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Christopher Dougherty

EC220 - Introduction to econometrics


(chapter 4)
Slideshow: Ramseys reset test of functional misspecification
Original citation:
Dougherty, C. (2012) EC220 - Introduction to econometrics (chapter 4). [Teaching Resource]
2012 The Author
This version available at: http://learningresources.lse.ac.uk/130/
Available in LSE Learning Resources Online: May 2012
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RAMSEYS RESET TEST OF FUNCTIONAL MISSPECIFICATION


k

Y b1 b j X j
j2

Ramseys RESET test of functional misspecification is intended to provide a simple


indicator of evidence of nonlinearity. To implement it, one runs the regression and saves
the fitted values of the dependent variable.
1

RAMSEYS RESET TEST OF FUNCTIONAL MISSPECIFICATION


k

Y b1 b j X j
j2

Since, by definition, the fitted values are a linear combination of the explanatory variables,
as shown, Y^2 is a linear combination of the squares of the X variables and their interactions.
2

RAMSEYS RESET TEST OF FUNCTIONAL MISSPECIFICATION


k

Y b1 b j X j
j2

Add Y to the regression specification


and test its coefficient
2

^
If Y2 is added to the regression specification, it should pick up quadratic and interactive
nonlinearity, if present, without necessarily being highly correlated with any of the X
variables.
3

RAMSEYS RESET TEST OF FUNCTIONAL MISSPECIFICATION


k

Y b1 b j X j
j2

Add Y to the regression specification


and test its coefficient
2

If the t statistic for the coefficient of is significant, this indicates that some kind of
nonlinearity may be present.
4

RAMSEYS RESET TEST OF FUNCTIONAL MISSPECIFICATION


. reg EARNINGS S
Source |
SS
df
MS
-------------+-----------------------------Model | 19321.5589
1 19321.5589
Residual | 92688.6722
538 172.283777
-------------+-----------------------------Total | 112010.231
539 207.811189

Number of obs
F( 1,
538)
Prob > F
R-squared
Adj R-squared
Root MSE

=
=
=
=
=
=

540
112.15
0.0000
0.1725
0.1710
13.126

-----------------------------------------------------------------------------EARNINGS |
Coef.
Std. Err.
t
P>|t|
[95% Conf. Interval]
-------------+---------------------------------------------------------------S |
2.455321
.2318512
10.59
0.000
1.999876
2.910765
_cons | -13.93347
3.219851
-4.33
0.000
-20.25849
-7.608444
-----------------------------------------------------------------------------. predict FITTED
(option xb assumed; fitted values)
. gen FITTEDSQ = FITTED*FITTED

We will do this for a wage equation. Here is the output from a simple linear regression of
EARNINGS on S using EAEF Data Set 21. We save the fitted values as FITTED and generate
FITTEDSQ as the square.
5

RAMSEYS RESET TEST OF FUNCTIONAL MISSPECIFICATION


. reg EARNINGS S FITTEDSQ
Source |
SS
df
MS
-------------+-----------------------------Model | 20372.4957
2 10186.2479
Residual | 91637.7353
537 170.647552
-------------+-----------------------------Total | 112010.231
539 207.811189

Number of obs
F( 2,
537)
Prob > F
R-squared
Adj R-squared
Root MSE

=
=
=
=
=
=

540
59.69
0.0000
0.1819
0.1788
13.063

-----------------------------------------------------------------------------EARNINGS |
Coef.
Std. Err.
t
P>|t|
[95% Conf. Interval]
-------------+---------------------------------------------------------------S | -.6956444
1.290509
-0.54
0.590
-3.230709
1.83942
FITTEDSQ |
.0303508
.0122302
2.48
0.013
.006326
.0543757
_cons |
16.35854
12.62009
1.30
0.195
-8.432256
41.14933
------------------------------------------------------------------------------

The coefficient of FITTEDSQ is significant at the 5 percent level and nearly at the 1 percent
level, indicating that the addition of the square of S would improve the specification of the
model. We saw this in a previous slideshow.
6

RAMSEYS RESET TEST OF FUNCTIONAL MISSPECIFICATION


. reg EARNINGS S FITTEDSQ
Source |
SS
df
MS
-------------+-----------------------------Model | 20372.4957
2 10186.2479
Residual | 91637.7353
537 170.647552
-------------+-----------------------------Total | 112010.231
539 207.811189

Number of obs
F( 2,
537)
Prob > F
R-squared
Adj R-squared
Root MSE

=
=
=
=
=
=

540
59.69
0.0000
0.1819
0.1788
13.063

-----------------------------------------------------------------------------EARNINGS |
Coef.
Std. Err.
t
P>|t|
[95% Conf. Interval]
-------------+---------------------------------------------------------------S | -.6956444
1.290509
-0.54
0.590
-3.230709
1.83942
FITTEDSQ |
.0303508
.0122302
2.48
0.013
.006326
.0543757
_cons |
16.35854
12.62009
1.30
0.195
-8.432256
41.14933
------------------------------------------------------------------------------

However, we also saw that it was better still to use a semilogarithmic specification. The
RESET test is intended to detect nonlinearity, but not be specific about the most appropriate
nonlinear model.
7

RAMSEYS RESET TEST OF FUNