .xe from the samplemeanx.Intuitively.t1.41. This fact shows up in the size of our prediction intervals. our predictions for valuesof xs close to the samplemeanx are more reliable than our predictions for values of xe far from the samplemean t.t" se("f) prcunp 4.-t -. . u-I ':!'n :th : -f | r | i I L N - -].se(/) (4. ----------------.s) Definingthecritical valuet.asmeasured the varianceof the by random errors ol.reis from the centerof the sampledatathe larger the forecast variancewill become. to be the 100(1.. the is of the larger the varianceof the prediction error and the less reliable the prediction is likely to be. In other words. . GOODNESS-OF_FIT. and we will have less accurate predictionswhen we try to predict outside the limits of our data.:dt .The more distant.(x.\\I) \4ODELING ISSUES i.78 PREDICTION. A point prediction is given by the fitted least squaresline !s : bt * bzxo.2 Point and intervalorediction. (x0-xl / -\Z I I I ). Becausethe forecast variance increasesthe farther xo is from the !o + r"se(/) b )s =b1+ 2xs fo .6) See Appendix 4A for some details related to the development of this result.which measures how farxe is from the centerof the x-values. the samplesize N is larger.The prediction interval takesthe form of two bandsaroundthe fitted least squaresline. farther. Following our discussion var(/) in (4.2. iv. this meansthat we are able to do a betterjob predicting in the region where we have more sample information. can we obtain a 100(1. and the valueof (xs .t . the variation in the explanatoryvariableis larger.:lllp '.t)'. the overalluncertaintyin the model is smaller. iii.ct)7oprediction interval as j'et r. The relationship betweenpoint and interval predictions for different valuesofxe is illustrated in Figure 4. .T)'JI . ii. .-: S The new additionis the term (ro . In practicewe replaceo2 in 14.)2 is small.. The squareroot of this estimated variance is the standard error of the forecast se("f): var(f) (4._-.af 2)-percentile from the r-distribution.

the basis of a single householdcharacteristic.6328) : [104. rhich is a complicatedphenomenon.o ..1. While income is a key factor in explaining food expenditure.1323.6) re obtainedthe values62 :8013. To more accurately redict food expenditurewe may needto include theseadditional factors into the regression rodel. We have obtained this wide prediction interval for re valueof xs : 20 that is closeto the samplemean7 : 19.1 LEAST SQUARES PREDICTION 79 riance of the 'ample mean of . If we select I . This should not be a surprise. f.61on food using the calculation io : br * b2xs: 83.09on food.7.2096(20): 287.08s4) thrr prediction interval suggeststhat a household with $2000 weekly income will spend r-rmewhere between$104.r.3b we predicted that a household with xs : $2000 weekly income would gend $287. The unreliable predictions may be i. For valuesof t that aremore 3\reme the prediction interval would be even wider.7)'var(bz) 1+ Lr the last line we haverecognizedthe estimatedvarianceof b2from(2.we can ^ .3818.6069 +2._ . Extending the simple regression model to include other factors will begin in Chapter5. The estimatedvariance :f the forecast error is :a.61 is not very reliable.2 (4.13and $471. rore reliable ws up in the :dictions for e fitted leasr s around the is from the rl 6328.s) rtion. the likely to be. in this example the magnitude of :re estimatederror variance62 is very close to the estimatedvariance of the forecast error .21).#+. @1 )cast (4.cr : 0.In Section2.sts. -r+ 6 '+ N \xo . on -:L-ome.2941ardi *@r-) :4.[r+*. .0244(90.However.60.rghtly improved if we collect a larger sample of data. : t(o.1 PnrnrcrroN rN THE Fooo ExpENDrrrrRE MooEr center of the t the forecast rb predicting less accurate Ln Section 2.Using these 'alues we obtain the standard error of the forecast se(/) : : meanx. then t.95.4. which will improve the precision eith which we estimatethe model parameters.zz\ :2. suggestingthat the primary uncertainty in the forecastcomesfrom large uncertainty r the model.fr|.6089 \ow we are able to attacha "confidence interval" to this prediction. since we are predicting household behavior. For the food expenditure :rta N : 40 and the samplemean of the explanatory variable is t : 19.tl increases. Sucha wide interval meansthat ourpoint lediction $287. and increase1n ridth as lxo .4160+ 10.we can imagine many -rher household demographic characteristics that may play a role.471.0244 and the 957o prediction ''rterval for ys is !e * r.se(/) :287.6048.3.. the confidencebands are their narrowest when xs : f.

. The breakdownin (4. into its explainable and unexplainable components. and e.3 the "point of the means" (f.i_y)+Zi (4 lo\ . of .y and a part that is unexplained2. as possible.\ll .\i prcunn 4.r..ld I . analogousto (4.nl As showninFigure4.80 PREDICTION.andits meanvalueyconsists apart thatis of "explained" by the regression model yi . separatingy. To develop a measureof the variation in y. Thesetwo objectivescome under the broad headings of estimation and prediction.7) we call r. Closely allied with the prediction problem discussedin the previous section is the desire to use x.) changes as the independent variable (x.0given an r0.3 Explained and unexplained components .. 10) leadsto a decompositionof the total samplevariability in y into explainedand unexplainedparts.. with the least squaresfitted line passing through it. we begin b1. While both of these parts are unobservableto us.4) that det = unexplained component \xi.8) I l where E(y..1."systematic" componentof y... xxi At .In the regressionmodel (4. This is a characteristic of the least squaresfitted line whenever the regressionmodel includes an interceptterm. to explain as much ofthe variation in the dependent variable y. that is explained by the model. In Figure 4. unsystematicand unexplainable component of y. into the li:yi-t?i (4.3 the difference betweeny. 2 Measuring Goodness-of-Fit Two major reasonsfor analyzing the model Yi:9r l9zxilei :we :rea (4. we can estimatethe unknown parametersB1 and B2 and.\T) MODELING ISSUES 4.9) where j. : br * b2x.Recall from your statisticscourses(seeAppendix C.is the explainable.We have assumedthat yi: E(yi) * ei Ihe :rd 1 .) : 9r f B2x. the "explanatory" variable becausewe hope that its variation will "explain" the variation in y. Ji) i=bt+bzx (x.yi.C! l-qu r:fd (4. ii) y) Cx. and ?i: yi . Subtractthe samplemean y from both sidesof the equation to obtain yi_!:(j. GOODNESS_OF_FIT.and to predict ). decompose value of y.1 changes.7 ) are to explain how the dependentvariable (v.. y) is shown.8). is the random.

10).Also known as the unexplainedsum of squares. it is interpreted as "the :roportion of the variation in y about its mean that is explained by the regressionmodel.called the coefficient of &termination.11)givesus a decomposition the "total samplevariation" iny into explained of nd unexplained components.4)that R':ssR:l-SSE s^sr ssr (4. and using the fact that the cross-productterm l(!.:Z(Y. When 0 < Rz < 1.If we square r-rd sum both sidesof (4. analogousto _ ur.4. r)' .If Rz : 1. N_l Thenumeratorof this quantity. --y)2 +2a? (4. is the ..4.2. then the leastsquares fitted line is "horizontal.ee Appendix 4B)." If the sample data for y and -r are :ncorrelatedand show no linear association.10) ts ofa partthatis :d 2.7) lent variable (x." r.y) ory liardlinj oxoy (4. the regression. so that SSR: 0 and R2 : 0. and the model fits the data "perfectly. or due to.between .11) becomes theseabbreviations SS?": SSR+ SSE This decompositionof the total variation in y into a part that is explained by the regression :. about the sample mean.u* of squaresdue to the regression: SSR:that part of total variation in y. . r:rd the samplemeany.8) y.r and y is defined in (B. are to the fitted regressionequation .20) as Ptv : cov(x.e) fittedline truares re whenever the 'ombothsides of (4.natory" variable del.1 Conngerro\T ANALvsrs Lr Appendix B. riability into iny rpendixC. l. these "sums of squares" are I . I(lr .11) F4uation(4.the residual sum of squares. we begin by re assumedthat (4.t2) romponent The closer R2 is to 1.or the sum of squarederrors." r-ndidentical to t.3 we discuss the covariance and correlation between two random iariables x and y. .. '-'iing (4. and e..y)Oi : 0 .y7v. . *. We will do so now to develop a :'eful relationship between the sample correlation coefficient and R2.r3) \\'e did not discussestimating the correlation coefficient.) e broad headings discussed the in in the dependent .two descriptive measures the sample are :rean t and the sample variance (4. (4. SSE : 0.y)2 : ." 1. the sum of squareddifferencesbetweenthe samplevaluesy.. that is explained by.f these parts are nd.. the closer the sample values y.y)' :2(i.odel and a part that is unexplainedallows us to define a measure. we obtain r(y' . The correlation coefficient p.Also known as the "explained sum of squares. = br I b2x. that is the proportion of variation in y explained by x within the =gressionmodel.r)' : total sum of squares: SSZ:a measureof total variationin y about the sample mean. then all the sampledatafall exactly on the fitted least squares line. I(yr . or R2.2 MEASURING GOODNESS_OF-FIT 81 :: *e havea sampleof observations)r. is a measureof the total variation in the samplevalues. Za! : sum of squaresdue to error : SSE:that part of total variation in y about its mean that is not explained by the regression. .)2.Specifically.

-rns The sample correlation coefficient r. iriati . and !. and it measuresthe strength of the linear associationbetween observedvalues ofr and y. This interpretthe ation is not far from that of R2: the proportion of variation in y about its mean explained by x in the linear regressionmodel. ! l a Look at the food expenditureexamplein Section 2. The second.r -.14t co :rplai :ls a where 6. 4.. Furthermore.: l ec :-aon ::'. falls between0 and I and measures strength of the linear associationbetweenx andy.in the simple linear regression model. Rz : *yi.alu :. AND MODELING ISSUES Given a sampleof data pairs (.1) 0x: :3por . has a value between . is algebraically equal to R2 in a simple regressionmodel. Intuitively this relationship makessense:f.). . . Consequently R' is sometimes called a measure of "goodness-of-fit.. the samplecorrelationcoefficientis obtained by replacing the covariance and standard deviations in (4.betweenthe the sample data and their predicted values.set :'.13) by their sample analoss: 'A'e o-. Go ahead. GOODNESS_OF_FIT. relation is that R2 can also be computed as the squareof the sample correlation coefficient betweenyi andyi : h -l b2x. ord.160 sSE: I(y.rbrr . N.t)/(N .. and the computer output Fi gure2. That is.-. The first is that Po: R2.y. 4.9..Thatis.1\t -')'lwr(y.r.lln .2.:.the conceptof obtaininga goodness-ofas fit measureby predicting y as well as possible and finding the squaredcorrelation coefficient between this prediction and the sample values of y can be extendedto situations in which the usual R2 does not strictly apply. 1 . -: an ':t4 :.y..ill b Cc -.y:Z(xi -7)(y' . andin particularthe data scatterand fitted regressionline in Figure 2. i : 1.)' :2a? :304505.r. The questionwe would like to answeris "How well doesour model fit the data?" To compute the R2 we can use the sums of squares SSZ: I(y. .I and 1.3.y)' :495132.I will wait until you get back. you will seein Section4.2. . (4. the square of the sample correlation coefficient between the sample data values x."lnst (/.ns ':lue 2.fl'l@ J:OSS- :agre '.82 PREDICTION. tel .3 TnE Fooo ExpENonurc Exervrprr . 1 .116 . :recis spen . A In ::Il C 1.2 CoRnpranroN ANALYSTs AND R2 -a sir There are two interesting relationshipsbetween R2 and r." This result is valid not only in simple regression models but also in multiple regression models that we introduce in Chapter 5. As suchit measures linear association.or goodness-of-fit. and more important.4.2. . .8.

the precision of their estimation.their statistical and economic significance.'onstructive.with only one explanatory variable. in Correlation analysisleads to the sameconclusionsand numbers. R 2: 0 .theseresults can be presentedquite simply. With cross-sectional data R2-valuesfrom 0.848)(tr2.176 :O.4r).an indication of statistical significance. rdness-oforrelation .57oof the variation in food expenditure (about its sample mean) is explainedby our regressionmodel. Other model diagnostic issues *ill be discussed the next section.. 3 8 5 .1s) asuresthe regression We conclude that 38.4 we plot the samplevaluesof y. You s-an corfiffi that the correlation between these values is riu: 9. 1.tendedto - Oxoy (6. when communicating regression results avoid using symbols like x and y.defining the variablespreciselyin for a separatesection of the report.Microeconomic household behavior is very difficult to explain fully.09)--. and their correspondingfitted values!.. The sample correlation between the y and x sample valuesis on 418.4 RrponrrNc rHE RssuLTs In any paper where you write the results of a simple regression.75 :oefficient r a simple en0andI interpret.and R2. f In Figure 4.2 MEASURING GOODNESS-OF-FIT 83 :fficient is :ir sample Then R2:1 ssE ssr " _ -304505. For the food expenditure example.160 (4. The key ingredientsare the coefficient estimates. A s e x p e c t e dr : 0 . routinely report R2-valuesof 0. we might have the variable definitions: FOOD_EXP . indicating a positive associationbetweenfood expenditureand income. in dollars INCOME: weekly householdincome.2.r4) (4. Macroeconomic analyses using time-series data. That is. While finding and reportingR2 provides information about the relative magnitudesof the different sourcesof rariation. its mean ted as the .67s) :0.40 are very common even with much larger regressionmodels. (2.onstruct the estimates.y :0. which often trend togethersmoothly over time. Is this a good R2? We would argue that such a question is not useful. with a maximum value of 1.21 (r") (43. which usesonly income as an explanatory variable. The sample correlation measuresthe strength of the linear association.42 + 10. debates about whether a particular R2 is "large enough" are not particularly . You should not evaluatethe quality of the model basedonly on how well it predicts the sampledatausedto .62. Use abbreviations the variablesthat arereadily interpreted. 6 2 2 : 0 . the Also. )tweenthe s called a :egression )hapter 5.weekly food expenditure by a household of size 3.but it is worthwhile to considerthis approachin more detail. in $100 units catterand iwillwait rdelfitthe Then the estimated equation results are INCOME FOOD-EXP :83.To evaluatethe model it is as important to consider factors such as the signs and magnitudesof the estimates.90 and higher. and the ability of the fitted model to predict values of the dependentvariable that were not in the estimation sample. standarderrors (or r-values).10 to 0. 3 8 5 : R 2 .3lt5 I 495132.4.62 The correlation is positive.62 indicates a non-negligible but less than perfect t i t . The value r.

f 2 x se. it changingany ofthe real underlyingrelationships betweenvariables.A-PDF Split DEMO : Purchase from www. A\I) MODELING ISSUES i3 . tc\ -.2 are greater than 30) is b7.000.023.'lOr '::nd Report the standarderrors below the estimated coefficients. ..3 t[odeling Issues 4. Sr . significantly different from zero using a two-tail test) coefficients.9.8)12. Asterisks are often used to show the reader the statistically significant (that is.0.com to remove the watermark 84 PREDICTION.was$8023.6 in as billion annually.rJ t00 FTGURE 4. can be alteredwithout analysis. The reader may then divide the estimateby the standarderror to obtain the value of the t-statistic if desired.L ' .600.llar .: lt c --. ir 4.3..JOn N ata _clc .While we cor.That is.4 y = weekly food expenditure in $ Plotof predictedH j'.-. . For example. r'fe : . of the lst quarterof 2006.09)land proceed with the steps of the test procedure. as in Fisure 2.A-PDF. 600 -:ih t v T} -.21 . 8 trillion 23 billion 600 million or dollars.000.r/duse long form of thenumberin a tableor in aregression the analysis. . written out.To test the null hypothesis Ho:92: 8.1 TnE Eprncrs or ScarrNc rHr Dana Data we obtain are not always in a convenient form for presentationin a table or use in a regression When the scaleof the data is not convenient.the real personal consumption the United States. a o Yo :. Furthermore. we can quickly constructthe r-statistic7 : l(10. with explanations in a table footnote: * indicatessignificantat the 107olevel x* indicatessignificantat the 5Volevel *** indicatessignificant atthe l%olevel The asterisks are assigned by checking the p-values from the computer output. The reason for showing the standardelrors is that an approximate 957o interval estimate (if the degreesof freedom N . $8. testing other hypothesesis facilitated by having the standarderror present. GOODNESS-OF-FIT.-.rlin Cc Jol a o loo a a: aao a aa ot a Oa -a ..againsty.

Bi + Bix* e*.* e. then therewill be no change in the reported regression results for b2.r*: x/c.the real 3. That is. /-statistics and R2 are unaffected. Such a changein the units of measurementis called scaling the data.1 we report weekly expenditures in dollars but we report income in $ 100 units. . but these magnitudes are more easily discussed. and c : 100. The choice of the scale is made by the researcherto make interpretation meaningful and convenient.This will affect the standarderrors of the resression coefficients.:0.by a factor of 100.3 MODELING ISSUES 85 there is no advantageto doing so. First. That is. The interpretationis "If weekly householdincome increases $1 then we estimatethat weekly by food expenditurewill increaseby about 10 cents." we have taken a long number and made it comprehensible.Forexample. and Bi is 100 times larger than B2.41)(0.1021.21. suppose we changethe units of measurementof the explanatory variable r by dividing it by a constant c.4. the results would have been TNCOME($)R'.Fr *Fzxf e: 9r* (cB2)(xlc) * + F)x. rr use in a :d without ." There is nothing mathematically wrong with this. so a weekly income of $2000 is reported as x : 20.385 FOOD_EX?:83. all the coefficients must change in order for the equation to remain valid. the r-statistic.e.0209)--(r") There are two changes.In thisrescaled model Bi measuresthe changewe expect in y* given a l-unit changein -r. Why did we scale the data in this way? If we had estimated the regressionusing income in dollars.thenr* is measured hundredsof dollars. y.42 + 0. Becausethe error term is scaled in this processthe least squaresresiduals will also be scaled.r.where9): c9zand. In order to keep intact the equality of the left. but it doesaffect the interpretation of the coefficient estimatesand some summary measures. The choice of the scale does not affect the measurementof the underlying relationship. When the scale of x is altered the only other change occurs in the standarderror of the regressioncoefficient.1021 (43. In Table 2. Then Bj in measuresthe expectedchange in y given a $100 increasein x.What are the effects of scaling the variables in a regressionmodel? Consider the food expenditure model.The interpretation of the parametersis made relative to the new units of measurement. By choosing the units of measurement be "billions of to dollars. Changing the scale ofx: In the linear regressionmodel y : Br * B2x * e. Changing the scale ofy: If we changethe units of measurement H but not . the estimated coefficient of income is now 0.ifxis ":9t measuredin dollars. the coefficientof r must be multiplied by c.sting other hypothesis nd proceed rt (that is. but the estimated intercept and residuals will change. All other regressionstatistics are unchanged. then ylc : (fu lc) + (9zlc)x+ (elc) ory* . as in of 2. this leaves the t-statistic and all other results unchanged. howing the of freedom nate by the . An increase income of $100 leadsto an estimatedincreasein food expenditureof $10. If the scaleofy and the scaleofx arechangedby the samefactor. but it leads to a discussionof changesthat are so small as to seemirrelevant. so that their ratio.Since the estimatedcoefficient is smaller by a factor of 100 also. The other changethat occursin the regressionresultswhen income is in dollars is that the standard error becomessmaller. but it changesby the samemultiplicative factor as the coefficient. is unaffected.6billion l0 million r analysis. Let us list the possibilities: l.and righthand sides. as in before. but it will not affect /-statistics or R2. anations in tput.

If you havenot doneso. readAppendix A.as incomeriseswe expectfood expenditures to rise. What it meansgraphicallyis that there is not a straighrline relationship between the two variables. AIso.we have assumed that the mean householdfood expenditureis a linear function of householdincome. but we expect suchexpendituresto increaseat a decreasing rate. That is. The variable transformationsthat we besin with are l . In fact. which implies that there is a linear. 3 .Instead. Power: if . 2 . This is not an easyprocess and it requiresgood analyticgeometryskills and some experience. The reciprocal:ifr is a variablethen its reciprocalis llx. we do not expect that as household income rises that food expenditures will continue to rise indefinitelyat the sameconstant rate." a straight line is a good approximation to many nonlinear or curved relationshipsover narrow ranges.4 and Appendix A. The simple linear regressionmodel is much more flexible than it appearsat first glance. and we wanted to easeyou into the more "artistic" aspects econometrics. What doeseconomics really say about the relation between food expenditure and income. and that it might look something like Figure 4. The natural logarithm: if r is a variable then its natural logarithm is ln(x).2. 5 A nonlinearrelationshipbetweenfood exoenditure and income. Mark Table A. we assumedthe underlying economic relationship to be E(y) : Pr * B2x.3 with paperclips so that you can find them easily. By transfurmfugthe variablesy andr we can representmany curved. demand and consumption functions.86 PREDICTION. examples are quadratic (x2) and cubic (x3) transformations. straightJine relationship between E$t) andx. Choosing an algebraic form for the relationship meanschoosing transformatio. .r is a variable then / meansraising the variable to the powerp.2 CHoosrNc e FuNcrroNer Fonnr In our ongoing example.rzs the of original variables. Why did we do that? While the world is not "linear.nonlinearrelationships and still usethe linear regression model. FIGURE 4. A\I) -\1 DELING O ISSUES 4. holding all else constant?We expect there to be a positive relationship between these variables because food is a normal good. But nothing saysthe relationshipmust be a straightline.2 and Figure A.4. of The starting point in all econometricanalysesis economic theory. GOODNESS-OF_FIT.Itmay not come to you easily.3. inyourprinciples of economics you classes may havebegunwith straightlines for supply. This is a phrasethat is usedmany times in economicsclasses.5.

The log-linear form is common.3 ODELING ISSUES M 87 nditure is lconomic dght-line linear. we will treat it fully in Section4.4.SeeFigureA. you may be less familiar with logarithmic transformations. In the log-log model both the dependentand independentvariablesare transformed by the "natural" logarithm." a er nalTow .r only the dependentvariable is transformed by the logarithm. becausethe logarithm is defined only for positive numbers.{A) loo The term 100(Ax lx) is thepercentagechangein x. which we expectto bepositive but diminishing.AA. or if 0 < 92 < 1 a production relation.You should readAppendix A. Thus in the linear-log model we can say that a lVo increasein.2.3f..3.For each different functional form.Theslopeofthisfunctionis LylL*:B2f xandit changesat every point.4 and ind them . 1. For example. asimplied by the linearJog model.let us summarize the Because rnterpretation threepossibleconfigurations. What this means for the practicing economist is that great attention must be given to result interpretation whenever variables are transformed.3 two possiblechoicesthat in are similar in some aspectsto Figure 4. because rct.we do te to rise enditures rrasethat eisnota hing like .4. 3. The model is ln(y) : 9t * B2ln(x).supposethat we are considering a production relationship where y is output. In the log-linear model ln(y) : 9r * Fz. In each case interpretation is convenient becausethe elasticity is constant.3 TnE Fooo ExpsNDrruR-EMoon Supposethat. in the food expendituremodel. if 9z > 1 the relation could depict a supply curye.onomics . .t glance.+.5. In panel (d).r leadsto a B2/ 100 unit changein y. A one-unit increase in x leads to (approximately) a I0O x B2% changein y.omplete discussion of the algebra. shown in Table A.3e. 4. If the estimated relationship is OUTFjT: 100 * 7001I(LABOR). In panel (c). The dependentvariable must be greater than zero to use this form. if 92 < 0 it could represent a demand curve. Lety be daily manufacturing output and x the number of hours of labor input per day.6for a in .4. such as labor. or al0%o increase labor will increase in in daily output by 70 units.nsof the try skills s that we L singjust thesethreealgebraictransformationsthereareamazingvarietiesof "shapes" that rre can represent. the function decreases. We can interpret B2 by rewriting the slope expressionas :xamples AY : 9z rooG. all else .This is so because the variablesare related nonlinearly.thenweestimatethata lZoincreaseinlaborinputleads to a7-unit increase y. loglog model specificationso frequently. For now. From the array of shapes Figure A. and x is an input.2.as shown in Figure A.3. its slope is larger for larger values of y. If Bz > 0 the function increasesat an increasing rate.3. A difficulty introduced when transforming variables is that regressionresult interpretationschange. In the linear-log model ):9r *B2ln(x) the variable x is transformedby the naturallogarithm. In orderro usethis model both y and x must be greaterthan zero. In this casethe slope of the function is the "marginal product" of labor.5 arethe reciprocal model and the linear-log model. A convenient interpretation for the log-linear model is developed in Appendix A.5. Referring to Figure A. you can seewhy economistsusethe constantelasticity. The parameter B2 is the elasticity of y with respect to r.4. 2. the expressionsfor both the slope and elasticity change from the linear relationship case. but at a decreasingrate. tionships \. we wish to choose a functional form that is consistentwith Figure 4.ightlines the more . If 9z < 0. note its possible shapesin Figure A.

REMARK: Given this array of models. While theseobjectives easilystated. this "marginal propensityto spendon food" diminishes.in the reciprocal model.Theseresults are consistentwith the idea that at high incomes. Even so. one practical guideline is to consider how the dependent variable changes with the independent variable. which says that as income increasesthe household expenditure on food stops increasing after some point.l . and large food expenditures. what are someguidelinesfor choosinga functional form? 1. Our job is to choosea functional form that satisfactorily meetsthe three obiectivesstatedabove. Choose a shape so that assumptionsSR1-SR6 are satisfied. and. as income increases.This model is linear in theparameters it is nonlinearin the an but variables. reality of modelbuilding is muchmore difficult. This property is <-9zl9r unrealistic.then the unknown parameters can be estimatedby least squares. If this is the case. ignoring the error term. asx becomesvery large the slopeapproaches zero. A\I) \ 1O D E L I N G ISSUES Thesetwo functional forms are different ways of modeling the data and lead to estimatesof the unknown parametersthat have different economic interpretations. GOODNESS_OF_FIT. Another property of the reciprocal model. As INCOME increases the slope \yIINCOME decreases. then is B2 there is a positive relationship between food expenditure and income. but at a decreasingrate. if the error term e satisfiesour usual assumptions.as economictheory predicts. that involve different transformations the of dependent and independent variables. 3. it implies that this functional form is inappropriatefor small values of income. Similarly. When choosing a functional form.lt I . in this context the slope is the marginal propensity to spend on food from additional income. and inferencescan be made in the usual way. Choosea shapethat is consistentwith what economic theory tells us about the relationship. household consumption offood increases a decreasing and at rate reaches upperbound 81. Choose a shapethat is sufficiently flexible to "fit" the data. no matter how elegant. thenasincomeincreases. are the You must recognize that we never know the "true" functional relationship between economic variables and the functional form that we select.88 PREDICTION. the elasticity. An alternative to the reciprocal model is the linearJog model FOOD_EXp: gr * B2Ln(INCOME)_r e )r li: :to . is only an approximation. is that when /NCOME the model predicts expenditure on food to be negative. Re :h FOOD-EXP: bffi+ BI- C -in For the food expendituremodel we might assumethat B1> 0 and 9z < 0.ensuring that the least squaresestimatorshave the desirable properties describedin Chapters2 and 3. The reciprocal model in this case is 1.If the parameter ( 0.the effect of an increasein income on food expenditure is small. In the reciprocal model the slopeof the food expenditure relationship -$21 INCOME2. 2.e :to For B2 > 0 this function is increasing.and some of which have similar shapes. B2l FOOD-EXP.Indeed.As noted above. becomessmaller for larger levels of food expenditure. .

99.sowe must baseour analysisof their normality . 6 EViews statistics for food exoenditure output: residuals histogram summary :xample. So. For a normal distribution the kurtosis value is 3. and hencethe dependentvariabley.2 and C. it is nevertheless desirableto havea model in which the regression errorsarenormally listributed. just checking the shapeofthe histogram is not a rutistical "test.968826 100 200 0 and r tcunr.tre "peakedness" of the distribution.0255 88. but there are some large gaps.. skewnessrefers to how symmetric :he residualsare around zero.4. and it does eot really appearbell-shaped. The skewness value for the food expenditure residuals is -0.However. is ly meetsthe Jarque-Bera 0.4.3 MODELING ISSUES 89 estimatesof +. Most computer software will createa histogram of theresidualsfor this purposeand may also give statisticsthat canbe usedto formally testa rull hypothesisthat the residuals(and thus the true errors) come from a normal distribution. one of the criteria we might examine is rhether a model specificationsatisfiesregressionassumptions." when choosing a functional form.097319 2..omic theory 'oaches zero. we see and rhat the food expenditure residuals have a kurtosis of 2.4.6. and in particular whether it -eads errors that are normally distributed (SR6). As noted in the last "Remark. Second. The Jarque-Bera test for normality is basedon two :neasures. sing rate and . the question we have to ask is isis the case.rr not.While our tests rnd confidenceintervals arevalid in large sampleswhether the dataarenormally distributed ." There are many testsfor normality.6.rn the least squaresresiduals.If the errors are not normally distributed we might be able to improve our model by considering an elternativefunctional form or transforming the dependentvariable. skewness and kurtosis. then [. as income . notice that it is centeredatzero.2.Dev. are normally distributed. The relevantEViews output for the food expenditureexample.2i : yi .93e-15 -$. In the presentcontext. What does this histogram :elf us?First..east squaresresiduals is always zero if the model contains an intercept. How do we check out the assumptionof to rormally distributed errors? We cannotobservethe true random errors. re results are : effect of an il "*l :s. so that we do not have to rely on large sampleapproximations.324473 212.using the linear relationship n ith no transformation of the variables.3.linearin the he unknown Le usual way. as shown in Appendix 48. Jer how the rl model the Bz ( 0.j. it seemssymmetrical.what are s about the I I Series: Flesiduals 1 Sample 40 Observations40 Mean Median Maximum Minimum Std. enINCOME property is .063340 Probability 0.0440 -223. For more on skewness kurtosis seeAppendicesB.989034 I ne that the I I z cianters I ore difficult.4.4 Anr rnn RpcnrssroN Ennons NorutlRrlv Drsrnrsurpo? Recallthat hypothesistestsand interval estimates the coefficientsrely on the assumption for :hat the errors. The skewnessand kurtosis r aluesare close to the valuesfor the normal distribution.From Figure 4. Kurtosis refers to .36190 -0. rs increasing fE increases slope is the he elasticity.097.sof income. Perfectly symmetric residualswill have a skewnessof zero. rip between r elegant. appearsin Figure 4. This is not surprising because mean of the the . Skewness Kurtosis 6. -200 -100 .

More will be said on thesepoints as we move through the text. Direct data on in changes technologyarenot available.onr' .99 is sufficiently different from 3.097 sufficiently different from zero. -':t t '-'r YIELU: 9r * B2TIMEI e1 .3. 48.{\I) \. ." Thus. we also fail to reject the null hypothesison the groundsthat 0.7 that wheat in yield fluctuatesquite a bit. GOODNESS_OF-FIT. Thesedatacanbe found in the filewa-wheat.+) where N is the sample size.ia I How doesone choosethe besttransformationfor y andx.rh I rt! .5 ANoruEn Eruprnrcar Exauprr ICt .48.The equationof interestrelates YIELD of to TIME. . we can examinehow wheatyield haschanged in but over time as a consequence changing technology.andthe IVocnticalvalueisg. Figure 4. .The Jarque-Berastatisticis given br tt:z (". . So far.063 < 5.99 thereis insufficientevidencefrom the residuals concludethat the to normal distribution assumptionis unreasonableat the 5Volevel of significance. The observations are for the period 1950_1997.1.9688 > 0.dat.and a tonne is a metric ton that is 1000 kg or 2205 lb-we are speaking Australian here!) for the Greenough Shire in Western Australia..IODELING ISSUES whether 2.rD __ r . we have focused on theoretical issues. overall. The 5Vocritical value of fromaX2-distributionwithtwodegreesoffreedomis5.063 Because 0.2l. An increase in yield is expected because technologicalimprovements. and -0.When the residualsare normally distributed. will lead to a largevalue ofthe Jarque-Berastatistic.te .5 acres. . 4. We reject the hypothesis of normally distributed errors if a calculated value of the statistic exceeds a critical value selectedfrom the chi-squareddistribution with 2 degrees freedom. where TIME . particularly toward the end of the time period. we have . and the increaseis at an increasing rate. large values of the skewness. S is skewness. and/orvaluesofkurtosis quite different from 3.The same conclusion could have been reachedby examining the p-value. One problem with the linear equation . 2. Thus. Applying these ideas to the food expenditure example. and K is kurtosis. Supposethat we are interested measuringthe effect of technologicalimprovementon yield.The best we can do is give examplesand describeall the issuesthat are worth considering.*.u:T(-o.with questionslike: Does a selectedfunction possessthe theoretical propertiesconsidered desirablein the economic relationship being examined?We also mentionedthat we should choosea function suchthat the propertiesof the simple regressionmodel hold. of suchas the development varietiesof of wheat that are higher yielding and more resistantto pestsand diseases. and hencethe bestfunctional form for describing the relationship between y and x. The p-value appearsin the EViews output describedas "Probability. to concludethe residualsare not normally distributed. .05.-) :0.Notice Figure4. it tendsto increaseover time. and time is measured using the values l. but.gg. Unfortunately there are no hard and fast rules that will work for all situations. In this sectionwe turn to some empirical issuesrelated to the choice of functional form.90 PREDICTION. . .the Jarque-Berastatistic has a chi-squareddistribution with two degreesof freedom.7 describesa plot of averagewheat yield (in tonnes per hectare-a hectare i: about 2. against time.

638+o.0 0.and residualvalue.rt it implies that yield increases the sameconstantrcte 82.5 i. 8 Predicted.7 thatwheat rcrease at an is rsein yield is of varietiesof )sethat we are )irect data on d haschanged relates YIELD -1.Notice that the of -.0022) unctionalform r hard and fast nd describeall al issues.The valueson the x-axis represent years 1950-1997. when. The the values 1.:i::/Vi:-i-"'.The least squaresfitted line (standarderrors in :intheses) is rIMEt fiEID.\pect this rate to be increasing.along with the actual valuesfor YIELD. tiom linear equation.]S +.5 0.64s .0 .0 Rz:0. tr 2. The lower part of the graphdisplaysthe residuals. ::. . at . '::eredaroundzero. Time rnclude that the rnce.V-'J i\f' 75 80 85 90 95 70 55 60 65 50 .7. 4.rl.:0.-' titted valuesfrom this regressio n lftEIO. with ies considered that we should J. t . are .0 1.More will be ome empirical :-a hectareis : are speaking rst time.The same : appearsin the I hypothesis on nt I .064) (0.p t 4 . from Figure 4.rvedin the upperpart of Figure4.21 .actual.8.--Residual Actual Fitted rr\ i I v:.:!'is a concentration positiveresiduals eachend of the sampleanda concentration at of 2'5 yierd ..o21o (s") (0.T. .3 MODELING ISSUES 91 )nt from zeto.to istic is given by e values of the rge value of the e-Bera statistic a hypothesisof a critical value 7ocritical value al valueis 9. 7 Scatter plot of wheat yield over time.

the R2-valuehas increasedfrom 0.2 -0. actual.082) The fitted.Boththese equations have the samedependent variable and the samenumber of explanatoryvariables(only 1). indicating that the equation withTIMECUBE fits the databetterthanthe onewith just TIME.9 makestheseconcentrations even more apparent." Before estimating the cubic equation note that the values of TIME3 can get very large. So. A\D MODELING ISSUES 0. this example. Runs ofpositive and/or in negative residuals suggest alternative. the predominance of positive residuals at the ends and negative residuals in the middle no longer exists.000 esrimated the equationis t1 VIEID. the slope is increasing as well. + The slopeof the expectedyield function is 392TIMEZ. Secondly. 85 90 9s negativeresidualsin the middle.plotting theresiduals against time wasinformative.6 0. examininga plot of the residualsis a useful deviceforuncovering inadequacies any chosenfunctionalform. It tums out that x3 provides the better fit. What alternativecan we try? Two possibilities arex2 and x3.4 -o.providing the estimateof B2turns out to be positive.68 TIMECUBET R z: 0 .649 to 0. and so we consider insteadthe functional form YIEL\: gr * gzTIME? e.8i4 + 9. 7 5 1 (s") (0. Furthermore.0 -0.036) (0. In these circumstancesthe R2 can be used legitimately to compare goodnessof fit.6 FTGURE 4. a plot of the original dependentvariable seriesl against the explanatory variable "r is a useful starting point for deciding on a functional form in a simple regression model.751.With cross-sectional usingplotsof residuals data againstboth independent and dependent variablesis recommended.10.They are causedby the inability ofa straightline to capturethe fact that yield is increasingat an increasingrate. Ideally we will seeno . The bar chart in Figure 4. What lesson: have we learnedfrom this example?First.:0. Thus the function itself is "increasing at an increasing rate.4 0. GOODNESS-OF_FIT.000.92 PREDICTION. the function will be increasing. Notice hou the predicted(fitted) valuesarenow increasingat an increasingrate. This variable is a good candidate for scaling. If we defirc TIMECUBET : TIME? 11.9 50 55 60 65 70 7s 80 Bar chartof residuals from linearequation. Furthermore. can an In with time-series data. Also. and residual valuesfrom this equationappearin Figure 4.

i! +:Lv*Je-i /)i+ 0.4.. as you becomemore knowledgeable experienced.6 and Section4. : equation tionshave ).!'ussion at relevantin a specificcontextthe slopecan be evaluated the samplemeany.1 Log-Linear Models -. wheat yield in Western '-.Also.i.and expenditures. you will discoverthat patterns theresiduals in can .4 -0.0 t .4. In this section we .+ LOG_LINEAR MODELS 93 2.f B2turns ncreasing stimating iable is a estimated 1." because . of garithmic transformationsare often used for variablesthat are monetary values.Because transformation the ln(x) hasthe effect of making .r mean many other specificationinadequacies..heteroske:. t p. Since y > 0.rrh considering." To make a . so that the . actual.. of andAppendices A.:-cervalues of .3 ^r'reregression modelsinvolving logarithmictransformations variablesare discussed.rtive and often havedistributions that arepositivelyskewed. ronseven thatyield rex2 and >nalform -:ir!rlS.rnometric models that employ natural logarithms are very common.5 1. :'rsure the "size" of something. Thus.2.. the slope is increasin-e -r' increases B2 ) 0. -.2 in Appendix B is representative the income distributionin the United States. or otice how ominance 1erexists.4 where .tralia is heavily influencedby rainfall.ussthis topic furtherandgive someexamples.a 4.rtionship betweeny and x is said to be "increasing at an increasingrate. For example..7/L_ ..7 0 55 60 65 70 75 80 85 90 95 Fitted.r ) hasa normal distribution. ln(x) will often be closer to a normal distribution for . The log-normal distributionis discussed Appendix 4C.0 4. prices.O 1.sales.2 -0. . A further possibility is the constantgrowth rate model that we considerin the next ..rables of this kind. Inclusion of a rainfall variable might be an option .As we travelthroughthe book.r less extreme.tlOn. of . The slopefor this functional as if rn is B2y.ris discussed of . and residual values from equation with cubic term. such as tr-{es.6 50 .with a long tail to the right.'.4.2. in in The basicinterpretation B2 in the log-linearmodel ln(y) : Fr f B2.iact the probability density function /(r) shown is called the "log-normal.4-A. In these at lessons le series -r' functional is a useful ive and/or a.rc properties logarithmsareintroduced.0 0.ticity.These variableshave the characteristic that they are -. such as omitted variables.5 Yield ---'*::* ---Fitted I i>: r^l. and autocorrelation.rpendix A.5 0.+. /\^-4 \t)L!t+to-{-t .. andthe residualhistogramandJarque-Bera will not rule out the assumption test of ' :mality. ' :ure B. . and in generalfor variablesthat salaries.. it makes senseto include TIME and TIMEz in addition to TIME-red. plotting fresiduals vill seeno . with the slopeandelasticitygiven in TableA. and : should be careful to consider other options. You shouldreviewAppendixA. income. .\ 'l- 2.

The elasticityof I'with respect x is B2x. a one-unit increasein r leads.0178.oo2l) (se.and for specificitywe to anotherinteresting might computethis value at the mean of the x-values.1 A Gnowru Moonr an Earlier in this chapter. U s i n g t h e p r o p e r t y t h a t l n (* x ) ! x i f l: x is small [seeAppendix A. equation(A. l3) and the discussionsurroundingit.os84) (o. over the period of the data. Specifically. which closely resembles scatterdiagramin Figure 4. we estimate that the growth rate in wheatyield is approximatelyg : 0.78Vaper year. FigureA.By substituting we obtain YIELDT: YIELDo(I * g)'. See equation (A.so it is probably unknown. we considered empirical examplein which the production of wheat was tracked over time.2 AVacp EquerroN (and The relationship betweenwagesandeducation a key relationship laboreconomics is in no doubt in your mind).3. Supposethat the rate of return to an extra year of education is a your wagerate rises r. constant That is.-. In the log-linear model.) 1 T h e e s t i m a t e d c o e f f i c i e n t b 2n ( l + S ) : 0 . supposethat due to advancesin technologythe yield of wheat produced(tonnesper hectare)is growing at approximatell a constant rate per year.5.01781 (o.approximately. or some other value. Taking logarithmswe obtain : Ln(YIELD.94 PREDICTION.3.in which casethe plot of YIELD againsttime looks like the upward slopingcurve in Appendix A. We expectgrowth to be positive.)rn(YIELDo)[tn1t s)]xr + + :Br*92/ This is simply a log-linear model with dependentvariable In(YIELD. Another way to representsuch a relationshipis using a log-linear model. and so on." the yearbefore the samplebegins.-1. to 4.so that 9z > O. with g being the fixed growth rate in I year. or time. in the first yearafter an additionalyearof education : fromaninitialvalueWAGEstoW-AGE1 (l + r)WAGEs. Here YIELDois the yield in year "0. 4. the Estimating the log-linear model for yield we obtain II(YIELD'): -0.l l) and the discussion following it].{NDMODELINGISSUES value.. 0 l T 8 .in Section4.) and explanatory variable/. An easier interpretationcan be obtained by using the propertiesof logarithms. Takinglogarithmswe havea relationship betweenln(WAGE) and yearsof education(EDUC) tn(wAGE): tn(WAGEo) lln(I + r)lxEDUC + : gr * \TEDUC yearof education l00\z% increase wages.7. with improvements in technology leading to wheat production increasing at an increasing rate.3434 * 0. To see how. GOODNESS-OF-FIT. a 100B2%changein y.Foranextra2yearsof education this becomesWAGEy: (1 + r)"WAGEs.4. in An additional leads an approximate to .4. supposethat the yield in year t is YIELDT: repeatedll 0 + )YIELD.or about l.

leading it to have increased -.using o' output.6408.exp(inS): exp(2. Furthermore. g 6 ' 1 : 7 . The problemsof obtaining . See model. -Je an R2-value.UES +. we estimate fi l. re effect of the correction can be illustrated using the wage equation.i {GE) is I"(WAG\: -":: 0 .Using this data the estimatedlog-linear model is : x ln(WAGE) 0. 7 8 8 4 0 . not ln(y).iical softwareis the percentof the variationin ln(y) explainedby the model. rriectiveis to explain the variations in y. 7 8 8 4 0 . 1 2 7 6 : 8 .:lo. logarithmthe antilogis the exponential function.:nav have noticed that when reporting regressionresults in this section we did not -.7884 0.dat. that can outweigh the benefit of the correctionin small samples. y. Using properties the log--::rl distributionit can be shown (seeAppendix 4C) that an alternativepredictor is ratln(l*x)ryxii rg itl. a one-unit -hta on hourly wages. : E6: exp(br I bzx -t "' 12): jns"'lz (and rr economics of educationis a 'ur wageraterise: rears ofeducation 'e havea relation- .In a log-linear regressionthe R2-valueautomaticallyreported by .rd shouldbe used. -r' of the correctedpredictor. 1 0 3 8x 1 2 : 2 .t the wage to be for a worker with 12 years of education? The predictedvalue of .000households conducted the United States in by :-.In small samples . whereaswe want to predict y.2.ility relative to j.0063) in Lmple which the rnology leading to represent such a ue to advancesin .ample sizeis large. 17oto ' : -j PRrnrcrroN rN THE Loc-LrNran Moonr ) and explanatorl ich casethe plot of FigureA.The : 0.i . --.0335): 7.n .r. 0 3 3 5 + + the value of the natural predictor is j. for The surveyhasbeenconducted . at approximatelr ar t is YIELDT: tituting repeatedlr 0. is - Lse wages..:rore than 50 years. A 957ointerval estimatefor the value of an additional year of education is 9.rr shall we obtain the predicted value of y? A first inclination might be to take the 'r of ffi : bt l b2x.yearsof educationand other variablesarein the file cps_small. : exp(ln(y)): exp(br * b2x) ^.3. -':.2402 from the regression .The reasonfor this incongruousresult is that the estimatedvalue of the error ---'." the yearbefore btain -'. :Jt a naturalchoice for prediction is y.g-linear the of modelthis is not necessarily bestwe cando. lf logarithms.1038 EDUC + ('") (0. on average. is. 1 :i .However.Forthenatural . 1 0 3 8x E D U C . in fc E6 : j t . . 6 4 0 8x 1. What would we -":::. which .:iul measureofgoodness-of-fit and prediction are connected. ^r-'iir'r choice.timatethat an additionalyear of education increases wage rate by approximately the : . closerto the actualvalue (lessthan30) the "natural" predictormay actuallybe .2. .78Voper year.] LOG_LINEARMODELS 95 I for specificity we r value.0 ...:Bureauof the Census the Bureauof Labor Statistics.-.'"'. .rce 62 adds a certain amount of "noise" when using j'. 6 1 6 1 2 . the fitted regression ' : f redictsln(y) : bt * bzx. .084e) (0.as we discussedin '.'.the "corrected" predictor!.e dataconsistof 1000observations from the 1997CurrentPopulationSurvey(CPS). .. -'^: CPSis a monthly surveyof about50.

because variations in individual behavior are difficult to fully explain. but we repeat our earlier message:R2-valuestend to be small the with microeconomic. The correctedpredictor includes the estimatederror variance.5). ' SeeAppendix 4A. then we must rely on the natural predictor j. exp(ln(y) + t.)] .&/2 i" always greaterthan 1. the correlation is the samefor both.As we have seen.that is relevant if we seekthe single number that is our best prediction of ..a905)]: 12. 4.\ /+ .what we may considerthe "best" predictor can changedependingupon the model under consideration.0335 1.4.That is. and then take antilogs.Las {-5. is the 100(1-cf2)-percentrle from the r-distribution and se(/) is given in (4. and $8.\l For the wage data. Then a 100(l-a)Vo prediction interval for y is f /+ lexp(tn(y)- t.62 ifwe usethe correctedpredictor. a 95Vo prediction interval for the wage of a worker with 12 years of education is exp(2. How doesthe correction affect our prediction? Recall that d" must be greater than zero ar. (In this casesince the corrected and natural predictors differ only by a constantfactor. It is a generalrule that the squaredsimple correlationbetweeny and its fitted value!.r Ibc .47392 : 0. wherei is the "best" prediction one can obtain. compute ln(y) : h I bzx and then ln(y)+ t"se(f).2146 from the regressionof ln(WAGE) on EDUC.oc-LrNnen MooEr We have a correctedpredictor j'" for y in the log-linear model.rd :1. Their average consistentwith the sample of data. In this casethe sample is large (N: 1000) so we would usethe correctedpredictor.1. as comparedto the reported R" : 0. GOODNESS_OF_FIT.lEs tlir rfii 1.4. The natural predictor tends to systematically under-predict the value of y in a log-linear model. or point forecast.1 Specifically we follow the procedure outlined in Section 4.96 x 0.0335 1.30. If we prefer a prediction or forecastinterval for y. .se(f)). a general goodness-of-fit measure. and the correction offsets the downward bias in large samples.20.or general R2 is y)]' Rl : [con(y. cross-sectionaldata. It is the "point" predictor.9184.) These R2-valuesare small.2246. : f..PREDICTION. Therefore the effect of the correction is always to increase the value of the e0 prediction because.r'.so the correctedpredictor is are 379 with 12 yearsofeducation. AND MODELING ISSUES We predict that the wage for a worker with 12 yearsof educationwill be $7. y.64per hour if we usethe natural predictor. 4. Among the 1000workers there wage is $8.i . is a valid measureof goodness-of-fitthat we can use as an R2 in many contexts.se(/).making the r-distribution no longer relevant in (4A.96 x 0.5 PnEorcrrou INrunvALs rN THE L. where the critical value /.) 12: 0.1). That is.00461 + [exp(2.4 A GElueRAr-rzrioR2 MEasrrr.4905). In the wage equationR! : kon(y.

such as experience.and N:20. -1. Comparethe width of this interval to the one computed in part (c). :16. Our model is not an accuratepredictor of individualbehaviorinthis case.5. -1. find6'.63 and 2a! :182'85' find R2' (b) Suppose that a simple regression has quantities N : 20. but not they values.5 Suppose you are estimatinga simple linear regression model.but not the. . or rt prediction of y. (a) If you multiply all the x values by 10. (e) a95%o prediction interval fory givenx : 7. is in (4.that E(yg) : ys? 1.ssz:552. 2 3 ) ( 0 . {.that should be relevant.which is so wide that ir is basicallyuseless.r and only a calculator (show your work) compute (a) the predicted value of y for xe : 5. and SSR:666.we can estimate E(y) for any value of x : xs asE(ys) : bt I bzxo.5). natural predictor en take antilogs. 1. (c) a95Vo prediction interval for y given ro : 5. (b) Find the expectedvalue and variance otffi.2* consider the following estimated regression equation (standarderrors in parentheses): y : 5 .) tend to be small iual behavior are int" predictor. what happensto the parameter valuesB1 and B2?what happens the leastsquares to estimates and b1 b2? What happensto the variance of the error term? (b) Suppose you are estimating a simple linear regressionmodel. Zy? : 5930.00.andtheleastsquaresestimators. ritical value /. (b) Al1 values of y were divided by 10 before esrimation. laterchapters will seeif we canimprovethismodelby In we adding additional explanatory variables. (b) the se(/) correspondingto parr (a).035.79ll.3 Using the data in Exercise 2. Whar doesthis tell us?Nothing we did not alreadyknow. (c) All values of y and r were divided by l0 before estimation. 8 3* 0 .5 EXERCISES 97 64 per hour if we s casethe sample 00 workers there octedpredictor is greaterthan zero the value of the tends to system:ction offsets the The interval predictionis $2. If you multiply all they valuesby 10. 1.what happens the parameter to valuesB1 :d to the reported rce the corrected e samefor both.5 Exercises Answer to exercisesmarked * appearin Appendix D at the end of the book. l gzx I e. (a) Describe the difference between predicting )s and estimating Z(ye).92-$20. Why did we define unbiasedness this strangeway? what is wrong with saying. Then a of with 12 years 184. 8 6 9 r R z : 0 3 5 6 ( s e )( 1 . where/is rhe forecasterror.0046] 3 the r-distribution no . (c) When discussing the unbiasedness the least squarespredictor we showed of that E(f): E(yo -lo) :0. (c) supposethatasimpleregressionhasquantitiesR2:0. wherej' it that we canuse st" predictor can I goodness-of-fit J.aswe havein other in unbiasedness demonstrations.ES 4. (d) a 99Voprediction interval for y given ro : 5.94. : h I bzxo.72. 1 1 7 ) Rewrite the estimated equation that would result if (a) All values of x were divided by 10 before estimation.1 PRonrnns I valuej.36.1* (a) Suppose that a simple regressionhas quanrities |'(yr -t)r:631..20.-l Giventhesimplelinearmodely : B. find R2.r values.

y)2. where ! is the predictor based on the restricted model in part (a).Compute Rl for the data in Exercise 2.The least squares Exercise 2. Does the sum of squares SSI: SSR+ SSEhold in this case? 4.5.datrs a crosssectionof 1519households British Family Expenditure Surveys.) at the point t : 49. say food.y)2 and SSR: I(y. where ! is the predictor decomposition basedon the restrictedmodel in part (a).9* For each of the three functions in Exercise 4.8 (a) Find the predicted value for yield when t : 49. equals the sampleaverageof -r'. (ii) plots of the residuals. (c) Compare the value of Rl in part (b) to the generalizedRz : fi. Variable definitions are in the file london. show that i : t.98 PREDICTION. show that the fitted line passesthrough the point of the means.I0 drawnfrom the 1980-1981 The file london. respectively. .4. (b) Find estimatesof the slopesdy. and (iv) values for R2.6 The fitted least squaresline is !. so the model is y. consider the three equations }r:Bol9'/let )r:cto+c-lr'(t)+et )r:^Yo+^yiz+e. (a) Estimate each of the three equations. The budget shareof a commodity. Data have been selected to include onlr households with one or two children living in Greater London.: | ..f dt at the point t : 49.2 4.+ er.7 In a simple linear regressionmodel supposewe know that the intercept parameteris estimatorof P2is developedin zero.^ (d) Compute SSZ : I(y' . (c) Find estimatesof the elasticities (dy. (b) Taking into consideration (i) plots of the fitted equations.dat containobservationson wheat yield in the Western Australian shires Northampton. ExnncrsEs The first three columns in the filewa-wheat. the That is. What is their importance? 4. For the Chapman Valley shire. where SSEis the usual sum of squaredresiduals. : B2x.8 CovrpursR. wherey:}yilN. is defined as WFOOD: expenditure on food total expenditure . (d) Comment on the estimates you obtained in parts (b) and (c). GOODNESS-OF_FIT. (a) Algebraically.SSE 12y7.r). : bt * bzxi. (b) Algebraically show_that averagevalue of j.4. Self-employed and retired households have been excluded. (x. Chapman Valley.ldt)(tly. 4. R' is often defined to be R?. and Mullewa. 4. There are 48 annual observationsfor the years 1950-1997. which equation do you think is preferable? Explain. AND MODELING ISSUES estimatesbl andb2?What happensto and B2?What happensto the least squares the variance of the error term? 4. (iii) enor normality tests. (a) What is the least squarespredictor of y in this case?^ (b) When an intercept is not present in a model.def.

with 594 and 925 observations.12 and3. )7. duringmid2005. respectively. arameteris lveloped in (a) Estimate this function for householdswith one child and householdswith two children. What is the prediction error in this forecast?Is it larger or smaller than the error computed in part (b). which was 1.dal contains dataon 880houses sold in Stockton.603Vo. (You may find it more convenient to use the files lonl.) (b) It can be shown that the expenditure elasticity for food is given by Br+9zfh(rorExP)+Il Lned to be r.if necessary. based on the sample data.17oof the vote? :. (a) Estimate the log-linear model Ln(PRICE): Fr * ?zSQFT * e. .82Vo.def. Basedon theseestimates. what value of GROI4TII would have led to a prediction that the nonincumbentparty (Democrats) would have won 50. Interpret the estimated model parameters.) How large were your prediction errors? (c) Construct 95Vo prediction intervals for the number of housing starts in May and June 2005.8.13 and 3.603Vo.dat) introdtced in Exercises2. l3* The file stockton2.00Vo and 5.12 Considerthe housing startsdata (house_starts. estimate the regression model VOTE : fu t 9zGROWH + e.respectively.dat and lon2.Predict the number of housing starts in May and June 2005. I (a) Using all the data from 1880 to 2000.Calculate the slope and elasticity at the sample means. (Source: Economagic. construct a95Vo interyal estimate for the 2000 value of VOTE using the actual value of GROWTH : 1.respectively.dat that contain the data for the one and two children households.CA. (b) The actual number of housing startsin May and June 2005 were 2041 and 2065 (thousands). 1x Reconsiderthe presidentialvoting data(faindat)introducedin Exercises2. Compute ere ! is the a predictor omposition Fr * Fz1n(ZOTEXP) Find estimatesof this elasticity for one and two children households. For the lots of the :quation do hat is their 1980-1982 clude only [-employed in the file :. Report and comment on the results. (c) Using the regressionresults from (b). Does the functional form seemappropriate?Is it reasonable assumethe errors are normally distributed? to -1.com. I 4 and3. rerageofy. Did your intervals contain the true values? vheat yield I Mullewa. what is the predicted value of VOTE in 2000? What is the least squaresresidual for the 2000 election observation? (b) Estimate the regressionin (a) using only data up to 1996 (observations1-30). Variable descriptionsare in the file stockton2. Do these estimates suggest food is a luxury or a necessity?(Hint: Are the elasticities greater than I or less than 1?) (c) Analyze the residuals from each estimatedfunction. (d) Using the estimationresults in (b).9. (a) The fixed interest rates for May and June 2005 were 6.4. evaluatedat average total expenditure in each case.5 EXERCISES 99 happensto A functional form that has been popular for estimating expenditure functions for commodities is WFooD: Fr * B2rn(TOTEXp)_t e the means. Predict the value of VOTE in 2000 using the actual value of GROWTH fot 2000. The data extendto April 2005.These data were considered in Exercises 2.ll .

and the Jarque-Beratestfor normality. (g) Based on the results in parts (a)-(0. (a) For each sample partition. Do you observe any patterns? (f) Using each model. females. GOODNESS-OF-FIT.dafcontains 1000observationson hourly wage rates. what percentageincreasein wages can the averageworker expect? (c) Construct histograms of the residuals from the linear and log-linear models in (b). What is the estimatedreturn to education in each model? That is. Which appearsmore normally distributed? arrd log-linear (b) Estimate the linear regression WAGE:9r * !2EDUCle regressionLI(WAGE):9r * P4EDUC *e. and other variables from the 1997 Current Population Survey (CPS). Which model fits the data better? (e) Plot the least squares residualsfrom eachmodel againstEDUC.Calculate the slope and elasticity at the samplemeans. 4. Which functional form would you use? Explain.)In this exerciseyou will extract of consistingof (i) all males. for an additional year of education. do you consider the distributions of the residualsto be compatible with an assumptionof normality? (e) For eachof the models (a)-(c) plot the least squaresresidualsagainstSQFT.dat. predict the wage of a worker with 16 years of education.(iii) all whites. education.(ii) all females. you can use the smaller file cps-small. AND MODELING ISSUES (b) Estimate the log-log model ln(PRICE) : Br + Fzln(SQFf) + e. and (c) and obtain the Jarque-Bera statistics. The datafile cps_small.14 How much does education affect wage rates?This question will explore the issue further. construct a95%optediction interval for the value of a house with 2700 squarefeet. subsamples observations (v) white males.(vii) black males. and (viii) black (iv) all blacks. (a) Constructhistogramsof thewAcBvariable and its logaritbn ln(WAGE).Do you observe any patterns? (f) For each model in (a)-(c).PREDICTION. Does one setof residualsappearmore compatible with normality than the other? (d) Compare the Rz of the linear model to the "generalized" R" for the logJinear model. predict the value of a house with 2700 squarefeet. (c) Comparethe R2-valuefrom the linear modelPRICE : Fr * gzSQFT * e to the "generalized" R2 measurefor the models in (b) and (c).dat. For a variable y it is (T. (g) For eachmodel in (a)-(c). wage of all workers in the sample Comparethesepredictionsto the actual average with 16 years of education.. (vi) white females.15 Does the return to education differ by race and gender?For this exerciseuse the file cps.if necessary. (b) Avariable's cofficient of variation is 100 times the ratio of its sample standard deviation to its sample mean. which functional form would you use? Explain. discuss the choice of functional form. Ap tL flu rl. obtain the summary statistics of WAGE. (b). 4. Based on your observations.If your software is a student version. (d) Construct histograms of the least squaresresidualsfrom each of the models in (a). (h) Based on your work in this problem. Interpret the estimatedparameters. (This is alatge file with 4733 observations.1 t .a C V : 1 0 0 x.

That is.4.Multiply the endpointsof the prediction interval by the total votes cast in Palm Beach county to determine a prediction interval for Buchanan'svote. (a) Estimate a simple regression using as a dependent variable the votes for Buchanan and as the explanatory variable the votes for Bush. Estimate the simple regressionof Buchanan's share on Bush's share using data on the 66 counties excluding Palm Beach.if f*etothe It is a measureof variation that takesinto accountthe size of the variable. (e) To control for total county population.97o prediction interval.APPENDIX 4A DEVELOPMENT OF A PREDICTION INTERVAL 101 rterpret the e means. ?E).4.What is the coefficient of variation for WAGE within each sample partition? (c) For each sample partition estimate the log-linear model ln(WAGE): Br * B2EDUC * e : models in /our obserratible with tSQFT.d return to ation.6 The November 2000 U.(br*bzxo). Where doesBuchanan'sactual vote in Palm Beach county fall relative to this interval? -{ppendix 4A Development of a Prediction Interval -yo: l : e f o r e c a s t e r r o r / s) 0 (Fr l9zxoaro) . especially Palm Beach county. Is the actual vote for Buchanan within the prediction interval? (c) Plot a scatter diagram of the actual Buchanan vote (vertical axis) against the predicted Buchanan vote (horizontal axis) using data on all 67 observations.Do quare feet. log-linear . Gore. e value of a ional form..Toobtainitsvariance i: : br * bzxo.S. re the issue wage rates.dat arecountyvoting datafor candidates Bush. voting irregularities were claimed.How well doesthe model explain the Buchananvote? (b) Predict the Buchanan vote for Palm Beach county and construct a 99. (d) Repeatparts (a)-(c) basedon a regressionusing as dependentvariable the votes for Buchanan and as explanatory variable the votes for Gore. the sample d you use? use the file s a student will extract )all whites.ou observe education.The variancesand covarianceofthe least c: us first obtain the varianceofj's \:jares estimatorsare given in Section2.9Voprediction interval for Buchanan's shareof the vote in Palm Beach county. Construct a 99. (viii) black What is the approximatepercentage return to anotheryear of educationfor each group? (d) Does the model fit the data equally well for each sample partition? (e) For each sample partition. using a two-tail test at the 5Volevel of significance. and two minor candidates. In Florida. "l(x.b2) le standard ozb?)ol^)-.Pat Buchanan and Ralph Nader. lnthe fileflorida.Interpret the model R2. we obtain var(yo):var(br * b2xs): var(br) + fivar(b2) *2xscov(b1. createvariablesthat are the shares ofvotes by county. Which .Using them. . Buchanan'sshareof the vote is Buchanan'scounty vote divided by the total number of votes cast in the county. test the null hypothesis that the rate of return to education is lOVoagainstthe alternativethat it is not.-r)Nl(xi-x)' T4rr--4rrv - I(xi-t)' . Presidential Election was won by George Bush over Al Gore. :y (CPS). what r models in ppear more : log-linear . Use the data on the 66 countiesexcluding Palm Beach.

<YJ:+ < 1 .I I -_: L l I -o . x)' I(x.4).I1 se(. . A little factorin-s gives the result in (4..t)' ZGi-7)' I LN:(xi 'l .) :1-ct Substitutethe /-randomvariablefrom (4A.r)2 ("0.r. x)'l -" c l r ( x 0 .If r.r .21 L " I(xr then (4A._ r l . I I(x.x ) 2 . Add the termo2Nf f NX"r .2xst . l -lt t" "'=' i l d / 1: a 2 l t + . AND MODELING ISSUES Now we usea trick.T .2t Pl-t. ( x 'n . is a critical value from the /1. We can construct a standardnormal random variable as f ffi-*{o''1. you shouldbe able to show that var(/) : var(yo) * var(ee) : var(io) + o2.1r where the squareroot ofthe estimatedvarianceis the standarderror ofthe forecastgiven in (4. LGi -7)' [I(x.4)is estimated replacing by its estimator in by o2 62. GOODNESS-OF-FIT. If theforecast errorvariance (4.Jzl Taking into account that xs and the unknown parametersB 1 and B2 are not random.as shownbelow: :h* var(j.<v<.v-: distribution such that P(t> tc) : al2.t.r)t lNl(x..PREDICTION.r)i afterthe first term (insidebraces below) and subtractthe sameterm at the end..l >l .s) o'*i {d5}l o2q_2xox1 f "2N-'2 I I [NXxi 7)' t t T rI. Then combine the terms in brackets.1) in to (44.j r J I LN-tG-.s) Using theseresults we can construct an interval prediction procedurefor y6 just as we constructedconfidenceintervals for the parametersB1.xt' xf . r)' -vr-T-l -vr-T-l +x2] . then P(-t..2) to obtain (44. -.

See Appendix 2A for discussionof the normal equations. or predictioninterval.substituting 22i : o and\x. Thus if the model contains an intercept it is guaranteedthat SSZ : SSR + SSE. Il however.Oi : e back into the original equation. rvhatare the mean and varianceofw? Recall that the "expected value ofa sum is the sum of .yZOi : br\?i I bzZxi/i .the model does not contain an intercept. Appendix 48 The Surn of Squares Decomposition To obtain the sum of squares decomposition (4. for ye is given by (4. .lN : 0.y)2:2(j'. we squareboth sidesof (4.Nh .2) Appendix 4C The Log-Normal Distribution Suppose that the variabley has a normal distribution.y)' +Za?+22(yt--iAt Expanding the last term we obtain tot random.bzbi :0 This last expressionis zero becauseof the first normal equation.tl.i_21- This result follows from the secondnormal equation.:Zr. ): } x i y i . you \ little factoring I(vr .y)Oi :0.4).b 1 .I 1).at :L(bt + b2x)?. .b1. . .fl'+a? +2(it -y)ai I(y. (2A. 2 : \A.btZxt .The questionthen is. That is. . The first normal equation is valid only if the model contains an intercept. .UES ide bracesbelow) as shownbelow: APPENDIX 4C THE LOG_NORMAL DISTRIBUTION Simplify this expressionto obtain Pl)o -r.10) in (v. It follows then that the sample neanofthe leastsquares residualsis also zero (sinceit is the sum ofthe residualsdivided by the sample size) if the model contains an intercept.b2xi) Zyi estimator62.bz\*? : O (4A. By now vou are familiar with this bell-shapeddistribution.y)Oi :2yi2i . with mean p and varianceo2.-r)': Then sum [(vr i +a. then IZi l0 and SS?" SSR + SSE.]': (yi.se(/) ( yo ( lo + tse("f)l : 1 . If we consider w: ev.6).cr A 100(1-cr)7oconfidenceinterval. + (44. (2A. The next termZxi|i: 0 because Zxi?.y22i Consider first the term22i : Zei :21r.we obtain I(i. The sum of the least squares residualsis always zero if the model contains an intercept.(y.b 2 x . .3). o2) and w is said to have a log-normal distribution. then y: ln(w) *N(p. This result always holds for the least squaresestimator and does not depend on the model having an intercept.1) brecastgiven in or )0 just as we from the /11.

Happily the expected value and variance w havebeenworked of out and are E(') : and var(w) : (""' . First. and the expected valueof nonlinear functionof y is not just the samefunctionof E(y). if SO) is some tunction of 1 then in generalEtg$)l * SIEO)1. Solving for r we obtain r .So the expectation E(w): E(et)fsE\t). unfortunately. given the loglinear model ln(y): Br * $zx * e.1. The second implication comes from the growth and wage equations discussed in Section 4. .t) "2tr+o2 Ch T "*+a"/2 N Theseresultsrelate to the log-linear regressionmodel in severalways.104 PREDICTION.var(b) : o2l\@i -.if we assumethat e-N(0.o2). For example. exponential the functionis nonlinear. If assumptionSR6 holds."But. in the wage equation we estimated 9z : ln(l * r). Consequently.if we want to predict E(y) we should use E6 : ebrtbzxi+6212 :. an estimator of the rate of return r is ?: 'b'+i&6p .| -t)2.4. where b1."a2/2 elt+P2xi+*12 kar ibed l. AND MODELING ISSUES the expected values. That is.)2). whereifrD : 62121p"i Icyr aL e cr:da bsr crtcal vi aE tFvi fEdne . Then E[eb') : "92+vt(b)/2 Therefore.): s1rtlzx.e9. then the least squaresestimator is normally distributedb2-N(9z. and 62 are from the log-linear regression. GOODNESS-OF-FIT. bz. then E(yr): -: E(e1r+92*t+a1 E(etu+Fzne"i) ePr+\zr'E("".

.. le expectation : been worked Chapter The Multiple Regression Model . and relatively low. Test hypotheses about single coefficients in a multiple regression model. Explain the circumstancesunder which coefficient variances(and standarderrors) are likely to be relatively high.rrdness-of-fit interval estimate least squaresestimates least squaresestimation least squaresestimators multiple regressionmodel one-tail test p-value regressioncoefficients standarderrors sum of squarederrors sum of squaresof regression testing significance total sum of squares two-tail test .]S linear.and standarderrors. 6. Keywords BLU estimator :r. in s discussed * r). : : Understandand explain the meaningsof the assumptions the multiple regression for model. for the estimated coefficients in a multiple regressionmodel. Recognizea multiple regressionmodel andbe ableto interpret the coefficientsin that model. Use your computerto obtain varianceand covarianceestimates. Interpret the interval estimates. and the 'E(y). Use your computer to find least squaresestimatesof the coefficients in a multiple regressionmodel. Find interval estimatesfor single coefficients. \. Compute and explain the meaning of R2 in a multiple regressionmodel. given the log- karning Objectives 12 =g\r'+l2'i+& *r. That is. Explain the meaning of the Gauss-Markov theorem. Interpret those estimates. In particular (a) What is the difference between a one-tail and a two-tail test? (b) How do you compute the p-value for a one-tail test. Solving is es estimator : :.ed on the material in this chapter. and for a two-tail test? (c) What is meant by "testing the significance of a coefficient"? (d) What is the meaning of the /-values and p-values that appearin your computer output? 9.rariance matrix of ieast squnresestimator --ntical value :ror variance estimate crror variance estimator r. you should be able to .

is the If increasein salessufficient to justify the increasedadvertisingexpenditure?Managementis also interestedin pricing strategy.We initially hypothesizethat salesrevenueis linearly relatedto price and advertising expenditure. Sincea he :. :\truCted a :--.:n price ch The param -.i niodel. 5. Because sales in bigger cities will tend to be greater than sales in smaller cities. As an examplefor introducing and analyzing the multiple regressionmodel. in most economic models there are two or more explanatory variables that influence the dependent variable y. we refer to it as a multiple regression model. 1 a ' . i\ very imp . u :.\. The economic model is '.106 THE MULTIPLE REGRESSION MODEL The model in Chapters 2-4 is called a simple regression model becausethe dependent variabley is relatedto only one explatatory variablex. we focus on smaller cities with comparable populations.and we will need to modify the assumptionconcerningthe characteristics the explanatory(x) variables.1 Introduction 5. Of particular interestto managementis how salesrevenuechangesasthe level of advertisingexpenditure changes. Does an increasein advertisingexpenditurelead to an increasein sales? so.rnfetefB1 ::.the degreesof freedom for the r-distribution will change. :lear econ -:.andincome. The first step is to set up an economic model in which salesrevenuedependson one or more explanatoryvariables.:reP:A -'.'ne variabl .1 ..i hich case I : .h product :-:. Investment will depend on the interest rate and changesin income. a price reduction that leadsto a large increasein quantity sold will produce an increasein revenue(demandis price elastic).::. havesee ..To assess effect ofdifferent the price structuresand different levels of advertisingexpenditure.: sr mbol " * .iblegiven : : erample. : the increas i:ed costof p *. 00 in adve : : p .. cities.crtising ex 9r : thech oneur AS LAel S:9r-tFzp+FzA ( s.ev( -' .how this : .1.Big Andy's BurgerBarn sets different prices and spendsvarying amountson advertising in different cities. . This economic information is essentialfor effective management. axpectthe 't.es in eacl The remair '. Most of the results we developedfor the simple regressionmodel in Chapters24 can be extended naturally to this general case.1 TsE EcoNourc Mooer 9: : thecb unit (l AS AP(A We will set up an economic model for a hamburgerchain that we call Big Andy's Burger Barn..---r:ionally u The signof .1) where S represents monthly salesrevenuein a given city.' Importantdecisions madeby the management Big Andy's areits pricing policy for of different products and how much to spendon advertising. When we turn an economic model with more than one explanatory variable into its correspondingeconometric model.: tits the di The other I -:. in a demand equation the quantity demandedof a commodity dependson the price of that commodity.:> revenue :r ersely.sales Ifa in revenuewill fall (demandis price inelastic)..'enditure. andA is monthly advertising expenditure in that city..=Jependen :.These of and other consequences extending the simple regressionmodel to a multiple regression of model are describedin this chapter. Both S and A are measuredin terms of thousandsof dollars. Output in a production function will be a function of more than one input.:ianatoryv :. Aggregatemoney demandwill be a function of aggregate income and the interest rate. i t .S. the prices of substitute and complementarygoods. While this model is useful for a range of situations.:ation (5. ' The data we use reflect a real fast-food franchise whose identity we disguise under the name Big Andy's . There are slight changes in the interpretation of the B parameters. we consider a model usedto explain salesrevenuefor a fast-food hamburgerchain with outlets in small U.r) 1 . P represents price in that city.ricity of de . For example.Will reducing prices lead to an increaseor decreasein sales revenue? reductionin price leadsonly to a small increase the quantitysold.

. hereP : A : 0. Thus. is With 93 < l. fries.and -'achproduct has its own price. and shakes. held constant.1). re Big Andy's. knowledge of the sign of B2provides information on the price :.That is.unlessthe ad is offensive.at the data poorly and does not predict well.price elasticdemandexistsifan increase price leadsto a declinein revenue.and the .1) in in S by 9: : thechange monthly sales ($1000)whenthepriceindexP is increased one is unit ($1) andadvertising expenditureA heldconstant as AP(eheldconstani as 0P dy's Burger rg policy for of different Barn sets 1er )f particular expenditure ? If so. always include an intercept in we ::.. : regression weconsider Lets small in Since a hamburger outlet sells a number of products: burgers.jrertising expenditure. the intercept of :irameter B1 is the value of the dependent variable when each of the independent.e model.5.We will ccasionallyuse this symbol. for a range riables that re quantity rf substitute function of income and ICOme. Omitting it can lead to a model '--. The parameter B3 describesthe responseof sales revenue to a change in the level of . fits The other parametersin the model measurethe change in the value of the dependent . . that describesoverall :rces in each city. That is. ble into its lel.l($ 1000)whenadvertising oneunit ($1000)andthepriceindexP is heldconstant as M(Ph"ld"onttunt\ as 0A (5. in Whetheror :ot the increasein revenueis sufficient tojustify the addedadvertisingexpenditure. Except in very special circumstances.The magnitude of B2measures amount of changein revenuefor a the ::ren price change. we expectthat an increasein advertising :rpenditure.rr B3 ) l. increase is economic ls on one or ly related to he symbol "d" standsfor "partial differentiation. all other variables held constant.If an increasein price leadsto an increasein . in SI 000 in advertisingexpenditure policy.then B2 ) 0.1) are the unknown parametersB1.\'e expectthe sign of B3 to be positive.'rplanatory variables takes the value zero. is by in expenditureA increased B: : thechange monthlysales.les revenue.we calculatethe change :. knowledgeof l.n of the I ryill need to These rbles.It meansthat.sales in .1) rtcity. clear economic interpretation. but you will not be askedto evaluatesuch derivatives.all other factors. The sign of B2could be positive or negative. when the variable P changes. anotherquestion. S.In this particular caseit is not realistic to have a situation . For this purpose managementhas -.-. measuredin dollars and cents. iriable given a unit changein an explanatory variable. The remaining symbols in (5.B2.isticity of demand.. an increase of will yield an increase revenuethat is lessthan $ 1000. . What we needis somekind of averageprice for all productsand information .l haveseenthis operation. is very important.A. Most of re extended .in termsof the chain'sadvertising j. as the definition states.nstructed a single price index P.l INTRODUCTION 107 dependent .)nversely. andA in terms of han salesin .is the is nagement decreasein y sold. it will be greater. and the demand for the chain's products is price inelastic.will leadto an increase salesrevenue. a in : s hich caseB2 ( 0. one variable." Those of you familiar with calculus -:. it is not immediately clear what price should be used in (5. (5. Thus. in many cases this parameter has -'. even if it has no direct economic interpretation. Mathematically. . However. ! rr example.Jded costof producingmorehamburgers.and B3that describe r:e dependence sales(S) on price (P) and advertising (A)..-quation r how this average price changes from city to city.

This random error represents all factors.1) describesthe average.1. 92. price.systematiccomponent. not As illustrated in Figure 5.Dev.2 ) The economic model in (5.other than price and advertisingrevenue. andA. P. The complete set of observationscan be found in the file andy.9)Fr+p2P Fz = slopein P direction t. the plane intersectsthe vertical axis at B1.to which we add the random efior e to determine S. and so on.price.2a 'l L rs usefu I' the gen n a numt rrinen ar 9: = slopein A direction fbe coefl raiables .1)describes.which causesalesrevenueto differ from its expectedvalue. We do not know what the value of salesrevenue will be until we observe it.1. e : S . where E(S) is the "expected value" of sales revenue.THE MULTIPLE REGRESSION MODEL The next stepalong the road to leaming about Br. Denoting the observationfor city i by the subscripti.) I ei : 9t * $zPi * }zAi I ei : t m *rdian llrr.E(S).riable. Thesefactors might include the weather. a line asin ChaptersZ4. and B3.a ne\r SurgeonGeneral'sreport on the deadly effectsoffat intake.the behaviorof competitors. As such we should write it as E(^f) : Fr * 9zP -t 9zA. 5. The expectedvalue E(.butaplane. The multipleregression lEameter . Data for salesrevenue.7 fbe parar . The in *econo I oore rei tur devel = +fuA E(.r trivative prcunp 5 .f) is the nonrandom.systematicrelationship between the variablesS.1) describesthe expectedor averagebehavior of many individual franchisesthat make up the complete chain run by Big Andy's Burger Barn. Thus S is a random variable.imum lGaimum trl. and advertising for different cities will not follow an exactlinearrelationship. Thesedata do not fall exactly on a by plane.1. and advertisingfor for somecities are displayed in Table 5. we have S.dat andis represented the dots in Figure 5. : E(S.The parameters and B2 B3measurethe slope of the plane in the directions of the "price axis" and the "advertising axis. 'nple (5.2 Trn EcoNoMETRrc Moorr TtbIe ! Andy's I lx) The economic model (5.is to convert the economic model into an econometric model.we add a random error term. Equation(5.Representative observations salesrevenue.'is alr plane." To allow for a difference between observablesalesrevenue and the expectedvalue of salesrevenue." respectively.l.1. as well as differences in burger-buyingbehavioracrosscities. but instead resemble a "cloud.

1 INTRODUCTION 109 ert the economic Ta b I e 5 .r.05 Summary statistics O..5 73 74 75 75.| 5 73.2).83 0.a new lll as differences y the subscripti. .A single parameter.9. heldconsrmt ae(y) 0x* The parameterB1is the intercept term. I 2 3 .q. x3.22 5. Dev.call it Pr. $1000 units Price (P) $l units Advertising (A) $1000 units City many individual arn.69 6. .2 Samplemean \ledian \taximum \linimum Std. ^ YK - Ar(y)l Lx1. . We do not The introduction of the error term and assumptions aboutits probability distribution turn '}reeconomic model into the econometric model in (5.49 5. all other variablesheld constant.. As such we value" of sales rill not follow an 24.71 5. B6 are unknown coefficients correspondingto the explanatory r ariablesx2.3 2. loth.In terms of partial Jerivatives. .45 6. 77.7 1. and Advertising in Big Andy's Burger Barn Sales (. . 3-1.9 0.69 5.4 67.4 81.50 91.5. We can think of it as being attachedto a variable x1 :hat is always equal to 1. measures effect of a changein the the r ariable.0 5. xK. a dependentvariabley is related :o a number of explanatory variables xz.3). . The econometricmodel provides a morerealistic descriptionof the relationshipbetweenthe variablesas well as a framework tor developing and assessing estimators of the unknown parameters. .63 6.50 0.80 3.3 5.x3. We use Kto denotethe number of unknown in rarameters (5.49 4.9s.0 2. .butaplane. Price.r5 through a linear equation that can be *ritten as yi : 9r I \zxizI 9zxl+ "' + Fxxix* ei ---/e (5.2) rip between the 3 Component.8 62.1 : l. 7 Observations on Monthly Sales.In a generalmultiple regressionmodel. That is. arameters and 92 the "advertising d advertisingfor n be found in the fall exactly on a rpectedvalue of or representsall todifferfromits mpetitors. .3 75.. .4885 5.69 6.2a The General Model It is useful to digressfor a moment and summarizehow the conceptsdevelopedso far relate ro the generalcase.2 71.84 1.. to able.02 1.37 76. .rt'.l 2.40 6.20 62.10 0.3) The coefficients B2. .upon the expectedvalue of y.8317 (s.4 89.8 0.5184 1.

Thus. some will be negative. Each random error hasa probability distribution with varianceo2.-'neralcasew i. The resultsgenerally will hold for modelswith more explanatoryvariables(rK > 3).rndadvertisin :asesin which . are not more likely to be further from the regressionfunction than others. o 2 ) . E(y 2 . The varianceo2 is an unknown parameterand it measures uncertaintyin the statistical the model.. Thus we rewrite(5.That is.cedure that -'.It is equivalentto E(e. E0):9t I $2xi2* F:xr. a subsequent observation is not more or less likely to be aboveE(y.rknown para .) :0. 4.110 THE MULTIPLE REGRESSION MODEL 5 The equation for sales revenue can be viewed as a special case of (5. cov MR5.gi\ . xiz : Pr. Some observationson ). In addition to the above assumptionsabout the error term (and hence about the dependent variable).N[(Br * gzxiz* B:xi:). each y.. The statistical properties ofy. yr . oz). cov(ei. 4. cov(y. It is the samefor eachobservation. 5. These properties are 1. o21. r ariable.N(0.).Thus we are assumingthat the valuesofthe explanatory variables are known to us prior to observing the values of the dependent MR3.For example. or less. The exp MR6..which is equivalent assuming to that ei .2 Estin Regressi . does not change with each observation.ntextof the . 3. assumptions about the probability distribution of the random errorserneedto be made.h a t i s . T Becauseeachobservationon the dependentvariabley. an of :.so that for no observationswill the model uncertaintybe more.:ze the sum ':rameters. any pair of errors is uncorrelated.. The first is that the explanatoryvariablesare not random variables.f the explana :. vtrCyi) :var(e): o2.3) in ASSUMPl MRl. The covariancebetweenthe two random errorscoffespondingto any two different observationsis zero. find an esti ':.. This assumptionsays that the averagevalue of yr changesfor each observationand is given by the regression function E(l) : 9t i \zxiz * p:xi:. Errors with this property are said to be homoskedastic. dependson the random error term er. are similar to those introduced for the simple regressionmodel in Chapter 2. e i .nor is it directly relatedto any economicvariable. We will sometimesfurther assumethat the random errors er havenormal probability d i s t r i b u t i o n s . The expected(average)value of y. The size of an error for one observationhas no bearing on the likely size of an error for anotherobservation. This i . We sometimeswill assumethat the values of y.1 LEes . Ii: MR2.y. Ji- -'-.2) as K Yi : 9r l9zxiz * 9zxit -l ei (5 4\ In this chapter we will introduce point and interval estimation in terms of this model with K : 3.N ( 0 . Any two observations the dependent on variable are uncorrelated. dependson the values of the explanatoryvariables and the unknown parameters. E(e. 2.4) complete. ris modelis s .e) : 0. xil : I. The varianceof the probability distribution of y.2b The Assurnptions of the Model To make the econometric model in (5. var( MR4. taken up fur The second : unction ofthe -\swe will see . Each randomerror has a probability distributionwith zero mean.r\tSqUareS p -. is also a random variable.1.1.if one observationis aboveE(y. over a large number of observations. 3.):0.). we make two assumptionsabout the explanatory variables. they will averageout to zero. )i : Si. They arc 1 .quares procec To summar ::rodel (5. follow from those of e.iues y.The assumptions that we introducefor e. var(.Some errors will be positive.ei): o2.) : cov(ei.andxs:Ai.3) where :3.this section . are normally distributed about their mean.e) :0.

2 PARAMETERS OF THE MULTIPLE REGRESSION MODEL 111 of (5. The valuesof eachx* arenot randomand arenot exactlinear functions of the other explanatory variables yr -N[(Fr -l gzxiz+ . + \xxix I ei. MR4. 5.aluesof y.lrr.{s we will see. .4) this model with dables(K > 3). lepends on the is equivalent to anges for each '\zxiz * 9zxis. (5. the least quares procedurefails.our analysiswill be conditional upon the values in must be made. .) : MR5. o2) MR6. first is that the he valuesofthe 'the dependent S(9r.-ases which this assumptionis untenable.) : I r * xiz\z * x6 B3. The in the statistical s will the model variable.to which we canrefer asneeded: ASSUMPTIONS OF THE MTILIIPLE R-EGR-ESSION MODEL MR1..ej) cov(y.5) :.)]' 92.we construct a list of the assumptions the generalmultiple regression nodel in (5..1 Lnesr SquanEs Esrrmerrox PnocsottRE To find an estimator for estimating the unknown parameterswe follow the least squares procedurethat was first introduced in Chapter 2 for the simple regressionmodel.r(y.2+. MR2. var(yi) : var(e.r 2.5.I.2.): Q MR3.3). yi : Br l9zxiz l9zxiz * ei tmerfof tetmei.y.. does not ore likely to be rnt variable are :quent observauted about their .This assumptionis realistic for our hamburgerchain where a decision aboutprices and advertisingis made for eachcity and valuesfor thesevariablesare set accordingly.4).2 Estirnating the Pararneters of the Multiple RegressionModel principle to estimatethe In this section we consider the problem of using the least squares parametersof the multiple regressionmodel. We will discussestimation in the :. They are :ro mean. . and its expectedvalue E(y.oassumingthat (s. given the data t the dependent . + grxix).3) where (s.F:).This assumptionisequivalenttoassuming .This issue of the explanatoryvariablesin our sample. which is a function of the unknown parameters. .arianceo2. Some rf observations.pz.. a condition called exact collinearity. r of y.or further assumptions is taken up further in Chapter 10. the probability : introduce foret ..if this assumptionis violated. 9r) : .Errors spondingto any ervation has no ny pair of errors mal probability variable. 5. With the leastsquaresprinciple we minimize the sum of squareddifferencesbetween the observed r.4) This model is simpler than the full model and yet all the resultswe presentcaffy over to the Eeneralcasewith only minor modifications. which we repeat here for convenience.+ BxxiaeE(e..9r . 'om those of e.) :62 cov(ei.gzxiz gzxiz)z . for To summarize. yi : Fr llzxiz+. E(y) : 9t * $2x.-N(0. much aswe havedonein the earlier chapters. The secondassumptionis that any one of the explanatoryvariablesis not an exact linear thatno variableis redundant.rnknown iontext of the model in (5. Mathematically we minimize the sum of squaresfunction S(Ft.ozle e. tunctionof the others.For .1(r.

To avoid too much notation. c P A R2:0.b2.6832 d :4. :r predictinl Includinger * \zxiz * 9:x. note that the regression function that we are estimatingis E(y. and b3.7217 -7.9136 -7.112 THE MULTIPLE REGRESSION MODEL y. it is important to understand the least squaresprinciple and the difference between least squaresestimators and least squares estimates. we frequently have models with more than two explanatoryvariablesin which casethe formulas becomeeven more complicated. and D3to denoteboth the estimators and the estimates.: The predictt Std.Details of this exercisearegiven in Appendix 5A at the end of this chapter.908 bz : 1.943 0.908x. we are concernedonly with the least squaresestimates.7. you will discoverthat thereis one relatively simple matrix algebraexpressionfor the least squaresestimator that can be used for all models.2 LEesr SquanEs Esrrlnerss usrNc HeununcEn CnerN Dnra ln terms of Ii1'ou were Basedon th 1 . which are called the least squares estimators of the unknown parameters. To interpret the coefficient estimates. Second. formulas for b1.863x. we never use these formulas explicitly. are estimationprocedures. .91 bz : -7. they arecomplicatedformulas that we do not expectyou to memorize.2. 5. For the moment.0000 0.863 The r zeto zero to re( have direc The various other entries on the output will be discussedas we move through the remainder of this chapter. Given the sample observations minimizing the sum of squaresfunction is a straightforward exercisein calculus.0080 REMAF negativer Iftaken li not keep regressio similar tc generally explanat the surro .First. Prob.0960 0.we use b1. Looked at as a general way to use sample data.The solutionsgive us formulas for the leastsquares estimatorsfor the B coefficients in a multiple regressionmodel with two explanatoryvariables.b2.2 lfux.7263 6' : 6'48854.2 contains the least squaresresults for the sales equation for Big Andy's Burger Barn.8626 SSE: 1718.5).3 : 118.4483 118.8861 t-Statistic 18. the least squares estimators are random variables.91.9079 r.2* 1.Third. computer software uses the formulas to calculate least squaresestimates. irrespective of the number of explanatory variables.which are br : 118. 2 Least Squares Estimates for Sales Equation for Big Andy's Burger Barn Variable Coefficient h addition the.8) for the simple regressionmodel with one explanatory variable. Computer software applies the formulas to a specific sampleof data producing least squares estimates.0000 0.) :9r and the fitted regressionline is Yi:hlb2x.Error 6. Although we always get the computer to do the work for us. general. There are three reasonsfor relegating these formulas to Appendix 5A insteadof inflicting them on you here. which are numeric values.7) and (2.2152 2.since their valuesare In not known until the data are observed and the estimates calculated.3 Ta b I e 5 . The r with revel incre the o to co price devie rever f The < an in rever addit will i Table 5.3516 1.They are extensionsof those given in equations (2. obtainedby minimizinC (5. If you proceedwith more advancedstudy in econometrics.hange..

914. The coefficient on advertisingis positive. A l0 cent changeis more realistic. SupposeBig Andy is interested in predicting salesrevenue for a price of $5.91 7. which are The estimatedintercept implies that if both price and advertising expenditurewere zero the salesrevenuewould be $118.This makes the following important point: Estimated regressionmodels describethe relationshipbetweenthe economic variablesfor values similar to those found in the sample data.St -'7. determinewhether an increasein advertisingexpenditures to will increaseprofit.2 and the surroundingdiscussion.We can usethis information. 9 1. as in many others.Predictingthe value of the dependent variablefor valuesof the explanatory variables far from the samplevalues invites disaster. A $l change in price is a relatively large change.2 is $77. on whatcan we say? I .863ADVERT = 1 1 8 .it is important to recognizethat the model is an approximation to reality in the region for which we have data.Clearly.0000 0. this prediction is S : t tS. in which casewe estimatethe revenuechangeto be $791. The negative sign attachedto price implies that reducing the price will increasesalesrevenue. J. with price held constant.0080 .6) you If youwerewritinga paper mightusevariable names aremoreinformative.656 The predictedvalue of salesrevenuefor P : 5. 8 6 2 6 x 1 .g08 PRICE+ 1.We do need to consider carefully the magnitude of the price change.a zero price implies zero salesrevenue. a reduction in price of $ 1 will lead to an increasein revenueof$7908. 9 O B P i 1 . TA In terms of the original economic variables. Extrapolating the results to extreme values is generallynot a good idea.In this model. 2 .7 . 0.this outcomeis not possible. expressed differently. r that thereis one that can be used mt to understand nators and least a.2 PARAMETERS OF THE MULTIPLE REGRESSION MODEL 113 r is a straightforat the end ofthis he B coefficients tensionsof those one explanatory ix 5.ndy's Prob. 2 :77 . REMARK: A word of caution is in order about interpreting regressionresults. 3 Andy'sBurger nates. with advertisingheld constant. 9 1 47 . Or.Refer to Figure 4. suggests that demandis price elastic. along with the costsof producing the additional hamburgers. Ifsuch is the case. If takenliterally. Including extra decimal places to get an accuratehand calculation.69 and its standard deviation is 0.a strategyofprice reduction through the offering of specialswould be successfulin increasingsalesrevenue. formulas for which are called : their values are he least squares las to a specific res.908PRICE+ 1. we estimatethat.50 and an advertising expenditureof $1200. instead of notexpectyou to rftware uses the odels with more rre complicated. that suchas Sffi : I 18.however.A. 3hthe remainder ion that we are In addition to providing information about how sales change when price or advertising change. Including an intercept improves this approximation even when it is not directly interpretable.an increasein price of $l will lead to a fall in monthly revenueof $7908. 9 0 7 9 x 5 .52. . 8 6 3 A t + (s.To avoid too he estimates. why shouldwe not keepreducingthe priceto zero?Obviouslythat would not keep increasing total revenue.0000 0.5. 5 * 1 . The negativecoefficient on P.656.5 and A : 1. an increase in advertising expenditure of $1000 will lead to an increase in sales revenueof $ 1863. S i : 1 1 8 .the estimatedequation can be used for prediction.The samplemean of price is 5.863 ADvERT Based theseresults. we estimatethat.

or. We can think of 62 as an averageof 2l with the denominatorin the averagingprocessbeing N . For ex 1718. The estimatefor our sampleof data in Table 5. Sometimes6 is referred to as the standarderror of the regression. we had K :2.K insteadof N. are estimates ei. However.1 is -: lre rre able tc r. suggest is large while small 2. It can be shownthat replacing e! by 2f requiresthe useof N .': N-K Itr#' (s. 8 1 4 Go back and have a look at Table 5.We now considerthose variances and covariances in the context of the overall properties of the least squares estimator..--iected the e-.1 Tns Ve llc variancesan ':-:ability of the r ^1 i . around the mean function of o2 Fr -t \zxiz * F:xis. Largererr is to be ex1 If o2 is lar . What c :"r-h application :oortance for th ::remeters of tht i-1.114 THE MULTIPLE REGRESSION MODEL J.Sometimesit is called the root znse(short for mean squarederror).3 EsrruerroN oF THE EnnonVanreNcs o2 5. equation(2.7.3 SAMPL 5.2.s4i 6 z : ->17'a? 2 3 .1) where K is the number of B parametersbeing estimatedin the multiple regressionmodel. J Sampli '- There is one remaining parameter to estimate.i generalconte :r. The first is the sum of squarederrors SSE: L e 7 : The secondis the squareroot of 62.: 1 7 i : nB. thent 'i:lples.(h * b2xi2* fuxp) An estimator for o2 that usesthe information from ?! and has good statisticalpropertiesis .2. Since 2.big valuesof 2. the squarederrorsel are unobservable and so we developan estimatorfor o2 that is basedon the squaresof the least squaresresiduals. A natural estimatorof this population mean is the sample mean62 : 2e?I tl .8861 Both thesequantitiestypically appearin the output from your computer software.: understandthe l. we meanbig positive ones or big negativeones. 2l provide information about the parametero2.model assun 'r:ression model ^) *:'a? ' o. given by s^? :r smaller their ':ear" the true p .en algebraic f -rmator.Different software refer to it in different ways. us how the es ::ability of the =:iased and tha . In the hamburgerchain examplewe have K : 3. suggesto2 is small. We know that o2 :var(ei): n(r?) Thus. recall that o2 measures the variation in e.K instead of N for 62 to be unbiased.4) these residuals are 0r : Yi .Using the squaresofthe residuals2l meansthat positive valuesdo not cancel with negative ones.rt'ability distril : rributed. To appreciate further why 0i provide information about o2. When we refer to "big" valuesof 2. equivalently.For the model in (5.Note that in Chapter 2. i'-. For this parameterwe follow the same steps that were outlined in Section 2. the variation in y.ji : yi . thus. A major reasonfor estimating the error varianceis to enable us to get an estimateof the unknown variancesand covariances the least squares for estimators.'[here are two quantitiesin this table that relate to the above calculation. we can think of o2 as the expectation or population mean of the squarederrors ef.943 rtrere r23is the si B l0) in Appen< t : '/zysza:4.1g).r the other varii :. where there was one explanatory variable and two coefficients.:t'mally distribu r. the variance of the error term.different valu and :.

The least squaresestimatorswill also have normal probability distributions. N .K: 50 will be large enough. then y will also be a normally distributed random variable.Its formula is given by rz3: ue.then the leastsquares estimatorsare approximatelynormally distributed in large iamples. rrocessbeing / . Larger error varianceso^2 estimators. the . For the multiple regression model.K instead here was one o2 measures ean function is large while positive ones valuesdo not r o2. are the smaller their variancesthe higher is the probability that they will produce estimates "near" the true parametervalues. In a generalcontext.For example.b2. seeequation r8. These facts are of great importancefor the constructionof interval estimatesand the testing of hypotheses about the parameters the regressionmodel. For this now that (h.-7 Sampling Properties of the Least Squares Estimator )rm.qrons Ltrelate to the The variancesand covariancesofthe least squaresestimatorsgive us information about the reliability of the estimators b1. Sincethe leastsquares estimators unbiased.This sinceo'measurestheoveralluncertainty themodel specification.3 SAMPLING PROPERTIES OF THE LEAST SQUARES ESTIMATOR 115 5. However. It dependson a number of factors specific to each application.if the model assumptions are correct. What constitutes large is tricky. timate of the rnsider those east squares (5. then the leastsquares assumptions estimatorsare the bestlinear unbiasedestimators(BLUE) of the parameters. we can show that var(b2) : 02 0 . If the errors are not normally distributed. This result remains true for the general multiple regressionmodel that we are considering in this chapter.They provide a basisfor assessing the reliability of the estimates. since they are linear functions of y.8) rvherer23is the samplecorrelation coefficient betweenthe valuesofx2 and xz. Different d ercor of the r). Lple data in of 5.3.1 Tns VARrnNcEs AND CovenreNcEs oF THE LEesr Squenrs Esrrrvr.4)2!:'(*.e) there are formulas of a similar nature..In Chapter 2 we found that the least squaresestimator was unbiasedand that there is no other linear unbiasedestimator that has a smaller variance.t) :ssionmodel. in is to^be expected function If o' is large. -ir)' (s.the leastsquares estimators they take on different values in different samples and their values are unknown until a sample is collected and their values computed. The sampling properties of a least squaresestimator tell us how the estimatesvary from sampleto sample. Frequently.then datavaluesmay be rridely spreadabout the regression .For K : 3 we can expressthe variancesand covariances in an algebraic form that provides useful insights into the behavior of the least squares estimator. If we are able to assumethat the erors are normally distributed.20) in Appendix B.4. basedon the .3 and Section4. if THE GAUSS-MARKOV THEOREM: MRl-MR5 listed at the beginningof the chapterhold.b) arerandomvariables.2. are properties is (s.bz.I. and fu.5.It is important For the other variancesand covariances to understandthe factors affecting the variance of b2: lead to larger variancesof the leastsquares I . of red errors ef.

20t -0.343 *(bt. quares es thenbase leastsqua . It is customary to arrangethe estimatedvariancesand covariancesof the least squares estimators in a square array.3 . hE +o. When K:3.4668 ]rr. This outcomeis in also an intuitive one.@r-) : r. which in turn meansv ar(b) willbe large. var(b3) . fu)l I var(b1) cov(b1.When the variation in one explanatory variable is connectedto variation in another explanatory variable.l fu) f cov(b1.2 about its mean addsmost to the precision of estimation when it is not connectedto variation in the other explanatoryvariables.bz.var(b) is small. the arrangement of the variances and covariancesin the covariance matrix is .fzt in of will be small. appears the denominator (5. Collinearity leads to increasedvariancesof the least squaresestimators.To estimateB2 Z(xiz . the estimated variances and covariances br.----_): "*(br. Note that 1 . Table 5 - C P a Table 5.oftware. 4. thesefactors affect the variancesof the least squaresestimators in the same way in larger models. If o' is small then data values are compactly spread about the regressionfunction E(y.3. | fu) I b3) cov(b2.874 and our computer software package.measuredin this caseby estimator. it is difficult to disentangletheir separate effects.The intuition here is that.2 1 \onmer (s. More variation in an explanatory variable around its mean.2or "*@td -o..8).0re7 | | -0. .2. it i rtandard e These t astlmates erample. more observationsyield more precise parameterestimation. D : -6. Of part \qUaferO( Although our discussionhasbeen in terms of a model where K : 3. A larger correlation between x2 and x3 leads to a larger variance of b2. it is difficult to measurethe effect of that change. we have :40.we prefer a large amount of variation in x.b z . A larger value of N meansa larger value of the summationL (xiz . b2) var(b2) cov(b2.795 "-(ail : -0.7484 r. If we add then the r .4.8).1484 . This matrix has variances on its diagonal and covariancesin the off-diagonal positions.) : 9t * \zxiz * B3r. and D3in the Big Andy's Burger Barn exampleare for cou(br.\gain.7)2 .ot97 . This difficulty will be reflected in a large variance for 02. 3. more simply.stimates estimate .46681 l-0. when it is larye.leadsto a smallervarianceof the least squares precisely.ful-) :0.In Chapter6 we discuss"collinearity. cov(b1.t+t -6.116 THE MULTIPLE REGRESSION MODEL 5. a covariance matrix. Larger sample sizes N imply smaller variancesof the least squaresestimators. if the variation or changein 12 is small.The reasonfor this fact is that variation in x.0197 0. 2." which is the situation when the explanatoryvariablesarecorrelatedwith one another. b s ) : b2) cov(b1.3and there is more information about what the parametervalues might be.ies -0.ri themee rrould lie :ts CoITeS[ c o v ( b y .stimates betweenZ "large" c .7es : 1.-onstruc Using the estimate 62:23. Since this term appears the denominatorof (5. It is called a variance-*ovariance matrix or.10) \\'e have i rt the end the paran Thus.i4841 | -6.x2)2.J ) E(y):FrlB2xi2*Frxi: and there is less information in the data about the parameter values.A valueof lryl closeto I means1 . which is called a matrix.

fu 'this fact is that r when it is not ariation in one I variable.Givenoursample.o96o : :0. Of particular relevanceare the standarderrors of h." th one another. A Since this term fhis outcomeis :ter estimation. We know that the least {uares estimatoris unbiased.1. This issue is consideredagain in later sections when we use the estimated variances and covariances to test hypotheses about the parameters and to ronstruct interval estimates.0197 -0.l r ( 0 .2. the standarderror of b2 is approximatelyse(b2):1. t .2. Whether a particular difference is "large" or "small" will depend on the context of the problem and the use to which the estimatesare to be put.tandard error column.It is in this sense that the estimated variance 82.o 2 ] e e i .3 SAMPLING PROPERTIES OF THE LEAST SQUARES ESTIMATOR 117 data about the rread about the brmation about s estimators. is normally distributed. :hen the dependentvariable y.10) If we add assumptionMR6 that the random errors !. it is time to go back and look at Table 5. if the difference betweenD2and B2is likely to be small.stimates if we were to obtain more samplesof 75 burger barns from different cities.2xse(b) :2.2012 -0.7951 -0. under the multiple regressionmodel assumptions MRl-MR5. if the of that change.he estimated example are (s.That is. Notice that these values appear in the . r ) .2.3433 var(b2) : JL2otz: t.6832 var(fu) t/oA6G8 Again. :tors affect the : least squares . t in this caseby ToestimateB2 :re is that.rianceson its e-covariance .in the model + lt : 9t * \zxiz* 9:-rrs "' + \rxx * et .If the differencebetweenb2 and 92 can be large. y i . tors.N [ ( 9 r I g z x i z + " ' + 9 r . tells us somethingabout the reliability ofthe least squares :stimates.3516 var(b1 : \/40. then b2 is reliable.7484 -0. Note that meansl .7951 1. f b2. have normal probability distributions. 5. : se(01) se(b2) : se(b3 : ) :6.soweestimate that 95Vo theb2values of * ould lie within the interval9z + 2.3 Covariance Matrix for Coefficient Estimates C L P 40.to be within approximately two standarddeviations olthe meanB2.ement of the Table 5 .2 TnE PnopsRTrES oF rHE Lnesr Squenrs EsrrmeroRs AssulrrNc \onrlrerry DrsrnrsurED ERRoRS \\'e have asserted that. Thesestandarderrors can be used to say something about the range of the least squares . they are given by the \quare roots of the correspondingestimated variances.the leastsquares estimatorb6is the bestlinear unbiasedestimatorof the parameter B7.If bz is normally distributed.3. and bz.obtainedby applying the . 1. bz.0197 0. For erample.4668 Table 5.5.eastsquares estimatorto other samples.so its mean value is E(b2) : B2.3433 -6. or of :ts correspondingstandarderror. o 2 ) . listed atthe end of Section5.b2is notreliable. it is "collinearity.7484 -6. thenbasedon statisticaltheory we expect95Voof the estimatesb2.3 shows how this information is typically reported in the output from computer software.

such that call . The proceduresare identical to those describedin Chapter 3.var(be)] That is. Rearrangin The interva t :m-N(o..975).t. the first step is to find a value from the /1721-distribution.1.we can transform the normal random variable bp into the standard normal variable Z.5-percentile of the /1r.8) for the K : 3 case. dependson the unknown variance of the error term.131as ori S1000).r). We now examine how the result in (5.--t. : 1. we obtain the estimated var(br) which we denote ut il@). is 0'025).. it r. Consulting the /-table inside the front cover of the book. \nother wi ..By subtracting its meanand dividing by the squareroot of its variance. is the degrees of freedom of the r-random variable..f an inten rarrower ir :he varianc rore indep :engeofpn :le rvouldnr :enerally r \lternativ! The quest lrocess is r(-r (s.the number of degrees freedom wasN .11) that hasmean zero and a varianceof l. the responseof sales revenueto a changein price at Big Andy's Burger Barn. only the degreesof freedom change.timated s -. the 2. In this chapterthere areKunknown of coefficients in the general model and the number of degreesof freedomfor t-statisticsis N_K.2.5-percentile the of /1rv-ry-distribution(the areaor probability to the left of t..when we replace o2 by its estimator 62.4 Interval Estimation Supposewe are interestedin finding a 95Vointewal estimate for B2. it is clear that. The vari anceof b1.Bas \ndy can c Followir t 957o inte ( .sts.993.118 THE MULTIPLE REGRESSION MODEL Since the least squaresestimatorsare linear functions ofdependent variablesit follows that the least squaresestimators are also normally distributed.2..14) r For this <r us do this . Jefinea 951 :he populat :actbeforer w -'ollected :ts perform A957oi :eplacingb :ntervalest h .2). That is. and the result in (5. and-t. : /1o. correct to two decimal places.ozs. l3) Using the notationintroducedin Section3. seeequation(3.omewhere :rore realis S1009..3 : j2 degreesoffreedom.95 P(-t.1) random variablero a /-random the variable. we discoverthereis no entry for 72 degrees offreedom. fort: r.75 .F r -r1rir-K) se(bt (s.11) changes N(0.K . This intervt . as illustrated in (5. but.99.r2) One differencebetweenthis result and that in Chapter3.Using this value.your computer softwarecan be used to find /.-distribution (the area or probability to the left of -/. erv reliabl In gener :nmediate .N[9t. Following the proceduresdescribed in Section 3.K ( s. 1.If greateraccuracyis required.12) can be used for interval estimation and hypothesistesting. t. br . is rv_r.12) for the secondcoefficient(k :2). eachbphas a normal distribution with mean B1and variance var(b1). : tp.7). o2. we can rewrite (5. Replacing var(b) by6@D in (5. is 0. : l.) : 0. In Chapter 3. and noting that we haveN . from the entriesfor 70 and 80 degreesoffreedom. < t1tz1 \\'e estimatr :elenue of (5.'-r. from (5. where there were two coefficients to be estimated.\tra adve 5.w_r1isthe 97.

It might be expensiveto do so. -eenerally Altematively we might introduce somekind of nonsampleinformation on the coefficients. We can establishthis alone. 1.10.1s) (s. 2 For this calculation we used more digits so that it would match the more accuratecomputer output.8).224) (L8626 .1.it is clear ed.95 '(be).a large sampling variability is reflectedby a large standarderror.092.993 se(b2)] (s. exhibiting more independentvariation.Or.By subtracting t the normal random Theintervalendpoints x x [b2 1.basedon the model assumptions of collectedwe have confidencein the interval estimation procedure (estimator) because its performance when used repeatedly. as its standarderror (which measuressampling variability) is relatively large.8626 1. A95Vo interval estimatefor B2basedon ourparticular sampleis obtainedfrom (5.and so whetherthe extra information is worth the extra cost. one solution is to obtain more and better data. a 10 cent price reduction will lead to a revenueincreasebetween $572 and 51009.6832.oritmay lead to arevenueincreasemore than threetimes the cost of the advertising.908 and se(bz): 1. A wide interval for the parameter B3 arises because the estimatedsampling variability of the least squaresestimator b3 is large.however.This solution is hewould needto assess not open to economists. Based on this information.13) 5-percentile ofthe tc : tp. then 95Voof them will contain the true parameter92.Before the dataare factbefore any dataare collected.r2) 2).who rarely use controlled experiments to obtain data. The question of how to use both sample and nonsample information in the estimation processis taken up in Chapter 6.993 x0. In the computation of an interval estimate.4 INTERVAL ESTIMATION 119 iablesit follows that (5. in terms of aprice changewhosemagnitudeis somewhere more realistic.l. is 'er thereis no entry [reedom.f freedom.15) by replacingb2 and se(bz)by their valuesbz: -7. yourcomputer It in (5.bz * 1.If this interval estimatoris usedin many samplesfrom definea95%o the population. This interval is a relatively wide one.501.5.993 se(b2).092. Big Andy can decide whether to proceed with a price reduction.Basedon rhe variance expressionin (5. You may see us do this occasionally. .993x se(b2)] 0.if an interval estimateis uninformative because is too wide. A niurower interval can only be obtainedby reducing the varianceof the estimator.6832) : (0.3. Another way of describing this situation is to say that the point estimatefu : 1. the response salesrevenueto advertising. our 957o interval estimate for B2 is given by (. iable to a t-random interval estimatorof B2. (s.oz5. < bz 11.we find a 95Vointerval estimate is given by' x0.11) g unknown variance ve replace o2 by its ----'-:> denote as var(Dp). the first (5.Thus. is the degrees of r coefficients to be rere areKunknown m for t-statistics is val estimation and Jhapter 3. Big Andy could collect data from other cities and set a wider rangeof price and advertisingcombinations.096.993xse(b2) 9.12) for the (s.14) .-5.724) price by $1 will lead to an increasein revenue that decreasing This interval estimatesuggests between$5724 and$10.993 + We estimatethat an increasein advertisingexpenditureof $1000 leadsto an increasein sales revenueof between $501 and $3224. only the e responseof sales rceduresdescribed .9626is not very reliable.14)we obtain Reananging : < P[b. it implies that extra advertising expenditure could be unprofitable (the revenue increase is less than S1000). there is nothing immediate that can be done. of Following a similarprocedureforB3. it In general.p_61is the left of -/. and the cost of making and selling more burgers.

5.K.a 12 : 0. To give a general expression for an interval estimate we need to recognize that the critical value t will dependon the degreeofconfidence specifiedfor the interval estimate and the number of degreesof freedom.ctl side of tl Jnd -t^ : l'^ :'-r'alue.BY-STEP PROCEDTIRJ FOR TE STING HYPOTHESE S For the alterni and . tg-o1z. Calculate the sample value of the test statistic and. if desired. l.N-n.{1. If we are to confirm this belief.r-rl: t . For a two-tail test. is the percentile value /1t-o72.y-r. We will follow the step-by-step procedure for testing hypotheses that was introduced in Section 3.i hethersales l. Sinct from perf( For testir t. i.F1s : 9z < c versusI11:52> c are called one-tail tests.025in eachtail of the distribution. Knowing aboutp-values(seeSection3. The numberof degrees . or too uninformative. we need to examine whether or not it is supportedby the data. We denote the degree of confidenceby 1 .5.cr.120 THE MULTIPLE REGRESSION MOI)EI We cannot say.xse(bt)l I lb1.12) provides the foundation for testing hypotheses about individual coefficients.to 5. Select a and determine the rejection region.975.5 Hypothesis Testing for a Single Coefficient As well as being useful for interval estimation. b1. we consider testing the significance of an individual coefficient. We will use both.are called two-tail tests. The c From At the time these steps were introduced in Chapter 3 you had not discoveredp-values.the r-distributionresult in equation(5.3. The . in the caseof a95Vointervalestimate ct:0. the p-value.1 TEsrrNc tHr SrcNrrrcANCEor e SrNcre CosrrrcrENr When we setup a multiple regression model. in general. what constitutes an interval that is too wide. we do so because believethe explanatory we variables influence the dependentvariable y. 4. Specify the test statistic and its distribution if the null hypothesis is true. As you discoveredin Chapter 3. It dependson the context of the problem being investigated and how the information is to be used. where c of is a specifiedconstant. 3.95.Hypotheses with inequalitiessuch as. 2.. Determine the null and alternative hypotheses.4. tg-o1z. we Thus. reje :rom the right . for one-tail tests some hypothesesof economic interest are considered.cr:0. To refresh your memory. In the case of a 95Vo confidence interval. sa! . which has the property that Pltq-r1 1 tg-a1z.In this sectionwe considerexamplesof each type of hypothesis. of freedom is N The value t. in Big Andy's Burger Barn example this value was 75 .05 and I .a)Vo confidence interval as se(b1). here again are the steps: STEP.we usethis valuebecause require0. | .r. If a given explanatoryvariable. Testing this null hypothesis sometimes is calleda testof significance the explanatory for variablex7. The nt The te 1.3.r. Using freedo distrib hypotl t<rejecti p>0 -1. hypotheses the form IIs ilz : c versusI11:92* c.3 : "12. we write the general expressionfor a 100(1 .p-ryx rind whether tl h1'pothesis rgainst the alt To carry out tl 5.has no bearing on r'.a1Z. then 9r :0. Stateyour conclusion.we rt In the Big . P Corn 5. Thus. FIo: 2. we needto ask whether the data provide any evidenceto suggestthat y is related to each of the explanatory variables.5) meansthat steps3-5 can be framed in terms of the test statistic and its value and/or the p-value.That is.

Since -7.215 < . : t@/z. 2.993.7 .05.05). Alternatively. The null and alternativehypotheses Hs:92 : 0 andH1:92*0. Using a 5% significance freedom.12) ficients.000' 5.rz) -l '993' Thus we reject the null hypothesis if the calculated value of t from step 2 is such that t) 1. and reject F1s the computed /-value is greaterthan or equal to t. we reject . tc: t6-o1z. p-value.Thus.025 in each tail of the : : distribution arc tq. perform the test. we have 1. Using the p-value to because0. introduced in Section if 3. the critical values that lead to a probability of 0. level (ct :0.12). 4. erval as find whether the data contain any evidence suggestingy is related to. is t : bzI se(b) . and noting that there are 72 degreesof 3. If a bsting this null ablexr. w h e r ec ities such as . The test statistic. The computed value of the r-statistic is ' : -7.torn. .cr.993 ot Stating the acceptancewe do not reject F16.993.s7s.N-n. The test statistic.5 HYPOTHESIS TESTING FOR A SINGLE COEFFICIENT 121 )o wide.F1s For testing whether salesrevenue is related to advertising expenditure.Ils : ider examplesof gnificance of an interest are conrtheses that was leps: For the alternative hypothesis "not equal to" we use a two-tail test. the explanatory lief. :d in terms the of From your computer software the p-value in this case can be found as < P (t 1t4> 7'215) + P (t 1tz1 . we need to vhetherthe data y variables. following our standardtesting format.tru-n. if rejection rule in terms of thep-value.908 Lo% : -l '215 rveredp-values. f the disrriburion.000 < 0. if we statethe acceptance-rejection ( ct and do not reject Hg 1f p > a.lz) l '993 and /1o. is t: br -r17v-r) '"(b) E r equation(5.05. which.cognize that the interval estimate nce by I . in Lmberof degrees rus75-3:'12. (the critical value from the left side of the distribution). if the null hypothesisis true. whether salesrevenue is related to price: are 1. we test the null hypothesis F1s: : Q Bp againstthe alternative hypothesis fu:Br*o To carry out the test we use the test statistic (5.215) : 2 x (2.ozs. t < -L993. e property that idence interval.5.3. we reject Hs if p In the Big Andy's Burger Barn example we test. we reject -FIs p < 0. (the critical value from the right side of the distribution) or lessthan or equal to -t.rr.1.2 x l0-r0) : 0.if the null hypothesisis true. As you : 9 z l c .if the null hypothesisis true.to 2.we rejectHo:92 : 0 and concludethat thereis evidence from the data to suggest sales revenue depends on price.If -1993<t<1. For a test with level of significanced. Ilo:9: :0 : a n dF I 1 9 2 * 0 .u-rc) rule in terms of the and-t. or too rted and how the .3. is t : bzlse(bz).05 and do not reject /Is if p > 0.000 Correct to three decimal places the result is p-value : 0.

as mentioned in Section 3. 4. To createa t so is valid b.215 and2.1 (demandis the proposi Since 0. Since -7. we wish to know if Fz > 0: a decreasein price leads to a decreasein sales revenue (demand is price inelastic). fron i\ually half that c I :rample because In Section 5.2 at the same time as we reported the original least squares estimatesand their standarderrors. Using a 5Vo significance level.008 < 5.It confirms an initial prior belief that a particular explanatory variable is a relevant variable to include in the model. Choosing t(o. In other words.4. assuming1/ 3. The value of the test statistic is If we are not Prepa the datato supportt as our null hypotht alternativehyPothe L r.We now are in a position to statethesequestionsas testablehypothesesand to ask whether the hypothesesare compatible with the data.The sametest outcome can be obtainedusing the p-value.72)- .2.2b Testing .5.72) - .2 j7 26) : 2 x 0. Treatingth distributiot 3.3.In terms of thep-value.we do not reject I1e. I/s: 9r < 1 2. we reject Hsif p < 0.we rcject Hs. and their outcomescan be read immediately from the computer output that will be similar to Table 5. 5. statistical significance should not be confused with economic importance.5. we would not conclude advertising is important.993 or t < -1. We should also be cautious about concluding that statistical significance implies precise estimation.993. but we also concludedthe corresponding 95vo intewal estimate(0.000 and 0.726 and their correspondingp-values0. Note that the /-values -7. but.1 we noted that two important considerationsfor the managementof Big Andy's Burger Barn were whether demand was price elastic or inelastic and whether the additional salesrevenuefrom additional advertising expenditurewould cover the costs of the advertising. The rejectic occur if tht significance _ rQ.3.1. 5. Because2.-ritical value.00( \otethe similariti( ryrformed in Secti Jifferent. If the estimatedresponseof salesrevenue to advertising had been bz :0.005. since the estimate implies increasing advertising by $1000 increases revenueby only $10.rnincrease sale ruch an increaser 1.01 with a standarderror of se(b:) : 0.5 3.or 9z ( 0: a decreasein price leads to an increase in sales revenue (demand is price elastic).501.8626 ': oss32:2'726 The p-value is given by P (t 1tz:> 23 26) + P (t 1tz1 . then we would have concluded b3 is significantly different from zero.122 THE MULTIPLE REGRESSION MODEL 5. The advertising coefficient fu : 1. Not onll --ritical values. Otherwise.gs.2 ONE-Tarr HyporHesrs TssrrNc FoR A SrNcrs CoErrrcrsxr Flo:Bz>0 H 1 : $ 2 < O( 2.004 : 0.993.008 < 0. we reject the null hypothesis if t> I. The value c The corresl 5. onc .2a Testing for Elastic Demand With respect to demand elasticity. we were not able to get a preciseestimateof 83.9626 was found to be significantly different from zero.O5.224) was too wide to be very informative.726 > 1. Significanceof a coefficient estimateis desirable. However. In this casewe reject I1s because 0.05.008 were reported in Table 5.05.5. 5. the data supportthe conjecturethat revenueis related to advertising expenditure. The other hypothe in .Hypothesistestsofthis kind are carried out routinely by computer software.

we first state the null and alternativehypotheses: l.05 as our level of significance. if assuming Hs:$2 : 0 is true.1. the test statisticthat hasthe rdistributionwhen -F1s true is. 1.2b Testing Advertising Effectiveness The other hypothesisofinterest is whether an increasein advertisingexpenditurewill bring en increasein salesrevenuethat is sufficient to cover the increasedcost of advertisins. To createa test statistic we act as if the null hypothesisis the equality 9z : 0. 0 I &3is significantly :rtising by $1000 |ortant.We should .666 or if the p-value < 0.t : . is ]NT nagementof Big : and whether the .666or if the p-value < 0.215) : 0.7 .008 . Ht:92 < 0 (demand elastic).uch an increase will be achievedif F. Since (demandis elastic) is more compatible with the data.5. from one side of the distribution.i _Z7 )1 t < l"o% :s 0.os. the p-value from the one-tail test is usually half that of the two-tail test.1 . w e r e j e c t H o t ! z ) 0 a n d c o n c l u d et h a t H 1 : 9 2 < 0 5.ritical value. Following our standardtesting format.224)was too ise estimate B3. I 1 o : 9 : < | a n dH 1 : 9 s > l . The calculated/-valuesare the same. 12) the test statisticis t : bz lse(bz).000 < 0. from (5.2): -1.12). If we define "unlikely" in terms of a 5Vo significance level. is 008 :urethat revenueis obtainedusing the 2.5. 6 6 6 . Since . Not only are the values themselvesdifferent.666.one from each side of the distribution. of p-value is P(t1tzy -'7 . fferent from zero.666. Also. Choosing a:0. . \ote the similarities and the differencesbetweenthis test andthe two-tail test of significance performedin Section5.000.the relevant critical value is t@sslz) : 1. Ho:92> 0 (demandis unit elasticor inelastic). it is appropriateto take the assumptionof an inelastic demand as our null hypothesis. then unlikely values of t are those less than the critical value te.over the costsof Le hypothesesand ldemand is price idemand is price 3.5. as ed with economic d b e e nb z : 0 . 3.000 and 0.05. > 1. although this fact is harder to appreciatefrom this erample becauseboth p-values are essentially zero.05. The value of the test statistic is ': b" rqb): -7 90t _ '.but the critical t-valuesare different.5 HYPOTHESIS TESTING FOR A SINGLE COEFFICIENT is if l> 1. Treating the null hypothesisasthe equality I10: 93 : l.05. the sameconclusionis reachedusing the p-value. 2 1 5 < . The rejection region consists of values from the r-distribution that are unlikely to occur if the null hypothesis is true. Thus. we reject lls if t < -1. 5.993or Otherwise. 2. from (5. -1.inal least squares :d out routinely by e computer output I prior belief that a odel. we also reject it for any B2 > 0.The sampleevidencesupports the proposition that a reduction in price will bring aboutan increasein salesrevenue. do we Ifwe are not preparedto acceptthat demandis elastic unlessthere is strong evidencefrom the datato supportthis claim.reciseestimation. However. with a two-tail test there are two .tW-xt.3. The corresponding < . we set up the hypotheses: 1 . With a one-tail test there is only one . Since 0.ritical values. Doing so is valid because we reject lLlsfor B2 : 0. Then.We reject Ho if t > 1.

However.v a l u eo f t h e t e s ti s P ( t r 7 2 . In the context of our hypothesis testing framework. Using the p-value to performthe test.124 THE MULTIPLE REGRESSION MODEL 4.16) The interpre the variation rhat. and SSEis the sum of squared least squares residuals(enors) and is the portion of the variation in y that is not explainedby the model. sl rhich SSEl -rfortunatel .6 Measuring Goodness-of:Fit For the simple regressionmodel studiedin Chapter4.8626 | r"(bt 05832 0. that the sample standarddeviation for y.. this estimateby itself suggests effective. As menti neasureof tl row well tht iample corr! :he linear as t essociation :hemodel is r :he valuesol Jata well. There is insufficient evidencein our sample to conclude that advertising will be cost effective.-reases. is usuall whereSSRis the variation iny "explained" by the model (sum of squares regression).> L ' i -" ..105 > 0. :e degrees :. refers to the predicted value of y for each of the sample values of the explanatory variables.we againconcludethatIls cannotbe rejected because 0. which is readily computed by most software. One diffic . providing the model includes an intercept(B1 in this case). SSZ of is the total variation in y about its mean (sum of squares total).666. Since 1. Another way of thinking about the test outcome is as follows: Becausethe estimate advertisingwill be bz:1.263<1.8626 is not significantly greaterthan I .105..f z: t _Ur. .tsz N-1 .?:.when we take into accountthe precisionof estimation. .y ior the dati The samplemeany is both the mean of y.Jding more r. we cannot conclude with a sufficient degree of certainty that B3 > 1. we find that b2 : | . we introducedR2 as a measureof the proportion of variation in the dependent variable that is explained by variation in the explanatoryvariable.lgebraica :rd thusR2 I : a model j An altern . That is.and the same formulas are valid.. andthe mean ofj.but sometimesSSZis not reported..05. however.s sssE .In the multiple regressionmodel the samemeasureis relevant.a?.5out the " . ariableexp ':e sample 1 One fina ' ::gression ::ratthe regl .| i?r"' $. and so T h e p . is given by o.r 1 -2!:.0r y)' : ' -. but now we talk of the proportion of variation in the dependent variable explained by all the explanatory variables included in the linear model.9z 1. >1 . The coefficient of determination is R r : S S R .rriationex <lecting the ::efer to con . ? -: 0 .Y ) 1 i " ssr I[. (s. - I N . 5. in our s r ariation in t 3rror term.measured by the standarderror.2 b3xs l' * " I byx. 4 3 3 . The value of the test statistic is 'bt . Recall. The notation !.8626 is greaterthan 1. 2 $ ) : For Big An SSE: 1718 5. we do not reject I1e. The value for SSEwill be reportedby almost all computer software. yt : h I b2x.

In :lude with a and R2:l - 1118'943 : u'446 .aluesof the I includes an .s ss7 EwN -D( ) / For the data from Big Andy's Burger Barn the value of this descriptive measure is R. : the estimate :ising will be on.{lgebraically it is a fact that asvariablesare addedthe sum of squarederrorsSSEgoesdown and thus R2 goesup. 0 5 .evenif the variablesaddedhaveno economicjustification. SSEgoesdown.}L'u? ^:.Using these sums of squares.2Voof the variation in revenue is left unexplained and is due to variation in the error term or to variation in other variables that implicitly form part of the error term. means that.!. This modified F is sometimes used and misused as a device for selectingthe appropriateset of explanatory variables. .6 MEASURING GOODNESS-OF. this corrected measureof goodnessof fit unfortunatelyintroducesanotherone.i.9S2 m ofsquared rxplainedby . If the model containsN .It losesits interpretation. measured Lterthan 1. An alternativemeasure goodness-of-fitcalled the adjustedR2.then R2 : 1.l).times SSZis :h is readily . in our sample.This practice should be avoided. If. . and so doesN .you are certain :hat the regressionplane passes through the origin..5.. The effect on R' dependson the amount by *hich SSE falls.becauseof rhe degrees of freedom term N .943. This measuredoes not always go up when a variable is added.8Vo the variation in salesrevenueis explainedby of It the variation in price and by the variation in the level of advertisingexpenditure. One difficulty with R2 using as a goodness-of-fitmeasureis that it can be made large by addingmore and more variables.433. for theoretical reasons.if R2 is high. and y.and often symbolized as of Rl. thereis not a closeassociation between the valuesof y. and the valuespredictedby the model.We preferto concentrateon the unadjusted and think of it asa descriptivedevice for telling us R2 about the "fit" of the model. As the number of variables K increases.485 SSE : 1718. For Big Andy's Burger Barn we find that SSZ:74x6. then B1 : 0 and can be omitted from :ession). In this case the model is saidto "fit" the datawell. The value of R2 is equal to the squared samplecorrelationcoefficient betweenj'.2..1. The (s.:0. While solving one problem. it is computed as s /( 1 n: ^ 2 r . the coefficient of determinationis also viewed as a measure the predictive ability of the model over the sampleperiod or as a measureof of how well the estimatedregressionfits the data.we have dence in our ]e p-value to ) .K. it meansthat there is a close association betweenthe valuesofy. The intercept parameter By is the y-intercept of the regression"plane.y)" 3l 15485 L|:rfi easure ofthe iation in the :vant.I variables. As mentioned in Section 4. If R2is low. it describes the proportion of variation in the dependent r ariableexplained by the explanatory variablesand the predictive ability of the model over the sample period.K in the numerator.16) The interpretationof R2 is that 44. is usually reported by regressionprograms. 55. j'. Since the samplecorrelationmeasures the linear associationbetweentwo variables. The manipulation of a model just to obtain a high R2 is not wise.2....R' is no longer the percentof r ariation explained. and the valuespredictedby the model.488542:3115.FIT 125 and so ssr: (N. 1 0 5> 0 .and the re dependent model. and the model doesnot fit the data well." as shown in Figure 5. One final note is in order.

3. Thus.the information from estimating a multiple regression equation is summarized by writing down (i) the estimated equation using informative variable names. While this is not a common practice.4.g\SpRrcE r.Thus. when your model does not contain a constant.F1s rejected. (ii) standard errors of coefficients below the estimated coefficients (or the /-values for testing zero null hypothesis). the /-value usedto test a null hypothesisof the form Ho:$r: 0 is given by the ratio of the least squares estimate to its standard error that appears underneath. then the measure R2 given in 15. an approximate 957o interval estimatecan be obtainedby mentally calculating the points two standarderrorseither side of the least squaresestimate. you know that a null hypothesisof the form Hs:$k:0 would be rejectedat the cr: 0.t)'* Lr(n -r)"+. / 5. go back and check the proofin Appendix 48 of Chapter 4.448 R2 + (6.rVhen writing a report or paper.126 THE MULTIPLE REGRESSION MODEL the model. For the construction of an interval estimate we needthe least squares estimate. If c is within the interval.as discussed Section 3.4. otherwise .its standarderror.To understandwhy. FIs is not rejected.16) is no longer appropriate.05 level of significance. and a critical value from the r-distribution.0e6) (0. i 1i: .y)Oi no longer disappears. ). If the ratio of an estimateto its standard error is absolutely greater than 2 (approximately). Remembering of these quick "inspection techniques" will help you make "on the spot" assessments reported results.71 The discussion and calculation of R2 completes our description of all the entries in Table 5. For a95Vointerval estimateand at least moderatedegreesof freedom the critical /-value is approximately 2.6832) (5. Under these circumstances it does not make sense to talk of the proportion of total variation that is explained by the regression.8626ADVERT : 0. ^ . from an interval estimatewe can in tell whether any hypothesisof the form I1s t}r: c would be rejectedor not in a two-tail is test.\rai .I_(yr N N N^ or SSTI SSR+ SSE.1 REpoRrrNc rrrp REcnpssroN REsurrs .2.17) From this summary we can read off the estimated effects of changesin the explanatory variableson the dependentvariable and we can predict valuesofthe dependentvariable for given values of the explanatory variables.17).LLr ( yi .and (iii) the R2-value. it does occur.1:f ( \ I ( sfB: (s") 1r8.. without an intercept term in the model.6. We are now in a position to report the results along the lines described in Section 4. it is better not to report R2.9 i.17). If the model does not contain an intercept parameter. and regressionsoftware includes an option that removes the intercept from the model.4)(1.The reason it is no longer appropriate is that. even if your computer displays on9. Similarly.Furthermore. It too can be calculatedmentally by inspectionof (5. 5.\nswe . In the sum of squaresdecomposition the cross-productt".2. For Big Andy's Burger Barn we have _<. from the information in (5.

. }yi xh. (g) Find the standard enor for b2. ri Consider the following model that relates the proportion of a household's budget spent on alcohol WALC to total expenditure TOTEXP.7:x3-x3. ii:ii-j *- (b) Calculate *iz.1* Considerthe multiple regression : xn9r I xiz9z -f xiz9z* ei li with the nine observations yi.That is.e 95Vo interval rrs either side of : 0 is given by lrs underneath.andfu.5. x. 1 estimate to its rw that a null 5 level of sigstimate we can rot in a two-tail .and R2. : . NKtakes only the values I or 2.1 to (a) Compute a95Vo rntewal estimate for 82.xi2 urd x3 given in Table 5.l. ritical l-value is . (d) Find the leastsquares residuals 21.bizris. and the number of children in the householdNK..^ . Remembering assessments of (c) UsetheexpressionsinAppendix5Atofindleastsquaresestimatesbl.1 ll the entries in res described in Latinga multiple equation using r the estimated : R2-value.9) to find the sample correlation between x2 and x3.5. (b) Test the hypothesis Hs: $2 : 1 against the alternative that H1 :92 * l.4.SSI SSR.r7) : xiz .7 Exercises Answers to exercisesmarked * appear in Appendix D at the end of book. age of the household head AGE.7.10 for more details about the data. Use equation (5. (f.rt.2e. and . (e) Find the varianceestimateo2. Note that only householdswith one or two children are being considered. 1 I z 5 0 1 2 a I -2 I 0 -1 -l I l -1 0 -l 1 -2 0 1 I Appendix 48 of . on Use a hand calculator to answer the following questions: (a) Calculate the observationsin terms of deviations from their means. . SeeExercise4. (h) Find SSE.J)ei no l to talk of the 'hen your model rmputerdisplays -N z I 2 0 5.. Pnosrprvrs model -5. b2. fiALC : gr * B2tn(TOTEXp) + %AGE -t g+NK -r e The datain thefile london. . t * Use your answersto Exercise5.xit.4 D a t a f o r E x e r c i s e5 .daf were usedto estimatethis model.Thus.7EXERCISES 127 ressionsoftware model does not 6) is no longer n intercept term Table 5.72.i:1(}t .22. Zyi bi? the explanatory ient variable for val estimate we re r-distribution. find '-t z I (s. Output from estimating this equation appearsin Table 5. 5.

0191 0.E. Error 0.0276 -0.0247 -0.What does this interval tell you? (d) Testthe hypothesisthat the budgetproportion for alcohol doesnot dependon the numberof childrenin thehousehold. 3 Itble5. (a) Write out the estimatedequation in the standardreporting format with standard errors below the coefficient estimates.The output is reported in Table 5.128 THE MULTIPLE REGRESSION MOI)EL Table 5. Canyou suggest reason thetestoutcome? a for 5.0004 0.5 O u t p u t f o r E x e r c i s e5 .0071 0.0315 0. (i) The /-statisticfor b1.Do you think the resultsmake sense b from an economicor logical point of view? (c) Are there any variables that you might exclude from the equation? Why? (d) What proportion of variation in the budget proportion allocated to transport is explained by this equation. l 650 -2.:riable C tn(TOTEXP) AGE N/< R-squared S.0133 6. (ii) The standard enor for b2.0091 0.9776 5.3542 Mean dependentvar S. b3.{ : IRITIO (a) Fill in the following blank spacesthat appear in this table. fu.6086 -6.0000 0.0000 0.1 0 2 . .D. Error 0.6347 0. TAX : fu PTRATIO Table 5.D. 1.(-cEss {. dependent 0.0606 0. (iv) R2.4* The datasetusedin Exercise is usedagain. (c) Compute a957o intewal estimate for B3.VE "ITOX tt-.9624 -4. 4 (e) Predic one-a sampl This ques usesthe d Demand f 8 1 . of regression Sum squaredresid 0. (b) Interpret the estimates 2.0000 0..6. andba. (v) 6.3 how the proportion ofthe householdbudget spenton transportationITIRANS dependson the log of total expenditureIn(TOTEXP).0002 0.0033 /-Statistic Prob.This time it is usedto estimate 5.8561 -0.E r/5f ar)OMS 5.AGE. and number of children NrK. 2 Compu Use a con a- Std. dependent var 0.0750 Mean dependent var var S.) Test t value (d) Test a will ir .1053 (a) The fi file lo equat for al the de . C Ln(TOTEXP) AGE NK R-squared -0.6 Dependent Variable: WRANS lncluded observations: 1519 Variable Coefficient (a) Repor (b) Find ! (c.3284 0.0000 0.8690 0.luded observa Std.7 ( Dependent Yariable: WALC Included observations: 1519 Variable Coefficient -)ependentVariab -:. (iii) The estimatebr.1323 0. O u t p u t f o r E x e r c i s e5 . and ba.04t4 -0.0130 0.T VALUE: CRIME: NITOX: ROOMS = AGE : PT DIST:W ACCESS .0001 -0.0187 0. .0055 /-Statistic Prob.0322 0. (b) Interpret each of the estimatesb2.RI.752896 1.0633 .

0000 ar r .and pupil-teacherratio by town.3'115 -0.uded observations: 506 Prob. and (h).2001 0.i.0000 0.0000 0.'endent Variable: UALUE --r.0000 -?t rtE '.1323 0.3924 0. The variables are defined as follows: VALUE : median value of owner-occupiedhomes in thousandsof dollars.and two-children households. and D. parts(c). It usesthe data of Harrison.7.1834 -22.0000 0.1768 0.6347 0.3284 0.0606 0.().0723 0.L. The output appearsin Table 5.1.000. increasesthe value of a house by $7000.0000 0.000.8690 0.7673 -3.5.6'714 3. CRIME: per capita crime rate.4409 Prob. 5 .0000 0.0000 0.0038 0.0275 -5.1. fuel.E ::-{ . "Hedonic Pricesand the Demand for Clean A:r. PTMTIO: (a) Report briefly on how each of the variables influences the value of a home. ACCESS : index of accessibility to radial highways.2 Prob. 0. The output is with standard sense from an n? Why? o transport is Conpurrn ExsncrsEs 0.7 and 36. (c) Test the hypothesis that increasing the number of rooms by one.l. ft) Find 95Vointewal estimatesfor the coefficients of CRIME and ACCESS. to : . Rubinfeld (1978). :.Error 5.0000 0.3353 0.for both one.D.0008 0. ROOMS : ?v!rogenumber of rooms per dwelling. AGE : proportion of owner-occupied units built prior to 1940.(a) The file lond_small.4824 16.dar.7 O u t p u t f o r E x e r c i s e5 .0009 0. NITOX: nitric oxide concentration (parts per million).0002 0.lable Coefficient Std.7 EXERCISES 129 :tble 5.0126 .0478 .2939 -5.2'723 -0.0633 -.3659 0.3399 -8.3861 -6. DIST : weighted distancesto five Boston employment centers. R|TIO (e) Predict the proportion of a budget that will be spent on transportation.0365 4. respectively.23't8 -3.1053 < 6 Use a computerto verify your answers Exercise5. .and other) in your results.e.daf to estimatebudeet share equations of the form w : gt -r g2tn(ToTEXp) + %AGE -t F+NK * e for all budget shares(food. i--. -i This question is concernedwith the value of housesin towns surroundingBoston. transportation." Joumal of Environmental Economicsand Management.when total expenditureand ageare setat their sample means. alcohol. (0.'tr r. (d) Test as an alternativehypothesisF11 that reducing the pupil-teacher ratio by 10 will increasethe value of a house by more than $10. (g).US 28. (e).8109 6. . I tell you? depend on the testoutcome? imate how the ependson the .4067 -0.0000 0. 8l-102. clothing.Reportanddiscuss .5.dot contains a subsetof 500 observationsfrom the bigger file london.which are 98. your discussion In commenton how the dataset.0187 0.1607 0.0141 0. TOX i . 0.1394 t-Statistic 5. Use the data in the file lond small.-CfSS t. TAX: full-value property-taxrate per $10.

and Ba? (b) Use your computer software to estimate the equation. The variables are PRICE . and Ba using leastsquares. and time? (d) It is claimed that the greater the number of sales.the higher the risk of getting caught.The dataare a subset of thoseusedin the study Caulkins. Bl. l 0 The mid (a) (b) . . PPr is the price of pork in year t (pence per pound). Consider the regressionmodel PRICE: Fr * \2QUANT + fuQUALI 9qTREND-r e (c) (d) . lighr Mur worl DEI (a) II(QB1): fu * $2ln(P * B3ln (Pr. QUANT : number of grams of cocaine in a given sale.) * * Becausethe data are observationsover time. Report the results and interpret the coefficient estimates. and number of children influence the various budget proportions. I t Rec (a) (a) What signs would you expect on the coefficientsB2.t a $ 130 THE MULTIPLE REGRESSION MODEL total expenditure. Set up I1s and H1 that would be appropriate to test this hypothesis.dat. 5.and R. quality.forthe period 1949-1965." Journal of the American Statistical Association. Interpretthe results. Carry out the hypothesis test.9* Data on per capita consumptionof beef. and IN1 is per capita disposable income in year t (Australiancurrencypounds). the price of lamb.) Bsln(INr) e.All prices and income have beendeflatedwith 1953as the baseyear. sellersare willing to accepta lower price if they can make salesin larger quantities. Padman(1993). For if < eachcommoditygrouptest^F/e:Fz 0 against H1:$2) 0 and commenton the outcomes.price per gram in dollars for a cocaine sale. "Quantity Discounts and Quality Premia for Illicit Drugs. age. 88. > 0 and necessities B2 < 0. of (b) Commoditiesare regardedas luxuries if 9. the price of beef. Considerthe log-log demandcurve (b) (c) I Eac Can driv. the price of pork. Pt is the price of lamb in year t (pence per pound).) * Baln(PP.Have the signs turned out as you expected? (c) What proportion of variation in cocaineprice is explainedjointly by variation in quantity.8 The file cocaine. The variables are defined as QB1is per capitaconsumptionof beef in year / (pounds). (a) What signs do you expecton each of the coefficients? (b) EstimateFz. J. (f) What is the averageannual changein the cocaine price? Can you suggestwhy price might be changingin this direction? 5 .Do they seem reasonable? (b) (c) (d) (e) . (e) Testthe hypothesis that the quality ofcocaine hasno influenceon price against the alternative that a premium is paid for better quality cocaine. andpercapita disposable incomeforAustralia. 7 48-757.dat contains observations variables 56 on relatedto salesof cocaine powderin northeastern California over the period 1984-1991. and TREND: a time variablewith 1984: 1 up to 1991: 8. we use a / subscript instead of an I subscript.are given in the file meat.Thus. QUAL : quality of the cocaine expressedas percentagepurity.P. PBr is the price of beef in year / (penceper pound).Also comment on the significance your coefficientestimates.B3. B.

test the null hypothesisthat leaving at 7:30 AM insteadof 7:00 AM will make the trip at least 10 minuteslonger (other things equal). Have you obtained precise estimatesof each of the coefficients? (c) Using a 5Vo significance level.arre ted with 1953asthe Report the results in standard format. Each morning between 6:30 AM and 8:00 AM Bill leavesthe Melbourne suburb of Carnegie to drive to work at the University of Melbourne. test the hypothesisthat having an older house reduces price by $1000per year for eachyear ofits age. Using this range of values as the null hypothesis. I l * Reconsiderthe presidential voting data (fairdat) introduced in Exercise 2. For Lndcomment on the J to salesof cocaine 'he data are a subset Quantity Discounts Statistical Associa- (c) Compute and interpret the estimated covariance matrix for the least squares estimator and the standarderrors. : 1 0 The file brdat containsdata on 1080 housessold in Baton Rouge. + :ript instead of an i rcy pounds). (a) Estimate the equation TrME : h -t FzDEpART + q3REDS* p+?RAINS * e (rN. sults. during mid-2005. TIM E is measuredin minutes.Use a two-tail test the with an cr : 0.test the hypothesisthat the incumbent party will get the majority of the vote againstthe alternative that it will not.and (iii) French style homes. . (b) For each of the casesin part (a). (c) Supposethattheinflationrateis4%oandthegrowthrateis-4Yo. the price i. For what values of B2 will the incumbent party get the majority of the vote. (b) Find 95Vo interval estimates for each of the coefficients.including the interceptB1.(ii) town houses. test the hypothesisthat eachtrain delays Bill by 3 minutes.7 EXERCISES 131 the various budget :fficient estimates. The time it takes Bill to drive to work (TIME) dependson the departuretime (DEPART).Alsoassumethat 9r : h and B3 : bs.Do they seem Report the results and interpret each of the coefficient estimates. (a) Estimate the regressionmodel voTE : h -l \zGROWTH + $3INFLATION * e . .05 level of significance. Louisiana. Did you use one-tail testsor two-tail tests?Why? (b) Predict the percentage vote for the incumbent party when the inflationrate is 4Vo and the growth rate is -4To. sitiesif Bz ( 0. (d) Compute 95Vointerval estimatesfor each of the parameters.and the number of trains that he hasto wait for at the lights that he encounters Mumrmbeena level crossing (IRAINS).14. the number of red (REDS). test the hypothesis that each red light delays Bill by 2 minutes or more against the alternative that the delay is less than 2 minutes.Construct a95Vo interval estimate for $3 in each case and discussthe differences.) e. dat.od1949-1965. and le td Ba? port the results and rt as you expected? intly by variation in r the risk of getting :y can make salesin opriate to test this { il nceon price against :aine.5. Are the estimates for B2 and 9: significantly different from zero at a lOVosignificance level. (a) Estimatethe regressionmodel PRICE : 9r * !ySQFT -t \yAGE * e for (i) all the housesin the sample. DEPART is the number of minutes after 6:30 AM that Bill departs. rn you suggestwhy :e of lamb. (d) Using a lUVosignificancelevel. (e) Using a 5Vo significancelevel. Observationson thesevariablesfor the 231 working days in 2006 appearin the fi le commute.

*t('r'nlo ttf'exp{e. manufacturing sector .3.\ppend -. What happensif you reversethe null and alternative hypotheses? 5.004. interpret the estimates. the (a) Predict rice production from t hectare of land. Has this elasticity been precisely measured? (d) Using a 57o level of significance. is labor.iltiplerr : rlel witl ::. .rtion ir it --. is grossoutput in time r. (a) Show that taking logarithms of the production function puts it in a form suitable for least squaresestimation. F:.dat. of 5. (c) Using Ht:9c>0. . 50 person-daysof labor.1242 as the alternativerather than the null hypothesis? (d) Find a 957o interval estimate for rice production from t hectare of land. K.1242. and 100 kg of fertilizer. is capital. test the hypothesis that the elasticity of production with respectto labor is lessthan or equal to 0. (c) Find a 95Vointerval estimate for the elasticity of production with respect to fertilizer.13* The file rice.test the hypothesisthat the elasticity of productionwith respectto land is equal to 0. Treating the data set as one sample with N : 352.The dataunderlying thesevariablesare given in index form in the file manuf. . o27.What assumptions about the true valuesof 92.nple reg . proceed with the following questions: (a) Estimate the production function (b) (c) Appen .S. Use a 57o significance level.132 THE MULTIPLE REGRESSION MODEL (f) Using a 57o significancelevel test the hypothesisthat the minimum time it takes Bill is less than or equal to 20 minutes againstthe alternativethat it is more than 20 minutes. Supposethat this price ratio is 0.test whether the farmer should apply more fertilizer.3 againstthe alternative that it is greater than 0.} wheree. t : models ' .ABOR).N(0. t.trix alge :nputatio : -::mates. hectaresplanted (AREA). is energy. For FERT : 100 and the predicted value for PROD found in part (a).blems i -t In(PROD): Br * B2Ln(AREA) gln(tABOR) + p+h(rE'nT) + e Report the results. Why did we choose 94> 0.13. show that the farmer should continue to apply fertilizer as long as Ba>0.. (b) Using a l%o level of significance.dat contains352 observationson 44rice farmers in the Tarlac region of the Philippines for the 8 years 1990 to 1997.1242 as the alternativehypothesis. andMl denotesother intermediatematerials. .:. and kilograms of fertilizer (FERT). (b) Your economic principles suggest that a farmer should continue to apply fertllizer as long as the marginal product of fertilizer APRODIAFERT is greater than the price of fertilizer divided by the price of output. Variables in the data set are tonnes of freshly threshed rice (PROD).r'n the le y. 50 person-days labor and I kg offertilizer. : . and Ba did you have to make to perform this test? 5. .15 Considerthe following aggregate productionfunction for the U.jer partir :::ting the -. E. and comment on the statistical significance of the estimates. person-daysof hired and family labor (I..5.s leastsc -:tltaneo .e first stt .Y..14a Reconsider productionfunction for rice estimatedin Exercise5.

E.gzxiz gzxiz)z 92.l. and b3 in a model with two explanatory variables. we will not show them.i)' (Irixir) Qrin . and B3 and to set the firstorder partial derivatives to zero. and b3 aregiven by the solution of this set of three simultaneousequations. In this appendix we proceed with a similar exercise for the multiple regressionmodel. Given sample observationson ltx2t and x:. i:l The first stepis to partially differentiate S with respectto B1.b2.(L'b*f)" rbor.13. xi2: xi2 .1) The least squaresestimatorsfor fu. andreananging yields Nh *Lxizbz*bnb3:ly. .1) to obtain the least squares estimates.2lsizti Setting thesepartialderivatives equalto zero. and Ba did you (b) Estimate the unknown parameters of the production function and find the corresponding standarderrors.n with respect to the elasticity of Lnst alternative the ill and alternative s(Pr.Fr . Pr) : i (y. Computer software used for multiple regression computationssolves normal equationslike those in (5A.That is.a\d b3 are bt:!-bz7z-bzlz S. Le Tarlac region of r set are tonnes of days of hired and ing the data set as Appendix 5A Derivation of Least SquaresEstimators In Appendix 2Awe derived expressionsfor the least squaresestimatorsb1 and b2 inthe simple regression model.xZ) xiz : xB ..2y i bizb t + \xaxizbz + b%h : L\3y . resevariablesare . let li : Ii . * Zxizxizbz b . This yields : zrBt *292L'ciz*29zLriz-22Yi aBu 0s 0s fr:'Br>.92. and :ontinue to apply t)FERT is greater rosethat this price r PROD found in tilizer as long as rether the farmer hy did we choose :? .D (bi?) .APPENDIX 5A DERIVATION OF LEAST SQUARES ESTIMATORS 133 mum time it takes hat it is more than 3.b2. the problem is to find values for 9r.tz)(Ixhxb) " _ (>i. (c) Discuss the economic and statistical implications of these results. we describe how to obtain expressionsfor fu..lXbir*ir) (>r*)(>ri?) (bi. and B3 that minimize e "FERT). is energy. To write expressionsfor this 'olution it is convenientto expressthe variablesas deviationsfrom their means. Fz.n a form suitable For modelswith more thanthreeparameters solutionsbecomequite messywithout using the matrix algebra.ctare of land. Laysof labor.(rvlx. : l*r izh * *rU.x3 Then the least squares estimates b1.t on the statistical the elasticity of .b2.dividing by 2.iz -t 2B2ls2^ 2ls>-xizxtzZLxizvi * 0s : e 5. manufacturing b2: (}yi.)(Ixt') . known as the normal equations. 50 # 'BtOiz *2gzLxizxiz -12$3\4?'. (5A.(Iyix.

Explain what is meant by collinearity and the consequencesfor least squa. how does its bias and variance compare with those of the unrestricted least squares estimator? 9. ar :. Fromoutputofyourcomputersoftware..res estimation. Obtain restrictedleast squares estimatesthat include nonsampleinformation in the estimation procedure.Chapter Keywords Further Inference in the Multiple Regression Model auxiliary regres collinearity F-test irrelevant varial nonsampleinfo omitted variabl Learning Objectives Based on the material in this chapter.ed to explain rrices of subst :ests involving -i variables. you should be able to 1. 4.F/1 a "not equal to" hypothesisand (b) I11is a "greater than" or "less than" hypothesis.. (c) the estimated covariance matrix for the least squaresestimates. locate(a)thesumofsquarederrors. :he r. 10. 1 . 2.cioeconomi . and identify the componentsof this test from your computer output.i condition call procedr rQu&rOS lhesetopics we rnd the constn iunctional forn: :ssuesrelated t if irappens we it . 5.i explanatory . Explain how the RESET test can pick up model misspecification. Explain how to test a single null hypothesis involving two or more coefficients is when (a).(b)the F-value for the overall significance of a regression model. Testthe overall significanceof a regressionmodel. Explain the conceptsofrestricted and unrestrictedsumsof squarederrors and how they are used to test hypotheses.lre not sufficie The assump In particular. Use the F-test to test single null hypotheses joint null hypotheses. 11..1 The I In Chapter 5 wr rultiple regres :han one pararr .and F-tes arrorsarenot n( :hey hold apprc 5. Explain what is meant by (a) an omitted variable and (b) an irrelevant variable.In particular. 6. 12. Explain the properties of the restricted least squaresestimator. Explain the issuesthat need to be consideredwhen choosing a regressionmodel. or 3. w. Economistsdev ceduresare usec of consisting a r This analysisca a single restrict restinga null hy lor thesetestsar ro test a null hy The theories canbe usedalo mod regression restricted least .ndincomego -:nchanged? 134 .and (d) the correlation matrix for the explanatory variables. Use your computer to perform an F-test. 8. of Explain the consequences omitted and irrelevant variablesfor the properties of the least squares estimator.

In Chapter5 we developed /-testsfor null hypotheses . The restricted least \quares procedure alsoplays a usefulpracticalrole when testinghypotheses.1 THE F-TEST 135 Keywords auxiliary regressions collinearity F-test irrelevant variable nonsample information omitted variable omitted variable bias overall significance RESET restrictedleast squares restricted model restricted SSE single and joint null hypotheses testing many parameters unrestricted model unrestricted SSE ilel luared errors and hou.onsisting of a single restriction on one parameterBpfrom the multiple regressionmodel. ify the components of or more coefficients lreaterthan" or "less squarederrors.Hypothesistesting pro. This analysiscan be extendedin two ways. 6.rrors arenot normal.'an be used along with the information in a sample of data to estimate the parametersof a :e-eression model. background.If the . 3 a regression n irrelevant variable.6. prediction. Economists developand evaluatetheoriesabouteconomicbehavior. r condition called collinearity.eduresare usedto test thesetheories. Should variables on .For example. There are. This assumptionis neededfor the t. do not involvetestingthe relevance a group but of ofvariables.renot sufficiently rich becausethe variables are collinear or lack adequatevariation.many instanceswhere testsinvolving more than one parameterare appropriate. The theories that economists develop sometimesprovide nonsample information that .or we may be concernedwith iestinga null hypothesiswith two or more restrictionson two or more parameters. i for the properties of :es for least squares ation.and F-test statisticsto have their required distributions in samplesof all sizes.We may encountera null hypothesisconsistingof .i single restriction that involves more than one parameter. we might want to test whether a group rrf explanatory variables should be included in a particular model. In particular.will quantitydemanded a commodityremain unchansed? . then the resultspresented this chapterare still valid in the sense in that they hold approximatelyif the samplesize is large.(b) the :1. we assumethe errors are normally distributed. In particular. and the theoretical information is good.ocioeconomic along with variablesdescribingeducationand experience. Model specificationinvolves choosing a functional form and choosing a set of explanatory variables. The tools :or thesetestsareconsidered this chapter. however.are:Does a productionfunction exhibit constant returnsto scale? Ifall prices for andincomego up by the sameproportion. rnd the constructionof prediction intervals. rpotheses. be usedto explain a person'swage?Does the quantity demanded a productdependon the of pricesof substitute goodsor only on its own price?Other questions that lead to hypothesis tests involving more thanone parameter. how stricted least squares model. additionto In :hesetopics we discussmodel specification the multiple regression for model. important new development the F-test used in An is :rr test a null hypothesiswith two or more restrictions on the parameters.It can be a useful techniquewhen the dataarenot information-rich. A procedurethat combines these two types of information is called restricted least squares. What happensif we omit a relevant variable?What happens we include an irrelevant one?We also discussthe problems that arise if our data if r. The assumptions MR1-MR6 listed in Section5.1 are adoptedthroughoutthis chapter.1 The F-Test In Chapter 5 we learned how to use /-tests to test hypothesesabout single parametersin a multiple regressionmodel. (c) the estimated he correlation matrix ple information in the or. In this chapter we focus on rssues related to variable choice.

then the statisticF has what is called an .SSEy > 0. For example. we expect little changein the sum of squarederrors when the null hypothesisis true.on the valuesthat the parameters take.J: 1. Insteadof finding least can squaresestimatesthat minimize the sum of squarederrors.1 ) Suppose that we wish to test the hypothesis in that changes price have no effect on sales revenue against the alternative that changes in price do have an effect.3) If the null hypothesisis true. the sum of squarederrors from the original model is called the unrestricted sum ofsquared errors or SSE6'.considerthe Big Andy's Burger Barn examplewhere sales(. The sum of squarederrors in a model that assumes null hypothesisis true is called the a restricted sum of squared errors or SSEa.Conversely. To illustrate what is meantby an unrestrictedmultiple regressionmodel and a model that is restrictedby the null hypothesis.F11: *0.S) a function of a are price index of all products sold (P) and expenditureon advertising (A) si : Fr -t gzPi -t gtAi -t ei (6. doesnot appearin the restricted model in (6. one-tailtestfor a singlenull hypothesis A mustbe testedvia a t-test.K) l(N (6. The null hypothesiscan be a single It true null hypothesisor a joint null hypothesis.2) will be larger than that from (6.Thus.which assumes arc 9z the null hypothesisis true. Let "/ be the number of restrictionsin the null hypothesis. The two testsare equivalent.F-distribution with J numerator degrees of freedom and N . is aiu'a_r's that SSEa. we expectthat the data are compatible with the conditions placed on the parameters. the sum of squarederrors from (6. is Si : Br t }tAi -t ei t 16. then the assumptionthat the null hypothesisis true has significantll reduced the ability of the model to fit the data.The F-test must be used to test a joint null hypothesis.for testingthe null hypothesis that led to the restrictedmodel in (6. or constraints.136 FURTHER INFERENCE IN THE MULTIPLE REGRESSION MODEL We distinguish between a single null hypothesis that is a null hypothesiswith a single restriction on one or more parametersand a joint null hypothesis that containstwo or more restrictions on two or more parameters.the subscript R indicates that the parameters have been restrictedor constrained.2). we find estimatesthat minimize the sum of squarederrors subjectto parameter constralnrs. unrestrictedmodel.What we discover in this chapter is that a two-tail test for a single null hypothesiscan be conductedvia a t-test or an F-test.To make a clear distinction betweenthe restricted sum of squarederrors and the sum of squarederrors from the original. The generalF-statistic given by is F_ (s.if the null hypothesisis true.2 SettingFz : 0 in the unrestricted model in (6. When estimating a model where a null hypothesisis assumedto be true. unrestrictedmultiple regression model with the sum of squared errorsfrom a regressionmodel in which the null hypothesisis assumedto be true. Some . and thus the data do not support the null hypothesis. The idea of the F-test is that if these sums of squarederrors are substantiallydifferent.sER ssBu)ll ssEu .1). The null and alternative hypotheses H0: 9z : 0 and.2). The F-test forajoint null hypothesisis basedon acomparisonofthe sum ofsquarederrors from the original. we place conditions. Thus.1) meansthat the price variableP.The imposition of the parameter constraints means the sum of squared errors will increase. The restricted model.K denominator desrees of freedom. a constrained minimum is larger than an unconstrainedminimum.

However. the F-test procedure for r-::ns whether price should be excluded from the sales equation is as follows: .97. The rejection r:::on where F ) F. FIs is rejected if p-value < 0.mparing valueof Fto a critical valueF. Thus.TEST 137 a single or more two-tail testsare reF-test :d errors rrs from what is the null tion of a . L-sing the hypothesis testing steps introduced in Chapter 3.SER 2961.97 camefrom. respectively.827 Imposing the null hypothesisHo:92:0 on the model has increasedthe sum of squarederrors from 1718. so the distributionof the F-test statistic when I1e is true is (6. with its typical shapeillustrated r Figure8. Tables of critical values for r .1) and (6.05.05 are provided in Tables4 and 5 at the end of the book.A large value r.es.tz1 Seta and determinethe rejection region: Using cr : 0. Ilo is rejected lf F > 3.6.K) ssEu/(N r7r8.tz) > 52./: l. Alternatively. Specify the test statisticand its distribution if the null hypothesisis true: Having one restrictionin lle means.zzy-distribution F.5.2).943to 2961.e43 .01 and ct : 0. ' State your conclusion: Since F:52. is illustrated in Figure B.1 rn sales rull and ISSUInC\ Itails about this distribution are given in Appendix B.e43) : 5 2 . S.implying thattheconstraintsplaced onthe modelby = null hypothesishave a large effect on the ability of the model to fit the data.ite value of the F-test statistic becomes too large.0000 < 0.05. .9s.06] : 0. the p-value: For the unrestricted and restricted models in equations (6.-nber of degreesof freedom using your statistical software. the reasonwhy the expression (6.K degreesof freedom. i Specifythe null and alternative hypotheses: Hs:$2:0 and H1:$210. we reject I1e becausep : 0.Alternatively. Calculate the sample value of the test statistic and.we rejectthenull hypothesis r '. if desired.3) has an F-distributionis given in an in rrrrendix to this chapter. the quared r single he null odel in : SSEu: 1718.3 r rn with Some : : .827 r7r8.827..1 THE F. the critical value from the :3.4. The F critical valuesin liries 4 and 5 at the end of the book are reported for only a limited number of degreesof ::rdom. loesnor e place ng least inimize rameter llum l: F_ (.9'1 Flr.06)F.3) lQs Fg.Thus. we find will be rors are ficantlr Lhe null tpatible sum of lled the tmeters ed sum lel. What is too large is decided by :. Also./ and N .8.3) /(7s Thep-value for the test is p : f lFlr.tz) 3. : F1g.943.might ask wherethe valueF. : F1o.1...8. (6.r. correct to four decimal places. If the null hypothesisis not true.Appendix 6A.05. The value of the F-test statistic is F: (ssER ssEu)lJ (2e6r.0000.. 0. then the difference =t*een SSE6andSSEybecomes large. we reject the null hypothesisand concludethat price doeshave a significant effect on salesrevenue. (6. which leavesa probabilitya in the uppertail the :t :he F-distribution with .exact critical valueslike the one for this problem can be obtainedfor any :.tz) is .t.r SSE4.ssERssEu) 11 ssBu . 0 6 I1 .SSEymeansthe valueof Ftends tobe large. recall that N: 75.

Underthese circumstances. we tested whetherthe dependent variabley related aparti.2 Testing the Significance of the Model An importantapplicationof the F-testis for what is calledtestingthe overallsignifican.215D2and the corresponding critical value is Fc:3. has distribution Fg. in the denominator.1. practice. (a When testinga single "equality" null hypothesis singlerestriction)againsta "not equ\\ to" alternative hypothesis.The null hr:' thesismay not include any "greater than or equal to" or "less than or equal : hypotheses. They areequivalent. : F1t-o. whereF. when the alternative an inequalitysuchas ">" or "<".and F-testsalso doesnot carry over when a null hypothesis consistsofmore than a sin: restriction. of We can summarizethe elementsof an F-test as follows: L The null hypothesisF10 consistsof one or more equality restrictions.Consideragain the generalmul:.and F-te:t.: regression model with K .1. The alternative hypothesis states that one or more of the equalities in the : a J.ru-r.null hypothesis. The test statisticis the F-statisticin (6.06: t2 : (-7. 5 .The alternative is hypothesis may not includeany "greaterth-' or "less than" options.K denominator degrees freedom.meaningthat we will always reachthe sameconclusionwhicheverapproachwe take There is no equivalence when using a one-tail t-test sincethe F-test is not appropr:. freedomandN .is to explanatory variable-rr usinga /-test.97 : r(1..The square of a /-random variable with m degreesof freedom is F-randomvariablewith one degree offreedom in the numeratorand mdegrees offreed' ' .F1s : 0 a_sai: It : Fz -1. of thep-valuesfor the two testsare identi. lt is called a joint null hypothesis. is customary test.215 and t.a: F-distributions. amodel.1 THs RErATroNSHrpBsrvGsN /. the /-testcannotbe used. an F-te..The F-value that we calculatec Hr :92 10. where. When testinga singleequalitynull hypothesis is perfectlycorrectto useeithe: ' it t..138 FURTHER INFEIIENCE IN THE MULTIPLE REGRESSION MODEL 6.^1.r. The nun:-.In Section 5. F has the F-distributionwith "I numeratordegrec. hypothesis not true. of restrictionsis denotedby -/. 2.1 explanatoryvariablesand K unknown coefficients )i : 9r * xiz9z*xi:B: + "' + xix9x-f ei .When using a /-test for .or F-testprocedure. Because this exactrelationship. Examplesof F-testswhere"/ ) 2 aregiven in the next two sections this chap:.The null hypothesis r2. If the null hypothesisis true. A t.When J > 2.5. The equivalence is betweent-rr. 6.: but available.AND F-Tpsrs Do you rememberthat we useda /-testto testI/s : 9z : 0 againstHr:92l0 in Chapter: Why are we now using an F-test? What is the relationshipbetweenthe t. of is if F > F.993.3). we found that / : F :52. The F-test is usually reservedforjoint hypotheses. eithera /-testor an F-testcan be usedand the testoutcomes be identical./ > 2.l. : 1. the null hypothesisis called a sir.is the critical value that leavescrpercent(r: probability in the upper tail of the F-distribution.9%)2.:: In it to restrictionsusing a 1-test. When "/: 1.In this sectionwe extendthis idea to a joint test(): relevanceof all the included explanatoryvariables.The reasonfor this correspondence an exactrelationship is betweenthe /.

which variablesthose ::Eht be.rlel is of little or no value.anc :dom is ar of freedorr= 0 agains: rlculatedi' . 3aterthan" l:e leastsquares estimatorof B1in this restrictedmodel is bi : }Lry t I N : y. (6.v-. other than the intercept parameterB1.We want to test whether the coefficients of price and of advertising :r:enditure are both zero. Ho:92:0.6) he numbe: ed a single null hypc: equal to" in the nul. the test ''r t6. Given the l-distribution can only be usedto test a single null hypothesis.<)-distribution. (ssz. hischapter l:e null hypothesis ajoint onebecause hasK . in which we are testing the null hypothesisthat all the model parameters ir. and thus our -.is zero..(ti -l)' N^ : SSZ ' :i'tisone case. The unrestricted sum of squarederrors is. is used to test the overall significanceof a regression It model. which is the .:-:rple mean of the observationson the dependentvariable. The alternativehypothesisdoes not indicate. 3. That is. The unrestricted in model is that given in (6. i. The restricted sum of squared :-.ana single an F-testi. none of the explanatory variables influence y.4).' l .5). then at least one of the is :u-ametersis notzero.r*)r 2 i:l N : Z. Fl : 0 against the alternative (6. states a conjecture is it It as -t eachand every one of the parameters81.. is "-.1() (6.2 TESTING THE SIGNIFICANCE OF THE MODEL 139 lr examinewhether we have a viable explanatorymodel. obtainedassumingthe null hypothesisis true. we test the overall significance of the regression used to explain Big r--J)'s salesrevenue.0. :'efore. Hr:9zl 0orB3f 0. or botharenonzero . ---rF-test statistic can be modified and written as F: degreeso: is rejectec cent of the : eitherthe test single heses.the restricted sum ofsquared errors is the total sum ofsquares 'r-ft from the original unconsffainedmodel.S --:c calculated value of this test statistic is compared to a critical value from the ' r r.rs from the hypothesis (6...the hypothesis testing steps r: as follows: We want to test Hs:$2: Q..1 components.5) is sometimesreferred to as a test of the overall significance of the regression ndel. againstthe alternativethat at leastone ofthese coefficients is not -::o. rppropriat< veen/-tesl! .9: .4. To illustrate. .I : K . we set up the following null and r:ernative hypotheses Chapter 5 i l nd F-tests "not equa:comes u. K for one (6. Since we are testing whether or not we have a viable explanatory model.D .L c - e identical. . SSEy : 559.. The restrictedmodel.ssE) /( I( l) ssE/(N .il. l:c numberof restrictions is . we take.5) O ? -. t .7) ificanceof Lparticular testof the Llmultiple . Thus. If the alternativehypothesis^F1q true. the sum of squarederrors from the unconstrainedmodel. n the t.and it is usually automaticallyreportedby computersoftwareas the "F-value".5) is : SSE4 21r' . to test the overall significanceof a model. however. . zeroexceptthe intercept.. ::-: outcome of the test is of fundamental importance when carrying out a regression r---lr sis. -: ihis null hypothesis is true.we use the ' :i'st for testingthe joint null hypothesis (6. and thus one or more of the explanatoryvariablesshouldbe included :--:he model. Recallingthat the model is Si : 9r -t 9zPi * B:Ai + ei.|.)EL 6.ration \:Bt*e.9r :0 H 1: At least of theB1is nonzero k : 2.

salesincrease from $72.1. is constant. What is required is a model where the slopechangesasthe level ofA increases. In reality. 5.Note that this conclusion is consistentwith conclusionsreachedusing separate/-testsfor testing the significanceof price and the significanceof advertisingexpenditurein Section . than when it is $1600.r rrr.25>3.1.s s E ) / ( 3 . U sing a 5 Vosignificancelevel. Having a linear model implies that increasingadvertisingexpenditurewill continue to increasesales revenueat the samerate irrespectiveofthe existing levels ofsales revenueand advertising expenditure.(31rs . p-value : PIF > 29. Note that the units in the grapharethousands ofdollars and so thesepointsappearas 0.correct to four decimal places. of 4 .72) degrees freedom is ft : 3. Thus.e) What c negati coeffic dimini in terrr .whereasat the higher level of advertising the increaseis a much smallerone.That is. we have S.25 and the correspondingp-value of 0.6.6 and 1.r718 12: . would expectdiminishing returnsto setin.e43lQs 29 . as the level of advertising expenditureincreases. and advertising expenditure is a good approximation to reality. Since29.943.S .12.rf expec rising.3 nn Extended Model So far in Chapters5 and 6 we havehypothesizedthat Big Andy's salesrevenueis explained by product price and advertising expenditures.which measures responseofE(S) to a changein the A.140 FURTHER INFERENCE IN THE MULTIPLE REGRESSION MODEL 2 . I .price.2s Also.-hangei s:gr *gzP_lgzA_le (6. which give an F-value of F- (ssr-ssE)/(I(.0000 that form part of the routine output? : IC URE 6.rK) -3) r7r8. To illustrate what is meantby diminishing returnsconsiderthe relationshipbetweensales and advertising (assuminga fixed price) graphedin Figure 6.SZ: 3115. We conclude that price or advertising expenditure or both have an influence on sales.943) r) ssE/(N .6. say.485and SSE :1718. A similar conclusion is reachedusing the p-value.$600. the coefficient B3. \dding . making the new model To find t a chang diminis Havi estimat r ariable where The let s:gr IgzP*F:A*gqAz+e (6. we fi nd the critical value for the F-statistic with (2.8) with the constantslopeB3 will not capture thesekinds of diminishing returns. If F1ois true F : ( s s r .48s . The figure showsthe effect on sales of an increase of $200 in advertising expenditure when the original level of advertisingis (a) $600 and (b) $ 1600.The linear model in (6. we reject H0 if F > 3.251: 0.I2.8) One aspectof this model that is worth questioningis whetherthelinearrelationshipbetween revenue.000.wereject 116 andconcludethattheestimatedrelationshipisa significant one. One suchmodel with this characteristicis obtained by including the squaredvalue of advertising42 as anotherexplanatoryvariable.from $78.400 to $74.0000.12. From Section5. An extra $100 spenton we advertising is likely to have a bigger marginal impact on saleswhen the level of advertising is.Can you find the F-value29. 5 Go back and check the output from your computer software.At the smallerlevel of advertising. it does not depend on the level ofA.-1 ) ssE/(7s 3) F.000.500to $79.

10) (6.6 0.72 7.1l) (6. Having proposed an extendedmodel that might be more realistic. xiz: Pr.7 ADVERT A modelwheresales exhibitsdiminishing returnsto advertising expenditure.0 1.9) as I Yi : 9t * 1zxiz l9zxit * Fqxi+ et rr'here /i : Si. rnship is a : conclude Note that t-tests for :nditurein alue29.using the data in the file andy.e41) (6.note that we expectthe response salesrevenueto of a change advertising be positivewhenA :0. increase Ls much a .l51Ai. Moreover.the coefficient of A has retained its positive sign and continues to be significant.e) What can we say about the addition of A" to the equation?Its coefficient has the expected negativesign andis significantly different from zero at a 5Vosignificancelevel.dat. Adding the term BaA2 to our original specification yields a model in which the response of expectedrevenueto a changein advertising expendituredependson the level of advertising.That is.8 2. it can be shown that the responseof E(S) to a chansein A is explained aE(s) AA _ aE(s)9 2 : AA -t29qA (Ptt"ta constant) (6.8) p between Having a easesales lvertising changein lvertising ) spenton lvertising reensales the effect I level of ofdollars . Allowing for diminishing returnsto advertisingexpenditurehasimproved our model both statisticallyand in terms of meeting our expectations about how saleswill respondto changesin advertising.4 0. to achieve in to diminishing returns the responsemust decline as A increases.O 2.4 1.)EL 6.640P+ l2.2 rrcunn 6. using a little calculus..046) (3.25 72 7l 0.2 1. Also.80)(1.6 1.72) 78 ch give an 7'7 SALES 76 74 . are Si : 109.2. we expectF: > 0.8 1. our next step is to estimate it. xic : A? The least squaresestimates. . That is. Specifically.slopeB3 vhere the obtained aking the To find the expectedsignsfor B3and B4. xrz: At.3 AN EXTENDED MODEL 141 80 wirh(2." That is. we can write (6. we expect 9+ < 0.s56) (0.768A7 i ('") (6. For estimation purposes the squared value of advertising is 'Just another rariable.

Basedon two separate t-testswe can conclude. that B3 is not zero and Ba is not zero.The corresponding p-valueis P [F1z. A joint test is appropriate. We will comparethe unrestricted model in (6.The first hypothesisrelatesto the significanceof advertising.Advertising doeshave a significanteffect upon salesrevenue. 9+ : 0.126.tt1 3.4) /(7s Fpll This h. we reject the null hypothesisthat both 9: : 0 and 5 . Big. The ma :reparir a( . Fo : 0.1 3) Solving !1014. The alternative is hypothesis is h:92 l0 or Bal0 or botharenonzero.4. Since F 9+:0 and concludethat at leastone ofthem is not zero.12) is S^tEu: 1532. then advertisinghas an effect on revenue.4. the extended model of the previous section provides a vehicle for testing some interesting economic hypotheses.zr.391.ss. we find that the critical value is F. leadingto a valuefor the teststatisticof F : 8. Selectinga5Vo significancelevel. The sameconclusionis reached noting that by p-value:0. : Fp. : 3 .0005<0. But the question we are now asking involves testing both B3 and Ba at the sametime. >8.126. This optimizing principle applies to Big Andy's Burger Barn as it attempts to choose the optimal level of advertising expenditure. which assumesthe null hypothesis is true.142 FURTHER INFERENCE IN THE MULTIPLE REGRESSION MODEL 6.05.3) to test Ho:9s : 0.3. The sum of squarederrors from (6. and in both cases they are of the correct sign.2 Tnr Oprrruar Lpvsr or AovsRTrsrNc The e calcu Economic theory tells us that we should undertakeall those actionsfor which the marginal benefit is greater than the marginal cost. .44. the sum of squared errorsfrom (6. :8. . :his am .4 Testing Some Economic Hypotheses As well as being more realistic.44> F.I THs SrcNrprcANcEor ApvrnrrsrNc ln the context of our extendedmodel. 2 .illustrating the use of l.12) to the restricted model. The restricted model is Si:9r*lzPt*ei The steps for carrying out the test are as follows: :nd Ba (6. giving a rejectionregion of F > 3. The test statisticandits distribution the null hypothesis true are if is l.44]: 0.ufficie :lterna The joint null hypothesis 11e:9:: 0. : r o m$ 1 si : Br -t lzPi * p:Ai * \qAi -t ei (6.126.0005. in turn..r2) * ith Ao how do we test whether advertising has an effect upon salesrevenue?If either B3 or one-tail Bais not zero.rlesre' 6.and F-tests in economic analysis.The joint test usesthe F-statistic in (6. 4 .'osts. From(6 . taS a 1 lhe de \ppen 6.13)is SSEa: 1896.z.084. F: \fter c (ssER ssEu) 12 ssEu .

8847742x3.+ZlS0l 1. +3.421967 : 12. He Big Andy hasbeenspending $1900per month on advertising.12) ricted s1014.13) F / s : B* 2 x $ a x 1 .taconstant) : Fz-t zfr+A plus the costof is The marginalcostof anotherunit of advertising the costof the advertising preparing the additional products sold due to effective advertising.2u +3'8ba) rared :F- is if the ras a /1711-distribution null hypothesis true.4 TESTING SOME ECONOMIC HYPOTHESES 143 in From (6.8b^): uil@J r 3.76796)A..288746 f The are variances covariance providedby your statisticalsoftware.74) . denoting the optimal level of advertising. 3 STS TS 1 / r : 9 :.8'.r2) 9: or re-tail CASCS 9z*29qAo:1 * ith A.The tricky part of this testis chlculating :he denominatorof the /-statistic. 8 8 4: 1 . 9 t ' l can thesehypotheses be written as \fter carryingout the multiplication. or where I (6. If we ignore the latter to shouldbe increased the point wherethe marginalbenefit costs.x0./0. Does the information from the estimatedequation.9676 0.6.3.6330 1 .6463 3.633 " :0.4.1512 2x (-2. 9 : l .we obtainAo :2..ufficient evidenceto reject a hypothesisthat $1900 per month is optimal? The null and rlternative hypothesesfor this test are .Using the least squaresestimatesfor B3 Aofrom and Ba in (6.8x.3.provide .implying is the optimal monthly advertisingexpenditure 1both ttistic .8bq). : I + Solving.82x "*@.6. 8 9 4 + l * The/-teststatistic usingeithera /-testor an F-test.21) of \ppendix B.| .Using the property of variance given in (B.6.ov@.8x3. :0.@.10)the marginalbenefitfrom anotherunit ofadvertisingis the increase expected salesrevenue: )vides /. I and lve a .65419 .and tising.| 2 x B a x l . Thishypothesis be tested can t: (bz 1.that +2x3.11)we can estimate 12. F 1 3 : B 3 . and The estimated is :alculated value ther-statistic of linal dy's :ure. H t : 9 21 3 . Ag9 AA 1en. |::: 0. advertising expenditures tiom $1 of advertisingfalls to $1.Il4. wantsto know whether :his amountcould be optimal.

976 .99q2.-distribution. we cannot e the null hypothesisthat the optimal level of advertisingis $1900 per month.that the stepswere you introduced a purpose: teachyou goodhabits.By being lessformal we can exposeyou to the type of you will find in research discussion remember.286 rs32.3365 h t( i n a ( n a i The result 0.andK:4. we find p .8Ai)+ ei Estimating this model by least squareswith dependentvariable )i : Si .4? ei Collecting terms and rearrangingthis equationto put it in a form convenientfor estimation yields r! lr 6 $ (Si.Please however. You may have noticed that our descriptionof this test hasdeviatedslightly from the stepby-stephypothesis testingformat introducedin Chapter3 and usedso far in the book.976.96761:0.05 At reject levelof significance t.obeying relationship the /between and^Frandom variables that we mentioned previously. the test statistic is F_ bt ul ul (ssER ssEu)lJ ssEu/(N K) Ir fc H rf where"/: l.Ai) : 9r * gzPi-r 9067 .Whenlloistrue.4 :0. 6. and explanatory variableS : P. For Given that F : 0.994.Somealgebraisrequiredtoobtaintherestrictedmodelthatis neededtoobtainavalueforSSEa. reports. t g > 0 .3.N:75. The critical value F. There is insufficient evidence to suggestAndy should change his advertising strategy. insteadof wanting to testwhether the datasupportsthe conjecturethat A : 1. using an F-test.. :3.286.994 <0. From now on we will be less formal aboutfollowing thesesteps.If he has .3365> 0.Following the steps for To ensures include a descriptionofall the relevantcomponents ofthe test and that you think aboutthe stepsin the correct order.v a l u e: r l F s .084.to decide on the hypothesesor the rejection region after you observethe value of the statistic.9362is equalto t2 : (0.If the test is done on the basisof its p-value.8Ai yields the restrictedsum of squarederrors riz SSER: 1552. ct : 0.zr.4.3. the a : 0. usingthe F-testyields the sameresultas usingthe t-test.9362 Frs32.9 is optimal.A.Big Andy wantsto testwhetherthe optimal valueofA is greater than 1.12)isSSEu: l532.89+andtherestrictedmodel becomes -r Si : 9r 'r FzPi+ (l .084171 The valueF : 0. comes from the F1r. The same ingredients were there but their arrangementvaried. and xiz: A? .3'884)Ai* 9a.9.B3:1-3. % 6 2 ] : Pltltj>0.05 the critical valueis F.9676 < l.2a A One-Tail Test with More than One Parameter Supposethat. Alternatively.05 leads us to conclude that Andy's advertisingstrategyis compatible with rhe data. It is not correct.9616) + Plt1tg< -0.9362 .The calculated value of the F-statistic is u cl h (rss2.becaus -1.144 FURTHER INFERENCE IN THE MULTIPLE REGRESSION MODEL The critical value for this two-tailed test comes from the /1711-distribution.--F. for example.084) / | :0.: 1.:3.Thesumof squarederrorsfromthefullunrestrictedmodel in(6.9676)2.994. Thus.

994.There is 6. 9 8 3 * 3 .for the one-tail test.4 TESTING SOME ECONOMIC HYPOTHESES 145 and this beenspending 1900per monthon advertising.There is not enough evidencein the data to suggestthe optimal level of advertising expenditureis greater than $1900. theconjecture in the sample data?We formulatethejoint null hypothesis of theevidence contained : F/s:B3*3'894 I and 9r *6Br+ 1 .4. Can you work out how to get it to test null hypotheseslike those we constructed?These tests belong to a class of tests called "Wald tests.At a sEosignificance to estimates predict salesrevenuefor P : 6 andA: I . Has Andy been usethe least squares too optimistic or too pessimistic about the level of sales? . For the two-tail test the a : 0.05 rejectionregion was: Reject Hg if t > 1. he doesnot want to increase amount $ unlessthereis convincing evidencethat the optimal amountis greaterthan $ 1900.05 )annotreject Lth.and F-values and their correspondingp-values when provided with a null hypothesis.DEL :hecr :0. we usean F-test.If he has The alternative is that at least one of these restrictions is not true.3 LIsrNc Conpurpn Soprrvanp )f esllmatron and explanaluared errors reent. the stepsin he rejection E(S): 9r * FzP -l}tA + 9+Az :Br *69z*1.egy is com'om the steprebook.99:+ 1. it is: Reject Hs if t>1.994or t < -l .9 .he will set up the hypotheses F1o * 3. advertising expenditure ofA : 1.it is often more convenient to use the power of modern statisticalsoftware.we obtain a computedvalue for the F-statistic of 5. we do not reject 11s. The will be less r the type of e stepswere you include .9will. on average. t as usingthe While it is possible and instructive to compute an F-value by using the restricted and unrestricted sums of squares.and Fres from the 99q2. Because there are "/: 2 restrictionsto testjointly.8Ba< 1. of 0." Your softwaremight refer to them in this way. :9: I/r : 9: * 3. which is left as an exercise. That is. 6 1 B :4 3 6 thatA:1. but the rejection region for a57o significancelevel is different.9676.In addition to proposing that the optimal level of monthly advertising expenditureis $1900. 6. Isthisconjecture aboutsales.9. the joint null hypothesis rejected.In this case. Constructing the restrictedmodel requires substitutingboth of theserestrictions into our extendedmodel.You should check your software.As an exercise.000. Because0. in the context of our model :0. Can you reproducethe answerswe got for Big Andy's tests? We concludethis sectionwith a joint testof two of Big Andy's conjectures. Most statistical software packageshave commandsthat will automatically compute t.894> 1 ricted model model thatis rictedmodel In this casewe obtain the samecalculated/-value of t :0.667.3365 .74 and a correspondingp-value is level. Becausethe F-distribution is not well suitedfor performing one-tail testsof this type.0049.9. Big Andy is planning staffing and purchasing of inputs on the assumptionthat a price of P : $6 and yield sales revenueof $80.9676<1.9'90 :80 with compatible and about optimaladvertising.661 . Using instead computer output obtained by supplying the two hypothesesdirectly to the software. we restrict ourselves to the /-distribution when considering alternative hypothesesthat have inequalitysigns like "<" or ">".

we begin with the multiple regression model Let the re . and if we combine it with the sample information. . t"@. + + + : 9r * B2ln(PB)+ + B3ln(Pr)+ B4ln(PR)B51n(1) +(92+B:+Bo+9s)ln(I) (6.r4) This model is a convenientone because precludes it infeasiblenegativeprices." Let us impose this assumptionon our demand model and see what happens. 1 8 )T h . To illustrate how we might go about combining sample and nonsample information.ita aretirr ti :.r7) By using constrai estimate .4.SeeAppendix A.1s) Comparing(6. If the nonsampleinformation is correct. * * (6. To obtain estimates that obey (6. (r") Bz*P3*9++F::0 (6.Having all prices and income change by the same proportion is equivalent to multiplying each price and income by a constant.fBs: -'rplainedI rn(Q): Br * Bzln(PB)+ p3ln(pz) + Baln(pR)+ Fsln(/) (6. particularly substitutesand complements.14) by \ yields Substitutin In(Q) = I"(Q): Fr * pzln(\PB) g:rn(r.imple mea \tedian \taximum \linimum i:d. we would expect there to be no change in quantity demanded. the price of liquor (PL). we can say somethingabout how quantity demandedshould not changewhen prices and income changeby the sameproportion. From the theory of consumer choice in microeconomics.quantities.. 9+.4.16) Thus. the price of all other remaining goodsand services(PR).)+ B4ln(pR.This assumptionis that economic agentsdo not suffer from "money illusion. To estimatethis demandrelationshipwe needa further assumptionaboutthe functional form. and multiplying each of the variablesin (6.it must be true that \\'e have u -i:ing the . 9:.that the log-log functional form is appropriate lable 6.) B5ln(f)* e. and because coefficients92.pr) B4rn(Xrn) B5rnlXr. Denoting this constant by \. will give a changein ln(O) equalto (92 + B3* F+ f 9s) ln(f).quareses estimates 6 . a doubling of all prices and income should not change the quantity of beer consumed.16) holds. jnd a samp ::om a ranc :.we know that the demandfor a good will dependon the price of that good. and this information can be written in terms of a specific restriction on the parametersof the demand model.): Fr * B.5 T}ne tlse of Nonsample Inforrnation In many estimation problems we have information over and above the information contained in the sample observations.FURTHER INFERENCE IN THE MULTIPLE REGRESSION MODEL 6. consider a model designedto explain the demand for beer.For example.This nonsample information may come from many places. then it seemsdesirableto be able to obtain estimatesthat obey this restriction. the A relevant piece of nonsampleinformation can be derived by noting that. if all prices and income go up by the same proportion.for thereto be no changein ln(O) when all prices and income go up by the sameproportion. Using "ln" to denote the natural logarithm. suchaseconomicprinciplesor experience. When it is available seems it intuitivethat we should find a way to useit.ln(pB.15)showsthat multiplying eachprice andincomeby ).and income.14)with (6.for this case. we assume. the precision with which we can estimate the parametersis improved. and income (I).and on income. and B5 are elasticities.16). denote To intro i.and hencethat the parameterrestrictionin (6. In the caseof beer. Thus.n\PLt PR f .) B3ln(pl. on the prices of other goods.in estima ln(Q. We call such a restriction nonsample information.it is reasonable relatethe quantity demanded(Q) to the price of to beer (PB). Dev. If we believe that this nonsampleinformation makes sense.

B5)ln(PR')* Fs ln(Ir) + er : gr * Bz + [m(rr.5 THE USE OF NONSAMPLE INFORMATION 147 Ta h I e 6 .088 4 \4) and a sampleof dataconsistingof 30 yearsof annualdata on beer consumptioncollected trom a randomly selectedhousehold. While it is always possibleto obtain restricted so estimatesby substituting the constraintsinto the model.39 9.1.. To get least ln(PL.602 32.that Surnmary Statistics for Data Used to Estirnate Beer Demand PL Sample mean Vedian Maximum \{inimum Std.re) +0.e4s8'"(ul)(6.) ln(PR1)] + +gr [m(r. 1 6 6 8 By using the restriction within the model we have ensured that the estimates obey the constraint.07 1.6422 8. we solve the parameterrestriction 9u + F: * 9.)] Br[n(Pt.17) (s") (0.r -1_ : 0 for one of the B1's.and dix A.r868'"(#) fi.18) is our restrictedmodel.37 8.'"(#) h(#) *s.) ln(PR. + b.0 .25 1.166) (0. called restricted least squares estimationproceduredirectly to the restrictedmodel in estimates.8574 3.7s8_ (6.284) (0.)* B3ln(PZ') + (-9. To introduce the nonsampleinformation.but for reasons Bs explained below we solve for Ba Fq: -Fz . ls) vill give a : in ln(Q) We have used the parameterrestriction to eliminate the parameterBa and in so doing. 2 9 9 4 ) . 1 8 6 8 0 .)] e1 :Fr * u. + b! : O. b\. let (6.Summary statisticsfor the data appear in Table 6.lPR).and : able to rodel (6.70 M.67 0. all prices change in ot change uffer from see what ivalent to ry \ and into the original model in (6.4.6.16) en prices terms of :striction :nse.18) (6.F: .) : Fr * Bzln(PB. 9 4 5 8: 0 .457 -11. To obtain leastsquares Let the restricted an estimate for pa we use the restriction bi: -b\b\ . and the new variablesln(PB. bi. andln(I.2es4'"(#) +0. ln(pR.427) in by estimates (6.bt: .73 0.we apply the leastsquares r6. + b.08 3.593 25.Which one is not important mathematically.17) gives Substituting this expression ln(Q. Dev. using the propertiesof logarithms.e l .l8).Thesedata are storedin the file beerdat.14) rtities.lPR.95 0. L aboutthe case.).11 4.a subscriptt (insteadofl) hasbeenused dataaretime-seriesrather than cross-sectional to denote the rth observation. consumer le price of ts.F: .D : _-4.90 81.4."G+) +e. 7 Ition conom many uitivethat ombine it rmetersis ormation.9s (6. 56.52 6. Becausethe data.18 |.2983 32. that b. .lPR ).7696 1.78 0. andb!.30 7..11 54. The last line iquares estimates that satisfy the parameter restriction. it may becomemessy if there are a .we have constructed in (6. The estimatedequationis t. and on re price of ices (PR).l9) be denoted b\.

148 FURTHER INFERENCE IN THE MULTIPLE REGRESSION MODEL number of restrictions or if the restrictions involve several parameters. Good economic theory is a very important ingredient in empirical research. What are the properties of this restricted least squaresestimation procedure?First.Evidenceon whether or not a restriction is true can be obtained by testing the restriction along the lines of the previous section. :espect \\'e estir rv $31 Wha :'itimat 6. This reduction in variance obtained by imposing restrictions on the parameters is not at odds with the Gauss-Markov theorem.You should check out the commandsavailable in your software. it is natural to ask where the model comesfrom. what is the best way to estimateits parameters? Given a particular model. The Gauss-Markov result that the least squaresestimator is the best linear unbiasedestimator appliesto linear and unbiasedestimatorsthat use data alone. {^ . the restrictedleast squares estimatoris biased.it is also used for model specification.A good economist will obtain more reliable parameterestimatesthan a poor one. the reduced variance comes at the cost of biasedness. The secondproperty of the restrictedleast squares estimatoris that its varianceis smaller than the varianceof the least squaresestimator.\|6 {. choice of functional form and regressors.E(bD + $p. becausea good economist will introduce better nonsampleinformation. the restricted least squaresestimator is unbiasedand has lower variance.. we are unambiguouslybetter off. hold. In any econometricinvestigation.Some software packageshave commandsthat automatically compute the restrictedleast squaresestimates when provided with the constraints. We need to ask: What variables are likely to influencethe dependentvariabley? How is y likely to respondwhen thesevariableschange? At a constantrate?At a decreasing rate?Is it reasonable assumeconstantelasticitiesover to the whole range of the data? The answersto these questionshave a bearing on regressor table i.6. choice r conside function choosin 6.autocorrelation.If the additional nonsampleinformation is correct.choice of the model is one of the first steps. Questionshave beenof the following type: Given a particular regressionmodel.In the caseof this particular demandexample. This is true at the time of model specification and later.the test is left as an exercise. This bias can be a big price to pay if it leads to estimates substantiallydifferent from their correspondingtrue parametervalues. For economic principles and logical reasoning play a prominent and vital role.whether the constroints imposedare true or not.In this section we focus on the following questions:What are the important considerations when choosing a model? What are the consequences choosing the wrong model? Are of there ways of assessing whethera model is adequate? Three essentialfeaturesof model choice are ( 1) choice of functional form.1'EDU . De .rmple \ledian \larimu \lrnimu ild.t h is pot onncipk rrhen it -'onside rsedby r ariabler Jepende rusband cducati Table 6. when constraintsmight be applied to the model.'onela i LUINI TEDU . This result makes an important point about econometrics.If the additional nonsampleinformation is incorrect. and no constraintson the parameters.Including additional information with the data gives the addedreward of a reducedvariance. unlessthe constraintswe impose are exactly true. Nonsample information is not restricted to constraints on the parameters. By combining nonsample information with the sample information we reduce the variation in the estimation procedure caused by random sampling. (2) choice of explanatoryvariables(regressors) be included in the model. listed in Chapter 5. and random regressors deal with violations of the assumptions. and (3) whether the multiple to regression model assumptionsMRI-MR6. we have generally taken the role of the model as given. how do we test hypotheses about the parameters of that model? How do we construct interval estimates for the parametersof a model? What are the propertiesof estimatorsin a given model? Given that all these questions require knowledge of the model. Later chapters on heteroskedasticity.6 Model Specification In what has been covered so far.

Alternative functional forms were considered Appendix A and Sections2.149 0.000) (6.Summarystatistics the dataappear on and for in fable 6. To introduce the omitted-variable problem.or lack of datamay lead us to drop a variableeven rvhenit is prescribedby economic theory.351 :essor 1.The dependentvariable is annual family income FAMINC defined as the combined income of husbandand wife. family income.57 12.65 t2 t7 5 2.14 0 2 0 0. Correlation matrix 9r2r3 83013 344t46 9072 44147 12.160 1. 6.000 0.dat.900 1. 4.: -5534+ 3r3zHEDUi 4523wED. and an additional year of educationfor the wife will increaseincome by $4523.000 0.82 2.594 0.362 -0. We turn now to consider the consequences in of choosing the wrong set of regressorsand some questions about regressorchoice.1 OurrrEr Venranrns It is possible that a chosen model may have important variables omitted.The r ariablesfrom this samplethat we usein our illustration are storedin the file edu_inc.2 with HEDU and WEDU denoting years of educationfor the husbandand wife.105 0.427 25. we considera sampleof married coupleswhereboth husbands and wives work.3.60 20.26 3.-/99 1. Good rsmaller I true or luce the ction in vith the rr is the a alone. Lt the is rtheses or the en that model eps.both the husband's education thewife's education.20) \\'e estimatethat an additional year of educationfor the husbandwill increaseannualincome by $3132.821 1. What happensif we now incorrectly omit wife's educationfrom the equation?Then. We are interestedin the impact of level of education.13 24.91 37. Our economic principlesmay haveoverlookeda variable.000 0.6.285 0..355 0.61 I2 l7 4 3.2r) Sumrnary Statistics for Data Used for Farnily Incorne Exarnple FAMINC HEDU WEDU KL6 X5 X6 Sample mean \ledian \laximum \linimum Std.000) TabIe 6.4MINC HEDU IT'EDU KL6 .035 t2.290 0.L 6. fiirther issuesin relation to in tunctional form are addressed Chapter 7. This samplewas usedby labor economistTom Mroz in a classicpaperon female labor force participation.000 0. and has ariance timates vhether r of the <ercise.392 12.In 'ations l? Are rice of rltiple lrs on rf the cgical ely to ange? S OVEf FAMINCi: -26191+ 5155 HEDUi ('") (8s41) (6s8) (p-value) (0. the rposeare :onomist )onomist iflcation )n is not n.129 0.000 .i * ('") (11230) (803) (1066) (p-value) (0.6 MODEL SPECIFICATION 149 software )stimates e in your First. the estimatedequation becomes glven. and 4.4.4.{5 \6 1.The estimated We relationshipis FAfriNC. respectively.3. definethe othervariablesasthey areintroduced.518 0.622) (0.072 0.836 0.37 5. choice and choice of a suitable functional form.2 (6.68 9.000) (0. ta gives colTect.052 F. Dev.002)(0.000 0.

000) (0.e minim r.6.31l.this bias is known as omitted-variable bias.21)is positive.the implications As in of an incorrectconstraintarebiasedcoefficientestimates.6.2 IRnrnvRNr VeRrRnr-rs -1.first note that B3 ) 0 because husband's educationhas a positive effect on family income.:oretica .3 : WEDUi. In the following equation we include KL6.22) lse. while omitting a variablefrom the regression usually biasesthe leastsquares estimator. However.Also. ) .Thereare.. Notice that. Th RT The consequences omitting relevantvariablesmay lead you to think that a good strategyis of to include as many variables as possible in your model.This for outcome occurs becauseKL6 is not highly correlated with the educationvariables. The larger the number of young children. from Table 6.In an appendixto this chapter. . b)be Let but the leastsquares estimatorfor B2whenx3 is omitted from the equation.-elevan .n-value wherey.24) We estimate that a child under6 reduces family incomeby $14. Also.20).2. xiz: HEDUi. On inc su rej Hc oc ab an (b) +.:. omitting WEDU leads us to overstate the effect of an extra year of educationfor the husbandby about $2000.rndard e --r alues ir o ::ecision -ccause. and x.trh expe ::'JSOnabl! Ch un( Ifr ma an (6. we show that . Such instancescan arise.compared to (6.20). Thus. doing so will not only complicate your model unnecessarily. (6. Omitting x3 from the equationis equivalentto imposing the restriction 9s : 0. 6.488) (0.rplied to --. if the sample covariance (or sample correlation) between x2 and the omitted variable-r3 zero. if data are not available for the relevant omitted variable. we write the underlying model for (6. This changein the magnitudeof a coefficient is typical of the effect of incorrectly omitting a relevant variable.:nproveI .r'anthat -. : FAMINCi. discussed the previous section."J>O because husband's and wife's levels of educationare positively correlated. Omission of a relevant variable (defined as one whose coefficient is nonzero) leads to an estimator that is biased.:tely.9 z : 9 r $ r 3 ) i varlx2) (6. the fewer the number of hours likely to be worked and hence a lower family income would be expected. the coefficient estimates H ED U andWED U have not changeda greatdeal.23) Knowing the sign of B3and the sign of the covariancebetweenx2 andx3 tells us the direction of the bias.3 C b i a s ( b :) E ( b . .othervariables that could be includedin (6.ff0 FURTHER INFERENCE IN THE MULTIPLE REGRESSION MODEL Relative to (6.From a generalmodeling perspective.3a ir'sting fi . Naturally enough.it may also inflate the variancesof your estimates r. means that useful results can still be obtained when a it relevant variable is omitted if that variable is uncorrelatedwith the included variables.l43ll KL6i ('") (11163) (7ei) (1061) (s004) (p-value) (0. To give a generalexpression for this bias for the casewhere one explanatory variable is omitted from a model with two explanatory variables.20) as yi : 9t l9zxiz * Fzxiz* e. FAMINCT : -7755 + 32Il HEDUi + 4777 WEDUi .6.i\e . a reducedvariance.ecauseof ^e add tw -. *r<E. e possi :'. Appendix 6B. the bias exhibitedin (6. Analyzing (6.004) l. b' ':.and our interest is on the coefficients of the included variables.000) (0.ofcourse.20) as explanators of family income.\'hat can r p-vah :. It can be viewed asan exampleof imposing an incorrect constrainton the parameters. then the leastsquares is estimatorin the misspecifiedmodel is still unbiased.. for example.23)in the contextof our example.doi . the number of children lessthan 6 yearsold.)nstructe rfluencef fIMiNC.

24) rmpared eal.nprove on it? It could be misspecified we have omitted important variables.6 MODEL SPECIFICATION 151 a year of fficient is Lrelevant is biased. to Also.the least squaresestimator of the correct model is :he minimum variance linear unbiasedestimator. These variables were . but are not expected to :nfluence family income. they could be causedby a misspecification such as the omission of an important variable.3a The RESET Test festing for model misspecification a way of asking is our model adequate.l42O0KL6i i 889X. as expected. when a variable has an insignificant coefficient. it is important to rememberthat failure to reject a null hypothesiscan also occur if the dataare not sufficiently rich to disprovethe hypothesis.008) (0. Some points worth keeping in mind are as follows: l. rpression with two because the presenceof irrelevant variables.010) (0.6.The inclusion ofirrelevant variableshas reduced the :recision of the estimatedcoefficientsfor other variablesin the equation.692) (O. There is no one set of mechanicalrules that can be .onstructed so that they are correlated with HEDU and WEDU. We conclude this section with a description of this test. Failureto reject hypotheses suchasthesecan be an indication that the variable(s)areirrelevant.F+ :0.More will be said aboutpoor datain the next section. Choosevariables and a functional form on the basis of vour theoretical and seneral understandingof the relationship. the bias . 6.This .For the moment we note that.luded in KL6. it can either be (a) discardedas an irrelevant variable or (b) retained becausethe theoretical reason for its inclusion is a strong one. Better choices come .i ith experience. for +. From a when a lles.s00) (0.22) luation is rosingan rlications Letb)be lix to this \\'hat can we observefrom theseestimates? First.doing so is often not an easytask. usband's itrl > o .00s) (0.What is important is to recognize ways of assessing whether a model is ::asonableor not.iL 6. or have a model that violates the .This result follows Tcause.the coefficients of X5 and X6 :ravep-values greaterthan0. the :hefewer vould be The possibilities of omitted-variable bias or inflated variances from irrelevant variables :rean that it is important to specify an appropriate set of explanatory variables. rategyis rot only stimates r..t067Xio (llles) (1250) (2278) (s044) (2242) (1e82) (0. of ire add two artificially generated variables Xs and X6to (6.3 CHoosrNc rHE MoDEL (6.23) direction it squares : omitted rnbiased. Unfortur. or unrealistic magnitudes.included if -elevant ones. The adequacyof a model can be testedusing a general specification test known as RESET.with .sel) (6. To see the effect of irrelevant variables. One method for assessingwhether a variable or a group of variables should be includedinanequationistoperformsigniflcancetests.5. and Lrise. What is neededis an intelligent application of both :reoretical knowledge and the outcomes of various statistical tests. : ('") p-varue) -7159 +334OHEDUi -t 5869wEDui ."-r'aluesincreasing correspondingly.6. The resultingestimatedequationis FAMiNa. If an estimated equation has coefficients with unexpected signs.05. by the Gauss-Markov theorem.24).pplied to come up with the best model. l-testsforhypotheses suchas Hs:$3:0 or F-testsfor hypotheses suchas lls:B3 . can \\'e is or . the .They do indeedappear be irrelevantvariables.Thatis.tandard errors of the coefficients estimated for all other variables have increased. chosen a wrong functional form. However. -) (6.itely.

2 b3xg * 6. x. if the original functional form is not correct the polynomial approximation that includes !f and y? *uy significantly improve the fit of the model. A failure to reject I1s sals the test has not been able to detect any misspecification. it needs to be kept in mind that it will not always discriminate between alternative models. you will get terms like f. l 6. xi2x3. For example. It is no rsolate th erplanato difficult tc rariable. Rejection of F16 implies the original model is inadequate and can be improved. x3s.26) and (6.27) In (6.984 F :3. Applying the two RESET tests in (6.. fu) be the least squaresestimatesand let ji: bt * b2x.1 T H s : 1 1: " l z : O In both casesthe null hypothesisofno misspecificationis rejectedat a 57osignificancelevel. 2 7 ) . The RESET test (RegressionSpecification Error Test)is designedto detectomitted variablesand incorrect functional form. and so on. Consider the following two artificial models * Y.rand 12..2s) be the predicted values of y.: -t ItY? + "t yi : 9t l gzxizI Fzxiz YY?* VY? + ei + (6. this fact will be detected through nonzero values of "). the general philosophy of the test is: If we can significantly improve the model by artificially including powersof the predictionsof the model. b2.7. although this equation was a useful one for illustrating the effect of omitted-variable bias.24) yields the following results F 1 6 : ^ y :1 Q F :5.015 : p-value0. Supposethat we have specified and estimated the regressionmodel Yi : 9r 1-9zxiz * 9zxiz* ei Let (h.25). it is possible for RESET to reject neither of them.if two different functional forms arebeing consideredfor a particular relationship.An F-test is required In for the second equation.26) a test for misspecification is a test of Hs:11 :0 against the altemative H t : ^ Y r * 0 . note that y! and !f will be polynomial functions of x. it could be improved upon as a model for explaining family income. : 9t l gzxiz 9:x. Furthermore. It proceeds as follows. if we have omitted variables. along with whether the householdis in a city or the country.123 : p-value 0. then the original model must havebeen inadequate. In purposes specified I sariablesi can be ider erperimen r ariablesa ls no guar rsolatethe Asane Burger Ba to advertis . t e s t i n g s : " t 1 : " l z : O a g a i n sftt : 1 1 1 0 a n d / o r * 0 i s a t e s t H V for misspecification.-oupon a( advertisin are flyers r measurin ofa sales r positivere of the two revenue. Since polynomials can approximate many different kinds of functional forms. then they are also likely to be correlated with terms like *.27) to the family income equation in (6. If you square and cube both sides of (6. To understand the idea behind the test.or an F-test can be used.2 and x6. and x!3.r.. So. and so some of their effect may be picked up by including the terms !/ and/or !f. b to sort oul As a se tunctiono productio As produc proportior i)'stemati or separa difficult. The conse ing an ext estimatio the model and wrote . and these variables are correlated with x.26) (6.2 and rp. [ n ( 6 . Although the RESET test is often useful for picking up poorly specifiedmodels. Perhapsthe linear functional form is inappropriate. If it does. Perhapsage and experiencecould be included in the model.045 \lost econ mental.2fp.7 Po (6. the first casea /.152 FURTHER INFERENCE IN THE MULTIPLE REGRESSION MODEL assumptionsof the multiple regressionmodel. overall.

7. proceeds 6.\'stematicrelationshipsthat epitomize "collinearity. The consequences ofcollinearity and/orlack of variation dependon whether we areexamin:ng an extreme case where estimation breaks down or a bad but not extreme casewhere -:stimation still proceed our estimates lack precision. When data are the result of an uncontrolled experiment ways. AND INSIGNIFICANCE 153 :cification . intuitively.consider productionrelationship a tunction of the amountsof variousquantitiesof inputs employed.If variables measuringthe expenditureson thesetwo forms of advertising appearon the right-hand side of a sales variables will showa systematic.\s production increases. @iz xz)z (6.1 oF Tnr Cor.we considered In but can :he model Yi : 9t l9zxiz I 9zxiz* ei estimatorfor Br as end wrote the varianceof the least squares var(b2) : oZ 1r. Section5. it needs odels. the because two types of advertisingexpendituremove together. it will be difficult for suchdatato revealthe separate effects !rf the two types of ads." nor that it will be possible to isolate the economic relationship or parametersof interest. in most casesthey are simply "collected" for administrativeor other purposes.3. In controlled experiments the right-hand-side variables in the model can be assignedvalues in such a way that their individual effects can be identified and estimatedwith precision.2). It is hard to estimatethe effect of chanseif there has been no chanse. Supposeit has been common practice to coordinate these tu'o advertising devices. For lationship.Proportional relationships between variables are the very sort of . and the problem is labeled collinearity.7 POOR DATA.Although it is clear that total advertisingexpenditureincreases sales revenue.it may be difficult io sort out their separateeffects on salesrevenue. Collinearity. revenue equation like (5. 6." Any effort to measurethe individual t.rsEeuENcES CoLLINEARITv (6.'i)IL.1. If the values of an :rplanatory variabledo not vary or changemuch within a sampleof data. so that at the same time advertising appearsin the newspapersthere are flyers distributed containing coupons for price reductions on hamburgers. such as labor and capital. explainingoutputovertime asa As a second example. d-variable ps ageand in a city or ls. in It is not just relationships betweenvariables a sampleof datathat make it difficult to rsolate the separateeffects of individual explanatory variables. and Insignificance Most economic data that are used for estimating economic relationships are nonexperimental.There arecertain factors of production (inputs).JL 6.26) (6.7 Poor Data. COLLINEARITY. then re of their re general utificially havebeen quation in ancelevel. at As an example.rrsep&rflt! effects (marginal products) of various mixes of inputs from such data will be Jifficult.then it is clearly Jifficult to use that data to estimate a coefficient that describesthe effect of changein that rariable. Such many of the economicvariablesmay move togetherin systematic variablesare said to be collinear.2s) (6. They are not the result of a plannedexperimentin which an experimentaldesignis specified for the explanatory variables. rthermore.thenthe dataon these positiverelationship.28) . Indeed.the changing amounts of two or more such inputs reflect equiproportionateincreases. that are used in relativelyfixed proportions.considerthe problem facedby the marketingexecutives Big Andl's Burger Barn when they are trying to estimate the increase in sales revenue attributable to advertisingthat appears newspapers in andthe increase salesrevenueattributableto in u'oupor advertising. In this casethere is no guaranteethat the data will be "rich in information.27) rlternative 0 is a test s required quate and letect any olynomial get terms y different olynomial he model. . C x6.

it is likely that the usual /-testswill lead to the conclusion that parameter estimates are not significantly different from zero.3 IoEN 3ecause none :rake senseto i}timated an ( 6.154 FURTHER INFERENCE IN THE MULTIPLE REGRESSION MODEL where ry is the conelation betweenx2 and4. Despite the difficulties in isolating the effects of individual variables from such a sample. however. There may be a problem. which says the values of x.or 3 . In general. Although there are :eve the expe :c* observati :ritigate collir :roblem. All the explanatory variables are related to the power and size of the car. In this c&sex2is collinear with the constantterm.-2)2 equals zero and var(b) again goes to infinity. variation in explanatory variables may be low but not zero. l. or --ars and smal rhose separa r ields \\'e estimatetl :allon. if . the deletion of an apparently insignificant variable. the least squares estimator is still the best linear unbiased estimator.. This outcome occurs despite possibly high R2. even though economic theory may indicate their importance in the relationship.dat contains observationson the followins variables for 392 cars: MPG : miles per gallon CYL : number of cylinders ENG : engine displacementin cubic inches WGT : vehicle weight in pounds Supposewe are interestedin estimating the effect of CYL. accurateforecastsof output may be possiblefor a particular ratio of inputs but not for various mixes of inputs.in which casar23. fhe estimated :umber of cyl ':reir coefflcier --rpotheses Ift :.28) we can seethat when r23is close to I or l(xa . accurate forecasts may still be possible if the nature of the collinear relationship remains the samewithin the out-of-sample observations. Exact or extreme collinearity exists when 12 andx3 areperfectly correlated. Similarly.From (6. We cannot obtain estimatesof 87.7.7. and WGTon MPG. then the condition of exact collinearity exists. but not exactly one. if the best we can do is not very good because ofthe poor characteristics ofour data.'susing the least squaresprinciple.2 AN Exelnprs The file cars.or F-values indicating significant explanatorypower of the model asa whole. and tl . A large variancemeansa large standarderror.In this case the least squares estimator is not defined. The effectsof this impreciseinformation can be summarized as follows.0 Cl'L and ENC .refficient of -onelationbel :ilects of eac .{2 exhibits no variation Z(xiz . The problem is that collinear variablesdo not provide enough information to estimate their separateeffects. The sampledata have provided relatively imprecise information about the unknown parameters.re fficient is fi :ust be nonze :=ducethe var r' highly corre 6. Hov :rpectations.1 and var(b2)goesto infinity.is violated.the varianceof b2will be large.By the Gauss-Markov theorem. or linear between more than two explanatory variables could be high but not exact.-2)2 is close to zero.For example. One simple rtween pairs --f linear asso iran two of th :airwise corn :dentifying th ln theseleast .1 are not exact linear functions of the other explanatory variables. 2.wheneverthere are one or more exact linear relationships among the explonatory variables. One of our least squaresassumptions MR5. which meansthe estimatemay not be significantly different from zero and an interval estimatewill be wide. dependencies These circumstancesdo not constitute a violation of least squaresassumptions. Estimatorsmay be very sensitiveto the addition or deletion of a few observations. ENG.bservewhat frl (P-' (s When estimator standarderrors are large. The more usual caseis where correlationsbetweenexplanatoryvariablesmight be high. i\ceptions.iternativel1r :'-ralueof 0. in an aggregateproduction function where the inputs labor and capital are nearly collinear.

s-3'ssScYLi (0.000) The estimatedcoefficient on CYL has changed dramatically. a second simple and effective procedure for :dentifying the presenceof collinearity is to estimate the so-called auxiliary regressions. we obtain an F-value of 4.014. and they are not sensitive addingor deletinga to :erv observations.Ifyou have to jstimated an equation where the coefficients are precisely estimated and significant.When we test the null hypothesisHo:92:9: elternative Hr:9210 anilor 9z*0. :educethe variancesof the remaining estimates.The estimatedmodel becomes WGTi MPGi : 44. highly correlatedwith ENG andWGT.A regressionof MPG on CYL f ields frFd. their coefficientsare not significantly different from zero at a 5Vosignificancelevel. observe what happenswhen ENG and WGT areincluded.IEL 6. If there are highly correlated variables.oefficient of CYL and B3 is the coefficient of ENG.00071) (p-value) (0.: ('") (p-value) 42.However.413) (0.0l27ENGi .ts when -r2 imilarly.Thesesamplecorrelationsare descriptivemeasures 'i linear association. they are not causing you a :roblem. r. They are variablesthat are likely to be highly correlated and whose separateeffect on MPG may be difficult to estimate. 6. In such instances. COLLINEARITY. which does not live up to .0083) (0. if Lity.7 POOR DATA. All the there are Because it nonexactcollinearity is not a violation of least squares assumptions.000) (0.7. . What is happening is that the high . In these least squaresregressions. AND INSIGNIFICANCE 155 .83) (0. then there is no reasonto try and identify or nitigate collinearity.0. The null h1'potheses Ho:92: 0 and Hs:$3 :0 are not rejectedby separate t-tests.onelation betweenCYL andENG (r: 0. and IVGTto be large for large cars and small for small cars. the collinearity may not be detectedby examining :airwise correlations. they rave the expectedsignsand magnitudes.6 miles per it eallon.s17) (0.overall we would expectthe valuesfor CYL. By the unbiased very good r23 close is le meansa from zero imprecise :ion can be exceptions. is useful to establishwhy the estimates poor.4 . ue nearly r ofinputs 3.where B2is the . are it One simple way to detectcollinear relationshipsis to use samplecorrelation coefficients retweenpairs of explanatoryvariables.000) (0. given CYLis an important variablethat :.0. doesnot :rake sense go looking for a problem ifthere is no evidencethat one exists.s) (0.95) is making it difficult to accuratelyestimatethe : 0 againstthe effectsof each variable. Nou.0.268 CYL: .000) We estimate the by that an additionalcylinder reduces gasolineconsumption 3.ignificant riables do 3n though yations. if you have a poorly estimated equation. or linear not exact.the dataarenot good enoughto prove the other coefficient nust be nonzero. If one . ns.3 IoENrrrvwc aNo MrrrcerrNc CoLLrNEARrry vill lead to iom zero.the left-hand-side variable is one of the explanatory . The null hypothesisis firmly rejected.146) (0. but. it is also likely to introduce omitted-variablebias.12s) (0.or an insignificant variable. and although we know that number of cylinders and engine size are important variables. when consideredseparately. but it is difficult to sort out the influence of each.'oefficientis free to takeany value. ENG. in some caseswhere collinear relationships involve more :han two of the explanatory variables.The data are telling us that together CYL and ENG influence MPG.00571 ('") (1. and the significanceof its coefficient suggests is an important variable.30 with corresponding -"-r'alueof 0. However.Should you drop one of the insignificant variables sayCYL? Doing so will . or >m such a collinear 'example.'\pectations.In this nore exsct xact collinot obtain sumptions rplanatory ht be high.

eITOTSel ?nd linear unbias where bp's ar. this is not always possible. xs3 the prediction problem is to predict the ).That is Yi:Bt *xiz9z*xBFs*ei Following the io t t"se(/). and better.One form the new information can take is more. the r of the results similar way. so that the reducedsampling variability is not bought at a price of large estimator biases. Given a set of valuesfor the explanatoryvariables.sample data.156 FURTHER INFERENCE IN THE MULTIPLE REGRESSION MODEL variablesand the right-hand-sidevariablesare all the remaining explanatory variables. Cross-sectionaldata are expensive to obtain.For example. The collinearity problem is that the data do not contain enough "information" about the individual effects of explanatoryvariablesto permit us to estimateall the parametersof the statistical model precisely.9 Exe where the !. In Section 5. The bad newsis that the resulting restricted estimatoris biased unlessthe restrictions are exactly trae. which is given by yo:9r lxoz9z-t'xoz9z*eo to .I we made the point that it is variation in a variable that is not associatedwith any other explanatory variable that is valuable for improving the precision of the least squaresestimator Dz. if new data are obtainedvia the samenonexperimentalprocessasthe original sampleof data. Consequently. as we did in Section 6. Unfortunately. it is important to usegood nonsampleinformation.L Pnor 6.9.{nswers e 6. To describethe extensions. for cross-sectiondata they represent values for an individual or some other economicunitthat was not sampled. Under these circumstancesthe new data will help little to improve the precision of the least squaresestimates. or 6. we assumethe random error e0to be uncorrelatedwith each of the sample you ot (a) R2 (b) Th rej . one must wait for the data to appear. in economics.29) describing how the original sampleof data was generated. xs2.We areassumingthattheparametervaluesdetermining ye are the sameas thosein the model (6. nonsample information in the form of restrictions on the parameters. The results in this section extend naturally to the more generalmodel that has more than one explanatory variable. (6.If R" from the auxiliary regressionis not high.xs2.x$) will be future values for the explanatory variables.consider a model with an intercept term and two explanatory variables . Th. Thus.one solution is to obtain more information and include it in the analysis. &reulcolr!lated random variableswith mean 0 and varianceot.5. and. linear and un The variar occursbecauf a consequenc val To obtain va explanatoryv rhusis uncorre . 1. A second way of adding new information is to introduce. and the estimator b2's precision is not affected by this problem. a general auxiliary regressionfor x2 is xiz : atxit + a3xB+ "' + aKxiK+ error If R2 from ttris artificial model is high. value average E ("f) :0. Alternatively.2e) 6. value of the dependentvariable ye. then the new observationsmay suffer the samecollinear relationships and provide little in the way of new.80 say. independentinformation.3.8 Prediction The prediction problem for a linear model with one explanatory variable was covered in depth in Section 4.T\us.say(1. then the variation in -r2is not explained by the other explanatory variables.r2 and .1 When If the data are time-series data.the implication is that a large ponion of the variation in x2 is explained by variation in the other explanatory variables.'ovarianceso varianceof a Each of th r arianceofthr of the forecas distributed. with time-series data. above0.r3.Also.This nonsample information may then be combined with the sampleinformation to provide restricted least squaresestimates.The good news is that using nonsampleinformation in the form of linear constraintson the parametervaluesreducesestimator sampling variability. (l.

then ection 6.9. if f : 1yo.imilar wav.The expressionfor var(yo .bz) +2xozcov(b1 bz) *2xozxozcov(b2.fu) .5.8PREDICTION 157 riables. then E (f) :0. we replaceo2 with its estimator62.2e) 'en a set of predictthe 6.Find (a) R'. The variance of forecast error var(ye . (6.b1 .rfthe results from the simple linear regressionmodel.b3 e portion of ection 5.3. Each of the terms in the expression for var("f) involves o'.the best linear unbiased predictor of ys is given by yo:h*xs2b2 Ixrr. riability is f_ se(. For K > 3. or if the sample is large.and that es is uncorrelatedwith the sample data. and es are normally distributed.This predictor is unbiasedin the sensethat the average value of the forecasterror is zero.7 PnonrErnls 6.3.n) vV I . and thusis uncorrelated with the leastsquares estimators(h.ter. where /. Thus. Do you reject or fail to reject Hs? .45222.1 When using N : 40 observations estimatethe model to rplanatory rme other termining f datawas he sample Yi:9r l9zxil9tzi*ei you obtain SSE : 979. .and D3areestimatesof the true parameters.9 Exercises {nswers to exercisesmarked x appear in Appendix D at the end of the book.i.t1N_K) coveredin xal model rplanatory Following the steps we have used many times. Thus. " about the etersof the mation and .f) ---.heoriginal rnshipsand stancesthe S.Y o . a consequence the unknown random error ee.ts). Under these assumptions.b2xs2 b3x$) : vat(eo : var(eo)* var(b1 -l fi2var(b) + fi3var(fu) ) *Zxozcov(b1. That is.j. 6. (b) The valueof the F-statisticfor testingHo:92 : F: : 0. nonsample ricted least m oflinear radnewsis true.4.. a 100(l-ot)Vo interval predictor for -r'eis i1 t t se(/). To obtain the estimated lariance of the forecasterror frffi. and to have the samemean 0 and variance o2.e) contains two components.(br * bzxoz t:xr)l -l var(/) : varl(Fr * \zxoz * F:xos1 "o) . bz. If the random errors e.sample al data are to appear.-distribution.The remaining variances and covariances the least squaresestimatorsare obtained using the rule for calculating the of varianceof a weighted sum in Appendix B.yo) is the forecasterror.830 and 6. The standarderror of the forecast is given by se(/) : \/ v&T).One component occursbecause bz.yo) is given by of .b3). For !rrorSe. the methodsextend in a .Y o r/var(v" .1 r any other )s estimator dnedby the is problem. To obtain var("f) we recognized that the unknown parameters and the values of the explanatoryvariables are constants.)EL 6. : 13. where Dp'sare the least squaresestimators. is a critical value from the /11v-r. The predictor is bestin the sensethat the varianceof the forecasterror for all other linear and unbiasedpredictors of y6 is not less than var(ye . the other componentis and bt. the methodsfor prediction in the model with K: 3 are straightforwardextensions .

E.1 I ut ttttl | | [ el - | T 3 | -2 lbrl: lb.919 12.Thecorrelationbetween.* [D] denotesthe estimated covariance matrix) : Dependent Varia observa Included Variable C l n ( f) ln(K) ln(PL) l n ( P F) In(PM) In(STAGE) R-squared \djusted R-squa -0. 5 1 9 3 R z: 0 .ofleast squares 20 observations thesevariables yields the following results (.t072 2.of regressio Sum squaredresi 6. 9: : 0.72(forliandli). yi:9i*9zxi*ei obtainedusingN: 35 observations.oleles -0. (b) Fr + 292:5.6 The RESET test suggestsaugmenting an existing model with the squaresof the predictions !f. What would happen if you augmentedthe model with the predictions themselves!.FURTHER INFERENCE IN THE MULTIPLE REGRESSION MODEL 6. Find 957o intewal estimatesfor B2 and B3.we obtainSSE: 696. RESET testsappliedto the secondmodel yield F-valuesof17.3 contains output for the two models Yi : Ft l9zxi I B3wiI e.00 rtK) r PL) 0.oso:or -0. from a sampleof 63 observations.l L I o 3l ol 1l ^.. 9 4 6 6 o' 0.1. : Testthe hypothesis F1s:2B2 Br.5.01 -0. 6 Coefficient Std.3 Variable O u t p u t f o r E x e r c i s e6 .031223 lu.1174 1.048526 . yi:9r lxiz9z* xiz\tlei Table 6.7i6e ) | : 2 . (c) 9r-92*$3:4' | 31.14 0. I | I -o.4 t 6.83 2 8 4.oreres 0. S.05 r PM) -0.01 rrPF) 0.975.00 :rSTAGE) .49785 w 2.03t2n url : I o. leastsquares the correspondingestimatedcovariance matrix are given by 1t.oser+ diDl : I o. Use a t-testto testthe hypothesis Ho:92> I against alternative Use your answersin part (a) to test the joint hypothesisHo:92: 0. Error t-value C X 3.037120 ) (a) (b) (c) (d) (e) Find the total variation.00 -0.2 Consideragain the model in Exercise6.? Table 6.i?1.240 .l ( a ) B z: 0 . and to testfor misspecification.99845 0.ztstz o.6356 -0.763 1.050301I I u. unexplainedvariation.235 0.000 0.5 t c ' Table 6. ) Ll.3383 -2.eosszl I o. Discuss following questions: the (a) Should wi be included in the model? (b) What can you say about omitted-variable bias? (c) What can you say about the existenceof collinearity and its possible effect? where VC price of f (a) Inte4 (b) Do tt (c) Whic (d) Does (e) Cons (0 Ifalli the sa (g) The tt you v TabIe 6. andexplainedvariation for this model.randwis rm :0.316 -0.1* In thepap Permane 645-657 contain o ln(VC) = Test each of the following hypothesesand state the conclusion: 6.5357.4 estimates and the Suppose that. or their squaresand cubes O?. After augmentingthis model with the yl Use RESET squares cubesof predictions andyl.8085 4. Error /-value Coefficient Std.s 6. covlbl:l-2 4 L-r.98(forl?) and8.33 :r f ) 0.f fo.3x Considerthe model to on and suppose that application. the H1:$2 11 .

(0 If all input prices increaseby the sameproportion. Tables 6.u PL) . 0 .64E-0s -0.000104 0. 645-657.989287 0.Vadali(1998).002929 -0.243818 1.802349 Mean dependentvar S.14 C . f: output.0000 0.056298-0. and STAGE : avera5! flight length.005419-0.919 12. the authors consider estimation of airline cost functions.rtK) .0000 0.000294 0. PZ .7 C ln(Ii) ln(K) ln(PL) In(PF) ln(Plt4) In(SIAGEI ble effect? t-value -2.275366 0. Test this hypothesis.. Test this hypothesis.H.002851 -0. ratesand the 1.001303 -0.000000 orthis model.000110 0. t H 1 : 8 21 7 .7 DependentVariable: ln(VC) Includedobservations: 268 \ariable Coefficient Std.5 to computetheset-statistics.0rr217 0.002159 3.898(05 0.000104 tr PM) -0.000179 0.002159-0.andS. PF : price of fuel.D.60E-05 0.001919 -8.528901 0.B.989528 0. Airlines.582172 0.otr2r7 -9.007059 0.000102 0. (b) Do the estimated coefficients have the anticipated signs? (c) Which coefficients are not significantly different from zero? (d) Does the RESET test suggestthe model is misspecified? (e) Constantreturnsto scaleexist if 9z f B3 : 1.000887 3. of regression Sum squaredresid 7.005419 0.002753 0.Explain how you would use the information in Thbles6.624638 6.000179 -0.R. Error 0.135334 41 10.M.680879 -6.036098 0.838-05 -8.002753 -9. Griffen.010068 0.93244 12.64E-05 o.4 and 6.)DEL 6.004939 .052879 0.000110 0.0t7152 0.056298 -0.000364-0.000294-0.price of labor.604139 12.679157 0.0t7152 0.S.002796 2.6 contain output obtained using their data to estimate a function of the form ln(vc) : Br * B2 h(r) + B3 ln(iK) Ba + ln(Pr) + 95ln(pr) + g6rn(pM) In(SZAGE)e * * BT where VC : variable cost.350305 0.3 l0 0.71856 6.0000 0.001097 0.100338 0.068318 -0.043807 0.000887 -0.4-6. ln(r!. dependent var F-statistic Prob(F-statistic) 0.028s77 t-value p-value esevariables : matrix): 0s0301 I 031223 | 037120) C rn{ ) I lntK) tnlPL) intPF) 'tnt PM) ''ntSTAGE) R-squared {djusted R-squared S.7* In thepaperBaltagi.001097 -0.89E-05 2. uares of the ppen if you model yield enx andw is Ta b I e 6 .004939 -0.28s921 8.053399 0. K : capital stock. and ln(PD.tt75t2 3.9 EXERCISES 159 rdel with the Use RESET Table 6. 5 Covariance Matrix for Least SquaresEstimates: Exercise 6. (g) The testsin parts(e) and (0 could alsobe carriedout using /-statistics.price of materials.0000 6.000364 0.002929 0.007059 -0.000817 A(STAGE)-0.rtf) .83E-05 0.321864 -0. variable cost will increaseby the sameproportion if Fo + Fs * B6 : 1.0000 0.0000 0."ExcessCapacity:A PermanentCharacteristic of U. (a) Interpret the coefficients of ln(If. PM .E.916433 -0.60E-05 -0. : uP F ) -0. J." Journal of Applied Econometics.F : : 0 .4966 0.000102 -0.4 Least SquaresOutput forExercise 6. 13.194390 0.338924 0.

7 il RamseyRESET Test: F-statistic(l term) F-statistic(2 terms) Wald Test: Null Hypothesis: F-statistic Wald Test: Null Hypothesis: F-statistic Con and Cob 3.15 we exoressed model the ' The r resp( Y. F : : 0 . Compare and contrastthese results to the restrictedcoefficient resultsgiven in (6.8F4: I in the model and 9r *692-ll.43246 l'.datto (a) Estimate the coefficients of the demand relation (6.15 to test the following hypotheses: ( a ) H o : 9 z: 0 a g a i n s t 1 : B 2 l 0 . F + : 0 a g a i n sH t : 9 z l 0 a n d / o r B 3 l 0 a n d / o r F c l 0 .160 FURTHER INFERENCE IN THE MULTIPLE REGRESSION MODET Table 6.l . into the model and rearranging show horr the modelcanbe written in a form whereleastsquares estimation will yield restricted least squares estimates. (a) 1 ( ' (b) (c) I f Follt subs are c HW HE HA CIT (a) I I (b) I .and1 : 50. l0'' Use the sampledata for beer consumptionin the file beer.2 Cortlpurrn ExrncrsEs Y= RG= RD= RF= 6. B +: 0 a g a i n sH 1 : $ 2 l 0 a n d / o r B a l 0 . : t ( d ) H 0 : 9 2 : 0 .380323 1.157729 (a) 9z*B3:1 6.PL : 10.6 T e s t R e s u l t sf o r E x e r c i s e 6 .9 In Exercise5.06'/120 0.000.00.00000(r I 6.9F:*3. (d) Use model (6. 6.} in termsof logarithmsand estimated using datain the file manuf.860108 p-value p-value 0.) (e) Repeatpart (d) using the unconstrained model from part (a).(Hint: Constuct the interval for ln(p) and then take antilogs.uYfz nf' rT' t+'tl'exP {e.dat. (b) Does collinearity appearto be a problem? (c) Testthe validity of the restrictionthat implies demandwill not changeif prices and income go up in the sameproportion. Comment.14) using only sample information. 6.F r + 9 q + 9 s * 1 . it Use the data and resultsfrom Exercise5.: .104834 p-value 0. t (0 Analyze the impact of collinearity on this model. 9 : : 0 a g a i n sH r : 9 2 * 0 a n d / o r F z l 0 .4.19) to construct a 95Va prediction interval for Q when PB : 3.9. H : ( b ) 1 1 0 : 9 2 0 .619+ :80 whi sr : gr -l gzpi* g:Ai + gqA?+ ei The tow Thor By substituting restrictions the variables. t ( e ) H o : 9 2* 9 r * F +* 9 s : I a g a i n sH t : 9 2 .00.19). t ( c ) F 1 oB z : 0 .3 we testedthe joint null hypothesis Hs:B3i3.' Usir p-value 0.014121 (b) 9+*Bt*90:l 75.PR : 2.8 In Section6.

that is.014121 0.. development.-f $3PL7 lqPRt * !sI. (c) Estimatethe model underthe restriction that the threeresponses rainfall arethe to same.1.dat to estimate the Cobb-Douglas production function.or flowering. + S5RF.Comment on the results. * Which model seemsto better reflect the demand for beer? .)DEL 6 .datcontains another subsetof the data usedby labor economistTom Mroz. The variableswith which we are concernedare only sample d coefficient wage in 2006 dollars. and rainfall at flowering (September-October). ' ilr' Using data in the file beer. the file hwage.dat.A model that allows for the yield for responseto rainfall to be different for the three different periods is Yt : 9t * \zt * B3RG. Report the results and comment on the signs and significance of the estimated coefficients. 9E X E R C I S E S 1 6 1 -.) + B3ln(Pt) * Baln(PR.6. and CIT : a variable equal to 1 if living in a large city.I e1 Use the data (a) Estimate this model.respectively. IIA : husband'sage. . Those variables are )s.l Thefiletoodyay. nge if prices for Q when t the interval nment.whereQ is the outputmeasure andL andK arelabor and capital inputs.067120 0.A popular functional form is the Cobb-Douglasequation 0.000000 rn(Q. I 1 Consider productionfunctionsof theform Q:f&. for the period 1950-1997. (a) Estimate the model HW:h*gzHE*gzHA-te What effect do changesin the level of education and age have on wages? (b) Does a RESET test suggestthe model in part (a) is adequate? x$alo.dat contains48 annualobservations anumberof variablesrelated on to wheat yield in the Toodyay Shire of WesternAustralia. and comment on the results. otherwise 0. .15'7729 : rn(Q) Fr * B2ln(r) B3 + ln(K)+ e (a) Use the data in the file cobb. The unit of measurement rainfall is centimeters. rainfall at development stage (July-August). K-. (b) Testthe hypothesisthat the response yield to rainfall is the sameirrespectiveof of whether the rain falls during germination. show ho\ ' eld restricted Y: / : RG : RD : RF : wheat yield in tonnes per hectare. -i Following on from the example in Section 6. HW : husband's I1E : husband'seducation attainment in years. * e. rainfall at germination (May-June). trend term to allow for technological change. Is there evidence of collinearity? (b) Re-estimatethe model with the restriction of constant returns to scale. Fz * B3 : 1.+ p4RD.) * B5ln(f ) * e1 Qt:9t * B2PB.perform RESET tests on the two alternative models 0.) :9r * 9z ln(PB.

. (Cany out the test in terms of the expected vote E(VOTE) and use a 5-r significance level.162 FURTHER INFERENCE IN THE MULTIPLE REGRESSION MODEL (c) Add the variables HE andHA2 to the original equation and reestimateit.(ii) torln houses.l :ntroducea X 'ingle or joir elready have --onespondin The startit ln words.11 to estimatethe resression voTE : fu t \zGROWTH + S3INFI. 1 * Recon 8 ln(l (a) the file Us wi (b) Us fur (c.12 usinethe datafile in the commute. on average. What can you say about the level of wages in large cities relative to outside those cities? (0 Do you think CIf should be included in the equation? (e)For both the model estimated in part (c) and the model estimated in part (et evaluate the followins four derivatives: .the following houses are all equally priced: (i) a new houseof 2000 squarefeet..ppendi This appendi :ras an F1. V1| r:ed to test 1 .) (c) Does a RESET test suggestthis model is a reasonableone?If not.) Us (b) (d) Us eq alt Reest and (ii estima RESE' .14 and model used asain in Exercise5. test the hypothesisthat the delay from a train is equal to three times the delay from a red light. and a 5Vo significance level.for HE: " OHE (11) -----. (ii) a2}-year-old houseof 2200 squarefeet. price of a 4O-year-oldhouse of size 3600 squarefeet is more than double that of a 5-year-oldhousewith 180(t square feet. on average. ^ .and (iii) French style homes.16* Reconsider the presidential voting data (faindat) introduced in Exercise 2. Describe the effect that education and age have on wages in this newly estimated model. Set up this conjecture as the alternative hypothesis and use a 5Q significance level. Great believes it is worth sacrificing some inflation as long as more growth is achieved. (a) Test the hypothesisthat a lVo increasein both GROWTH and INFLATION wrll leave VOTE unchangedagainst the alternative that VOTE will increase. test thr hypothesis that..PresidentWillie B. the (a) For eachof thesecategoriestest that.for HA: 6 and HE : 15 35 and HA : 50 (b) Us . can you make suggestionsfor improving it? 6.15 In Exercise5.11 Reconsider commutinstime model estimated Exercise5. 1HW ^ (i) . (b) Using all the houses in the sample.) 6. atw ^ isi tht (c) Wt lea tes thr (d) Su ler hir thr (e) Su on Does the omission of CITlead to omitted-variablebias? Can you suggestwhy? model 6.ATION* e In order to get reelected.10 you used data in the file bxdatto estimatethe regression PRICE : Fr * \zSQFT + %AGE * e for (i) all the housesin the sample.r. (Cany out the test in terms of the expected pnce E(P RICE). (d) Does a RESET test suggestthe model in part (c) is adequate? (e) Reestimatethe model in part (c) with the variable ClI included.{. and (iii) a 40-year-old house of 2400 squarefeet.dat TIME : fu * \zDEPART + 93REDS* BaZRAINS* e (a) Using a57o significancelevel.-. (b) Test the hypothesisthat Willie will not get reelectedagainstthe alternativethat he will get reelected when the growth rate is 4Vo and the inflation rate is 5%.

. The other is to :rroducea 1t 1chi-square) statisticthat is also usedfor testingnull hypotheses containing . test thc lually priced: (i) .'rresponding The startingpoint is the result that. V1could be of ..I degrees freedom. (d) Suppose that Bill encounters red lights andno trains. Ils: Fz : 9: andBz * F: * Ba : 1. Bill leavesfor work at 7: l0 AM insteadof 7:15 AM. when the null hypothesisbeing testedis true. IABOR : 100. testthe null hypothesis that leaving5 minutesearlieris enoughtime to allow for three trains against the alternative that it is not enough time.jointly test the two hypotheses parts(a) and in (b).Using a 5% significance no that leavingCarnegie level. Appendix 6A Chi-Square and F-tests: More Details s worth sacrificing I INFI. ' 18't Reconsider productionfunction for rice estimated Exercise5.testthe hypothesis that the elasticityofproduction with respectto land is equal to the elasticity of productionwith respectto labor. 13 using datain the in the file rice.:: ivords.rran F1. in each casecheck to see if the of RESET test has picked up the omitted variable. CHI_SQUARE AND F_TESTS: MORE DETAILS 163 . Fz.There are t\e'oways of overcoming the problem of an . Ho:92 * 9: + 9+ : 1. Describe :stimatedmodel. in .1() (6A. What can you e thosecities? imated in part (e (b) Using a 5Vosignificancelevel. (c) Using a5Tolevel ofsignificance.' C0square feet.That is.. (d) Using a 5Volevel of significance.anu testin terms of thc not.dat rn(PROD): + 9r * B2Ln(AREA) lzln(tABOR) + F+tn(FERT) -t e r suggest why? regression mode. the and (iii) AREA omitted.sERs.In eachcasediscussthe effect of omitting a variableon the estimates the remaining two elasticities. ill increase. :? ed. and Ba.ed to test the null hypothesis.ready have noticed and wondered about computer output that gives a 1'-value and p-value in addition to the F-value and its p-value.sEu) o- x?n (64. : sample.ATION wil:.1) -. Vt: e . (b) Using a l}Vo level of significance.V1has a 12-distribution -.his appendixhas two objectives.9'i' Reestimate model in Exercise6.. the hypothesis test that the meanof log output equals1. (Carry out the test in terms of the expectedtime E(TIMD.lay from a train i: (s.test the hypothesisthat the production function exhibits constantreturnsto scale. Find a957o interval estimatefor the time he arrives at the University.5whenAREA : 2. (c) Wonied that he may miss an important meeting if there are three trains.You may .testthe hypothesis atl:15 AM is early enoughto get him to the University before 8:00 AM againstthe alternativeit is not.Also.J MODEL APPENDIX 6A.Statethe null and alternativehypotheses terms of Fr. the alternative that flation rate is 5% E) and use a 5ci lusing the datafile .2) with .If o2 was known.v-r1-distributionwhen a specified null hypothesisis true. andF ERT : 175. test the null hypothesisthat the delay from a train is at leastthreetimes greaterthan the delay from a red light againstthe alternative that it is less than three times greater.:rsle or joint hypotheses about the coefficientsin a regressionrelationship. (ii) LABOR omitted.) (e) Suppose that Bill leavesCarnegieat 7:00 AM and encounters red lights and six one train. 83. Using a 57osignificance level.' ldhousewithlStX esis and use a 5'i rce level.(ii) tou r 40-year-old hous.timateit.The first is to explain why the statistic F_ (ssER ssEu)lJ ssEu/(N.14 anc (a) Using a57olevelofsignificance.18 with (i) FERZomitted. That is.. can you make Exercise2.

1).m2) In the context of our problem The secondequ 68.5) and (64. Noting thatGL : SSE7I(N .Thep-values are F : A i + g q A ?+ e i Thus. If sample size is sufficiently large..i v':7#-x?vt (6A. respectively?A moment's thought reveals that -Vl .That is. One leadsto the F-statistic in (6A.We can confirm this relationship by reexamining some examples.nr.and X2 This statistic can be used to test hypothesesabout the unknown regressioncoefficients. Omi equationyields nonzero mean remaining varic .44 p-value: 0. : B3 F:y#r-F(m1. from (B. *here v. To describe the secondway of eliminating the unknown o2 we introduce the result Appendix Consider the n -x?r-*t vz:w -r)62 (6A. Consideringthe secondone first..3) The F.2.3) and (6A. the restr .0002 Becausethere are two restrictions (J :2).r.. the other yields the 12-statisticyou may have beenwondering about.K). one way to obtain a workable test statistic is to replace o' in 161.with its estimate o2 from the unrestrictedmodel.5) is the one we have usedthroughout this chapterfor testing hypotheses.4) Supposethat v This result is the multiple regressionextensionof the simple regressionresult given in equation (3A. F-value is half the 12-value.orifthe p-value PIX?. When testingHs:$3 : B+ : 0 in the equation Si : Br *gzPi* we obtain F :8.5).1) yields (6A.-ovariance betv tiom the regres :he simple corn estimatorin the that omitting an $at sucha viole sntement. it will be approximately true that For testing (ssER ssEu) . We are now in a position to use the result that the ratio of trvo independent degrees offreedom. although we have not done so. What is the relationship between V 1 andF given in (6A.the different becausethe tests are different.the mei The two o''s in Vl andV2cancel. is 1'random variables. Atasqosignificancelevelwereject H1ifitisgreaterthanthecriticalvaluel2a.eachdivided by their respective an F random variable.4) of the appeldix to Chapter 3. The F-statistic in (6.0005 X2 : 16.{.1) are identical. it is possibleto prove that V1 andV2 are independent.Also.FURTHER INFERENCE IN THE MULTIPLE REGRESSION MODEL unknown ot.5) : ----F- (ssER ssEu)/J - r17'w-K) Hence.35) in Appendix B at the end of the book. we can seethat (64.05.> Vrl is lessthan 0.:T The F-value is equal to the 12-value divided by the number of restrictions in the null hypothesis.88 p-value:0.

7z)z r in the null p-values are -.thenthe leastsquares x2 : -:rmator the misspecified in model is still unbiased.DEL . but again the p-valuesare different. '.. rectively?A :92 +D?----. .3) coefficients.l ) yields (6A. If APPENDIX 68 OMITTED-VARIABLE BIAS: A PROOF 165 For testingt1e: B3 * 3.. Knowing the sign of B3 and the sign of the . in for -B.v a l u e: 0 . Then.4. -tz)(y.5 r bi: l 9 z I F z Z w i x i zL w i e i E(bil:92 llz}wixiz ible to prove Ientical. J .4r n in equation rt the ratio of f freedom.8 94 : I (seeSection6.n the regression (or usually biasesthe leastsquares estimator.: L(*.2 . the samplecovariance if -: simplecorrelation)between and the omittedvariablex3 is zero.ariance betweenx2 andx3tells us thedirectionof thebias.2). while omitting a variable .:-ration yields an error that we havecalledv1in the abovediscussion.and 12-valuesare equal because : l.. we obtain F :0.936 p-value: 0.1) follows from Appendix2D in Chapter2.-. This error will havea ' rzero mean and the consequences biased estimatesfor the coefficients of the are -:lainins variablesin the model..3365 p . cov(x2.'' S/ \Z ^ I(to -iz)xiz L\x.7z)z \xi2 .".. Way back in Section2. \ jppose that we incorrectly omit x3 from the model and estimateinstead )i:Br*9zxizlvi ^rere vi :9$n usedfor B2 is + er.Omitting an importantvariablethat is correlatedwith variablesincluded in the :"..x21 -72)(4 -tu) : B z * 9 : L(r.it omitting an importantfactor will lead to violation of the assumption SR2 E(e) : Q3n6 ::t sucha violation canhaveserious consequences.--.1) ^ rere ' / -\ l:e second equalityin (68.Also. Substituting v....The hypotheses.2...rs. cannow be morepreciseaboutthat We '-:terrrert.y) : 9 2 *Lwtvt L(xn ..x3) .". 3 3 3 3 (6A. : ^ -r ^ Pz I'3 rlt2 @ - Z(xiz . . ..the estimator b.. the restricted estimator is biased... .\ppendix 68 Omitted-Variable 'onsider the model Bias: A Proof I )i : 9t l9zxiz * 9zxrz ei (6A...is ok.-.o r i f t h e the result lhe F.936 x2 :0..we suggested -.i212 (68.x2) L1xi2 .. ..ticyou may r a workable ld model.. s .

intera or . 7 ( a ) 166 . How to include a productof two dummy variablesin a regression. 3.hou this affects model interpretation. microeconomi .rually 0 and 1.The essence a linear relationship that its slopeis constant by of for changes anddoesnot depend the valuesofthe variables.etionship. How to include a slope dummy variable in a regression. The consequences ignoring a structural change in parametersduring part of the sample. 1. for f We will consid .we usedu i'inally. where we examined the choice of model functional form and I la r .. ?. Fi in Keywords annualdummy variables binary variable Chow test collinearity dichotomousvariable dummy variable dummy variable trap exact collinearity hedonic model interaction variable intercept dummy variable log-linear models nonlinear relationship polynomial reference group regional dummy variable dummy variables seasonal slope dummy variable In this chapter we consider methods for adding more flexibility to the regressionmodel. :iscoveredthat by .. on Ifthe slopeofthe relationship any reason.e will discussea 7. and give an example.with o -.. .i o or more expla . How to test the equivalence two regression 9. how this affect: -5..we meanthatrelationships between is represented straightlines.Chapter Nonlinear Relationshipt Learning Objectives Based on the material in this chapter you should be able to explain L The difference between qualitative and quantitative economic variables. couldaccomm e \..lvnomials a r are -:: curved. How to interpret the coefficient of an interaction betweentwo continuousvariables. of equationsusing dummy variables.rges. 6.1 Polyno 2.1 Cosr eN -:. 8.1.rnsider :re use of dummS . T -raracteristics ofi :e neral.3 and 4. how to interpret the resulting model.3 and A. eriables.:tuations whicl in usefulne . and give an example.4.By that.-ral cost and totr sh :ubic" shapes :rr. How to model qualitative factors with more than two categories(like region of the country).then the relationshipis said to be nonlinear. aI average . and give an example. model interpretation. we make t ' . How to interpretthe coefficienton a dummy variable in a log-linearequation. c n e7 .4. The tools we introduce allow us to deal with the fact that most economic relationships are cannotalwaysbe economicvariables not linear. and give an example.:orrn in Figure ' 'r'lresented reg by -:e easily repres --'. This problem was introducedin Sections 4. How to include a 0-1 dummy variable on the right-hand side of a regression.how this affects model interpretation. of 7.

taking the standard "cubic" shapes shown in Figure 7. Consider the following examples.ie will discusseach of thesecases. nuousvariables. .\.:nages. which are explanatory variables that take only two values.or interaction variables. and geographicregion ofresidence. Total cost and total product curves are mirror images of each other. These simple variables are very powerful tools for capturing qualitative . and . uring part of the mmy variables. Finally." However.1 Cosr eNo Pnooucr Cunvps In microeconomicsyou studied "cost" curves and "product" curves that describe a firm.how 3ar equation. squares.When using either polynomial terms. For example. a suitableregression in model is AC:9t+?zQ-rFzQ'*e :lationship roup mmy variable Lmmyvariables ny variable Cost (7.race.1. such as gender. is affects model how this affects ike region of the rle. r c u np 7 . dummy '' ariables.re easily represented polynomials. cubesofvariables and s e could accommodate relationships with manydifferentshapes. The slopes of these relationships are not constant and cannot be :r'presented regressionmodels that are "linear in the variables. iables. Averageand marginal cost curves. averageandmarginalproductcurves. 7 (a) Total costcurve and (b) total productcurve. we make use of interaction variables. -. regression. with one or more peaks and valleys. In :eneral.we explain of lhe use of dummy variables.-onsider usefulness polynomials to capturecurvilinear relationships. 7. we . These are variablesformed by multiplying :$ o or more explanatory variables together.l POLYNOMIALS 167 discovered that by creativelyusing logarithms. in First. theseshapes by .1 Polynornials Polynomials a rich classof functionsthatcanparsimoniously are describe relationships that . We will consider several procedures for extending the multiple regression model to .2a.T.-haracteristics ofindividuals.usuallyrepresentedas -hown in Figure 7.2.re curved.we usedummy variables describe to any eventthat hasonly two possibleoutcomes. Sections See . ::sually 0 and l.ituationsin which the slope of the relationshipchanges one way or another. some changesin model interpretation are required.1) gression model. AppendixA. if we consider the averagecost by :r'lationship.3 and A.1.reciprocals.Second. for further discussionof linearity versusnonlinearity. Figure 7 .takequadraticshapes. elationships are annotalwaysbe ilopeis constant shipchangesfor n introducedin ional form and a (a) (b) .4.and their mirror .

It is sometimestrue that having a variable and its square or cube in the same model causescollinearity problems.6).. fhe peakofthe :t which the slr To illustrate -ontainedin tht :trefficients on :nd are statisti For these 19 :nateachadditi< -. The variables Q2 and are explanatoryvariibles Q3 that are treated no differently from any others. An interesting aspect of models of nonlinear relationships is the interpretation of the parameters-they are no longer slopes.2).ob Mincer ( 195 :.rill begin to de J) cle pattern of .O (7.la a cubic polynomial is in order. is dE(TC\ t: cr2 2uzQ* 3a+e2 * (7. S yearsis ' This importan .1) with a slope that depended advertisingexpenditure. still be estimated can using the least squaresmethodswe have studied.2709 Input FrcuRE 7. Their inclusion does not comp_ licate least squaresestimation. Nov . the slope of the averagecost curve changesfor every value of p and dependson the parameters and B3. otrcmy.168 NONLINEAR RELATIONSHIPS Cost Table 7. TC : ar -t aze I azez+ aae3+ e Thesefunctionalforms.:0.As we have shown care must be taken when interpreting the parametersof models containing polynomial terms.XPER LXPER2 !t.2) ord cr4. 1 )i s ln Section4.For a d.idrtion the relatior -:etly summarized \tA: Addison-Wes . See Section6.7 \ ariable C EDUC T. a3 ( 0.2 A Wa This quadratic function can take the "U" shape we associate with average cost functions. '..r ) 0. on Using polynomial terms is an easy and flexible way to capture nonlinear relationships betweenvariables. the slope of the average cost curve ( 7 .3) That is. and a.4 :-ducation.2 (b\ \a) Averageand marginal (a) cost curves and (D) product curves. Another example of a polynomial nonlinear relationship is the quadratic nonlinear relationshipbetweensalesand advertisingexpenditureintroducedin Section6.66(4).4) The slope is a quadratic function of Q.3. with one exception. . For the total cost curve in Figure 7. U-shapedmarginal cost curve we expect the parametersigns to be cr2) 0. involving the parameterscr.7. which is the marginal cost. It was similar to (7.For this U-shapedcurye we expect gz < 0 and B2 B: > 0.3.rorker's years :raverelatively . which represent nonlinearshapes. the estim .i wages Ttr obtain the i :'\perienceon r dEAC) :92-r 2$tq . Indeed. The slope of the total cost curve (7.1.28 .

28I-302.6292 -4.)gfficients education.0000 0. Chapter5. and with this .0012 -9. we expect B3 > 0 and F+ < 0.08 AP \r. and ct4. holding education and other factors constant. the estimateof the marginal effect of experienceat the samplemedian experienceof .2 AWecs EquerIoN ln(wages)asa functionof andwe expressed a In Section 4. The estimated :onrainedin the file cps_small.6).0702 0. The marginal effect of :rperience on wage.2282 6. \1. Input 1. See curve occurswhere EXPER : -92129q. with additional experiencetheir wages will rise.1.3. as we do in Section7'5.2we introduced wageequation. namely the u orker's years of experience.1s76 : o.21.iJirion the relation in equation (7.66(4). "nd For these 1997 data.2r0r 0. Error /-Statistic Prob.the dependentvariable is earningsper hour ($). but the wages + ill begin to decline after middle age.34oe + 2(-o.2515 0.4.2709 t'.Wagesare often expressed logarithmicform.::ob Mincer (1958) "Investment in Human Capital and Personal Income Distribution. on are statistically significant.\: Addison-Wesley. Using in :hateachadditionalyearofeducationleadsto an increase hourly earnings -.dar..1.T.s) To obtain the inverted-U shape..3) I dependson the >0. inexperienced workers will rave relatively low wages. and Jratic nonlinear :tion 6.7 \ ariable C EDUC EXPER EXPERz Wage Equation with Quadratic Experience Coefficient Std.0051 SSE: 28420. .0514 0.l POLYNOMIALS Table 7 . -9.For a t 0. I This important economic relationship.oo5l)18 lurrr*:.experience.2) matedusing the natory variables nterpretation of rragecost curve -l * * WAGE: 9r * P2EDUC 1tEXPER 9+EXPER' e (7.as the worker nearsretirement.0000 0.Now we add another important determinant of wagesto the model.0550 0. cr3( 0.. It was rlinear relationinterpreting the loes not compe that having a problems." Both the theory and empirical issuesare :carly summarized in Emst Bemdt (1991) The Practice of Econometrics: Classic and Contemporary.5) is called the "Mincer equation.was discussedby economist .8t77 t.6) is zero.4) ].ri wages : cost functions (7.()nomy.0000 0.What we expect is that young.6) (7.0000 R::0. still widely studied by labor economists. S yearsis YWJI 1EXPER :0.is aE(wAGE): Br * 2B-'EXIER AEXPER (1.3409 -0.. (7. To illustrate we use data on 1000 workers from the 1997 Current PopulationSurvey The estimationresultsare in Table 7. Thus we estimate of$1. education.'1cle pattern of wageswe introduce experienceand experiencesquaredto explain the level . Reading.3062 17." Journal of Political in . and experiencesquaredhave the anticipatedsigns --.' To capture this life. This is the point The peakof the wage--experience :t which the slope in (7.

170

NONLINEAR

RELATIONSHIPS

We estimatefor a worker with 18 yearsof experience,that an additional year of experience increaseshourly wage by 15.76 cents. The turning point in the relationship, after which wages are expected to diminish with additional experience, is estimated to occur at -0340912(- 0.0051):33.47 years. EXPER : -Fsl29+:

Dummy variable \\'e consider thes 7.2.1 lNrsacr

7.2 Dsrnrny Variables
Dummy variables allow us to construct models in which some or all regression model parameters,including the intercept, changefor some observationsin the sample.To make matters specific, let us consider an example from real estateeconomics.Buyers and sellers real estate appraisers,and mortgage bankers are interested in of homes, tax assessors, predicting the current market value of a house. A common way to predict the value of a houseis to usea hedonic model, in which the price of the houseis explainedas a function of its characteristics, suchas its size,location, number of bedrooms,age,and so on. The idea is to break down a good into its component pieces, and then estimate the value of each characteristic.2 For the present,let us assume that the size of the house,measuredin squarefeet,SQFT,is the only relevantvariable in determining houseprice, PRICE. Specify the regressionmodel
AS

The most comm( rarameter. Addir :.]rameter 6, we ,

The effect of the i :ramining the re1 -orrectly specifie

PRICE: gr * B2SQFT e *

( 1 . 1r

In this model B2 is the value of an additional squarefoot of living area,and $1 is the value of the land alone. In real estatethe three most important words are "location, location, and location." Hos can we take into accountthe effect of a property being in a desirableneighborhood,such a. one near a university, or near a golf course?Thought of this way, location is a "qualitative " characteristicof a house. Dummy variablesareusedto accountfor qualitative factorsin econometricmodels.Ther areoften called binary or dichotomous variablesasthey takejust two values,usually 1 or 0. to indicate the presenceor absence a characteristic.This choice of valuesis arbitrary but of very convenient as we will see.Generally we define a dummy variable D as n _ | | " i0 if characteristic present is if characteristic not present is

(7.8 r

.r thedesirable nr -r other areasthe ij:eure7.3, assu Adding the dt :.'lationship th by :rrameter 6 is th . tated in the des ::'gression model -rlled an interce :.:gherin a desir The least squ :rplanatoryvaria ..iriable.We can :'astsquaresesti :ouseprice is "st :.*ighborhood in

Thus, for the houseprice model, we can define a dummy variable, to accountfor a desirable neighborhood, as

^ _ lt " l0

if propertyis in the desirable neighborhood if propertyis not in the desirable neighborhood
Fr+6

Such models have been used for many types of goods, including personal computers,automobiles and wine. This famous idea was introduced by Sherwin Rosen (1978) "Hedonic Prices and Implicit Markets," Joumal o.i Political Economy,82,357-369. The ideas are summarized and applied to asparagusand personal computers in Ernst Bemdt (1991) The Practice of Econometrics: Classic and Contemporary, Reading, MA: Addison-Wesle1. Chapter 4.

2

Fr

: t c u n n 7 . 3 Ar

7.2 DUMMY

VARIABLES

171

r of experience lp, after which :d to occur at

Dummy variablescan be usedto capturechanges the model intercept,or slopes, both. in or \\'e considerthesepossibilitiesin turn.

7.2.1 INrrRcspr Duuuv Venreerss
The most common use of dummy variables is to modify the regression model intercept rrrameter. Adding the dummy variable D to the regression model, along with a new rrrameter 6, we obtain

ressionmodel nple. To make 'ersand sellers : interestedin the value of a n a function of on. The ideais value of each :feet,SQFT,is model ;ression

PRICE: gr * 6D+ gzSeFT e +

(7.e)

The effect of the inclusion of a dummy variable D into the regressionmodel is best seenby :ramining the regression function, E(PRICE), in the two locations.If the model in (7.9) is -orrectly specified,then E(e): 0 and

[ ( B-r+ 6 ) + B z s O r Z w h e n D : I E(PRICE\: i " whenD:0 l9r + BzSQFZ

(7. 0) r

(1.'7) is the value of rcation."Hou rhood,suchas "qualitative" models.Thel usually I or0. s arbitrary but
IS

(7 8) or a desirable

. r thedesirable neighborhood : 1,andthe interceptofthe regression D functionis (B r * 6). .r otherareasthe regression function interceptis simply B1.This differenceis depictedin fisure 7.3, assumingthat 6 > 0. Adding the dummy variable D to the regression model causesa parallel shift in the ::'lationshipby the amount 6. In the context of the houseprice model the interpretationof the :rrameter E is that it is a "location premium," the difference in house price due to being 'catedin the desirableneighborhood.A dummy variable like D that is incorporatedinto a :r'gression model to capturea shift in the intercept as the result of some qualitative factor is -illed an intercept dummy variable. In the houseprice examplewe expectthe price to be -.:gher a desirablelocation, and thus we anticipatethat 6 will be positive. in The least squaresestimator's properties are not affected by the fact that one of the -'rplanatory variables consists only of zerosandones-D is treatedasany otherexplanatory . rriable. We can constructan interval estimatefor E, or we can test the significance its of 3dstsquares estimate. Sucha testis a statistical testofwhether the neighborhood effect on :r)useprice is "statisticallysignificant."If 6 : 0, then thereis no locationpremium for the :.eighborhood question. in

=(Br +6) +pzSQFr E(PRICE)

0r*6
tobilesand wine. <ets,"Joumal of :lal computers in \ddison-Wesley.

= E (PRICE) Bt + p2SQFT

Fr

: rcunp

7.3

An interceptdummv variable,

NONLINEAR

RELATIONSHIPS

7.2.1a Choosing the Reference Group The convenience the valuesD : 0 and D : I is seenin (7. 10). The value D : 0 defines of the reference group, or basegroup, ofhousesthat arenot in the desirableneighborhood. The expectedprice of thesehousesis simply E(PRICE): 9r * PISQFT. Using (7.9) we are comparingthe houseprices in the desirableneighborhoodto thosein the basegroup. A researchercan choose whichever neighborhood is most convenient for expositorl purposes,to be the referencegroup. For example,we can define the dummy variable LD to denote the less desirable neishborhood , n _ I 1 if property is not in the desirable neighborhood "" \O if property is in the desirable neighborhood ThisdummyvariableisdefinedjusttheoppositefromD,andLD: - D.IfweincludeID I in the model specification PRICE: BI * }\LD + \ZSQFT * C

in ,-hange the slopt tor housesin the r D, reighborhoods. .rtherexplanatory :rvodifferent locat :nto the economic : E(PRICE)9

In the desirable nt 'rher locations.\\ lesirable neighbo Anotherway to :artial derivative ,rhich gives the s

then we make the reference grorp, LD : 0, the housesin the desirable neighborhood. You may be tempted to include both D and LD in the regressionmodel to capture the effect of each neighborhood on house prices. That is, you might consider the model PRICE: Br * ED + \tD l \2SQFT _l e In this model the variablesD andLD aresuchthat D I LD : 1. Since the intercept variable xr : 1,we havecreateda model with exact collinearity, and asexplainedin Section6.7, the least squaresestimator is not defined in such cases.This error is sometimesdescribed as falling into the dummy variable trap. By including only one of the dummy variables,either D or LD, the omitted variable defines the reference group, and we avoid the problem.' 7.2.2 SropE Duumy VRnresrss

ii the assumption :ave their usualgc
PRICE

Pr>
Instead of assumingthat the effect of location on house price causesa change in the interceptof the hedonicregression equation(7.7),let us assumethat the changeis in the slope of the relationship. We can allow for a changein a slope by including in the model an additional explanatory variable that is equal to the product of a dummy variable and a continuous variable. In our model the slope of the relationship is the value of an additional square foot of living area. If we assume this is one value for homes in the desirable neighborhood,and anothervalue for homes in other neighborhoods, can specify we

I L
I

PRICE

PRrCE: Br * \2SQFT+ t6QFTxD) -l e

(7 r1t . Fr

The new variable (SQFT xD) is the product of house size and the dummy variable, and is called an interaction variable, as it capturesthe interaction effect oflocation and size on house price. Alternatively, it is called a slope dummy variable, becauseit allows for a

,rr
tu?
(a

3 Another way to avoid the dummy variable trap is to omit the intercept from the model. This choice is less desirable than omitting one dummy variable, since omitting the intercept alters several of the key numerical properties of the least squaresestimator.SeeAppendix 48 and Section 5.6. Omitting the intercept causesthe basic definition of model R2 to fail. which is inconvenient.

L

rcunn 7,4

7.2 DUMMY

VARIABLES

173

) :0 defines ighborhood. ring(7.9) we basegroup. 'r expository riable LD to

change the slopeof therelationship. in The slopedummy variabletakesa valueequalto size when D : l, and it is zero for homes in other lor housesin the desirableneighborhood, just like an1 neighborhoods. Despiteits unusualnature,a slopedummy variableis treated otherexplanatoryvariable in a regressionmodel. Examining the regressionfunction for the trvodifferent locationsbestillustratesthe effect of the inclusion of the slopedummy variable into the economicmodel,

gr E(pRrcE): * gzseFr +t6eFrxD) :

f Br * (Br + "y)SOFZ whenD : -

I

t;; *Or'sqi7

whenD:0

s include lD

In the desirableneighborhood, price per squarefoot of a home is (Fz + 1); it is p1 in the other locations. We would anticipate "y> 0 if price per squarefoot is higher in the more desirable This situationis depictedin Figure 7.4a. neighborhood. Anotherway to seethe effectof includinga slopedummy variableis to usecalculus. The partial derivative of expectedhouse price with respect to size (measuredin square feet). shich gives the slope of the relation,is

rborhood. , capture the : model

aEeRrcE)
ASQFT

[92+t lBz

whenD: I whenD:0

If the assumptions the regressionmodel hold for (7. I 1), then the least squaresestimators of in havetheirusualgoodproperties, discussed Section5.3.A testofthe hypothesis as that the :eptvariable :tion 6.7,the lescribed as ables, either problem.3
PRICE

Slope=B2+y

E (PRICE= Ft + (Fz+9 SQFT E (PRICD = Bt + p2SQFT

Slope= P,

ange in the rge is in the [e model an iable and a n additional Ledesirable specify

= E (PRICE) (Br + 6) + (gz+i SQFT

(7.r1)
able, and is and size on Lllowsfor a

E ( P R I C E= ( p r + 6 ) + p 2 S Q F T )

Fr*6 Fr

E (PRICE=Bt+ B2SQFT

choice is less <ey numerical rusesthe basic

SQFT (b)

(b) r r cune 7 . 4 (a) A slopedummy variable. A slopeand intercept dummy variable.

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Table 7 .2
PRICE

RepresentativeReal Estate Data Values
SQFT

Table7.3
POOL 0 0 0 I I 0
FPLACE 1 I Variable
L

F

AGE 6 5 6 28 0 6

UTOWN 0 0 0 1 I I

205.452 185.328 248.422 287.339 255.325 301.037

23.46 20.03 27.77 23.67 21.30 29.8'l

0 0
I I

UTOWN SQFT SQFTXUTOWN .1GE POOL FPI.4CE

value of a squarefoot of living areais the samein the two locations is carried out by testing the null hypothesis Hs:1 :0 againstthe alternative Ht:^y lO.ln this case,we might test :0 against Hs:1 H1:\) 0, sincewe expectthe effectto be positive. If we assumethat house location affects both the intercept and the slope, then both effects can be incorporated into a single model. The resulting regressionmodel is PRrCE: Br *6D+\2SQFT +t6QFTxD) *e (7.121

R2: 0.8706

In this casethe regressionfunctions for the house prices in the two locations are

R 2: 0 . 8 7 0 6 i n c SQFTxUTOWN I null hypotheses exceptfor the coe we r-tests, conclu rheir price per sq The estimate

E(PRICE): ' {f'

.iliil'

: + t)sQFr whenD 1
whenD :0

PRICE: (24

f Br + 92SQFT

+.

In Figure 7 .4b we depict the house price relations assuming that D > 0 and ^y> 0.

51

For housesin ot 7.2.3 AN ExauprE: TrrE UNrvrRsrry EFFEcT oN FIousE Pnrcss

FFidE:2

A real estateeconomist collects information on 1000 house price salesfrom two similar neighborhoods,one called "University Town" bordering alarge state university, and one that is a neighborhood about 3 miles from the university. A few of the observationsare shown in Table 7.2. The complete data file is utown.dat. House prices are given in $ 1000; size (SQFT) is the number of hundredsof squarefeet of living area. example, first housesold for $205,452andhas2346square ofliving area. For the feet : AlsorecordedarethehouseAGE(inyears),locanon(UTOWN lforhomesneartheuniversity, 0 otherwise),whetherthe househas a pool (POOL: 1 if a pool is present,0 otherwise)and whetherthe househasa fireplace(FPLACE : I if a flreplaceis present, otherwise). 0 The economistspecifiesthe regression equationas

Basedon these
a

the locatir

a

the price p in other a

a I a

that hous

that a po(

that a fire

7,3 Appr
PRICE: Br * \:UTOWN+ \ISQFT + TGQFTxUTOWN) + %AGE+\IPOOL-I\zFPLACE + e

(7.r3)

Dummy variabl ive consider sot 7.3.I

We anticipatethat all the coefficientsin this model will be positiveexcept83, which is an estimateof the effect of age,or depreciation,on houseprice. Note that POOL andFPLACE are intercept dummy variables.By introducing thesevariableswe are asking if, and by how much, thesefeatureschangehouseprice. Becausethesevariables stand a7one, and arc not interacted with SQFT, we are assuming that they do not affect the price per squarefoot. The estimatedregression results are shown in Table l.3.The goodness-of-fit statisticis

INrrn-t

We have seen modr regression effect of each q

7.3 APPLYING DUMMY

VARIABLES

175

Table 7 .3 FPLACE I I 0 0 I 1
!'ariable C LITOWN

flouse Price Equation Estimates
Coefficient Std. Error t-Statistic Prob.

sQFT SQFTxUTOWN
4GE POOL FPI-A,CE Rr : 0.8706

24.5000 27.4530 7.6122 r.2994 -0.1901 4.3772 1.6492 :230184.4 SSE

6.19t7 8.4226 0.2452 0.3320 0.0512 1.1967 0.9720

3.9569 3.2594 31.0478 3.9133 -3.7 t23 3.6577 1.6968

0.0001 0.00 2 r 0.0000 0.0001 0.0002 0.0003 0.0901

lt by testing 3 might tesr ,, then both del is

(7.r2)
are

R' :0.8706 indicating that the model fits the data well. The slope dummy variable is SQFTxUTOWN.Basedonone-tailr-testsofsignificance,atthee:0.05 levelwerejectzero null hypotheses eachof the parameters and acceptthe alternativesthat they are positive, for erceptfor the coefficientonAGE, which we acceptto be negative.In particular,basedon these r-tests, concludethat housesnearthe university have a significantly higher baseprice and we their price per squarefoot is significantly higher than the comparisonneighborhood. The estimated regressionfunction for the housesnear the university is

: FRrcE (24.s 27.4s3) (7.6122r.zss4)seFTo:slrAGE + + +
+ 4.3772POOL l.6492FPL4,CE + : 51.953 8.9I I 6SOFT- 0.190IAGE 4.37 2POOL t.6492FP E 7 tAC + + + For houses otherareas, estimated regression functionis in the F RidE : 24.5+ 7.6r22SQFT 0.90rAGE + 4.377 ooL + r.6492F LACE 2P P
.wo similar ty, and one vations are uarefeet of living area. :university. :rwise) and ;e).

>0.

Based theseregression on results, estimate we
a a

the location premium for lots near the university is $27,453 foot is $89.12for houses nearthe universityand$76.12for houses thepriceper square in other areas that housesdepreciate $190.10per year that a pool increasesthe value of a home by $4377.20 that a fireplace increasesthe value of a home by $1649.20

a a a

7,3 Applying Dummy Variables
(1.r3)
zhichis an I FPLACE nd by how nd are not uare foot. ltatistic is Dummy variablescan be usedto ask, and answer,a rich variety of questions.In this section ire considersome common applications. 7.3.1 INrERecrroNs BETvEEN Quaurarrvn FecroRs

We have seen how dummy variables can be used to represent qualitative factors in a regression model. Intercept dummy variablesfor qualitative factors ne additive. That is, the effect of each qualitative factor is added to the regressionintercept, and the effect of any

176

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dummy variable is independentof any other qualitative factor. Sometimes,however, we might question whether qualitative factors' effects are independent. For example,suppose are estimating awage equation,in which an individual's wages we areexplainedasa function oftheir experience,skill, and other factorsrelatedto productivity. It is customaryto include dummy variablesfor raceand genderin suchequations.If we have modeledproductivity attributeswell, and if wage determination is not discriminatory, then the coefficientsofthe race and genderdummy variablesshould not be significant. Including just race and gender dummies, however, will not capture interactions between these qualitative factors. Is there a differential in wages for black women? Separatedummy variablesfor being "black" and "female" will not capture this extra interaction effect. To allow for sucha possibility considerthe following specification,where for simplicity we use only education (EDUa as a productivity measure,

FEMALEist statisticallyr Suppose do we test tt rhejoint null ofthe indicat of the regres To test tht reststatistic

WAGE: Fr * \2EDUC + 64I_A,CK * \zFEMALE-f "y(BLACKxFEMALE) e *

('7.r4)

whereBI,ACK atd FEMALE aredummy variables,and thus so is their interaction.Theseare intercept dummy variablesbecause they are not interactedwith any continuousexplanatory variable. They have the effect ofcausing a parallel shift in the regression,as in Figure 7.3. When multiple dummy variables are present, and especially when there are interactions between dummies, it is important for proper interpretation to write out the regression function, E(WAGD, for each dummy variable combination.

uhere SSEa * hich the nu the original, numberof de lhe test statis Jenominato

E(^AGE, {ili

+ g|EDUC

+ 6r)+ !2EDUC WHITE-FEMALE + 62) + \\EDUC ^y)* * 6r * 6z -| !zEDUC BI^A,CK-FEMALE

WHITE-MALE BLA,CK-MALE

f. isthecritic To testthe "/ = .um of squa .um of squar leadingto th

In this specification white males are the referencegroup, becausethis is the group defined when all dummy variablestake the value zero, in this caseBIA,CK : 0 and FEMALE : 0. The parameter bl measuresthe effect of being black, relative to the reference group; the parameter62 measures effect of being female, and the parameter^ymeasures effect of the the being black and female. Using the CPS data (cps-small.dat) we obtain the resultsin Table 7.4. Holding the effect of education constant, we estimate that black males earn $1.83 per hour less than white males, white females earn $2.55 less than white males, and black females earn $3.80 less than white males. The coefficients of EDUC, BI-{CK, and FEMALE are all significantly different from zero usine individual /-tests. The interaction effect between BLACK and

* hich hasSS '-rnrestricted t

The lvo cnt tha .'onclude '.3.2

Que

Table 7.4
Variable

W a g e E q u a t i o nw i t h R a c e a n d G e n d e r
Coefficient

Std. Error 0.9675 0.0697 0.8957 0.3597 t.2170

t-Statistic

Prob. 0.0009 0.0000 0.04r2 0.0000 0.6291

C EDUC BIACK FEMALE BI,ACKxFEMALE R2:0.2482

-3.2303 I 1. 168 - 1.8312 -2.552r 0.5879 SSE:2930'7.71

-3.3388 16.0200 -2.0444 -'t.0953 0.4831

\tany qualit .-fthecountr -ourregion

b,strmann :rimate of 1.2 .naller standan i.rmplex effects :s\ults can be r(

7.3 APPLYING DUMMY

VARIABLES

177

lowever, we lual's wages rroductivity. s.If we have lnatory,then rt. Including tween these :ate dummy rn effect. To licity we use

FEMALEisnot estimated very preciselyusingthis sample 1000observations. it is not of and jtatistically significant.a we Suppose are askedto test the joint significanceof all the qualitative factors.Horr' do we test the hypothesisthat neitherrace nor genderaffectswages?We do it br testing ihejoint null hypothesis I1s:61 : 0, 6z : 0, ^y: 0 againstthe alternative that at leastone of theindicatedparameters not zero.If the null hypothesis true,raceand gendertall out is is of the regression,and thus they have no effect on wages. To test this hypothesis usethe F-test procedure we that is described Section6.1. The in teststatisticfor ajoint hypothesisis F:

(ssER ssau) lJ
ssEul(N- K)

(7.r4)
n. Theseare explanatory Figure7.3. interactions : regression

*here SSE6is the sum of squaredleast squares residualsfrom the "restricted" model in * hich the null hypothesis assumed be true,SSEyis the sum of squared is to residuals from the original, "unrestricted,"model, J is the numberof joint hypotheses. N - K is the and numberof degrees freedomin the unrestricted of model. If the null hypothesis true,then is the test statistic F has an F-distribution with "I numerator degreesof freedom and N - K denominator degrees freedom,F1t, N-x). We reject the null hypothesis F > F., where of if F. is thecritical value,illustrated Figure8.8 of AppendixB, for the levelof significance in a. To testthe,/ : 3 joint null hypotheses : 61 : g, 6z : 0, ^y: 0, we obtainthe unrestricted F1e .um of squarederrors SSEy : 29308 from the model reported in Table 7 .4. The restricted ium of squaresis obtainedby estimating the model that assumes null hypothesisis true, the leadingto the fitted model

U

s
rup defined VIALE:0. , group; the .heeffect of g the effect than white r $3.80less ignificantly TLACK and

fredE:-+.s122 + r.r3ssEDUC ('") (0.e668) (0.0716)
: rvhichhasSSEa 3 1093.The degrees freedomN - K : 1000- 5 : 995 comefrom the of unrestricted model. The value of the F-statisticis

'p

-

-

-2e308)13 (ssER ssEu)lJ (31093 - ,K) 2930819es ssEu l(N
-

, I l

, l l

The l% critical value (i.e., the 99th percentile value) is F@.ss,z,sss):3.80. Thus ue that race and/or gender affect the wage equation. "-onclude 7.3.2 QuernerrvE FACToRSwrrrr SEvrneL CATEGoRTES

Prob.
0.0009 0.0000 0.0412 0.0000 0.6291

\lany qualitative factors have more than two categories.An example is the variable re_eion of thecountryin ourwageequation. The CPSdatarecordworkerresidence within oneof the tbur regions: Northeast,Midwest, South, and West. Again, using just the simple u aee

* yieldsa coefficient 4733 observations, Estimatingthis model usingthe largerdatasetqrr.dat, which contains !'stimateof 1.2685with a t-value of 2.37. Recall from Sections2.4.4 and 5.3.1 that larger samplesizeslead to rmaller standard errors and thus more precise estimation. Labor economists tend to use large data sets so that complex effects and interactions can be estimated precisely. We use the smaller data set as a text example so that results can be replicated with student versions of software.

NONLINEAR

RELATIONSHIPS

specification for illustration, we can incorporate dummy variables into the wage equation as WAGE : 9r * 92EDUC * 6$OUTH -t \zMIDWEST -t itWEST * e (7.15)

Howwould' ioint test of the the context of t null hypothesis This yields an i
F 0 . g 5 , 3 , 9 g: 2 2)

Notice that we have not included the dummy variablesfor all regions.Doing so would have created a model in which exact collinearity exists. Since the regional categories are exhaustive, the sum of the region dummy variables is NORTHEAST + SOUTH+ MIDWEST + WEST : 1. Thus the "intercept variable" \ : I is an exact linear combination of the region dummies.Recall, from Section6.7, that the leastsquares estimatoris not defined in such cases.Failure to omit one dummy variable will lead to your computer software returning a messagesaying that least squaresestimation fails. This error is the '7.2.1a. dummy variable trap that we mentioned in Section The usual solution to this problem is to omit one dummy variable, which defines a reference group, as we shall see by examining the regressionfunction,

l07o level of s: significant regi, 7.3.3 Tpsrn

In the Section hedonic equatir

E(WAGE):

I[[l lfi'

+ E:)+ !2EDUC WEST + Ez)+gzEDUCMIDWEST + 61)* pzEDUCSOUTH
NORTHEAST

The regression

* 9zEDUC

The omitted dummy variable,NORTHEAS4 identifies the referencegroup for the equation. to which workers in other regions are compared. It is the group that remains when the regional dummy variablesWEST, MIDWEST, andSOUTH are setto zero. Mathematically it does not matter which dummy variable is omitted and the choice can be made that is most convenient for interpretation. The intercept parameter 91 representsthe base wage for a worker with no education who lives in the northeast. The parameter 61 measuresthe expectedwage differential between southernworkers relative to those in the northeast;62 measuresthe expected wage differential between midwestern workers and those in the northeast. Using the CPS data cps_small.daf,let us take the specificationin Table 7.4 and add the regional dummies SOUTH, MIDWEST, andWEST.The results are in Table 7.5. Based on thoseresultswe can saythat workers in the southearnsignificantly lessper hour thanworkers in the northeast,holding constantthe factors education,experience,race, and gender.We estimatethat workers in the south eam $1.24 less per hour than workers in the northeast. Ta b I e 7 . 5
Variable

: uhereo.1 P1 and slope dum neighborhoods sep estimating rhis idea, whicl Chow test is ar By includinl rariable in an Consider again

WAGE:9

Wage Equation with Regional Durnrny Variables
Coefficient

' We might ask rest of the cou regions can be How intercept. dummy for ev dummy variab WAGE:9t +

Std.Enor 1.0510 0.0700 0.9034 0.3600 r.2152 0.4794 0.5056 0.5154

r-Statistic -2.3365 15.7526 -1.7795 -6.9475 0.5320 -2.5953 -0.9880 -1.0597

Prob 0.0197 0.0000 0.0755 0.0000 0.5949 0.0096 0.3234 0.2895

C EDUC BIACK FEMALE BI,ACKxFEMALE SOUTH MIDWEST WEST R2:0.2535

-2.4557 1.1025 -t.6077 -2.5009 0.6465 -1.2443 -0.4996 -0.5462 SSE:29101.3

+

In (7.16)we h addedfive nev SOUTH and tl

5

Using the la

7.3 APPLYING DUMMY

VARIABLES

179

Lto the wage

e

(7.r5)

io would have :ategories are

,+

SOUTH+

How would we test the hypothesisthat there areno regional differences?This would be a joint test of the null hypothesisthat the coefflcients of the regional dummies are all zero. In the context of the CPS data, SSEu : 29101 for the wage equation in Table 7.5. Under the null hypothesis the model in Table 7.5 reducesto that in Table 1 .4 where SSEa: 29308. This yields an F-statisticvalue of 2.3452.The cr : 0.05 critical value (95th percentile)is :2.6138 and for ct : 0.10 (90th percentile)it is Fp.oo3,eszl: 2.0893.At the Fe.ss,z,ssz) l07o level of significance we reject the null hypothesis and conclude that that there are significant regional differences.We cannot make this statementat the 57o level.5 7.3.3 TesrrNc rnr EqunzarENCEoF Two REcnrssroNs

linear combiitimatoris not rur computer is error is the ich defines a

In the Section 7.2.2 we introduced both an intercept and slope dummy variable into the hedonic equation for house price. The result was given in equation (7.12)

pRrCE: Fr * 6D+ g2SeFT tGeFTxD) * e +
pricesin the two locations Theregression functionsfor the house are

: E(PRICE) D tB, +g,zseFT :o
the equation, ins when the rematicallyit : that is most e wage for a neasuresthe northeast;62 those in the .and add the .5. Basedon lhanworkers Lgender. We re northeast. wherec.1 : 9r * 6 and a2 : Fz * 1. Figure 7.4b showsthat by introducing both intercept and slope dummy variables we have essentially assumedthat the regressionsin the two neighborhoods are completely different. We could obtain the estimates for (7.12) by estimatingseparate regressions eachofthe neighborhoods. this sectionwe generalize for In this idea, which leads to the Chow test, named after econometrician Gregory Chow. The Chow test is an F-test for the equivalenceof two regressions. By including an interceptdummy variable and an interaction variable for each additional variable in an equation we allow all coefficients to differ based on a qualitative factor. Consideragain the wage equationrn (7.14) WAGE: 9r * !2EDUC *6$LACK -t\zFEMALE +1@LACKxFEMALE) + e

(er+ozsQFT D:l

Prob. 0.0197 0.0000 0.07s5 0.0000 0.s949 0.0096 0.3234 0.2895

We might ask "Are there differencesbetweenthe wage regressions the south and for the for rest of the country?" If there are no differences, then the data from the south and other regions can be pooled into one sample, with no allowance made for differing slope or intercept.How can we test this? We can carry out the test by creating an intercept and slope dummy for every variable in the model, and then jointly testing the significance of the dummy variable coefficients using an F-test. That is, we specify the model -T\zFEMALE *1(BI,ACKxFEMALE) WAGE: Fr * gzEDUC -f\fitACK -r \:SOUTH -r }2(EDUCxS)UTH) + U(BLA,CKXSOUTH) -l 0+(FEMALE x SOUTH) + 05(BLACK x FEMALE x SOUTH) * e

(7.16)

In (7.16) we have twice the number of parametersand variables than in (7 .14). We have addedfive new variables, the SOUTH intercept dummy variable and interactions between parameters. Estimating(7.16) is SOUTH and the other four variables,and corresponding

5

Using the larger CPS data file cps.dat, F : 8.7909, which is significant at the l%olevel.

180

NONLINEARRELATIONSHIPS

Ta h I e 7 . 6

Comparison of Fully Interacted to Separate Models
(l) (2) (3) Full sample Non-south South Coefficient Std. Error Coefficient Std. Error CoefficientStd.Enor

Variable

:egion relative in 3stimates tt The test ing \)r the sum o 19307.7from

-3.577 c 5 EDUC 1.1658 -0.4312 BLACK -2.7540 FEMALE BLACKxFEMALE 0.06'73 souTH 13023 -0.1917 EDUCxSOUTH -1.7444 BLACKxSOUTH FEMALExSOUTH 0.9119 BLACKxFEMALExSOUTH 0.5428

1 . 1 5 1 3 -3.5775 0.0824 1.1658 1.3482 -0.4312 0.4257 -2.7540 1.9063 0.0673 2.1147 0.1542 1.8267 0.7960 2.5112

1.2106 -2.2752 0.0866 0.9741 l.4t'16 -2.1756 0.M76 -1.8421 2.0044 0.6101

1.5550 0.114_1 t.08Gr 0.5896 1.4329

The denominat critic The 107o 'Jre same in tl .isnificance.6 I

ssE
N

29012.7 1000

22031.3 685

6981.4
Jl)

equivalentto estimating (7.14) twice-once for the southernworkers and again for workers in the rest of the country. To see this examine the reqressionfunctions

E(AAGE):{

fu * \zEDUC +6$L-A,CK-I\zFEMALE )- 1(BLACKxFEMALE)

:0 SOUTH

REMARK of the lineat : regressions all obse for of the data, . data.In suc Section8.4. be aware th,

(9r + 01)+ (Bz+ 0)EDUC+ (6r+ U)Br"\CK : S0UTH I (r + (Ez L4)FEMALE+ + 05)(BLACKxFEMALE) +

1.3.4 CoNr

Note that each variable has a separatecoefficient for southernand non-southernworkers. In column (1) of Table 7.6we report the estimates and standard errors for the fullr interacted model (7.16),using the full sample.The basemodel (7.i4) is estimared oncefor workers outside the south [column (2)] and again for southernworkers [column (3)]. Nore that the coefficient estimateson the non-southdatain (2) are identical to thoseusing the full sample in (l). The standarderrors differ becausethe estimatesof the error variance, o:. differ. The coefficient estimatesusing only southern workers are obtained from the full model by adding the dummy variable interaction coefficients 0; to the correspondingnonsouth coefficients. For example, the coefficient estimate for BLACK in column (3) is obtained as (6r + 0r): -O.4f t2- 1.7444: -2.1756. Similarly the coefficienr on FEMALE in (3) is (Sz+0+):-2.1540+0.9119:_1.8421. F u r r h e r m o r e .o t e r h a r n the sum of squared residuals for the full model in column (l) is the sum of the .lsE from the two separate regressions : SSE : SSEnor-,oulp SSE,orly 22031.3 + 6981.4 : 29012.7 yru * Using this dummy variable approach we can test for a southern regional difference. We estimate(7.16) and test the joint null hypothesis l l s : 0 1: 0 2 : 0 : - 0 +: 0 s : 0

The earlierext '.rsed regres in '

.3.4a Seas Summermea of charcoalbr var Jependent .i supermarke :ompetitive b charcoal ligl ;oupons).W} .easonaleffec months than i erampleAUC .\merica, SUi In regression. In theUnited I Jt. and Labot

against the alternative that at least one 0; I 0. This is the Chow test. If we reject this null hypothesiswe conclude that there is some difference in the wage equation in the southern

6 Using the I t The.loint te :nteraction varia :undamentally d

7.3 APPLYING DUMMY

VARIABLES

181

(3) South
ficient Std. Error

region relative to the rest of the country. The test can also be thought of as comparing the estimates the non-southand south in columns (2) and (3) in Table 7.6. in The testingredients the unrestricted are SSEu:29012.7 from the full model in Table7.6 tor the sum of the SSEs from the two separateregressions),and the restricted SSER: 29307.7 from Table 7.4. The test statistic for the ,/ : 5 hypothesesis F-

2752 1.5550 9741 0.1143 17s6 1.0804 8421 0.5896 5101 t.4329

(ssER ssEu) lJ ssEu/(N- 1()

(29307 - 29012.7) .7 /s : 2 . 0 1 3 2 29012.11990

Thedenominatordegreesoffreedomcomefromtheunrestrictedmodel,N-K:1000-10. Thel0TocriticalvalueisF.: l.85,andthuswerejectthehypothesisthatthewageequationis the same in the southem region and the remainder of the country at the 10Volevel of .ignificance.6 p-valueof-this test is p : g.g144.7 The

6981.4
JIJ

ain for workers

S O U T H: 0

REMARK: The usualF-test of a joint hypothesis relieson the assumptions MRI-MR6 of the linear regression model. Of particularrelevance testingthe equivalence two for of regressions assumption is MR3 that the variance the errorterm, var(e;): o2, is the same of possiblydifferentslopesand intercepts parts for Ifwe areconsidering for all observations. of the data,it might also be true that the error variancesare different in the two parts of the is data.In sucha casethe usualF-test is not valid. Testingfor equalvariances coveredin Section8.4.2, andthe questionof pooling in this caseis coveredin Section8.3.3.For now, in be awarethat we are assuminsconstanterror variances the calculations above.

S O U T H: 1

7.3.4

CoNrnortrNc

FoR TrME

thern workers. s for the fulll nated once for mn (3)1.Note 3 usingthe full : variance,o2. from the full lponding non:olumn (3) is :oefficient on )re, note that n of the SSE

The earlier exampleswe havegiven apply to cross-sectional data.Dummy variablesare also usedin regressionsusing time-series data, as the following examples illustrate. 7.3.4a SeasonalDurnmies Summermeansoutdoor cooking on barbequegrills. What effect might this have on the sales of charcoal briquettes,a popular fuel for grilling? To investigatelet us define a model with dependent variabley, - the number of 20 pound bagsofRoyal Oak charcoalsold in week r at a supermarket.Explanatory variables would include the price of Royal Oak, the price of competitive brands (Kingsford and the store brand), the prices of complementary goods rcharcoal lighter fluid, pork ribs and sausages), and advertising (newspaperads and coupons).While these standarddemand factors are all relevant, we may also find strong :eaSon&l effects. All other things being equal, more charcoal is sold in the warm summer monthsthan in other seasons. Thus we may want to include either monthly dummies(for dummies(in North example AUG : 1 if month is August,AUG : 0 otherwise)or seasonal into the America,SUMMER:1 if month: June,July,orAugust; SUMMER:0 otherwise) effects, holidaysarespecialoccasions cookouts. for regression. additionto theseseasonal In Day (July In theUnited States theseareMemorial Day (lastMonday in May), Independence l), and Labor Day (first Monday in September). Additional salescan be expectedin the
o Using the larger data file cps.dat F :3.975, which is significant at the 17olevel. t The ioint test is significant at the l\Vo level despite the fact none of the individual coefficients on the south interaction variables are significant at even the 207o level, reminding us that joint and individual lests are fundamentally different.

7 ifference. We

ject this null the southern

An examplecan be found in Exercise7. aEeIZ of $1 in normal 5 called th 1986 Ertimatesof (7 Iu A macroeconomic investment equation might be INV: : Fr + 61TC' lzGNPt* $3GNP. reinstatedin 1970.the overall price level is affected by demand factors in the local economy.The law was suspended 1966. and to homeownerstrying to sell their housesas well as potential buyers.and incomegrowth. Economic regimes may be associatedwith political regimes (conservatives poweq liberals in power). as they attempt to agree upon a selling price. D99 : I if year: 1999. aE(PIZZ pizza ch exPect hr consum the effe< expendit 2.182 NONLINEAR RELATIONSHIPS week before theseholidays.'qardless th of :n pizzaexPen :hatasa Person : persona$es' *hich the effe< . who must reassess market value of homes in order to compute the annual the property tax. hyperinflation). The real estatemodel discussedearlier in this chapter provides an example.ignificant coe Thesearethr . NJ: Prentice-Hall. 53. such as population creating"costchange.2ndedition. every year. who must reevaluate the value of their portfolio of loans with changing local conditions.In addition to housecharacteristics. It is also important to mortgage bankers and other home lenders.4c Regime Effects An economic regime is a setof structuraleconomicconditions that exist for a certain period. then 7..unemployment rate. 7. every month.tglootherw$e .4b Annual Durnrnies In the same spirit as seasonaldummies.recession.We will considera The signs of tht . annual dummy variables are used to capture year effects not otherwise measuredin a model. or changesin the legal environment(tax law changes. 7.UpperSaddle River.3. The simplest method for capturing theseprice effects is to include annual dummies (for example. interestrates. o .) An investment tax creditE was enacted in 1962 in an effort to stimulate additional investment.rish to study tht rurposewe take :'\penditure on .1996. Thus we might create a dummy variable rr| I IIL:<^ 1962.ariableis mod :nteractionvar l\COME aret mo( :egression PZZ Intriligator. o. but they mar behave differently during another.-1a e. * If thetax creditwassuccessful 6 > 0. Real estate data are available continuously. Supposewe have data on house prices for a certain community covering a l0-year period.bservationsare As an initial The implication t.D99: 0 otherwise) into the hedonicregression model.13).TechniquesandApplications.4 Interactions Between Continuous Variables When the product of two continuousvariablesis included in a regressionmodel the effect is to alter the relationshipbetweeneachof them and the dependentvariable.ife-cyclemodel '.. meaningthat dummy variablesfor eachshouldbe included into the regression.3. The idea is that economic relations may behaveone way during one regime. and eliminated in the in Tax Reform Act of 1986.EconometricModels. unusual economic conditions (oil in embargo. such as thoseemployedin (7.Economists of-living" or "house price" indexes for cities must include a component for housing that takes the pure price effect into account.BodkinandHsiao.Understandingthe price index is important for tax assessors.1965.4.

It would seemmore reasonable assume That is. to on a personages. as thatasa persongrowsolder. Thesearethe implicationsof the modelin('7.4 INTERACTIONS BETWEEN CONTINUOUS V A R I . every month.One way of accountingfor suchinteractionsis to include an interaction variable that is the product of the two variables involved. to regardless in ofthe ageofthe individual.58AGE+ 0. For that purpose take arandom sampleof 40 individuals. Since AGE and INCOME are the variables that interact we will add the variable AGExINCOME) to the resression model.is itreasonable expectthat.17).However. Lte additional Linatedin the AEIITZ.who appear to consumemassivequantities of pizza.less ofeach extra dollar is expectedto be spentonpizza. The result is . The full data set is contained in the file pizza. the expectedexpenditureon pizza changesby the amount B2 with an additional year of age.an increase incomeby $ I shouldleadto an increase by to in pizzaexpenditure B3dollars?Probablynot. the effect of one on variableis modified by another.A) IAAGE : }z:For a given level of income.their marginalpropensity spend pizzadeclines. we expect the sign of B2 to be negative.27) the effect is Il considera The signs of the estimatedparametersare as we anticipated. d i n ( 7 .Sa(AGExINCOME) e * (7. UpperSaddle PIZZA: Fr * gzAGE* \zINCOME1. an increasein income of $1 increases expectedexpenditures pizza by B3. The parameter B3 might be called the marginal propensity to spend on pizza.1. rity covering a . AEIIZZA) IAINCOME : B3:For individuals of a given age. That is. but they may with political cnditions (oil law changes).0024[NCOME 342. with r-statistics parentheses. This is a casein which the effect of income depends the age of the individual.88 (3. What would you expect here? Based on our casual observation of college students. of PIZZA: (r) -7. 1 3 )t h e r as population creating"costrr housing that lportant for tax rutethe annual lers.The first five observationsare shown in Table 1. 20 28 25 life-cyclemodel to illustratethis idea. we expect the sign of B3 to be positive. Since pizza is probably a on normal good.Suppose areeconomists Gutbusters we for Pizza and rvishto study the effect of income and age on an individual's expenditure onpizza. An 109 0 0 108 220 15000 30000 I 2000 20000 15000 . their income (INCOME). we expect that as a person ages their pizza expenditure will fall.7 PIZZA PizzaExpenditure Data INCOME AGE to capture year d earlier in this t. in are Estimates (7.7.17)..18) . { I ]L E S 183 be includedinto TabIe 7 . basedon their r-satistics.who must litions. andrecord their annual we erpenditure on przza (PIZZA).dat. and age (AGD.es) (-3.With the effects of income removed. age 18 and older. As an initial model let us consider gzAGE_l \zINCOME* e PIZZA: gr _F Theimplications this specification as follows: of are I (7.BothAGE andINCOMEhave significant coefficients. and to :temptto agree dummies(for rionmodel.r7) :ertain period.

\\\\NCOME . on the marginalpropensity spenc to on pizza.1a A R i :rst. If our logic concerningthe effect of aging is conect then Ba shouldbe negative Then.1 Dun --et consi( us I'hat is the . greaterthe incomethe greaterwill be the fall attributableto a chanst the in age. which is the marginalpropensityto spendon pizza. when the productof two continuou.000 incomewill reduce pizzaexpendiper turesby $17.2.com to remove the watermark 184 NONLINEAR RELATIONSHIPS Just as in the caseswhen we interacteda continuousvariablewith a dummy variable. Using theseestimates us estimatethe marginaleffect of age upon pizza expenditurc. Some additionaldetail is provided in Appendix 7A.ing the Pro .rd the anti- :ubtract I fr wA W .anc when we interacteda continuousvariablewith itself.000income and the other with $90.47) (.i. 2. rus we esti -:ick andsim ' : r s l a r g ea d -.because is expectec is to Ba to be negative.000income.0.8e) (2. as AGE increases.0j level usinga one-tailtest.2wasof a wageequationwith dependenr variable ln(wAGE). butAGE.000 f Thatis. but then in (7.}8AGE + 0.' effects of INCOME andAGE are as follows: | . Usin AE(PIZZA\ ' -dAwz : bz I b4 INCOME .8s) The estimatedcoefficient of the interaction term is negativeand significant at the cr : 0.98per year.dummy variablesand interactionterms. we expect an individual that with $25.'\.4.A-PDF Split DEMO : Purchase from www.40 for INCOME: $90.now depends o:: AGE.00016 INCOME fot INCOME: $25. .000 income will reduce pizzaexpenditures by $6.tccall from -rproximatel 0E%. the The estimatedmodel (7.98 . let for two individuals. cre lhat is 3ut what abo' lhe answerir -.all otherfactors heldconstant. IE(PIZZA) rcAGE : Fz * \aINCOME : The effect ofAGE now depends income on As a personagestheir pizza expenditure expected fall.00016(A GExINCOME) -. variables is included in a model the interpretation of the parametersrequires care. -.: -2.that is. iriable.40 year.47.The reasonfor the changewas to simplify expositionof models with polynomial terms.5. .5 Log-Linear Models In Section4.000 : {-0.0.while theindividual with $90.1b An. AEe ITZA) I aINCOME : 9: * I qAGE:The effectof a change incomeon expectec in pizzaexpendirure.A-PDF. by itself.e4 -17. take th( (r) (-0.In this sectionwe explore the interpretationof dummy variables and interaction terms in logJinear models.18) including the product (AGExINCOME) is FIn : 161. no longer appears be a significant explanatoryfactor.The signsof othercoefficients remainthe same. This suggests to thatA GE affectspizz' expenditure throughits interactionwith income. and. value of the partial derivativedeclines.one with $25. Th. .t.4 and Appendix 4C we examinedthe log-linear model in some detail. You might havenoticedthat the examplein Section4.5) we changedthe example to have wage level as the dependent variable.5.e can ove ::iferenceis Ir 7.

.0. lu' \ wAGEya15.5 LOG-LINEAR N.9290 + 0.r.5.05 rtAGE.1b An Exact Calculation W'e can overcome the approximation error by doing a little algebra.dar.Ln(WAGE)=%LWAGE: l00E%.4.?!^ ^* t) : a rn(W GE)vp7a u.WAGEuercs: WAGErnuatos _WAGEuercs _WAGEreueus p6 _ . take the difference between ln(WAGE) of females and males ln(WAGE) p61at1s5 ln(WAGE) rotut : A ln(lIzAGE) : 6 Recall from Appendix A.26Vodifferential betweenmale and female wages.12). o* But what about the fact that the dependentvariable isln(WAGE)? Does that have an effect? The answer is yes and there are two solutions. The wage difference is TNCOME) atthea:0.ln(y) : ln(xli.5. orr-s : n ( A A 6.5.small. The 7.2 thereis close to al}Vo approximationerror with this large a difference.1026EDUC .19) \\'hat is the interpretation of the parameter 6? FEMALE is an intercept dummy variable. but as shownin Table A. 7. and the anti-log is the exponential function. creating a parallel shift of the log-linear relationship when FEMALE : l. Using the data file cps .1 Durvriuy VenrelrEs Let us considerthe los-linear model :pends onincome.byitself.19) is the lt (WAGE) : 0.5.2526FEMALE ('") (0. . a expenditures tizza expendi- w-. so that I00L. y:i::. WAGEyaTBs WAGElatlBs WAGElaayBg These are natural logarithms. :. estimatedlogJinear model (7.? rur. You ith dependent e level as the 'models with e explore the Lodels. re detail.IOT)ELS 185 nmy variable.This is quick and simple. CE affectspizza pensityto spend zzaexpenditure income. useBais expected utableto a change comeon expected L now depends on Lould negative.tn(W GE).*.!. that 100 times the log difference is rpproximately the percentage difference. equation (A.0300) Thuswe estimatethat there is a25.7. be ln(WAGE): 9r f \2EDUC + \FEMALE (1.1a A Rough Calculation First. Some WAGEptuercs _ -6 -' WAGEyaL65 Subtract I from each side (in a tricky way) to obtain .0061) (0. and rf two continuous equires care.0837) (0. That is tn(wAG E: { ) lJ. 1 using the property of logarithms that ln(x) ..

we estimatethat an additional year of experience leadstoanincreaseinwagesof approximately 100(0.000s4) In Septem data for thr affecting t emergenc were229c moons (a t Memorial . How do we extendthis resultto higher order models? Consider the wage equation ln(wAGE) : 9r * \2EDUC -t \zEXPER -r ^y(EDUCxEXPER) (7. will adjus change the Using tl following ti HOLIDAY 0 otherwis there is a fr. ( c ) Test tl alterni .6 Exercises Answers to exercisesmarked * appear in Appendix D at the end of the book..100(93+ 294EXPER+ IEDUC)% HOLIDAY FRIDAY SATURDA FULLMO( NEWMOO 7.' Appendix A.Se.holding education constant?Roughll.185 NONLINEAR RELATIONSHIPS The percentage difference between wagesof femalesandmalesis 100(eE I)%.20 (a) Interpr (b) How t ries th otherv (c) How v same I t' What is the effect of another year of experience.: ('") 0.Does taking econometricseffect starting salary?Let SAI: salaryin Rz : 0.we showthat 100timesthe log difference approximatell is the percentage difference.20) to obtain fiWAG.0127) (0.1528+ o]34tEDUC + 0.Using this result. Using the data filc cps_small.000962x16)%:0. using a little calculus. econometl which coI regression The approximatestandarderror for this estimateis 2. the approximatepercentage changein wa-gc given a l-year increase in experience is 100(9: + IEDUC)%.1 Prom"Eus An Economics department at a large state university keeps track of its majors' startingsalaries.337o.267o. What if there is a quadratic term on the right-hand side.0071) (0.12).1': ( a ) Interp calls? (b) The r MOO. with standard error 0. G. 7.From this.r'722) (0.000962( ED|CxEXpER (0.13) and the surrounding discussion. we estimate the wage differential between males and females to be 100(e6 r)%: t0o(e-0252u D%: -22. we find that a l-year increasein experienceleads to an approximate percentagewage change of %LWAGE .216.0249 O. (A. equation(A.wegive an interpretation B2by saying to that given a l-unit changein x the approximatepercentage changein y is 100B2%. making this exact calculation more than one standard eno: different from the approximate value of -25. as in ln(wAGE): ^y(EDUCxEX?ER) 9r * 7\EDIJC -t gzEXpER-r la.32% dollars. ALn(WAGE\l LiT*^ lrrurn*o: B: * IEDUC In AppendixA. Emergen For a person with 16 years of education.o249EXpER 0.7 1.6.EXpER2+ Variable C I Then.5-2 INrEnecrroN AND Queonanrc Tpnus sl (s In the simple log-linearmodel lnlv) : Fr + B2x.dal we estimate (7.95189. 7.which is a calculation that may be provided by your software.

as shown below. otherwise.dat.and local police may change the number of officers on duty. 0 otherwise.0938 3.NEWMOON Emergency Room Gases Regression-Model 1 !) (7. GPA : grade point averageon a 4.2727 4. FUI. thenhospital administrators will adjust numbers of emergency room doctors and nurses.0000 0.0338 13. HOUDAY:1if thedayis aholiday. ixPER) leadsto an C T HOLIDAY FRIDAY SATURDAY FULLMOON NEWMOON R 2: 0 .1509 3. They collected data from a local hospital on emergencyroom casesfor the period from January 1.5048 0. pproximately ange in wage the data file CxEXPER) rf experience :0.7. andEaster). and METRICS :0 which contains information on 50 recent graduates. FNDAY:1if thedayis aFriday. (b) How would you modify the equation to see if women had lower starting salaries than men? (Hint: Define a dummy variable FEMALE: 1.6166 l.0 scale.0025 0.1tr3 2. 1 7 3 6 93.0326 0.6 EXERCISES 187 )%.44s2 2.SATURDAY:1 if the day is a Saturday. Using the data file metrics.If there is a full-moon effect.0000 0.998'l 0.LAIOON : I if 0 otherwise. Comment on any changesyou observe. we obtain the estimated regression onthatmaybe standard error sn : ('") 24200 r643GPA+\033METRrCS :0.229) andtherestaredummy variables.0012 0.0111 6. a local TV station contactedan econometricianto analyze some data for them.1338 its majors' L: salaryin (a) Interpret these regressionresults. 0 otherwise. econometrics. Using the data in the file fullmaon. They were going to do a Halloween story on the legend of full moons affecting behavior in strange ways.0otherwise. . Error t-Statistic hob. Fromthis.')* (a) Interpret the estimated equation.dat we obtain the regression results in the following table: Zis a time trend (f : | .1184 3. 0 otherwise. (c) Test the joint significanceof FULLMOON and NEWMOON.) (c) How would you modify the equationto seeif the value of econometricswas the same for men and women? In September1998. dollars.9809 4. When should emergencyrooms expect more calls? (b) The model was reestimated omitting the variables FULLMOON and NEWMOON.9098 10.5382 0. There were 229 observations.82 SSE r. Variable Coefficient Std.6958 0. . there is a full moon. State the null and and alternative hypotheses indicatethe teststatisticyou use. .4545 6. See esult higher to .5894 2.9518%.8629 6. Memorial Day.4059 :27108.0580 2.What do you conclude? .2569 60.74 + R2 (1078) (3s2) (4s6) r B2by saying 10092%. 1998 until mid-August.5592 0.During this time there were eight full moons and sevennew moons (a related myth concernsnew moons) and three holidays (New Year's Day.3.20) rt?Roughly. .2. 0 : 1 if there is a new moon.METRICS : I if student took otherwise. if female.

807 -1.3421 : SSE 27424.93 1'7 A< C ALCOHOL PRICE INCOME GENDER MANTAL STATUS AGE t2-20 AGE 21-30 BLACK HISPANIC 4.0215 0. (c) compute the price elasticity at the means of alcohol price and income.r9i) BLACK-a binary variable : I if individual is black (0.13 17.116) HISPANIC-a binary variable : 1 if individual is Hispanic (0.001: 0.< 0.marijuana cocaine.9g9.7g) lLCoHoL INCOME-rotal personal income in l9g3 dollars (12.188 NONLINEAR RELATIONSHIPS Emergency Room Cases Regression-Model 2 Variable C t -l Coefficient Std. HOLIDAY FRIDAY SATURDAY R2 : 0. 7. and heroin using a sample of size N : 44..479) MARITAL STATUS-a binary variable : 1 if married (0.0frr:.6168 6.00'.3 Henry Saffer and Frank chaloupka ("The Demand for Illicit Drugs.0568 2.19 1. sq Stockton construct we estim the size r variables PRICE. and their significance.5458 0.569) AGE l2-20-a binary variable : l if individual is 12-20 years of age (0. (b) Discu (c) What The variable definitions (sample means in parentheses) as follows: are The dependentvariable is the number of days alcohol was used in the past 3l dar.580 -0.1r53 60.4511 2.07g) (a) Interpret the coefficient of alcohol price.1r37 2.1 08 1 3.531 0. If we measuredincome in $1000 units. (b) Compute the price elasticity at the means of the variables.425) GENDER-a binary variable : I if mate (0.97 0.1640 94.155) AGE 2r-30-a binary variable : I if individual is 21-30 yearsof aie (0.51 8. quadratic YIE (a) Find a of yie (b) Find a of yie . Error t-Statistic Prob 0. 1999.637 -0..23 12.2404 4.035! 0.s (3.849r 10.099 -0.The estimatedequati. Economit Inquiry. for a married black male.0000.4e) PRICE-pice of a liter of pure alcohol in r9g3 dollars (24. whar would the estimated coefficient be? (e) Interpret the coefficients of the dummy variables.84 6.03 C SQFT AGE D92 D93 D94 D95 D96 (a) Discu ation.0338 13.03s -0.045 0.564 29.37(3). An agricr relationsh acre) and NITRO: PHOS: A total N. (d) Interpret the coefficient of income.8891 In the file prices.000057 r.0111 6.98 5. age 2l-30.8219 3.40r4rr) estimatedemandequationsfor alcohol.on fu alcohol use after omitting a few control variables is Demand for lllicit Drugs Variable Coefficient The resul Stockto Variable lr-statisticl 17.

signs.0001 t7.and statisticalsignificance.001l 0.4623 -4392. (a) Find and commenton the estimated functionsdescribingthe marginalresponse yield to nitrogen. One of thekey problemsregarding housingpricesin a regionconcerns construction "house price indexes. NITRO :2.1 0 0 5 .4b.The estimated A total N :27 observations quadratic model.385 + 8. when PIIOS : 1.0000 0.7-7'73 .0000 0.7.7878 -r79.4770 1232.5100 1839. rss) (0."as discussed Section1.what tnce.0112 r270.01lNlrRo 4.3.220) (0.71 72." Economic l.6 EXERCISES 189 I Prob 0. is rast days 31 +. omitting the dummy variable for the year 1991. and NITRO : 3.800PHOS + (0. of (b) Find and comment on the estimatedfunctions describing the marginal response when NITRO : I.0000 0.l 3 1 7 3 .8739 -15.8080 1194. and annual dummr' variables.000(.0400 1. of yield to phosphorus.9300 123 1.8300 -23663. ?RICE : 9r * \|SQFT * \tAGE -t 6rD92 -r 62D93 * 6:D94 * 6+D95 -l6sD96 * e The results are as follows: .e41) (0.10.9280 r1.T78PHO9 O.19040.4'. PHOS : 2. for a units.78) (0. marijuana.000t-t 0. (c) What would have happened we had included a dummy variablefor 1991? if An agricultural economist carries out an experiment to study the production relationshipbetweenthe dependentvariable YIELD: peanut yield (poundsper acre) and the productioninputs NITRO : amount of nitrogen applied (hundredsof pounds per acre) PHOS : amount of phosphorus fertilizer (hundredsof poundsper acre) were obtainedusing differenttest fields.220) .and other characteristics 4682 housesthat were sold in of Stockton.2000 72.264) (0.4564 -8.445r .8033 0.197) fEB .0000 0.66'.0006 0. including as explanatoryvariables the size of the house (SQFT). (b) Discussthe estimatedcoefficientson the dummy variables.8000 1211.e41) (r.10.To illustrate. .dat havedatafrom January1991to December1996on house we prices.S'IU|TROPHOS x (0.7 t7 .r. with an interaction term. of in we estimatea regression model for houseprice.5496 -3. CA.0000 0. squarefootage. the age of the house (AGE).8460 -10435.0. Error t-Statistic Prob C SQFT AGE D92 D93 D94 D95 D96 21456. In the file stockton. equation for Stockton House Price Index Model Variable Coefficient Std.002: 0. including their interpretation.0000 0.0359 0. r5s) ome.I44NITRO2 :1.0000 (a) Discussthe estimatedcoefficients on SQFZ and AGE.4700 . and PHOS : 3.19.

1b.G. (e) Compute the percentagechange in price of a 2500 squarefoot home near the university relative to the samehousein anotherlocation using the methodolo-er in Section7.* be) : 0. 1 canned tuna APR2. 2 and 3 of cannedtuna DISP : a dummy variable that takes the value I if there is a store display for brand no.la and the exactcalculationin Section7.7 Data on the weekly salesof a major brand of cannedtuna by a supennarketchain in a largemidwestern U.13) using Ln(PRICE. 9:.5.5.5. Refer to Section 4.a dummy variable that takes the value I if there is a store display and a newspaperad during the week.1a and the exact calculation in Section7. estimatethe model (7.1b. of In Sectio age of th (a) Use t expe rem{t to cft (b) Estin paral (c) Estin paral incor (d) In (7 test t (e) Cons to sP estin (0 Modi incor soby . (iD .S. by least squares. (b) Discuss the estimatedcoefficients on SQFT andAGE.price per can ofbrands nos.what levelsof nitrogen and phosphorus give maximum yield? Are these levels the optimai fertilizer applications for the peanut producer? (c) Are t withr 7. There are 52 observationson the variables SAL| : unit sales ofbrand no.1b. (a) Estin mate (b) Estin mate 7. The dependentvariable u a-.5.dat. (i) .6 In (7. 0 otherwise DISPAD .in dollars.233 var(bz -l 4ba.4 for help with interpreting the coefficients in this log-linear functional form.6. APR3 . Real estateeconomistshave found that for manl data sets a more appropriate model has the dependentvariable In(PRICE). F. (iii) j (iv) . the price of the house. (d) Compute the percentagechangein price due to the presenceof a fireplace. Use both the rough approximation in Section 7. as the dependentvariable. I canned tuna APRI : price per can ofbrand no. when (1) PHOS: I and NITRO : I (11)PHOS: 1 and NITRO :2 (iii) PHOS: I and NITRO :3 Note: The following information may be useful: var(bz* Zbq-f ba) : 0.ar this they < PRICE: AGE: a OLD: a NET:a sites). (c) Computethe percentage changein price due to the presence a pool.2 CoMpursn Exsncrsns 1. (a) Using the data in the file utown.the log-linear model ln(SAL1) : Fr * P1APRI + %APR2 + P4APR3 gsDISPa $6DISPAD-t e * (b) Discussand interpretthe estimates 92.13) we specifieda hedonic model for houseprice. (e) Disct exect 7. Use both the of rough approximationin Section7.city during a mid-1990'scalendaryear contained the file are in tuna.190 NONLINEAR RELATIONSHIPS (c) Test the hypothesisthat the marginal responseof yield to nitrogen is zero.)Forthe function estimated. and Ba.| (d) Test.5.5. Mixr in the Mu investigat to be pric ferencesi lessthan 1 TV-progr or tape.040 var(bz-t 6b+* ba) :0. 0 otherwise (a) Estimate. 1 during the week but no newspaperad.233 (d)O(This partrequiresthe useof calculus.dat.

5.17). (b) Estimate the model PRICE: mated model.(It might be simplest use in to create a new variable INC = INCOMEllO00. Do income onpizza expenditure on soby addingtheterm(AGE2xlNC) to themodel.17.18) test the hypothesis That is. Interpret the esti- mated model. 5 . hasmuch morelimited competition. Ho:92 :0. Inrerpret the esriFr * 7zOLD +6NEZ*e. and live. 5 . Ressler(2000)in "A Note on Elasticity and PriceDispersions in the Music RecordingIndustry" (Reviewof Industrial Organization. l b .andnow want on CD. and 50.The number of substitutesfor old CDs is lessthanfor new.up to a point.ol.W. what levelsol els the optimai 7.What signdo you anticipate .Before estimatingthis model.Useboth the Section 7.For example. Comment on the signs and significance of the parameterestimatesand on the effect of scaling the income variable.4 the effect of income onpizzaexpenditure was permitted to vary by the age of the individual.when (c) Are the signs and relative magnitudes the estimates B5 and B6 consistent of of with economiclogic? Interprettheseestimates usingthe approaches Sections in 7 . (f) Modify (7. Use calculation in home near the e methodolog\ arket chain in a ainedin the file Fr * gzAGE + ENEr * e.Mixon and R.dat to estimatethe regressionmodel in which pizza expenditure depends only on income.G. -. 0. That old favorite you had on vinyl record on or tape.9* I iplay for brand 'display and a SPAD -l e In Section7 . radio. 1 a n d7 . Their explanationof this pricing schemeis differencesin the price elasticity of demand. Commenton these estimates.18) to permit a "life-cycle" effect in which the marginal effect of increases with age.465470) investigatethe pricing of compact disks.8 F.new musiccanbe heardon VHl.05 level of significance.7.18). at the cr : 0. . 0. empiricallytest To this they obtaindataon 118CDs. Comment on the signs and significanceof the parameter estimates.4 for nal form.dat The variables are PRICE: retail price of the CD (US $) AGE : age of the recording (l999-copyright date) OLD : a dummy variable : I if the recording is not a new release NET : a dummy variable : 1 for Internet prices (Tower Records and Amazon web sites). d. What do you conclude? test thejoint null hypothesis (e) Construct point estimatesand 957ointewal estimatesof the marginal propensity to spendon pizza for individualsof age 20. MTY in movie and TV-program soundtracks.1b. ft:g5lo H1:g6lo I11:B5orFol-0 11r > B: :9e (e) Discuss the relevanceof the hypothesistests in (d) for the supermarketchain's executives. t fireplace.40. and thenfalls.0 . 9:. (a. each of the following hypotheses: (i) 110: : Fs (ii) illo:p0: (iii) I1o:9s: < (iv) F1s:90 0. Fo . (a) Use the data in the file pizza.) Estimate the model PRICE: :nt variable wa: d that for manr )RICD. (c) Estimate the model in (7. that age doesnot affectpizza expenditure.They note that it is common for new releases to be priced lower than older CDs. The dataarein the file music. andfor the remainderofthis exercise.6 EXERCISES 191 en is zero. incomemeasured $1000s.Is there a significant interaction effect between age and income?What is the effect of scaling income? (d) In (7. sing ln(PRlCEr Section4. 30. a (d) Test.) (b) Estimate the model in ('7. 9+ : 0.

17). variable. dummy variable? Is gender a relevant explanatory variable? (b) Begin with the model in (7. (a) Begin with the model in (7. (c) Calculate a 95%o intewal estimate for the marginal effect in (b). The dummy variable FEMALE : 1 for females.10 and7 .Add theterrr. (d) CalculatethemarginaleffectdE(PIZZA)ldAGEtoranindividualofaverageage and income and test the statisticalsignificance the estimate. the first column contains his final score (Actual score . (g) Checkthemodelusedin part (0 for collinearity(SeeSection6. (c) When he 13 Use the data tn(.lL golf professional. estimatethe following model and obtain the withinsamplepredictions.4. COLLE GE.par) for 150 tournaments.COLLEGE.What are the characteristicsof the cubic equationthat might make it appropriate? (b) Use the within-samplepredictionsto answerthe following questions: (i) At what age was Lion at the peak of his career? (ii) When was Lion's game improving at an increasingrate? PARW : I there is PERSON: DURATIO incumb partyha and so .4. Testthe hypothesisthat separate regressionequationsfor male.0 otherwise. and GRAD asexplanatoryvariablesand estimatethe resulting model. scoRE: gr * 7\AGE * gzAGE2* 9+AGE3+ e (iii) Whr (iv) Atv year (v) Wh. of 7.The secondcolumn contains his age (in units of 10 years). (AGE3xlNC) to the model in (f) and check the resulting model for collinearitl 7 . There are scoresfor six major tournamentsin eachyear for the last 25 years. COLLEGE : 1 for individuals whosehighestdegree is a college diploma. females are identical. In the file golf.dat. (f) (This part requires the completion of Exercise 7.11 Use the data in pizza. against the alternative that they are not. What is the effect of including these dummy variables? Is level of educationar attainment a significant explanatory variable? (c) Consider(7 .darincludes additional information aboutthe 40 individuals usedin the pizza expenditureexample in Section 7 .WAGE): 9r - +l (a) Discusst its sign z (b)o(large d do you c I 1o (large data s (a) Reestim Estimate basedor (b) Estimatt Test the significa (c) Estimate to those (d) Estimatt betwee (e) Estimatt wagesb - 15* ProfessorR models that at http:llfait paper entitlt model is tt Republican election)is relating to tl whether the electionyea VOTE: pe The exP (a) Test the null hypothesis that a quadratic function is adequateagainst the cubic function as an alternative. of (e) Calculate a 95Vointerval estimate for the marginal effect in (d). FIS : I for individuals whose highe:t degreeis a high schooldiploma. Include the dummy variables HS.12r' Lion Foresthasbeena very successful is not quite what it usedto be.3). He startedthe pro-tour when he was only 20 and he ha: beenlooking back examining how his scoreshavechangedas he got older. the individual did not complete high school. and GRAD are all 0. However.17).datto do the following: (a) Estimatethe model (7.at age45 his game 7. GRAD : 1 if individuals have a graduate degree.11). Use the 5c? and level of significance and discussthe consequences your findings.192 NONLINEAR RELATiONSHIPS this term? Estimate the model and test the significanceof the coefficient for thi. If llS.10. What is the effect of including thi.7. andGRAD aredummy variable' indicating level of educational attainment.) Write a repon (250 + words) to the president of Gutbusterssummarizing your findings from Exercises 7. (b) Calculate the marginal effect dE(PIZZA)IAINCOME for an individual of averageage and income and test the statistical significance of the estimate.18) and compareyour resultsto thosein Section7.Include gender(FEMALD as an explanatorl variable and estimate the resulting model. COLLEGE.The variables HS.10 The file pizza.Denoting his score by SCORE andhis age by AGE.

econ. and variables relating to the politics.See his website at http. 31 observationsfor the variableis electionyearsfrom 1880to 2000. (b) Estimatethe model given in (7. and comment on its sign and significance. l5'r ProfessorRay C. will he be able to break 100?Assume par is72.What of educational ttionsfor males ot.1 if there is a Republican incumbent. Test the hypothesis that the interaction between BLACK and FEMALE is significant.In the file .19).dat to reestimatethe equation. Discussthe results and comparethem to thosereportedin Table 7.WAGE) : 9r * PyEDUC -t !1EXPER -t F+FEMALE * \sBLACK -t \aMARRIED -T\UNION -r \ySOUTH t \gFULLTIME a $rcMETRO * e (a) Discussthe resultsof the estimation. If F1S. Add theterm for collinearity. Testthe hypothesisthat there is no regional effect.16) and test the hypothesisthat there is no difference between the wage equations for southern and non-southernworkers. The explanatory variables include PARTY : 1 if there is a Democratic incumbent at the time of the election and . igh school. What changesdo you observe? Estimatethe marginal effect of experienceon wage and comparethe result to that basedon Table 7.S.edu/vote2008/index2.htm.1. Fair's voting model was introducedin Exercise2. LSection7.6 EXERCISES 193 efficient for this 3).' lfairmodel.1. presidentialelections.par) for 150 ars).The dependent VOTE : percentageshare of the popular vote won by the incumbent party.50for four consecutive terrns. (a) Reestimatethe model reportedin Table 7. an explanatorJ f including this s HS. individual of :he estimate.25if the incumbent party hasbeenin powerfor threeconsecutive terms. such as how long the incumbent party has been in power. luals usedin the TMALE: I for ummy variables r whose highesr r highestdegree degree. r. Estimate the percentagedifference in wages between males and females. I and see in particular his paper entitled "A Vote Equation for the 2004 Election. What changes do you observe? . He builds models that explain and predict the U. l3 Use the data in the file cps2. (e) Estimate the log-linear model in (7. There are Loting score his ain the within- dnst the cubic o equationthat tions: ." The basic premise of the model is that the incumbent party's share of the two-party (Democratic and Republican) popular vote (incumbent means the party in power at the time of the election) is affected by a number of factors relating to the economy.dat for the following. and whether the Presidentis running for reelection.1. and so on.it" u . DURATION : 0 if the incumbent party has been in power for one term.5. COLLErg model. Are things as you would expect? (b)i(large data set) Use the data cps.Interpret each coefficient. Comparethe resultsto those inTable L4.yale. ofaverageage (iii) When was Lion's game improving at a decreasing rate? (iv) At what age did Lion start to play worse than he had played when he was 20 years old? (v) When could he no longer score less than par (on average)? (c) When he is aged70. PERSON: 1 if the incumbentis running for election and 0 otherwise.l4).4. (d) Estimate the model in (7.nt. I if the incumbentparty hasbeenin powerfor two consecutive terms. Jr (large data set) Use the data file cps. Use the 57r ings. (c) Estimate the model reported in Table 7. Fair's data. 14. are inthe filefaixdat.5.dat to estimate the following wage equation: ."pon 'findings from ge 45 his game y 20 and he has rlder.7.1.

For the other variables specify GOODNEWS : 1. Add this variable to the model and reestimate.1944.Carry out a Chow test ofthe equivalenceofthe regressionmodels for traditional versusnontraditional styles. and WATERFRONT (:1 if on waterfront). 0 if vacant or rented). (c) Createa variable that is the product of WATERFRONTandTRADITIONAZ.NONLINEAR RELATIONSHIPS APPENDIX 7 WAR : 1 for the elections of 1920. SQFZ(total squarefeet). GOODNEWS : number of quartersin the first 15 quartersof the administration in at which the growthrate of real percapita GDPis greaterthan3.t*6D I: ne let E(y) a --omputetheir 1 %^n67 . GROWTH :2. INFIATION : absolutevalue of the growth rate of the GDP deflator in the first 15 quarters of the administration (annual rate) except for 1920. 1944. BEDROOMS (number). FIREPLACE (:I if present). where the values are zero. where the values are (a) Consider the regressionmodel VOTE : h * 9zGROWTH + 93INFL^\TION -f FTGOODNEWS *Q1WAR* * psPERSON* FaDURATION*\PARW (e) Usin hous atthe the u - e Discuss the anticipated effects of the dummy variables PERSON and WAR.Discuss the effects of this specification. and 1948.dat containsdata on 1080housesalesin Baton Rouge. and PERSON : 1. What do you conclude? 17* Recentd stockton2 BEDS(nr dummy l (a) Exan varia (b) Estin SQF the s (c) How (d) Omil that i (not (e) Carq Appendix Interpreta \bu may haven.AGE (years).0. rodel we omitt To do so we mal r e noted that fc . GROWTH : growth rate of real per capita GDP in the first three quarters of the election year (annual rate). Discuss the estimation results. (b) The binary variable PARII is somewhatdifferent from the dummy variableswe have considered. Write outtheregressionfunction E(VOZE) forthe two valuesof PARTY. What is the effect of adding this variable?Interpret the coefficient ofthis interaction variable. Divide the variable SQFT by 100 prior to estimation.1944. WAR :0. Discuss the signs and statistical significanceof the estimatedcoefficients.BAZFIS(number). except for 1920.l. and discussits sign and statistical significance. DU RATION : 0.Louisiana.7. (c) Use the data for the period 1916-2000to estimate the proposedmodel. 0 if other style).2Vo an annualrate zero. and 1948 and 0 otherwise. Comment on how well the model fits the data. and 1948. POOL (:1 if present). 7. and INFLATION : I.Are the signs as expected?Are the estimatesstatistically significant? How well does the model fit the data? (d) Predict the outcome of the 2004 election using PARZI : .:len the expect E Srarting from t :rleraction teflI LetDbea 3:+92.Are the signswhat you expect?Give an exact interpretation of the coefficient of WATERFRONT.OWNER(:1 if occupiedby owner. What do you observe? (b) Estimate a regressionmodel explaining ln(PR1CE/1000) as a function of the remaining variables. The variables arePRICE ($). predict the outcomeof the 2008 election. TRADITIONAL (:1 if traditional style.16 The data file br2. during July and August 2005. (f) Using datavaluesof your choice (you must explain them). In particular construct a histogram of PRICE. (a) Compute the data summary statistics and comment. (e) Construct a 95Voprediction interval for the outcome of the 2004 election. (d) It is arguable that the traditional style homes may have a different regression function from the diversesetofnontraditional styles.

\(i rt 1ss E ( v o ) %a'E : .STOR/ES(number).and a BEDS (numberbedrooms).] -| exp(pr 9zr) . BAIFIS (number). There . (e) Cany out a Chow test of the equivalenceof the regressionmodels in (d).that is 20 yearsold.N(0. 1OODNEWS:1. Comment on the difference. Discuss matesstatisticallr DURATION:0. and we did not discussthe regressionftnction E(WAGE).AGE (years).with a fireplace. (b) Estimate a regressionof ln(PRICEl1000) on the remaining variables.Commenton the signs and significance of all variables except VACANT. Divide SQFT by 100 prior to estimation. Adding this to our logJinear model we have ln(y) : E(y) : exp(Pr * Fzx * 3: *Fzr*6D+eand ety) : exP(9r * B2x-F 6o)xexp(o2 /2) Ii rvelet E(y1) and E(y6)denotethe cases when D : I andD: :ompute their percentagedifference as ' w . .estimate the regressionmodel separatelyfor those houses that are vacant at the time of sale and those that are occupied at the time of sale (not vacant). IEWS :WAR+ e SON and.9zx exp(9r B2"r)exp(6) * . bedrooms 2 baths..Califomia. feet).dat The variables arePRICE ($). if the error term e .but no pool andnot on 3 and the waterfront. which is orvneroccupied housewith 2500 square at thetime of sale. mmy variableswe )rthe two valuesof :d model.Discussthe estimationresults. l7* Recentdataon 880 housesalesfrom Stockton. Add ct of adding this rd discuss sign its Terentregression a Chow test of the traditionalstyles. Appendix 7A Details of Log-Linear Model lnterpretation \bu may havenoticed that in Section7.WAR. respectively.5 while discussingthe interpretationof the log-linear rodel we omitted the error term. Louisiana. Let D be a dummy variable.APPENDIX 7A DETAILS OF LOG_LINEAR MODEL INTERPRETATION 195 'wise. (c) How does vacancy at the time of sale affect house price? (d) Omitting UACANT. arecontainedin the datafile stockton2.o2) :ren the expectedvalue ofy is : exp(9r + Fzx) xexplo2f2) "'12) Srarting from this equation we can explore the interpretation of dummy variables and rrteractionterms." * LfE(-l:10' l 7' " I then we can 0. ict the outcomeof louge. e noted that for the log-linear model ln(y) : 9r * $2x I e. and 1948. To do so we make useof the propertiesof the log-normal distribution in Appendix 4C.exp(9r1. predict the value of a traditionalst1le feet of area. exp(9r + + : l00l + Fz-r E)xexp(o2/2) exp(Pr 9zx)xexp(o2/2)l " e * p ( g '+ W)xe*p(o14 )" - :t*[ . 1004election. Compare the estimation results. e quarters of the lator in the first 15 t. . dummy (a) Examine the histogram of the variable PRICE. variable VACANTthat equalsone if the housewas vacantat the time of sale.cular constructa a function of the or to estimation. What do you observe?Createthe variable Ln(PRICE) and examine its histogram. SOFZ (total squarefeet of living area). : administration in Voatanannualrale (e) Using the equationestimatedin part (d). 1944.1l% %: 100lexp(6) .totalsquare :1 if occupiedb) ITIONAL (:l if dWATERFRONT .ns and statistical u expect? Give an IDITIONAL.

1 The Na . Explain hor 1 .The percentage difference the expected in valueof y is 100[exp(6) 1]%.r* 9zz+ 1@z) e. Instead a dummyvariable. l . holdingx constant.5 hold in general. Specify a t Breusch-Pe 8 . Explain the exhibit hete f Describe at squaresesti -1. of with respect z. The interpretationswe developedin Section 7. Compute ht +. with z ln(y) : 9r * 9z. Test for ht subsample is hypothes Keywords te 3reusch-Pagan :eneralizedleast s Goldfeld-Quandt I pa :eteroskedastic :eteroskedasticit 8. Describe h< 6 .nd household inc . Then * E(y) : exp(Pr* Fzx* 9zz+ 1@z))xexp(ozlz) The derivative this expression.196 NONLINEAR RELATIONSHIPS The interpretation dummyvariables log-linearmodelscarriesoverto the regression of in function. usintroduce of let another variable andits interaction . Compute gt the variance function of partitioned -). the only refinement is that here we have calculated the percentagechange in the expectedvalue of y. then the left-hand-sidenumeratoris the percentage changein the expectedvalue of y resulting from a 1-unit changein z.r Chapter2 the re .r. to is 0E(v) exp(Fr* lzx r F:z + 1(xz))xexp(o2lz)x(B:+ 1x)) 3:: Dividing both sidesby E0) andmultiplyingby 100gives Chaptt Heterr Learning Ol Basedon the mate : roo(F: ts6foE(YX!!l^j +y)% Lozj Interpreting "0" as "A".

1 The Nature of Heteroskedasticity on In Chapter2 the relationship betweenaverage meanhousehold or expenditure tbod Elr r rnd householdincome x was described the linear function by E(v):Fr*Pzx (8. Specify a variance function and use it to test for heteroskedasticity with (a) a Breusch-Pagan test. Test for heteroskedasticity using a Goldfeldt-Quandt test applied to (a) two with potentiallydifferentvariances and (b) a model wherethe vanance subsamples is hypothesized dependon an explanatoryvariable. Describe how to transform a model to eliminate heteroskedasticity. ) .is . Computegeneralizedleastsquares estimates heteroskedastic for modelswhere (a) the variance known exceptfor the proportionalityconstant (b) the varianceis a is o'. rtage changein the rs we developed in Lvecalculated the -) -3.)r to theregression )xp(6) 1l%.1 ) 197 . function of explanatory variables and unknown parameters. Computeheteroskedasticity-consistent standarderrors for least squares. Explain how and why plots of leastsquares residuals can revealheteroskedasticity.eneralizedleast squares Goldfeld-Quandttest partition reteroskedastic reteroskedasticity heteroskedasticity-consistent standarderrors homoskedasticity multipliertest Lagrange mean function residual plot transformed model variance function weightedleast squares White test 8.^yx)) Learning Objectives Basedon the material in this chapteryou should be able to Explain the meaningof heteroskedasticity give examplesof data setslikely' to and exhibit heteroskedasticity. iinteraction "r. with Chapter Heteroskedasticity .and (c) the sample is partitionedinto two subsamples with different variances. 6 . and (b) a White test. to Keywords Breusch-Pagan test . Describe and compare the propertiesof the least squaresand generalizedleast squares estimators when heteroskedasticity exists. l . -+.

.the probability densitr is function f (yrlxr) is suchthatyl will be closeto E(yr) with high probability.hasa higher A probability of taking on large valuesif its varianceis high. . At 11. That is. is large. 40.the probability densityfunction f (yzl*z) is more spread out. the model used to describe expenditure on food for the ith household is written a: Yi: Fr *9zxi*ei (8.When homoskedasticity exists.r l'i) .rimationtechn We can furth :.It is harder to guesstheir food expenditure Another way of describingwhat we havejust said is to saythe probability of getting large positive or negativevaluesfor e.Thus. Conversely. r. = . Thus.' hereh(.198 HETEROSKEDASTICITY The unknown parametersB1 and B2 conve! information about this expenditure function.hat are the con -'.Comparatively.If you were to guessfood expenditurefor a low-income household and food expenditure a high-incomehousehold.appearst :.1. To recognize that not all householdswith a particular income will have the same food expenditure. High-income households the other handcould havesimple food tastes extravagant on or food tastes.. Knowledge of theseparameters aidsplanning by institutions suchas governmentagencies food retail chains.r. be the difference betweenexpenditureon food by the ith householdyrand meanexpenditureon food for all households with income x. When we previouslyconsidered model in the u l:re assumption -.3. . increase ab in the obs Since .monstrate an .)ints that devia f :.)dependdirectly on incomex.).asthat part of food expenditure explainedby income.in this casee. as that part of food expenditure explained by other factors.d. income is relatively less important as an explanatoryvariable for food expenditureof high-income households.They might dine on caviar or spaghetti.n of the form .r. The intercept parameterB1 measures expenditure on food for a zero income level.9r .Factor: other than income can have a larger impact on food expenditurewhen householdincome is high. and larger values are possible. we let e. the probability density function for the errors doesnot changeasx changes.To estimateBq and 92 we considered or a sampleof N : 40 households indexedby i: l.we say that heteroskedasticity exists.. we arelesscertainabout where y2 might fall.3. The heteroskedastic assumption illustratedin Figure 8. Alternatively. with the pair (y.is higher for high incomesthan it is for low incomes..An equivalent by statement to is say var(y. . we assum .r-.and yi and ei are homoskedastic.pzxi (8.. Note that the existenceof heteroskedasticity a violation of one of our least squares is assumptions that were listed in Section5. 2.rints Scattered 'jirture is to say .ther havefew choicesand are almost forced to spenda particular portion of their income on food.while their low-income counterparts have to take the spaghetti.as we illustrated in Figure 2.we say that homoskedasticitl exists.and e. ifall observations come from probability density functions with the samevariance.E(yi) : li .\..dat is \ vraphofthis e .givenby e.1.var(ei) :. Food expenditureyr can deviate further from its mean E(yi) : 9r * pzxi when x.7 He Thus.andthe randomerrorerareheteroskedastic.) increasesas rr increases. . We begin this chapterby asking whether the mean function E(y) : 9r -t \zx is better ar explaining expenditure on food for low-income householdsthan it is for high-income households. .When we move to 12.-i.r. for which guess you think would be easier? do Lorr income householdsdo not have the option of extravagantfood tastes. ei : yi ..) : 9r * B2x. parameter describes The response how meanhousehold food expenditure changes when B2 householdincome increasesby one unit.. we can capturethe effect we aredescribing having var(e. and in line with our generalspecification the regression of model. ). How can we model this phenomenon? randomvariable.2r Probability density function f(r) :ccne 8.) is a I This chapter i '.when the variances all observation-s for are not the same. we say the random variabley.) denoting expenditure on food and income for the ith household.In sucha case.-:uares estimati --juares residual ' .nstantvariance We canview E(y.

Figure8.).$zx is betterar for high-income rseholdand food be easier?Lou nparatively.2l xi \ _eraph this estimatedfunction. reexamining least by . i) :0 e r rcune 8. Factor: ehold income is ) ei.The least squaresestimatedequationfrom the observations the file in '.2 alsosuggests the unobservable . in errors residuals(2i) areestimates the unobservable of leastsquares Sincethe observable that errorstend c.r from its mean all observations say the random iervations come noskedasticitl babilitydensit\ Whenwe move is certainabout city exists.quaresresiduals.2lxi :') increase absolutevalue as income grows.tod.ther incomeon food. xi) denoting ve the same food todel.42 -l l0. ure changes when suresexpenditure ing by institutions z we considereda r (yi. extravagant food nterparts have to tory variable for rod expenditure.9r . we assumed random error terms with mean zero and that the !. of \\-hat are the consequences the properties of least squaresestimators?Is there a better for 3\timationtechnique? How do we detectthe existenceof heteroskedasticity? We can further illustrate the nature of heteroskedasticity.!zxi.There are more foints scatteredfurther away from the line asrr gets larger.. r ofgetting large ncomes.definedby ?i:yi-83. as income (x. by income x1and : E(e1) 0 l.appearsin Figure 8.lvgte uncorrelated ronstantvarianceo2. the prevalence data of rcints that deviate further from the estimated mean function increases. that increasesas -rr increases. along with all the observedexpenditure-incomepoints of i. This chapter is concernedwith the consequerrces a variance assumption like (8.ri and the correspondingleast .) : var(e.) : o2.4).3). the re illustratedin r least squares d the model in v a r ( e i ): 6 ' cov(e.8. 7 Heteroskedastic enors.4) . "{r). and at the same time lemonstrate an informal way of detecting heteroskedasticity.) grows.) is a function of x. givenby ei : yi . be ln expenditureon Probability density function fo) 9r + Frr ( 8 .3. 2r rold is written a: (8. Our discussion suggests it shouldbe replaced that with an assump:ion of the form var(yr): var(er): h(xi) (8.rhere ft(x. The assumptionwe arequestioningnow is the constantvarianceassumptionMR3 that states r ar(y.2.datis li :83.42-l}.hasa higher rre the effect we t statement to is . That is.quaresestimation of the mean function E(yi): Fr * pz. Another way of describing this :eatureis to say that there is a tendencyfor the least squares residuals.. 8.1 THE NATURE OF HETEROSKEDASTICITY 199 3nditurefunction. Notice that. we let e.

r both hetero To obtain thr . data on hourr holds will involve households with varying numbersof householdmembersand differe: levels of householdincome. That is. fall into this category.standar . and inpu:. economicunit becomes larger.the more difficult it is to explain the variation in some outconrvariable1.4). The plotting of leastsquares residuals an informal way of detecting is heteroskedasticirr More formal tests are consideredlater in the chapter. is possiblethat the error variance or will change. by the variation in a set of explanatoryvariables. differenceb is shownin . or tllarger the household. as the size of th. a aa a o t a a 1f at a a 7a aa a :ince the existen 'l is violated.. as This observation consistent with the hypothesis that we posedearlier. r. The least best. household. data invariat'.: holds than it is for high-incomehouseholds who might be spaghetti or eaters caviareatr':.tuares residua . We can capturethe increasingvariation of y.What this meansfor the linear regression model is that. .. given in (8. function is betterat explainingfood expenditure low-income(spaghetti-eating) for hou.For example. we might measurethe sizof the firm by the quantity of output it produces. : (.namely. includedataon costs. in a number of retail establishments.Frequently.) increases income -rl increases. it w'ouldbe true if therewasan externalshockor chansein circumstances created that more r : less uncertaintyabout.. u Heteroskedasticity not a propertythat is necessarily is restricted cross-sectional to dat. thevariationoffood expenditure aroundmean food expenditure E(y. evena whole economy..iirrator for B2 'here lu. Th:.First. however. around its mean by the heteroskedastici:.:rors (the stan :her coefficien heteroskedast robust.r = weeklyincomein $ 100 FIGURE 8.The household at dataon incomeandfood expenditu:. \\'ith time-series data.that the meanfood expenditL::.8 The stand Confident misleadin 05101520253035 . or commodities. The ter:: is cross-sectional data refersto having data on a number of economicunits suchas firms .wherewe havedataover time on one economicunit. l a r g e rt h e : i z e o f t h e e c o n o m i c n i t .timatorand wl !.thereis more uncertainty associated with the outcomes-.lch an estima ..2 Least squares estimated expenditure function and observed data points.HETEROSKEDASTICITY a 8. This greateruncertaintyis modeledby specifyingan error variancethat is larger.6) to comput This problem .iuares residua . .the larger the firm. \ori. households.we examine thl consequences heteroskedasticity least squares of for estimation. a givenpoint in time.' suppose the ::i. and data on quantitiespurchasedand prices for somecommodir. With data on a number of firms. c ! a I .\'e considerthe For the simpl e showedin Cl to increase absolute in valueasincomeincreases.th..The: l. suchas a firm.2 Using a lrv=83'+z+ EV a tl.r. :. for a number of firms. assumption Heteroskedasticity often encounteredwhen using cross-sectionaldata.Larger firms and househoie..]'. w -'. Cross-sectional involve observationson economic units of varying sizes. Otherpossible examples outputs.timatorand its .A . are likely to be more diverse and flexible with respectto the way in which values for are determined.

ta.-t Lwioi I[' [('' -t)'"?] fIilr (x' -x)')' (8.'stimatorand its usual standard errorswhen var(e. we proceedto use the least squares . and that we recognize this differenceby putting a subscriptI on o2. or simply robust. or the me outcome I households valuesfor 1 re size of the outcomes_'\'r.7) It is shownin Appendix 8A at the end ofthis chapterthat the varianceofthe leastsquares . standard errors.6) \ow supposethe error variancesfor each observationare different. The term "robust" is usedbecause they arevalid in large samples lor both heteroskedasticand homoskedasticerrors. we obtain the least of luares residuals2i : li . ta invariablr ta on houseand differenr . Confidence intervals and hypothesis tests that use these standard errors may be misleading. There is another estimator with a smaller variance.surethe size : firm.b2xi andreplaceof in t8.i6): : L w7e7 _7)']' [I[. oskedasticitr . so that we have yi : Fr * gzxi * ei var(ei) : s! (8. 2.b1 .. :xamine the v?rlD. 2U S I N G T H E L E A S T S Q U A R E S E S T I M A T O R 201 8. the :ctionaldata.8) with the squares the least .8). d expenditure ating) housecaviar eaters.ther coefficients in the multiple regressionmodel) have become known as White's heteroskedasticity-consistent standard errors. The leastsquares estimatoris still a linear and unbiased estimator.duaresresiduals. it is no longer but best. or heteroskedasticity robust. This atedmore or skedasticitl. we need to ask what consequences violation has for our least squares this estimator and what we can do about it.. hasafirm. s larger.rhere if w.a change. The term .6) to computethe standard error of D2when we should be using an estimateof (8.) : 62 (8.f J . The resulting standard by r-rrors(the standarderror for b2and the standarderrors for the least squaresestimator of .tl:o2 Lli-t?i -r)' (8.) : o2 is violated.5 ) ri e showed in Chapter 2 that the variance of the least squaresestimator for b2 is )xpenditurer rbservation i.8).2 Using the Least Squares Estirnator meansthat the leastsquares Sincethe existence heteroskedasticity of assumption var(e. we will be using an estimateof 3.8).: (xi . by of Such an estimatorwas suggested econometrician Hal White. To obtain the White standarderror for b2 corresponding to (8. The standarderrors usually computed for the least squaresestimator are incorrect.h as firms or I expenditure ts. (".7) is in N var\b2): .t)12(xt -x)2.8) .'stimatorfor B2 under the heteroskedastic specification (8. This problemcanbe overcome using an estimatorfor the variance bz givenin (8. There are two implications: l.9) . Consequently.) : oi. The White variance estimator is siven bv .and input: : commoditr. What happensto the standarderrors? For the simple linear regressionmodel without heteroskedasticity yi : 9r * gzxi I ei var(e. (8. We consider the secondimplication first.

.l0.6) in Chapter 3.When u e we recognize the existence of heteroskedasticity. depends on the unknown ol.81: 16.fl 8. basedon tlr usual formula in (8. .41) (2.ozN with only N observations without making a restrictiveassumptionabout how the of change.42f.09 : [5.45. White : Incorrect : : b2 L t"se(b2) 10.rggestedthat re variance o In this case.2l I2.2lxi (27. White's estimator for the standarderrors helps us avoid computing incorrect inten'ai estimates or incorrect values for test statistics in the presence of heteroskedasticitl However. estimatethat B2 lies between 5.10r .97. Thatis.rriation in fo. it does not addressthe first implication of heteroskedasticitythat we mentioned at the beginning of this section.o that (8. The least sq reteroskedast this P -ipproach :rrors. cov(ei. we obtain yi: 83. Most regressionpackages include an option forcalculating standarderrorsusing White'i estimator. we tend to -ee: confidence intervals that are wider than they should be.6).024x 1.3. This further assumptionbecomesnecessary becausethe best linear unbiasedestimator in the presence of heteroskedasticity. 'lur earlier in.. we ass irrnstant parar :roportional tc ..kedasticerror :erried out.1 Tnar.l0) by . 14.Iat. the tra and zero co .In the nerr sectionwe describean alternativeestimatorthat hasa smallervariancethan the leastsquare! estimator..Thus. we can construct two corresponding 95Vo confidence inten'al' for p2.some structure is imposed on of . tt is not practical to estimate N unknown variances ol.024x2. define tl (8.ignoring heteroskedasticityand using incorrect standarderrors.81) (White se) (43.\lso.97 and 14. D :ecome clear i.09) (incorrect se) .12) Although it is possibleto obtain the White heteroskedasticity-consistent varianceestimates by simply assumingthe error variancesof can be different for eachobservation. Three alternative structuresare consideredin the next three The beauty < homoskedas . namely /i: E(e.55.ol.202 HETEROSKEDASTICITY and the White standard error is given by the square root of this quantity. In multiplc regressionmodels the formulas are more complex. 13.-l The GeneralizedLeast Squares Estirnator Consider again the food expenditure example and the heteroskedasticity assumption employed in the last section.46) (1. To demons s.se(b2) : l}.to develop an estimator that is better than the least squaresestimator we need to make a further assumption about how the variances ol change with each observation. to make the generalizedleastsquaresestimatoroperational.ubsections.21L2.Replacing of with the squared residuals ?! leads to a variance estimator with good properties ir large samples because large variances tend to lead to large values of the squarec residuals.our information is more precise.45] If we ignore heteroskedasticity. If we do so for the food expenditure example. Leavin .that the least squares estimator is no longer best. low le' for : rnction E(Y.87] b2 t t.an estimator known as the generalized least squares estimator. Specifically. and ue estimatethat 9z lies between6. but the principle is the same.): ol.) :rplained by tl rore from the I a\ specific tast .87.:.e) :0 \ow. . aP 3!timator. Pr*9zxi*ei var(e.55 and 13.) : g. following the resul: in (3. tends to understate the precision of estimation.

and zero correlation between different observations. rariances on about ral.10) so that (8.):Fr*B2r. cov(ei.' '-12 *xi \/ i\ * c. As explained earlier. it is possible to turn the heteroskedastic error model into a homoskedasticenor model. Ll -!nt (8. define the following transformed variables (8.arried out.(#.that reside in the error term. The least squaresestimator is not the best linear unbiasedestimator when the elrors are We heteroskedastic.3 THE GENERALIZED LEAST SQUARES ESTIMATOR 203 In multiple e. Once this transformationhasbeen to .3. At high levels of income. we begin by dividing both sides of the original model in r8. and u'e :ct interval ledasticitr..\ \r/xi/ I | - - l11 -var\ei) : -o-xi: o' ) ( 8 . mentioned In the next rst squares That is.Expenditureonfoodforlow-incomehouseholdswillbelargely :xplained by the level of income. This meansthat there arelikely to be many other factors. Details ofthe generalized leastsquares becomeclea. 3) I (8. the transformed error term will retain the properties of zero mean. E(ei) :0.1 ) 1 i. food expenditurescan deviate morefrom the meanfunction. Replacin-e )roperties in the squared singWhite's estimatorand the issuesinvolvedrvill subsections.-* lSumption \ow."(h).. When we le. To demonstratethese facts.ras we work our way through these sections. some ext three Jxi yi : Fph * g2xi2-r ei (8.. we assumethat the varianceof the lth error term of is given by a positive unknown !'onstant parameter o2 multiplied by the positive income variable x.1-l) The beauty of this transformed model is that the new transformed error term ei is The proof of this result i s : homoskedastic. food expenditure(y.):o?:ozxi asedon the tend to ger g the resulr :e intervalr (8. application ofleast squares the transformedmodel givesabest linearunbiased estimator. As a . that rhe variance o! that has this characteristicis vn(e. so that var(e) is proportional to income.for low levels of income (x.such as specific tastesand preferences. eri):0 for ifj.12) 1 -J --Il t.1 TneNsron-nnrNcTHE Moon Our earlier inspection of the least squaresresiduals for the food expenditure example as Onepossibleassumptionfor suggested the error varianceincreases income increases.10)by . 5) l Also.12) can be rewritten as estimates o develop a further s further presence rstimator./7J ft:..8. 8.).) will be clusteredcloser to the mean runctionE(y. var(ei) - rrer r q I | ----:- / e. and that lead to a greater rariation in food expenditure for high-income households. Leaving the basic structure of the model intact. in economic terms this assumptionimplies rhat. What is the best linear unbiasedestimator under thesecircumstances? approachthis problem by changing or transforming the model into one with homoskedastic errors.

These estimates are somewhatdifferent from the least squares estimates : 83. we estimate intercept the term as B1 : 78.3e) (8. One way of viewing the generalized least squaresestimator is as a weighted least squares estimator. The old x. andxi.871.levice convert for ts somethingthat The standarder :han their least sql .onfidence interv :onfidenceinterv 2. is a straightforwardmatter to compute "the it observations"on thesevariables.In short.e(b1):27.there is no constantbecause As xh*1. \. Use least squares estimatethe transformedmodel given in (8.They havenot been affectetj by the transformation.tandard errors ar nagnitudes of va Thus.14).rhere ^yis an ur How do we Jiscussionsugg .42 and b2: 10. all thes :ncludes (se)(23. proceed. and the least squares estimators defined in terms of the transformedvariables are BLUE. lar(er): ozfiat Why :ncreases.you do not have to worry about transforming the variables before estimation.Theseare B1 the original parameters that we are interestedin estimating. and xi. noted before.' /'.2 i-l Esrrlrer Z e i 2 :it.When . are all observable.'/'". is important to recosnize that the It Then.arianceo2. andxit to we obtain the best linear unbiased estimator for B1 and B2.You will have to be careful to exclude a constantif your software automaticallyinsertsone. to obtain the best linear unbiased estimator for a model with heteroskedasticity ofthe type specifiedin equation(8.. lr r'stimates.204 H E T E R O S K ED A S T I C I T Y consequence. When afi is large. and apply least squares.45. xir. the data contain less information and the observationsare weighted lightly. In this way we take advantageof the heteroskedasticityto improve parameter estimation. The transformed model satisfiesthe conditions of the Gauss-Markov theorem. This staten .68*10. :eductionin variar hav :he variances The smaller sta . Recall that the least squaresestimator yields values of B1 and B2 that minimize the sum of squarederrors.be careful not to include a constant in the regression. can apply least squaresto the transformedvariables. ln the previous r ariancefunctior The errors areweightedby *.ft is small. If your software falls into this category.yi.the reciprocalof Jn. Most software has a weighted least squaresor generalizedleast squaresoption. taking th . xi. (weighted)least squares procedureto our householdexpenApplying the generalized diture data yields the following estimates: /i:78.An important difference.however.1 is implicitly equal to 1 for all observation: The new transformedvariable xh : I I t/n is no longer constant. To do so :notivate this fri That is.ition.21that bt did not allow for the existenceof heteroskedasticitv. that is.but you can stiI . l6) '.xir. to The estimator obtained in this way is called a generalizedleast squaresestimator. we are minimizing the sum of squared transformed errors that is given by t The least squares :_1. In this case.11) l.The transformedmodel is linear in the unknownparameters and B2.2 N i:l tG.46 an procedure than lea . you create yi.nor do you have to worry about omitting the constant.68andthe slopecoefficientthat showsthe responseof food expenditureto a change in income as B2 : 10. Calculatethe transformedvariablesgiven in (8.3.the transformedmodel is a linear model to which we car: apply least squaresestimation. To summarize..n each variablt '.is that the model nc longer containsa constantterm.ower.If you do the transforming yourself. Note that the transformed variablesyi .7e)(1.The computer will do both the transforming and the estimating.l1X:1 N N.45x.13).)' . for rnterpretations lhe untransformed . Do :quation with 1 ^Y Because is .the datacontain more information about the regressionfunction and the observationsare weighted heavih.

a 95Vo . To motivatethis framework we take logs of (8. timator. l0).utyou can still d 82. The standarderrors (8. Theseare 't beenaffected >which we can nditions of the terms of the el with hetero- model in (8. Second.8.): o2*'.21that nize that the Then.81.For example.17)? Our earlier . For example. Do you understand why? Go back to (8. 8) l .rtol error model into a hontoskedastic device convertinga heteroskedastic for as something that changes the meaning of the cofficients.1 azzi) + + (8.17) to yield h(ol):tn(o2)+1ln(x1) hatshowsthe se estimates : 10.2 EsrruerrNc rHE VARTANcpFuNcrtoN le datacontain ghtedheavill.)] : exp(.1'havethepropertythattheerrorvarianceincreasesasx.13.386 : 17. remember that standarderrors are square roots of estimated variances.3 THE GENERALIZED LEAST SQUARES ESTI]\{ATOR 205 i . . that the variances have the structuregiven in (8. however. lower standarderrors do not always mean better estimation.26) The least squaresconfidence interval computed using White's standarderrors was [6. the variables oomputerwill )lf.024x1.55.-onfidenceintervals.11).:)o ? : o 2 x 7 (8.t 6 ) *. Transformationof the variables should be re-qarded a error ntodel.Thus. do expectthe generalizedleastsquares lower. Since generalized standarderrorsto be procedure we than leastsquares.871. in a single sample the relative magnitudes of variances may not always be reflected by their corresponding variance estimates.Why not choose one of these functions? A more general specification that as includesall thesespecifications specialcasesis v a r ( e .14) as the) are in interpretations B1 and B2 are the samein the transformed for as the untransformedmodel in (8. There are other alternatives. Because^yis unknown. t3.39. To do so it is convenientto consider a framework more general than (8. 10.3. taking the exponential of both sides. of : expfln1o2) lln(x.namely. veighted leasr Fr and B2 that um of squared 8. are weighted )ve parameter rption.65. How do we proceed with estimation with an assumptionlike (8.. Doing so will lead to a transformed error term with constant rarianceo2.that is.) : ozx! andvar(r. 7) l ( 8 . increases.xir. to re transformed r compute "the at the model no I observations.liscussion suggests that we should transformour model by dividing the ith observation t'rnesch variable Ay i'!/'. we must estimate it before we can proceed with the transformrlion. The smaller standarderrorshave the advantageof producing narrower more informative .vill have to be . andxi.451 2. This statementneeds to be qualified in two ways.however.If your . ). using the generalized least squares results.79andse(81 : 1.16).arebothlower 1 rhantheir least squares that were calculatedfrom White's estimator. in namelyse(B1): 23.both rar(e. you rnstant in the ehold expen- In the previous section we assumed that heteroskedasticitycould be described by the r ariancefunction var(ei) : o2xi.the reductionin variancehascome at the cost of making an additional assumption.15) and redo the little proof in this equationwith 1 included.'onfidenceinterval for B2 is given by : * 92 + r"seiB2. First.namely counterparts least squares a betterestimation is :e(b1):27.46 and se(b):1.here 1 is an unknown parameter.17).

we could do so by dividing both sidesoi the equationyi : 9r * gzxi * . iieps4and5 .Recall how we get the least the squaresestimator for the mean function E(yr) : 9r * pzri. Also. Yi 3.2: \. Griffiths. if we believe the variance is likely to dependon more than one explanatory variable.18)can be extended the function to zi3. However.by il'. d.. say :i:.t+s2zi (8.10) o? : exp(ar* o.and thus the obvious "fix'o is to use the intercept estimatordr : dr +1. of Returningto (8..os.20.. E(v.. it can be shown that the least squaresestimator for ct2(anC any other slope parametersthat might be present) is unbiasedin large samples. The next stepis to transform the observationsin such a way that the transformedmodel hasa constanterror variance.21oJ Interestingly.. 3 2 9 2 i Notice that the estimatedz : i : 2. Hill.aod 4..2 r To summar Regressing ln(Zf) on a constantandziyields leastsquares estimates and apply leastsquares.1.) I 0 and the vr areboth correlated and heteroskedastic. defined as zi: ln(x). that we introduced in (8.) t Further discussion of this advanced point can be found in Introduction to the Theory and Practice r.: 9r * lzxi * ei We and then applied least squares.3.) : 9r * B2r.2 1 Estima Compt Compt K>2 Applv 6?:exp(d.The lea-st squaresestimator for the intercept al is asymptotically biased downward by the amount 1. 2 1 )i s t n ( 6 -)f : 0 .206 HETEROSKEDASTICITY where a1 : ln(o2).this correction hasno effect on the generalizedleast squares estimatesofthe p coefficients becauseol cancels out during the calculations. ue 2f function using the squares ofthe leastsquares residuals asour observations.9. we rewrite it as h(ol) :o. (8..to obtain :iace of the ur ::rd apply leas (8. l The variance c The exponential function is convenient becauseit ensuresthat we will get positive values cr1 for the variances for all possiblevaluesof the parameters .zis. the least squaresestimate o f ( 8 . Estima residua d2Z. We expressed observations )t as yi: E(yi)* e.. : ln(x.2104. Writing the variancefunction in this form is convenientbecauseit showshow the variance can be related to any explanatory variable : that may or may not be one of the variablesin the mean function E(y.' Econometrics.cr2..It suggests earlier the assumption could be too restrictive. in line with the more general specification in (8. write nG?) :h(o/) + vi : crl I qzzi r vi Thus.' In the food expenditureexample. for ctl and ct2.zziz*"' * asz. 365-369.2nd Edition (Wiley. Following :rpenditure e ..As suggested earlier.329 is more than twice the value of ^y: 1 that was an implicit assumption thevariance of specification usedin Section8. Does it have a zero mean?Is it uncorrelatedanC homoskedastic? The answerto thesequestionsis no.).rttware aut( you : -nunate. 9 3 7 8 * 2 . pp.21). Whether or not this procedureis a legitimate one dependson the properties of the neu error term v. 1988) by Judge.s) ( 8 .with z. can follow a similar strategyfor estimating the variance That is. Liitkepohl and Lee. However. and now addressthe question of how to estimate ct1 and cr2..19). we can obtain varianceestimates from ihe stepsfor r l.18).r+drz. rnd then dividt lea :eneralized by o.

. C o m p u t e a r i a n c e s t i m a t e6 7 : e x p ( . (8.8. ..* I aszis) (8.25) by least squaresand compute the squaresof the least squares residuals?f..a z z i z + . v s .. .22) Thus.10)by o.26) The stepsfor obtaining a generalized least squares estimatorfor B1.os by applyingleastsquares the equationln(Z/) :ar* to a 2 Z i I2 ' ' + c t s z r s + v i .21) 'esestimates s of the new rrelated and h correlated for ct2(and s.24).".19) rsitivevalues andthen divide both sidesof the equationby 6. t if your software automatically computes weighted least squares estimates. say zi:. rtesof the B 'esestimate (8. Both strategies ultimately lead to the same generalized leastsquares estimates B1and B2. .. 1 .': (#)"o (.) (#)"-. or to an extendedversionof (8. * B. Compute the transformedobservations definedby (8. the earlier ned model rthsidesof specifica- to 5.\ . .usingthe estimates in for 6f place of the unknown o! .e7) ( 8 . Following these steps to obtain generalizedleast squaresestimates for the food expenditureexample yields Practice of ti :76.\ (. Fz.\ ^ /l\ ^ /r.20) get the least observations (8. $z-ri.) "r: (#) the variance .) (. we define the transformed variables : . .2704. i r . if iable. The least the amount t -l1.hat was an ..tI) (0.r ' (8.oz.Also. . you will havesoftwarethat performsall five stepswith one click of 1'ourmouse.If you are very tortunate. /r.Why doesthe second for onework? Dividing t8.(. Steps and5 can be replaced weightedleastsquares 4 by with weightsdefinedby o. Apply least squares (8.24) To summarize these steps for the general case.23) yi : gtxh -t gzxiz ei + (8./ : B.l The varianceof the transformederror is constant(homoskedastic) because : : (1)":: "-(.. 2..23). including xiz. Br are 1.05 * 10. + & s z i s ) . 1)7 . Estimateo4.24).25) var(ei): o! : exp(ct1 azziz* . yields /v.3 THE GENERALIZED LEAST SQUARES ESTIMATOR n this form is rry variable z. .xi* if K>2..63x (s") (e. . l./ (a.to obtaina generalized leastsquares estimator B 1 and B2. supposewe are estimating the model yi : Ft * 9zxiz+ "' + \rxir * ei rl here (8. if K > 2. Estimate (8.. That is. . . we and apply least squaresto the equation (8.

Nu W A G E R i : B n rf B 2 E D U C p . g t E X P E R n i e n i i : 1 . ' x(ey1) : vatleni) ::Stl[Ie that the er ihat is. se(82): 1. 8.29b) i{orvever. To introduce a framework for investigating this question.a Proble for -'. we partition our sample into two parts. gender. . years of experience (EXPER).524METRO + + ('") (1..dat the least squaresestimated equation for this model is error lhe estimated 'r the rural wage e( : . 2 . In that chapter several equations were estimated using variables such as level of education. we return to a data set that was used in Chapter 7 to estimate wage equations and to illustrate the use of dummy variables. we cannot conclude with certainty that allowing for a more general variance specification has improvedthe precisionwith which we haveestimated and B2. race. the explanatory variables that were used are typical of those included in labor market applications.i agesis the same (o "ctter estimates irta and aPPlYin ::cognition given fo The strategY rrevious section' . sufficientlYlarge . .in this particular B1 caseit is distinctlypossiblethat our improvedresultsareattributable bettermodelingand to better estimation.29a7 (8.914+ 1.431) (8.. and region of residence explain differencesin the mean level of wages.3.52 per hour higher than the averagewage in a rural area.234EDUC O.08) (0.but the intercepts differ. that me 'bservationsare t (wAGEMi\ \"" ) /wAGEni\ Implicit in the above specification is the assumptionthat the coefficients for EDUC and EXPER (9: and B3) are the same in both metropolitan and rural areas.39 The variances rre both equal to . ilaving two subset rto what we have t ln the file cPs2.However. "r .. . N n * * (8. .oteQual.the averagemetropolitan wage is $1.sparatelyYieldsvt To introduce a third form of heteroskedasticityand the generalizedleast squaresestimator corresponding to it.208 HETEROSKEDASTICITY t Comparedto the generalizedleast squilresresults for the variance specificationo? : o2xi.914 + |. and a dummy variableMETRO that is equal to I for workers who live in a metropolitan areaand 0 for workers who live outside a metropolitan area. given a particular level ofeducation and experience.:andarddeviatio rertition. This assumption in line with the estimated is equation (8.524: -8.In this sectionour illustrative exampleis anothersimplified wage equationwhereearningsper hour (WAGE) depends on years of education (EDUC). underthe previousspecification.|33EXPER |. The question we now ask is: How does the variance of wages in a metropolitan area comparewith the varianceof wagesin a rural area?Are the varianceslikely to be the sameor different? One might suspect that the greater range of different types of jobs in a metropolitan area will lead to city wages having a higher variance. ..28 ) The resultssuggesteducationand experiencehave a positive effect on the level of wagesand that.\'e defer such a tes One setof estim -'estsquaresestim WAGE: -9. Using data in the file cps2.: 9 m -t \zEDUCm * * S3EXPERyi eyi i:1. because standard errors are themselves estimates. Usin6 bservations.2.39. one for the metropolitan observations(for which we usethe subscript " M") andthe other for the (for which we use the subscript"R") rural observations W A G E 6 . but there has beena considerable were se(B1):23.3 A HErmosKEDASTrc PeRrrrroN fhe new assumPtio For the le :.28)wherethe estimate in for is Dp1: -9.timates B3.01s) (0.070) (0. As mentioned earlier.Although the equationswere to simplifications designed to aid the interpretation of dummy variables.79 and drop in the standard errorsthat.. the estimatesfor B1 and B2 have not changeda great deal.914 and the estimatefor py1 is Ba1 \on/ bm : -9.

For the least squares estimates (8.282.) : srfl (8. one theother for the However.29b) (wAGERi\ ^ (t\.Is this fact obviousto you?No? Go back andcheckout (8. the intercepts he estimatefor ^(EXqERR\ /.28) to be best linear unbiased.79 :lates.y and all rural 'bservations divided by oa.29a)and (8. assumethat oh + 62R.956. var(ea. for the moment.29b) that turn out to be of but : -9. partitions the sample rnto what we have called a heteroskedastic partition.. o. require in we tar(ey1): var(en.Thel f :re bothequalto 1.29) is that the variancesof the two error terms e74.3 THE GENERALIZED LEAST SQUARES ESTIMATOR 209 cation03 : o2xi. that means that all metropolitan observations are divided by o.2.^(EDUC*.quares estimator :o estimatewage ieveralequations :r.dat there are N.28r vel ofwagesand rpolitan wage is etropolitan area o be the sameor s of jobs in a To introduce a two parts. We nou' assume that the error variances in the metropolitan and rural regions are different. bm : -6.166. \\'e defer such a test until the next sectionand. the error variance is constant for all observations.termodelingand The new assumption in (8. The variables are transformedby dividing each observationb1' the .rbservations. a problem with these estimatesis that we have two estimates for B2 and two :'stimates B3.r t t .eastsquares estimates (8.3Ia) tor EDUC and . \ / (EDUCpli\. are not equal.rl5:l \onl\onl\oRl\oR/\on/ i:1.2. oA: 15.29a)and (8.052.or r\ sufnciently large to conclude that o2r l do..I o ^) are the same. The strategy obtaininggeneralized for leastsquares estimates the sameasit was in the is rrevious section. and region of : equations were the explanatory rlications.l : oir.u: 808 metropolitan observationsand Np : 192 rural .In this :arnings perhour (EXPER)..Given this assumptionis correct. b n z: 0 ] 2 6 0 o - (8.) : o2. One set of estimatesthat recognizesthat the error variancesare different are the separate .29a) (8.datthe least The estimatederror variancefor the metropolitanwage equationis approximatelydouble that Ior the rural wage equation. "etter estimates(oneswith lower variances)can be obtainedby combining both subsetsof jata and applying a generalizedleast squaresestimator to the complete set of data. lnd ep..29)we tue assuming effect of educationand experience for the on .29b) become are (wAGEMi\ _.we cannol specificationhas . In our example of a heteroskedastic rartition. with ::cognition given to the existenceof heteroskedasticity. buz : 1.30) Having two subsetsof observations. Using theseobservations and least squares estimate(8.8.221 .Whetherthis differencecould be attributableto samplingerror.29a)and (8. : var(e1ai) 62r. o y) and (.when in (8. That is.\ l:l5RIl-l-uzl-l. buz :0.i agesis the samefor both metropolitan and rural areas.29bt to \eparately yields variance estimates 6 2 u: 3 1 . and a rolitanareaand 0 ps2.\ / r \ | . it somethingto decideusing a hypothesistest. in this particular .1346 bnz:0.tandarddeviation of the corresponding error term.\ lrl-l i:1.I + F : l o Fu oM ay \oul \ / \ / \ou/ IM ? (8.NR t8.15)and (8.. en a considerable and i0') : 23. ^ (EXpERazi\ /rr.| + F z l . Equations(8.243 .. In the file cps2.3lbr The variancesof the transformederror terms (e1a.n. 8 2 + ..each with a different variance..NM (8.

however.a yields a generalizedleast squaresestimator that has good propertiesin large samples.02) (0.28). . an outcomethat is not surprising given that both least squaresand generalizedleast squaresare unbiasedin the presenceof heteroskedasticity. Thus. t _ _oi _ _ r:)B * .. of .398 + l. but this time it is transformedin the same way as the other variables.r.31a)and (8.. 8.ForEDUC they are se(bya2) to : 0.The second complication relates to the fact that the metropolitan and rural intercepts are different. it will be clear to you that the combined set of error terms is homoskedastic.The standard in (8.01s) (0. . _ fp 3 r _ _ _ _ _ _ : _ .l stematic we 8.r ratio of one .06e) (0. [ . : squares separately the metropolitan and rural observations.28).rr.33 ) Thesecoefficient estimatesaresirnilar in magnitudeto thosein (8..I32EXPER l. application of least squares to the complete set of transformed yields best linear unbiasedestimators.1.) .however.1 Rrsm whenMETROi: I I o..we comparethosein (8.3Ib) and sumwe Collectingall thesefactstogether. Obtain estimates6. Apply least squaresto the transformed model /1\ rtouc. in tt .K. Our second different vari .025. +{uU!o. .onsideredm that the error lls Oi4 : ^ ' . Using least squareswith White standard errors avoids the need to make an assumption about the form of heteroskedasticity.. ^ .080and se (bp2): 0.yr : Bnr * 6. but it arisesin this casebecauseboth the mean and variance of wage depend on the dummy variable METRO.4 Detec in our discussi< rroblem and dt r-lowever. that the greaterprecision of the We generalizedleastsquares enors estimatoris reflectedin smallerstandarderrors.346) (8. ) + B r [ : = \ / \oi/ \ oi / \ c. REMARK: The generalizedleast squaresestimatorsdescribedin the last three subsectionsrequire an assumptionabout the form of the heteroskedasticity. l.|96EDUC+ O. The different interceptsareaccommodated includingMETRO aswedid in the original by equation (8.\.f data? Is the :eneralized lei The .133.539METRO + ('") (1.incertaintY abr .'an be followt When we h l5 not so easil agai residuals . andfor EXPERthey arese (b6): 0. observations There aretwo complications.y and 6a by applying least squaresseparatelyto the metropolitan and rural observations. (:) o.luestions.eastsquares . does not realize the potential efficiency gains from but generalized least squares. Letoi : { ^'o^ whenMETROi:0 I 3. can combineequations marize the method for obtaining generalizedleast squaresestimatesin the following wa). We solve and 6p. 0. would hope. (8.28) are not a good basis for comparison becausethey are incorrect under heteroHowever.) where B.33) with thoseobtainedby applying least skedasticity.2 Tnr WAGE: -9.dat yields the estimated equation OnewaYof inv a .l Jr'( I conclude tha The back degreesof I subsamPle samPlesof that whereNy UsuallY.k:How do Ik .The first is that oaaand oa areunknown.4.hould be no Pi :end to exhibit srpenditure da (Secti --hapter :eported them tendto :ndeed . This complication will not necessarilybe present in all models with a heteroskedasticpartition.(EXPERi\ (wlcn. \ ) \".'lasses stati S.018and se (ba3) Using the larger combined set of observationshas led to a reduction in the standarderrors. Following these stepsusing the data in the file cps2. Doing so this problem by transforming the observationswith their estimates 67. 2.210 HETEROSKEDASTIC ITY When you are comfortable.

of S. Doing sc Thc .In words. The other two are more formal . 4 Detecting Fleteroskedasticity In our discussionof the food expenditureequation. there *ill be :-rncertainty about whether a heteroskedastic assumptionis warranted.KyandNp. for the household r'\pendituredata. :#ffi . Ifthe errorsare homoskedastic.rf data? Is there a way of detecting heteroskedasticity that I know whether to use so reneralized least squarestechniques?We consider three ways of investigating these questions.We now ask: Are thesevaluessufficientlydifferent to jr)ncludetnat o2r 7 olt in The backgroundfor this test appears Appendix C.wp-Kn) r t8.3.243. not so easily depicted on a diagram. under the title "A Heteroskedastic Partition.In Section 8.-l-1 rihereN. to seeifthose residuals againsteachexplanatory vary in a . r.r stematic way relative to the specified variable. For example.4 DETECTING HETEROSKEDASTIC ITY 211 )f error terms i: of transformec nown.it can be shorrn :hat .. It is natural to rsk: How do I know if heteroskedasticity likely to be a problem for my model andmy set is .'lasses statisticaltests. We solr e d 6p. (8. under heterotpplying leasr arese(by2) = :0.or against!.r cmethatis noi nbiased thc in ecision of the tandardenor. I intercepts arc.3.lifferent variances. 3 l b )a n ds u m following war re metropolitan 8. r with a heteroriance of wage d in the origina.1.eastsquares and to plot the leastsquares residuals.we usedthe nature of the economic problemand data to arguewhy heteroskedasticity a particular form might be present. :31.onsidered metropolitanand rural subsamples estimatinga wage equation.hould be no patternsof any sort in the residuals. the estimatedleast squaresfunction . rther variable: i .{. of However.we estimated their variances could be differentfor these : .and a denominatorequal to the .1 Rrsrouer Prors your modelusing Oneway of investigating existence heteroskedasticity to estimate the of is . of Usually.Ku: Kn.Kparcthe degrees freedomforthe two subsample re-sres\ion\.34) says:The F statisticthat has a numeratorequal to the :atio of one varianceestimateto its true populationvalue.8. in this and in other equations that use other types of data. what we can do is plot the least squares :esiduals variable.we suspectthat the varianceincreases incomesincreases." we for . In the context of the example we are considering. t three subUsing least n about the gains from Our second test for heteroskedasticity designedfor two subsampleswith possibly is .y.:.If the errors are heteroskedastic.' 62.3.Suspecting :hatthe error variances two groups. as Earlier in this (Section8. However. We discovered that the absolute values of the residuals do :ndeed tendto increase incomeincreases.The only differenceis that the Jegreesof freedom change becausewe are consideringthe enor variancestiom t*rr .1) we plotted the estimated -'hapter leastsquares function and the residualsand :eported them in Figure 8..2 THr Gororrm-QuaNor TEsr tx { d equation (8.7. they may :end to exhibit greatervariation in some systematic way.025 bns) tndard errors.ubsamplesof a regressionequation rather than the variancesfrom two independent .F11s.. there .-ry. When we have more than one explanatoryvariable..824 and&2p 15.2.amples of data.e samples. The first is the informal use of residualplots. as This methodof investigating heteroskedasticity -'an be followed for any simple regression.

^1 r292r..9. doesnot matterwhetheryou put the largervariance it estimatein the numeratoror the denominatorof the F-statistic. with the observationsordered according to income x. Given that (8. has an F distribution with (Nu . under fly.rsq) and Fgr: F(o. Since 3. To perform the test under thesecircumstances. . described Following these stepsfor the food expenditureexample.the first half of the samplewill correspond observations to with lower variances and the last half of the samplewill correspondto observations with higher variances. and the ymple split into two equal subsamples 20 observations of each.andrecallingthatN1a the relevant lower and upper critical values for a 5Vo significance level are F1.if you alwaysput the larger estimate in the numerator. then you reject lls at a 5Vo level of significance if F ) Fu.212 HETEROSKEDASTICITY ratio of the other variance estimate to its population value.61 3574.it can also be used where. Although the Goldfeld-Quandt test is specifically designed for instances where the sample divides naturally into two subsamples.26.22.09 > I.qs. say 2. yields 6i : 3574. The form of the variance function used for testing is slightly different from that used for . Thenull and alte Tc . order the observationsaccordingto zi so that.rss) Sincewe originally hypothesized that greaterjobvariety in the metropolitanareamight leadto a greatervariance.34) reduces F:&rlAk. a one-tail test the critical value changes..sos. in this casewe reject /1s and concludethe wage variances the for rural and metropolitan regions are not equal. lo2* Then.:e?-E we !.61 > 2. (8. not decrease but with income.Kn) degreesof freedom.. Nn . .22. when F16 true. or F ) 1.4.-10).ords. Fy.Np-Kp).sos. In terr th r-onsequently. : : 0.. we split the sample into approximately two equal halves.resl: We reject Holf F I Fy. if ft:o27a > ofr.andKy : IQ: 3.we usea one-tail test wirh 5Vocritical value F1o.from which we obtain D_ t -:i- Thisis a generalf iesirablefeatures Eramplesare the h(o . a null hypothesis of homoskedasticity is rejected in favor of the alternative that the variance increaseswith lncome.M oF (8.: F(o.es. When following the aboveprocedure.22. carry out two separateleast squares regressionsthat yield variance estimates.rs.one could arguethat a one-tail test is appropriate.tz.81 F(o.9 oJ :3. NR: 192.3 TEsrrNc rnr VaRraucn FuNcrroN CtV. and proceed with the test as previously.26.ots. say 6l and 61. when ctz . can r In this section we consider a test for heteroskedasticity basedon the variancefunction. Since 2. ifheteroskedasticitl we exists.aos. we reject F1sat a 5Volevel of significance F > F. : F@.35)is a two-tail test.However.:2.qzs.8 Believingthat the variances could increase. is to equation is F6. Supposewe want to test in estimation Sect the meal letween rppears in the reg H():ozM:62R against4:o2.re substituteinl 8. the variance is a function of a single explanatory variable.onstant.nd its specialca \nother examPle \otice what haP The term h(or) .:teststatistic.Then.ozs.n the variance I o.8 and 6i : 12921. For For : I.Ku.Ny-Ky.35) and its value for the wage t#:2.0e The variance func :size that the vari :'r)rm for the varia :808.

It collapsesto h(ot + dzZiz "' + crers) : ft(crr) * The term h(ctr) is a constant.38) \otice what happensto the function ft(') when dz : 6y3: ' 'i ' : as : 0.).40). . The that used for * e? : E(e?) -l v.'+ l a s z . (8.4 DETECTING HETEROSKEDASTICITY distribution with estimation in Section 8.3e) Hr: e use a one-tail hypothesis of increaseswith not all the cr"in /1s are zero are The null and alternativehypotheses the first componentsof a test. under H1.The next componentis a teststatistic. heteroskedasticity not present..n1e!) be the difference between a squarederror and its mean.5 v.). In other is *ords. One of the functions ft('). Then. .1 is .Then. desirablefeaturesof the testthat we developis that it is valid for all reasonable Examples are the function specified in Section 8. reamight lead to nces where the :. ndKy: I(^. evel are Fu : '{FuorF> rariancesfor the relarger variance lu alwaysput the : significance if : changes. : e! . Consequently. .35) (8.) o7 : n@I : h(ot + d2zi2 " * asz.the null and alternative hypothesesfor a test for heteroskedasticitybased on the variance function are HO: ct2:Ct3:!r':695:0 (8.onstant.2 z i * " ' * c t s z .8.18) : ft(or + rtzzi) exP + lln(o') 1ln(x.41) . The mean function appearsin the regressionmodel y i : E ( y i ) * !i : 9r -l B 2 x 2+ " ' + 9xxix t ei (8.3. when olz: ry3: .r8e)1. : a1 | a2Z. we split e least squares vith the test as irationsordered l0 observations (8.8os. In terms of notation that you are familiar with.8.As before.2.3. we can write o2:h(er).36) re for the wage The variance function is relevant when heteroskedasticityis a possibility and we hypothesizethat the variance dependson a set of explanatory variableszi2.we can write function.37) to obtain var()r). it is important to distinguish between the mean function E(y) and the variance function vtr(y. I (8.40) Let v.. from .38) that t|e substituteinto (8.3.o? : E(e!) : o-r azzi2* "' * aszis + (8..22. .2+ . For : s. ..the varianceis . but the idea is the same.{notherexample the linearfunction h(ot + d2zi2 + "' * ctszis): ar * qzZiz*' " * aseis T -.: crs:0. namely h(ot +azZiz*.37) This is a general formbecausewe have not been specific aboutthe function ft(. it does not depend on any explanatory variables.zis. s ) ) z and its special casethat appearsin (8.s) +. zi3. + cr5Z.A general form for the variance function is var(y.).To obtain a test statistic we considerthe linear variancefunction in (8. s : e x p ( c r+ a . the r the test under teroskedasticity ariances andthe r.

your exposure to the X2-distribution has been limited.1 degreesof freedom.41) as O?: ot * azziz+ "' + crsZis vr * (8. One of the * amazingfeaturesof the Breusch-Pagantest is that the value of the statisticcomputed from the linear function is valid for testing an alternative hypothesis of heteroskedasticity where the variance function can be of any form given by (8..42). Appendix 6.t:. are automaticalll calculated by a number of software packages. we reject FIs and conclude that heteroskedasticityexists when 12 ) X2ro..4..* crszis).. we find that the "dependent variable" ef is not observab^le. for a5Vo significancelevel.41r Zit.i ith the variance .5help explainthe variationin 2f . it is a natural candidatefor a the test statistic. In (8.we write an operational the leastsquares residuals . by usinga qu SuPPos :.)tentially a func I the variance fur t *02x.43) holds approximatelyin large samples. so far.iveknowledge o of :r pothesis heter .214 HETEROSKEDASTICITY Notice that the addition of v.36) the dependentvariabley. . There are severalimportant features of this test: l. r.*v.The 5Vor -oncludethat the For the White' .nd p-values. obtained ?f from estimating version of (8.The one provided by your software may or may not be exactlythe sameasthe NxR'version in (8.37).The relationships between the different versions of the test are described in Appendix 88.43)is in the right tail ofthe distribution.43). however. As you proceed through the book and study more econometrics.4. the Thus.4..nd testHg"ot2: ' . We motivated the test in terms of an alternative hypothesis with the very general variancefunction o? : h(q + o2zi2^+. -.1 x2 : NxR2 (8.. :1d >rncethere is onl ::eedom.rnctions.replacing e! Ay a! also changesthe definition of v.. +ctsz.)ne problem with :-. . x2 The 57ocritical vu . It is a large sampletest.8.36). That is.r azziz+ .it was usedfor testingfor normality in Section4.z. You will often seethe test referred to as a Lagrange multiplier test or a BreuschPagan test for heteroskedasticity.3a The Vhi ..s_ri.4) to derive an earlier version of the test that was later modifiedby otherresearchers theform in (8. .we . a X2random variable takesonly positive values. overcomethis problem by replacing e! with the squares We of (8. to the variancefunction serves similar purposeto addition of e a to the mean function in (8.radratic The White test :re 12 : NxR2 te -'-'onometric soft\ :iouse. when I1sis true.43). -rcluding interacti terms (e. It was introducedin Appendix 8.3. The variance function test for heteroskedasticityuses quantities obtained from least squaresestimation of (8. statisticfrom (8.2.sf v.and its relationship with the F-test was explored in an appendixto Chapter 6. .42t Strictly speaking. .bY 2.v Lagrange multiplier testscan be written in the form NxR2 where R2 comes from a convenient auxiliary regressionrelated to the hypothesis being tested. one of which is an F-test.'.In reality :re relevant varial :efining the z's as t :requently.It is a distribution that is used for testing many different kinds of hypotheses. .Like an F random variable..The result in (8. Sincethe R2goodness-of-fit measures proportion of variation in 2f explainedby the z's. Breusch and Paganused the Lagrange multiplier principle (seeAppendix C. .If we try to estimate(8.The testvalues to fortheseandother slightly different versions of the test. the samplesizemultiplied by R2hasa chisquare (12) OistrlUutionwith S . but we will retain the same notation to avoid unnecessary complication.1.ss.the var tlso. lhe White test wit -x'tr-. rejectionregionfor the statisticin (8. We are interested in discovering whether the variables :i:. is observable..43 r It is likely that. you will find that man.5.Zs. There is an important difference.Becausea large R2value provides evidence against the null hypothesis (it suggeststhe z variables explain changes in the variance).41).3b Testing t :o test for hetero r. we proceeded carry out yet to the test using the linear function 0i : s.36).Thus. 3.It can be shownthat.

er. econometricianHal White suggested definingthe z's as equalto the x's.84.4.With this point in mind.we rejectlls and treedom.from which we obtain (8.rl: 5. 3 8 t. then some of the z's are redundant and are deleted. It was 'n 4.2. reality we may wish to testfor heteroskedasticity In :1. The 5Vocritical value is 3.441 large samples.4.42) e will retain the Lnedfrom least te variables z.4.43). Its test values are routinely calculatedby many cconometric software packages and can often be found by the simple click of a mouse. 4 : xl). very general d to carry out .NxR2 test defined in (8.g. In (8. is of without preciseknowledgeof . .Because . of Frequently.2s.37). 1 8 4 61 .43t imited. rhe relevant variables..749. . In this case..3a The White Test that \\'e One problem with the variance function test describedso far is that it presupposes have knowledge of what variables will appear in the variance function if the alternative we hypothesis heteroskedasticity true. Supposethe mean function has two explanatory variables E(vi):9rl$2xi2*9:x. the squares the x's. by least squares.42) candidatefor a byR2hasachi- 8. The White test is performed as an F-test (see Appendix 88 for details) or using rhe 12 . or a Breuschnge multiplier that was later heseand other automatically your software : relationships x 88. As you nd that many comesfrom a : Rz rend o'1846 ss"ry4: X 2: : N x R z : 4 0 x 0 . and possiblytheir crossproducts.we have X 2: NxRz:40x0.023 r (8..If the mean function contains quadratic terms (e. we concludethat heteroskedasticin riith the variance dependenton income. lasticity exists : SSE 3.rndp-values.99. One of the itic computed ris of hetero- Sincethere is only one parameterin the null hypothesis.onclude that the variance dependson income.18888 :7.4 DETECTING HETEROSKEDASTICITY 215 r to addition ofe.159. by using a quadraticfunction we can approximatea number of other possiblevariance tunctions. 169 SS7: 4.* v.4. .8.Again.36) the the "dependenr th the squares of e an operational (8.38 is greaterthan 3.\lso.3. stic from (8. exists The5Vocritical value is X?o.It is a e an F random value provides :hanges in the re distribution.the variablesthat affect the varianceare the sameas those in the meanfunction.610.555 : p-value0.84.In otherwords. For the White version of the test we estimate the equation 2? : ot I ctzxi+ %t + vi end test Hs:a2 : o: : 0 againstH1:u2 f 0 or ct310.We begin by estimating the function 2f : crI * ct2x.3b Testing the Food Expenditure Exarnple To test for heteroskedasticity in the food expenditure example where the variance is potentially a function of income..: The White test without cross-productterms (interactions) specifies z2: x2 z3: x3 z+: xZ zs: x? Including interactions adds one further variable. 8.nr.a2:0 againstthe alternativeH1:a2f 0 in the variance function o? : h(q + oLzxi).556.the 12-testhas one degreeof 7.and its ndix 6. z6: xzx3. we test Hs.it assumes areableto specifl'::.including both the test .

8) simplifiesto that given in (8.) : 6ri and its transformed homoskedastic version yi : Broit + gzxi 4.2) x: (1.6) when o? : o2. That is I = ('.:Z*ivi (a) Show that B1 and B2 can be written as 2yixi Loi -I"-/Iorty'\ /Io. ande! : o.rxi)B' + (Ixi'z)8.dat.(Lo. Supposethat you have the following five observations ! : (4. The data are in the file vacation. Use the fication (c) Table 8 least sq squares (i) Hc kic (ii) Hc en . xl : oitxi. o.*)' f>L.5.3 Res (a) Theequ age and (b) Orderin aPPlYin observa Use a hand calculatorto find generalized least squares estimates B1 and 82.. the following model was estimated MILES: 9r * 9IINCOME -l\zAGE + 9qKIDS -r e The variablesare self-explanatoryexceptperhapsfor AGEthatis the averageage of the adult members of the household.a.Measuringdistance miles per in year. of 8.txi) Bz : 2oi 1 vi (Io.216 HETEROSKEDASTICITY 8.r)2"i] : o' 8.zxl .3.2.r)'1' rL'(''.ei where yi : niryi.2 Considerthe model yi : 9r I lzxr * ei with heteroskedastic variancevar(e.tei.2xi\2 >"7 \ >.5 Exercises 8. [('' .-+ A sample of 200 Chicago householdswas taken to investigate how far American households tend to travel when they take vacation.'7 Zo.:Y2-(#)u (b) Show that 91 and B2 are equal to the least squaresestimatorsby and b2 when o? : o2 for all i. That is.3.2x.1 PnoersN{s 8.1. (c) Does a comparison of the formulas for p1 and B2 with those for b1 and b2 suggestan interpretation 0r anO Bzf for 8.4) tctnp 8. The normal equations whose solution yields the generalized least squares estimatorsB1 and B2 are (Ioi') 0' + (Io.0. the error variancesare constant.3 Considerthe simple regression model Yi:9r *7zxilet where the ei are independenterrors with E(ei) : 0 and var(ei) : ozx?.: \E-l\x.1.1 Show that the varianceof the leastsquares estimatorgiven in (8.\ 9.

and applying least squaresto the first 100 observations.9471x107 SSE2 1.1 contains three sets of estimates. What do thesegraphssuggestto you? (b) Ordering the observations according to descending values of INCOME.5 EXERCISES 217 2000 1000 mplifies to that Eo -1000 evar(ei):6) "i .4: data. -1000 and b2when 'or -2000 b1 and b2 i.and the number of kids in the household? (ii) How do White's standarderrors compare with the least squaresstandard errors? Do they change your assessment the precision of estimation? of .8. Use the Goldfeld-Quandt test to test for heteroskedastic errors.and again to the second 100 observations.rcunn 8.hose solution i+ where -2000 0 2000 20 40 60 Income 80 100 r20 1000 ! l)0.those from least squareswith White's standard errors.0479x107 1 and B2. (c) Table 8.3. Supposethar (a) The equationwas estimatedby least squaresand the residualsare ploned against age and income in Figure 8. Include specification of the null and alternative hypotheses.rAmerican in miles per erageage of dat. a. and those from generalized least squaresunder the assumption o? : o2 xINCOMEZ.3 20 30 40 Age s0 60 plotsfor Exercise vacation Residual 8. age.yields the sums of squarederrors : SSEr: 2. (i) How do vacation miles traveled dependon income.those from least squares.

3r 7.55 t4. AGE.000 0.65 1.20 15.644 -4.849 -5.78 1.000 0. Error 7.s3 -3.50 9.80 3.811 6.000 0.3.19 -3.02 2t.83 142.000 0.52 0.tr -2.72 -76.5 In Exercise 5.00 13.430 -9.:nable Least squaresestimates r_.003 0.000 0.1.74 -81. 7 Variable Output forExercise 8.360 0. Enor t .22 Std.02 0.048 ..1 -0.003 .372 -0.0 .335 0.81 -391.000 0.2'72 -0.08467 (b) Do yt (c) What . t b I e8 .' : 0.001 Continuin following ??:qf (iii) Is there evidence to suggest the generalized least squaresestimates are better estimates? 8.574 -4. 3 r-Value p-Value I .000 0.97 29.000 0.380 0.32 3.)OMS .232 9.VE 'Rl. 2 9 r-Value 3.2.'. a 8.000 0. 7 1 6 .89 4.74 7. ROOMS.83 169.13 C INCOME AGE KIDS -391.000 Use a hat (a) Find (b) Find (c) Estin (d) Find (e) Find Exerr . 6 5 7 28.2 CovrP r.007 0.283 -5.g The file CAinl Exercise .!a"9:9f-g! 14.1't7 SSE:14.000 0.035 4. (a) For the coefficients of CRIME. -:PendentVariab .5 with those from Table 8.81 121.')oMS^z RI.075 0.85 -3.97 -2.5 J.2. 6 Generalized least squaresestimates C INCOME AGE KIDS -425.5.013 -1.48 3.5 an equation used for the valuation of homes in towns surroundin-e Boston was estimated.000 0.022 0.190 0.vE^2 Least squaresestimates with White standard errors C INCOME AGE KIDS .76 27.20 15.4 Coefficient Std.95 t6.74 -81.2 EstimatedMean Function forExercise 8.00r 0..000 0. 18 3 -22.42 5.55 -2.652.006 .. (a) Discu variar (b) Test f Consider v You have 1.000 0.5 where ?. and TAX.011 0.522 p-Value 0.r24 : S S T4 2 . compare95Voconfrdenceintervals obtainedusing the standarderrors from Exercise 5.r5 0.218 HETEROSKEDASTICITY TabI e 8.407 . Table 8.000 0.665 0.433 -7.J Dependent Variable: VALUE Observations: 506 Heteroskedasticity-Consistent Standard Errors Variable Coefficient C CRIME NITOX ROOMS AGE DIST ACCESS TAX PTRATIO R 2: 0 . Reestimating that equation with White's standard errors yields the output in Table 8.44 1.94 3.019 3.

84 4.522 63.5.000 0. 1. CRIME. of (b) Find the least squaresresiduals.): "! : exp(azr) You have the following eight observationson yi.1.4.92 -4.5EXERCISES 219 Table p-Value 8.4 1.019 2.datused tor Exercise7.0-11 0.000 0.: o.006 Rr : 0.3 contains output for the following leastsquares regression ?7 : o.3 Estimated Variance Function forExercise 8.039 -4.466 SST: 5. are the least squares residualsfrom the meanfunction estimatedin Exercise 8.000 0.6 DependentVariable: EHAT_SQ Included observations:506 \hriable C ROOMS ROOMS^2 CRIME CRIME^2 DIST Coefficient 0.dalcontains 940 observationson home sales in Stockton.5 with those where 2.000 0.000 0. + azROOMSi * qROOM$ + (\ CRIMEi + asCntUn? + q6DISTi + vi 0.04 -t.+ p-Value 0. (b) Test for heteroskedasticity.067 0. and zi.7 6. xi. 0 3 8 .000 0.003 ro1't. cif (e) Find generalized leastsquares estimates B1 and 82.79 0. (d) Find varianceestimates .822 2.07-l 0.5.5 -3 0. Thev are a subset of the data in the file stockton.84 -2.000 0.2 r.088 4.000 Use a hand calculatorto: (a) Find least squares estimates B1 and B2. CA in 1996.2) {.Z 7.037 -305.000 0.Error 204.9 1.4 3.8 4.9 J.8 -3.5 6.000 0.007 0.1 -0. 6 Continuing with the example in Exercise 8.022 0.8.8 A< 1A !.0 -0.08467 (b) Do you think heteroskedasticityis likely to be a problem? (c) What misleading inferencesare likely if the inconect standarderrors are used? $ . Table 8.3 18.9 .5 3. (a) Discuss how each of the variables ROOMS.000 0.000 0.285 -0.000 0.5.000 0.525 0. . Consider the model yi : 9r * gzxi * ei E(e) :0 var(e.000 0.00r 3s estimates are vns surrounding standard errors parc 95qo confie 5.31 l 23.844 1 )4) t-Value p-Value 4. (Hint: Use the resultsin of Exercise8. 504. 4 5 8 Std.001 0.8 Conrpursn ExEncrsEs The file stockton96.419 S S d: 5 .000 0.92 1.000 0. and DISZ influences the variance of house values. (c) Estimatea. -1 -0.3 -0.000 0.

we have the model yi:Br *9zxi*ei l 2 In the fil domesti hypothe GDP. (0 Use the results from part (e) to estimate the prices you will get for your two houses.000. is food expenditurefor the ith householdand x.8 asthe parameter values. Find generalized least sq^uares estimatesfor Br-and $r-under the assumqtions 1(a) var\ei) : o't/xi (b) var(ei) : o'4 : (c) var(e1) o2ln(xt) Comment on the sensitivity of the estimatesand their standarderrors to the heteroskedasticspecification. (e) Using the variance assumption from part (d).000and (ii) your 1800 squarefeet housesells for less than $110. Computethe squares the residualsfrom of the transformedmodel usedto obtain the estimatesin(8.27). of in Comment on the results. and the datafor which are in the file food. and test for heteroskedasticity. and test for heteroskedasticity. (b) We now ask whether the variancespecificationo? : ozi'! introduced in Section 8. is income.and assuming normallr distributed errors.220 HETEROSKEDASTICITY (a) Use least squares estimatea linear equationthat relateshouseprice PRICE to to the size of the housein squarefeet SQFT andthe age of the housein yearsAGE.000and (ii) your 1800squarefeet housesellsfor lessthan $ I 10. 8. (d) Estimate cr.dat. Regress squares the of the residuals on x. (b) Suppose feet. use the estimatesobtainedin parts(d) and (e) of Exercise8. -l':' In the fil (B) for functior where I indeper (a) Est Do . Regressthe squaresof the residualson x. find generalized least squares estimatesfor the parameters the equationestimatedby leastsquares part (a1.000.TI where It is sus (a) Wh1 (b) Estn resi< (c) Test (d) Use stan stan conl ignc (e) Ree resu relat 1 .For eachcase. (c) Comment on and compare the answersyou obtained in parts (a) and (b).3.16).t t ' Conside Assume time-se (a) Finc (b) Tes (c) Wht in (l (d) Unc esti wherey.8 as the parameter values.2'704.1 has been adequateto eliminate heteroskedasticity in the food expenditureexample in the text.rand cr2in the variance function o7 : exp(ctr -t a2SQFT). find the probability that (i) your 1400 squarefeet house sell: for more than $l 15. Both are 20 years old. 8. l0'r' (a) The purposeof this exerciseis to test whether the variancespecificationol : o2x. find the probability that (i) your 1400 squarefeet housesells for more than $115.use the White NxR2 statisticand the residuals from the transformed model to test to see whether heteroskedasticityhas been eliminated. That is. introduced in Section 8.2 eliminatesheteroskedasticity. the otherhas 1800 that you own two houses. I I Reconsiderthe householdexpendituremodel that appearsin the text. (c) Use the White test (with cross-productterm included) to test for heteroskedasticity.9 (a) Using the estimates and assumingnormally distributed errors. One has 1400square squarefeet. 8. obtainedin part (a) of Exercise8. (b) After making the correctioncrr : crr + 1. What price do you estimate you will get for eachhouse. Comment on the estimates. Compute the squares of the residuals from the transformed model used to obtain the estimates in (8.3.

.r. + + rrsto the heteromd the residuals iticity has been ezt whereE(e1) : E(ezt): 0.): 03. We use a subscript because observations r the are time-series data. Report the results. (a) Estimate each function using least squares. Bz.) : o2xi.duced Section in re residuals from gress squares the :. and population(P) for 34 countriesin the year 1980.) o2Qtt.t \ q Q l . of (b) Test the hypothesisBr : F+ : 0. * \qQi. and the datafor J'r . Use these standarderrors and those obtained in part (b) to construct two alternative 95Vo confidenceintervals for B2. Comment on its width relative to that of the confidence intervals found in pan (d). and Ba. recificationof : inate heteroskete the squaresof the estimates in rr heteroskedas. ). -eross domesticproduct (GDP). l 3 ' l Consider the following cost function where C denotescost and Q denotesoutput.. (c) What can you say aboutthe natureof the average cost function if the hypothesis (b) is true? in (d) Under what assumption about the error term would it be more appropriate to estimate the averagecost function than the total cost function? In the file cloth.+ \ z Q i .8.-t E+Q1. : B r . 6tQ3. They are stored in the file cloth. (a) Why might the suspicionabout heteroskedasticity reasonable? be (b) Estimatethe equationusing leastsquares. in get for your t\r'o parameter values.It is hypothesizedthat per capita expenditureon educationis linearly related to per capita GDP.Report and comment on the results. Do the estimatedcoefficientshave the expectedsisns? . there any evidenceof heteroskedasticity? (c) Test for the existenceof heteroskedasticity using a White test. (a) Find generalized least squares estimates 9r. eh arTd ate independentof each other and over time.:Fr where l9zxi*ei a2SQFT).What can you say about the confidenceinterval that ignores the heteroskedasticity? (e) Reestimatethe equation under the assumption that var(e. ez. * eu firm 2: Cz. Construct a 95%oconfidence interval for B2. (d) UseWhite's formula for leastsquares variance estimates find somealternative to standarderrors for the least squaresestimatesobtained in part (b).dat there ne 28 time-seriesobservationson total cost (C) and output (Q) for two clothing manufacturing firms. .t B z Q r .. and var(e2.:(T) . C r . plot the leastsquares function and the Is residuals. zed least squarei squares part (at.5 EXERCISES ))1 seprice PRICE to rusein yearsAGE. That is. It is hypothesizedthat both firms' cost functions are cubic and can be written as: Find generalized firm 1: Cu : 9t -t 7zQv+ ?tQi. AIso.dat. : Assumethat var(ey.83. + e t . that (i) your 140[) 1800 squarefeer nates obtained in lsumingnormallr 'e feet housesell: sellsfor less than (a) and (b).dat there are data on public expenditureon education (EE). var(err): o?.:(T) and It is suspectedthat"ei may be heteroskedastic with a variance related to . the otherhas 1800 te you will get for for heteroskedas- 12 ln the file pubexp.: 6r * 6zQz.

the per capita stock of cars. testthe hypothesis that -F1s : 63 againstthr :o! alternative thatH1:oll ol. Data on these variables appear in the file gasga.15* (a) Reconsiderthe wage equationthat was estimatedin Section8.6 t ' F z : 6 2 . significancelevel. (c) Find White standarderrors for the least squaresestimatesof the mean functio: How do they comparewith the generalizedleast squares standarderrorsobtaineJ in part (b)? 8. Fz :62. if we usethe l . will t we =.. PRICE is the real gasoline price. $o \()te that we areasl . for metropolitan an. rhevariancesare nplification is no rhat derived in I Appendix 8A Properties of the Least Squares Estirnator We are concemed with the properties of the least squaresestimator for B2 in the model Yi:Br l9zxi*et where E ( e .. 9+. estimate the error variance f. one the other for rural.e wrote the least ' nere .\.rt were best und The final conse -nulas for the lei '-. Germanyand Austria for the period 1960-1978: ln(GAS) : 9r * B2ln(INC) * B3ln(pRICE) + B4In(CARS) e + where 1NC is per capita real income.33). (c) Find generalized least squares estimates the coefficientsB1.16 Consider the following model used to explain gasoline consumptionper car i:.'reroskedasticit '\ e summarize the . estimate the two variancesusing the model o3:exp(ctr *a2METRoi) and one single combined sample. re nextresultis th -:. (d) Test the hypothesis I I s : B 1. ): 0 : var(ei) cfi c o v ( e .. rus. (9: > . Are your variance estimatesdifferent fror thoseobtainedusing two separate sub-samples? Why? (b) Find a new set of generalizedleast squaresestimatesfor the mean function an: comparethem with thosein (8. present. 9:. :llsexpresslon a rs ' :reroskedasticity " rs derived unde .3.biased.3.l) againstthe alternativethat demandis elastic Br < . .Report and comment on the results. (b) Test the hypothesisHs:ozc: oi againstthe alternativeH1:o261&o at a S. 'tiware for least s .?. of (d) Use the resultsin (c) to test the null hypothesisthat demandis price inelasri. Insteadt: estimatingthe variancesfrom two separate subsamples. (c) Estimate jointly assuming both equations that Bl :6r.m (8A. 9 : : 6 3 a n d B 4 : Comment on the test outcome.: by considering -. .? HETEROSKEDASTICITY APPENDIX 8 (b) Using a 107osignificance level. unlesstold . 8. (a) Using separate least squares estimations. and the error variance for Austria ol.'twe shouldbe t rlerval estimates a . and CARSr.3).: Germany o2".1). is no lo it .dar.t.. Fz. 9: :61. an. e ): 0 (i+ i) . 9+ : E+.

APPENDIX 8A PROPERTIES OF THE LEAST SQUARES ESTIMATOR 223 : o? againstth.\ here ( 8 A . and CARSi.anr: \ote thatwe areassuming existence heteroskedasticity.nbiased. e) (8A.2). present. Using incorrect standarderrors meansthat :.We showedthis result in Section .rtiware for least squaresregressionwill compute the estimatedvariance for b2 basedon iA. 1 ) . (e i. s price inelastie . the of In ive wrote the least squaresestimator for B2 as bz : Bz lZwiei '.That is.it follows from (8A. Specifically.13).3) to obtainthe standard we error for Dzwhen in :lct we should be using an estimate of (8A. \\-e summarize the results here for comDleteness: E(bz): E(92)+ E(\w.terval estimatesand hypothesistestswill no longer be valid.it is no longer the besrlinear unbiasedestimator.62. This property '. sothe resultin (8A. then the next to last line becomes o?lr'1.and deriving alternative estimators :hat were best under thesespecifications.3.) -fe ce.Insteado: metropolitananc :l This expressionis a useful one for exploring the propertiesof leastsquares estimationunder reteroskedasticity. jcov . although it is still . will be usingan estimateof (8A. var(b2): var(Iltie.3).3.ras derived under homoskedasticity in equation (2.) : g. this are .dat. . .^t2 ll(xr r)'] Ii the variances all the same(o? : o'). cr variance for : 2w?var(ei) I V. Appendix2D of Chapter2. file gasga.2) is different and :o that derivedin Appendix 2E.2) that ct2 YLfl0'tl# - lstimator 2 in the model I(xi .2) :Lwlo! L+"i ata 5r. : r o m( 8 A .. ean function anc 3 meanfunction d errorsobtainec ption per car ir. .) :s different frorr.rmplificationis not possible underheteroskedasticity. Thenext result is that the least squares estimatoris no longer best.) 1 ' xi--r r1t.-3by considering alternative variance specifications. Note that standardcomputer . : 9z *ZwiE(e.3) Thus..11' 8.e. 9z'9:.) : g.. r . The same proof holds under reteroskedasticity becausethe only error te(n assumptionthat was used is E(e.l)' (8A. Fs : E3. The final consequence using least squaresunder heteroskedasticityis that the usual of :ormulas for the least squaresstandarderors are incorrect.if we usethe leastsquares estimationprocedureand ignore heteroskedasticity when it :.l. To prove this result we write. The first property that we establishis that ofunbiasedness. unlesstold specificallyto computeWhite standard errors. 9+.

The degreesof freedom of the ci: squaredistribution are S .4.1). is nonzero.Hi . Note that i: :r the mean of the dependentvariable in (8B. .ctionthantha-.r (8B l in The chi-squarestatisticX2: (S. . S.n-s.n a critical v where SST: -F >la? I i:ll J Nr 12 N and SSE: L0? t:l For the seco :LrJassary. . or. Beca :::usch-Pagan -<J as an estin arethe total sum of squares and sum of squarederrorsfrom estimating(8B . be begin by rewriting (8B.In Section8.2) as -::. =nableis 2. That is. multiplying an F-statistic by its numerator degreesof freedom gircr another statistic that follows a chi-squaredistribution. note that .the averageof the sQUsr!:r level.3) i'ieir A .('r)-: . .ssr-ssE ---.: . Tl (ssr-ssE)/(s-r) ssE/(N s) ( 8 B: . the sameas that for the numerator of the F-distribution.5 v.7) for testing the significanceof a meanfunction. 6 ) w . we have F_ \ote that oj : r .:rificance lel :r. Substituting(8B. Two further tests. r and assumeour objective is to testHs :cr2 : cr3: .1). which crr be estimatedfrom the sum of squared errorsin (88.l)xF: ffi -xrtr_. : t t h ez ' s c h t That is.s-r. its est -nexpected.4) into (88.-.224 HETEROSKEDASTICITY \PPENDIX 8B Appendix 88 Variance Function Tests for Heteroskedasticity More insights into variance function tests can be developedby relating them to the F-te-: introducedin equation(6.nd SSE. : as : 0 againstthe alternativeth. * (8B.. 'N(0. r n g( 8 B .1)xF has an approximateX2{s_t)-distribution larg samples.1). .1.ssE N-S ( 8 8: Softwareoft . quantity is r::lten as the t( *--:ple size.ce{ur.3we considered more genera vrriar. e l u eo r a y z . Next.2).1) is valid for testing more general alternative hypotheses.. .7) to test the overall significanceof (88 . Please patient aswe work through thesemodifications. endtheir squ r . Adapting the F-value reportedin equation(6. the original Breusch-Pagantest and the NxR2 version of it can '*: obtainedby modifying (8B.ersionsoccur I If it is assum . 1). tre R2is the .butwe alsopoirned outthat using thelinear tunction : (8B. o3).ls.ir'(8B.42) ei : This test statisti '. To put that testi: the context of a variance function consider eouation (8.Ata5Vo significance the leastsquares to reject 110if the F-value is greater than a critical value given by F1o.. Su : x2 (s.tl . Tbr background for this result is given in Appendix 6.for s : 2. var\ei ) (8B: .:sedsthe cril var(e!):. a valid te.4.{.' residuals from the meanfunction. equivalently. the varianceof the dependentvariable is the sameasthe varianceof the error.tatistic for the ^) ctl * dzZiz l "' f ct5. :-:.:: a at leastone crr.

' ieedom of the ch. To put that testr: ssr . is Because this assumption not used. in The and cross and possibly' crossproducts.7) rersionof it can i' :modifications. At a 5Eo is :nificance level.\PPENDIX ItB VARIANCE FUNCTION TESTS FOR HETEROSKEDASTICITY 225 This test statisticrepresents basicform ofthe Breusch-Pagan the statistic.5) the assumption normally distributederrors is not of -'. (8B.7) into (8B. ersionsoccur because the alternativeestimatorsusedto replacevarle!). of it If it is assumed e. a null hypothesisof homoskedasticity rejected when 12 :NxRz .6) /o.1 . canbe shownthat var(e!) : Zo!. rn. of freedom gir.4.The variance a 1f.6). Thus.. ereda more gener* he linearfunction :' pificanceof(8B l \ote that o! : (o2")2 the square the error variancefrom the meanfunction. :rh the z's chosen the x's and their squares as (8s: the error. / )\ vat\ei ) : -''l': *. I :2 \oa / rl\ =>lvare!) l^ .2 -> varlei t 2oj (88.r. F-distribution. a valid tesr .rna critical value from the 12u 1.3aas an . When -1/(0. then (r.unlike SSZ is of .The samplevarianceofthe squared .3)yield (88.S ) ..is norrnallydistributed. 1). 1l-r'alueis tiom thestatistic (8B. / v a r [ .r ) into (88. It can also be Ils rtten as the total sum of squaresfrom estimating the variance function divided by the :iip1esize.which c. 1). The result var(e!): 2oj might be -rexpected. with the z's chosenas the .N .we set B. is the test. and (r?1"?) -X7. For the secondversion of (88.rd SSE. ol).-essary.36).lo") -N(0. distribution.\\ :rs quantity is an estimatorfor var(ef) under the assumption is true. .4).Notethatge ofthe squares ' level. e e d st h e c r i t i c a lv a l u ex 2 * n rr .8). random of .. 9 5 S .its estimatecomes from estimating(8. Softwareoften reportsthe outcomeof the White test describedin Section8...ssE ssz/N (8B.8) \ ssr/ : NxR/ istribution in lar-i.it is often called the robustversionof the .5) yields X2: (88 ' :N^(t-ssE) (88.Threre R2is the R2 goodness-of-fit statisticfrom estimatingthe variancefunction.ltisticfor the first version of the Breusch-Pasan test is g them to the F-te. lnd theirsquares possibly products. The F-value is from the statisticin (88.-< .Its two different . Specifically.:eusch-Pagan leastsquares residuals. t the alternative th. we reject a null hypothesis homoskedasticity of when the 1r-value is greater .riableis 2.i'f'r Y ssz. .rlue or a 12-value. Here is a little proof so that you know where it comes from.: . andthe that -:. ef.:d as an estimatorfor var(e!).ing (8B. Substituting(8B. .ssE ^^4 (88.

a particularva -. er for . Explain why lags are important in models that use time-seriesdata and the q ar . and Forecasting 9. 7. 10.usehold. estimate. -::ent interestrl -: und slightly. you should be able to 1. -:tmployment r -.. relat *. Use a conelogram of residuals to test for autocorrelation. Compute nonlinear least squaresestimatesfor a model with an AR(l) enor. :ese effectsdo :. 4. Specify. res'househo 'rner than anoth With time-se iJered accordin -:il be correlate . -:.rss-section da! i. One :4.Chapte. 2. : Joing so.: input supplie .: aresaying. in which lags can be included in dynamic econometric models.rllectedhas an -: particular. Find distributed lag weights from an estimated ARDL model.ir is likely to b . Estimate an autoregressive model and use it to obtain forecasts.1 T 226 . Specify and estimate autoregressive distributed lag models. Compute and explain delay and interim multipliers and the total multiplier.nse to work Keywords autocorrelation autoregressive distributed lag models autoregressive error autoregressive model correlogram delay multiplier distributed lag weight dynamic models finite distributed lag forecast error forecasting HAC standarderrors impact multiplier infinite distributed lag interim multiplier lag length lagged dependentvariable LM test" nonlinear least squares sample autocorrelation functio: standarderror of forecast error total multiplier 7xR2 form of LM test ['l' i'RE ffi 9.whi. 8. 9.uppliers.iables can las : . it ir -'. Describethe propertiesof an AR(l) enor.1 valuesof ar . Use a Lagrange multiplier test to test for autocorrelation. Autocorrelation.'ccuned. shora As :.iddition.7 lntrod Learning Objectives Based on the material in this chapter.posableincon : . . 3. 6.-. :. and interpret the estimates from a finite distributed la: model.-':'rods.The .fr . 'A'hen modeling :.'onomicunits r 'r oneparticula oservations are -:.:re effectson t Giventhatthe rodel the dyn. 5. erplanatoryvi .. 9 Dynarnic Models.

are households. The consequences economicdecisionsthat result in changesin economic of ::.al multiplier. betweenvariables can becomedynamic. data (dataon a numberoi :.rbles consumers haveless can last a long time.: f(xt.x. levelof incomeobsen'ed the Smith'.uppliers.c effectson the economy at time /. doesnot impacton.rparticular variable typicallyunconelated. or is not affected the level of incomein the by. te distributed l..rnputsuppliers.but alsoon theratesin previoustime periods. .::L'r than another. L'ne 9 .ddition. When the income tax rate is increased.'.\-sectiondataareoftengenerated way of a randomsample.1 + Effect at time r+2 Effect at time r Effect at time r+l las The disrributed effect. l. Examplesof economicunits from which we often obtain -. by cross-section obsenation.that the currentrate of unemployment depends just on the not :ent interest Turnin_e interpretation thi. economicactionsor decisions As takenat one point in time I .rrticular.That is.r is likely to be relatedto the level of incomein the Smith'shousehold the 1'ear in befbre. S.1 Introduction . andcountries.) data and the ur t.rresaying..it is importantto distinguishbetweencross-section .1 ) -' . t.Moreover. :'\e effectsdo not occur instantaneously are spread. firms.. One way is to specify that a dependent variableyr is a function of currentand -l valuesof an explanatoryvariable.and so on. distributed. ren modeling relationshipsbetween variables.which reduces demandfor productiveinputs...t * 2.'rvations individuals. .the nature of the data that have bee n lectedhas an important bearing on the appropriatechoice of an econometricrrrodel. n AR(l) error. beginby recognizingthreedifferentways We Joing so.curred.it meansthat a changein the interestrate now will hare ln irrrpact -'nrployment now and in future periods.The levelof incomeobserved the Smith'shousehold one :.geographical regions. and so on. -r\)sable profits which reduces income. be correlated in in overtime.which reduces profits of the the . are The in -. ' . Becaus.ehold.n9! work its way through the economy.nomicunits at a parlicularpoint in time) and time-series data(datacollectedover time ' . to Economic action at time I ent variable squares relation functior of forecasterror LM test .1 INTRODUCTION 227 9. rate. needto askhow in are we ':rodelthe dynamicnatureof relationships.9.' household.thereis a naturalordering:the observation:are '-:red according time. \\-ith time-series dataon the other hand. with time-series datait is likell' thatthe obserr ation' to . on .reducingtheir expenditures goodsandservices. j.it takes time for the effect of un interest rate . shownin Figure 9. . but also at times t + l.)neparticulareconomicunit). Thereis no particularorderingof the observations is more naturalor that . .-tr:. The effect of the tax increase ripples throughthe economy.for example.. Giventhattheeffectsofchanges variables not all instantaneous.over future time but or .. on :rnd slightly. (9..for example. ::r)ds. . .A changein the level of relationships implicationsbeyondthe time periodin which :rplanatory variablemay havebehavioral .

!2 ard y3 that appearin Figure 9. Forecastingfuture valuesofeco nomic time series. Plot. unemployment. 2 ( a .2b r.x9 .It is likely to affect the price of oil in the future as well as during the current period.We arenot only interestedintracingthe impact of a change in an explanatoryvariable or an error shock through time.which then drives up tlr price ofoil.or the exchangerate.-r.xt) (9.The variabler that appearsin Figure 9.Figure 9. : f (Y. but also its future values!t+rt!t+2. The terrorist act is an unpredictableshockthat forms part ofthe error term er. That is. A third way of modeling the continuing impact of changeover severalperiods is via tk error term. Including a lagged dependentvariable can capturesimilar effects to thoseobtainedby including a lagged error.)re1 et: f(et-t) ' (9.For example. tendsto wanderor is "slow turning.period< of high unemploymentwill tend to follow periodsof high unemploymentandperiods of lou unemployment will tend to follow periods of low unemployment. or a long history of pas values of an explanatory variable. What we discover is that these three war s are not as distinct as one might at first think.2a is consideredstationary becauseit tends to fluctuate around a constantmean without wandering or trending. .2 containsgraphsof the observations three differenr on variables. Assuming a positive relationship.This assumptionwill take on more meaningin Chapter 12 when it is relaxed.but also explore the relationships between them. of this kind are routinely consideredwhen examining time-seriesvariables. ." while y3 in Figure 9.Theseconceptswill be defined more precisely in Chapter 12. AUTOCORRELATION. t ' r . For examole. AND FORECASTING A secondway of capturing the dynamic characteristicsof time-seriesdata is to specify a model with a lagged dependentvariable as one of the explanatory variables. For the moment we simply illustrate the nature of stationary and nonstationan variableswith somegraphs.The current error e. In Figure 9.such as the inflation rate. governments. Relatedto the idea of modeling dynamic relationships betweentime-seriesvariablesis tlr important conceptof forecasting.2c possesscharacteristicsof nonstationary variables. Y." . and the generalpublic. the graphsshow how the value ofeach variable changesover time.228 DYNAMIC MODELS. At the present time the important thing to remember is that this chapter is concerned with modeling and estimating dynami.3 where the function et : f (et-t) is used to denote the dependence the error on its value of in the previous period. An assumption that we maintain throughout the chapter is that the variables in our equationsarestationary. and lagged values of the error term. the dynamic nature of thii relationship is suchthat the impact ofany unpredictableshock that feedsinto the error terrn will be felt notjust in period r.suppose that a terrorist act createsfear of an oil shortage. plotted against the observation number.2c is trending. we not only consider the three kinds of dynamic relationships.. we can write yv: f(x.3) implies et+t:f(et). they neither "wander" nor "trend. Thus. As an example.2b and 9. Because(9. . Describing how dynamic models can be usedfor forecastingis anotherobjective of this chapter. lagged values of the dependent variable. Becausethe observationsare ordered according to time.^ relationships between stationary variables whose time serieshave similar characteristic: to those of y1. : r . affects notjus the current value of the dependentvariabley. On the other hand. but also in future periods. is something that attractsthe attentionofbusiness. eriablethat is "s '-t "trends". In this chapter we consider these three ways in which dynamics can enter a regression relationship-lagged values of the explanatory variable. .1r In this casewe are saying that the unemployment rate in one period will depend (among other things) on what it was in the previousperiod..

period.2 (a) Time seriescf a stationary variable.^ 15n 300 250 200 150 100 50 0 100 150 t (b) 2m 250 300 r00 150 (c) icuns 9. . . Plot. variablesin our apter12whenit i. andperiodsofloro Llperiodsis via th.lationship. tl lR I6 (e: ill depend(amoni . nt period.is somerublic. Describing [is chapter. The variabler luctuate around a y3 that appearin ln Figure 9.' 14 I2 10 8 6 / (e. (c) time seriesof a nonstationary variable :aat "trends".-: ) error on its valuc nic nature of thi. into the error tern: r e. For example. enter a regresslo: of the dependen: . (b) time seriesof a nonstatlonar\' rariable that is "slow turning" or "wandering". -.l INTRODUCTION 229 data is to specifl ' bles. s.It i. Ind nonstationar-\ on threedifferenr tions are orderec s over time.. thesethree war.CASTING 9. ies variablesis th...2b v1 Lese concepts wili rportant thing to mating dynamic ar characteristic: z 150 t \a) Y2 20 15 l0 5 0 _10 s0 .. affectsnotju:: tltlt+zt'. Ldentvariable ca-' rng historyofpa.: kinds of dynami.Asa:" then drives up thr' e errorterm er. mpact of a chan-si ure valuesofeconge rate.

L Anra RrspoNsn Moopr ron SucRnceNs One way of modeling supply response an agricultural crop is to specify a model in whicl: for areaplanted (acres)dependson price. :eriod r is compos :reviousperiod.) : gr f B2rn(P1)* e1 In line with our earlier notation.if we consider an error term in any one period. we can write this equation as . It is important to know whether existing sugar processingmills are likely to b< able to handle predicted output.2.230 DYNAMIC MODELS. -2.r --.we introduce them in the context of an area responsemodel for sugarcane. (qi random errors . Th -. whether there is likely to be excessmilling capacity.<reis a one-perio ::plicationsfor est :r'tore turning to tl i. AND FORECASTING 9.'--onomicvariable :'riernment policir :snouncementOf i :-. anc whether a pricing policy linking production. assumpt'on'rT ' n period to peri .r)delassertsthat :rriod. LettingA denoteareaplanted. re related to perce \ model that capt 9. I :-ranceol (seeas where y. Supposenow that we wish to investigatehow to include lags in the error term where c dependsononeormoreotspastvaluese. Since variablesfor theseperceptionsare not explicitly included in the model.the current perceptionsthat form part of e. This model is a convenient one to introduce first becauseit leads naturally into other models that involve lags in the dependentvariable y and lags in one or more explanatory variables. we use the subscriptr to describe area and price in year t. wii- E * -' alsoassume thz --:. or correlated with.da: on To convert our economic model into an econometricone.i here p (rho) is a :rndom error term.2 Fnsr-On . : ln(A.determining the r . Also. : ln(P1). To make theseconceptsmore concrete.liameworkof th ::i_ehtforward. plant more of that crop than when its price is low. an arearesponse model of this type can be written as ln(A) : Fr * Fz ln(P) We usethis model to explain the areaof sugarcane plantedin aregion of the Southeast Asiar country of Bangladesh. we say that autocorrelation exists..-1. AUTOCORRELATION. When circumstancessuch as these lead to error terms that are correlated.andP denore output price.. Information on the area elasticity 9z is useftrl for governmen: planning...2 Lags in the Error Terrn: Autocorrelation The first dynamic model that we consideris one with a lag in the error term.metimes called r (e.le. and assuminga log-log (constantelasticity) functional form. We introduce a direct way of modeling impacts of the error term that last beyond the current period. o: at least not in a completely random manner. This carryover will be related to.du .and consumption is desirable. We ask the question: Is there a way of including lags in the error term to recognize that any unexpectedshockfelt through the error term will take time to work its way through the economy or the industry describedby the equation?Given that a shockdoestake several periods to work through the system. -toregressive moc :. if !t about the areaof sugarcane plantedwill dependon their perceptionsaboutfuture prices.i: beginby summ 'r: are considerin i:iv oneexplanato -.':ough 7.2. the earlier shocks. When the price of the crop's output is high. anc about government policies on prices and the establishment of processing mills..rre slowly the sh Given a particuli . farmer.) andx. say x. processing.. it will contain not only the effect of a current shock. That is. to give ln(A.' /r: Fr*9zx.Itislikelythatfarmers'decision. if perceptionschangeslowly over time.but also the caffyover from previous shocks. their effect on area plantedwill be felt through the error term e1. The param . Data comprising 34 annualobservations areaandprice aregiven in the file bangla. and add a random error term e.re larger the mag --:.

STING 9. the "carryover" might be farmers' perceptions of policies on pricing and the establishment mills.7) )nly one explanatoryvariable is included to keepthe discussionrelatively simple and to use ':e framework of the sugarcane example.odel assertsthat shocks to an economic variable do not work themselves out in one how quickly the effect of a shock dissipates. cov(v. e period. .9 r '. the model in (9.1 * 1 1 (9.determining the extent of the carryover.-1 (9.l0t ^his assumptionimplies that the e. It is called "first-order" because -:ereis a one-periodlag on the right side of the equation.dat pt / to describe 'A'e begin by summarizingthe model and statingthe new assumptions aboutthe AR( 1) enor. The parameterp in (9. This of :-.) oi. in Chapters 2 ':rough 7.\'e are considerins the regressionmodel )r : Fr *9zxt I et (e.The rationalefor (9. will : var(v.r govemmen: rre likely to be .The erroret is assumed follow a first-orderautoregressive AR(1) model to .1 and v. d.dueto the inertiain economicsystems.or Lpart of e.That is. and MR4 statedin Section5.ometimescalled an AR(l) process) !7 : p !7 .B1and B2. more simply. A new shockcould be the of : rvernment ::roouflcerrrorrt a new policy or information on sugarcaneshortagesor excesses. rers' decisions ure prices. llebangla. Thatis. we needto investigatethe propertiesof AR(1) errors. 9. term where e. When circumutocorrelation ntextof an are. et:pet-t+vt t9. and (ii) vr is a "new" shock to the level of the .' 1&fe0 f9SpOnsr' . and g mills.'lonomic variable.8 ) (95r lhe random effors v.2 LAGS IN THE ERROR TERM: AUTOCORRELATION 231 :e relatedto perceptionsheld in the previous period that form part of the lagged !rror !1-r. farmer. -riod. are uncorrelated randomvariableswith mean zero and a constani :nance ol lsee assumptions MR2. is a neu' :"ndomerrorterm.): g. the v. an AR(1) model. reviousshocks.here p (rho) is a parameterthat describesthe dependenceof !7 otr !. Since effect on area y overtime.The randomcomponent in time e. In our example.bles. are assumedto have the properties assumedabout e. aboutyr. andPdenot.anc is desirable. MR3. alsoassume p is lessthanI in absolute that -1<p<1 t9. :criod / is composedof two parts: (i) pel-1 is a cruryoverfrom the random error in the r:eviousperiod.\'e value.say l.6) is known as a first-order Given a particular setof assumptions :jtoregressive model or.2. \ model that capturesthese effects is This model is : els that involre .it uil.6) determines lne larger the magnitude of p the greaterthe carryover from one period to anotherand the :'. : 0 fort f s u") t9. capacity.2 Frnsr-OnosR AuroREGRESsrvE Enrons outheast Asiar: f.6r modelin whicl: s high. are stationary and have properties that do not chanse --:omperiod to period. \tr'e ond the curreni m to recognrze its way through oestake severa. with the magnitude the parameter of .ore slowly the shock dissipates.1): E(v..:aightforward. 3etore tuming to those implications.The existenceof AR(1) errorshas rplications for estimationof the unknown parameters our regression in equation.6)is a simpleone. '.Extensionto more than one explanatoryvariable is .

"we arereferring t.Note that the symb.et-k) vat\er) .it is usefulto get a bette: example. AUTOCORRELATION. .. "the covariancebetweenerrorscorrespondingto different observations..4) yie In Chapters2 through 7.lowedby a long i.linear unbiasedestimator. o? _ t-p' (9.. when we sa.13)for estimation.we use the correlatio: in formula (B. C O I T ( e / .'. when the equationerrorsfollow an AR( I ) model. :reresultsindicat . Becauseol doesno: change over time.we say that autocorrelation exists. somemore of -. they continue to have a zero mear: For the variance of the e. is also homoskedastic. To describethe correlation implied by the covariance (9. the properties the leastsquare.itive correlati corr(er.en compute the ..115 -0. .43'. the error e. we saw in Chapters whether the estimator for B1 and B2 dependon the properties of the er. So. and so on.1: This equation describesthe relationship between the variance oj of the original eQuatio: erroret and the varianceol of the uncorrelatedhomoskedasticerror v.. it can be shown that var\et)-oi: /\ . 0.8).:sedto describea From (9.14)is oneof t :'eenthe most com .303 An interpretationor definition of the unknown parameterp can be obtainedby settingk : Specifically..r: o ? p k k > O ) ( 9 .18 0.1 I enor modelsthat k :o (9. This covariancewill be nonzer..(9. Let us investig B( rJtocorrelation.. v That is.and (9.3. Also.thet ' .13) says that th< covariancebetweentwo errorsthat areft periodsapartdependson the varianceol. !t-k) : cov\e|.232 DYNAMIC MODELS. We need to assess It estimatoris still the best. we assumed this covariancewas zero. is in the covariance between the errorcorrespondingto different observations.Where the properties of the er difte: from those assumedin Chapters 2 through 7... The expression in (9.e r t ) : P rq t< Thus. and correlations) of the enors e1?This question is ar: of 2.14).275 -0.20) from Appendix 8. periods apart is c o v ( e . it :. variance. r-: ::. sometimescalled the autocorrelation coefficient.10)fo: the properties (mean.raracteristicssin --raminingthe cha ::odel in (9. and on thc parameter p raised to the power k.1ev correlated are ':. as importantone because. it can be shown that the covariancebetween any two errors that are .13). p representsthe correlation between two errors that are one period apart. . when the errors in different timc periods are correlated.: :te -0. :.t : iince-l<p< \tween enors is fl -onelation betwee -raracteristicof a :!-lenomena.423 -0. However.5 and8. the covariancebetween errors for different time periods..beforedoing so.) : g (9. Writing this formula in terms of our quantitiest': interestyields COV\et) eFk) :-- .iuationappearir From both the ':. e . understandingof (9..9). can be shownthat tht leastsquares mean of er is E(e.idualsto follow ! 'r example.| : /\)L oAp' oa 1 y .7 k Ir et JiiGJii@i (9. we will needto examinr the implicationsof (9. l3) and what it meansfor the sugarcane ft is used to represent the time between errors.503 0.rt elasticity the :. becauseof the existence of a lagged relationship between the enors from different tirnc periods.wt lecome further aP rpart.7 -0. AND FORECASTING What arethe implicationsof theAR(l) error modeldefinedby (9..tble9.-.4.Since we are using time-seriesdata..254 0. There are a variety ofdynamr.36'l ... Specifically.

it :...historicallr. (se) (0.t :3.*..two periodsapart.cause doesn. From (9.16) .7) to find leastsquares estimates andb2 and b1 ..145 0.14). I38 0.36 r -0. The residualsfrom this to iiuation appearin Table 9.rietyof dynamr.10)fi. AR(l) error model that leads of The : ' (9.091 0.254 -0. (9.1'ncompute the least squaresresiduals2t:lt -raracteristicssimilar to those of the errors et.7 = pt ( 9 .it the elasticity of arearesponse price is approximately0..277) (e. 10 1l t2 l3 l4 l5 16 I7 18 -0. the values in this sequenceare declining.and(9. However.. ' llowedby a long run of negative residuals from observation to observationI 1. Can you 6 .: our quantities.lEl 0.254 0. .017 0. the "centhe most commonly usedone. .059 0.p3. to : . Becausethe e1arenot observable.i.137 0. ' ol ies of the e.and eventually ne.b2x.0J0 0.336 -0. somemore of these"runs" ? This kind of behavioris consistent with an assumption of -.134 -0.2 LAGS IN THE ERROR TERM: AUTOCORRELATION 233 )..776x.threeperiods . This -raracteristicof an AR(l) error model is one that seemsreasonable manl econonric for ^:renomena.651 -0.303 bysettingk: . and suggest :.the . Becausethe ?.1-' :riod apart.e\ arecorrelated.itive correlationbetweensuccessive residuals.121 0.iduals follow negative to residuals and for positiveresiduals follow positiveresiduals.0-18 0. thle 9. Let us investigatethe errors in the sugarcanemodel to see if they might exhibit -tocorrelation.ed to describea regression model with AR(l) enors.21 8 0. Application of least squares the arearesponse of to -rrrflsl (9.14)is oneof those models. have zeromea: a i:nce -l < p < l.t .. autocoffelationcan be investigatedby . we obtain the sequence p. (9. Consideringone period apart. However.we can also considerthe sequence ofcorrelations betweenerrors as the\ -<comefurther apartin time. difl'r: )tween the ent :. we arereferrin-e : e will be nonze:rm different tin.as the errorsbecomefurther apart.3. 0.b1 .: ris question is a: rf the leastSQUarc-.503 0.1 and are plotted againsttime in Figure 9.r15 -0. lata. in different tinr. rssess whetherrh: be shown that thr -'normodelsthat leadto the existence autocorrelation.9).9 30 31 3l 33 -t+ -0..andon thr se the correlatit.t81 .rminingthe characteristics the 2.8.275 -0.]ASTING 9.4) yields the following estimatedequation ir (e. :reresultsindicate that both coefficients are significantly different from zero. :te fot the SugarcaneExample Least SquaresResiduals Time Time at Time el -0. The greatestcorrelation -ctweenerrorsis forthose that areone period apart.036 0.437 -0.we would not . will have .t37 25 26 27 28 2.r example.061) (0.p2.I75 -0.1 . cannotinvestigate we directly whether ':.eligible.517 -0.we can use(9.the more generalterm "autocorrelation" is sometimes .: o errors that are .304 0.1: original equati(' ..106 19 20 2l 22 L) 1A -0.423 -0..rart.367 (9.there is a run of positive residualsfrom observation2 to observation5. and so on. 13) saysthat rhnceof . From both the table and the figure we can see that there is a tendency for negative --'.1 I needto examineful to get a betr:: te that the symb.435 -0. because AR(1) errormodelhas.when we :. With uncorrelated errors. : j.893 10.1 2 8 0.nelation betweenthem becomessmaller and smaller.6s6 0.

-r'ntiallythe si expectto seeany particularpattern.x andy areestimates thepopulationmeans of E(x) andE(y).:rc consisten . :Jasticitycons . .when replacin x. and hence var(e1): var(e. the In some books and some software you will find slight variationsof (9. that the varianceof e.18) to the residuals from the sugarcaneresponseequation yields r correlationof 11: 0.istent) stand . without .8 0.We considersuchtestslaterin this chapter. wouiwe expectthe residualsto show a tendencyto oscillatein sign.delthe dynan ::reeprocedure . the sample correlation between 2..2 *0.18) that girr siightly differentnumericalvalues.-' *.\lt l Y (9.]] LT:r @. to suggesthow to estimatea model with autocorrelated errors. The magnitudeof the correlationbetweenresiduals that areone periodapartis given t .i.Before doing so. To illustrate I :.6 -0.17).*r ) ( y.ect and inc( . t " r r ^r)l s rr . ani g yt by et-r we can replacex and y by zero. E(e..o. That is.and leas .tion. L!-ral-' (9. Recall from Section 4. :. it is convenientto note two simplificationsthat can be usec In (9.234 DYNAMIC MODELS. Applying (9. The least It is poss variance r to its tru( probabili l.4 o. is constantover time. AUTOCORRELATION.sometimes denominatoris written r.:en the errors lR-l.-1. t.. correlationbetweentwo variablesx..For example.These . suggesting residualsare moderatelycorrelated. e.1 .*l b. The formt are no lor thesestar . against time. Our next taski..Gi. the formal hypothesistest is neededto assess whether this value is sufficiently large to bc significantlydifferentfrom zero.The summationsstart from t : 2 to accommodate laggedresidual2. and 2r-1..404.0 . 1 assumption This resultmeansthat only one term is requiredin the denominator.. .. l L r . andy. is given by cov\hlyt ) I .If the errorsare negativelyautocorrelated. The t\ .l' 2 sr t\.) :i u ay..t / .1 0.r.y) t. We areassuming th": all errorshavezero means. :iroughthe us :rpute corTec -elated.::Jnce.cov(e. that the co . we canreplac xyby?1and . the Zl.\e are unawa . AND FORECASTING 0. The samplecorrelatic.although:.4 -0.1E We haveusedthe subscript"1" on rbecausewe are considering errorsthat are one perioc apart. The secondsimplification comes from th.:n1ple.r L .rcorrelation Itidence inter rind the follc .: between and?1-1is then givenby ?1 .6 0.2 ! 9. for 2t e by ?.-r) : 0..2 . Thus. .) : E(r.-t Ll]:zo.J .::ification of t .8 Lnasr I 51015202530 Observation residuals plotted FTGURE 3 Leastsquares 9.2 that the sampi.J Estimr ':r en thatan AF . between 0.i to includeall observations.by e.1- To obtainan expression thecorrelationbetween and2t-r.

ae find the following 95Vo confidenceintervals for B2: (0. is violated.related.062) (0.1. To illustrate how confidence intervals can be misleading. and least squaresestimation of a more general model. The least squares estimatoris still a linear unbiasedestimator. The .rrrect and incorrect standard errors for the least squares estimator of the sugarcane . and mes from the ) : v a r ( e rr ' . The formulas for the standarderrorsusually computedfor the least squares estimator are no longer correct.we would tend to overstatethe reliability of the leastsquares estimates.For example. : 2.211.-rample. assumingthat ngxlby e.006.11' >xlby 21andt. If we ignored the rutocorrelation.cov(er.r.recification of the dynamic elror model that is needed to get an estimator with a lower r:rriance. the reliability of least squares estimationis such .546) (correct) Ii rve are unaware of the autocorrelation. although a y large to be turnext task is ted. we need to ask how to estimate such a model. : pet_r I vt. They have the advantageof ting consistent for autocorrelatederrors that are not necessarily AR(l) and do not require .776x.The two sets of standarderrors.sentially l . can be used.-onfidence intervalswould be narrowerthanthey shouldbe.277) (0. 9. It is possible to find an alternative estimator with a lower variance. we estimate that the elasticity of area response . and are analogousto the hetero-iedasticiry consistent standarderrors introduced in Chapter 8. These standarderrors are known as IIAC (heteroskedasticityand autocorrelation :. .):}for t f s.211 and 1. along with the estimated equation are h :3.340.378) re one period tl ?. we would rartis given br at the sample (9.3.037.3 ESTIMATING AN AR(1) ERROR MODEL 235 9.resbetween0.e.3 Estirnating an AR(1) Error Model t.340) (inconect) (0. the least squaresassumption \1R4. rle correlation (9. or Newey-West standarderrors.1. nonlinear least squaresesti:ration. without recognizing the AR(l) error.1 Lresr Squenrs EsrruerroN -A-hen the errors follow an AR(l) model e. \lthough the usual least squares standard errors are not the correct ones.Suppose proceed we with leastsquares estimation x\way. lfuee proceduresare considered-least squaresestimation.1. What are the consequences? They are the same as ignoring heteroskedasticityshould it exist. It also means hypothesis tests have greater power and a lower probability of a Type II error.061) (0.STING 9.rnsistent) standardelrors.but it is no longer best. "-.using/.iiren that an AR(l) enor model is being usedto captureautocorrelationin the errors and to :odel the dynamic effects of the error term. it is instructive to compute :.18 t incorrectse's correctse's \ote that the correct standarderrors are larger than the incorrect ones. and hence confidenceintervals and hypothesis tests that use these standarderrors mav be misleadine.18) that give r is written as fion yields a rd. .In reality.Having a lower variancemeansthere is a higher probability of obtaining a coefficient estimateclose to its true value. (0. it is possible to :"rmpute correct standard errors for the least squares estimator when the errors are auto-.893 -t 0.

Darticular. S.eseestimat . it is preferableto employ a better estimatio.546.cedure. : n ga n e s t i m r\ to obtaing .. that this result is in line with earlier practicein the book. The advantage doing so is that we can now proceed.8 1 .19)yields Substituting )r : 9r *Fzx.la Gene .P) I }zx.minimizing the sum of squares uncorrelated of errorsS. yield. There are. De -1 .ranroN While it is possibleto computecorrectstandard errorsfor the leastsquares estimatorwhe: the errors follow an AR(l) error model.2 NoNrrNraR LEasr Squerus Esurr.29 that has an error ternr'.20)into (9. . 9.PB2x1-1 v1 lq 1j r'q ai . The second .-:eesta sligt -.however.Chapter8 v .-rctionof thr ^tained us by : r . autocorrelatederror term et into a new model given by (9.PFr . somet ::h a lower ':mselves s e -sT:34n '-':rerestima What have we done? We have transformedthe original model in (9.22) by p yields P!t-r : P!t-t .procedurethat gives us narrower. as illustratedin this example. an estimator that is best and whose standarderrors are correct (in large samples).is the more commor of occurTence. note that the coefficientof x1_1 equal to -ppz that is rht the is .ril thosetha :3 not compu -:'\'are Calle : usualdesir :trvare.Not.23)into (9.9zxr-t /O a' Multiplying (9. d e r nc o m p ::thodsusea .r onesfrom least squares. that is uncorrelated over time. f P).r>ts.l : lt-t - 9r . rew uncolT ::nsformed rr .i. more informative confidence intervals than the corre.1 *v1 /q 1{ *?zxtlet (9.-r .19) with th. To developsuch an estimator.a n d p y i e l (9. AND FORECASTING that the interval estimate should be from 0. In previousperiod we can write !t .006 to 1. B2.two importantdistinctivefeaturesabout the transformedmodel ir. AUTOCORRELATION.To appreciate first.Although autocorrelation car: lead to either overstatementor understatement the reliability of the least square. of to find estimates (81. (9. rlanatoryva Returningtr .:Ll:zvT. of estimates.rfendent var . Indeed using an it : .3 Esrtv : resultsfor -rrr model w .ir.|e Jsativeprodu -.7) )r:9r and the AR(l) enor representation !7 : p !1 . overstatement reliability.-: not exact .although .-':rieen least li9 is smal : .19) holds for every single observation..S":LT:rr' yields the least squaresestimator that is not the best.However. _ .Minimizing the sum of squaresof the correlated errors . The least squares estimaroused in Chapters2 through 7 minimizes a sum of squares uncorrelated of errors.-r (9.we return to the model in (9. and whose standard errors &rr not correct.PFz-r.p) that minimize the sum of squares uncorrelated for of error.s u g g e -:ter.21)yields Substituting * )r : Pr (1 .236 DYNAMIC MODELS.3. t pe1-1 t v1 /q 1t Now note that (9. in terms of th.24).

3.3 ESTIMATING AN AR(1) ERROR MODEL autocorrelation car f the least squarei s the more commor res estimator wher a better estimatioc als than the correcr (9.buinedby using calculusto find the valuesof (Fr. and then apply least squares to the transformed model.3 EsrruanrNc e Monr GENEner MooEr (9. 9..t. It has to be kept in mind. The seconddistinguishing feature about the model in (9._tI v..893.19) with the has an error term ) can now proceed ncorrelated erron rrorsS. aS well as x. Indeed. it is not a linear (B1.776). Numerical athods use a systematicprocedure for trying a sequenceof alternative parametervalues rntil those that minimize the sum of squaresfunction are found. This same kind of approach can be pursued when autocorrelation erists.l 3781.159is smaller than the corresponding correct least squares standard enor [se(b2) : .re rgative product of p (the coefficient of y'-1) ild Fz (the coefficient of x.suggestinga more reliable estimate. B2. B2..ECASTING 9. Nevertheless.20 ln(A. and p yields the following estimated equation (9. that standard errors are dremselvesestimates of true underlying standard deviations.24) is equivalent o using an iterative generalized least squares estimator called the Cochrane-Orcutt procedure. a sample size larger ihan I: 34 might be necessaryto realize the potential lower variance benefits from the lener estimator.422et-t * vt ('") (9. arodern computer software can be used to find the estimates numerically.25) came from estimating the AR( I ) error model written as the transformed model * )r : 9r (l .but These estimates similar to the leastsquares are estimates ir.2se) (0. (9. so that it has r new unconelated homoskedastic error term. Estimates obtained in this way have rie usualdesirableproperties in large samplesand are computed routinely by econometric oftware. The standard error se(p2) : . 3:. Also.24) is that it containsthe lagged dcpendent variable )r-r.422 is also similar 'cut not exactly the same as the estimate rt :0.arger. For this reason the summation Su : ZT:zr7 begins at t : 2.26) .Nore squaresestimator 'elated errors. p).and4_1. tbey are called nonlinear least squares estimates.888In(P1) et :0. and x1-1.p9zxt_t py.404 obtained from the correlation between least squaresresiduals that are one period apart. The usual linear least squares functionof the parameters formulas cannot be .and that a convenient r ay to obtain generalizedleastsquares estimatesis to first transform the model. :2T=r". although(9.3.2 r ar.The estimate0:0. however.2s) (9'2. )1_1.r1.p) * Fzx.but the standarderror for p1 is unexpectedly . Returningto the sugarcane example and applying nonlinear least squaresto estimatePl.23 (bt:3. bz:0. something that we do not expect since we have used an estimation procedure rith a lower variance. in terms of the (0.r-sgestslightly higher arearesponse a elasticity. the current and lagged values of the arplanatory variable. Becausetheseestimates rre not computed from a linear formula.899+ 0. but they still minimize a sum of squaresfunction.Details are provided in Appendix 9A. (9. rsformed model in o -ppz that is the The resultsfor the sugarcane example presentedin (9.p) that minimize S. 9.2a Generalized Least Squares Estirnation h Chapter 8 we discoveredthat the problem of heteroskedasticitycould be overcome by ising an estimation procedure known as generalizedleast squares.21 n (9.) : 3.24) is a linear function of the variabl!s. This fact means tat.). :andard errors are :d errors Suyields ge samples).it can be shown that nonlinear least squares estimation of (9..0e2) (0.166) (e.

26).27) differ? What characteristicsdo they have in common? The firsr thing to notice is that they contain the samevariables. We went on to examinehow a lag in the error term can be modeled through an AR( I ) process.rr-1 to the original linear equation.namell" they have zero mean. This observation raises issues about a generaj modeling strategyfor dynamic economic relationships.26) and (9.26) and (9.21). or whether the more generalmodel in (9.27) rs the samear (9. nndom errors w :ort I s. and p. but more complicated.27) and then test tlr validity of the AR(l) error model by testing a null hypothesis I1s:61 : -Q1[o? Considering estimation first. nevertheless. note that (9.27) do not have lagged errcr terms.26) and (9.26) is a restricted version of (9.9t.61..21) is equivalent to the AR(l) error model.and 01.27) thereare four unknown parameters. Mo( eppearsto be a r 9. and are uncorrelated.2'7).and showedsuch a model is equivalentto (9. than those consideredin Chapter 6.7 where uc discussa generalclassof autoregressive distributed lag (ARDL) models.Notice that (9. AUTOCORRELATION. There is a difference in the number of parameters. Complications occur becausethe hypothesisinvolves an equation that is nonlinear in the parameters. 66. x1and y.however.Itfollo :n the context ol 3utocorrelationi \\hen looking .The presenceofthe laggec dependentvari abley.'rnwhetheror no :s important.238 DYNAMIC MODELS.27)? What techniqr should be used for estimatingQ. in both cases1l.cients of x and its lag are denoted b1 subscripted Es.2' How do (9. that we consider the model )r : 6 * 6sr1 * 61x1-1* 9jt-t * vt Applying the r ields (9.26) there ar threeunknown parameters. In (9 .9z. constantvariance. In the introduction to this chapterwe observedthat dynamic characteristics time-serier' of relationships can occur through lags in the dependent variable. AND FORECASTING Suppose.Instead of estimating the AR(l) errs model. it can be seen that (9.zT)? Is it possible to estimate (9. we haveusedthe symbolsD (delta)andt (theta).however. the number of parameters reduce> from four to three and (9. In (9. would it be better to estimate the more general model in (9.dependsotrxs. the least squaresestimator to hold.Thus.27) would be preferable?The answeris "yes".now. and the coefficient of the lagged dependent variable )r-t is given b1' a subscripted 0. b.4 Testin Then. We can nc longer make this statementif the vr are correlated.Also.27) is new.but.1.Suchcorrelation will lead to thc least squaresestimator being biased. the We considert :u o proceduresa Lagrangemulti SeeAppendix C The third tes \bu will almost \ ourcomputer ol end smaller valu iong-standingffr :heLagrangemu rssumptions are 9.4 0 rnterceptestimat . These observationsraise a number of questions.27).27) can be estimated by least squarel providing the v1satisfy the usual assumptions required for least squares estimation.-onelated. the notationin (9.oefficients are s 'quare (Wald) tel e corresponding error model. The intercept is denoted by E.27) with the restrictior6r: -0160.or lags in the error term. whicl in turn is a special case of (9. the dynamic featuresof a model implied by an AR( 1) error can be capturedby using instead a model with a lagged y and a lagged x. we can capturethe samedynamic effects by simply addins lagged variables)1-1 and. To establishthe relationship between (9.Equation (9.. This new notation will prove to be convenient in Section 9. the coeff. \\'e have discove modelingof dynt AR(1) errors me lagged explanat .1 REsrou Our objectiveis I Inthe . even in large samples.but they do havea laggeddependentvariable and a laggedexplanatoryvariable.27).l meansthat a large sampleis required for the desirablepropertiescv.26) rt we set 6:9r(1-p) Eo:92 6r:-ppz 0r:p Because lagg the than 34 observat {uares estimate estimate : 0. Is it possibleto test I1e: 61 : -6160 and hencedecide whether the AR(l) model is a reasonable restricted version of (9. retween the lear .{. we note that (9. lags in the explanatorl variables.it can be performed using modem software. If this restriction is imposed on(9.Insteadof explicitly modeling lagr through an autocorrelatederror. the test is similar to.1is a member of this class. but the least squares procedureis still valid.

404is the sameasthe correlationobtainedusing :nterceptestimateis lower than the valuesobtainedin our earlier estimations.) : g v : o r t I s . The third testing procedure.6s6) (0. \bu will almost certainly seea value for a Durbin-Watson statistic d routinely reported on no r ourcomputeroutput. lag are denoted b1 le yr 1 is given by " '. we computedthe correlation tretweenthe least squaresresiduals 2r and those residuals lagged by one period ?' 1 and . .4) suggest iong-standingtraditional test.2e7) Becausethelaggedvariablesyr-landrr lappearontherightsideoftheequation. x1'r. In (9..2. .27)wouli nplicated. .26).' t7) and then test thr' r : -0rDo? ted by least square.nownparameters.33rather :han34 observationsare usedfor estimation.27) using the data for the sugarcaneexample i ields i : 2 .quaresestimate from the original equation relating 1og of area to log of price. b e c a u s e t h e n e .11 valuesof d near2 suggest autocorrelation d ). We considertwo testing proceduresin this sectionand a third in Appendix 98.the Durbin-Watson is lessconvenientthan the correlogramor their :heLagrangemultiplier test.Equation(9. than those involves an equation :rmed using modern \\'e have discoveredthat the existenceof autocorrelationhas an important bearing on the nodeling of dynamic relationshipsand the choice of estimationtechnique. v. We can nc lation will lead to the of aristics time-serie. uredby using insteac rues about a general rlicitly modelinglag.4 Testing for Autocorrelation with the restrictior.Because x 2(l .2.Thus.That is.167) (se) (0. Applying the least squaresestimator to (9. T h u s .n whetheror not we imposethe coefficient restriction implied by the AR(l) error model.onelated. It :s important.t 0 . while the The leastsquares residuals. therefore.Modeling strategy. : 1 .26) there are 6.ECASTING 9.29. end smallervalues(lessthan about 1.we do not rejectthe restrictionimplied by the AR( I t via of the dynamicsof arearesponse sugarcane an AR( I ) enor model crrormodel. 6 1 t x .1 Rlsrruer Connsrocnam elinthercgressionmodelyr: 9r I Bzxt + etare Ourobjectiveistotestwhethertheerrors that the vr areuncorrelated ..' dels.8.4c for some general information about Lagrange multiplier tests.Usin-ea chi91 * 1 u a r e ( W a l d ) t e s t t o t e s t t h e h y p o t h e s i s F:l s :-6 1 6 o y i e l d s a v a l u e o f X i r . is the Durbin-Watson test.v. (9.:.ction 9.. :ctsby simply adding he AR(1) model is r rodelin (9.21 n common?The firsi 1 dependsotr\.The existenceof \R(1) errors means we should transform our model into one with lagged dependentand depending -agged explanatoryvariablesand estimateit with nonlinear or linear leastsquares . correspondingp-value 0. so called because is basedon a testingprinciple with that name. Although it is a positive autocorrelation. 3 6 6 . parametersreduce.t I 0 .Theselatter two testsareeasierto implement and. 9. we assume randomerrorswith zero mean and constantvariance. 'esence the laggec of esirablepropertieso: ltill valid.27) is the samea.All estimated .05 level of significance. Ltingthe AR(1) eno: Z7)?What techniqu. rppears to be a reasonable 9. s in the explanatory the error term can be rlent to (9.280) (0. ol) and E(v.The estimate9z : 0.7 where ir. they are applicable to a wider variety of situations. mbols 6 (delta) and t' .(0.2. SeeAppendix C.4 TESTING FOR AUTOCORRELATION 239 (9. tsrimate0 : 0. consideredin Appendix 98.oefficients are significantly different from zero at a 0. 4 0 4 y 1 .1. :n the context of the AR(l) enor model. The main :u o proceduresare ( 1) examinationof a device known as a residual correlogram. namell.I t f o l l o w s t h a t t h e e y w i l l b e u n c o r r e l a t e d w h e n p : 0 . l 1 5 u i t h : .because issumptions are less restrictive.Thus. s estimation.777 is similar to the least . and (2) a it Lagrange multiplier test.1 tQ rRr (0. 7 1 7 x 1 -0 . to be able to test for the existenceof correlated errors.In theAR(l) errormodelet : pet-r * vr.which rot have lagged error ratoryvariable. the null and alternative hypothesesfor a test for lutocorrelation are Hs:P:0 h:Pl0 \Vhen looking at the sugarcane example in Section 9.

. Suppose4 is the correlation that aretperiodr between?t and 2.nstead . . where of Thebarsin Figure 9 . Thus. k : l. Figure9. namely z:.4 illustr :he model (9. t0.Consequently.We recognized is coefficientp. we use a relativell To obtain a test statisticfor testing../Tn -N(0.404 (9. To provide an easyway of checkingthe inequalitiesin (9.1 -- r. the sugar In can examplethe correlationsup to six lags are \ : 0. rp is significantly different from zero at a 5Vosignificance level if ft) " .4 Cone Hence.96ort/Tn < -1. . Then.96 or nan.The signi model.olate and focus o if -:isturbed the outl .and so on.9.96I t/T superimposed that graph on sothat the econometrician seeat a glancewhich conelationsaresignificant. againstthe alternativeI11.404 rz :0. This result can be generalizedto all lags.rgnificance bounds :rom zero. note that rejecting . In Sect -'r-ror aetweenerrors ft pe :lised to the power t :hey are hard to er or J!)rrelation it mi1 Your software wi :right have the con ofbars to de . Thesecorrelationsare estimates the populationcorrelationfunction given by pb pz.Fls is simple result that holds in large sampleswhen -F16 true.. we have :2.96 Z : t/34x0.96 Or h.most econometricsoftware providesa graphof the correlogram with thebounds+1 . AUTOCORRELATION.122 rs : 0.werejectlls:p: (l standardnormaldistribution.30) in a slightlr when different and more general form. is called the sample autocorrelation function or the correlogram ofthe residuals.404..one way to testfor autocorrelation to examinewhetherrr : 0.reslightly differen . whenfr1 > l. < In the sugarcane examplewhere I : 34 and h : 0.. 1).961t/T as boundson rr outsideof which 11is significantlr different from zero. 2.F1e to Ils t/Tn> 1.161 Foliowingdetectio \R(l) error model and the bounds are *1 96lt/T: Figure 9.it is the correlationbetween residuals apart.-d in otherwords.4. .96 r .t'np.31 The sequenceof correlations4. g vT We can view | .'/T 1.084 r+ : -0353 rs : -0.threeperiods apart.36> 1.two periodsapart.1) ' (9. Most econometric software automatically performs the test in (9.404. These results appear in the correlogram in tl Ii theassumption from estit :esiduals the .ata5Vo .961fi and -1 .96.32.1. %. To describe this form.29 () The product of the squareroot of the samplesize and the correlation rl has an approximate significancelevel. .31).404 i: significantlydifferent from zero. we reject the null hypothesis of no autocorrelation and conclude the errors are correlated.It showsthe correlationbetweenresidualsthat are one period apart. .420 ra : -0. 74 -N(0.96 is equivalent rejecting when r. .96 '/T (9.ndits significance :. .336.240 DYNAMIC MODELS.30 r.0. AND FORECASTING of that this valueis an estimate the autocorrelation found it to be r1 .96orJTr.rsing correlogr :orrelation at lag :emain.

The correlation hetweenerrors k periods apart is equal to the correlation between effors one period apart. 1 6 1 :elogram in .336 are the 'ignificance bounds. pk : pk. to be uncorrelated. an approximate iectHs:p : 0 6 F 0. In Section9.* e .0 (. use a relativel\ 0.404i.1. It might have the correlations on the x-axis and the lags on the y-axis.4 and do not be .and lhey are hard to explain in terms of sugarcanearea response.it is because they usea refinementof the large sampleapproximation r i"4 -1919.32t The bars in Figure 9. fromleast squares estimationof the model it :9t * 9 z x .Ifthe significance bounds ereslightly different. The correlations 14 and 15do not conform to this expectation.we would expectthe residuals from estimatingthis model.24) /r : Fr (l .6 0.31t :ocorrelation residuals thar rrelations are rere (9.5. It could use spikes instead barsto denotethe correlations.2we found that.4 representthe correlations and the horizontal lines at +0. Your software will not produce a correlogram that is exactly the same as Figure 9. s significantlr .orrelation or it might suggestsome other kind of model misspecificatron. and 15are significantly different liom zero. of it . Figure 9. the i.indits significance boundsmight be slightly differentthan ours. raisedto the power of t. : pet_r * vr and then estimatethe derivedmodel (9.4 nt '! I (9.2.) ll Lag r I (9.for the AR(l) model.30.listurbed ifthe output is slightly but not substantially different. In the sugar Followingdetection a significant of correlation lag l.P) I !zx.P1zx-_t vt * If theassumption that the enors v/ areuncorrelated a reasonable is one.29. tric software )n that graph .From this figurewe notetharthe in correlation at lag I has been eliminated. a reasonable at strategy to assume is an {R(1) error model e.So.4 illustratesthe correlogramfor the residuals ?. be prepared!Learn to rsolate and focus on the information corresponding to that in Figure 9.4 TESTING FOR AUTOCORRELATION 241 autocorrelation ef r1 : 0. might provide a host of additionalinformation.\STING 9. rcuns 9.t4.0 .hecorrelation rt are fr period: tif (9.4. =.It might be a spurious . although the large correlations at lags 4 and 5 remain. This fact can be checked usingthe correlogram fortheil's that appears Figure9.'s.. The significant negativecorrelationsat lags 4 and 5 are not capturedby an AR(1) errormodel. * PY'-r .4 the errors are ) in a slightlr :ting ^F1e when Correlogram for least squares residuals from sugar cane example. They suggestthe correlatioDs11.

that Powe IfHs:P:Qi5 Rl are the samP :'stimationof (9.1a f l d t o u s e a / . replaceit by the laggedleastsquares Because then perform the test in the usual way.33 (r:1)rr If e1-1 was observable.949 p-value: 0.+ at : 9t * S2x. : bt I bzxt * 2t. 3 3 )a s )r:Br *\zxtlP?t-tlit order lag additione of their i degrees< test is th 9.4. 5 Conelogram for nonlinear least squares residuals from sugarcane example.o r F . *here11 : Fr . where Z is the number of sample observations and R' is the goodness-of-fit statistic from an auxiliary regression. Proceeding in this way for the sugarcaneexample yields t :2. we begin by writing the test equation from ( 9 .and we ey-1is not observable. AUTOCORRELATION. LMtests are suchthat they can frequently be written asthe simple expression TxR2.4 -0.242 DYNAMIC MODELS.b) are cer rower.2 4.t e s t t o t e s t t h e s i g n i f i c a n c e o ft h e c o e f f i c i e n t o f residuals26-1. The general principle in is described Appendix C.34) as br I bzx.2 A LecncNcE MULTIPLIEnTPsr A secondtest that we considerfor testing for autocorrelationis derived from a generalsetot hypothesistestingprinciples that produceLagrangemultiplier (LM.6 Rearrangingthis r 0. 9.: I i' ln the introduc introducinglag trf the dependen so far has been model.overed have r as crpressed a n Section9. AND FORECASTING 0.6 0. we can rewrite (9. at autocorrelation a 57o significance As we discoveredin Chapter8. We have AttOf !1-1 The p-value is less than 0. our calcu omitted i 2.439 F : 5. The 5Vocritical v .an obvious way to test the null hypothesisI1e: p : 0 is to regress-'r er-1.I P2.8.2 ii U 4.wh Further variat :ollowing: 1.f autocorrelati LV:5. return to equation(9.0 I I I TI Lag I Frc uRE 9 .To introducethis test.st result-the s! :he intercePt and :'stimating(81 *hich the ZxR2 b ..4c. To derive the relevant auxilia4 regression for the autocorrelation LIUI test.4.In more advanced coursesyou will learn the origin of the term Lagrange multiplier.21) that war written as ]r:Fr * 9 z x t * P e 1 .021 are often.1l v .34t Noting that y.ignificanceofthe :. tests.Howeve .4'74.7 we models.3 RrcaP (9. These . o n x l a n d e y . When es (e.05 and thus the LM test rejects the null hypothesis of no level.

One is to set 2o : 0.irfficient of e1 i iiduals 21-1. the LM test can be used by including the additional laggederrorsin (9 .]ASTING 9 .35) le example.b) are centeredaround zero.35).019.35). a 12-test can be used for the TxR2 version of the test. Alternatively. .br) + (92. 9. leading us to reject the null hypothesis of autocorrelation.becausein (9.bt) and r9z . When estimating the regressionsin (9.involving higher order lags such as !t-2. The resultschangevery little if the first observationis omitted instead. -distribution is 3._1 I i1 (e.Bothyieldthesame test result-the samecoefficient estimate for 21-1and the same /-value. The other is to omit the first observation.from least squares estimation of (9. These are models containing both lagged explanatory variables and lagged . the first-order autoregressive model.7 we study a class of models known as autoregressive distributed lag (ARDL) models.In our calculationswe set2n : 0.35) we are estimating(Pi .21) that war (9.b2) insteadof B1 and 92. thenLM : TxR2 hasan approximate 1f. or.To test for more complicated autocorrelationstructures. In as Section 9. The simple regression model with AR(l) error was expressed a model with a lagged explanatoryvariable and a laggeddependentvariable.474 fhe 5Vocritical value from a 1f. An F-test can be usedto testthe relevance of their inclusion. The estimatesfor the intercept and the coefficient of x. it is important that you appreciatethat some of the things that we have covered have wider applicability.3-3 0 is to regress.34) or (9. if (9. The degreesoffreedom for the X2-testand the numerator degreesoffreedom for the Ftest is the number of lagged residuals that are included. respectively. Further variations and generalizationsof the Ltr[ test are available.bz)x. and so on. : (h .35).34)or(9. through lagged values ofthe dependentvariable.onecanestimate(9. Two ways of overcoming this lack of knowledge are often employed.16101 5. However. You should note the tollowing: 1.Our focus >ofar has been on a particular model for a lagged error term.34) ot (9. !t-3.474.br) and (B2 . however.84. we can reject Hs by examining the p-value for LvI :5.35). : lr * ^lzxt I p?.4.35).b1 and ^yz: 9z . We have beenconcernedwith testing for autocorrelationinvolving only one lagged ertot !7-1. If H(): p : 0 is true. The auxiliary regression from *'hich the TxR' version of the LM test is obtained is (9. p\.34t In the introduction to this chapter we indicated that we would consider three ways of introducing lags into a regressionequation-through the error term. which is 0. For the sugarcaneexample : LM : TxR" : 34x0.. +A N I N T R O D U C T I O N TO FORECASTING 243 Rearrangingthis equation yields -r ?. When testing for autocorrelation by testing the significanceofthecoefficientof 2t-t. that power will come from 2r-1.b2. will be different.35) is a regressionwith significant explanatory power.. n'here "y1: Pr ._t I i.and through laggedvaluesofthe explanatoryvariables.3 REcnpprNc eNl LooxrNG FoRvARD n a generalsetoi n more advanced Ieneral principle t (9. using the first observation (r : 1) requiresknowledge of 2o.-distributionwhereZand R? are the sample size and goodness-of-fitstatistic. and rpothesis of no bewritten asthe s and R2 is the evant auxilian equation from (9. Because(Br . 2.

6 is useful for estimating the impact of a change in an explanatory variable..The finite distributedlag model discussedin Section 9. the AR(l) enor model can be viewed as a specialcaseARDL dependent variables. AND FORECASTING Thus.when (9. AUTOCORRELATION. investment strategies. Notice that there are no explanatory variables in (9. DL. In general. depends only on a history ofits pastvaluesandno x's.z * "' I Qryl-o *v1 Recall from APPen . the . dependson its valuesin the lastp periodsand a random error that is assumedto have a zero mean. Recall . Thus. that for lag u :utocorrelations .hangein the logarit :r'rmsof percentag :ie changein the lol 169. Finally.and find forecaststandarderrors and forecastintervals. estimate ::fferent from zer The estimated riF|t'r. In this section we give (AR) a brief introduction to forecastingusing one classof models known as autoregressive models. a constantvariance and be uncorrelated over time. The order of the model p is equal to the largest lag of y on the right side of the equation.02 (9. Before we formally introduce ARDL models in Section 9. The model relies on correlations between values of the variable over time to help produce a forecast. eriablecan elimin :rough laggedY's \ simple model w :re may not wanl .iS ('. you will find that there are whole books and coursesthat are devoted to the various aspects of forecasting-methods and models for forecasting.36). In this context.re not significant . The AR model discussed Section9. What needsto be emphasizedis that the correlogram and the Lagrange multiplier test.36)is usedfor forecasting.. and practical examples. we are using the current and past values of a variable to forecast its future value. In the earlier sectionsof this chapter we were concemedwith an AR(l) error model !t : p!t-r * vr and its implications for estimating B1 and B2 in the regressionmodel )r : Fr I 9zx. Because of its importance. :. ileving threelagsI used bservations ot -nderstandhow ::at observation . we discussAR models (that contain laggedvaluesofthe dependentvariable) in Section9. Also. are valid testing proceduresin more general models. it was a convenientone for introducing testsfor autocorrelation in the errors.5 and finite distributed lag models (that contain lagged values of the explanatory variable) in Section 9. denotedas AR(p). and ARDL).'luding distant -omplicatethe m To seehow the :or 3 months into -rse where P : .) (0. Accurate forecastsare important for decision making on government economic policy. The value ofy. The correlogram and the Lagrange multiplier test are appropriate proceduresfor doing so. as you read through the next three sectionskeep in mind the two generalreasons for estimating dynamic relationships:(1) To forecastfuture values of a dependentvariable and (2) to trace out the time path of the effect of a changein an explanatoryvariable on a dependentvariable. and a multitude of other things that affect our everyday lives. * e1.5 An Introduction to Forecasting: Autoregressive Models The forecasting of values of economic variables is a major activity for many institutions including firms. ways of evaluating forecasts and their reliability.the AR classof modelshas wider applicability than its use for modelingdynamic error terms. banks.7.you comPute It-L -.However. is given by /r : E * 0rlr-r * 0z!.The data are s To use an AR m' What tec -r r9. The AR(l) error model was not only a convenientmodel for leading into a discussionof more general ARDL models.ritablep.and individuals.l In (9. _ | 9.It is alsousedfor modelingobserved valuesof a time series y.36). model.37) the e :'r el.re significant bu r. it is important to test for autocorrelation in the errors. In all these types of models (AR. Supposethat it is :rte for each of the :ronthly observatiot Then. The more general ARDL model is used for forecasting and estimating multiplier effects.an autoregressive model of orderp. here we are concernedwith delay and interim multipliers.Jdition.:0.the supply of goods to retailers. governments.hservations n are ::om/:p+l.244 DYNAMIC MODELS. ARDL models can capture very flexible dynamic relationships.36) In this model the current value of a variabley.umberof lags P? :i\cussion in Secti isged valuesof th :roblem.5 is useful for forecastingand so in the discussionin that sectionconcentrates the important ingredientsof forecasting-hori on to forecast. designed for picking up correlated enors.6.

The residual correlogram for autocorrelationsup to lag24 appears Figure 9.2179INFLNT-z -t o. Thus. In (9. that for lag 3 is significant at a lOVosignificance level.5 and atory variable) in portant to test for rultiplier test are 'o generalreasons ependentvariable :ory variable on a orecastingand so brecasting-hos ite distributed lag 'a changein an ipliers. the next step is to estimatethe model in (9.CASTING 9. ways of sectionwe give regressive(AR r (1) error model :gressionmodel ility than its use l of a time series given by (9. The estimated AR model for the inflation rate. we ue. do so we multiply the changein logarithms by 100.5.36) can be estimatedusing least squares.For all observationsto be available for estimation. Most of the estimatedautocorrelations in arenot significantly different from zero. following the line of discussion Section9. Most software automatically makes this adjustment. one may not want to be concerned about eliminating autocorrelations at long lags. 269.5 AN INTRODUCTION TO FORECASTING 245 pecial caseARDL . it is conventionalto expressratesofchange in in terms of percentages. To seehow the estimatedAR(3) model in (9.3.5 that the rate of changein a variable can be approximatedby a .37). Il. To use an AR model to forecast the inflation rate. the number of observationsused in estimation is reduced by three from 269 to 266. It was decided that including distant lags to eliminate theserelatively small correlations would unnecessarill' complicate the model. : lln(CPI1) ln(CPI. The model iuce a forecast. as follows CPIt . In addition. The more fects. on Then. we begin by rewriting the more generalmodel in (9. with p :3.061s) (0. u'e in Section9.02s3)(0. you compute values of the inflation rate y.) Jx f OO ( = x 100 cPIt_l ) rany institutions re important for s.3. in Having lagged values ofthe dependentvariable as our explanatory variable does not present any problem.37) can be usedto forecastthe inflation rate tor 3 months into the future. inflation rate for each of the next 3 months. Recall from Section 9.38) . equation(9.S. 13. These presample observations not available.3733INFrN1-1 + o37\ (0.dat.37) the estimatedcoefficientsat lags I and2 are significantat a l7c significance level. and that you are interestedin forecasting the U. nto a discussion oi ts for autocorrelaand the Lagrange ing proceduresin r Section 9.0613) Having three lags meansthat the equationis estimatedfor t : 4.6. .lationships. There are also other issues.36t .namely 169.3 that including lagged values of the dependent r ariable can eliminate autocorrelationin the errors. then.r883 0. estimates of the coefficients can be checked to see if they are significantly different from zero. Defining y1 as to the changein the log of the CP1meansthe number of observationson y1is one less.You will discover that observations are needed for lNFtNo.Also. . What technique should be usedto estimatethis model? How do we decide on the number of lags p? Providing the errors vr are uncorrelated. To find past data on the inflation rate you collect 270 monthly observations the consumerprice index (CP1)from December 1983 to May 2006. be uncorrelated provides one way of selecting a suitable p.rol3INFLNy4 0. INFLN-b and INFLN 2. is given by IfFr.p periodsand a re uncorrelated ight side of the e ofy." try substitutingt : I into (9.36).-hange the logarithm ofthat variable. Recall from Appendix A.3. Because lhat are devoted asting. There are significant but not large autocorrelationsat lags 6. To ensure you understandhow are observations "lost. the requirement that v.0. Thus. Supposethat it is May 2006. one way to proceedis to include enough lagged y's to eliminate autocorrelation. . we begin are t-romr: p + I.064s) (0. The data are stored in the file inflation.with thosefor the early lags being negligible. depends Forecasting.36) for the casewherep:3 Yr : E + 0]tq -l 9z!t-z *9zYt-z * vt (e. A simple model with fewer lags is preferred to a complicated one with many lags.7. Also. . however.: ('") . and 14.4. the supply of y lives.CPII_ r \ y.

2 Fort \lonth I 0.2 -0.2487 uz: ( For three Periods al u3: Becausethe v.39t There is an important difference in the way the forecasts!111 and j7a2 areobtained.Thus I Yr+t: D* OrYr 0zYr-rI 9zYr-z* vr+r andthe forecast this valuegivenby the estimated of is equation 9 r + r : 6 + O r y r* } z y r .and for forecastsfurther into the future.we have jr+z :6 + 0r!r*r -t Tzyr * 0:yr-r : 0 .we replace yr+t by its forecast!.rt : (6 .we canobtainthe equation that generates !7a2.0. th . time subscriptsappropriately.1 U.2602 Moving to the forecast for two months ahead. How are they obtained? The forecast error at time Z * I is ut : yr-t . 1 8 8 3 0 . However. 2 6 0.2 . 4 4 6* 0 . 0 2 0 3 )a n dt . The forecastsobtained for 3 months into the future are given in Table 9. 5 9 8 8 2 8 * :0.I .7*1 and the correspondingrealized value yz+l can be attributedto the differencebetweenthe actualcoefficientsand the estimatedcoefficientsand The standarderrot 6 . 3 7 3 3 x 0 .S) + (0r .*1.38). 1 0 1 3 x 0 .42).4 0.4 t0 12 14 16 r8 20 22 24 Lag FrcuRE 9. 2 1 7 9 x 0 . \ u g 0 6( i : 3 ) a -0. 4 4 6 . J u l0 6 ( 7 : / .0 .t I } z y r .2 are standarderrors for the forecast errors and 95Voforecast intervals. 3 5 1 0 8 8 * :0. For forecastingy713. 5 9 8+ 0 .because!7a2 possibleto calculate on depends on )r+ r .1.'s a ionvenient for deri tnd (9. 3 7 3 3 x 0 .3 -0. along the linr chapters. 2 1 7 9 x 0 .6 for Conelogram leastsquares residuals from AR(3)modelfor inflation.39).0 . rheunpredictablera \\ e were forecasting to ignore the enor fr' rs large relative to torecasterrorsfrom rheerrorfromestimi I month ahead as Now suppose haveobservedthe last sampleobservationy1 and we wish to forecasty1.246 DYNAMIC MODELS.}t)yr-. all values for the lagged y's are forecastsobtained for earlier periods.in large s The difference betweenthe forecastj. This equation is For 2 months ahead not only v112.but al .z : 0 .1 4.3 0.2. + (02 .U F rll-trl ll-rrlt-.)y. we hav (9.ide of (9. we y711by changingthe and!7a3. 'i: Table 9 . Using (9. AUTOCORRELATION. AND FORECASTING 0. rel The AR model rariable can be ur popular model. the forecastsfor both J712 and yr+l are neededon the right side ofthe equation. 1 8 8 3 0 . It is j7a1 usingonly pastobservations y.r 'lr I 0 Jun 6(i: 1.Or)yr-t + (0: . Also appearingin Table 9. 1 0 1 3 x 0 . are comPuted fror as negative well as rhe forecaststand into the future.2. 0 r ..i. which is unobservedat time ?l on the right side of the equationfor j. -t v7-1 Then.

0.43) with t.8 when .gts. (9.It i. we replacr' t7'r2 and )i"11 arc (e. the .248'/ 0.Thus. nd (9.2 05 1 l 0 .1972 0.The forecastintervals 6. and 03. . * vr+r r'aluelr+l canbe J coefficients and at The standard errors in Table9.Notice how as and the widths of the intervals increaseas we forecast further rhe forecast standarderrors into the future.96961. when examining errors.1282.1.02. : to.: and95Vo foreca:l ir)vr-.2 Forecasts and Forecast Intervals for Inflation Rate Forecast Standarderror of tbrecast enor (o7) Forecast interval .3510 Becausethe v1's are uncorrelated.In Appendix 9D we examine another popularmodel.0 . 6 6 3 3 ) 0 (-0. ause!712 depend.42). sts obtained for . evaluated the coefficientestimates deviationestimate : 0. 2 1I (-0. standard 6.:q ol : var(ut): "3 ol : var(uz): + o?) "3(t : o! : var(4) 10r)'+ 0? t] + "?[(o? Then.all value. 01.969 j) G + \lonth ir+i 0r*.43) : future.expressingthe forecast errors in terms of them is From (9.o 1) are obtained. 4. 02.+0) ish to forecast _yr_ bychangingtl^7"11 we For 2 monthsaheadthe forecasterror getsmore complicatedbecause haveto allow fbr that occursfrom using!7a1 insteadof )r+ r on the right rot only v712. we have ).tro 1' !r.40).6854) rr inflation.41).1r+1 1.y r + r ) * v r + z : 0 1 4 1 * v r + 2: 0 t v r + t I v r + z For three neriods aheadthe error can be shown to be uz : 0fl2 I 02u1 vr+z: (0i + 0z)rr*r I 01v7a2 vr+z * I (9.5988 (9. . the exponentialsmoothingmodel.2602 0. :\ large relative to the variancesof the estimatedcoefficientsand so.along the lines of confidenceintervals that were constructedfor parametersin earlier .969.What we aregoing to do differentlynow is usingthe regression of the Usually the variance therandomerror :o ignorethe errorfrom estimating coefficients.1 A :heunpredictable randomelror v711.42) tx0. month aheadas ul : vT+l (9.6485) ( .ECASTI NG 9 5 A\ I\TI{OI)UC-TION TO FORECASTING 247 TabIe 9. The wide intervals that include are that negative well aspositivevaluessuggest the forecasts not very reliable. reflectingthe additionaluncertaintyfrom doing so.it is commonto ignore :orecast errorsfrom AR models.39). 16 5 8 .\e wereforecasting model. the forecasterror for two periods aheadis u z : 0 t ( ) r * ' . for :onvenientfor deriving expressions the forecastenor variances.andcomputingtheir standard errorfor Doing so meanswe canwrite the forecast :heenor from estimating coefficients.2697 0. l u n0 6 ( 1 : l ) iut 06 (j : /1 \ug 06(7: 3) 0.0.2 &re01.butalsofor the error ..r jr+2. 1-t t.41) \9.e3) anAthe error rre computedfrom (9.1972.-hapters. modelswherethe history of a The AR model is just one of a largenumberof forecasting r ariable can be used to forecastits future values. large samplesa 95Vo confidenceinterval for a forecast of yr+j is given by in (!r '1 .zaz):1.ide of (9.1460. similar situationarosein Sections and 6. .

Irrespective of the line of reasoning.-qlv.*Fr.the total effect in period t * I will be 9o + B1.248 DYNAMIC MODELS. when the growth of wages is held constant in other periods.U.): 0. is the s-period delayedeffect of a changein x. there will be a BrVoincreasein the inflation rate in period r * s.. then the econometricmodel for thi: relationship can be written as yt :d. It is called a finite distributed lag model because it is assumed that after a finite number of periods q. it takes time for wage changes to impact on inflation.3 Variable Constant Leas i.. ignoring the error term. the immediate effect will be an increase inyr by Beunits. fable 9. an issue are we also encountered the AR model of the previous section. up to periodr * 4 whenyr*n will increase Buunits. v. These quantities are called interim multipliers.. for Equation (9.6 Finite Distributed Lags model to investigatehou In the previoussectionwe usedthe framework of an autoregressive the past history ofthe inflation rate can be used to forecast future inflation rates. is increasedby 1 unit (l%oin our example).S. where we assumethat E(v.Oneperiodlatery. oE(_y. estimates .r'ed to forecast the T 0 1 2 J .. For example.in period t + z. Then. on expected current inflation. ..In by by period r * q -l I the value of y will return to its original level. We add together the effects from the changesin all proceeding periods. be the inflation rate and let-r. and ire uncorTelated o.:.44) is called a distributed lag model becausethe effect of changesin.7 (9. AND FORECASTING 9. B. That is. that also pushes up prices. If we assumea linear relationshipbetweenthe inflation rate and the rate of changein wages. is distributed over time. 'thereWAGEris the i 're for the U. ue turn to a different question. AUTOCORRELATION. . the two-period interim multiplier ir (Bo + 9r + Br). then only Z . ecor Allowing for a 3-r Yluaresestimatesrel immediate increa .lead Finite distributed :stimated equationtr :nknown. &-4. supposethat x and y have been constantfor at leastthe last q periods and that x.:nbiased Constructionof the d ' timilar way.. In this casethe immediateimpact will againbe Fo.. and so on. l of Forestimation the. it maY be y.-z+ .r. . by will increase 92 units.rr-r l!zx.) : tt . we de xs: ln(WA.R Otr-" To appreciatefurther the interpretationof the lag weights B. (t + 2). If the rate of growth of wagesincreases 170in period r and by then returns to its original level.n l-month laggedincr ::npactsarefelt immt . The total multiplier is the final effect on y of the sustainedincrease after q or more periods have elapsed.) : 0. Thus. . It measuresthe effect of past changesin the growth of wages Axl-.ignificantly differet qultipliers are repor The interim multiPli :tier 3 months. +Qqx.andso on. be the rate of changein the wage rate in period r.. t : q*1. and then returned to its original level..-..*1will increase Bl units. lety. One way of modeling the impact of wage changeson inflation is through a finite distributed lag model To introduce the conceptof a finite distributed lag.r. It is also relevantto ask what happensifxr is increasedby I unit and then maintainedat its new level in subsequent periods (r + 1).the relationship between wage changesand inflation is unlikely to be a totalll instantaneousone. and a greater demand for goods and services. xt-2. The parameterct is the intercept and B.q complete observations are available for estimationsince 4 observations "lost" in the creationof xr-1. changes in r no longer have an impact on r. is called a distributed-lag weight or an s-period delay multiplier. :orecast with a con rclicy variable like .. var(vr) : o2.*90x.theny.and also that wage changesup to q monthsinto the pasthave an influenceon the current rate of inflation. On the demand side wage increasesmean greaterdisposableincome.Now.). Setting s : 0 yields what is called the impact multiplier Bs.. . andcov(v.it will be Bo * B1 f Fz.What impact do wage changeshaveon the inflation rate?On the supply side we expect wage increasesto increasethe costs of production and to drive up prices.it is given by I3:0F. If we have Zobservations on the pairs (yr..

1990 0.0487 0. it may be necessaryto independently predict thesevalues before proceeding to increasein the forecaststandarderror.-t)lxtoo(Y49!:--!4sE':l) = x.0495 0. 1 61 5 0.' u'hereWAGE.6 FINITE DISTRIBUTED LAGS 249 Ta b I e 9 .580 2..l6Vo. Enor Lag Model /-value p-value o investigatehou In rates.1990 .Now.In in a similar way.we setq : 3 and computethe least vluares estimatesreportedin Table 9. l-month laggedincrease 0.0879 2. lead to an increase of 0. Constructionof the data seriesfor the inflation rate was discussed the previous section. 1 51 6 0.0495 0.t or an s-period wages A-r1_.itwill be Lall proceeding the two-period !'ecton y of the =09.5l%oin the inflation rate.IlVo.Valuesofx are usedin the estimatedequationto forecastfuture valuesofy.0851 0.05Vo. Table 9. and a greater re of the line of :ly to be a totally ion.1219 0 .) wAGEt_t \ x r00 / ve have Zobserre available for .3131 0.2636 0.4 alongsidethe correspondinginterim multipliers.5t21 0 I z 0 . ue ltion rate?On the n and to drive up me. The biggest impactsarefelt immediately and after a 3 month lag. xt-q. The dataused for estimation are in the file inflation.In . on n other periods.013 0. is .The data we use are for the U.t64 1.1075 0. our nmediate effect Lunits. Providing the errorsy. and y have been Ln example).207 0.Also. are uncorrelated and homoskedastic. a in a of l-month lagged increaseof O. We find that al%o increasein wage growth leadsto an immediateincrease the inflation rate of O. with a consequent policy variable like the interest rate or the level of taxation.264 0.1561 0. t:_ I l:2 0. The lag weights for lags I and 2 arenot significantly different from zero at a l}Vo level of significance.3.S.eby Buunits. : rate and letx. The interim multipliers suggestthat a sustained increaseof l%oin the growth of wageswill.562 0..least squaresestimation of (9. One way of butedlag model.079 0. .then/r+: . if thex variableis a forecasty.264 0.ASTING 9.4 Multipliers for Inflation Exarnple Multipliers Lag Delay lnterim 0. Finite distributed lag models can also be usedfor forecasting.is the averagehourly eamings ($/hour) in private industries.0885 0. be Lship betweenthe r to 4 monthsinro ric model for this \ariable Constant f.505 t.024 Forestimationof the lag weight coefficients. . and a 3-month lagged increaseof 0. economy from January 1984 to May 2006.2OVo.44) yields best linear unbiasedestimatesof a and the B. Becausefuture valuesofx will generallybe unknown.The lag-weights or delay multipliers are reported again in Table 9.: ltn(WAGE. is the s-period zo period I and in rn rate in period naintainedat its mediate impact t + 2.dat. after 3 months. an issue fchangesin r. we denote the percentagerate of change in wages as '"rT (9. 3 Least Squares Estirnates for Finite Distributed Coefficient Std. a distributed lag model can be usedto forecast the effects of different policies.we can useleastsquares.44t -In(WAGE. Allowing for a 3-month lag for our inflation example.1075 0.e it is assumed an impact on r.0853 0.

. It still containsa finite number (4) of laggedxr's.it can t'< shown that an ARDL model can be transformedinto one with laggedxr's going back to the infinite past ifm.0989 se) (0.r.DYNAMIC MODELS.q l 0 r l r . withp lags of y and q lags of r.-t* "' * et :cr.y. . Becauseit doesnot have a finite cutoffpoint. .. and (iii) a modr with lagged values of an explanatory variable. laggedyr's. (ii) a forecastingmodel with laggedvaluesof y. We expect the effect of a change to gradually die out in which case the values of B" for large s will be small and decreasing.0468 +0.r * "'l|pyt-plvt (9.'' covered.'s (9.3) is given in Figure 9.:0. this model is called an infinite distributed lag model. but it is possiblethat wage rate changeshave a: impact on inflation beyond 3 months. and lagged valuesofr although we did seehow the AR(1) error model could be conveniently transformedinto : model that includes y6-1&ndx.1: ( ( ( rl E ol u_1 Cone \s an alternative.and to ask where improvementsareneeded. q) model can hc written as rcuRE9.'s an. (the AR(p) model). A secondpotential problem with a finite distributed lag model that can be correctedbr using an ARDL model is that of autocorrelatederrors.+ " ' + 6 q x .ignificant correlat .7.rherex1 : PCWA( :re two lags of the dr .7 Astoregressive Distributed Lag Models It is useful at this point to stop and think about what we have coveredand what we have n.-15 overcomesthat problem. Like before.However. In the inflation example we chosee : 3. Estimatesfor a for the lag weights B" can be found from estimatesof the 6. is the distributed lag weight or the s-period delal multiplier showing the effect of a change in r.7 1 ) r : 6 * 6 6 x 1 f E 1 x 1 . the point in the pastbeyond which it is assumedchangesin -xno longer have an impact o: y..*Ip"xr-"*e. s:0 (9.i inflation is distr )r:6 Then. the parameter B. in the finite distributed lag model is not a reasonableone. c< As we will discover.45).236 (0.082 * lt : a* 9ox. In its generalform.46. The precise in relationshipbetweenthem dependson the valuesforp and 4.rlue and three lagl .We have seenhow the dynamic aspec'-. is I3og.we return to the inflation example.the co The next questic lag Jistributed weil . how a changein xr has multiplier effects over a number of time periods).using the res :he first five lag w 0 B F F e r .The inclusion of lagged valuesof the dependentvariable can serve to eliminate such correlation. AUTOCORRELATION.i ere these values I :hoosing p and q. In the finite distributed lag model it is necessary choosea value fo: to 4. AND FORECASTING 9.timates fot PCW :'r el. the ARDL model overcomestwo potential problems with the finitr distributed lag model. property that is necessary the infinite sum lp6B" to be finite. an ARDL(p. To make theseideasconcrete. of modelingtime-series datacanleadto (i) amodel with a laggederrorterm(theAR(1) enir model). These results suggest that the assumption of uncorrelated errors v. What we have n. (a finite distributed lag model that shori. and there are several correlations at longer lags that are marginally significant. An autoregressive distributed lag (ARDL) model is one that containsboth laggedx. The relatively large autocorrelationat lag I is significantly different from zero at a 57o significance level..* 9rxr-r * 9zxt-z 9zx.'s and 07. on y11".The total or long run multiplier showing the long-run effect of a sustainedchangein x.ignificant).ignificant and whe r. At first glance it is not clear how the model in (9.': coveredexplicitly is a model that containsboth lagged values ofx. but thosefor I :eiained the curren --onelogramfor the .The correlogramfor the residualsfrom the finite distributed lag model (whoseestimatesappearin Table 9.

: 0t0z+ 02Bt 63: 0..0734 .o.gedvaluesof _r.197 I NFlN t-z (0. Then.0834) P E IN 6 + 0.0604) (0.2361 CWAG t-z + 0.lL4g PCWAGET +0.0812) (0. The precise recorrected by d valuesofthe :logramforthe le 9.2434 0o:0r0.0593 (0. we have y.11 0r : 0t0o+ 81: 0.+or9r:0. : 6 + 6oxr* 6txr-r 1624-2 * 6311-3 0r)r-r * 0z!..usingthe resultsin equation(9C.1149 : x0.3 4. We havenevertheless ore retained the current and early lags of PCWAGE.0468) (0.0784 + : 0.3 0. INFINI-1. given its clear importance at lag 3.2.0 u -o. Two things to consider are whether the estimated coefficients are significant and whether the resulting residuals are uncorrelated.45r )wever.3) is given rent from zero lags that are related errors wherexl : PCWAGL is the percentagechangein wages.47) in terms of its coefficients.45t 0.7 AUTOREGRESSIVE ISTRIBUTED LAG MODELS D 251 tvhatwe have not dynamic aspect-s r(theAR(l)enor and(iii) a model nodel that shou s fhat we have nor .47) (e.-3.4 2 4 6 8 101214 1618202224 for .-2 are significant at a 57o significance level.082e) (0.7 (9.47) the coefficient estimatesfor PCWAGE.6)of Appendix 9C.46) are : Bo: Eo0.3) model s with the finite toosea value for Lve impact on an :hangeshave an model in (9.0..The settingp : 2 implies there aretwo lags of the dependentvariableINFLI/while the settingq : 3 meansthat the current value and three lagged values of PCWAGE appearon the right side of the equation.finitedisributed model. Writing (9. :0t0t + 0t0o E20'0643 + 0.1 F 0.47).46t listributed lag s-period delal run multiplier t the effect of a I be small and :.0812) (0.3536 FLNt. The next question to addressis the implications of the estimatedmodel in (9.0989 ('e) PCWAGET-z +O. the correlogram does not suggestthe residuals are autocorrelated."rioultTr. Estimatesfor i). rnsformed into a h lagged-4'sand 4) model can be r:TGUrrE 9. lag Correlogram leastsquares As an alternative.:0.andPCWAG&-2 not. and INFLN.1+ 0.l J't ) -0.3536 49+ 0.ASTING 9.In (9. How nere these values for p and q chosen? In general there is no one unambiguous way of choosing p and q.butthosefor PCWAGE.it can be ring back to the lfrFfr. consider the following least squaresestimated ARDL(2.r . PCWAGET-1.0604) (e.0377 0.-z * vt * from (9.andthe estimates the first five lag weights for the infinite distributed lag representationin (9.2 c '5 0.47) for the distributedlag weights that describehow the impact of a changein the wage rate on the rate of inflation is distributed over time.0377 PCWAGE.8. With the exception of a few marginally significant correlations at long lags (correlations that are relatively small despite being significant). The correlogramfor the residualsappearsin Figure 9.

any dynamic modelir.Thesemodelscan alsotr usedfor forecastingalong the lines describedfor pure autoregressive models in Section9.10 0.4 0.j With respectto a general modeling strategy. finite distributed lag models.o 4.252 DYNAMIC MODELS.- rrcunr 9.8 1012141618202224 LaE Correlogram leastsquares for residuals from autoregressive lag distributed mode.3 0.8 Ex er 1. an: in 7. Consi 0.E 9. J 0. T I where var(e.2 nl .1 Pnor lr Consic * o. There are other important issues to be considerea however.53V0. after which the weights are close to zero indicating that there is little effect on inflaricr after 7 months.IlIl. A grap: of the first l2 weights appears Figure 9.2 -0.9. 9 Distributed lag weights for autoregressivedistributed lag model. exerciseshouldnot focus on one of the more restrictive classes modelswithout giving drr of consideration to an ARDL model.05 01234567891011t2 Lag Let ?1 equat r r cu nx 9 . Our focus in this sectionhasbeen on the use of autoregressive distributed lag models frr modeling the laggedeffect of a changein one variable on another. . AUTOCORRELATION.4 r rrrll.3 4.and AR error models. t The fo The weightsdecrease first. The sum of the lag weights giving the total impact of a l%ochange in t}.20 0.becauseARDL models are more generi than AR models. increaseatlag3. andthendecline.05 0. These will become apparentin Chapter 12. 2 4 6 8 Also. 1 0. 6.suggesting a change at :: that the growth of wages has its largest effect on the inflation rate after a 3-month lag.8.c growth of wageson inflation is 0.1 I Ih.15 oo where expen Surve .28 (a) Us (b) Te di.25 o. There is a small negativeeffect at lags 5.00 -o.lll a -0. AND FORECASTING 0.

) o. lag 9.e11) (0. .r rt : --i\e2_2 . show that rtributed model.2) (e.the following least squaresregressionwas estimated DISPT:-388 + 24.8DUR. i are more general lynamic modeling without giving due to be considered.03 1.201) (9.:. where E(v. ('") (rr2) (r.02 (a) Use a hand calculator to compute the sample autocorrelations I T 22ft. Given that var(e.8 Exercises 9.17 78910 -0.31 -0.49) .t l 12: LOt0t-z T L el-z t-a (b) Test whether (i) rr is significantly different from zero and (ii) 12is significantly different from zero.2* ng that a changein nonth lag.l. Provethat var(e1-1) and E(v1v. 4 : 16.37 -0. 0. 6. and effect on inflation IVa cbangeinthe rtedlag models for nodelscan alsobe lels in Section9.1 PnonrsMs 9.8. Also. Consider the following estimated equation t2 l.165 ('") (0.0. E(ep1-) : slp .39 -0.5.CASTING 9. var(v1) : o3.2) : o?p' l0: The following least squaresresiduals come from a sample of size T : 1123456 e.03 -0.09 0.8 EXERCISES 253 9.Using 26 annual observationsfrom the Department of Commerce's Survey of Current Business.) :0.l94DURt * 0.03 0.o? p2 and E(ep.6.48) Let 21 denote the residuals from this equation.28 -0.1 Consider AR(l) errormodel the et:Pet-r+vt :o7. A graph ectat lags5.):0 for t f s.l Consider the model DISp:gt*gzDUR*e where DISP representsfactory shipments of disposers and DUR is durable goods expenditures.42821-1 R2 : 0.

5x Considerthe model Yt : 9t * \zxt I et et : pet-l + vt Using mon (DIP) for t model was 6iP. (b) Suppose abovemodel is appliedto the sugarcane the examplein this chapter. a Zr : ln(Ar). the estimatefor p in (9.3. Comment on the difference between your answersfor parts (a) and (b).2. . find forecasts for e7a1 and e7:.5.t : 1.and given 6. (c) Using Z1 from part (b). : 6 + 6:tr-: * 0tlr-t * 9zlt-z * 9zlt z I vt lr (a) Estima the res (b) Foreca Ur+l' . .4.l0 and assum (a) Use th Constr (b) Use an about confidr (c) Reesti new 9i relatio this mr As an alter I8"". (ii) the correlation between e1 and es-4.:0. Z What formula you use to forecast would (1) er*t (11) e7p Ifinf.findforecasts forln(A711) andln(A7. AUTOCORRELATION. Note that Zrefers to the last sample observation.6 Consider the infinite lag representation . l t: a+ s:0 for the ARDL model y.49) to conduct two separatetests for first-order autoregressiveerrors.2.2).4DU& ('") (200) (2. (a) Usethi (Value DIPr-t (b) Find 9 S* Using the e representa that shows distributior 9-8.25). AND FORECASTING (a) Use the results from (9..Use equation (9.2 .' Review Section 9.201) : Show that What effect doesignoring autocorrelationhave on inferencesabout the relationship between disposer shipmentsand durable goods expenditure? 9.0r .2.? (b) Repeatpart (a) with p : 0.25) to find To investip rate (U).+ r . 9.254 DYNAMIC MODELS.4 Consider the model et:pet]+vt (a) Supposep : 0. (d) AssuminEPr+t : 1 and Pr+z: l..6) et :0. (e) In light of the discussion Section4.9 andol: 1. (b) The model with AR(l) errors was estimated as : DISPT -343 + 24.2854. (a) Suppose (unrealistically) thatyou can observe !1.: s. . . 9.. and the formulas you gave in part (a). suggest in two alternative forecastsfor 4711 and A7p.92mlrr.9* Coupur with the usual assumptionsabout vr.419et-t I vt (0. What is (i) the correlation between !1x\d e1-y.4 and o? : l. (iii) the vananceof.

2 CornrpurrnExnRcrsns . for Constructa95Vo confidence interval for 82.8.t + 0.28). (b) Forecast ln("/lf for two periods beyond the sample observations. are DIPT-2: 1.200D1P. DIPT-1: 1.what can you say about the original assumptionsfor the error et: what can you say about the confidenceinterval for B2 found in (a)? (c) Reestimate model assuming errorsfollow an AR(1) error model.221. (a) Use the data in the file vacan.particularly in relation to your answersfor part (a).Comment this and I1e: on the result.-3 o" :0.109 + 0. Comment on this lag distribution." To investigate relationshipbetweenjob vacancies("tV)and the unemployment the rate (U). index of industrialproduction on in (DIP) for the period January1985to December2005. (b) Use an LM testto test for AR(l) errors. respectively. 1e.find the first six lag weightsof the infinite la. . a researcher setsup the model ln(JV): 9r * B2ln(U.006andDIPT: 1. considerthe relationship ln(JV1): 6 -f 6o1n(U1) 61ln(u'-r) + erm(r%-r) * v.s in representation m lt:a* s:0 IB"x.-. (Values for October. 154. suggest tu t. Z What formulr . fferencebetween \ : Using the estimates equation(9.datto find least squares estimates B1 and B2. and assumes that the er are independent N(0. + (a) Estimate relationship testthehypothesis 61 : -0r60. Usc tulas you gave in r) and ln(A712 r.Assume Ur+t : Ur+z: 5 .) (b) Find 95Voconfidenceintervals for your forecasts.S.]ASTING 9..) -t e1 this chapter. Does the correlogramfor the residualsfrom this model show any evidenceof autocorrelation? () As an alternativeto the model in Exercise9. February. andMarch 2006.8 EXERCISES )ia r first-orderauto- Show that 9o:Br:92:0 F::E: 9+: or9: Ps:or9+*0z9r * F.236DIPFz-t 0.In light of this result. that showsthe effect of laggedprices on areasown to sugarcane. Find a the the new 95Voconfidenceinterval for B2 and comment on the results. the following autoregressive model was estimated 5D. 3 fors) 6 rt the relationship Using monthly observations changes the U. November and December. :0.041.4293 (a) Usethis estimated equationto forecastDIP for January. ol) random variables. : 0t9'-r * 029"-z 0:F.033DIPt.2005.9.

That is ln(A.3* B a l n ( P .Let the xr as the mor We are interr (a) Estimate (i) Cor eXPt the (ii) Tes wh (iii) Doe (b) Estimate (i) Cor (ii) Use 12 If cts ) 0 and crl < 0.(Continue to assumethe leasr squaresstatistical assumptionsare appropriate.instead. Under what assumptions theseestimatesappropriate?What do the are least squaresestimatessuggestis the profit maximizing level of output? (d) After rounding the optimizing output to an integer. total cost (IC) and output (Q). l3 (c) Create tl (d) Usethe e on them priori ex (e) How do earlier? Thefile hous starts(in thor 2005. 9.Supposethat the monopolist'. (b) You will havediscoveredthat the lag weights obtainedin part (a) arenot sensible One way to try and overcome this problem is to insist that the weights lie on a straight line 9i:cr0*ari i:0. predict total revenue. AND FORECASTING 9 . examplein Sections that farmers'decision. theseweights will decline implying farmersplace a larger weight on more recent prices when forming their expectations.+ ) + e . .dat to estimate this model.1-9.12 In the sugarcane 9. reestimatethe by equationsassumingAR(l) enors. (g) What is the profit maximizing level of output suggestedby the results in part (0? (h) Given the output level found in part (g). appearin the file monop.ot) (c) Use the least squares estimator to estimate the total revenue and total cosr functions.) : ct * Bsln(P. Suppose.Compare the predictions with those from part (d). 1 Data for a monopolist'stotal revenue(ZR).that expectationsabour future price dependnotjust on current price but also on prices over the last 4 years. What are the estimated delay and interim multipliers? Comment on the results. Substitute Con (iii) Dor (iv) For (v) For . (f) Where autocorrelationhas been suggested the testsin part (e).256 DYNAMIC MODELS. and henceprofit for the next 3 months.3.total cost. for aS l<) consecutive months.by TR:\rQ*92Q2 TC : at -l ooQ I utQz (a) Show that marginal cost and marginal revenue are given by MC : az -t 2a3Q MR : gr + zFzQ 9i:ao be writtr where Zto (b) Show that the profit maximizing quantity that equatesmarginal revenue and marginal cost is c-z-9t nr _ ' 2(92 .dat. economic models for total revenue and total cost are given.)* Blln(P1_1) B2ln(P1_2) * f B 3 l n ( P . andprofit for the next 3 months.total cost. AUTOCORRELATION.2.4 it was assumed about area sown dependon current price.usethat output to predict totai revenue.4 .) (e) Separatelytest the errors for each of the functions to seeif theseerrors might be autocorrelated.1. respectively. ) (a) Use the observationsin the file bangla. and the autocorrelation assumption.

February. and x1.-3) * ln(P.IR. Substitutc . : cro* crli and comment to on them. (a) Estimate the model )r : E * 6orr * 6rtr-r * 0rlr-r * ur (i) Comment on the results.-z I 03y14* v1 (i) Comment on the results.-r) -tln(P. Comment on the results. and March 2006. FIs the ^F11 What does the result of this test tell you? (iii) Does the residual correlogram suggestthat v.Compar: mers'decisionr lectationsabou: the last 4 year.-2) * ln(P. by Fi : cro+ crli into the original equationand henceshow that this equationcan be written as l n ( A .+".-a) (c) Create the variables Zroand e1 and find least squaresestimatesof as and a1.-t nal revenue anc s and total cor: ate?what do rhc of output? rt to predict tota assumethe lea--: : errors might fr ).8 EXERCISES 257 rtput (Q).ASTING 9.-016s against alternative : Dr I -0160.1) + nnlr' -.What are *x Its. (iii) Does the residual correlogram suggestthat v.rr as the monthly changesin HOUSE and IR.respectively. and . Are the signs of the coefficients in line with your expectations? testsof significanceon the estimatedcoefficients suggest Do the model is a reasonableone? (ii) Testthe hypothesis : 61 . ue not sensible veights lie on . Has the original problem been cured? Do the weights now satisfy a priori expectations? (e) How do the delay and interim multipliers compare with those obtained earlier? li The file housing.Define y.6 to find estimatesof the lag weights up to lag 12 for the infinite lag representation :1. (d) Use the estimatesfor as and cr1 find estimatesfor B.r. ): a * o s z 6 * a f t t * e t where z6:ln(Py) + ln(P.February.r7+ 3ln(P'-3) * 4ln(P. and March 2006..and 1R.-a) : 211 ln(P. are correlated? (b) Estimate the model )r : 6 * 63t1-3* 0r)'-r * \zy. That is lt: HOUSET HOUSETT xt: IRt .dat containsmonthly observationson new privately owned housing starts(in thousands)and the 30-year mortgagerate from January 1985 to December 2005. Let thesevariablesbe denotedby HOUSE. for 1r :he monopolist'' ctively. (v) Forecasthousing starts for January. rsplace a lar-se: ons. for January. )r:s1+ iB. reestimatetr y the results i: ion assumptior onths. are correlated? (iv) Forecasty.-. We are interested in the dynamic relationship between y. (ii) Use the result in Exercise 9.

insforming the mod -.) : 9r -t gzln(CUMPRODl) * e1 (a) Use an LM test to test whether the errors in this model are correlated. Considerthe model ln(Pow): 9r * $2t -t B3tz-t $atn(pRol) * e1 l.24).rd then rearrangeit 9r:at*61D1 where Dr is dummy variable that takesthe value I for the period I 985: I to I 999:I and is zero otherwise. (a) Estimatethe model using leastsquares. Doesthe test outcome depend which modelis estimated? on What canyou concludeaboutthe effectsot model misspecification on tests for structural change? 9.9 and the file learn. (d) What is the total multiplier estimated from the model in part (b)? 9. rrh an error term tha ::. Does autocorrelationappearto be a problem I (b) Estimatean ARDL model that also includes t andt" .dat.DYNAMIC MODELS.16 Reconsider Exercise 9.The model is In(UNITCOST. Comparethep-value of this testperformed on the model in part (a) witl: that from part (b).rear unbiasedestin There are two adt l.\'e have formed a ne . (b) For both modelsin part (a) testthe hypothesis Hs:61 : 0. (a) Estimate the model R O B .15.l8 The file cons disposablepe personalcons (a) Construct (b) Estimate (i) y' on (ii) z' on Explain y' (c) In each ce (i) the la (ii) the to Comment where / is a time trend. Comment.tributed(0. AUTOCORRELATION. in the United States.14 Consider the learning curve data and model given in Exercise 2.15 In the file mining. Because lagg were createdt But. and electric power use for mining (POW).15(a)and (b) assumingthat the Appendix 9A ''\'e are considering t )ur objective is to ':. (a) Re-estimate models in Exercise9. _ 1 s .dat are seasonally adjustedquarterly observations indices of on mining production (PRO).17* Thefilerobbery. AND FORECASTING APPEND 9.2 Does the residual correlogram from this model suggest that the errors are correlated? (b) Find 95%o confidenceintervals for the number of armed robberiesin November and December1975. U . (d) Suppose cumulativeproductionin year I 97 I is 3800. Commenton the signsof the estimateii coefficients and what they imply. equals 1. a itier defining the fo v * r' c&r rewrite (9A. ol). How many lagr did you use for UNITCOSfl For CUMPROD? Why? (c) Find estimates of the first five lag weights of the infinite lag representation Comment on theseestimates. we have . to apply least squ 'cgin with (9. . (b) Estimate an ARDL model relating UNITCOSTTo CUMPROD. How many lags of POITanc PRO did you include?Why? (c) Supposethat you wish to test the null hypothesisthat the coefficient of ln(PRO.Do you expectcostper that unit in l97l to be more or less than it was in 1970? 9.: 9 r * B z t* 0 R O B . wl .datcontainsmonthlydataonthenumberofarmedrobberies(ROB in Boston from January 1966 to October 1975.

. and real personalconsumptionof durables(DUR) for the period 1952Q1to 2006e1.Plzxt-r I vt end then rerlrrangeit to give lt .3) rt the errors are ies in November lVe have formed a new model with transformed variables yi.I ) new observations werecreatedbythe transformation.9 and the file 9.7. real personal consumption (CONS). r ith an error term thatis notthe correlateder. (c) In each case find estimatesfor (i) the lag weights for eight quarters. : [ln(CONSl). (eA.*t._1 x 100 )] (b) Estimate ARDL models for (i) y. Explain your choice of lags. xh. andxi. (ii) the total multiplier.. How many lags lag representation. and.*ir.in the United rs of the estimated r to be a problem:' Ly lags of POITand ficientof ln(PRO.Plt-lt ae can rewrite (9A. : lln(INC1). xh : 1 . however: 1. (a) Construct the rate of changevariables x. Wehavevalues (yi.p&-t. that we assumedto be listributed (0.2) as xlz: xt .-1)]x 100 7. Becauselagged valuesof y. . o3). correlated. per capita real disposable personal income (INC).ln(INC. but the uncorrelatedv. on xr. But.24).1) (e4.p (ROB lrobberies r Yi:xirBr rxiz9z1.e 2. There are two additional problems that we need to solve.S.\fier defining the following transformed variables i thetestoutcome bouttheeffects of yi : yt .ln(CONS.p) + gz(*. you expectcost per ions on indices of )W).2) l 1985:1 1999:3 to .v.*i). D. which is lt : 9t I 9zxt I PY. Comment on these results. and x.. We would expectapplicationof leastsquares (9A. .3.xlr) for t :2. we have no (yi.3) to yield the best to -inearunbiasedestimator for B1 and 82.CASTING APPENDIX 9A GENERALIZED LEAST SQUARES ESTIMATION .Ln(DUR.-1)lx 100 y.ri .r del in part (a) with Appendix 9A Generalized Least Squares Estirnation \\'e are considering the simple regressionmodel with AR(l) enors )r : 9t * \zxt * et et : Pet-l + vt t (bx I that Our objective is to obtain the generalized least squares estimator for B1 and B2 by ransforming the model so that it hasa new uncorrelatedhomoskedastic error term.. enabling is to apply least squaresto the transformed model. only (T .PFr .pxFt) + vt (eA. .plt_t: pr (l . : [ln(DUR.) .dat cor'tains quarterly observations on U. To specify the transformed model we -gin with (9. (ii) zr on x. importantly. had to be formed.18 The file consumption.

fy. The first observation the resression in model is yr : 9r I xr9z* er with error variancevar(e1) : o?: .p z) ( e1) :l .r: J.250 DYNAMIC MODELS. The value of the autoregressive depend on p.o' lfit: var "" We also requirethat ei be uncorrelated with (v2.: has the samevarianceas the errors (v2.r.l) observations. v7). reestimate which we then use again in (9A. . + t/r . The transformation that yields an err(: "?lQ varianceof ol is multiplicationby Jt . it:identical to the nonlinearleast squares estimatordescribedin Section9.least squares can be applied to (9A. What aboutthe problem of having (f .3. estimatesb1 and bl. where (9A. .p2). The transformedfirst observationr: (9A.This result will hold becau. . we usethesenew estimates B1and B2in (9A. an indicationthat 1 'ir1:lthend=( ::icldelerrors are col . and . (9A.Flg:P:0in .4) to estimatep. v3.4) canbe estimated Equations iteratively.f . . Th:..On convergence. or YT: xir 9r -t x\r$r '1. Alternatively. adoptedby the estimators haveconsidered we far. The result is 9..3). sometimesknown as the Prais-Winsten estimator.3) to reestimate and B2.-' y\: \[r ..v3.. w valut .i'the estimated . xir. vr). vz. . v7)..prr. . : Jt . .notetha: ( var(e:i ) (1. B1 iterative procedureis known as the Cochrane-Orcuttestimator.(9A.3) and(9A.g2x. + r/t . eachof the v1doesnot dependon any pastvaluesfor e. AUTOCORRELATION.i herethe 2.rmmation.9r .:etisticfor testing fc tf-t .5) can be used with the remaining transformedobservationsin (9A. .we needto createa transformederror th. The las :cspectively.1) can be rewritten as )r . .it is a reasonable strategy. Since yi.fh . After replacing B1 and B2 with the least square. we usep from (9A.Fr .ecause of the need Ecause its distributi . This procedure :._) I v1 Appendix 98 (9e. ".lzxt: p$r_r .1) insteadof Z transformed observations? On.tt. rriable.4. That is the strategy . p. that It is assumed :rat the alternativeh' l-he statisticusedto .2. way to solve this problem is to ignoreit and to proceedwith estimationon the basisof th.. .f*rg.2...4 i:r Section two tes . which is the same &s !1: pet-r I v'.6 fhe last line in (98 'rrough the exclusi To confirm that the varianceofej is the sameas that ofthe errors (v2.nd a Lagrangemult :3st statisticshave th :rat is exactin the sen :' the Durbin-Watson ::'stfor.3) to obtar: generalizedleast squaresestimatesthat utilize all I observations. If Zis large. (T . f4 'ir : e\: (9A. we cannot compute these transformed observations withou: estimatingp. l5 Considering second the as an estimatorfor p.and so on.if we wish to improve efficiencl' f. we can usethe samplecorrelationr1 definedin (9. . Then.fg.Thus. arethele . That is. However. AND FORECASTING parameterp is not known.4 t r' for estimateB1and B2from (9A. including a transformationof the first observation. . problemfirst.

rbservationswithou: Appendix 98 The Durbin-'W'atson Test In Section9. nprove efficiency b.2 L. l usep from (9A.The last term differs from2rl through the inclusion of . were considered. and thus a low value for the Durbin-Watson statistic implies that the nodel errors are correlated.1) as we t that yields an err(.3.rnd a Lagrange multiplier test.the samplecorrelogram . 31and B2in (9A.t t:l s.ariable.WATSON TEST 261 Sinceyi.4 two testingproceduresfor testingfor autocorrelation.tatisticfor testing for autocorrelation.2 Let-r t-A 1s . random errorswith distributionN(0. d first observationii in (9A. expand(98. rs the Durbin-Watson test. ri. as we describe below.v7). 1i the estimatedvalue of p is 11 : 0.2) holds only approximately.-t1' u--T- T^ (eB. rn on the basisof thc 'e haveconsidered s.e rr : I then d r 0. a.and so on.. the estimateof p happenedto . was the standard :estforfls : p : 0 in the AR(1) error model !t : P!t-r f ur.2 LLr t:l \"1 ze7 t--l xlll-2rr (9A.. . Thi. i B2.: s- TTT 2a7+2a? '-2}i-t?t-t >a7 J'e 1 1 T TTT s.Thus. and recause its distribution no longer holds when the equation contains a lagged dependent '. The first two terms differ from one :hrough the exclusion of 2l and ?27from the first and second numerator summations.To seewhy dis a reasonable 2t .2. |-1 :'---L!'::L TTT s. ransformederror th.. one :hat is exact in the sensethat its distribution doesnot rely on a large sampleapproximation. ol).notethai 2 (eB.4)t. i. :d observations? On. their :est statistics have their specified distributions in large samples.|ECASTING APPENDIX 9B THE DURBIN..An alternative test./act s.ummation.That is H s : P: 0 The statistic used to test I1s against I11 is : F 1 1P > 0 rn 11definedin (9.6 The last line in (9B.. then the Durbin-Watson statisticd = 2. 'e27 in the denominator :espectively.: 2. it n 9.ui'ft.These are two large sample tests. we have dx2(l-11) 3.bt .3) to obtair.rherethe 2.(a. aretheleastsquares residuals : lt .2) (9A. It was developedin 1950 and.. which is taken If :r an indication that the model errorsare not autocorrelated. n convergence.2 . and "r).3) rlt will hold becau:.-.bzxt. and o ) 0.4) r. are independent :hat the alternative hypothesis is one of positive autocorrelation. and It is assumed that the v.1 'ith the least square. rte p.It is usedlessfrequentlytoday fecause of the need to examine upper and lower bounds.1-< (9A. for a long time.1) >a7 .-1 r 1 (e8. This procedure i.

05.169) 0.) : 0. suchthat P(d < d.l.05. If this p-value is less than the specified significance level. There are two ways to overcome this problem. In the sugarcanearea response model. and y?. it follows that d I d" and Hs is rejected. A difficulty associated with/(d). : p-value P(d < 1. :robability distributir :.1 THs DuRBrr -:r the absenceof soft -. If d < dp.F1s:p: 0 is rejected and we conclude that autocorrelation does exist. or by computing the p-vahe..: is possibleto tabul Thus. With other tesr statistics. for example.The value be .. the critical value d" for any given problem will also dependon the valuesof the explanatoryvariables. AUTOCORRELATION. as illustrated in Figure 9A.wecanstatetheresr procedurein terms of thep-value of the test.l we find that this value is much les jtat the equation's en 98.0044 : f(d Odc prcunp 'The 94.Also.2 Up . For a 57o significance level. the probability distribution f (d) is required. possibleto tabulate . and conclude that autocorrelationexists?Using suitable software. software packagesSHAZAM and SAS. rrcune 9A. Thus. in Figure 9.Alternatively.05.Y.This property meansthat it is impossible to tabulate critical values that can be used for every possible problem. knowledge of the probability distribution f (A underHo allows us to find d.4 :rbulated.ed to partiallY over \\'atson considered tv :epend on the exPlan Thatis.andfalltorejectHsifd>d". and one that we have not previously encounteredwhen using other test statistics. Instead of comparing the calculated d value with some tabulated values of d' we ger our computer to calculatethe p-value of the test. Because/(d) dependson the values of the explanatory variables.Is this value sufficientlycloseto zero (or sufficientlylessthan 2). The first way is to use software thar computes the p-value for the explanatory variables in the model under consideration. and Hs is accepted. is rejected. Determination of a critical value and arejectionregionfor the test requiresknowledgeof the probability distribution of the test statistic under the assumptionthat the null hypothesis..-annot found witl igure that ifthe calct .Different setsof explanatory variables lead to different distributions ford. do r'o1 ifdu<d1du.169. If the p-value is greater than 0. F.. such as t. .whether the testresult is found by comparingd with d". ifthep-value is lessthan or equal to 0. In any event.7 Testing for positive autocorrelation. AND FORECASTING The question we need to answeris: How close to zero does the value of the test statistic haveto be before we concludethat the errorsare correlated?In other words. Hs: p : 0.rejecl if d > du.is that this probability distribution dependson the valuesofthe explanatoryvariables. what is a critical vallued" such that we reject lls when d<d. the tabulated critical values are relevant for all models. will compute the exact Durbin-Watson p-value. is true.262 DYNAMIC MODELS. .Forthis one-tail test. the calculated value for the Durbin-Watson statisticis d : 1.05. sunded by an uPPe : robability distributic --itical value from P d21 du) :0. Then.werejectHoifdld.utthatdrr<d<d rhether to acceptor :ollowing decision r :esl. to reject F1e. irrespectiveo. then d ) d.thep-value is given by the areaundet f(d) to the left ofthe calculatedvalue of d.

That is.'/ is rejected. let du.. but : is possible to tabulate the alternative values for different T and K.becausewedonotknowthelocationofd'.2 dc dU. be such that P(du < du.1 THE Dun-eIN-\trATSoN BouNps Tnsr rires knowledge of rh: tt the null hypothesi. rords.The valuesd6 anddu. that th:. f(d) a dk Durbin-Watson p-valut . *'ill be in Thatis.we can statethe te. These considerations Durbin and Watson to suggestthe led :. is Lbles.. irrespective the explanatory of upper bound dy and a lower bound dt.2 we havethreecritical values.) : 0.iently less than2).in Figure 9A.f(d). possibleto tabulatethe critical valuesd7. Durbin and l\'arson consideredtwo other statistics dy and dy whose probability distributions do not jepend on the explanatory variables and which have the property that dL<d<du d variables the model underconsideration. a test known as the bounds test can be :..05 significance This valueis much lessthana conventional aat the equation's error is positively autocorrelated. the Durbin-Watso.. r ftware.05.If it turns !lhatd7. the test is inconclusive.' r-valueis givenby rh: ue is lessthanor equ. rutocorrelation doe. 0. thenit mustfollow that d < d r..:ccns 9A. canbereadily ::bulated. if dL. an. the: ..2. reaterthan 0. The relationshipbet\ een the rrunded by an :robability distributions/(dr). the one in which we are really interestedfor testing purposes. Let d6be rhe5Vc --:rtical value from the probability distribution for dt. and ure is .<d<du. reject I1e:p : 0 and acceptI11: p > 0.ed to partially overcome the problem of not having general critical values.wecannotbesure r hetherto acceptor reject. which are known collectively as the Durbin-Watson bounds If d < du. : f(d) dependson rh: 'en problem will al' ts that it is impossib. it . statistics. Similarly. -rnnot be found without a specializedcomputer program. < d 1 du. then it follows that d ) d. Thesevaluesdo dependon Zand K. d6 is such that ? d1 1 du) :0.l we find thi: h the absenceof software that computesap-value. we conclude. The value d.: ant for all models.05. andf(dg) is depictedin Figure 9A. it is clear from the : _: that if the calculatedvalue d is suchthat d < du.then. Thus.therefore. to use softwareth:' rnder consideratio: valuesof d.y. if d ) du. Different sets. we gc' :ssthan the specifie.lueof the test statisrr.05. Also.RECASTING APPENDIX 98 THE DURBIN_WATSONTEST 263 . 98.. if d ) du' do not reject I1o: p : 0.. anddu.llowing decision rules. :obability disrributio: rs illustrated in Figurr . With other re. . rlem.. However.whatis a critic" level. and^F16 accepted. or by computingrh: rciatedwith/(d). 4 Upper and lower critical value bounds for the Durbin-Watson test. Since the :robability distributions f(d) andf(du) do not depend on the explanatory variables.

usrng a resr can be derived from the coefficients in the ARDL representation y ' : E + E o . Then. af -:'rghts do not get * lt : o -l Foxr lrx.2 Lec WEI< -: principlethe lag 'rme steps those as .''.ntinuing a to for Yr:6+01[ Theseboundscanbe found in thepreviouseditionof this book.:ismodelis alsoc .r1-.e. Altematir.. we will examinetwo specialcases.: and substiruting (9C. p 92. + 6 q x . in the infinite distributedlag representation \.tonceS. -:re geometriclag ":Jely for supplyt --..2) inro (9C.4) : ... The critical bounds for the sugarcaneexample for T : 34 are du:1.bus.+ IB"x.but it does not affect the lag weights. The error term in the infinite l. Appendix 9C. howeve :e.For this reasonit is preferableto havesoftwarethat can calculaterlr required p-value if such software is available.1 Trc GromErnrc Lec I and.264 DYNAMIC MODELS. .. For example. -bstituting!t-2 : tt - . representationwill be different from vr.2 (ec.-" 1g.C. .d thendeclinege ':al multiplier shc To derive its lag weights we will ignore the error term. i T p ! .. :.edu/hill/poe.'ll'J. r : severalperiods i:ged y's will yie ::ometrically decl . _ pl v . in earlie: equations. . Wiley (2001). . x f 6 r ..lsu. + !t : s. . andhencewe reject Hs.514 . r r _ + .:. Griffiths and Judge. there is evidenceto suggestthat autocorrel-: tion exists. disadvantage ofthe test. + 0{be Appendix 9C Deriving ARDL Lag W'eights :6(1 + t In this appendix we are concernedwith showing how the distributed lag weights Be. .r'..'r. for tht The simplestARDL model is that wherep: model )r:E*6o-xr*0r/r-r*vr (ec: . yields * 'tlr-t )r: 6* 6oxr : :i. r r | To do so.go to the Web page http://www.393 du.leading to the ARDL(l. given by !t-1 :6 * E s x l * 1* l 1 t . AUTOCORRELATION. Q:O..169 I dy. ealsthat.2Sinced : 1. u : conclude rhatd < d.r -mparing(9C. and for that reason we have called it e. AND FORECASTING The presenceof a range of values where no conclusion can be reached is an obvio::.2nd editionby Hill. .I'irij'. "undergraduate Econometrics. noting that the equation fory.let/ ---+co. . _ q. s:0 :ere.:1.1).O r l r _ t * . Table 5.-t * gzxt-z* gzxt-s+ .

-2* 0?y..-.eegedy's will yield weights that decline according to a structure more flexible than the geometrically declining weights.-z ). that can calculatethe Substituting z: lt yields E + boxr-z* 0rlr-: into this expression * + )r : 6 * 016* EexlI 016ex1-1 e?(Ef 6sxy-2 0rlr-r) : 6 + 0rE + e?S+ 6oxr* 0r6oxr-1 0l6ex.-: * Continuing for a total of7 substitutionsyields d: 1.3) : 6 ( l+ 0 r+ 0 ?+ ' .3) becomes *eights do not get bigger in the more distantpast.4) t:0 29. . .l m in the infinite la: :alled it e' in earlie: equationfor y.0) model. lt: 6 ot+ iaseit.169 d6. 9C.0 B": 6o0i the This model is also called a geometriclag model because lag weights begin at the point Es :nd then decline geometrically through time according to the relationship B" : 0 r 9. however.0 i * r y . progression ahere.z ' * + 0{6ex.-" (9C. + e t :erealsthat.) (ec. Comparing (9C. and assumethat . * e. Alternativelr in principle the lag weights for more general ARDL models can be derived following the eme stepsasthosewe usedfor the geometriclag or ARDL( I .r .: The geometric lag model has the advantageof being relatively simple and has been used ridely for supply responsein agriculture and inventory demand models.Fo z t t . the peak effect may not occur :rrr severolperiods. letT + oo. while more .|ECASTING APPENDIX 9C DERIVING ARDL LAG WEIGHTS 265 sachedis an obviou. an assumptionnecessary ensurethe lag (9C. The :oml multiplier showing the long-run effect of a sustainedincreasein x is m.2 Lec WucHTS FoR MonE GSNERALARDL MooErs lr-z) t?v. Table 5. 0{*tY.I-9':60(l+0r f 0i+ ): ljq (ec. where it is unreasonable assumethe largest lag weight is the initial rne.v: 1 gestthat autocorrela- .0) model.p to \ow.6n (ec. to the ARDL(l.1 a U. for the ARDL(l. ) : " + ' 1-0r v!t-p I v. 0 1 6 e r v -0 ? 6 0 x+. + e i )+ i b o e j x .*.*.. . althoughthe algebra .4) with the general infinite distributed lag representation m Jt: a -* I 9 r r r .1 . " * 1 * ) r : 6 * e l E + e ? s + " ' + e { a + a s x .Then. This effect can be capturedby including more lagged x's. .-(. For example.x.. a on using result thesumof uninn# geometric a : 6 ( l * o r. a 1. . There are many to :xstances.when modeling monetary or fiscal policy. * 1 1 + I lag weightsBs.-1 i.

the objectiveis to forecast nerr (yr.!r).!rt.1t That is. (9D. ..-r * 029"-z fors ) 4 (9C. It has the form: 9r+r:ctyr *a(1 . Now.The exponential smoothing model is one such forecasting model. to one where more weight is put on recent information or. . . T .elue of a can reflec i. the observationy711. Note that when k: l.the averageof the last /cobservations.is rc usethe averageof pastinformation.o)lyr-r *ct(l . F o ri -rmple forecasts !r. all weight is placedon the most recentvalue and the forecastis lr+r : . .Also.a)2yr-z+ . AUTOCORRELATION. AND FORECASTING APPENDI is more complicated.7 to capture the relationship between wage rate changesand the inflation rare -f * )r : E * 66. . In this appendix ue examineanotherpopularmodel usedforpredicting the future value of avariable on the basi.5 we saw how an autoregressive model can be usedto forecastthe future value of a variable by making use of past observations on that variable.lr. However.6 Appendix 9D Forecasting: Exponential Smoothing In Section 9. say. The exPonential sr :.-.2t . substitt 3r successive ' : 1 . the proposed forecast is lr+Y7-rtlr-z Yr+l : This forecasting rule is an example of a simple (equally weighted) moving averagemodel with k: 3. put anotherway. one that has someintuitive appeal. . let us extend the moving averageidea by changing the equal weighting system. The weights for models with fewer terms (p less than2 or qlessthan 3 or both) can be fourr by setting the relevant coefficients equal to zero. it can ht shown that the lag weights for (9C. example.c r ) 3 y r . :0.ternativelY it can be \luares of the one-ste To illustrate how to t :. in this case the weights decline (exponentially) as the observationsget older.l.:+ . (9D. the forecast ft sriod and the actual .2* 63x1-3 * 0r}r-t * 9z!tz * vt :ilows us to simPlifY tl rfinite sum bY a singl (9C. Given a sampleof observations yz. .3) model usedi: Section 9.a)yr-r *a(l .o)zyr-z*a(l .266 DYNAMIC MODELS. where the weights are all (l lk). . 2 .forexamPle.it canbe shownthat the weights sumto o n e :f p 6 o ( l . . We assumethat 0 < cr < 1..ast squaresestimate The weight attachedto yr-. using information from the infinite past is not convenient for forecasting. In this section we give the weights for the ARDL(2. of its history-the exponential smoothing method. which meansthat the weights get smaller ass getslarger (aswe go further into the past). using resultson the infinite sum of a geometricprogression. Recognizing that: (l ")yr : c(l . Using recursive substitution.{1 61x1-1 62x. is given by ct(l .5) are 9o:Eo Br:0rFo*6r 9z:0rFr*0290*62 r 9 s : 0 r B z * O z 9* 6 r -l9z9z F+:0r9: F" : 0rF. lessweight is placedon observationsfurther into the past.ct)". itrf!caSterrors Yr : ) . One possibleforecastingmethod.rrecastattime : lr . For if we adopt this method with k : 3.d ) ' : l .timate of the smooth .

(9C. for each possible value of ct there is a different series of 'orecastelrors vr :lt .rlue of a can reflect one's judgment about the relative weight of current information.that is. f o r e x a m p l e .3) model usedi: md the inflation rare z+vt illows us to simplify the model.2.2) into (9D. 9 ! 2 a n d s o o n .[ey.[a]. rt for forecasting (9D. vrng averagemodc.1 )<c<1.a)y. Substituting(9D. r.-r + (l . a ? c h v a l u e oc r y i e l d s a d i f f e r e n t s e r i e sn -f !s f io smple forecasts jr. (9C.L(2.whic: : past).Forexamplc. and a value for j7 to generatethe forecastlr+r. F o r a g i v e n t i m e s e r i e 1 .rrecast time t : I equal to the first value in our time series. 1 y 2 + 0 . The '. s to forecastthe ner: .RECASTING A P P E N D I X 9 D F O R E C A S T I N G :E x P o N E N T I A L S M o o T H I N G 267 .1 . Thus. is ations. To estimatect we choosethe nonlinear . it can 1.3astsquaresestimate that minimiz es L|:zv! . The exponenti. l ._ . -ilternatively it can be estimated from historical information by minimizingthe sum of \luares of the one-stepforecasterrors u111 : !+t . l y r + 0 . 2 3r' successive substitution.1) meanswe can replacean :nfinitesum by a single term. w e c a n o b t aji'n : 0 . Also. ::1. ecentvalue and thc weighting systen: :entinformation or st.s:. letting !1 r : 0 .7.hts decline (expo- ' (9D. the forecast for next period is a weighted averageof the forecast fbr the current -riod and the actual realized value in the current period. but one needs an i\timate of the smoothingparametercr. The exponential smoothing method is a versatile forecasting tool.we setthe :. or both) canbe foun: ubstitution..6 )othing )castthe future valu: ln this appendix s: variableon theba.". : y1.-r]. so that the forecastcan be more convenientlypresented as 9r-r: a)r*(t-o)..u. at Then. + (l _ a)ir].ntuitiveappeal. To illustrate how to compute a seriesofforecasts and hencethe forecist errors.: That is.. we obtain a whole seriesof forecasts for the sample period !. 9 i 1 a n d ! 3 : 0 .using theweights sumr.

SR4. and the consequences rejectingthe null hypothesis.) SR6. E(e.. explainingthe null and alternativehypotheses. Describethe propertiesof a good instrumentalvariable. In this chaptert iondered about tt . 9' State the large-sampledistribution of the instrumental variables estimator for the simple linear regressionmodel. we re :or all observation '.paying particular attention to the assumotion: upon which the derivations are based. In thischapterwe re m.i.t. of In Chapter8. and how it can be used for the construction of interval estimates and hypothesistests.'onditional expecta variabl r'ndogenous :nors-in-variables :'\ogenous variable :inite sampleprope Hausman test Learning Objectives Based on the material in this chapter you should be able to l' Explain why we might sometimesconsider explanatory variables in a regressio:: model to be random. Describethe "errors-in-variables"problem in econometrics its consequence\ and for the least squaresestimator.3ast squares. 10' Describe a test for the existenceof correlationbetween the error term and the explanatoryvariablesin a model. 3' 4' Give an intuitive explanationof why correlation between a random x and the erro: term causesthe least squaresestimator to be inconsistent. 6' Discusshow the method of momentscan be usedto derive the least squares anc instrumental variables estimators. . 7 ' Explain why it is important for an instrumentalvariable to be highly correlated with the random explanatory variable for which it is an instrumeni. Explain the difference between finite sample and large sample properties o: estimators.) : Q SR3. rold under slightly The purpose of with the --orrelated . The variab 5. 8' Describehow instrumental variables estimation carriedout in the caseof surplu. is instruments.rnear regression we trssumptions ma S R l . and ). cov(e.): r 2.e.Y . : 9 r * SR2. are usl r ay. Discussthe r test whether case Present These are cr Provide estir with the err< 268 . (optional) SR5. .rhich the assump :lined. We have consid ::gressionis based :pon the sample w Thirc . var(e. . ariablesin Appen jn experiment is .RANDC chapter 1 0 Randotn Regressors and Mornent-B ased Estirnation Keywords :symptotic properti .

and y. These are caseswhere x is correlated with the effor e. N S R 2 .r. The purpose of this chapter is to discussregressionmodels in which x.it simplifies the algebra of !ait squares. y correlatedu ir. In an economist's nonexperimental world. In this chapterwe relax the assumptionthat variable.xis not random.xrditional expectation instrumental variable =dogenous variables estimator just identified equations :-ors-in-variables . making x and y random in the same L a)-.E ( e . Thirdly. es in a regressi. rriables in Appendix B. and how to test whether our data satisfiesthese conditions.or ifwe are conditioning our results :lon the samplewe have. Provide estimatorsthat have good properties even whenx. var(e. SR6. is not random. .t: least squaresai": the assumptio::. :stimator for rhr constructiono: or tenn and thc tive hypothese'. . tecaseof surplu. .In Chapter 9 we consideredregressionswith time-seriesdata in rhich the assumptionof serially uncorrelatederrors.): o2 ple properties r: rm x and the errcr its consequenc<. Presentcasesin which the randomnessof .c o v ( e .RANDOM REGRESSORS AND MOMENT_BASED ESTIMATION 269 Keywords sr mptotic properties instrumental variable :."rrrelatedwith the error term e.rogenousvariables large sample properties ::ite sample properties over identifiedequations H:usman test population moments random sampling reduced form equation sample moments simultaneousequationsbias test of surplus moment conditions two-stageleast squares estimation weak instruments n -: this chapterwe reconsiderthe linear regressionmodel. SR5. it is a proper assumption. Discussthe conditions under which having a random x is not a problem.Secondly. .e ) : 0 .) : o2 that the error varianceis the same ::r all observations.y . cov(ei. oz1 Chapter8. we relaxedthe assumptionvar(e. The variable.ej) : O. The usual r. is random and correlated with the efiot e. even if x is random. We will initially discussthe simple :=ar regressionmodel.. are usually revealedat the same time. . You may have -lrndered about the validity of this assumption. .It{(g. but our comments apply to the general model as well. and it must take at least two different values. We have considered the variable x to be nonrandom for several reasons. ) : 0 SR3. We will .First. -S R 4 . : 9 r * F z x i I e i i : 1 . the values ::. .. . we said that a variable is random if its value is unknown until r: experiment is performed. the properties of the least squaresestimator still lld under slightly modifled assumptions.. cannot be main--lned. is random and .umptions we make are S R l . (optional) e.r.xcausesthe least squaresestimator to fail. *'hen ::gressionis basedon datafrom controlled experiments.In our original discussionof random .

2 statesthat both y. assumptions. i: 1. . all we have done is bring back the explicit conditioning notation introduced i:. correctlydescribes relationshipbetweeny.. rnuSttake at least two different values. assumption A10.).va lar ::ls increasinglY ..npling. The distribution of the error term.2we will exploresomecases which u e x..N. squaresestimation procedure is no longer appropriate.. andxr in the the population. is an unobservablerandom error term."{.then cov(x. is normal.BASED ESTIMATION 70.. and (iii) there exi': no factors that causethe error term e.let us clearii state the interpretationof 410. in Section10.First.2 AsYmPro : \or ReNootu :.r..o2). A10.rpx 70.1. property of the leastsquaresestimator.. ': jressionmodel. fixed.ei) :0.7 Linear Regressionwith Random x's Let us modify the usual simple regressionassumptionsas follows: A10.In eachsuchcasethe usuallea.2 The data pairs (*. Assumption A10.\\'!ris found in : -:. Such data are said to be independentand identically distributed. are obtained by random A10.. Becauseit plays a key role in the propertiesofthe least squaresestimator. sampling. the third may not be. th ' : .r)*0. Under assum conditional u waY. lf E(ei l"r) :0.y. * nanowlY You t ::.iblished.: x.--quired. and we can show tha: . A10. In in can anticipatethat correlationwill existbetween andei. 410.thenwecanshowthatitisalsotruethatxiandeiareuncorrelated.(ii) used the correct functional form.r's. ioncentratedabor --. The result that under the classica. is i: a finite sample. where B1 and 92 are unknown (fixed) parametersand e. or a small sample. that the result does --.3. That is. .1 y. .cprobabilitY aPPr '.lxi): o2.NutthetrueParam .-ltJ(O. We discuss the consequencesof correlation between and e. is a constanto2.7 A .1. Conversely.esample size is N The finite samPle '-mmarized as follo l..What this mean. is zero. and the random error term ei.6 eilx. '. E ( e i l x i )l O . : Fr I lzxi* e. While the first two of these implications are intuitive.. by assumingthat the pair. There is only one new assumption this list. In the other assumptions. are independent.:rsical assumPtio \rares estimator if ----. 10. The expectedvalue of the error term e.. Chapter 2.1. l. are correlated.1 TrrE Suau SanprE Pnoprnrrss oF THE Lnasr Squenrs Esrrueron In Chapter 2 we proved the Gauss-Markov theorem. conditional on x. and the ot .\ rat these results s . and. to be conelated with x. .x. conditional on the value ofx.r in are obtainedby a samplingprocessand thus are random.this implies that assumptionSR4 holds as well.t.anc that cov(x.4. A10. the data pairs are collected from the same population by a processin which eachpair is independentof every other pair.3 E(eilx1):0.Conseq are valid. lhis sectionwe exa .. ..4 In the sample. This assumptionimplies that we harc (i) omitted no important variables.if xi and e.. t h e n E ( b 2 ): S .Also. Section10. Under assum Under assum unbiased esti usual estimat' .lxi):0.270 RANDOM REGRESSORS AND MOMENT.3 eliminatescorrelationbetweena random explanaton variable . conditional on r. The variance of the error term.5 var(e.the leastsquares and estimator thebestlinearunbiasedestimator. E(e.perty are called t :c least squareses Thus in addition to the usual specification errors of omitted variables and incorrec: functional form.

" The same is true for b1.r pair..r. no matter one that a least squares i-r)wnarrowly you define the term "close.the varianceof the least squares estimatorfor the simple linear :sgression del. as long as the data are obtained by random .r. Such data rditional on the A10. and.t's 271 . in etersand e. les and incorrecr tdom explanaton :es of correlation .This is a very reassuring ::reprobability approaches estimateb2 will be close to 92. let us clearlr rlies that we harr' and (iii) rhereexi:: .1.1uired. and the usual estimatorof o2 is unbiased. the least squaresestimatoris unbiased. 7 Fz e F2+ An illustration of consistencl'.-nmarizedas follows: weenJ/.Second. thenE(b2) : B2.and consistencyis a nice large sampleproperty of :re least squaresestimator. '. the probability distribution ofthe least squaresestimatorcollapses :ruut the true parameter. Figure 10. ani we can show thar Asyuprotrc r Nor ReNoou Pnoppnrrps oF THE LEesr Squenrs EsrrnanoR: -: this sectionwe examinethe large samplepropertiesof the leastsquares estimatorunderthe :-. Under assumptions conditional upon the x's.r. converges zeroasN + oo. holds in everysample. *. is What this means Fz-! : rcunp 7 0. Under assumptionsAl0. is s that both y.1 LINEAR REGI{ESSION WITH RANDOM.6 the distributionsof the least squares estimators. 1-410.If we focus on the slope estimator -. Estimators with this rroperty are called consistent estimators. Consequentlythe usual interval estimation and hypothesistesting procedures are valid. no changes our regression in methodsare -:.ATION 10.Its consequence that asN .cc. .ame population . 50.5 the least squaresestimator is the best linear unbiased estimator of the regression parameters. l-A10.cnpling. It whether :< sample sizeis N :20. :hattheresultdoesnot dependon the sizeof the sample. and their variancesare estimatedin the usual way.conditional on the x's.tt. First.oo? The iswer is found in two properties of the least squaresestimator that we have already rtablished. is a itional on .ssical assumptionsSRl-SR5. : uncorrelated.r ming that the pair. l-A10. and the other usual assumptions hold. : . is aboutB2.. or when the sample size N .As N . all the probability In . Under assumptions l. What happensto the probability distribution of the least \iuares estimator if we have a very large sample. The finite sample properties of the least squaresestimator when x is random can be '.2 rnal on x. not be.and r. are normal.7)z.oo. As the samplesize mo to :ers increasingly large.asesin which u e lse the usualleasr N+>N:>NZ>Nr fbnr) EsrrueroR Lder the classical asedestimator.r concentrated result. Al0.. the other assumption introduced i: lator.000. or 10.var(b2) : oz ll(xi .4 the least squares estimatoris unbiased.hat these results say is that if x is random. . is an by random .1 this is illustratedfor b2.

We have stated in anotherlargesamplepropertyof the leastsquares estimators Section2.272 RANDOM REGRESSORS AND MOMENT_BASED ESTIMATION is REMARK: Consistency a "large sample" or "asymptotic" properfy. A10. then the least squaresestimator fails. whether the erors arenofinally distributed or not.ei) : 0 andE(r.How large must the samplesize be for theselarge samplepropertiesto be valid might be enough. We want to exPl :orrelated. A10.3* is actuallya weakerassumption thanA10. Using r: .:ccne 70.) l0sothatx. and ei are correlated.our usualinterval estimatorsand test statistics are valid if the sample is large. A10..i..nie parameters' I :egressionfunctiot vquares PrinciPle v .3 by A 1 0 .uch that each has :rpulation correlati' Figure10.ande.9789+1. If the error term e.then the least squaresestimatorsare inconsistent. or that any of the other finite sample propertieshold. In Section 10.1we provide a way to test whether-r. 3 .Furthermore.1..In the next sectionwe shou that if x.) stematic Part of t i-'r') an error term' tmple value of Y.3isnottrue. Furthermore. and e. 10. are The data values are Thus when x is random.4.1.) : 0 =+cov(x.5. is correlatedwith.2.e. We then create an :seression.3 Asvuptorrc r Rewoon Pnoprnrms oF THE Lrasr Squenrs Esrrneron: For the purposesof a "large sample" analysisof the least squares estimator.the relationshipbetweenx. is correlatedwith the error term ei.l.) : 0 =+E(e.What is importantfor now is that you recognizewe are discussing situationsin to this chapterin which the samples must be large for our conclusions be valid. ei) : 0.3. dependingon the quality of the data. h this section we u .l*.4 WHv LPe We can make this replacement if because assumption A10.andinparticularif cov(-x. and A10.underA10.3* we cannot show that the least squaresestimator is unbiased.E ( e .70 . none of our usual hypothesis testing or interval estimationprocedures valid.the numbermight be much higher.:emonstratewhY th rroof is given in APl B1 creating data fr :rocedures work ur :egressionmodel it . the least squares 2. .In approximations reality? In a simple regression. the least normal distributionsif the samplesizeNis large squares estimators still haveapproximate enough.3.is convenientbecausewe want to investigatehow to estimatemodels in which a random regressorr. E( The regressionI * orld" we would r .E(r. when we violate the assumptionthat cov(x. (any xpi in the multiple regressionmodel).) :0.6. The values of Y.ilnd er are correlated. then the least squaresestimator fails.3*.e i ) : 0 .3 is true it follows that A10.'\Nefound that even when the random errors in a regressionmodel are not normally distributed. is the crucial factor when deciding whetherleastsquares estimationis appropriateor not. true.2 Plot 10.4. converge to the true parametervalues as N ---+ co. While it doesnot seemlike much of a change.1Introducing assumptionA10.r. because A10. l' If assumptionAl0.:0.. the leastsquares are That is. Under assumptions estimators have approximate normal distributions in large samples. Al0.it is convenient to replaceassumption 410. Under assumption estimators consistent.Thatis. [See Appendir 10A.3*.They do not convergeto the true parametervalues even in very large samples. What we can say is the following: A10. ther 1.l*.3.are correlated. ): 0 a n d c o v ( r . observations of 50 multiple regressionmodels. that is.2.

4 WHv Lresr Squenrs Fens lowsthatAl0. 1l' t. this section we use a tool of econometricscalled the Monte Carlo simulation to :. and j' are plotted against-r in Figure 10. becauseof the correlation that exists between-{.r.7034x The valuesof y.and e.6. a oa ata.rue parameters.-i .ei)lO. A Monte Carlo simulation usesartificially createddata.r rr fails.r. Specifically. By adding to -:. we can evaluate how alternative estimation ::ocedures work under a variety of conditions. Thus.i orld" we would neverknow where this line falls. [See Appendr.1 LINEAR REGRESSION WITH RANDOM .. we can create a .In ng on the quality of rssingsituationsin r be valid._ a oa t a a 'oo oo a. r ) an error term value. -a aa oo aa . ther the least square. Thesevaluesareplotted in ligure 10.dat.' .are o not converge to tone of our usual fhe data values are contained in chl].l.r's rty. Using random number generators.3':. eem like much oi : r A 1 0 . which will be a random number we create. line E(y) : 9r f B2x : I *.rch that each has a normal distribution with mean zero and variance one and the rrpulation correlationbetweenthe. E(y). that i. .. y : E(y) * e : 9t * Fzx * e : 1 I lxx -f e rthat4 ande. whether tht :valestimators anc -:. The least squaresestimatesare j' : br I b2x :0.2. r investigate hou r.That is. x '-tt.2.we create 100 pairs of x. ..The fitted line but E(y) : Fr * 92.tl . 3r creating data from a known model. tples. .."mple value of y..cnp 70. portion of the We thencreatean artificialsampleof y valuesby addinge to the systematic :egression.2 Plotofcorrelated ande.Wefoundthar istributed. In the "real The regression .IATiON 10.x. the .. and e. = 0.tt t' t t. valuesis pr" : 0. nor term e.the leasr nple sizeN is large )pertiesto be valid ight be enough.7034xis anestimate the true regressionfunction tor when decidin-s correlated with. 3 * e c a n n: w ( other finite samplr stent.Note that the data values are not randomly scatteredaround this :egressionfunction. sincewe neverknow the valuesof the '. let us specify a simple :r'gression model in which the parametervalues are B1 :1 and 9z:1.it is convenic:' . We havestated . of : :0.'monstrate why the least squaresestimatorfails when cov(x.An algebraic ::oof is given in Appendix l0B.9789 'l 1. is also plotted in this figure. We want to explore the properties of the least squaresestimator when x.6.9789 * l. The least rQu&reS principle works by fitting a line through the "center" of the data.istematic part of the regression model is E(y): Br * $2x: | * lx.5t'. a MATOR: -3 -2 -l ttor. and ei are -onelated.3. In Section t sectionwe sho* . and er values.

274 RANDOM REGRESSORS AND MOMENT-BASED ESTIMATION :--easure permanen :errnanent income.3) explan the 'rl l\ In order to estirr -:.the xi least squares idea is not going to worl Whenx.2 Casesin Which x arrd.:ecify a simple reg The errors-in-variables problem occurs when an explanatory variable is measureduiri error' If we measurean explanatory variable with error. the explanatoryu*iuut" is said to t endogenous'This term comesfrom simultaneous " equationsmodels. one is said to have a: "endogeneityproblem. consider rhe 1e1m'1O following important example. The leastsQUArr: estimatorsare inconsisrent.2. Furthermore the systematic overestimation the slopewilr not go away in larger of sampres. the true parametervalue (here bz : l. rike their consumption.. when r.7}34compared to the true Bz : l)." 70. ande.Using this terminology when a:_ explanatory variable is correlated with the regression error. 3 plot of data. in this case.}i : 9r * $2xi -t vi ( 1 0r. estimated the sloie tendsto be too largerelativer. -:-.. trnotheryear of edur . Both of . if nor impossible. A . and means "determined within the system.year rrrospectiveexperir :ris case haveorn we rotivation. For the purposes of a regression.3.which we will conside: in chapter I l.is thereanc : Section10. thus rhr and leastsquares estimators not correcton average are evenin large samples.rort of truly measu i heredo they go? L rore talentedand m :ov(EDUCi. Let y."iled a proxy vari y2 i lere Ltiis a randon :'mitting that obse -luently that we ha -::t u.wedosobyr -l a -3 1 prcuae 7 0 . are Correlated e There are severalcommon situations in which the least squaresestimator fails due to the presence of correration-between an explanatory variable and the e.'or tenn.annua_ savings of the ith worker and let ri : the permanent annual income of the jth worker. is independen rt.2 'A Ollrrrso ERRon hen an omitted v ::'gression error will =boreconomics. in largesamples .'orrelatedwith tt *riables.een explana the j. to observe.because andei are correlated.ith mean B2 and vi ::\ way.it.ei)*0. .2. .egr"riionr.. is based on their "permanent" or long-run income. have asterisked (x) the permanent income variable !e because it is difficult.using the 10. arepositivelycorrelated. As an illustration. 10. A simple regressionmodel representingthis ielationship is . suppose that we attempt ro eirh EDUC .1 MEesunrurNr 1e leastsquares es -ct\\. then ii is correlated with the erro: the least squares estimator is inconsistent.. '.s personal saving. Let us assume that an individual. explanatoryvariable and the elror tenn are correlated.trueand fitt"d .

2 OmtrrEo Venrenrss . into (10'l) to obtain ' i'.*0 (10. When . ) we In order to estimate(10... : too largerelatir e : : 1). random. f the ith worker.in theregression place of :-i: iri isindependent v.ich we will considr.a. using the fact cov(x.: rariable is said to i. least squaresestimator b2 is an inconsistentestimator of B2 becauseof the correlation .s.ed a proxy variable.:rminologywhen ": .J : E(-Fz"?):-9zol.in large or small samplesb2is not approximately . We can expectthat we expectthat :ore talentedand motivated peoplehave more yearsof education. Thus.they go into the effor tenn et. Let y. Furthermo:.) : I' it . Furthermore. ei): E(xiei): E[(xi -t ui)(vi . .. andseriallyuncorrelated. .with mean 0 and varianceol' Wittr this statement'we are !:::titting that observedculrent income only approximatespelrnanent income.r.years of education.2. It is somettmes r.* (ED(JCi..... then the -:-iression variable'A classicexampleis from with the explanatory error will be correlated in part by their level of education'Let us A :ror !conofiiics.3) explanatory of is variable. amples. : xt .therefore. ror term..gzui)) __l J (10.) :9r*p2xilei errorln . rn large surnplrr.lother year of education will be biased and inconsistent' . When ordinary leastsquares fails in -. we do so by replacement' x! That is' substitute yi:9r *}zxi*vi : 9r * 9z(*.\ hen an omitted variable is correlated with an included explanatory variable. of the retums to .r'I | -.rh EDUC .ii.onelatedwith the random that E(e.ables.. casewe haveomitted many factors. and con-.suchasexperience. is thereanotherestimationapproach . we can expect that the least squaresestimator :. consider th. .creilr is a random disturbance. wa!.10. havealso omitted ability like IQ scoresfall Both of thesefactors are difficult to measure..tort of truly measuringabilify.. must determinewhether or not ti is betweenthesetwo random e.=""n"nt inCome.u1) vi * : 9r * gzxi * (ri .l)2. Furthermore. : annu.-:. .5) ( 1 0r.: rsonal saving. lik: e. much less a person's motivation.4) ator fails due to ri.:.\zu.e . ei)*0. rn"un pz anOvariance var(b2): o2 lL(xi we will see that works?The answeris yes. 2C A S E SN W H I C H ' r A N D e A R E C O R R E L A T E D 275 ) :(r\ure pefinanentincome using ri : culTentincome' Current income is a measureof income exactly.3. what else affects wages?what else is omitted? This model is formulated' In :rrospectiveexperimentshouldbe carriedout eachtime a regression and We ... if nor hat we attempt r(' .from the assumption measurement the '. The leastsquar. If we omit these factors i heredo they go? Like all omitted factors.. . andthusr:..as .-1) s not going to u tr:. is difficult.MATION I 1 0 . Section10.{ (10.s said to have r: ':.lr i . person'swage is determined .let us assume in When we usex.t-'t\\!eIIthe explanatoryvariable and the error term' Consequently. '-tt.ently that we have measuredpermanentincome with error.3) by least squares.: rtion. To capture this feature let us specify that E--l xi:xilui t l0..but it does not measureperrnanent .1 .Even measures :-^orivation.The covariance disturbance ---.b2 doesnot convergeto normal -:.ecify a simple regression model explaining observedhourly wage as WAGEi: Br * \zEDUCi * ei e is measured uir: lated with the errt.

: cov(x. .r studentsof economicsdeal with such models from their earliestintroduction to supplr =:^: demand. that will work in large samples. feedbackrelationship between Pi and Q. estimators biasedand inconsistent. directly on eFt.4. The leastsquares procedure estimation will fail if appliedto (10. becausey1-1 depen:. When faced with such a situation we mu\: consider alternative estimation procedures. and we will treat simultaneous equationsmodels fully in Chapter 11.ll consequer -rrrTI!S.the pricesandquantitiesof goodsaredetermr:e.1. because they arejointly determined simultaneous systemof two equations. which is an alternative to the least squaresestimatio:principle. One way to make models dynamic i. Supply and demand models permeateeconomic analr. of leadsus to the least squares estimator. aslon-s. atd Qi areendogenous. 3E S c 10.we cansaythatP.i) 10. and the resulting bias (and inconsistency)is called ::r simultaneous equations bias.: . are none of their usual nice properties holding. .: the samPle(of We know that changes price affect the quantitiessuppliedand demanded.V. laggedvariableyr-1 is a randomregressor..2.-::le momentsto ( -i:ible with mean -::cndixB . but )r : 9r I 9z!. that for the first ::'notethe mean( -1:IICQParameter r.entsof Y are In Chapter 9 we introduced dynamic models.': methodof mor ---c methodof mo -.9)' :. --' . : introduce a lagged dependent variable into the right-hand side of an equation.onverge to th -'i'' are "best" itl . '.6)beca*< of an endogeneityproblem..: Br *lzxi *e. we can shou '. equationfor the supplycurveandthe otherequa::r one for the demandcurve.:der to estimat '' ::lation moment -' :'. Supposethat we write down the relation Qi:9r*9zPiiei 11.i:io ?II estimate( 10.: side.: squilibriumprice and0. when x. .2.:r VerueNce Another situationin which an explanatoryvariableis correlatedwith the regression error ri:':: arisesin simultaneousequationsmodels. Becauseof this feedback.rsbegin with a si ' . While this terminology may not sound fam:-. ande1-l directly affectsthe value of e1. Thar -..: jointly bytheforces of supplyanddemand. : moments" principle of estimation.:ruse reP (10..The it is uncorrelatedwith the error term then the least squares estimatoris consistent.-* price and quantity are jointly.called instrumental variables estimation o: two-stageleast squaresestimation. --:. : equilibr:*:: quantity.then we can see that the laggs: dependentvariable 111-1 must be correlated with the error term er.the least squares $r:..2.If pf O. Thus it is very important to test for ::i: presenceof serial correlation in models with lagged dependentvariableson the right-hr.Inthis casethe leastsquares between estimatorappliedto the laggeddepende :' variable model will be biased and inconsistent.. In this section we discuss the "method . Thus if P.therewill be a correlar:.3 SrmurreNrous EquerroNs Bres 3..Recall that in a competitivemarket. There :.. determined.ei):E(nei)lO. so it is v -. * e1.Hou er rit is possiblewhen specifying a dynamic model that the enors will be serially correlated -' the errors e1follow the AR(l) process.t I 9zx.-: of the random that an "exPe ---.:. -f :.3 Estirnators Based on the Method of Moments In the simple linear regressionmodel y. 10. See Section9. is random ar.276 RANDOM REGRESSORS AND MOMENT_BASED ESTIMATION 1 0 .--:moment bY P a -. the method of momenr. rh* method of moments leads us to an alternative. -rl . with:: .-:r cov(P.!t: pett * v1.not make mu< ---.If r is random and conelated with the error term. y1-1ande.1 MErnol .-. in But it is also:--r that changes in quantities supplied and demanded lead to changes in prices.:.which results bec. or simultaneously. When all the usual assumptions the linear model hold.4 LaccEn DrpsNorNr Vemesr-E Moorrs wrrH SERTAL Connnerro: -'-' method of mol --.

6)becau :y) is called r:.. There i.1 MerHor '.12) in .rather than the this -. I: : that the lagge: rsey. re method of moments estimator of the variancehasN in its denominator. 1 ) ents is random anc :onsistent.rd convergeto the true parameter valuesin large samples.lpgndixB var(I):o2:E(Y-t)z:E(Y2)-tLz (10.{TION 10. : error term. the s estimationor populationmomentby its sample .':ll not make much difference.we can solvefor the unknownmeanand :]ilnco parameters. rulation moments to two sample moments.ev are "best" in any sense. 1 1 ) ( 1 0 . That is. an example. of . 'te thatfor the first populationmoment p1. P":}yilN :.. Letermined withiI the otherequari -': us begin with a simple case.1.andreplacing ' : r t m o m e n tp . -':. - (10. But it is alsorrrrices. it is customary drop the subscript to and usepr" Jenotethe meanof I With thesetwo moments. Howei c: Lllycorrelated.istent.The ftth moment of a random variable I/ is the expected -. Consequently.let Y be a random As . )h resultsbecau.7) . E(Y-) : Frr : kth momentof Y (10.ie of the random variableraisedto the tth power. The first two population and sample ' .3. re the sample(of size N) analog (ltt' E@l :l.rr : kthsamplemomentof V :}yf lN [. we must equate two '. be a correlatic': tggeddepender: lt to test for th: n the right-han.9) )RRELATIO\* . are that .In general. can show rh_ -.9).order to estimate the two population parametersp and o2. . there is no guarantee but :.able with mean E(Y): p and the varianceexpression from equation (B. ftthpopulationmomentin (10. onomic analrr:.en use(10.:r VRnteNcE $rOSSlOfl !ITOr tc':- oF MoMENTs EsrrruRrroN oF A PopurerroN MraN lot soundfamil:_ )tion to supph d: odsaredetermin: d 0i : equilibn-. over an infinite number of experimental -:Jomes. ( 1 0l. b y ( 1 0 . Equate the first sample moment to the first population moment to ':ain an estimateof the populationmean.8) :' method of moments estimation procedure equatesm population moments to m -::rplemomentsto estimatern unknown parameters. But in largesamples we ._l depenc.. . E(Y):Pr:P E(Y\ : rLz i'":2ytlN ir:Lyllu (r0. .rll that an "expected value" is an average.10) '.methodof momentsestimators consistent.replacingthe second value.2 ) 1 . re methodof momentsleadsus to the sample meanasan estimator thepopulationmean.3 ESTIMATORS BASED ON THE METHOD OF MON4ENTS 277 .but aslon-e . so it is not exactlythe samplevariance areusedto..mentsof Yare Population moments Samplemoments ls dynamic is : quation.ual N. to (10.:.wirl: ration we musl he "method oi aresestimation rodof moment.7)canbe estimated the consistently -.or.That .

. In the linear that regression model y.3a The IrnPo Eramine the varian :orrelation between .3 1 (10. that there is another variable z such that 1.4)l and their solution yields the least square: estimators b2 0l They are consis I("r-z)(yr-y-) Z(xi -t)2 :Y-b2x In large sampl distributions. Thesetwo equationsare equivalentto the least squares"normal" equations[seeChapterI Appendix A. explanatorl' 3.15 Thesenew estimator . A variable z with these properties is called an instrumental variable. so that E(x. equations(2A. we usually assume If such a variable z Thenwe canusethe twr .If we replacethe two population in samplemoments.rmple moment condit E(t.ei) 10. This terminology arisesbecause while z doesnot have a direct effect on H having it will allow us to estimatethe relationship between x and y. then if Furthermore.however... ariable estimator'If rompare the efficien :nstrumentalvariablt B e c a u sP u < l t h e ' e :hanthe variance of I :he instrumental va intervals :onfidence . .):o+E(yi . zi is not correlatedwith the regressionerror term e.14) are moment conditions.3.!zxt):o with e. 10.3 EST 10. Suppose. : Fr * 9zxi + e.3. z doesnot have a direct effect on ). and thus it doesnot belong on the right-hand side of the model as an explanatory variable. 2.we havetwo equations two unknowns. The error varia Problems for least squares arise when xi is random and correlated with the random disturbancee. Solvingtheseequation rre instrumental vari *t.is fixed.2 MrrHoo or MorumNrs EsTIMATIoN IN THE Srmprp LrNeen Rrcnrssrou Monpr The definition of a "moment" can be extended to more general situations.Br .Fr.14) invalid. This makes the moment condition in (10. the endogenous variable. Variableswith this property are said to be exogenous.r.278 RANDOM REGRESSORS AND MOMENT_BASED ESTIMATION 10.-b1-b2xi):e *t*.3 IusrnurmNrer RrcnrssroN Mopsr Vanresres EsrrmerroN rN THE SrMpre LmEen" where r| is the regrgssor. that we are using to achieve our obiective.x. 10. Ir Thus under "nice" assumptions.3) and (2A.. method of momentsprinciple of estimationleadsu: the to the same estimators for the simple linear regressionmodel as the least squares principle..-by-b2xi):s (10. It is a tool. "r. z is strongly (or at least not weakly) correlated with x.rr.in instrumentz that il .or randombut not correlated : E(xie1) o+ Elxi(li.pzxi)l: o ( 1 0 .13) and (10. or instrument.3.14 Equations(10. . momentsby the corresponding which define the method of moments estimators for B1 and B2.

then we can use it to form the moment condition : E(zlei): o+ Elzi(li.r. that leastsquares still an option.in instrumentz that is highly correlatedwith x to improve the efficiency of the instrumental r ariableestimator.-oz'i):o (10.gzxr)] o lations. They are consistent. if In large samples the instrumental variable estimators have approximate normal distributions._ This terminologl v us to estimate the .7 ) Solvingtheseequations leadsus to methodof momentsestimators.3 ESTIMATORS BASED ON THE METHOD O F M O ] \ 1E \ I S 279 If such a variablez exists. Note that we can write the variance of the rnstrumental variablesestimatorof Br as .onfidenceintervals. x and e are uncolrelated. (1 0 .-9t-9r*.14)invalid the righrhand side th this property are enousexplanaton 10.3.)' o?v: N-2 t with the randonin (10.Using ihe instrumentalvariablesestimation procedurewhen it is not required leads to uider .:s(.The ( of rample moment conditionsare f:0. The error variance estimated is using the estimator I(v.I 3) and ( 10. The denominator includes the squared :orrelation between the instrument z and the endogenousvariable x. LrNren regressor .. E(ziei) : 0 (seeAppendix lOC).3a The Irnportance of [Jsing Strong Instruments Eramine the variance expressionin (10. : !>r.F' ozxi)o ( 1 0r. the least square. thanthe varianceof the leastsquares estimator.r 9t:! .0. oz-N("'d#-*) estimation leadsu. . " NZziyi-LziZyi NLzixi _ LziLxi- Z(zt-z)(y -r) L(zi -z)(xi -7) (10. which areusuallycalled lhe instrumental variable (1Il) estimators. 1 9 ) wherelu is the squaredsamplecorrelation betweenthe instrument z and the random .9zr Thesenew estimators have the following properties: .ng to achieveour Because < t ne varianceof the instrumentalvariablesestimatorwill always be larger Q.Fr . inference. and thusit is saidto be lessefficient.19).. In the liner (10't-r ( 1 0r. . thanifleast squares andlessprecise estimation used.r. We want to obtain .V{ATION 10.18) ( 1 0 'l .-0.Ifthe is .var(b2) : --/.I 6) to obtainestimates B 1and B2.6 ) Thenwe canusethe two equations 10.In the simple regression model Ltions [seeChapteri ls the least square. .^-rn r var(p2J ot i.ri : the two populatio: ns in two unknown.we can If so is Jompare the efficiency of the two estimators.

).765lx (0 rVe estimate that at h .i age equationis bia _'rrorsare ln(wAGE): ('") -0 9ru-2..Spec .r is pr.797.9640-f l.dar).askingwhat wt -irch as labor marke -'rer. In the process creatingthe artificial data(chL}.1924with a standard errorof 0.195.9'789 1. The correlation between the first instrumentzr and.ually have no me .1724.rriable.3: 0. 3E correlation between andx is 0. 1 5 7 o .irility.The variablezz is correlated to with x.which is abouteight timesaslargeasthe leastsquares standard enor. but more at -. experimentintroducedin Section 10. the strongerinstrument. In recentyearsthere has beena greatdeal of research the behaviorof the instrumental on variablesestimatorwhen the instrumentis weakly correlatedwith the endogenous variable.5.n the wage equatio :erson'sability. The lVestimates using z1 are iVhen we specify ar ::on.:1.2s6) (0. When using a weak instrument.r : 0. Using the weakerinstrumentz2produces slopeestimate 0. is logical tl :reir work and their -. instrumental variables estimation is not reliable.1.3b An Illustration IJsing Simulated Data Let us return to the simulation.. and hypothesis tests using the e : 0. evenin large samples.'.5. but it is correlatedwith the error term e.yields an estimateof the slopeof 1. Recall that we artificially createda sampleof N : 100 observations from the true model y:1+x*e.3cAn Illustrr in Section10.3.thenthevariance the instrumental of variables estimatoris four timesaslargea: the varianceof the least squares estimator. tl .rtta on married won in -lscussed this cha .6. is 0. The resultswith the weaker instrumentare far less satisfactorythan the estimates basedon the strongerinstrumentzt.thenthe variance the instrumental of variables estimator is z 100times as largeasthe varianceof the leastsquares estimator.What happensif we use instrumentalvariablesestimation with the invalid instrument? The resultsare jry-. 957o confidence intervals may not work 95Vo of the time. with correlationp":3 : 0.and its distribution is not approximatelynormal. with correlationpx. Thus z: is not a valid instrument. wherex and e are normally distributed variables with true means0 and variances We setthepopulationcorrelation 1.rrrelation between -. between ande to be p"" : 0.3451 0'1724x + ('") (0. Thus point estimate: can be substantially off. the instrumental variablesestimator can be badly biased.the estimatedslope is far from the true value B2 : 1.1011*1. and the correlationbetweenthe second instrument:: : and x is P. r'orS education.3.3. To carry out instru .which is abouttwice the standard errorof theleastsquares estimate.5.or Monte Carlo.etweenwages.1924x ('") (0.7e7) Using zr.088) (0. also created of we two instrumental variables both of which are uncorrelatedwith the error term.09s)(0.asit is supposed be. a of anda standard enor of 0. labor economi It .7034x \s you can see.-1.r72) ' SeeAppendix 10B .i ages.05.2we i .les) and the lVestimates using z2 are jw-rr: 1.280 RANDOM REGRESSORS AND MOMENT-BASED ESTIMATION 1 0 .3. or in Jrta.1. we have the nr :Jucation itself doe rropose that more e Thustwo of the con< is -iuestion whether To .05 level of significance may not have a probability oi Type I enor equal to 0. Another problemthat an instrumentcan haveis that it is not uncorrelated with the error terrn.: 0.. 10.r.z2 0.Leastsquares x estimationyields -t iou : 0.which is far from the true value. The bottom line is that when instrumentsare weak.0e0) As noted earlier.10e)(0.lucation? be a va :or illustrationpurp( To implement ins lates of what is call (se) (0. t ) . the correlationbetween-If and.o l d i n ge v e will be r :hisestimate .y of ln(tVA ('") (0.rrrelationexists.using valuethanthe lei ::-ue variu :heinstrumental 1t.

causing a :relation between the error |erm e and the education variable (EDUC).instrumen:- .:ire11's are ability. It is logicalthat a person's ability (andindustriousness) affectthe qualitl of may .region of the country. true means0 a:r =0. Hori-'r. light of issues to in -. variables estimator ill be inconsistent.The mother's :-rcation to itself does not belong in the daughter'swage equation. than the estimatc. or intelligence. 3 E S T T M A T ( ) 1 1 .0132) ( 0 .. The reducedform equation estimator SeeAppendix 10B for a discussion the large :rmplc bias of the least squares of .:rable. Usingthrom the true valuc st squares standar. holding everythingelse constant. ) r sa r e ..we have the number of years of educationfor the woman's mother.I 'om the true mor:.then ' .Leastsquar.ir work and their wage. requirea variablethat doesnot belong we rhe wage equation itself.: . ^.1 u s Z 3i Sn o t a l a l i . ogenous variable ur be badly bia:c. atedwith the err.6.rrs of education.:re equation biasedand inconsistent. like theleastsouares iust 'Wage . these mustbe uncorrelated.1075xEDUC + 0. estiTo implement instrumentalvariablesestimation. : :elationp_.. 5] . estimate will be overstated. :lation betweent: :condinstrumenr .Suchvariables difficult to obtain.dat examinethis relationship.:i\\!elrwages. .If ability has a positive effect on wages.{TION i I 0 . estimate.-. a: ve a probabilitr weak. :h as labor market conditions.0004) t24 with a standar-. The remaining .'asthe contributionof ability is attributedto the education .posethat more educatedmothers are more likely to have more educateddaughters. asking what we might have omitted. of the instrumen:.and it is reasonable : . There are severalfactors we might think of.specificallylog(WAGE).and yearsof education(EDUC).J:two of the conditionsfor a valid instrumental variableseemsatisfied.\ ou can see.the estimationof the relationship . n with the inlalr.2 we introducedan important example. we must always question our specificar.Let us specify a simple model in which ln(lUAGE)dependson in .we first obtain the least squares ires of what is calledthe reduced form equationfor EDUC.t WeCzl : (. but is uncorrelatedwith the .ren we specify an equation for estimation.:J. :d two instrumen:..: 'r r estimate that an additional year of education increaseswages by approximately --57o. 1 e 8 6 )( 0 .::r on married women in the file mru.Thesevariables components the error term e.0008xEXPERI (0.yearsof work experience.tz. is The leastsquares estimates and their standard .:3 0. 'hus point estimatr 7oof the time.") -0. ln(WAGE): + 9r * \2EDUC -f }zEXPER + $aEXPER2 e I in Section10.rces.. will assume We so : illustrationpurposes.'ussed this chapter. and experiencesquared. 0 1 4 1 ) (0.but more able individuals may also spend more years in school.3c An Illustration Using a Equation Section 10.rlly have no measurefor them.1.labor economists most concerned about the omissionof a variablemeasuring are -:litv.usingthe invalid instrument produces slopeestimate a evenfurtherfiom the --!' valuethanthe leastsquares estimate. The problem is that not only might ability aff'ect .0416xEXPER 0.5220 * 0. We will usethe . Using an invalid instrumental variablemeansthat -: instrumental u estimator. To carryout instrumental variables estimation.but in ThomasMroz's . then EDUC is endogenousand the least squaresestimator of the .r'rtionis whether a woman's ability and intelligenceare correlatedwith her mother's variables : lcation?To be a valid instrument... If such a :relation exists.and union membership. that is correlatedwith EDUC. \ S E I ) O \ THE METHOD OF MOIvIE\T\ 281 Lriables estimator rrelationbetweei rurtimesaslarge. sincerie are of ..

beca . least squaresestimation.ast squares . One way rrmize the sum -ies.or two-stas. leadsto the t\ ng thesecond -'.):tut:o (10. fact that the least squaresestimatortends to overestimate the effect of education. so that we have the additionalmoment condition E ( w . . e i ) : E l w t ( y i..937awhich is lower thanthe leastsquares is This is consistent with th: estimate. 0 4 1 7 ) (0.O489XEXPER O.282 RANDOM REGRESSORS AND MOMENT-BASED ESTIMATION 10 .9 r .0374) (0. This :.4 INsrRumsNrer VaRranus Esrrna-rroN wrrrr Sunprus INsrnuvrnNrs i0. }tnu. even after accountingfor the other exogenous variablesin the model.. 2 Stage is ot In the simple regressionmodel.0311) Note that coefficientof MOTHEREDUC is very significant. :: possible. the estimated return r estimates.gzxi) mz: o : f r.2677 XMOTHEREDUC ('") ( 0 ..we havemore instrumental variablesat our disposalthan are necessar.. .7751* O.^:tdetailsare be :.rtion all ct in lrother usefulI . preferableto use software commandsdesignedfor instrumentalvariables.0..gzxi): mt : o leas rtunately.. tormula for I fro.OA |xEXPER .412e) (0.: instrumenta -'J two-stage k r . notice. It is alwar . variables estimates. important. obtain the predicted values of educationfrom the reduced form equation.rles estimate .011I error reportedwith the leastsquares estimates This reflectsthe fact that evenwith good instrumental variablesthe instrumental variablr.}O}9xEXPER} ('") (0.r.0012) (0. For example.3. ar..The least squares estimates are -T EDUC : 9.Al.however.that the standarderror on the coefficient ofeducation (0. To implement the second stage.EDie .:les estimati ':.3a.3.5 times larger than the standard (0.:hted sum of sr x Regress o Usei as an .riginalmode .How can we improve th.17).p z x .rring awaygoo :rent condition .insert them into the wage equation to replace EDUC.]t .ible.0. and that is correlate: with x but uncorrelated with e. Estimating the reducedform equationis the first stagein the two-stageleast square' approach to instrumental variables estimation.0493xEDUC+ O.or we can obtain more and strongerinstrumentalvariables. putting th( . . 10. ) ]: 0 Now we have three samplemoment conditions . :-r alues.1982 ]_0.This first s becomingcl .asit indicatesthat our instrumentis correlated with the variablewe suspect f': to endogenous.which we solve for the two unknown model parameter. we need only one instrumentalvariable. Then we estimate the resultir:-equation by least squares. however.the accompanying standard errors are not correct.. Stage1 is the r'.OO13 XEXPER2 0.with a /-value of 8.0136) (0. efficiency of the instrumentalvariablesestimator?We can obtain a larger sample.0374) is or. u.: 2.0004) Note two changes comparedto the leastsquares as First.6.-0'- pr*. education 4.let w be anothervariablethat doesnot directly affecty. Usually. as discussedin Section 10. 4 2 4 e )( 0 .The instrumentalvariablesestimatesof the wage equation ar: nfWeC-nl: 0.20) we have : of the conditir .: \quaresestin . 3 hasexplanatory variablesthat include all the exogenous variablesin the original equation plus any instrumentalvariables. 0. estimator is not efficient.(r..While this two-step processyields proper instrumenr. yielding tu moment conditionslike (10.

or two-sta.24) Ll*i-7)' rtortunately. This first stageis called the reduced form model estimation..r original model. l.rctdetailsare beyondthe scopeof this book.)' N -2 .to use weighted least + . rle. zandw.:owing awaygoodinformationis hardlyeveragoodidea. z and w.23) Jrst squares estimationof (10.N: (10. . StageI is theregression x on a constant of term.are also .:. lt is best. ESOe .. \'.9r .. largesample.-rares. yielding trr. One way to do this is to use the least squares principle. least squaressoftware cannot be used to obtain appropriate standarderrors -::Jl-values. .: fiion.isleadsto the two samplemoment conditions l^ rr(r'-9r-gzxi):o 1^ (10. We could simply throw away -e of the conditions and use the remaining two to solve for the unknowns. we improve th. we have and t4) stimatedreturni :onsistent with tl-. the valuesof B1 and $2 that minimize this jishted sum of squares can be obtainedusing a two-stepprocess.2tt I(r''-9. var( lJ) ) o2 (r0.lrt rr'se instrumentalvariablesestimators. )i : 9r * 9zxi * e. Regressr on a constant term.6. and obtain the predicted valuesi. ar. Usei as an instrumentalvariablefor x.20)we havethreeequations with only two unknowns.23)is numericallyequivalent obtainingthe instrumental to . While the . variance $2 is givenby the of . )9xEXPER2 . 1.: (0. because estimator the errorvariance the of mustbe based the residuals from on . Anotherusefulresultis that the approximate. becausethey can be obtainedusing ' o leastsquares regressions like we did for the wage equationin the previoussection.. .with the terminology becomingclear in Chapter 11. yielding 6.22) 9': j . It is alwar.Iii(ri . usingthefact thati : x. ^. choosingp1 and B2 to ' :nimize the sum of squaresai + n3 m!. however. . (r0. bles.putting the greatest weight on the momentswith the smallervariances.0111 itimates umentalvariablc. le we suspect h: to r the model.led two-stage least squares (2SZS) estimators. derived using the method of moments..3 ESTIMATOI{S BASEI) ON THE METHOD OF MOMENTS )Rl ) original equatio: MOTHEREDL'( ilue of 8.20) as closely as .to obtainthe predicted values i.sible. This :.:imationin all cases. larger sample.Sincetwo-stage leastsquares estimation andinstrumental 'riables estimation are equivalent.\TION 10.gzxi):0 r ing these conditions.2r ) .ual formula for the varianceof the least squares estimatorof (10. ) t (0.: nate the resultir:)per instrumentJ :ect. Lodel parameter. an are necessar\ that is correlatee :ondition Yi : Bt 't 9zit I error. tage leastsquar.22).23).0374is or. Stage 2 is ordinary least squaresestimation of the simple linear regression 'STRUMENTS . f education.However..svageequation ai.:iablesestimates using(10.-0r*. 10. -. we will simply refer to instrumental variables (1Ir) .Al.An alternative usesall of the that )ment conditions is to choose values for B1 and B2 satisfying (10. :: (r0. second stage.

40:: 0.3906 5. leastsquares instrumental or variables estimationoption is chose: estimatorif a two-stage 10..3.r- The standarderrors are basedon the estimatederror variancein (10.married women using "mother's education" as an instrument.1e4) (10. The first steP of -. Let us add "father'. as shown :: ( 10.:^ . : 1. and forms combinationsof them in an optimal way..-ation This estimatedvariance can be used as a basis for r-testsof significanceand inter"Econometricsoftwarewill automaticallyusethe propervarian-.1.0399.1947 * 0.we obtain the instrumentalvariablesestimatt to . we havetwo parameters estimateand thus ne.3 ES Thus the appropriate estimator of the variance of $2 is .0338 21.r5'76 0.and the two momentconditionsproducedby 2SLSare gir c' in (10.3.23). 10.A-PDF.A-PDF Split DEMO : Purchase from www.1376 1.establishing the.0481 +g. .3.0012 0.I 895 0. c It is a necessary ughinstrumenta '.. are in Table 10.:.0009 (0.0314) (0.Gt:#:fr (1 0 .206822 (se)(0. Two-stage instrumentswe have.itions. Note that the two instrumentalvariablesare statisticallysignificant.'to only two momentconditions. The ( r l Using the predictedvaluei as an instrumentalvariable as in (10. < -' r.8386 4. yields an estimate the slopeof 1. Using the two valid instruments of leastsquares estimationtakesti: example.0359 0. or applying le" squares the modified equation(10. we estimatet:.0399x ('") (0.3.6152 0.ER: 0.3.0403 0. eridentified. comprises f sta in the second ):Pr*9r .-' endogenous.3cwe illustratedinstrumentalvariablesestimationof a wage equation1.26).l4Vo to . : : npared to the previ ':ducation 6.21).4a An Illustration Using Simulated Data in what is the outcomeof tu Returningto our simulateddata. estimationusing the two instruments and zz?First.4003) (0.: correlationwith education.0010 0.. a regression x on the two instruments and 22.1 16) (0.o442EXpER 0..' rave endogenou ' -h notationisinva :k of G : Good e ':rumentalvariable : The Luclq.is closeto the true value of Bz : l. which is wt .discussed Section10.08e) (0.3b.Since form equati :.07e) (0. which.00'.4b An Illustration Using a Vage Equation In Section 10.077) (10.3396 r.: stageleast squares er reducedform model.5 INsrnumnx 3\tend our analYs Br*Fzrz+"' -r * :0.r5) we know.00(' xc+j : irj - the :.-l:1rj +'yzjx Ta hl e 7 0.:G[ * iN-r. Error t-Statistic Proi' : reduced form p -rtion. G variables(x61 .0452 -0.0004) . in th .com to remove the watermark RANDOM REGRESSORS AND MOMENT-BASED ESTIMATION 10.-rced C EXPER EXPER2 MOTHEREDUC FATHEREDUC 9.00(' 0. education" as an additional instrumentalvariable. 2 6'l 0. of 4 .WG4: ('") EX.onefor eac ::ced form equatio val :heexogenous va -' L instrumental 1. 7 ReducedForrn Equation Variable Coefficient Std.senousvariablest .: the model Para -rruments than are .The reducedform equationestimatr'.22). estimationof parameters.0134) (0.-ation is statistic was useda :-.t026 0.4266 0. just identified or t .In the simpleregression model.implicity.25). 0 .The instrumentalvariablesestimates are 'rderto cary out 1 .ariablesinto tl .0614EDUC +0. .1236 -0.57002r 0.

which alsomust be exogenous. r c + r. : the propervariai:ion optionis cho. haveomittedthe observation We subscript .29) _ O. + B 6 x y e G exogenous variables B endogenous variables ( 1 0 ..or suspect. 396 236 i386 i906 tI52 ic-j:it1114x2+"'+ --:. :1.1. . ln the secondstageof estimation..which. whereas it was not when only the mother's :-rcation was usedas an instrumenl. .considerthe multiple regression model .\senous variablesthat are uncorrelated with the error term e.4ATION 10. and the model is sometimessaid to be for :. nt.' haveendogenous ' . ' 0.l4Eo.5 INsrnuuENraL VAzuABLES EsrruRrroN rN e GrNrRer Moorr the outcomeof tri 'irst.'u-gh instrumental variables carry out lVestimation.we apply least squares to ): Br*\zxz +.3 ESTIMATORS B .Suppose have I instrumentalvariables. ' + r \x*xlerror ll0.8 comprises the first stageof two-stageleast squares estimation..lr 0. : r* " ' + \ t i z t . : : ficance and inter.-:rumental variables.16) being !.{ S E 1 )O \ THE METHOD OF MOME\TS 28-. The first step of two-stage least squaresestimation is to estimate B reduced form .OOO}EXPER: (0. seethatthereis an increase theestimate the return \\'e to in of education 6.: just identified or exactly identified in this case. (10l 2). . .(r. 0.-. variables estim!:.. eridentified.x612. . .. .x2.r ..in r: .et us add "fathe: n equationestim': th.we have :heexogenous variables.. as shosn itimateand thus n.andthusthey .If L: B. . The secondgroup ofB : .Then we haveThe Good. sincewe arelucky to havethem. .tf.-Gvariables(x611.. .8 reducedform parameters('y's and 0's) take different values in each reducedform . i c -+ . B reducedform equations The ' .j' .On the righrhand side.and a slight reductionin the standard to error. ed by 2StS are-si. lt is a necessary conditionfor lVestimation that L> B...': endogenous. 9t * Fzxz+ "'+ 9rxx -t e... the left-handsideofthe On :irced form equations. TheBad.:h notationis invariablyconfusingandcumbersome.xr)iscorrelatedwiththeregressionerror.:ation. i c . then therearejust '. r 6 _ 0 1 .'. ertend our analysisto a more generalsetting. estimationtaker :: al way.implicity. .:r. and then obtain the predictedvalues tistic Pr ' 0. including the G explanatory variables that are exogenous.andL: Luclcy B .. . and ': L instrumental variables. rmpared thepreviousresults.. xx) we know. havean endogenous we variable. : Bad explanatoryvariables.If L>8. then we have more '. j:1. Divide -:' \'ariablesinto two groups. The multiple regression model including all K variablesis then -+---I / : 9 r l l z x z + .. 0.. . .we must haveat leastas many instrumental variables as variables..j : ' l r 1 * " y 2 1 x 2 + " ' + " l c 1 x 6l 0 r j z r + " ' I l u z r l v j .- a wage equatlon: . + \ c x c I F c + r .. Sincethe righrhand sidevariablesare all exogenous.onefor eachexplanatory variablethat is endogenous.which is why they havea" j" subscript. can estimatethese we :jJc!d form equationsby least squares. ..The model parameters saidto to are '. . .rderto carry out lVestimation. . Suppose that amongthe explanatoryvariables(xt : 1.The term identified is usedto indicate -:i the model parameters can be consistentlyestimated. we estimate:r I zz.:ruments than are necessary lVestimation. . --': (10.. that several may be correlated with the errorterm e.0004) i:1..0399.. 2)8 ( r 0r ?5\ ..l The Luclq. or applyinglc.-l0t . establishing . we " . may help to keepthingsstraightto It -:rk of G : Good explanatoryvariables. .t-'.The estimated return to :rucation is statistically significant now.'.+ \ c x c + P c .3. (1 0 ..itions.. . with the first G variables(xr : t.

may be basedon the chi-squaredistribution with the number of degrees freedomeq. If our model is y: Br -tFzx* e.. or a Lagrange multiplier (LW test.:rator.c ) / s e ( B 1 )i s v a l i d i n l a r g e s a m p l e s .practiceto usecritical values. Once again.'-7r.andp-valu.1) distributi. Such corrections to standard errors require large samples in order : work properly. these models exhibit feedback.then critical valuesfrom the two distributions ri : of be very close. . T: motivation for using the F-test is to achieve better performance in small samp)c. the instn ' lator fails. .the test statisticreportedmay be called an F-statisticwith "I numeratorde-err: of freedom and N .K arelarge. Another issue is whether to use standarderrors that are "robust" to the presence (in heteroskedasticity cross-section data) or autocorrelationand heteroskedasticitl time-series data).rometricianJer i:native hypothe .:r of regressionpa -:rally endogenous r . this quantity can be negativeuh:' basedon lVestimates.: squaresand i :tputersoftwaret ':.K denominatordegrees freedom.: When there are endogenousvariables on the righrhand side of a regressionequation.such as the Wald statistic.' residualsare 2 : ). the (r-r. the rr. distribution convergesto the standardnormal distribution N(0.4 Specification Tbsts We have shown that if an explanatory variable is correlatedwith the regressionenor teEl the least squaresestimator fails.rameters basedon l: two-stageleastsquares/instrumental variablesestimates.but not universal. When using softwareto test a joint hypothesis.7 Tur Her ::1r'previous sect ::r'lation betwee . for some related discussion. H 0 : B t = c . i Jra are SeVeral :. These options were described in Chapters 8 and 9 for the lin.problemis pairedwith a numericalone.5a Hypothesis Testing with Instrurnental Variables Estimates We may be interestedin testing hypothesesabout the regressionpa. and other test statistics will be computedproperly.'regression model. These tesr.3.r.: procedures are all asymptotically equivalent and are discussedin Appendix C. of (J) to the numberof hypotheses being tested. If the null hy instrumental themdoesno the null hypc consistent. of by dividing one of the chi-squaretests statistics. u s e o f t h e t e s t s t a t i s t i c I : ( .4. Unfortunately. We have shown that if a strong instrumental variablc' ii)me software pac ^..the lVest ::rples.by .rlable./. /-statistics. iconceptof measuring how well thevariationiny is explained ther variables by breaksdori : becauseas we discussedin Section I0.r However. and they are also available in most software packages for .It is common. . distribution rather than the more strictly appropriateN(0.9t . Asymptotically. the testswill all lead to the sameconclusion.'itionscome to r Can we test f of when to u . .4.Many softwarepackageswill report the goodness-oi: measure R2:1 _ La?12(yt-y)2.' idea of the tes .and this is an option with ma: software packages.::umentalvariab r\\ lng: .. But.'ult to carry ou 10.are not large. use the . Appenc 6. basedon the r11. Use econometric software designed r two-stage least squaresor instrumental variables estimation so that standard erro. suchas Hg:82 : cz.'. If the degrees freedomN .' estimation.2. The -::lation betwee ^:opriateestima lhe null hypothe . W e k n . if we r rot uncorrelated .9z: c:.The test itself may be called a "Wald'' re. 01 that asN -+ oo.3. : Can we test w associated Can we test i required? :'\e questionswi.92. 10. joint tests can be made "robust" : potential heteroskedasticity autocorrelation or problems.:rusing the leas . 10. The reasonis that testsbasedon the t-distribution tend to work better in samplesof datarf. When testingthe null hypothe. bur should not be done this way in applied work.See Chapter6. then the. If the null hy variablesesti to converges true.This F-value is often calculai. or a likelihood ratio (ZR) test.286 RANDOM REGRESSORS AND MOMENT-BASED ESTIMATION This two-stageestimationprocessleadsto proper instrumentalvariablesestimates.5b Goodness-oGFit with Instrumental Variables Estimates We discourage use of measures the like R2 outsidethe contextof leastsquares estimati.This logi.

Fls:cov(x.c + O. variablesbreaksdo'. so that we can use the . usually called the Hausman test.the instrumentalvariablesestimator. .IMATION 10. which is consistent. -'-.'.If themdoesnot converge zeroin largesamples. ates rst squa. .rer of regressionparameters.4 SPECIFICATION TESTS 287 iablesestimates.1 sQuores and instrumentalvariablesestimates. Given this unappetizing menu of choices. ::. as required? -:se questions will be answeredin this section. or worse. Can we test for whether-ris correlatedwith the error term? This might give us a guide of when to use least squaresand when to use lVestimators. :rn using the least squaresestimator.rometrician Jerry Hausman'spioneering work on this problem.:rumental variables estimator..Thus. then lVestimation can be as bad.. 4 : (bors . If the null hypothesis is true. where K is the total . We nal distributionN(0. Use the correct degreesof freedom B..the difference between Thatis.and the instrumentalvariablesestimator is consistent. These test::. and uncorrelatedwith the regressionerror.t h e t r . We also provided an :-::mator. ing the null hypothe.rnativehypotheses.'icult to carry out. Thenullhypothesisis.that can be used when the least squares in of "::mator fails.This is incorrect. which is the least squaresestimator. or K-7. or that is invalid in the sense that it But.:' idea of the test is to compare the performance of the least squaresestimator to an -. .:.-.:heprevioussections discussed fact that the leastsquares we the estimatorfails if thereis . rge samples. if we usea weak instrument. e two distributions u : Llvalues.: Chapter 6. degreesof freedom. :relation between an explanatory variable and the error term.Consequently.rees calleda "Wald" tt) test.{.\zx + e.:rtially endogenous See ( 10.1) disrriburi. The questionwe address this sectionis how to test for the presence a . for these null and the betweenthe One form of the test directly examines differences ".orving: .the lVestimator is consistentand approximatelynormally distributedin lar-ee .This log:-eedback.2 '-r're regresslon effor ter:' strumentalvariablt Some software packagescompute Hausman tests sith K. Appen. Can we test if our instrument is valid.' re made "robust" s an option with m"- . if the null hypothesisis true..res estimat: gressionequation.rilable.{:nples. L Can we test whether our instrument is sufficiently strong to avoid the problems associatedwith "weak" instruments? imates ffameters basedon t:. right-handside variables.. L in Appendix C. not uncorrelated with the regressionerror. T: . ld statistic. ei)10. Naturally. by "/. in samples datatlof st" to the presence heteroskedasticitr and 9 for the lincare packages for ./ numeratordegrr'lue is often calcula:. F z : c a . That is. If the null hypothesis is false.:: . both the least squaresestimator and the instrumental variablesestimatorareconsistent. Some rputer softwareprogramsimplement this test for the user. then the ' lrt the goodness-of :an be negatile \\ii:- &re several forms of the test. :relation between an explanatory variable and the error term. use the more efficient estimator. Under the null and alternative hvootheseswe know the .1 THs Heusr{eN TEsr poR ENoocENErry ..r h. rropriate estimation procedure. several : iistions come to mind: I .28t.samples in order : c z . ' offreedomeq-. .. ce in small samp. in large samplesthe differencebetweenthem convergesto zero. but software designed i' that standard error- :r. I . . ei):}againstthealternativethatHl:cov(x. q : (bou . in recognition of -. equal to the number oi '. an instrument .. the least squaresestimator is not consistent. use the instrumental variables estimator.which can be computationally . kn..prv) .as we have describedabove...!ru) --+0. to the null hypothesis is not true. andp-valucateN(0.

can be thought of .ri : Jl * 0rzir l\zziz * v.::rtments com and .I ' is null hypothesismust be soundly rejected. 2003..r of thevalidity o In order for:r to qualify as an instrument. regression.288 RANDOM REGRESSORS AND MOMENT. Addison-Wesley.r. However :ng eachF > 10 d . see Cameron and Trivedi. . 352. supposethat we have one instrumentalvariable zl . 11t at of significance not enoughto insurethat we do not havea weak instrumentproblem.the instrumental we variables estimatorcan sufferi": biasesand standarderrors. I f t h rr alid and the 1V ' i1etested for val -. is is For more on this issue seeStock and Watson.rlid instrument : . Microeconometrics: Methods and Applict.. Further. rejectingthe null hypothesis the ct : 0.. the instrument rr e. : 9r t 9zxi + Eii + e.:tions... )i squares.' the joint significanceof the coefficientson the included residuals. . and its large sample distribution may not be approxint.3 TEsrrNc I If the instruments chooseareweak. rheleastsquare '\'hat shouldoned -.r1 = ments 1. to and obtain the residuals vi : x i ..rrd the weakesto . Thus we can test the null hypothesis : 0q : 0 againstthe altemr: I1s just hypothesis :0 t 10. variablesnot suspected be endogenous. Considerthe model ) : 9r Ilzxz + "'+ \cxc + 9c+fic+r * e . rlid. by least squ':. are 10.. -'-an usean F-testf :ld be concemed :j. 2 ' 2 Regress on Obtain the rer Compute NR: goodness-of Ficonometricjargon :r()nS meanswe have ^. . Estimatethis "artificial regression"br .:.T z Z i z lt' rvehaveL> | 1 xG+ If more than one explanatoryvariablesare being testedfor endogeneity.ttnot be zero. andei) H 1:6 l0 (correlationbetweenx. At an advanced graduate level.) and 3.' require only one Ht:0. Unfortunately. Let z1 and --.o duction to Econometrics.2 TrsrrNc FoR VEAK INsrRurcurs . while -r1.4.)r models with I rts..-: ro large standar .A common rule of thumb is that if the F-:statistictakesa valuelessthan 10. Include the residualscomputedin step I as an explanatoryvariablein the ortr. pp. reperr:' estimation eachone.2005. txG areexogenous uncorrelated and with the error terme. is correlated with e.rbly endogenou ':nlum numberof av B instruments ^ . ' Compute the variables. endogenous.or if the t-statistic lessthan3. .] t .'.. e 1 ): 0 .and F-tests in steps 2 and 3 can be made robust if heteroskedasticity anautocorrelation potentialproblems..x.that might be correlatedwith the error term. At a minimum one instrumentis requiredfor each van. for 2.02:0.BASED ESTIMATION An alternative form of the test is very easyto implementand is the one we recomm(See Appendix lOD for an explanation of the test's logic.05 1.: place. The r. Cambridge.the coefficient0r in this reducedform equal nut. we wish to know whether x. 1. l l t r o n4s . normal. In the regression Pr * $uxi + ei. Then carry out the following steps: l. Suppose thatx2. e. If more than onevariableis being testedfor endogeneity. instrumentalvariablesfor. pp. reducedform equationin this caseis xc+t:"ltI^yzxz +"'+'lcxo* o r z t* v \n intuitive apprc . 104-l 10. . How can determinewhether it is a "strong" or "weak" instrument?The key is to examint-" strengthofthe relationshipbetweenzl and the endogenous variable x611after accoun: for the influence of the other exogenousvariablesalready included in the model... To test instru -. thenwe wor -'.3.T t Z i t. including on the right-hand side all instrumental variables and all exose. Estimatethe reducedform model . testwill be an F-r.:ingresearched ht ..1r1l. and employ the usual /-test for the hypothesisof significance Hs :D : 0 (no correlation between.research this on \ tinal diagnostic ':Jarderrorsof the .

joint test. so that ..a . T .form groups of B -:ruments and computethe lVestimatesusing eachdifferentgroup.we must have at leastB instruments.this is anotherindicationthat instruments ueak. natorcan suffer1.:ethods and Applicui: ' jargon for surplusmoment conditionsis "overidentifyingrestrictions. If the 1V standard errorsare much larger ^:n the leastsquares standard errors. . . 0 * r * v : . . where N is the samplesize and R2 is the usual ComputeNR2 from this regression.like (10.t place.ZL. we can test the validity of the I . on . :i.l9) we know that weak instruments .. r -+ . .alid instrument z must be uncorrelatedwith the regressionerror term.ei):0.lowing steps: ..or surplus..3 TEsrrNc INsrRunrnr Velrnrry dogeneity. One answeris to search amongthe instruments and -.nificance :stwill be an F-te.while-rc.. s . To test instrumentstrength. .an F-test should be done in each of the reducedform -." Moment conditionslikc 6 t c a n b e t h o u s h to f a s r e s t r i c t i o no n D a r a m e t e r \ .\n intuitive approachis the following. :oskedasticityan.not every instrument .ing eachF > l0 doesnot guarantee that we have avoideda weak instrumentproblem. Let 21 and --_ ired for each vari. ble zr. l c x c | .9 r . .eing researched heavily at this time. We test the null hypothesis ': : 01 : 0.. pp.B : r : .If all the instruments :-' r'alid.moment rditions.. thereis to :i. If this conditionfails then the resultingmomentcondition. .vi by least squr:. .05 le . Regress on all the availableinstruments 2 describedin step l. 0r : 0 against alternative the that at leastone of the 0's is not zero.T is that if the F-t.This is possibleonly if surplusinstruments availablein the of are -. . -.'. ot be approxinrr:: tetme.MATION 1 0 .\ final diagnosticis to simply comparethe standarderrors of the lVestimates to the ''ndard errorsof the leastsquares estimates. again.ard the weakest them.' I regression" ).B extra.0 r z r* .16). luced form equar: .theseindividual F-testsdo not constitutean overall.t of the validity of the surplusmomentconditionsthatis easier compute. xz'.rations. In order to compute the lVestimator for an equation with B ..there must be L> B instru' :nts. For models with B > 1 endogenous explanatoryvariables.ibly endogenous variables..ir'require only one instrumentto carry out lVestimation. eoodness-of-fit measure.' S. + .+.Ratherthando this. s and all exogen iduals If we have L > 1 instrumentsavailablethen the reducedform equationts x c + t : T r f J : .2003. .: be testedfor validity.The steps to are . repeat: riable in the orig. Compute the IV estimatesBi using all available instruments. :rvalidand the IV estimatorwill not be consistent. is n-Wesley. e1. : lS P E C I F I C A T I O N TE\T\ 289 e one we recommi: the regression-.thenwe would expectall the lVestimates be similar. . instrument wel.. umentproblem.However..including the G variables xt: l. ..In the casein which we have B instrumentsavailable. br . and ' . The validity of this iimum numberof requiredinstruments cannotbe tested. l.xG that are presumed be exogenous. hence"overidentifying. t l: :."A surplusof momenr Econometric -litions meanswe havemore than enoughfor identification.. the L instruto and mentszl. .i: canusean F-testfor thisjoint null hypothesis. Unforlunately. .if the F-valueis lessthan l0 we but . -:e research this topic is still developing. _ b x x x . .ainstthe altemar: at the ct : 0. I O b t a i n h e r e s i d u a? s ! ... From (10. 02 : 0.J to large standard errorsfor the lVestimator. From the set of I instruments. are \\'hat shouldonedo if weakinstruments encountered? are This is a difficult questionthat .uld be concemedthat we are using weak instruments. How can :y is to examine 6a1after accounl I in the model.

290 RANDOM REGRESSORS AND MOMENT_BASED ESTIMATION 5.03 Jistributionwith or ..05 level.2 I < I 0. pp. endogenous.31 The R2from this re5 .1376 1. 10. If s e consider using just zl as an instrument. 2 1 9 6* 0 .eems to be the cul1 Include the residualsas an extra variable in the regressionequationand apply least squarer y : 1. is indicating that we have at least one strong instrument.The reducedform equation usingboth instruments shownin (10.5 Specrprc * : 0 .tbIe10.\PER2 . Ifv i. If all of the surplusmomentconditionsarevalid. 227-228.which is shou: in (10.11.080) (0. Princeton.the critical value)from the the test statisticexceeds 100(l . then we conclude that at least one of the surplus moment conditionsis not valid. Econometrics. distriUution.0.4a The Flausrnan Test To implement the Hausmantest.2140 -l0.es IJsrNc Srnurerno Dere 10.23) The r-statistic 6.4. then we are faced with trying to determine which instrument(s)are invalid and how to weed them our 10.3.-EDUC-EDU( 'nd estimate resu the . 10. value comesfrom the r-distributionwith 97 degrees freedom and is 1.4c Testing Ii we usez1 andz2i rre shownin (10..4T .985._rl.2' :n intercept..1. .rriable Ha ( :.This featu The instrumenta .4.andtheF-testfortheirjoint significanceis24.Xi.133) (0.rriables..4b v "mothe .0399x 0. l:r Section10.DUC -:--{PER :. the conesponding F-value is 5.we will use the simulated data(chlO.9951i * + (se) (0. fact.timates. 2000.i : x . If we usejust z2 as an instrument. A ven advancedreference is Hayashi.26) using the instruments andzz.4.206822 (10. 5 This test is valid if errors are homoskedastic and is sometimes called the Sargan test.26). 5 7 1 1 2 r (/) (6.dar) that we introduced first ir Section10.Computethe residuals Zr i : x .28.4.we first estimatethe reducedform equation.rdding led us to r z: .urpiusmomentcon :irst testedthe valid .1947 0.e.rstruments :rplanatory variable To implement tht . . indicating that z2is a weak instrument. If we reject the null hypothesisthat all the surplusmoment conditions arevalid. ir In T. The critica.3. thenNR2.28) While the /-statistic 2.there is a more general test called Hansen's "I-test that is provided by some software.4 Nunnrnrcer Exenpr.57002r 0.but nr j.rmresiduals.urplus moment co If we use21 22.rstrumentalvariablr rg variables.163) The t-statisticfor the null hypothesisthat the coefficient ofi'is zero is 6.4and then usedaeainin Section10.t If the valueor (i. z1an regressionis 0.hown in Table l0 .23corresponds an F-valueof 38.3.4.and thus ri e of reject the null hypothesisthatx is uncorrelated with the error term and concludethat it i.209022 (/) (2.92thatis well abovethe guidelinevalue to of 10.28 indicatesstatistical significanceat the 0.ct)-percentile the X2s-u.re shown in Table The Hausmantes :.the estimatedreducedform is i :0.2 .\timates using the :esidualsand regrei To illustrate the tests.4b Test for Veak Instruments The test for weak instruments again begins with estimation of the reduced form. If the errors arc heteroskedastic. the estimatedreduced form is 10.quaredistribution r . -'Jucation endoge is -renificantat the 10 :i idenceofthe endo . H.

. are identical to their instrumental variables -timates.l798zz T h e R 2 f r o m t h i s r e g r e s s i o n i s 0 . Calculate the residualsfrom this equation. but not their standard errors.99.s If the valueof ) :ritical value) from the the surplus moment s are valid.4c Testing Surplus Moment Conditions If we usez1 ardZ2as instruments. thus we fail to reject the validity of the surplusmoment condition.0481 0.0009 -0. a n d N R 2l:3 . whichis shoun :z (10.]MATION 1 0 .0614 0. 0 5 c r i t i c a l v a l u e f o r t h e c h i of nuare distribution with two degrees freedom is 5. e reduced form.HAT argan test. \rriable (:DUC !.XPER IXPER2 . Enor t-Statistic Prob.3.985. -.0482 0.and thus rr c' and concludethat it i. The 0. t is 1.628. zz.z1 andzz to obtain 2:0. l 3 l l .-rrm residuals.0201.r2r9 1. thus we reject the validity of the two .note that the coefficient estimatesof the remain:ng variables. we concludethat rducation is endogenous. level. The N estimates using thesethree instruments 9u_r1. The R2 from this regressionis 0.urplus moment conditions.0442 -0.27).0189*0. and then regressthem on an intercept.84.r2..0626* 1.3363 -2. This test doesnot identify the problem instrument.0.5 Spscrprcerrox TEsrs FoR THE WecE EquarroN we introduced first in uation. If the errors ar: I by some software. then we are row to weed them out.08812r -0.2355a I0. ire shown in Table 10. This feature of the regression-based Hausmantest is explainedin Appendix 10D.i.. Using these estimates we calculate the least squares residuals .10332r 0.0004 0.31 nd applyleast square:.4. 18l8zz.0310 0.The fVestimates are shown in (10. To implement the Hausman test we first obtain the reduced form estimates. Note that the coefficient of the reducedform residuals(VHAT) is 'ienificant at the l}Vo level of significance using a two-tail test.ariables. 2 llausman Test Auxiliary Regression Coefficient Std.EDUC.1.r3:1. The instrumental variables estimator does not work well with weak instrumental . A ven 0. While this is not strong :r'idence ofthe endogeneityofeducation.horynAlable 10.Second. and NR2 : 3..2706 -l. and then found that edding z: led us to reject the validity of the surplus moment conditions.05 critical value for the chi-square distribution with one degree of freedom is 3.11. Insert the residuals in the ln(WAGE) equation as an extra variable.4.there are two surplusmoment conditions.67tl 0.3535x.0348 o. 10.0954 . T h e 0 . In fact. ro is 6. thereis one surplusmomentcondition. If ue nis rve the guidelinevalue mis ln Section 10. andzzas instruments. : EDUC .2 The Hausmantest of the endogeneityis basedon the l-test of significanceof the reduced :.0009 0. :nd estimatethe resulting augmented The resulting estimates regressionusing leastsquares.3946 0.but sincewe nrst tested the validity of ztandzz and failed to reject their validity. If we reject the null hypothesisthat the coefficient is zero. The critica. using the two :nstruments"mother's education" and "father's education" for the potentially endogenous erplanatory variable education (EDUQ.0132 0. l l . the correspondreducedform equatior: is rt significance 24.9030 0.4bwe examined aIn(WAGE) equation for married women. If we use zt. instrumental variables estimation can be worse than using the least Ta bI e 1 0. IS P E C I F I C A T I O N T E S T S 291 '\\L_D v7.which are . the instrument z3 :eems to be the culprit.0582 0.28. it is sufficient causefor concernto considerusing :rstrumentalvariablesestimation. 10.Obtainingthe are residualsand regressingthem on the instruments yields 0 : 0.03628.9815 3.0237 0.

The resulting F-statistic value is 55.rf y .The test statistic is NR2 from this artificial regression. 10. ().5 Exercises 10. (c) Suppose w square. x1-2 ztl potentially useful instrumental variables.on all available exogenous and instrumental variables.l PnoslErvrs The geometric lag model (Chapter 9.and R2 is the usual goodness-of-fitmeasure.5. 10.-r * 9zx..KIDSI-6 is the number of children in the household who are less than 6 years old.4e.4.we require that at leastone of them be significant in the reducedformThe F-test null hypothesis is that both coefficients are zero. In order to be valid.4. KIDS6IS is the number between 6 and 18 years old. As discussedin Section 10.3779 R2 The 0. and the value is greaterthan the rule-ofthumb threshold of 10 that was mentioned in Section 10. Appendix C1) reduceswith some algebra to lt : 9r l9zl.the minimum number of instrumental variableswe needis one.we can test thejoint squares significanceof the two proposedinstrumentsMOTHEREDUC andMTHEREDUC using a standard F-test. Thus we can safely conclude that at least one of the two instrumentsis relevant. Sinceue have two instruments. why not? (b) Explain why x1-1. To test for weak instruments. contained in th. and NWIFEINC is household income from sourcesother than the wife's employment. WAGE is hourly wage. Given that we are using two instruments. The test is carried out by regressingthe residuals from the ln(WAGE.2.5. distribution.2 Cor"rpurpn . . which has ap-value lessthan 0.If the surplusinstrumentsare valid.4. * v1with random !rror V1: (e.000883 :0. then the test statistic has an asymptotic 11.000883.B : I extra instrument. Since we have only one potentially endogenousvariable in the wage equation. For the artificial regression : 0.we cannot tesl the validity of both instruments.calculatedusing the instrumentalvariablesestimates.If the test statistic value is greaterthan the critical value from this distributionthen we reject the null hypothesis that the surplus instrument is valid.05 critical value for the chi-squaredistribution with one degreeof freedom is 3.4.Consider the following supply equation specification HOURS: Fr * B2WAGE-t FzEDUC + 94AGE * 9sKIDSl.3. and if we reject this null hypothesis we conclude that at least one of the coefficients is nonzero.:1 The25 valueso software to can (a) Createthe I 1*lxx* (b) In the sam E ( Y :)t + (c) Using the d the parame true values . equation. (a) Estimate th (i) the slrc (11) the wet (b) Examineth to the varia (c) Obtain robu standarden (d) It is argued variables a measureof share of GI instruments equation. (e) Test the str< software pe (f) Use the Hau the regress estimating 1 (g) Test the va (h) Test the rel 10.r).2. (a) Is least squaresestimation viable in this model? If not. (b) Explain why this supply equation cannot be consistently estimated by least squares regression. and Inl Prediction.292 RANDOM REGRESSORS AND MOMENT-BASED ESTIMATION estimatorif instrumentsareweak.and the test statisticvalue is NR2 : 428x0. the instruments MOTHEREDUC and FATHEREDUC should be uncorrelatedwith the regressionerror term. and only one potentially endogenousvariable.-).3 Toexaminethe Growth.1 l0. where the degreesof freedom are the number of surplus instruments.6 * 9oK/DS618 I STNWIFEINC { e where HOURS is the supply of labor. EX satisfy the (d) Is the supp (e) Describe tt estimates. we have L . (c) Describe the steps (not a software command) you would take to implemenr 2SLS IIV estimation in this case." So INFI"ATIOI whereINFl'ATt the growth rate national output 9: : -l' Dr'I 10. (a) Discuss the signs you expect for each of the coefficients. With this result we arereassured that our instrumental variables estimator for the wage equation is consistent.0001.only the "overidentifying" or surplusinstrument.8-1.2 The labor supply of married women has been a subject of a great deal of economic research. thuswe fail to reject the surplusinstrumentasvalid. EDUC is years of education.

Sinces.-f The25 valuesof. on L6 + 96KIDS618 wherelNFl. thenthe teststatisrre the numberof surplu. why not? tal variables. plot the value of _r against x. software (0 Use the Hausmantest to check the endogeneityof OUTP UT GROWTH.I s with some algebrai Qe.l -1. (g) Test the validity of the overidentifyingrestrictions. (c) Obtain robust standarderrorsfor the model and comparethem to the leastsquares standarderrors. : -1. (ii) the weak joint hypothesis9z: I and B. and NWIFEINC . (d) It is argued that OUTPUT GROWTH may be endogenous. INITIAL : initial level of real GDP.lL! estimates.If r.Because the regressionerrors may be heteroskedastic.If your permits make the tests robust to heteroskedasticity.3. I if we reject this nu.Four instrumental variables are proposed.Accordingto theorywe shouldobser\.: Growth.Comparethe estimated B1 true values. (e) Testthe strongand weak hypotheses listed in (a) using the lVestimates. Brumm kindly providedus the data he usedin his paper. Do the data fall randomly about the regression function? (c) Using the dataon y created part (a) andx.dat. and id. : from this distributio: valid.4 (b) In the same graph. satisfy the logic of instrumentalvariables. For the artifici. Useyourcomputer software to carry out the following: (a) Createthevalueof the dependent variableyfrom the modely : Br * \zx I e : I + lx-r * e by the method describedin Section 10.datweregeneratedartificially. (e) Describethe steps(not a computercommand)you would take to obrain -'.-t). (d) Is the supply equationidentified?Explain. |HEREDUC should b"t 10. an.f: /e arereassured o.2 Compurrn ExrncrsEs t -3 To examinethe quantitytheory of money. yment.5.4. nonzero.ATlONisthegrowthrateofthegeneralpricelevel. all availableexogenoL. : 3x 0 . Linrhp:i of Prediction. obtainthe leastsquares in estimates of valuesof the parameters the to the parameters and B2." SouthemEconomic Joumal. 10. in of (a) Estimate the model by least squaresand test (i) the strong joint hypothesisthat Br :0..Brumm (2005) ["Mone1 Grori rh. rle.' .Given that we ar: :antin the reducedforn-. and the regressionfunction E(y) :1 + lxx. Dr.r the INFIATION: BI * 92MONEY GROWTH * 7IOUTPUT GROTITH . 10. lly estimatedby lea. s variable in the wagr s one.e that B1 :0.2.661-6671specifies c-quar:r.IIMATION 10.randeinivregl.wehaveL-Brls from the ln(WAG[. ial regression. Using these share of GDP.\'EYGR()liTHrr the growth rate of the money supply. ge. (b) Examinethe leastsquares residuals thepresence for ofheteroskedasticity related to the variable MONEY GROWTH.EXPER2. ree offreedom is 3.Itconsists 1995dataon 76 countries. R: :.The resultin: we can safelyconcluti: greater than the rule-o:.5 EXERCISES 293 nts.. and 9r : -1.4. Explain how these rariable.and OUTPUT GRO\WH is rhe gro* rh rrrC rri nationaloutput. and Inflation: A Reexamination the Modern Quantitl' Theory'. 3 7 . rld take to impleme: 3reatdeal of econom:. 9z : l.1. EDUC is years i: ld who are lessthan rld.use robust standarderrors when estimating the auxiliary regression. use a robustjoint test. 0 0 0 8 8 3 0 . (c) Supposewe consider the woman's labor market experienceEXPER and it: square.: that :lt. cannotte. and POPRATE instruments obtain instrumental variables QSLS\ estimates of the inflation equation..VO. IW : &Vrr?g! : averagepopulation growth rate.' we us instrument. SCHOOL : a measure the population'seducational of investment attainment.. to be instrumentsfor WAGE.we can testthejoin: MTHEREDUC using.qhich i: 9:: contained the file brumm.TI(3). B: : l. (h) Testthe relevance the instruments of usinga joint F-test as described Section in your softwarepermits. Ourp.

lVestimates? they getting closer to the true values as the sample size increases. Compar. : (d) Estimatetheregressionmodely Br * $yx * ebyleastsqua. and compare it to your answer in (a).A. the differences.. using econometric software designedf. : br -l bzx. Using the algebra. 22.andN : 500.estimation.'.Comment thevaluesof the correlations. clas data.andzz in ivreg2. to the estimates. .Repeatusin-: N:20. betweenxand. carry out the Hausmantest (via a: artificial regression)for the existenceof correlation between r and the rando: disturbancee.tatistical assumption ' . (c) Using the stepsoutlined in Section 10.Repeatusin-r N :20. (e) Compute the least squares residualsfrom the least squaresregressionin part (d Find the sample correlation matrix of the variables x. : instrumental variables. not? I: or not. Repeatusing N . e.!.The datafil "Th Mroz.varianceo? : 2. Zt. Note that the data do not fall randomly about the regressic: function. solvefor th.and /-statisticsto thosein part (b) and comment.standarderrors.b1 . Which t : 2 on theseconelationscould you not computeusing a sampleof datacollectedfror: the real world? 10. N: 100. cannotget data c years of experie of MGTi. l an instrume residuals. The 1 (a) Estimate the (b) Find colrest sample aver (i) 10 year (ll) 20 yea (iii) 30 yea (c) John is conc error term. Th.'. as in pi r'i' A consulting firn of wine product I where Q. not? If no: or why not? (g) Estimatethe model y : 9r * B2xI e by instrumental variables using a samplr consistingof the first N:10 observations and the instrument22. (a) The explanatory variable x follows a normal distribution with mean zero ar. 10. on and averagedincome (z) in savings.with instrument z.lr on N : 100. and the regressionfunctic: E(y):3 * lxx.50'Using your computersoftware. is an . and to be correlated with x but uncorrelated with e.dat were generatedartificially.dat (a) Estimatea least squares regression savingson income.I. plot the value of y against x. variable) : Fr * $zx -t e : 3 I lxx * e. and the valuesof 9r : 3 and B2 : I. of (b) Estimate the relation between savings and income (x) using the instrument. Using th. and the least squarr-residuals : ! .(1987) .The covariancebetweenx and e is 0. find the samplecorrelationsbetweenz1. consistingof the first N: 10 observations y and x. or two-stage least squares. &r\dc Will zr andz2 make good instrumental variables?Why? Is one better than th: other?Why? (f) Estimatethe model / : 9r * lzx -t e by instrumental variablesusing a sampl: consistingof the first N:10 observations and the instrument21. determine the correlation between x and e.x.N: they getting why not? C< instrument I (h) Estimate the consistingo using N:2 A estimates? or not? If nc one.. income {. Compar.294 RANDOM REGRESSORS AND MOMENT-BASED ESTIMATION (d) Plot the data and the fitted least squaresregressionline j. 0 and variances1.resusingasamp. (c) In the same graph. why not? (e) The variableszr and zz were constructedto havenormal distributions with mean.and the 50 observations savings(y).T. (b) Given the valuesofy andr.9.What do you observe Arc aboutthe.4. variablesestimator.It estimatedin (d) Use the inst with AGEi.What do you observe aboutthe leastsquares estimate: Are they getting closer to the true values as the sample size increases. results and r (e) Find coffest sample aver (i) 10 yea (ii) 20 yea (iii) 30 yea Compare th t The labor suppl A research. quantity and qut CAPi is an inde.andN : 500. The random error e is normally distributed with mean zero ar. this plot to the one in part (b). valuesofthe randomdisturbances Find the samplecorrelation e. (d) Use two least squaresregressions obtain the lVestimates in part (b). varianceoZ : l.b2x.definition of correlation.6 The 500 values of x. full setof 500 observations.

n with mean zero an: ed with mean zero anJ ). He decidesto do a Hausmantest. :lation betweenr and . using the manager'sage (AGE. le increases. Compare these interval estimateswith those obtained in part (b).). Hausmantest (via r zeenx and the randor:: :s in part (b).IMATION 1 0 . where Qi is an index of wine output for the ith winery. data.John setsup the productionfunction Qi : 9t -t FzMGTi * B3CAPi* F+LAB:+ e. Ithe lTestimates? Arr )reases. not? Ifno:. on Johncollectsobservations the number cannotget dataon management yearsof expeience (XPER. (c) John is concernedthat the proxy variable XPE& might be correlated with the error term. Repeat using N: lt astsquares estimate. and LABi as the instrumental variables.: iquares usinga sampi. (1987) "The sensitivity of an empirical model of a married woman's hours of work to economic :l statistical assumptions.def The ' Mroz. why not? Comparingthe resultsusing zr alone to those using zz alone. solvefor th. re regressionfunctio: I about the regressic. and comment on the outcome of the Hausman test. T. Using th. What do you observeabout the 1I' Are estimates? they gettingcloserto the true valuesasthe samplesizeincreases. why not? Is estimation more precise using two instrumenls than one.A classic work6 is that of ProfessorTom Mroz. not? Il or itributionswith mean. 5E X E R C i S E S 2 9 5 100. Include these residuals as an extra variable in the equation you estimatedin part (a). (e) Find correspondinginterval estimatesfor wine output at wineries that have the sample averagevalues for labor and capital and have managerswith (i) l0 years experience (ii) 20 years experience (iji) 30 yearsexperience. 765-800. Repeatusin-: . and the least squarecorrelations. rt (b) and comment o: . and lABi is an index of labor input. who kindly provided us his ." Econometrica.) of each winery managerand usesthat variable in place of MGT1.Repeat and zr using N:20.datand the variable definitions are in the file mroz. and N:500. MGT1 is a variable that reflects the efficiencl. Because efficiency. u hich instrument leads to more precise estimation? Why is this so? (h) Estimatethe model ):9t * S2x I e by instrumentalvariablesusing a sample consistingof the first N: 10 observations the instruments andz2.'iablesusing a sampir nent 21.Repeatusin. Compar. not? If not. atedwith e.dat.RegressXPERi onAGEi. as in parts (0 and (gX . CAP. )tween 22. Using the algebrar:en x and e. he CAPi is an index of capital input. r g The labor supply of married women has been a subject of a great deal of economic research.andN:500. The 75 observationsare stored in the file chard. andLAB.Compart s regressionin part (d .rated artificially.7x A consultingfirm run by Mr.r rsing the instrumentr software designedfc: ation. or :iablesusing a samplr nent zz.A. (b) Find correspondinginterval estimatesfor wine output at wineries that have the sample averagevalues for labor and capital and have managerswith (i) I0 yearsexperience (ii) 20 years experience (iii) 30 years experience. or not? If not.'of mana-eemeni. Th. JohnChardonnay investigating relativeefficiencr is the of wine productionat 75 California wineries. :h*b2x. md savethe residuals..Which o: of datacollectedfron: lvings (y).x. (a) Estimate the revised equation using least squaresand comment on the results. income (. CAP. taking into account both quantity and quality. What do you observe Are N:20.The data fiLeis mroz. Comment on the results and compare them with those obtained in part (a).) as an instrumentfor XPERi. (d) Use the instrumental variables estimator to estimate the equation Qi : h -t \zXPERi + \3CAPi I $aIABi * ei with AGEi. 55.N: aboutthe lVestimates? or they getting closer to the true values as the sample size increases. | 9z : I.Lnd t z1) Is one better than th. N:100.

her husband's education (HEDUC and the woman's number of siblings (SIBLINGS). (i) Write a 200-wordsummaryof what you havediscovered this exercise in aboutth. test the endogeneity of ln(WAGL using the Hausmantest. EXPER2. Checkthe validity of the surplu.-.and in Sectio \ppendix 10 . 10.\ppendixB. . Ar.What do you conclud. . following supply equationspecification HOURS: Br * B2In(WAGE)* \rEDUC + \4AGE + 95KIDSL6 -l\TNWIFEINC * e f 96K1DS618 The variable NWIFEINC is defined as NWIFEINC : FAMINC .S.r mean) value of be . w.296 RANDOM REGRESSORS AND MOMENT-BASED ESTIMATION A P P EN D I ] datafile containsinformationon women who haveworked in the previousyear anc thosewho havenot. Discussthe suitab:due (MOTHEREDUC lity of using asinstruments woman'smother'seducation the her father's education (FATHEREDUQ. thisappendix t we . labo: force participation. endogenous. instrumentusing the test suggested Section 10. Discussthe estimates'signs and significance. (b) Estimate the reduced form equation ln(wAGE): rrr * T2EDUC -l rzAGE + I4KIDSL6 + rrsK1Ds6l8 + IT|NWIFEINC + TTEXPER + figEXPER2 + v using least squaresestimation and test the joint significanceof EXPER an: EXPERZ.7 The dar. (e) Estimate the reduced form equations for EDUC and ln(WAGg including a.WAGEXHOURS (a) Considering the woman's labor market experienceEXPER and its squarc EXPERZ to be instruments for ln(WAGE).3.like to thank Professor Bennett Mccallum for his generous help. and SIBIINGS.9 Consider a supply model for edible chicken. In each reducec form equation test the joint significanceof EXPER. Department o: Agriculture calls "broilers. (g) Compute the 2SLS estimatesof the supply equation..in about the validity of the overidentifying variable? (d) It is also possiblein the supply equationthat the woman's level of educationi. thereany surprises? (h) Test the validity of the overidentifyinginstruments basedon part (g).Wewou. I equationis ln(QPROD where QPR( freshchicker equationis < termined va 1 ) 5t) external instt wherePB is t yearl-lto exportsof cL (a) Estimate the signs (b) Estimate available (c) Test the describe (d) Checkwl describe (e) Do you sr ones.nditionaldistribut .3. which takes the value I if a woman worked and 0 if she did nor Use only the dataon women who worked for the following exercises. . The variableindicatingwhethera woman worked is lFP.rdom variables ' -:obability distribu compute the con -'lue of )z given th .1 CoNplrro :.4. ' "Simultaneousequationeconometrics:Themissingexample. labor supply of married women." The datafor this exerciseis in the file newbroilerdu:.44(2). ln(WAGE) are endogenous. to the omissionof ability from the model. (l) Usetheresultsof(e)tocarryoutaHausmantestoftheendogeneityofEDUCanc tn(WAGE). Do these instruments seem adequate? (c) In this problemwe haveone surplusinstrument. which the U. assuming that EDUC an. HEDUC. instrumentsin (b) and the potential instruments listed in (d).:nrilarlywe can de . Considerth. which is adapted from the dataprovidedby Epple and McCallum (2006). -l for preliminary 1rtA.374-384." Economiclnquiry. are annual.MOTHEREDL'( FATHEREDUC.

hat do you conclud.. ._r ) .4.ei 9sKIDSL6 PER and its square geneity of ln(WAGE )St6 + n5KIDS6l8 flXPER2 + v :ance of EXPER an. In the discrete case it is var(Ylx: x):? |. using the test for weak instruments describedin Section 10. Lndsignificance.y).r) is rhe avera-se or mean) value of Y given that X takes the value x. (a) Estimatethe supplyequation leastsquares.. We can use rhis condirional pdf :o compute the conditional mean of Y given X.1 to l.4. (c) Test the endogeneity of ln(P. then the conditional rrobability distribution of I given X is /(yl.log of exports of chicken. labo: . In the discrete case it is defined :r')be E(Ylx: x) :LyP(Y: ylx: x):\yf (ylx) J.) where Iis real per capitaincome:lnrpB.) using the regression-based Hausman test described Sectioni0.r.) + 93ln(PF.' level ofeducation :.) -t 9+TIMEI+ln(epROD.). The conditional expectation E(YIX: .-1) : laggedlog of real price of chicken. 1n(P.iMATION APPENDIX 1OACONDITIONAL AND ITERATED EXPECTATIONS the previous year ani Lworked is lFP. we can obtain the expecred . which ones..7 The dar.TLIIE.but in the estimations datafrom 1960-1999.52) is included capture to technical progress production.52. . . 104. (d).M)THEREDL'C.S.and why? Check the instrument validity using the test proceduredescribed in Section10. we definedthe conditional probability distribution.d and 0 if shedid nor rercises. rm (2006).3for preliminary definitions.2. POPGRO : percentagepopulation _gro\\ from rh year t . Appendix See ts. .: -vy ( l 0 A .): 9r * B2ln(P. In each reducec R2. by Discuss esrimarion the results.1950-2001. Considerthe are annual.4.TIME : l.1 CoNorrroNan ExprcrerroNs In Appendix B. This supplr equationis dynamic.P : real. price inder oi freshchicken. That is.2. in Someporenrial externalinstrumental variablesareln(I.alue of I given that X : . Are the signs and significance what you anticipated? (b) Estimatethe supplyequationusing an instrumental variablesestimatorwith all available instruments. l. in (d) Check whether the instrumentsare adequate.What do you conclude? (e) Do you suspectthe validity of any instrumentson logical grounds?If so. Appendix 10A Conditional and Iterated Expectations In this appendixwe provide someresultsrelatedto conditionalexpectations. .374-384.1.3. where PB is the real price of beef. hisexercise aboutthc where QPROD : a1gregate production of young chickens. E(Ylx:if' f 0l*) .. . with lagged production on rhe right-hand side. . l) Similarly we can define the conditional variance of Y given X. A(2). This predetermined variable is known at time / and is treated as exogenous. This is the variance of the -'onditional distribution of I given X. Discussthe suitab:n(MOTHEREDUC :ducation (HEDUC WAGE) including a.Wewou.In(EXPIS r . If X and f are t*'o :andom variables with joint probability distribution f(*.1. . Compare these results to those in (a).PF : real price index of broiler feed. validity ofthe surplu.3.. Department o: e file newbroilenda:.eneityof EDUC anc ning that EDUC an. Arr on part (g).The suppll use equation is II(QPROD.

thejointpdfofxandycan Yis be expressed /(x.298 RANDOM REGRESSORS AND MOMENT.2r :0 Thus. cov E(Y): Ex[E(Ylx)] (10A.lE(e1lx.[xiE(eilx.4) The law ofiterated expectations saysthat the expectedvalue of lis equal to the expected value of the conditional expectation of ygiven X.): E. .BASED ESTIMATION APPET 704.lxi) if :rom(10. take expected r EV'.)l:4.1)is thr rhen it is not.Using the law of iteratedexpectations (10A. t L J \ y l xJ \ x ) l ) Y ff LX J !"lerewe provide an a -'or'(x1.r. will usetwo factsaboutprobabilitydistributions We discussed Appendir in B.) :.1r .y)andsecond. theexpected valueof theerrortermis zero.) : E.x)E(vlx)] Y) (10A. Two other results can be shown to be true in the same way: multiply both s W'.In the regression model yi : Fr * 9zxi + !i.5r The least squaresestit Z(xi . solvefor gz 10A.3 r cov(X.bcnrssroN MonEr ApprrcerroNs The resultsaboverelate to assumption A10.) : 9r * B2 .l*i):9r *B2. Appendix 108 :zyf(y): E(y) ?rl?re.using(104. / | \ . E(e if What this means becomes clearerwith the following demonstration it is true in the that discrete case.' L x I v (by changing orderof summation) .sz . wa have assumed that the conditional mean of y. E(xp.x (10A. B..3* made in Section 10.f(*.[0] : 0 Next.ind using (10A. Ow r< e. : >E(Ylx: x)f (x) : ExlE(Ylx)l In the final expressionEy[ ] meansthat the expectationof the term in bracketsis taken assuming that X is random. subtract this ex : I lrl01")l ' l /(") -.1. That is.rrat E(y. f O. E(e.First.Then. l l .7).3.{.E( E(xY): Ex[xE(Ylx)] and (10A.6r bz: s/-. So the expected value of y can be found by finding irs conditional expectationgiven X.3. : Ex[(X p.2 Irrnerrn ExpncrroNs .h0] :0 (10A. If we can assumet E(e.5)]..* ' . iquation(10B. Equivalentlywe have assumedthat E(eilxi) :0. is E(y.i) . / \ l : .)]: E.. and then taking the expectedvalue of the result with respect to X. conditional on x.2).3 f.y) : f (ylx)f (x) [see as Appendix equation (B. it then follows that the unconditional expectation of the error is also zero.3).themarginalpdfof f(y):2.

.)le. Appendix 108 The Inconsistency of Least Squares Herewe provide an algebraicproof that the leastsquares estimatoris not consistent when -'or'(x.5)1. In the regression al mean of y. Leto.3.y') cov(.l) 3. i.E(yi) : Fzfui.l) is thebasisfor showingwhen the leastsquares Equation estimator consistent.): 0.E(x.4) equal to the expected cov(x.n@)l' -r E{lxi .E(yi)) : gz[xi .pectations r. yi .3 rr cov(x. is and .lxi) : 0 it follows thatE(ei) : 0. Thus.r) (l0B.5 Theleastsquares estimator be expressed can as -*)(yi . then cor (. Then. e)+0. Under A10.)l0 then cov(x.1t Lthat it is true in the scussed Appendir in intpdf of Xand Ycan r.-1 .F")0] :0 (10A.6.r) (108. E(xie.gr -1:hatE(y.7).. .I(xi xt(li )=)/(N l) ------=l--r L(xi -7).-var(x) var(.E(x. e of the result wirh .4. Our regression gzxi + e.).if E(e.) :9.rhen it is not.E(e.ei) : E..r.)]: E.ei) : 0.l(x. take expectedvalues of both sides E[x1 E(x.}.)]ls4 E(y)l : gzE\i .) lxl . (10A.Then. .E(x.{.. subtract this expectation from the original equation. I(xi _ rljl(N _ l) *"tr. _.lx. If we can assumethat cov(x. e) t (10A. However. solvefor Bz ^ r":----^ cov(x.r.l(ri . and cov(x.E(x. multiply both sides by x.7) (10A... :rom (10A. 0.l. . e) ---------.1*)E(e. .et)*0.t .n@)]' + h . (l0B..2) (10A.E(xi)le.)lfyi .o model is yi .t) ^ _ L(r. mmation) in bracketsis taken ound by finding ir.y) : B2var(x) cov(r.2 .) ^ tJ:: var(.) : Br * g2E(x..)) + ei .dt (10. ei) : 0.lx.if E(e. Conditional on (10. .MATION APPENDIX 1OBTHE INCONSISTENCY OF LEAST SQUARES :nd using (10A.r.

On the other hand. If . P2: ...: convergesin large samplesto B2.r is correlatedwith t riased and inconsiste An instrumental vi :e valid. a condition we imposed on the choice of the instrumental variable z.1).y) cov(x. A correlatio :hem (see Appendix :egression Appendix 10C The Consistency of the 1V Estimator The demonstrationthat the instrumental variablesestimator is consistentfollows the logic used in Appendix 10B. The problem.: If the instrumental variable z is not correlated with x in both the sample data and irthe population. - (lOc. in the denominatorof B2 in (10C.r In this case b2 is an inconsistent estimator of p2 and the amount of bias that exists ever: asymptotically. it must be uncorrelated with the error term e but correlated with the explanatorl variable r. here E(r) : rro+ 'r :.we can cons ' .1) and (10C.3 \ow.RANDOM REGRESSORS AND MOMENT_BASED ESTIMATION This shows that the least squares estimator b2 is the sample analog of the population relationship in equation (10B.2).) var(xJ (10B.ffi:tr.rbsritute(10D. We obtain ^ 9r: *Gu)-*fr:.5) int 0. If factors in the error are positively correlated with the explanatory variable x. suppose a mr for .'sression model(l0J The sample covarianceconvergesto the true covariance in large samples. xJ (10c. The samplevariance and covarianceconvergeto the true variance and covarianceas the sample size Nincreases.4.rplied to this equatio . is cov(x. if cov(x.ei) : 0 then to cov(x.e) :0.-l l(N ): >ki y) cov(2. then the least seu&r!: estimator will overestimatethe true parameter.r . r.Thus for an instrumentalvariableto br valid.e) ^ P2: un(r) "ar(r) The least squilresestimator now convergesto 6 Thus if cov(4. Now.r i').z)(y.)) c o v ( 2e ) .so we can sa\ 0.if ld e. The to direction of the bias dependson the sign of the covariancebetweenx and e.4114: B.+8.. so that the least squaresestimator converges B2.-l(xi. cov(2. The lVestimator can be expressedas There is a correlatior i "reduced form" eqr :egressionassumptio 5 i') :0.'j cov(2. (10c.when samplescan be assumed be very large. -.) (r0c. then the instrumental variable estimator fails.y) cov(x.e) : ( r-onsistent. br:# showing that the least squaresestimator is consistent. obtain the fittedredr --in rearranqeto obta If we can assumethat cov(2. vartx. since that would mean a zerc.l .y) .2). then the instrumental variables estimator in equation (10C. i. a situr in correlation between . in the re retweenv and ebeca We cannot exactly ilowever..1we 1 using an artificial reg: regression model is cov(I'l) gz Y!2 : * b. ifx and e are correlated.rriables in the regn .e)fvar(x). follow the same stepsthat led to (108. We can dil Z(zi. r) I (N . then cov(x. That is. Appendix 10f InSection 0.a114 cov(2. In fact.r) .

4) (10c.s) (r0c. Will least squares in work when 'pplied to this equation?The explanatoryvariable E(x) is not correlatedwith the error term e or v). and e.3)..andtheresiduals x .r+u (10D. (10D. . This regressionis called r "reduced form" equation for reasonsthat you will discover in Chapter 11. suppose a moment thatE(x) and y can be observed for and are viewed as explanatory . mental variable to br with the explanaton (10c.6) . The standard :. then the instrumental variable estimator of B2 is -Lrnsistent.any correlationbetween and e implies correlation :nd e. The problem.rhereE("r) : r0 * n'rz.3)into the simple :egression model (10D.r)* pzv f e. e ) : 0 a n d c o v ( z .Th.1) obtain Substitute into the originalequation to (lOD.3) (10c. .Let us explore how and why this test might work.1 . as x:E(x)*v (10D. v We cannotexactly createthe partition in (10D. a situation in which the least squaresestimator is not consistent due to in -orrelationbetweenx and e.whichwe i: -'anrearrange obtain an estimatedanalogof (10D.2) . In fact.ariables the regression y: 9r + FzE(. This means that we can describe their relationship as a :egression x:Tiotrrtz+v (10D. . to x--.4. can consistently we estimate reducedform equation(10D.1) to obtain + / : Pr* Bzxf e : 9t+ BzlE(.3) because do not know n"eand tr1.: \ow. A correlation between z andx implies that there is a linear associationbetween :rem (see Appendix 8. r ) t'}.4.1 mples..comesfrom a correlation between (therandompart of x) r.1 -t / : Fr* 1zx e : 9r + zzlir nl+ e :9r*lzi-tFzi1.r is endogenous and the least squares estimatoris ^iasedand inconsistent.i. sample data and i: at would rrlearro Zer.E(x). I r') : 0. in the regression -r retweenv and e because : x . we However.5) (10D.IMATION APPENDIX 1ODTHE LOGIC OF THE HAUSMAN TEST rlog of the populatio: ce convergeto the tru: leastsquares estimatr': l h u si f c o v ( z . The simple ::sressionmodel is ]:Fr]-gzxle (10D.2).if thereis one.If we knew n6 and n1.1we present testfor whetheror not an explanatory a variableis endogenous -:ing an artificial regression.3 n the choice of the in equation(10C. An instrumental variable z must be correlated with x but uncorrelatedwith z in order to "e valid.'gression assumptions apply to (10D. Iffactors in rhr hen the least square.so we can sa.2)by leastsquares the :oobtainthefittedreducedformmodeli: fro + rrl. we could substitute (10D.r is correlatedwith the error term e.1) (10B: f bias that existser e: cov(x. then.timator itent follows the log:- Thereis a correlationbetweenx and z ii and only if.1).e (10D. We can divide x into two parts. Appendix 10D The Logic of the Hausman Test ir Section10.3). in particular the error term y has mean zero. a systematicpart and a random part.: .t10.e)f var(x).r)v)+ e : Fr * \zE(x)-r }zv * e (10D.

7).7) will . that if we omit a variable from a regression with the includedvariable(s).9t 5. of Consequently. let the coefficient of i be denoted as T. if x is endogenous then the least squaresestimator of 1 in (10D. in This is much easierbecause ordinary software automatically prints out the t-statistic for this hypothesis test. so that (10D.22t.Add andsubtractBli to the risht-hand side to obtain Sirnult Modelr Learning Obj Basedon the materi L ).7) are consistentwhether or not x is exogenous.becausethey are the lVestimators. Explain why Thus instead of testing Ho:92:T. Describethe in a simultan least squares Keywords endogenousvariable exogenousvariables rdentification For most of us. and conclude that it is endogenous.7) becausethe least squares residualsi are uncorrelatedwith i and the interceptvariable.302 RANDOM REGRESSORS AND MOMENT_BASED ESTIMATION To reduce confusion.7t (10D. recall from Section6. Ifx estimator of ^yin (10D.23). then we reject the exogeneityof . we can simply use an ordinary /-test of the null hypothesis IIs: b : 0 in (10D. is correlated with the error term e. least squares the estimatorsof Br and B2 in (10D.6) becomes Chapte y:gr *gziIli-le If we omit i' from (10D.7).r*6i*e Define the rr usefulness.'haptersbecausein r 0 t !. equation(6.7)and(10D.9zS : 9r * Fz(i + t) + (r . Explain why ordinary leas Explain the d -1.B2)i+ e :gr*Fz.1.7) regression the becomes /:gr *Fzi_te (10D. 6. .andareequalto theIV estimates.8)are theIV estimates.r. Carryingout the testis madesimplerby playing a trick on (10D. However. our I .8 r as The leastsquares estimates B 1and B2in ( 10D. l. definedin(10. which is exactly the test we described Section10. andhencev and e areuncorrelated.If we reject the null hypothesis Ho:92 .andin fact that is uncorrelated the least squaresestimatesare unchanged! This holds true in (10D. Thus the least squares estimates B1and 9z in (10D.7) will also converge in large samples to B2.?o/convergeto B2 in large samplesbecausei. This observation makes it possibleto testfor whetherr is exogenous testing the equality of the estimatesof B2and 1 by in (10D. : Fr * gzi -l 10 + e * gzn.then the leastsquares What about "y? is exogenous. Define the "i ).-onsidered far bec eredeterminedby th equat Simultaneous rhan one equation.4.rnd demand models Jetermined by the econometricmodels Thesesimultaneous . (10D. of Then.9). Simultaneousequ so .1.6.8)areidentical.1.thereis no omitted variablesbias. like v.

2.price andquantity For rre determined the interactionof two equations.The least squaresestimation 303 .which containmorethanone dependent variableand more than one equation. consistent whethert. Explain the differencebetweenexogenous and endogenous variables. asdefined (10.7) because the lea. 3.andin fac: ). onvergeto B2 in largL' observation makes :: : estimates B2and-.r Add and subtract$.TMATION rt (10D. by Thesesimultaneous equations modelsdiffer from thosewe have considered previous in chapters because eachmodel thereare nlo or more dependent in variablesratherthanjust DIlE. in which the market price and quantity of goods sold are jointly Jetermined by the equilibrium of suppll' and demand.- chapter 1 1 Simultaneous Equations Models (l0D.6)becomes (10D. require special statistical treatment. ral to the1V estimate. (l0D. However. L Define the reduced form of a simultaneous equations model and explain its usefulness.r r. Learning Objectives Basedon the material in this chapteryou should be able to l. Describe two-stage the leastsquares estimation procedure estimating equation for an in a simultaneous equations model. Simultaneous equations modelsalsodiffer fiom mostof theeconometric modelswe have considered far because so they consistof a seto.ind demand models. In this chapter we consider r'conometric modelsfor datathat arejointll. determined two or more economicrelations. riables bias. of :t the exogeneityof .21 in able from a regressiol-. Explain why estimationof a supply and demandmodel requiresan alternativeto ordinary least squares. our first encounterwith economicmodelscomesthrough studyingsupply . and how it resolves estimationproblem for the least squares. example.s i. Define the "identification" problem in simultaneous equationsmodels.: Thus the leastsquare.4. uy t-test of the nul rcdin Section10.1 t the r-statistic thi for Keywords endogenous variables exogenous variables identification reducedform equation reduced form errors reducedform parameters simultaneous equations parameters structural t\\. to by 6.e 5. .o-stage least squares For most of us. Explain why it is acceptable estimatereducedform equations least squares.: . B2. for supplyandthe otherfor demand. thenthe leastsquarc. if .fecyrcttions. by one Simultaneous equations models.

Random enors ar we assumethat theY 11. If youhave notread Chapter I 0. In this model we assumethat the quantitl' demanded(Q) is a function of price (P) and income (X).2 Infl variables. Quantity supplied is taken to be a function of only price. respectively. you recall that market equilibrium occursat the intersectionof the suppll and demand curves. which is self-contained.This chapter on simultaneousequationsis presentedseparatellbecauseits treatment was the first major contribution of econometricsto the wider field of statistics.In practice we would include intercept terms in these models.1 A Supply and Dernand Model Supply and demandjointly determinethe market price of a good and the quantity that is sold. the referencesback to portions of it provide a deeperunderstandingof material presentedin this chapter. An econometric model that explains marker price and quantity should consistoftwo equations.The rar betweeneach of the see this leads to fai Income X is an exo feedback from P ar The factthatPis equationsmeanstht usualassumptionol by itself doesnot rn prcune 7 7 . In this model the variablesP andQ are called endogenous variables becausetheir values are determined within the system we have created.The incon variables are said to natory variables.If you hat'e read Chapter 10.are determinedat the sametime.3 In . for price and quantity.1. The point we wish to make very clear is that it takes fwo equationsto describethe suppll' and demand equilibrium. Graphically. We have omitted the interceptsto make the algebraeasier. Recognizingthat betweenthem.l r (11. sugg model we seethe tw determined. A very simple model might look like the following: Demand: Q: Supply: Q: gtP I azX * ea pf + es (ll. The two equilibrium values. prcunp 77. as shown in Figure 11. and the demandcurve to be negatively sloped.you will observethat much of what you learnedtherewill carry over to this chapter. reading Chapter l0 is not aprerequisitefor reading Chapter 11.304 SIMULTANEOUS EQUATIoNS MoDELS procedure is not appropiate in these models and we must develop new ways to obtain reliable estimatesof economic parameters. and becauseof its importance in economic analysis.one for supply and the other for demandIt will be a simultaneousequationsmodel sinceboth equationsworking togetherdetermine price and quantity. P* and Q'. However.2t Based on economic theory we expect the supply curve to be positively sloped.cr1( 0.The endogenousvariablesP and Q aredependenlvariables and both are random lrt us emphasizett modelsusing influer relationshipsbetwee the supply and der diagramsin Figure ables and error termt analysisthe directic error term to the del will lead quantity de to adjustto the mark and from Qto P. B1 ) 0. Some of the conceptsin this chapter were introduced in Chapter 10. rtcunp 77.1 Supply and demandequilibrium.andhow simultaneousequationsmodelsfitinto the big picture.

Ifyou ftare :will carry over to this e.The squares representexogenous explanatoryvariables. / sloped. Such rariables are said to be exogenous.11. As we will seethis leads to failure of the least squaresestimator in simultaneousequationsmodels. ( 1l ."") (l1. r .3) ( lr . implying the influence diagramsin Figure ll.1 A SUPPLY AND DEMAND MODEL 305 ) new ways to obtain 10. 2 Influence diagrams two regression for models.2.) : O.If youhavenotred :rstanding of material presentedseparatell s to the wider field of ):) .Br ) 0. Random errors are added to the supply and demand equations for the usual reasons.__@ I/ I . this by itselfdoes not mean that standardregressionanalysisis inappropriate./- . rariables.or feedback. and we assumethat they have the usual properties d the quantity that is rsection ofthe suppll that explains marka lhe other for demand. The fact that P is an endogenous variableon the right-hand sideof the supply and demand equationsmeansthat we have an explanatoryvariable that is random. suggestinga correlation betweeneach of the endogenousvariables and each of the random error terms. This is contrary to the usualassumptionof "fixed explanatoryvariables. Income X is an exogenousvariable that affects the endogenousvariables.An "influence diagram" is a graphical representationof relationshipsbetweenmodel components./ r t cu np 7 7 .The random error terms e4 andesaffect both P and Q. and rme that the quantir) rlied is taken to be a rraeasier.In the simultaneousequations the model we seethe two-way influence. RecognizingthatpricePandquantity Qarejointlydetermined. In this casethere is no equilibrating mechanismthat will lead quantity demandedto equal quantity supplied at a market-clearingprice.gtogetherdetermirr ng: E(ea): g.andthatthereisfeedback betweenthem.The real problem @tr | rrcvne 77. )sP and Q are called he system we have nd both are random let us emphasizethe difference between simultaneousequations models and regression modelsusing influence diagrams. l . reading :ontained.3 Influencediagram for a simultaneous equationsmodel. The income variable X has a value that is determined outside this system. var(e"): 6l :0 cov(ey. P* and Q'. there must be an influence running from P to Q and from Q to P." but as we explained in Chapter 10.3. but there is no feedback from P and Q to X.In the previous chapterswe would havemodeled the supply and demand relationships as separate regressions.In practice rdescribethe suppll luantity.-y' (aaHxl -\l leal \_-. suggests influencediagram in Figure I 1.betweenP and Q because they arejointly determined. va{ea) : ofr E(e. For price to adjustto the market clearing equilibrium. However.In this diagram the circles representendogenous dependentvariablesand error terms.In regression analysisthe direction of the influence is one-way: from the explanatory variable and the error tenn to the dependentvariable. @_@. and these variables are treated like usual "x" explanatory variables.

after market adjustmentslead to a new equilibrium for P and Q.ed andes.s variablesP and Q asfunctions of the exogenous variable X.c t l !s {Bt-". so we will substitute P into (11. po.the I This bias persistsever is inconsistent. p -d2 cgtP+ dzx + ed (B'-o')': trtX * vt y- ' !d . const2rl variances. 9tP * e': Then solve for P. substitutethe value of P in (11.a r ) (ll.e t ( F r.. ifthere is an increasein income X. It is not correlated with thc disturbancesv1 andv2. and see I :aying: (Br-ar^: 1T2x v2 + u . J .making the leastsquares estimator biased and inconsistent.4) into either the demandor supply equation.3 The Fail 11. Thc explanatory variable X is determined outside this system. the estimatedreducedform equationscan be usedto predict vallues of equilibrium price and quantity for different levels of income. rr1 is the expectedincreasein price.and using the samelogic. This reformulation of the model is called the reduced form of the structural equation system.-lt To solve for Q.2 The Reduced Form Equations The two structural equations (11.Thus. The reduced form is verl important in its own right. + (11. n2 is the expectedincreasein the equilibrium value of Q.1) and (11. As income . The reduced form equations can be estimated consistently by least squares.4 The Ide ln the supply and de r .4) and ( 11.2) and simpli$ Q:9f T + es ^^ e . size N ---+ See Sec estimators.Thus the leastsquares estimatoris BLUE for the purposes of estimating n1 and n2.Theseequationsrelale the equilibrium valuesofthe endogenous variablesto the exogenous variables.This r *'ill ultimately "colle oo.SIMULTANEOUS EQUATIONS MODELS is that the endogenous regressorPis correlatedwith the randomerrors.2) simultaneously for P and Q. o D x + 1a_ie=. e I Th" least squares 'I andinconsistent be I variables on the ri6 The parametersn1 and nz in (ll .5r 9roz In this sectionwe exp equationin a simultar section. To solve for P. The reducedform equationsare important for economic analysis. \ t e a .r : B ' L G . which themselveshave the usual properties of zero mean.To find the reduced form we solve (1l l) and (11. The least squarese ofthe negatil because ln large samples.P and The failure of lea follows: least squares for the effect of chanl changein the error ter e. 17. the parameters by any estimat the slope of th How are we able to illustrated graphica shifts and a new equ demandcuryes dl. and it also helps us understandthe structuralequationsystem.and zero covariance. set Q in the demand and supply equationsto be equal.2) can be solved to expressthe endogenou. The supply equation is simpler.5) are called reduced form parameters. It is the estimatedreduced form equations that make such predictions possible- 11. (Question:how did we determinethe directionsof thesechanges?) Secondly.which hasa devastating impact on our usualleastsquares estimationprocedure.1. Thc error terms v1 andv2 are called reduced form errors. d income. Similarly. we focus on r ariable P on the righl give an intuitive ex1 explanation is in App Supposethere is a this change through ransmitted to the ec rhat hasP on the left at a direct linear effect t rime there is a chang Consequently. . Clearly CEOs and otlrer market analystsareinterestedin the ability to forecastboth prices and quantitiessold oftheir products.

cannot be consistentlyestimated of by any estimation method.e4ande".2). data on price and quantity will be observed around the . the endogenous variableP on the right-hand side of the equationis correlatedwith the error term e".11. ( 1 1 . What happens when income X changes? The demand curve shifts and a new equilibrium price and quantity are created.say Aer. every time there is a change in er. The least squares.r5 The least squaresestimator of parametersin a structural simultaneousequation is biased and inconsistentbecauseofthe correlation betweenthe random error and the endogenous variables on the right-hand side ofthe equation.This means that the probability distribution of the least squaresestimator will ultimately "collapse" about a point that is not the true parametervalue as the sample size N. ifthere ket adjustments lead e in the equilibrium rges?) Secondly.2 for a general discussionof "large sample" properties of estimators.3 The Failure of Least Squares ln this section we explain why the least squaresestimator should not be usedto estimatean equationin a simultaneousequationsmodel. This occurs becausewe do not observethe changein the error term. Consequently. As income changes. and thus the least squares estimator is inconsistent. Thus. and d3 and equilibria.To rPandQ. but only the change in P resulting from its correlation with the error estimator of B1 will understatethe true parametervalue in this model.we focus on the supply equation.crl flIrd o2. The blip Ae" in the error term of (11. Since B1 > 0 and o1 ( 0.1) and (11. ' lI nand or supply equa(11. The correlated with the zero mean. b. can be consistently estimated. For reasonsthat will becomeclear in the next section. ( l 1 . .2) . This follows from the reduced form (11. This bias persistsevenif the samplesize goesto infinity.oo. The least squares variable P and the error term es. if Ae" ) 0. The failure of least squaresestimation for the supply equation can be explained as follows: least squares estimation of the relation betweenQ and P gives "credit" to price (P) for the effect of changesin the error term (e").2) and simplifl. See Section 10. Trace the effect of this change through the system.1. er. An algebraic explanation is in Appendix 11A. in the error teffn es. 'm parameters. but the slope of the supply equation. We will give an intuitive explanation for the existence of this correlation here.4 we show the demand curves dt. equal. and c. the parameters the demandequation. B1.or blip.which hase Lakingthe least square_s 17. then AP < 0. 11.the least squaresestimator will tend to be negatively biasedin this model.4) that hasP on the left and e" on the right. and see Appendix 11A for an algebraic derivation. we summarize by saying: press the endogenoui mulation of the model reduced form is ven il equationsystem.P and e" are negatively correlated. Thus. How are we able to make such statements?The answer is quite intuitive and it can be illustrated graphically.4 THE IDENTIFICATION PROBLEM 307 i. because ofthe negativecorrelationbetweenthe endogenous In large samples. at points a. In the supply equation (I1. and Ito predict valuesof ly CEOs and orher Lantities sold of their redictions possible.2) is directly transmitted to the equilibrium value of P. constant E for the purposesof reseequationsrelate iables. dz. In Figure 11. Supposethere is a small change. Every changein the supply equationerror term e" has a direct linear effect upon P. there is an associatedchange in P in the opposite direction. Here. for three levels of income.4 The Identification Problern In the supply and demandmodel given by (11.

308 SIMULTANEOUS EQUATIONS MODELS FTGURE 7 . As income changes. there is no way to distinguish the true demand curve from all the rest.at least M . Tl . b. which is called a condition for identification of an equation. resulting in observationsalong the supply curve. The shifting of supply relative to a fixed demand curve (since Wis absent fromthe demandequation)would createequilibrium observations along the demand curve. In our supply and demand model there are M :2 equations.then the equationis is said to be identffied. intersections of supply and demand. an :s unidentified and its I .so we require at least M . The identification ct lquation is not identi estimated. s\ggesting that we can fit a line through them to estimatethe slope B1. lessthan M . income Q estimated.imultaneous equation echievedand should b good solution to the ic This paragraPhis I rdentificationcan be e) lquaresestimation pro rariables estimator. Q. However. The variable P is cr random part.| : I variable to be omitted from an equation to identify it. It is the absenceof variables in one equation.ide endogenousvaria 11. Any one of an infinite number of demand curyes passingthrough the equilibrium points could be correct. If we were to add a variable to tlr supply curve.and there is no way to estimate their slope. and c. thar makes parameter estimation possible. say 17. The problem lies with the model that we are using.| variables must be absentfrom an equation for estimation of its parametersto be possible. A general rule. The data valueswill trace out the supply curve.'omesfrom the fact tl :rplain how it works rpply the usual leas variable I endogenous letrn er.5 Two-Sta The most widelY use equationis called two .f instrumental variat model is equ equations equationwithin a simu rght-hand-side. which it ln the suPPlYequatio is estimator v1. There is no variable in the suppll equation that will shift it relative to the demand curve. Given the data.I If variables are omitted from an equation.the demandcurve shifts but the supply curve remains fixed.7)theexPlan and it is not correlat consistentlYestimate . each of which could have generatedthe data we observe.4 7 The effectof changing income. is this: A NECESSARY CONDITION FOR IDENTIFICATION: In a system of M simultaneousequations. c :mportantvariable sho . that arepresent in another equation.. The datavaluesfall along the supply curve because income is present in the demand curve and absent from the supply curve. Through the equilibrium point a we have drawn a feu demand curyes. There are no datavalues falling along any of the demand curves.then it is said to be unidentified andits parameters cannotbe consistentlyestimated. Thus i $e equationin questio *rogenousvariablesin .and its parameters be estimated can consistently. The random errors e7 and e.When estimationof an equation'sparameters possible. creating equilibrium observations on price and quantirr that are scattered about the intersections at points a.the rar Supposewe knew the In(11. then eachtime lTchangedthe supply curve would shift and the demand curve would stay fixed. cause small shifts in the supply and demand curves.whichjointly determine the values ofM endogenousvariables. making it possibleto estimatethe slopeof the demandcurve and the effect of income on demand. There are a total of threevariables:P.rnevariablo.

That is. We could apply least squaresto (11. before it is cstimated. explain how it works by considering the supply equation in (11. In the demandequationnone of the variablesare omitted. It is not a random variable and it is not correlated with the error term e+. 11. This paragraph is for those who have read Chapter 10. P: E(P)+ vr : ntX *vt (11. the random part. However. The identification condition must be checkedbefore trying to estimatean equation. which is its expectedvalue E(P). no rmportantvariable should be omitted from an equationjust to identify it. and there is no way ro ives passingthrough the ly to distinguish the true e we have drawn a feg observe. The number of instrumental variables required for estimation of an equation within a simultaneous variables.2) by (11. at least rf its parametersto be :. then changing the model must be considered.| fied andits parameters In the supply equation (11.In a tlpical equationsmodel is equal to the number of righrhand sideendogenous equationwithin a simultaneousequationsmodel. Creating a false model is not a good solution to the identification problem. There are a total of In (1 1.If less than M . and a random part.If an cquation is not identified.5 Two-Stage Least SquaresEstimation The most widely used method for estimating the parameters of an identified structural equationis called two-stage least squares. is omitted. thar called a condition for &ree variables:P.2) the portion ofP that causesproblems for the least squares estimatoris v1. changing the model should not be done in a haphazard way. Recall that we cannot apply the usual least squares procedure to estimate p1 in this equation because the endogenous variable P on the right-hand side of the equation is correlated with the error tern er. The structureof a simultaneousequations model should reflect your understanding of how equilibrium is rhieved and should be consistentwith economic theory. severalexogenousvariablesappearon t}r Thus instrumentsmust come from thoseexogenous variablesomitted from right-hand-side..7) to consistently estimateB1. thus it s unidentified and its parameterscannot be estimatedconsistently.rlr n observationsalong t}r s. It is yl that causes to be correlatedwith the error tern er. The necessarycondition for identification can be expressed an alternativebut equivalentfashion.7) . me variable. P Suppose knew the value of n1. Then we could replaceP in(I1.o we require at leasr t. then the equationis Ltly. which is the reduced form random orror v1. This ensuresan adequatenumber of instrumental variables. andX. The name We will comesfrom the fact that it can be calculatedusing two least squaresregressions. .6) to obtain we Q : g t l E ( P*) v r l+ e .S T A G E L E A S T S Q U A R E SE S T I M A T T O N 309 -o es causesmall shifts in n on price and quantitr we can fit a line throush curye because income is As income changes. the equationin question. s T W O . The two-stageleast in rquaresestimationprocedurewas developedin Chapter 10 and shown to be an insrumental variablesestimator.7) the explanatoryvariable on the right-hand side is E(P). The variable P is composedof a systematicpart. which is often abbreviatedas 2SlS.In the supply equation.Consequently. o variable in the suppll to add a variable to ttr uld shift and the demand :mand curve (since lTis ationsalong the demand and the effect ofinconr n another equation. : BrE(P) (9rvr* e") * : Bfi(p) * e* (11. Q. the supply curve is identified and its parametercan be cstimated.1 1 .2).6) a system of M simulnous variables. This procedure is developedfurther in the next section. income (X.identification requiresthat the number of excluded erogenousvariablesin an equationbe at leastaslarge asthe number ofincluded right-handside endogenousvariables.

which is consistent and normally distributed in large samples. quantity supplied. The 2SZS esti In large sampl Thevariances i but for large s mations.5.x2. we can estimatenl using 61 from the reducedform equation for PThen. P and the random error 0* are uncorrelated..8r Estimate the P 11.Ifyouobtain2.7) obtain for we * e: Byp A* (11. Least squaresestimation of the structural equation in which the right-hand-sidc endogenousvariable P is replaced by its predicted value P..t We have described ht equations. 2. Let there be K exogenous variables. Estimate the parametersof the reduced form equations yz: 1t12xt 1t22x2 * +''' + try2xy* v2 Truffles are a gourmi rhey are often locate< Actually the Pigs di them. To summarize. and consequently thc parameter 9r can be consistently estimatedby applying least squaresto (11. . The ProPe ..310 SIMULTANEOUS EQUATIONS MODELS 11.. as do the Fren< supply and demand y3 : rtnxr * tr4x2 +' " + ltr3xr I vz by least squaresand obtain the predicted values l I jz : frpxt * frzzxz "' I irczxx I l iz : frnxt * frzzxz "' I drzxx ( 11 .8) by least squares generatesthe so-called two-stage least squares estimator of 9r. For a general explanation ofthis estimation method.sincewedonotknowtlrc value of rr1.1 TnE GrNEnar Two-Sracr Lpesr SquenEs EsrrmamoN Pnocnpunr The two-stage least squaresestimation procedure can be used to estimate the parameters of any identified equation within a simultaneous equations system. .6 An Exa SquaresEstir If this equation is identified. In a system of M simultaneousequationslet the endogenousvariablesbe yt. . However. 11.!M. Thest standard errorl 11. least squaresI second regres 2SIS or instrt equations. .x6.3.A is the hourlY rental 1 rhat P and Q are en intercept variable. ln the demand equa place. .indexedbY i.8)..yz.2 Tnr PtoP In large samples. xr.9 equation P:i6 P Using asa replacement E(P)in (11. P.There we derive the two-stageleast squaresestimator and discuss its properties.wecannotusethevariableE(P): "rrXinplaceofP. a consistentestimator for E(P) is 2. 1 0 ) ' The discussion above is an intuitive explanation of the two-stage least squares estimator.6 AN EXAA Ofcourse.5. Suppose the first structural equation within this systemis yt:szyz*ct:y:*Brxr -l9zxz*er (11. Estimating (11. Replacethe en (11. Least squaresestimation of the reduced form equation for P and the calculation of its predicted value. then its parameterscan be estimated in the two steps: l. . the two stages of the estimation procedure are 1. see Section 10. real truffles (anoth disposableincome .9) . .

S T A G E L E A S T S Q U A R E SE S T I M A T I O N 311 rce we do notknow t}r d form equation for p.10) Ir : rlzjz * a:y: * Brxr * lzxz -t e\ Estimate the parametersof this equation by least squares. PS is the market price of a substitutefor real truffles (another fungus much less highly prized). and DI is per capita monthly disposableincome of local residents. DI. 8 r 11. which we can use as approximations. In large samplesthe 2StS estimator is approximately normally distributed.1 1 . 6A N E X A M P L E O F T W O . which in this case is the hourly rental price of truffle-pigs usedin the searchprocess. The 2SZ. the standarderrors and /-values reported in the second regression are not correct for the 2SlS estimator.which report standarderrors.2 urd consequently the e st o ( 1 1 . PF. a4DIi + e! + Supply: Qi : fu -t \zPi * QzPFi+ ei ( 11 . The variancesand covariancesof the 2SZS estimatorare unknown in small samples.on the right-hand side of the structural equation(11. For a general Lst squaresestimator and ln the demand equation Q is the quantity of truffles traded in a particular French marketplace.r2) (l 1.just like an ordinary least squaresregressionprogram.5. They are edible fungi that grow below the ground. Replacethe endogenous variables. Theseformulas are built into econometric software packages.!2 ar.indexedby i. 1 ) 1 (rr. asdo the French. and the intercept variable. The exogenousvariables are PS.9r the two steps: Demand: Qi: at + dzPi * cr3PS. . .The supply equation contains the market price and quantify supplied.6 An Exarnple of Two-Stage Least Squares Estirnation Truffles are a gounnet delight. To TrrE PropnRrrEs oF rrrE Tvo-STAGE LEAST Squerus Esrrueron We have describedhow to obtain estimatesfor structural equation parametersin identified equations.lf . ON PnocsoURI mate the parameters r.Also it includes Pfl the price of a factor of production. but it is consistent.10) )stimator.Let there be K quation within this 11. In France they areoften locatedby collectors who usepigs to sniffout the truffles and "point" to them.9) by their predictedvaluesfrom (11. Actually the pigs dig frantically for the truffles becausepigs have an insatiable taste for them. -stage least squans n large samples. P is the market price of truffles. If you obtain 2SIS estimates applying two leastsquares by regressions using ordinary least squaresregressionsoftware. Always use specialized 2StrS or instrumental variables software when obtainins estimates of structural equations.and they must be restrainedfrom "pigging out" on them. 8 ) . Considera supply and demand model for truffles: (11.y1a.In this model we assume that P and Q are endogenousvariables. md the calculation of r the right-hand-side . .Sestimator is a biased estimator. and /-values. In a system of .d13. but for large sampleswe have expressionsfor them.The properties of the two-stage least squaresestimator are . ( 11 .

312 11.1 OBS I 2 J RepresentativeTrufHe Data o 29.53 1. P and Q.r3 22.02 4. 62. The data file truffies. A few of the observations are shown in Table 11. The R2 : 0.64 40.D1 is in $1000.525 2.75 5.1.870 1. The reduced form equations expresseach endogenousvariable.6 AN EXAMP lonNrrrrcerroN Table77. indicating The R2 :0.9s 13.more than enough to satisfy the identificatioo condition.697.0001.1 variablesmust bc omitted from each equation in order for it to be identified.55 19. 7.973. The specifications we used are based on the microeconomic theory of supply and demand.889 implie F-statisticvalue is 69'l has statisticallY signific 11.6. and PFis the hourly rental rate ($) for a truffle-finding pig.04 19.1 Pi : rn * n22PSi nzzDli I n+zPFi * viz * We can estimate these equations by least squaressince the right-hand-side variables are exogenousand uncorrelated with the random errors v.2bwe l Pi Table 71 . In Table lI.3 TnE SrPuc: The reduced form equa handsideofthe suPPlY From Table 11.87 19.2a \ ariable Red Coefl Before thinking about estimation.2b \ ariable Red Coef C P5 DI PF t.61 4.DI.79 2. Dev.37 PS DI PF The 2StS results are g arein Table I 1. check the identification of each equation. tt. 1.. In Table ll. in this reducedform equation.We conclu& that each equation in this systemis identified and can thus be estimatedby two-stagelea-s squares. the quantit The standarderrors tha are valid in large sam is .1 SIMULTANEOUS EQUATIONS MODELS 11.2 TrrE REnucEn Forur EqueuoNs C P5 DI PF '1. Becauseeconomictheorl Why arethe variablesomitted from their respectiveequations? says that the price of a factor of production should affect supply but not demand.36 20. In the demand equation thc variable PF is not included and thus the necessaryM .74 17.46 22.3a.2awe seethat the estimatedcoefficients are statistically significant and thus we conclude that the exogenousvariables affect the quantity of truffles traded.08 3. and the intercept variable.7 | 22. The rule fs identifying an equation is that in a systemofM equationsat least M . plus an error term.ignificant.71 41.M3 1.04 22.89 13.33 25 Cr Mean Std.| : I variable is omitted. and thc price of substitutegoods and income should affect demand and not supply.2b the estimated coefficients are statisticall-v .9'l 18.1 and v.04 . They are Qi : rn * n21P$ * nzrDli * nalPF.67 13.72 Summary statistics 18. and the overall F-statistic is 19.52 19. Q. Note too that the variables that are omitted are different for each equatiorl ensuring that each contains at least oneshift variable not presentin the other.23 34.6.PS is measuredin $ per ounce.61 17.3a \:ariable C P PS DI 5 19.72 18.dat contains30 observations eachofthe endogenous on and exogenousvariables. I v.6. Q is measuredin ounces.-urv! significantlY c increasethe demand I effect of income is Pos TabIe11.Not' price rises.43 53.2.709 10.8 0.1 -0. In thc supply equation both PS and DI are absent.2. The results of the least squaresestimations of the reduced form equations for Q and P are reported in Table 11. PF. in terms of tlr exogenousvariables PS.5 TabIel1.r03 2.6 2.The price P is measuredin $ per ounce.which has a p-value of less than 0.

6 A N E X A M P L E O F T ' W O .I variablesmust be demand equation the lble is omitted.The estimateddemandcurve results arein Table 11. $ per ounce.ause economictheon tnot demand.2960 5.7243 0.1672 -0.0140 Std.8682 4.3509 1.0001 0.2795 -0. They and the /-values are valid in large samples.0938 -4.2bwe have u' :-_::. The specificad demand.4342 4.2729 3.3b. he other. C PS DI PF -32..870 . of the reduced form y significant and thus iles traded.The p-value indicates that the estimated slope of the demand curve is significantly different from zero.6488 2.5356 0.7719 -2.6051 3.2 b Variable Reduced Form for Price of TruIHes (P) Coefficient Std.103 PF The 2SZSresults are given in Tables 11. 0.2985 t-Statistic hob.:.Enor 3. .3aand 11.889 implies a good fit of the reduced form equation to the data.5070 2.7005 o.51 19.6564 2. The standarderrors that are reported are obtained from 2SZSsoftware. Error 5.5124 1. The overall F-statistic value is 69. which is a characteristicof substitutegoods. Finally the effect of income is positive.189 that has a p-value of less than 0.1 1 . All of thesevariables Table 11.. -0.S T A G E E A S T S Q U A R E SE S T T M A T T O N L 313 Table 11.4089 4. The R2 : 0.3 Trc SrnucruRAl EquarroNs .0004 0. in terms of the error term.u3 .709 10.6.4471 0.J-.5439 0.:: . l 809 Table 11 . on the righthandside ofthe supply and demandequationsin the secondstageoftwo-stage least squares.3a.which hasa ents are statisticallr The reducedform equationsare usedto obtain P.71 17.l2t3 Prob.0721 4.:': .Error 7. in this t 19. Variable Std.613.6025 1.7081 7.w of the observations .1957 .as predicted by the law of demand. indicating that the model has statistically significant explanatory power.044't 0.3539 -4.04 22.0372 .7: ).0221 0.0000 0.9842 0.Note that the coefficient of price is negative.D1 is in . the quantity demandedof truffles declines.and the rupply. Q.3a \ariable C P PS DI ".2836 t-Statistic Prob.3745 1.indicating that asthe market price rises.973.:.2434 0.0001.1648 0.52s . We conclude ted by two-stage leasr . 3s4PFi DI |.3552 2. In the tisfy the identification nt for each equation. indicating that truffles are a normal good.0315 0. From Table 11.71 2 S L SE s t i m a t e s o t T r u f f l e D e m a n d f Coefficient -4. Increasesin the price ofthe substitutefor truffles increasethe demand for truffles. 0.nd-sidevariables are r data file truffies. The rule for .0002 0.1425 0. that will be usedin place of P.8951 0.0001 nd Q.0003 c PS DI PF 7.: :.The price P is . indicating that the exogenous variables have an effect on market price P.0012 0.95 13. They are significant.dat riables. 11.2a Reduced Forrn for Quantityof Coefficient Truffies (Q) t-Statistic :quation.:.53 .

At the start of tlrc day.314 SIMULTANEOUS EQUATIONS MODELS 11.l IonNrrrIce 11." working paper.itm equation.Estim squaresestimation c two-stageleast squa right-hand-side end . when the market is opened.The first interesting feature of this example is to consider whether prices and quantities ne simultaneouslydeterminedby supply and demandat all. See http://www.with higher demand leading to higher prices. The key point here is thar "simultaneity" does not require that events occur at a simultaneousmoment in time. and weatherconditions during the period December2. Kathryn Graddy2 collected daill data on the price of whiting (acommon type of fish).dat. Or. + d.or dealers.and increasesin the rental rate for truffle-seeking pigs.7.1992.4TU& + qsWEDt Prior to estimation.! We might consider this a market with a fixed.2 THr Rrot The reduced form t exogenousvariables ln(QUAN1) = In(PRICE. Suchmodels are said to be recursivc and the demand equation can be estimatedby ordinary least squaresrather than the more complicated two-stage least squaresprocedure.graddy/research.7 SUI Table 11 .ifthe price isjudged too low.0009 r.thus tracin SimilarlY.0m 0. The authors would like to thank Professor Graddy for permission to use the data from her study.3380 -1.0249 0.ox. perfectly inelastic supply.7 Supply and Demand at the Fulton Fish Market The Fulton Fish Market hasoperatedin New York City for over 150years.stormycon( demand curve. quantitiessold. If supply is fixed.0m whereQUANlis the qu Note that we are using of the time series natu: days of the week." Journal of Economic Perspectives.1991to May 8. with a vertical supply curve. However whiting fish can be kept for several days before going bad. The supply equationresults appearin Table I 1. Error t-Statistic C P PF 20.Both of thesc variables have statistically significant coefficient estimates. Kennedy (2N6) "When are supply and demand determined recursively rather than simultaneously? Another look at the Fulton Fish Market data. The coefficient P2 is variableindicating sto the supplY equation t supply of fish broughr ll. In the dem e appearin the suPPlY in the de are included while the suPPlYrema variables). then sellerscan increasethe day's catch with additional fish from their buffer stock. and dealers can decideto sell less.and add to their inventory orbuffer stock. reducessupply.223r 0.As anticipated. in hope for better prices the next day.increases the price in oftruffles increasethe quantity supplied. Freshfish arrive at the market about midnight.4.3b.3785 13. Thesereduced form r variablesare all exol the Graddy's data (fi in Table 11.uk/members/kathryn. 1 3 ) See Katlnyn Graddy (2006) "The Fulton Fish Market.economics. w identified. and n It.ac.0328 0.) = + a6TH(L + ef ' ( 11 .5629 -12. Thesedataare inthefilefultonfish.sell to buyersfa retail shops and restaurants.Thus despite the perishable nature of the product. witl demand. if the price is unusually high on a given day. The wholesalers.0m 0. but no increase in the quantity supplied.1281 0. 3 b Variable 2SLS Estimates for Truffle Supply Coefflcient Std. See Kathryn Graddy and Peter E.20(2). daily price is simultaneously determined by supply and demand forces. then price is demand determined. If this is true then thc feedbackbetweenprices and quantities is eliminated. The tn(Q have statistically significant coefficients and thus have an effect upon the quantiq demanded. The necess M --2equattons.0825 16. and the daily resupply of fresh fish.7.207-220.the supply of fish availablefor the day is fixed. Let us specify the demand equation for this market as ln(QUAN1): ct1* a2ln(PRICEl) I qzMON.htrn.which we ex shifts in demand. 3 The authors thank Peter Kennedy for this observation.The prices for fish are determined daily by the forces of supply and demand. which is an increasein the cost of a factor of production.

): rr1l + rr2lMONsI r3lTUEs * ralWED.The prices for fisb .1s) (1r.thus tracing out the supply curve. and making it identified. The coefficient a2 is the price elasticity of demand.29 )81 0.1 1 .If supplyis vith higher demand his is true then the . lrs. tracing out the demand curve. as shown in Figure 11.2OQ). then stock.4.) : nr2 * r22MON1l r32WE1 I rqzWEDt I rr52TH(11 * nezSTORMYt vtz * (l l.It is a requirement for successful two-stageleastsquares estimationthat the estimatedcoefficientsin the reducedform for the right-hand-side endogenousvariable be statistically significant.Using the Graddy's d ata(fultonfish. The remaining variables are dummy variables for the days of the week.htm.4. Thesereduced forrn equations can be estimated by least squaresbecausethe right-hand-side variables are all exogenous and uncorrelated with the reduced form errors v'1 and vr2. while the supply remainsfixed (sincethe supply equationdoesnot contain the daily dummy variables). ( 11 .16) tives. daily price is point here is that oment in time. in pounds.0m 0. which we expect to be negative. 17. the four daily dummy variablesthat are included in the demand equation are omitted. reducing the supply of fish brought to market.7. The daily dummy variables capture day-to-day shifts in demand. Thus the demand equation shifts daily.207-220.dat) we estimatethese reduced form equations and report them in Table 11. This variable is important in the supply equation becausestormy weather makes fishing more difficult. In the demand equation the weather variable STORMY is omitted. andpRICE.aid to be recursive rther than the morc d. making it identified.the averagedaily price per pound.ED. 1 3 ) ll. 7 S U P P L YA N D D E M A N D A T T H E F U L T O N F I S H M A R K E T 315 stic Prob. The variable sroRMy is a dummy variableindicating stormy weatherduring the previous 3 days. Similarly. Estimation of the reduced form equationsis the first step of two-stage least squaresestimation of the supply and demand equations.ddy'collected daill l weatherconditions iefilefultonfish. The necessary condition for an equation to be identified is that in this systemof M:2equations. we must determine if the supply and demand equation paramerers are identified. in n a given day. but it does appearin the supply equation.14) The coefficient P2 is the price elasticity of supply. In the supply equation. er E.1: lvariablemustbeomittedfromeach equation.): 9r * B2ln(pNCE.itmustbetruethatatleastM .Both of ther ln(QUAN. Market rs. j y.l IDsNrrrrcATroN Prior to estimation.7. Kennedy (2006) lookat theFultonFish lylresearch. '85 . r study. At the start of the is fixed.dat. * n51THU1 * ra$TORMYt lvtr In(PRICE.Thus despite fish.0m 0. stormy conditions shift the supply curve relative to a fixed demand.) gtSrOnUy. . sell to buyers for mple is to consider and demandat all.2 Trrr RnoucEo Fonin Equa-rroNs The reduced form equations specify each endogenous variable as a function of all exogenousvariables ln(QUAN.0m whereQUANI is the quantity sold. with Friday being omitted.* ei + (11. and dealers can sjudged too low. We have specified the . The supply equation is t upon the quantiq increases the pricc in rte for truffle-seeking supply. Note that we are using the subscript "t" to index observationsfor this relationship bicause of the time series nature of the data.

and tw' dummy variables are n' s!verecollinearitY in tht $pply equation can bt reduced form estimate significant.5569 4.13) and (11.not their significance.625t 0.1106 0.0496 -3.4891 -2. the variable STORMY must be statistically significant. To identify the demand curve.The answer comes from a grcat deal of econometric researchin the pastdecade.4097 -2.11.1045 t-Statistic C STORMY MON TUE WED THU -0.3 Two-Stect Applying two-stagelei given in Table 11.3937 -0. To illustrate our point let us focus on the problem of * See James H.2058 0.2717 0. Tt l% increasein fishPri< estimate is statisticall' rgative and statistica lower on these daYsrt 5 Even if the variables a F-value <10 is causefor co csrimation.which showsthat the two-stageleastsquares estimatorperforms very poorly if the shift variables are not strongly significant.7.6387 -r. meaning that there is at least one significant shift variable in the demand equation which permits us to reliably estimate the supply equation. Stock and Mark W Watson (2007) Introduction to Econometrics.017t 0.3878 0.0747 0. Peanifi Education. Also.0764 0.1010 -0. See Section 10 . so that we can reliably estimatc the demand equation. V exact collinearitY bet srpply equation.2010 Co C STORMY MON TUE WED THU 8. 2nd editinn.9r72 0.4 & Reduced Form for ln(Price) Fish Coefficient Std.2671 ZSLS Std.SZ: 0. but still intuitive discussion. However.4753 0. we calculate h(P RI CEt) : ff n * i 22MO$ I fr zzW Et * ir a2WED * ir szTHUt * iTaSTORMYt l where itp2 are the least squares estimates of the reduced form coefficients.2065 0. Error 0.00flf 0.9225 -2. Thus the key reduced form equatioo is (11.1073 0. meaning that supply has a significant shift variable.a Recall that to implement twostageleast squareswe take the predicted value from the reduced form regression and include it in the structuralequationsin place of the right-hand-sideendogenous variable.00il) 0.6356 cstimating the suPPlY itz : i. Then lf we replaceln(PNCE structural equations(11. Why is this so? The identification discussionin Section I 1.4 requires only the presenceof shift variables.006 0.16) for 1n(PRICE").1045 0. To identify the supply curve.0G. and then replace Ln(PRICE) with ln(PR1CE1).5 r-Statistic s9. Appendix 12.0537 0.1069 0. so that we canno this case the suPPlYeq for it.1470 0.In this equation . Error 0.STORMY ' reliably estimated bY cstimation is that each supply equation is nor cstimation of the dema rariables for the strur cquationsmodel is for 11.That is.0525 -0. 0.8101 -0. the jo 0-65.0118 0.008t 0.2011 0. meanin zero.7899 c l^(PRICE) t40N TUE WED THU t -l -( -( -( ( Table 11 .4 a Variable Reduced Form for tn(Quantity) Fish Coefficient Table11.rt29 -0.14) wilhln(QUAM) as the left-hand-sidevariable and In(PRICS as the right-hand-side endogenousvariable.6876 0.7 SUPP 316 SIMULTANEOUS EQUATIONS MODELS Tahle 11 .5 for a more technical.5531 0.2950 0.1437 0.4847 -0.6946 0.5. .0411 -0. the daily dummy variables must be jointly significantThis implies that at least one of their coefficients is statistically different from zem.3464 -0.6979 0.

0525 t.0254 -0..4b..00E. meaningthat the coefficientson the daily dummy variablesareall identically zero. the joint F-test of significance of the daily dummy variableshasp-value .3 Two-Srecp Leesr Squenrs EsrrlrerroN oF FrsH DEiueNn t-hand-side variablean.4097 !.12.1093 51 .5 tatistic Prot' \ ariable C -nTPRICE) 2SIS Estirnatesfor Fish Demand Coefficient Std.625.4286 0.16).upply equationcan be computed.5059 -1. Pears.That is. L coefficients.0090 0.2.1194 -0. but arejointly insignificant. none of the daily dummy variablesare statistically irgnificant. 0. Also.See Section 10. 9 1: : 0.The price elasticityof demandis estimated be -I. 1 9 0 8 -2.and this in ::timate is statistically significant at the 5Volevel.they will be unreliable.exact colhnearitybetwee I"(PNCEJ and the variable STORMYwhich is alreadl in the " . .upplyequation. and we will not report estimates :or it.638'l .3937 ).78(A rtoN rLE '.STORMY is statistically significant. netrics. i Even if the variables are jointly significant there may be a problem.6115 -0.1183 -2.7 SUPPLY AND DEMAND AT THE FULTON FISH MARKET 317 Table 11. If the coefficientestimates thedailr will and on Jummy variablesare not exactly zero. + fr62STORMY.267r 0.s In :his casethe supply equation is not identified in practice.' in the demand equatior-. 0.6-1:^ In(PRICE. raresestimatorperforn I that to implement t'*tn regression includr' and ous variable.5664 0.2080 0.An advantageof two-stage least squares 3itimation is that eachequation can be treatedand estimatedseparately.J-Z_: 0.yreducedform equatiO: tst be jointly significan: ally different from zer.upply equation is not reliably estimable does not mean that we cannot proceed with :stimation of the demand equation.The check of statistical significanceof the setsof shift .Then r.14) and take the extreme case that i22--i1.Error 0.. .it meansthere will be 'er erecollinearity in the secondstage.00t.resonly the presence o: :eatdeal of econometn. ^' . ..:rren in Table 11.2088 /-Statistic Prob..thereu ill in . two-stage leastsquares fail. rr s 'HU. .In Table 11.00l.2128 0. 11. 2nd edition. -r alue < l0 is causefor concem.5569 t. -c increasein fish price leadsto aboutal.4753 ' 0.2148 0. meaningthat the demandequationmay be :eliably estimated by two-stage least squares. .0103 0. the fact that the so ..5.69a0 ..4.0122 0.1 106 ).so that we cannot reject the null hypothesis that all these coefficients are zero..ower or these days relative to Friday.00r.5308 -0.t'ED THU 8.14)with this predictedvalue.1662 0.and while the two-stageleastsquares estimatesof the . 0. However. and the: focus on the problem o: {pplying two-stageleastsquares estimationto the demandequationwe obtain the resultsas .65.5233 tatrstrc Prob istimatingthe supply equation (11.4891 1.29: 0..6620 0.9225 .. : statisticallysignifican:. meaningthat a to .: :.7. 0.5518 -2.6876 ). This problem is the same as that of weak instruments in instrumental variables srrmation. we can reliably estimar.: . 0.egative indicating that demandis and statistically significant for Tuesdayand Wednesday.01 0.11. The significance must be "strong.6018 ).6979 ).00r 0.0000 0.l2%o decrease the quantity demanded..ariables for the structural equations should be carried out each time a simultaneous aluations model is formulated.9061 0. -0." An .) : fr n * ir ozSTORMYt f i we replaceLn(PRICE) the supplyequation(1 1.showing the :educedform estimatesfor (11. The dummy variable coefficients are :.

so that there may be an auxiliary relationship such as HOURS: ql * a2ln(WAGE) * a3KIDS * u .2 Supply and demand curyes as traditionally drawn in economics principles classcr have price (P) on the vertical axis and quantity (O) on the horizontal axis. (b) What are the equilibrium values of P and Q from (a)? (c) Calculate the predicted equilibrium values of P and Q using the estimared reducedform equationsfrom Table 11. suppose that the estimated reduced form equations are P: 18X and Q:5X. r estimatesof to those in T (b) Using the 25 demand "at ll. PF* :23. (f.Eus : 1.3 and on graphpaper accuratelysketchthe supph and demand equations. PS. (1987) "Tht statistical assumptions.er in (a). calculatethe income elasticity of demandimplied I the shift in part (d). show the consequences ofincreasing income frm DI* : 3.Your classm. lHint: magnitudes .5. (Hint: look at the expressionsfor r1 and r).1 Consider the foll I 1. class data." . why not? (b) Is the wageequation "identified" ? What doesthe term identification meanin thb context? (c) If you seek an alternative to least squaresestimation for the wage equatim* suggestan estimation procedure and how (step by step and NOT a compuc command) it is carried out.318 SIMULTANEOUS EQUATIONS MODELS 11.2a and compare to yotr graphical solution. holding the values of PF and PS at the values gir.8 Exercises 11.1. (a) Take the estimatesin Table 11. (e) Calculate the changein equilibrium price P and quantity O in (d) basedon yorr sketch.8. and EXPER is years of experience.3 Supposeyou want to estimate a wage equation for married women of the form tn(wAGE): Fr * \\HOURS * gzEDUC r BaEXpERI e (a) How would (b) How would 11.2 Connpurnn l . What is an estimated value of 9t.2. Using the resultsin part (e).. Calculatean estimateof the income elasticity of demandfrm the estimated reduced form equation in Table 11.8. T.1 Can you suggesta method for using the reduced form equations (1 1.5 (a) Useyourcon estimation. and PS* :22.l.i 7* Supply and dem have price (P) o (a) Rewrite the priceP on tl this rewritter (b) Using the da that you har correct? Are (c) Estimatethe (d) On graph pa estimates frl variables Dl (e) What are the predicted eq equations fn How well d< (f) Estimate the ordinary lear significantly whereK/DSis the number of children underthe ageof six in the woman's household (a) Can the wage equation be estimated satisfactorily using the least squarer estimator?If not. The data fi The data file con 6 d Mroz.5 to DI** : 4.4) and ( I l5l to obtain an estimate of the slope of the supply function Q:ltP *e"? lr particular.i -8* The labor supp\ A research.1 Pnonr.c observes that higher wages can bring forth increased work effort.5. using the samevaluesof the exogenocr variablesas thosein (a). Do they seem to agree. 11. HOURS is the number of hours worked per weetEDUC is years of education. and PF to be DI* :3.A. and that manid women with young children may reduce their hours of work to take care of them.or not? (d) On the graph from part (a).I 6 Estimateequati that they form a results to those ir economic reasor where WAGE is hourly wage. Comparethesepredicted equilibrium valuesto thoseb (b). For these sketches set the values of the exogenour variablesDI. . 11.

I I .5 (a) Use your computer software for two-stage least squaresor insffumental variables estimation. Do the signs of the least squaresestimatesagreewith economic reasoning? I 1. and PS*:22.ons are P: 18X aarl :he expressionsfor e1 nics principles classcr rorizontal axis. so (a) How would you estimate the parameter p? Is it identified? (b) How would you estimate the parameter a? Is it identified? 11.Are the signs correct? Are the estimated coefficients significantly different from zero? Compare the results to fhose in part (b). equation (A.dat to obtain 2SlS estimatesof the system in equations( 11.12) with price P on the left-hand side. (d) On graph paper accurately sketch the supply and demand equations using the estimates from part (b).compute the price elasticity of supply and demand "at the means.3. Use the data in truffies. ately sketch the suppll ues of the exogenonr nd PS*:22. Compare your results to thosein Table 11. and PF tobe DI* :3. I using the estimarod aluesofthe exogenm rium valuesto thosei Lcreasing income fror PS at the values girtr O in (d) basedon yc 'of demandimpliedI sticityof demandfrm lnd compare to yE rvomen of the form ER*e rrs worked per weet. PS. PF* :23. 55.prP*e.A. Compare your results to those in Table 11. using the same values of the exogenousvariables.4)and (l l5t on Q.7* Supply and demand curves as traditionally drawn in economics principles classes have price (P) on the vertical axis and quantity (Q) on the horizontal axis. What are the anticipated signs of the parametersin this rewritten system of equations? (b) Using the data in the file trufiIes. and that maniod ) take care of them." Econotmetica. The data file is mroz. who kindly provided us his data. (e) What are the equilibrium values of P and Q obtained in part (d)? Calculate the predicted equilibrium values of P and Q using the estimated reduced form equations from Table 11.12). How well do they agree? (f) Estimate the supply and demand equations that you have formulated in (a) using ordinary least squares.dat.8.I 1) and ( I 1.] Comment on the signs and magnitudesof these elasticities. (1987) "The sensitivity of an empirical model of a married wornan's hours of work to economic rd statistical assumptions. estimatethe supply and demandequations that you have formulated in (a) using two-stage least squares.Are the signs correct? Are the estimated coefficients significantly different from zero? (c) Estimatethe price elasticity of demand "at the means" using the resultsfrom (b).? h . (a) Rewrite the truffle demand and supply equations in (11.def.dat and the variable definitions are in the file mroz. 12) by least squares regression.11. ence." The summary statistics for the data are given in Table 11.7). Exsncrsss | | .ignoring the fact that they form a simultaneoussystem. Your classme Tort.1. Assume that x is exogenous.8 EXERCISES 319 I l.8* The labor supply of married women has been a subject of a great deal of economic research.2 ColrpursR. and the 30 observations in the file truffies.A classic work6 is that of ProfessorTom Mroz. T.-l Consider the following simultaneousequationsmodel. I I . . For these sketches set the values of the exogenous variablesDI. md NOT a computer 6 Mroz. (b) Using the 2SIS estimatedequations. 765-800. The data file contains information on women who have worked in the previous year : woman's household ng the least squarer tification mean in thb r the wage equatioo. y1-Bxle y2:oyr+u tions(11. [Hint: See Appendix A. 11) and ( 11.dat.3.11) and (11.5.2.6 Estimateequations( I 1.

" Economic Inquiry. (a) Calculate the summary statistics for the variables: wife's age.4ln(PBt)+ ef where Q : per capita consumption of chicken.Did things come out as expected?If not. which takes the value 1 if a woman worked and 0 if sbc did not. what is the effect upon wage of r additional vear of education? (e) Check the identification ofthe supply equation. why not? (d) Estimate the reduced form equation by least squaresfor the women who worked ln(WAGE): Tr * nzEDUC * ngAGE * TqKIDSL6 + nsK1DS618 + T6NWIFEINC + nTTEXPER n|EXPER2 * v * Based on the estimated reduced form. What are tbc endogenousvariables?What are the exogenousvariables? (b) The demand model ef : model in "f ln -[tn(C Aln (i)Whatcha ofinterest al (iv) What ir Appendix A signs do yot (c) The supply. number of childrea lessthan 6 yearsold in the household. The variable indicating whether a woman worked is LFP. l0 Reconsiderthe Fulton Fish Ma .) : ar * azln(Yr) * cr3ln(P." The data for this exerciseis in tb file newbroilendat. P : real price of chicken. Y : real per capiu income.3721-384. Department of Agriculture calls "broilers. which tbc U. considering the availability d the exffa instruments EXPER and its square. PB : real price of beef. (f) Estimatethe supply equationby two-stageleastsquares.S. labor force participation. using softwaredesigncd for this purpose. (i) of the estim predict the i 95Vo predrcl (f) Use the data (i) Discuss estimated cc the real price actual value (g) Use the datu usi squares.)+ r. your results canceofthe estimatesfc (h) Reestimate additional i: instrument? ' "Simultaneous equation econometrics:The rnissingexarnple. You mu st createNWI F EI N C and ln( l{zAGE). and why? What dc NWIFEINC measure? (c) Estimate the supply equation in (b) using least squaresregressionon only tlu women who worked (LF P : I ).whichis adaptedfrom the dataprovided by Epple and McCallun (2OOO.7 (a) Consider the demand equation ln(Q.We worl like to thank Professor Bennett McCallum for his senerous helo. (b) Consider the following supply equation specification HOURS: Fr * B2In(WAGE) -t \zEDUC + FqAGE * 9sKIDSL6 * 96K/DS618 * fuNWIFEINC * e The variable NWIFEINC is defined as NWIFEINC : FAMINC _ WAGEXHOURS What signs do you expect each of the coefficients to have.SIMULTANEOUS EQUATIONS MODELS and those who have not.44(2). Comment on any differencesyou observe. in pounds.and the family income for the women who worked (LFP : 1) and those who did not (LFP : 0).Discussthe signs and significanceof the estimatedcoefficientr ll. rn(QP where QPA price index This supply This predet TIME is inc endogenou the interPre of the parar (d) Is the order (b) (in diffe (e) Use the dat Aln(Pr).9 This exerciseexamines a supply and demand model for edible chicken.

ing softwaredesigncd :stimatedcoefficientr le chicken. :.) + pgln(P4) * F+TIMEI *9sln(QPROD. PF : nominal price index of broiler feed. magnitudes. and why? What ds regressionon only tlt VCandln(tVAGD.4.) + aqln(PB) + e! -[ln(0.-r) : ctr + crzln(Y. (ii) Use the estimated reduced form equation to predict the approximate percentagechange in prices for the year 2000 and its 95Vopredrction (confidence) interval.) * ctaAln(PB.)* vf iE -l9sKIDSL6 (i) What changesdo you notice after this transformation?(ii) Are the parameters of interestaffected?(iii) If p : t have we solved the serial correlation problem? (iv) What is the interpretation of the "A" variables like Aln(Q. The data are in the file fultonfish.N rewomen who woilicd i + T5K1DS618 PER2 + v ect upon wage of r ing the availabiliq c( . (b) The demand equation in (a) suffers from severe serial correlation.)? (Hint: see (vi) Appendix . (c) The supply equation is In(QPROD. including the signs and significance of the estimated coefficients. which tbc 'this exercise in tb is Epple and McCalluo -ef s.{. In(EXPZS). (i) Discuss the estimated model. using the exogenousvariablesin the systemas instruments. 44(2). This predetermined variable is known at time / and is treated as exogenous. 10 Reconsiderthe exampleusedin Section 11. and significance of the estimated coefficients? (ii) Interpret the numerical magnitudes of the estimatesfor cr2and B2.dat. wout We .(i) Discuss your results. (i) What are the endogenousvariables? (ii) What are the exogenous variables? (iii) What is the interpretation of the parameter B2? (iv) What signs do you expect for each of the parameters? (d) Is the order condition for identification satisfied for the demand equation in (b) (in differenced form) and the supply equation in (c)? (e) Use the data from 1960 to 1999 to estimate the reduced form equation for Aln(Pr).). ln(O.-r) + e'. This supply equationis dynamic. Is the actual value within the interval? (g) Use the data from 1960 to 1999to estimatethe two equationsby two-stageleast squares. Epple and McCallum estimatethe model in "first difference" form.. In the AR(l) modelef : p4-t + 4 the value of p is near 1. Discuss the logic of using this variable as an instrument? (Hint: What characteristicsdo good instruments have?) l I .7 on the supply and demandfor fish at the Fulton Fish Market.) + o3aln(P. including the signs and significance of the estimated coefficients.t t: where QPROD: aggregate production of young chickens. TIME : time index with 1950 : Ito20}l : 52. with laggedproduction on the right-hand side. (h) Reestimate the supply equation using the log of exports.-r)+ ef-r] Aln(Q1) : azAln(Y.-r)+ a:ln(&-r) + c+ln(PB. Is the actual value within the interval? (0 Use the data from 1960 to 1999to estimatethe reducedform equationfor ln(P. What are thc .374-384.6) (v) What is the interpretation of the parametercr. as an additional instrumental variable.2? What signs do you expect for each of the coefficients? Explain. (i) Discuss the estimatedmodel. I : real per capiu I beef. paying particular attention to the signs. (ii) Use the estimated reduced form equation to predict the real price for the year 2000 and its 957oprediction (confidence)interval.): 9r * B2ln(P. TIME is included to capture technical progress in production. : ctr + cr2ln(y') + cr3h(r.11. 8 E X E R C I S E S voman worked is LF?m worked and 0 if sbc rge.number of childrcr me for the women 'lt ornment on anv diffa.

(d) Obtain two-stageleast squaresestimatesand ordinary least squaresestimatesc: the augmented demand equation in part (b) and the supply equation (11. I 6) and te. to their responsiveness prices. Estimatethe reducedform equation( 11. i:ere hi: PilZP?.and significance. Derive the algebrarr reduced form for Ln(PRICE)for this new specification.Are the estimatesconsisten: with economic theory? (e) Augment the supply equation with the variable MIXED.Based on this test.their signs. and discuss these estimate. use the aug' mented model in pafi (b). squares? (f Estimate the supply and demandequationsin (e) by two-stage least squaresarr ordinary least squaresand discussthe results.Comment on the signs and significanceof the estimatedcoefficients What is your estimate of the elasticity of supply? which (b) It is possiblethat bad weather on shorereducesattendanceat restaurants. in Comparethem to the estimates Table 11.4. For the demand equation. (a) Use the subsetof datafor daysin which inventory changeis large. and simuh' neity is no longeran issue. WED.1 and further discussedin Appendix 10D.: the significanceof STORMI Discuss the importance of this test for the purpo* of estimating the demand equation by two-stage least squares.13). Bat (0 Obtain the two the demand eq mates to each betweenthem Appendix 114 A of Least Squares ::rst.-.322 SIMULTANEOUS EQUATIONS MODELS (a) Carry out two-stage least squaresestimation of the supply equation in equation (11.Derive the algebraic reduced form for Ln(PRICD trv Test this new specification. I I Reconsiderthe exampleusedin Section 11. Cany ou in part (b). 8 This test is introduced in Section 10. I I .1-l Discussthe estimates. Ha.Estimatethis reducedform by least squElres.: squares using the data when CHANGE: 1. in turn may RAINY and COLD to the demand equation in (11.The l:e leastsquaresestimat .5. THU.7 on the supply and demandfor fish at tlx Fulton Fish Market. 01 :- IP. Add the variable. The data are in the fllefultonfish.Test the join: significance of the variablesMON. LJ -E( Br9r- . this improved the chancesof estimating the supply equation by two-stagelea-r: Explain your answer. TUE.05 level? Is the addition of M/l-i and COLD to the demand sufficient to allow reliable two-stage least square' estimation of the supply equation?Explain. (b) Obtain the least squaresresiduals ipfromthe reducedform equation estimatet in (a).let us obtainthe co e. asindicatedt'l the variable CHANGE : 1. Graddy and KenneCi (2006) anticipate that prices and quantities will demonstratesimultaneity on dar r with large changesin inventories. WED. If i72is a significant variable in this augmentedregressionthen we may conclu. (d) Estimate the re Compare these (e) Obtain the leas in (d). estimating the resultir:5 and testing the significanceof in using a standard/-ter: model by least squares.jr thatln(PRICE) is endogenous. (c) Estimate the reduced form you derived in (b) by least squares. which indicates por'{ but not STORMY weather conditons.\ hat impact doesthe ne1 l:e least squares estim .) cov(P. N: thesevariablesjointly significant at the a : 0.dat. as these are days when sellers are demonstratin. the joir:: significance of the variablesMON. RAINY. Cany out a Hausmantest6for the endogeneityof Ln(PRICE)by adding i ' as an extra variable to the demand equation in (11 13). RAINY and COLD. reduce the demand for fish at the market.and COLD. tlr anticipation is that feedback between prices and quantities is broken. TUE.:ercept term) is i-bstitute for B from the .14).Inthis exercisewe explor: the behavior of the market on days in which changesin fish inventories are larsr relative to those days on which inventory changesare small. THU. On days when inventory changes are small. : EIP : E(PI :Elnr : Elle . what do you conclude? (c) Estimate the demand equation using two-stage least squaresand ordinary lea-.

) F.simplify. let us obtain the covariancebetween P and e..1"" (11A. Graddy and Kenne{ : simultaneity on dasr lers are demonstrating hanges are small. cov(P. .3) estimator biased is because andP arecorrelated e" implyingE(h.) : EIP . * (11A.. Discuss the relationships between them.E(P))le.) : EltrtX I v1]e. rct. as described in part (b).\l wo-stage least squarer rst squaresestimates ct pply equation(ll.e. Ate s the addition of RAl.)10.e'.1) have on the least squaresestimator? The least squares estimator of the supply equation (11. Theleastsquares D. Add the variabler t. : PtlLP?.16)andtes his test for the purpo$ luares.2) (which does not have an mterceptterm) is br: LPiQi >1 (11A.2) and. *r rhere ft. which indicates pocr equation. .e. Compare these estimates to each other and to the estimatesin (c). The expected is valueof the leastsquares estimator E(b1): 9t + ZE(n. f -".) : Q) (substitute forP) (sincen1X is exogenous) ^ f " o:"18. stimating the resulting using a standardt-te-.Hx tion by two-stage leas stageleast squaresarr: d demandfor fish at tbc his exercisewe explac h inventories are la4r . Appendix 11A An Algebraic Explanation of the Failure ofLeast Squares Fnt. tbc s broken. rm equation estimate{ (PRICQby adding i. Derive the algebrasquares.4b. (sinceE(e.:Y&#@: e. Testthejour 'AINYandCOID.r then we may concludr do you conclude? res and ordinary lea< cuss these estimatei (d) Estimate the reduced form equation (11.Test the joir IAINY and COLD.l{. he estimatesconsisteu . and simulte' is large.1) : -E("?) 9r -ar 15t dt (sinceea.APPENDIX 11A FAILURE OF LEASTSQUARES ly equation in equatic estimated coefficients which ce at restaurants. .2) Substitutefor Q from the supply equation (11.E(".16) for the data when CIIANGE : O. use the augbrm for In(PRICE) fs it squares. (e) Obtain the least squaresresiduals it'2from the reducedform equation estimated in (d). what do you conclude? (f) Obtain the two-stage least squaresand the ordinary least squaresestimatesfor the demand equation for the data when CHANGE: 0.. asindicatedt1 luation(1 1.)] : E(Pe. u.. Comparethesereducedform estimatesto those in (a) and those in Table 11.e" assumeduncorrelated) :=-o3 - <o llhat impact does the negativecovariancein (11A. Carry out a Hausmantest for the endogeneityof In(PRICE"). Based on this test.

E(Pe. of whichareaverages.E(PO ^ *.E(PQ). take expectations.i. Multiply through the supply equationby pricc P. P from (11A.) . Explain why we alternative hypot Explainwhatisn : . as sample analogs expectations. Chapter pg: p1P + pe" E(PU:Fp(p\*E(pe. see hn .64 <91 Fr i4.Consequently. Perform DickeyExplain the mea Explain the conc 5.) E(PQ) E(Pe. That becaur the covariance between ande. to Nonstat Data atr karning Objec Based on the material ir Explain the differ Describe the ger process.t .SIMULTANEOUS EQUATIONS MODELS In large samplesthere is a similar failure. converge to the expectations.1). Keywords uoregressive process . N---+oo. -E6 pt : E(p\ In largesamples.trrntegration Dr-key-Fuller tests .-:-!-.n1P2). Lf! lW -.2).) ^ .Pi/N br:ifrr.4: [3r ffi: The leastsquares estimator the slopeof the supplyequation (11.\QthlN -. ol/(B1 -a') ^ _ZQ.fierence stationary can reversion rnstationary h 1003 the Nobelr P +rrnometricians: Profer sies with time-varyir: rthods of analyzing e sr of this and the follo' For more details. is.and solve. Explain how to cl data.in largesamplesof converges a valuelessthan B1. is negative.

11. 3." 7.2). 325 .supply equationby pricc chapter 1 2 Nonstation ary Tirne-Series Data and Cointegration ile averages. you should be able to l. Explain what is meantby the statement that a seriesis "integrated of order l " or I( l ). Engle "for methods of analyzing economic time rries with time-varying volatility (ARCH)" and Professor Clive W. 6. Perform Dickey-Fuller and augmentedDickey-Fuller tests for stationarity. Explain the concept of cointegration and test whether two seriesare cointegrated." The eim of this and the following two chaptersis to discussthe backgroundthat prompted these ' For more details. Explain why we need "unit root" tests. Explain the meaning of a "spurious regression. Consequently. convergelc . and state implications of the null and alternative hypotheses.in large samplei 2. Explain the differencesbetween stationaryand nonstationarytime-seriesprocesses. Keywords process eutoregressive cointegration Dickey-Fuller tests difference stationary mean reversion mnstationary order of integration random walk process random walk with drift spurious regressions stationary stochasticprocess stochastictrend tau statistic trend stationary unit root tests tn 2003 the Nobelr Prize in Economics was awarded jointly to two distinguished econometricians:Professor Robert F. Granger "for methods of analyzing economic time series with common trends (cointegration).J. Explain how to choosean appropriatemodel for regressionanalysiswith time-series data.org/economics/laureates/. see http://nobelprize. 8. Describe the general behavior of an autoregressiveprocess and a random walk process. +.becaur 3r-q') 1p1 <9t Learning Objectives Based on the material in this chapter. 5.

&t. the consequences nonstationaryvariables for regressionmodeling are profourrl of The aim of this chapter is to discuss the time-series concepts of stationarity (and nonstationarity) and cointegration. such as macrc: economists studying the behavior of national and intemational economies. Thus Ayl is the changein the value of the variable. Alternatively.NONSTATIONARY TIME_SERIES DATA AND COINTEGRATION 7 2 .I to period L The time seriesof the changeson the right-hand side of Figure 12. The seminal contributions of the Nobel laureatesat to show that the econometric consequences nonstationarity can be quite severeand s of offer methods to overcome them. as you u:f learn. from period t . Note that whilc changesin the inflation rate and the two interestrates appearto fluctuate around a const2rr value. "wander up and down" with no discernablepattem or trend. the FederalFunds rate (the interest rate on overnight loans betweenbanks).I are the changesofthe correspondingvariables on the left' hand side. The firs question we addressin this chapteris: which data seriesrepresentstationary variablesarrJ which are observationson nonstationary variables? Formally. We saw how including lagged values of the dependentvariable or explanatcr-r variables as regressors.It is time now to learn the difference betweenstationr! and nonstationaryvariables. The figures on the left-hand side are the real grossdomesticproduct (a measureof ag$eg* economicproduction). 86 88 90 92 9. For example. both the Federt Funds rate and the Bond rate show "wandering up and down" behavior. Similarly. if we are interested in forecasting fu growth of gross domestic product or inflation. can be used to model dynaru relationships. an important assumptionmaintainedthroughout Chapter9 was that the variablo have a property called stationarity. and. (a) Realgtossdom 7 6 5 J 2 I 86 88 90 92 9. : y. and to show how the proposed methods have revolutionized the way rr conduct econometricswith time-series data.In each of these cases.or considering lags in the errors. the annualinflation rate (a measureofchanges in the aggregate pn* level). 7: contributions.1.7 USeco . The analysis of time-series data is of vital interest to many groups.1 Stationary and Nonstationary Variables Plots of the time series of some important economic variables for the US economl' ar displayed in Figure 12. The changein a variable is an important conceptthat is usedrepeatedlyin this chapter:l is worth dwelling on its definition. and agricultural economists predicting supplies ad demands for agricultural products. or more like fluctuations. and th 3-year Bond rate (interest rate on a financial assetto be held for 3 years).The figures on th right-hand side ofFigure l2. a time seriesyris stationaryif its mean and varianceareconstantovertime.!t-t. if the covariancebetween two values from the seriesdependsonly on the length of tirr 868890929 (e) Federa t2 t0 868890929 (g) 3-Ye . also known as its firg difference. while the inflation rate appearsr. if we a interested in a particular business.rcune 72. The data for these figures can be found in the file usa. Observe trcr the GDP variable displays upward trending behavior.1display behaviorthr can be described as irregular ups and downs. the changesin the GDP variable appearto fluctuatearound an upward trend.we are analyzing time-series data. (c) Inflt 12. is given by Ly.finance eccc omists analyzing the stock market. we look at various indicators of econorx performance and consider their behavior over recent years. The change in a variable y1. We also showed how autoregressivemodels can be used in forecastirt: However.we analyze the history of the industry in an atten4r to predict potential sales.Many economic variables are nonstationaryand. We havealreadyworked with time-seriesdatain Chapter9 and discovered how regressicr models for thesedata often have special characteristicsdesignedto capturetheir dynaru nature. .

Note that whik ratearound a constarr pward trend.finance et-t* predicting supplies d restedin forecasting rn s indicators of econr:lrn.-r.8 0.2 -1.4 0.0 --0.0 0. and rbr 3 years).8 -1.0 4. such as ma.7 US economictime series. I display behavior rhr ions.2 0. The firs Ltionaryvariablesarr )nstantover time. stweenbanks).0 t< 86 88 90 92 94 96 98 00 02 04 (g) 3-yearBondrate rrcunr 72 .. as you r:I nodeling are profourr ts of stationarity raec the Nobel laureatesrq r be quite severe and r: 86 88 90 92 94 96 98 00 02 04 (a) Realgrossdomestic product(GDP) 7 6 5 86 88 90 92 94 96 98 00 02 04 (b) Change GDP in 3 z 1 86 88 90 92 94 96 98 00 02 04 (c) Inflationrate 1. 86 88 90 92 94 96 98 00 02 04 (h) Change theBondrate in .i A.d. if we rr : industry in an attemEr rg time-series data.lternatively.r.5 1. arr rn the length of tinr 88 90 92 94 96 98 00 02 (e) FederalFundsrate 868890929496980002M (/) Change theFederal in Fundsrate t2 10 1.6 1.5 0.4 -o.{TEGRATION 12. variable or explanarcrr used to model dynarrs.lso known as its firs value ofthe variable . iscoveredhow regressrirr lo capture their dynarrr. Observe tx'r flation rate appear r larly. The figures on th . variables on the lefi tedly in this chaptent .z a measureof aggrege s in the aggregatepn. both the Fedenr rior. be used in forecasr4 '9 was that the variat'ler ence betweenstationar tionary and.1 STATIONARY AND NONSTATIONARY VARIABLES 327 yolutionized the wa1-rr groups.6 86 88 90 92 94 96 98 00 02 04 (d) Change theinflationrate in es r the US econom\-c nd in the file usa. :conomies.5 -1.

Thus. (covariancedependsons. the Federal Funds rate.and varianceo"2.and not on the actual times at which the variables are obsen. To appreciate this condition for stationarity look at the plots shown in Fig. before we introduce the tesr it is useful to revisit the first-order autoregressive model that was introduced rn Chapter 9.and every time period. is stationaryif for all values.c cov(yr.whether a series is stationary or nonstationary.However.1 0.1 4. Nonstationary series with nonconstant means are often described as nc having the property of mean reversion. is the feature that has received the mor: attention.p). whereasthe samplemeansfor r-bc variables in the original levels.4 2.3.\amples of stochastic 1 L'ld current and Past err' :xdels do not contain i fi The autoregressive rodel for explaining thr t\ 6. their changesdisplay characteristir.7 Sample Means ofTime SeriesShownin Figure 12.328 NONSTATIONARY TIME-SERIES DATA AND COINTEGRATION 72.) : p var(Y.9 -0. An examPl :endomelTorsis shown r]bserve how the time :haracteristic of station The value "zero" is *rme algebraknown as relue at time t :2 and )1 : J2: tt- T}remean of y.!1-") : ^y. is !:nce the elTorYrhas ze :en be showntobeacor i+ra-rt can be shown I lr s\ample of a stationar Real world data rar rplacing y.1 TrrE Frnsr-ORDER AuToREGRESSTvE Moou Let yr be an economic variable that we observe over time. A formal test is describedin Section 12. the time seriesy. it is true th.The econometricmodel generatingI time-seriesvariable yr is called a stochastic or random process.03 -0.) 1995:1 20Otr to 9465.utionary.2a) 12. rhere the errors v/ are i lrmally distributed. Sinc utoregressive model oI :p to yr-p.7 119.1 -0. the sample means for the change variables shown on the right-hand side 6q Figure l2. in (12. In r: "shocks" or "inno .r of stationarity. both its level and its change display characteristics of noo. but this does not constitute a hypothesir test. In line with most economx variables.ed That is.1 ]orhs that the stochast . as well as the changein GDp differ acrosssampleperiods. that of a constant mean.not/) The first condition.2 79.l and their samplemeansshown in Table 12.1.1 periods Sample Variable Real GDP (a) Inflation rate (c) Federal Funds rate (e) Bond rate (g) Change in Change in Change in Change in GDP (b) the inflation rate (d) the Federal Fund rate (f) the Bond rate (h) 1985:1 1994:4 to 5587.It is one ofmany possiblc ehich can then be rear ehereo: p(1.a E(y.) :62 (constantmean) (constantvariance) (12.1t ( 1 2l. For GDP.7 J. stationary series have the property o{ mean reversion.3 7.t ( 1 2l. ure l2. shown on the left-hand side. A sampleof observed _r valuesis called a particular realization ofthe stochasticprocess.4 4. Looking at the sample means of time-series variables is a convenient indicator as r.we assumethat yr is random.1.02 -0.1 separatingthe two values.With the exceptionof the chanec in GDP. We never knoq the valuesofrandom variablesuntil they are observed. while the inflation rate. and 15c Bond rate display characteristicsof nonstationarity.7 rith the "de-meaned .l aresimilar acrossdifferent sampleperiods. That is.The AR(l) Pt r proportionp oflast Per .7 Table 72. sincewe cannot perfectly predict it.1 -0. stationarity.yrar) : cov(!1.

-z* "' + p'yo The mean of y.onstitute a hypothesii we introduce the terrLt was introduced ir *'here the errors vr are independent. We neverknon ric model generatingr sampleof observed-r one of many possible *'hich can then be rearrangedas lr:a*pyt-tlvt.1) randomerrors is shown in Figure I2. a .t t s. andmay be normally distributed. not /) (l2. in (12.p) as follows: 0'-rr) :P(y'-r-p)*v. and independent N(0. Real world data rarely have a zero mean." As we will see.la ( 1 2l.2a)with (y.1plus an error u.p2). is itationary.-zl '' ') : o >incethe error vr has zero mean and the value of ptyeis negligible for a large t.2a)is a classic example of a stationary processwith a zero mean.2a. drawn from a distribution with mean 0 and variance ol. The AR( 1) processshowsthateachrealization of the random variabley.Thatis.with zero meanand constantvariance ol.Note that the datahave been artificially generated.-tI pzu.2b) wherec: F(1 . + Pvr-r * Pzv.02 -0. Since we are concernedwith only one lag. is a useful univariate time-series model for explaining the difference between stationaryand nonstationaryseries. with most economic Cictit. The autoregressive model of order I.) : E(r. We can introduce a nonzero mean p by replacingy. In generalan AR(p) model includes lags of the variable y.7 I 19. and *r display characteristici :haracteristics nonof ften described as nc l have the property o: renient indicator as r. the AR(i) model. The variance canbe shownto be a constan ol I Q .t ) or introducing the intercept term ct in the . These values are lt : y2 : plo _f vr pyr + vz : p(pyo+ vt) * vz : pzyoI pvt + vz lt : vt -l pv.alueat time t :2 and so on.p).4 z-+ 4.ed ne period.2a) variables are obsen. l p l< l (12. it is true thar (l2. .p2) while the covariancebetweentwo errorss periods t apartT" can be shown to be olp' lQ .and it can be determinedby doing somealgebraknown asrecursivesubstitution. contains a proportion p of last period's valuey'. In the context of time-seriesmodels. lPl< 1 (12. then its r. thus. the assumption lpl < 1 implies y.Considerthe value of y at time r : 1.7. An example of an AR(l) time serieswith p :0. the errors are sometimesknown as "shocks" or "innovations. Observe how the time series fluctuates around zero and has no trend-like behavior.-haracteristicof stationary series.re 12. univariate time-series models do not contain any explanatory variables (no x's).1 4.It is given by lt : Plt-t I v1.lc has received the mcr: re plots shown in Figrception of the changs the right-hand side o: e samplemeansfor tlr las the changein GDP :ral Funds rate. is E(y.1 paths that the stochastic process could have taken. The value "zeto" is the constantmean of the series.wecanaccommodateanonzeromeaninyrbyeitherworking with the "de-meaned" variable (yr .{TEGRATION 12.1 -0. the AR(l) model in (12. the model is describedas an autoregressive model of order 1.1 rle periods 1995:lto 20O{:: 9465. up to yr-p.1 STATIONARY AND NONSTATIONARY VARIABLES 329 gu. Univariate time-series models are examplesof stochasticprocesses where a single variable y is related to past values of itself and current and past error terms. In contrast to regressionmodeling.1 0.

-t+ v.2a. or the variable y. + + 50 1001502002503003504004505{r (A yt= lt + vt *. autoregressive processof y1as in(12. 7 y F t + v t *hich canbe rearrang d'l 50 100 150 200 250 300 350 400 450 500 (c))r = 1+0.1.7 'hows the addedinfluen nonzerovalue. This no E . with no re of observations will nonstationaryseries. ( b ) y r = 1 +0 . . 2 Time-series models. as . In this case.2b. .7yr-1+ v.01t y.330 NONSTATIONARY TIME_SERIES DATA AND COINTEGRATION 7 2. with cr . p : 0.here cr : (f-r(l _ p) by described this model series(y.1.we have used the samevalues of the error v.): p*6/dePend ls correct. As we I uend.2b). stationary around its mean value p : "/(l An example of a time seriesthat follows this model. we regressivemodel (Y' 50 100150200250300350400450500 (a) y. we describethc "de-meaned" variable (y.-1 v.p). so the figurc The random walk mc iar in the past that its . + This model is known realization of the ranc An example of a time I Thesetime seriesareci Jownward.when lpl < 1 rend line p * 6t.01r 0.\nother extension to ( uend (p * 6t).1+ 0. = o. L + y F t + v t ptcunx 7 2.7y.7 is shown ia Figure l2. This 12.2 ReNrou V 60 50 1 Consider the sPecialci 1000 800 600 400 2W 50 100150200250300350400450500 ( e )y r = o . We can understand recursivesubstitution. as in Figure r2.p rended .rr) as being stationary around zero.rnthe time separatingc rhe "de-trended" serie Er-v. Correspondingto thesetwo ways. 50 100 150 200 250 300 350 400 4505Cr. 50 1001502002s03003504004505fr' (f) yt= 0.

ure 12.7.p).6 r ) : p ( y .3a) 250 300 350 400 450 5fr1 t. + + This model is known as the random walk model. the time at which they are observed.p ): r l Q . is more usually describedas stationary around the deterministic trend line p + 6t.01r yr_1 u. An example of a time seriesthat can be describedby this model is shown in Figre 12. We can understandthe "wandering" behavior of random walk models by doing some recursive substitution. This is a characteristic of nonstationaryseries. the values of sample means calculated from subsamples of observations will be dependent on the sample period. a-r 1 . . Note that the seriesnow fluctuatesaround a oonzerovalue. ) : p : a / ( 1 . .p) + p6) and )t : 6(l . with no real pattern. In this case.2d.The detrendedseries(y1.While this observation is correct. which implies thatyr is nonstationary.1. and 6 : 0._r+ \t + u.7yr_t vt + 1))+v1.0 . Equation (12. As we have seenin Figure 12.2a) is to consider an AR(l) model fluctuating around a linear trend (p. p : 0 .2c.6 ( / r l0 250 300 350 400 450 !.t . lpl<1 nhich can be rearranged as lt: ot f py.An astutereadermay have noted that the mean of yr.F . we let the "de-trended" series (yr .In other words.3a) shows that each realization of the random variable y1 contains last period's value y1-1 plus an elror vr. This nonzero value is the constant mean of the series E ( v .2c) shere q : (p(1 . -. some real world data appearto exhibit a wnd. This is discussedfurther in Section 12. 7 ) : 3 . or the variable y.3 3 Another extension to (12. E(y.6t) behave like an autoregressivemodel ( y .) : p"+ 6/ dependson t. (r2.NTEGRATION 1 2 . Thesetime seriesare called random walks becausethey appearto wander slowly upward or downward.1+ 0.p . 1S T A T I O N A R Y A N D N O N S T A T I O N A R Y V A R I A B L E S 331 :hows the addedinfluence of the constantterm. An example of a time seriesthat can be &scribed by this model with p : 0.2a) lt:!t-t*vt (r2.01 is shownin Fi gtre 12.5.tvt 12. when lpl < 1. 0 250 300 350 400 450 5f-r.2a. ct : 1.2. )r:)o* Yz:lt* 'o ways. rhe "de-trended" seriesis stationary. we describe*r '. * 6r). )yt=!.r: + 0.so the figure lt : !t-t vt 2 vz:(yo+vr)+vz:yo+ t IY" s:l *vt:ys* Lv" The random walk model contains an initial value ye (often set to zero because it is so far in the past that its contribution to yr is negligible) plus a component that is the sum . y.p .1. 7 i s s h o w ni n .2 Rexnoirn'W'arx Moners Consider the special case of p : I in equation (12.E/) also has a constantvariance and covariancesthat dependonly not on the time separatingobservations.

1.2 Spurious l z : s . We can see the yl:cr*6*yo*vt Jz:a*E2*yr*r )r:cr+6t+yr-l+ The random walk hasa meanequal to its initial value and a variancethat increases over tirr. v. E(y. This term arises because a stochastic component v. the stochastic trend componer (Ll:rv") and now a deterministic trend component le. This latter component is often called thc stochastic trend. N behavior. The variable y wanders up and down as well as increases by a fixed amount at each time r. is added fa each time / and becauseit causesthe time series to trend in unpredictable directions.332 NONSTATIONARY TIME-SERIES DATA AND COINTEGRATION of the past stochastic terms ). for a fixed initial value ys. * v ) :762 We can extend the ra . y. Although the mean is constant. random walk with drift modeb show definite trendseither upward (when the drift ct is positive) or downward (when the drift cr is negative). .Now g( figure 12. it will have the appearanceof wandering upward then downward. arc E(yt) :ta + y 0 * E ( v 1* v z + v : * . In this case both the constant mean and constant variance conditions for stationaritv are violated. followed by e sequenceof negative shocks.In the nextI exhibit proPertiesasso ared with nonstationari 12. we s regressionof series or var(y') : var(vr I vz +v: *. Again. In general. is subjected to a sequence of positive shocks.i:tv".{n example of a time ser 'hown in Figure 12. and so samplemeanstaken for differer periods are not the same. taking the expectation and the variance ofy.3a) lt : a. .-lassof models when P nonstationarity. Another nonstationarymodel is obtained by adding a constant term to (12. is added for each time /.) : lo * E(v1 * vz + "' * ur) : yo v a r ( y r :) v a r ( y l* v z + .1) is shownin Figure 12. I y. . Recognizing that tle v.-r * vt (12. < 0. eventually becoming infinite. Ask Yours Frgure12.2. are independent. It is called a deterministic trend because a fixed value cr. The main reason whY oonstationary before c obtaining apparently si seriesare used in regrt To illustrate the Pro The value of y at time t is made up of an initial value ys. the increasing variance implies that the seriesmay not return to its mean. in truth.. ' * v . We have used the fact that yr is a sum of errors to explain graphically the nonstationa4 nature of the random walk. ) : r c r* y o .3b) shows that erb realization of the random variable yr contains an intercept (the drift componentcr) plus las period's value yr-1 plus the error v. > 0.. we can get a better understanding of this behavior by applying recursirc substitution: /l:ct*yo*vr 2 The additional term has To recap. An example of a time seriesthat can be describedby thir model (with ct : 0. The mean ard variance of y.. * v1): 62 where Yrr arld vzt ate Figure 12.2e.Notice how the time-seriesdataappearto be "wandering" as well as "trending" upward. yields.3bt nhere we have used the This model is known as the random walk with drift. Equation (12.3a-the dat dently and.2f. We can also use it to show algebraically that the conditions fa stationarity do not hold. * y r + v 2: q * ( c t* ) o + v l ) + v z : 2 s * t o * It : a*/r-r * vt : td+yo + ir" s:l Iv. If the variable y. we have ct c rheydisplay ProPerties . ha' rn Figure 12'3b.

To recap.3a-the data are in the file spurious dat. 1.. followed b1 r of wandering upt*art :ally the nonstationa4 that the conditions fcr ng the expectationad We can extend the random walk model even further by adding a time trend: )r:q.1) random errors.yet when we plot them. haveno relation to one another.u. The mean and -lo where v11and v21are independentN(0.2 SPURIOUS REGRESSIONS 333 is often called t. E : 0.t * r t : t s .3a) (12'-?t' 1. We showed that random walk models display properties of nonstationarity.70 * (40. we see a positive relationship between them.3c) An exampleof a time seriesthat can be described this model (with a : 0.bc rnent u1 is added fct dictable directions. We can see the amplification using the same algebraic manipulation as before: )l:cr*6*yo*vr l z : o . > 0.2f .3b)shows thar eacL rmponent cr) plus lasr n be describedby rhir :ries data appear to bc rlk with drift modelr nward (when the drift z applying recursirc tl16+yo + i.1with those in Figure 12.+E/+!t-t*vg (r2. Ask yourself what models might have generatedthe different data series in Figure12. go back and comparethe real world data in Figure 12. 1+2+ 3+'.837) . To illustrate the problem.842rw2. + 6 2 + h | . We havealso discussed random walk the class of models when p : 1. and which seriesexhibit properties associated with nonstationaritv.Rz : 0. for stationarity are fri: (4 17. These serieswere generatedindependently and.l exhibit properties associatedwith stationarity.'*t:t(t+I)12 The additional term has the effect of strengthening the trend behavior.Now. in truth.EGRATION 12.2.01) is by strownin Figrxe I2.2 Spurious Regressions The main reason why it is important to know whether a time series is stationary or nonstationary before one embarks on a regression analysis is that there is a danger of obtaining apparently significant regressionresults from unrelateddata when nonstationary seriesare used in regressionanalysis. *( t ( t t at increases over tifits: increasing variarxr ms taken for differen )rm to (12. : o + 6 r + ! t . we obtain the following results: . 12. E r. Such regressionsare said to be spurious. let us take two independentrandom walks: rwti lt : !t-t * vy fW2i \:X1-1 *V21 ) * Lv" tic trend componenr Ldeterministic trend rble y wanders up ) t. If we estimate a simple regressionof seriesone (rw1) on series two (rw2).818 0. Note how the addition of a time-trend variable / sfrengthensthe trend behavior. Two such series are shown in Figure 12.1. we have consideredthe autoregressive class of models and have shown that theydisplay propertiesof stationaritywhen Ip | < 1.3b. aswe havedone in Figure 12.v 2 : o * 2 b * ( a * 6 * y o + v l ) + v z: 2 u + 2 3 D+ y s * L v " s=l y .Inthenextfew sections shallconsiderhowto testwhich series we inFigure l2. \z'/s:l where we have used the formula for a sum of an arithmetic progression.

In other words.. it is particularly important to take carewhen estimating regressionswith macroeconomicvariables. see The null and alternativt the null hypothesisthat reject the null hypothe . the /-statistic is huge! These results are. How then can we test whether a series is stationary or nonstationary and how do we conduct regressionanalysis with nonstationary data? The former is discussedin Section 12. where"y: p .however.l andA. while the latter is consideredin Section 12. In fact. This result suggeststhat the simple regressionmodel fits the data well (R2 :0.3 Unit Roo There are many tests fc most popular one.3. completery meaningless.70).!& "S" i+:-l*:: . ffiF This test is basedon thr Ir : Plr-l * vr is statio randomwalk process)t value of p. p or ^yas follows: )iote that the null hypot rejectthe null. 3 Time series scatter and plot of two randomwalk variables. or simply p form by subtracting y120 30 40 50 0 l0 s"#i. and /-statistics are not reliable.4ry. In other wor Testsfor this purpose a To formalize this prr t0 _10 :?ffid+ " a!$- where the v1are indepe can test for nonstationa rhatlpl( 1.t.? -d-.**sqt{11": . Similar and more dramatic results are obtained when random walk with drift series are used in regressions.. The apparent significance of the relationship is false. ":!4_.2 and that the estimated slope is significantly different from zero. In these cases the least squares estimator and least squarespredictor do not have their usual properties.prot tat ptcunr 7 2 . In fact these series have nothing in common nor are they causally related in any way.4. 'Typically.3. the resuls may spuriously indicate a significant relationship when there iJnone.1 Drcxnv-Fur (a) Time series 60 50 40 1 JT' .2 DtcxEv-Frn The secondDickey-Fu suchregressions alsohaverow Durbin-watson wilt statistics. We begin by des rhen outline the testing 100 200 300 400 500 600 700 12. Appendix98. and t discussionof the autore or excludea constantter of the Dickey-Fuller te rend. Since many macroeconomic time series are nonstationary. we concl that 1 : 0. then we cot 12. It results from the fact that we have related one series with a stochastic trend to another series with another stochastic trend. or spurious.3.dHq*8" "' "B-de c""". when nonstationary time seriesare used in a regression model.334 NONS TATI ONARY TIME-SERIE S DATA AND C O INTE GRATION 12.

it becomesthe nonstationary randomwalkprocessyr:!t-t*vl. stochasticprocesses include q excludea constantterm and can include or excludea time trend. and the one that we discuss.Jt-t : Plt-t . In these casesthe : usual properties. we thenull hypothesis is that that the series stationary. 12.!t-r I v1 Ay.thehypothesescanbewrittenintermsofeither p or ^yas follows: HsiP: I <+[1s:"Y:0 H 1 : p1 1 { + F I 1 ^ y 0 : < J.Then.if we reject the null hypothesis that 1 : 0.1 where we note that the AR(l) process -rt : plr-1 * vr is stationary when lpl ( 1. We begin by describing the test equations and hypothesesfor thesethree casesand 6en outline the testing procedure.we conclude theseries nonstationary. consider again the AR(l) model: It:Plt-ttvt (r2.Hence. 12. it is :roeconomic variables. We can test for nonstationarity by testing the null hypothesis that p : 1 against the alternative that lpl ( 1. and are nonstationary. The apparenr tt we have related one chastic trend.-l TEGRATION 1 2 . we test whether p is equal to one or significantly less than one. but. fact.4) where the u1are independentrandom errors with zero mean and constantvariance ol.sb) rpendix 9B as In if hypotheses the same before.2 Drcxrv-Furun Trsr 2 (WrrH CoNsreNr sur No TnENo) The secondDickey-Fuller test includes a constant term in the test equation: Ay. There arethreevariations of the Dickey-Fuller test designed to take account of the role of the constant term and the uend. we conclude rejectthe . 3U N I T R O O T T E S T SF O R S T A T I O N A R I T Y 335 12.3. or simply p < 1. thiscase.^' : 0. rnary and how do we i discussed Section in (I2.is the Dickey-Fuller test.2and "t. null hypothesis 1 :0. we concludethat it is a nonstationaryprocess. we do not reject are Thenull andalternative If that is that^y: 0 (or p : 1).3 Unit Root Tests for Stationarity tuqJ I __l )7W I There are many tests for determining whether a seriesis stationary or nonstationary.lote that the null hypothesisis that the seriesis nonstationary. the results ne. if we do not rejectthe null.In other words. In facrd in any way.3.:o]_^yyrr]_vt (12. Tests for this purpose are known as unit root tests for stationarity. the /-statistic is rurious.70). This one-sided (lower tail) test is put into a more convenient form by subtractingy1-1 from both sides of (12.The most popular one.l)!t-t +vt : ^i/YFr+ vt . Similar lrift series are used in isionmodel. To formalize this procedure a little more. then we conclude that the seriesis stationary.1 DrcxEv-FurrEn TEsr 1 (No CoNsreNr axo No Tnrr.sa) wherel:p-landAyr:lt-y1-l.ro) This test is basedon the discussionin Section 12. when p : 1.4) to obtain: lt . In other words.onewaytotestforstationarityistoexaminethe ralue of p. : (p . As noted in our and can discussionofthe autoregressive random walk models.

3.3. 12.:6x+If+"YYr-l+v ( Asbeforethenullandalternativehypothesesarellg:T:0andF11:10.5ct !. An important extension of the Dickey-Fuller test allows for the possibility that the error term is autocorrelated.5 Tnr Drcxr cons . (l2. .2.5a). if r.If ue reject the null hypothesis that 1 : 0. use tesr equation (12. Table 12. Unfortunately this t-statistic no longer has the r-distribution that we have used previously to test zero null hypotheses for regression coefficients.Expressedin a casual way. Specifically. Note that critical values are generatedfor the three different testsbecause.is nonstationary. we conclude that the seriesis nonstationary. If the series appearsto be wandering or fluctuating around a sample average of zero. Bond rate (81)-1-year *andering behavior' performing DickeY-Ft or (12. Originally these critical values were tabulated by the statisticians Professor David Dickey and ProfessorWayne Fuller. we reject the null hypothesisof nonstationarityifr ( r". suggeststhe seriesis stationary while r > rc suggestsnonstationarity. rhan the nonaugmente 12. . y1 is nonstationary and has a variance that increases as the sample size increases. the addition of the constant term and the time-trend term changes the behavior of the time series. This implies that the r-statistic must take larger (negativel values than usual for the null hypothesisofnonstationurity I : 0 to be rejected in favor of the alternative of stationarity I < 0.Ifwedonotreject the null hypothesisthat 1 : 0 (p : I ).2 contuns the critical values for the tau (r) statistic for the three cases: they are valid in large samplesfor a one-tail test. but in deferenceto the seminal work. A suitable equationfor the test is then chosenon thc basis of a visual inspection of the plot.Ifr)t"thenwedonotrejectthenullhypothesisthattheseriesy.eries has a unit root. but one that avoids the proliferation of "double negatives. New York: O' When carrying out a Dickey-Fuller test.Such autocorrelationis likelv to occur if our earlier models did not nhere Ayr-r : ()r-t difference terms as w( discoveredin Sections ! ro eliminate autocorrele eramining the autocorr cstimated lag coefficiet excluded or trend inc hlpotheses for station n ay and the test critici Table 12. is the critical value obtained from Table 12.5c). we conclude that the series is stationary.336 N O N S T A T I O N A R Y T I M E . When 1 : . when the null hypothesis is true.3 Drcxrv-Fr-rrrpn Tssr 3 (Vrrn CoNsraNr ervo WIrrr TnrNo) Table 12 . l.use test equation(12. use test equation (12." r ( r. If the series appearsto be wandering or fluctuating around a linear trend.-r*\l+v. A problem arises because.2 \todel l-v.we simply estimate the test equation by leas squares and examine the r-statistic for the hypothesis that "y :0. a useful first step is to plot the time seriesof thc original observationson the variable.3.v.S E R I E SD A T A A N D C O I N T E G R A T I O N t2.2.4 TnE Drcxnv-Furr-sn TssrrNc Procnoun-E critical values Srandard \bre: These critical values ar Econometics. The valueshave sincebeenrefined.{s anexamPle. . to carry out this one-tail test of significance. If the series appears to be wandering or fluctuating around a sample average that is nonzero. This increasing variance alters the distribution of the usual /-statistic is when -Fl6 true. To recognize this fact the statistic is often called a r (tau) statistic.as we have seenin Section I 2. Note that the Dickey-Fuller critical values are more negative than the standard critical values (shown in the last row). and its value must be compared to specially generated critical values. unit root testsusing thesecritical valueshave becomeknown as DickeyFuller tests.5b).:1y1-1 lvr Cdtic The third Dickey-Fullertestincludesa constant a trendin the testequation: and Ayr-o*^yy. have sufficient lag term nith an intercePt as an To test the hypothesis in all three cases.:ct*YYr-t*Yr !_r'.5b) that inclu deterministic time tre the because seriesflu< lagged difference ter described procedures is sufficient to elimin estimating the resultil .

672\n-l (tau) (-2. The h1'pothesesfor stationarity and nonstationarity are expressed in terms of 1 in the same * ay and the test critical values are the same as those for the Dickey-Fuller test shown in Table 12.0e0) + @ :0. Lthe standardcritica ake larger (negatire e rejected in favor oi ie-tail test of signifire null hypothesis of sisthat the seriesy. tuse. 708.5b) is the appropriate test equation because seriesfluctuate around a nonzero mean. or (12..6) and its variants (intercept ercluded or trend included) are referred to as augmented Dickey-Fuller tests.o.The results from estimatingthe resultingequationsare + G :0.: 0.57 -J.p.le and l2. r (tau) statistic. so we suspect that they may be nonstationary variables.3 UNIT ROOT TESTS FOR STATIONARITY irH TnrNo) retest equation: /l1 < Table 12 .As we Jiscoveredin Sections9. lusly to test zero nu.G. ans ProfessorDar ic :d.3.vt lt':a+It+"yyr-l+v. neknown as Dicke.3. If we do not reje.a v.i.4.: test equation by lea. u: If is stationary..o. Standardcritical values y < 0. As suggestedearlier. When performingDickey-Fuller tests.sts nonstationaritl. 12.lg. Following procedures describedin Section9.Using the model * ith an intercept as an example. use te..o37FA o. sibility that the error Lrliermodels did nor : *here Ay1-1 (yr-r-!t-z).-z:(y. -2.o568r-ro. or (12. rt the time seriesof rh: .285. (12.|y.t is then chosenon rhr havesufficient lag terms to capturethe full dynamic nature of the process. *andering behavior. consider the two interest rate series-the Federal Funds rate (F.:ct]-11. We also have to decide on how many the lagged difference terms to include on the right-hand side of the equation.2. respectively.rtic for the threecase\.3l5AB'-r (-r.-r * f a. including lags of the dependentvariable can be used to eliminate autocorrelationin the errors. we always use the augmentedDickey-Fuller test (rather than the nonaugmentedversion) to ensurethe en:orsare uncorrelated. jreases the sampir as I the usual /-statisrr. when the nu.yt_t].-r-!*z). In practice. in addition to saying the seriesis nonstationary. anc :s. i .62 -2.-.we needto decidewhetherto use(12. Estimation and Inference in lronometrics.Ly.but in deference r.94 -2.)-plotted in Figure l2. iferation of "double .) and the Both seriesexhibit -i-yearBond rate (B.3.2 \todel Critical Valuesfor the Dickev-Fuller Test lVo 5Vo 107o lr'r:^yyr_l+y.3.The number of laggedterms can be determinedby eramining the autoconelationfunction (ACF) of the residualsv.5 Tnp DrcxEy-Furrsn Tssrs: AN Exerlprr As an example. Unfortunately th:.I J -3. n .5c) that includes a constant and a deterministic time trend /.178. or the significanceof the estimatedlag coefficientsa".. sampleaveragethar :.1.56 -3. Davidson and J. When 1 : 0.65 -1.86 -1.r is nonstationary. the behavior of rhr.5b) that includes a constant term. Note that criticas e e n i n S e c t i o1 2 .28 \ote: These critical values are taken from R.96 -Z.JJ -t.5a)with no constant. we find that the inclusion ofone laggeddifference term is sufficient to eliminate autocorrelation in the residuals in both cases. : o *"yy. MacKinnon (1993).4r ... W e a d d a s m a n y l a g g e df i r s t Jifference terms as we need to ensure that the residuals are not autocorrelated. The unit root testsbasedon (12. the extendedtest equation is Ay. also say the we :eries has a unit root.976) (tau) . lJ.43 -3. s:1 (r2. r linear trend.TEGRATION 12..6) ample averageof zer. New York: Oxford University Press.2 and9.

are that the variables AF and AB are not stationary. In general..:: tical valuesfor a test -:lude extra terms lik :. Stationaryseriesare said to be integrated oforder zero.We similarlr concludethat AB. we do not reject the nu. t A line.lf and 12.. thereis insufficientevidence susse. this case.we usethe test equationwithout the interceptterm. Again.:y.: residuals.to avoid the Pro . : 9t l$zxt * e.Series like y.I(0). o"2) random variable. to F. Thetauvalue(r)fortheFederalFundsrateis -2.415 < -1.to determinethe order of integrationof F and B.-:n and. becausethe seriesAF and lB appearto fluctuatearoundzero.007) I6B-t: (tau) -057s(LB)Fl (-6.007 < -1. Expressed anotherwav..r. .-. being rindependent(0.AF -r and A(AB)' . : integration. Basedon thelargenegativevalueof taustatistic (-4.4 Cointegra 72. we hypothesis nonstationarity t < r.340(Ar)r-r (tau) (-4. .3. We say that the seriesF.minateautocorrela There arethree setso are derived from a . i: stationary? Figure 12. .nstantand a time tre AGD.94).338 NO NSTATI ONARY TIME-SERIES DATA AND C O INTEGRATI ON -2.94) This resultimplies that while the level of the FederalFundsrate (F.86." Recall that.since -2.rression equation wit . .$ 2 . Crit where A(AF) t : LFt .the critic . and. an and The test for stationat : i e r eA 2 1 2 t . 12.-lt-t:rt An interestingfeatureofthe seriesLy.41s) I'tble12.sincethe dil .-Pxltey ). : y.a 1 : . If r ) r.090 > -2.? t ' r .LBt-t. which can be mad: stationary takingthe first difference. Similarly. thenwe do not rejectthenull hypothesis of if th' the seriesis nonstationary.seemto suggestthat they are stationary. In hypothesisthat the seriesis nonstationary. If y. Note that '-'iression is residuals i -. .F1-1) stationan Is the first differenceof the Bond rate (AB. gr * 6r* pzx : :e: These critical values i -66. is stationary. t efficient. .6 Onosn oF INTEGRATToN Up to this stage.86. is t(0)].LB.. and x..090. .greater th. I . Note that the null hypothese.Also. is I(l) because had to bc it differencedonce to make it stationary[Af'. saidto be integrated oforder 1.t cointegrated. the tau value for the Bond rate .the order t : integrationof a seriesis the minimum number of times it must be differencedto make :: stationary.1h. then 1 : 0 and the first differenceof becomes Ay. if yr follows a random walk.) is nonstationary.we have discussedonly whether a series is stationary or nonstationar. For example.) is stationary. and denoted by are "I(1). In the next sectionwe investigate implicationsof of the theseresultsfor regression modeling.: -0. are stationary..86 andagainwe do not rejectthenull hypothesis the seriesis nonstationarv.' thanthe5Vocitical valueof -2.-::t SQUi[eS . : Ft.combination 3 . . is stationary(-6.. recall that to carry out this one-tail test of significance.werejectthenullhypothesir the that AF is nonstationaryand accept the alternativethat it is stationary.3 model -'cression t.rration is effectivelYa -.x1 saidto are t.:Bt-81-1) Their plots. we then ask the ner: question:is the first differenceof the FederalFunds rate (AF. are nol combinationof thr :. ir. reject the nu.andthe5Tocriticalvaluefortau(r. . and B. a n d a 2 : .. a general rule' nons rdels. Similarly we havealso shownthat the Bond rate (Br) is integrated order I .)r-r is that it is stationarysincev.e.rnimPortantcasewhe rre said to be cointeg --'nds. We can take the analysisanother step forward and consider a concept called the "order .\ natural way to tes :)'r-Br -$2\arc residuals. first difference (AF. The resultsof the Dickey-Fuller testfor a random walk applied to the first differencesarc given below: :..ear .

Sincewe cannotobservee. nary.4 Cointegration {s a general rule.). The proper :ritical valuesfor a test of cointegrationaregiven in Table 12.7) Larysince 11. .8 cept term. trn y1and xy are said to be cointegrated.9t .le.and any apparentregressionrelationship between them is spurious. are nonstationary I(1) variables. there is an exception to this :. or any ''near to combination of them.76 -5. : 9 r * l z x tI e t -1) r:Fr*6tl9zxtle. Cointegration implies that y. 2 t y .8b)].9t .07 -3. and r.bxt Equation2: 2t : Jt . and r" are said to be cointegrated.Asbefore.2. Hamilton (1994).96 -3.weexaminethet(ortau)statisticfortheestimatedslope :oefficient. such as !t : lt .If the residualsare stationary.1a v .3.\zn is a stationaryI(0) process. the critical values will be different from those in Table 12. at -.However. nonstationary time-series variables should not be used in regression aodels.766.nce.ir 'der 1.br .B2x1. i: e first differencesar rhereA2l . anda2: 1.8b) ( 12. There are three setsof critical values.they never diverge too far from each other.bzx.. 4 ...39 -3.8a) (12. Also.: !.8c)].2t : lt .IEGRATION 12.At.-p2. 'ALinearcombinationofxandyisanewvariablez:aolarxtazy.being which can be ma.b2x1 b1 Equation ?.Ft_i stationan ary? Their plors.rfe. then we expect their difference. ) -3. The test for coin'cgrationis effectively a test of the stationarityof the residuals. :. theny. However. we test the stationarityof the i:ast squaresresiduals.4 COINTEGRATION 339 tical valuefor tau(r.3 Critical Values for the Cointegration Test l7o 5Vo lOVo (r2. : 1 2 r . and denotedei general.r3 \bre: These critical values are taken from J.are derived from a regression equation without a constant term flike (12.Herewesettheconstantsa0: -9r. :cause it had to be llso shown that the the implications oi Regressionmodel l.b1 . and.5 I -3. and call z the seriese. Equationl: 2t : lt . on the right-hand side if they are neededto :liminate autocorrelationin v. and x7 are cointegratedis to test whether the errors t. (r2.8a)] or a rgression equation with a constant term flike (12.r be I( I ) as well. the order. rt called the "order "r he first differenceoi .' ifferenced to mahe :: ve then ask the ner: r . l series AF and l. T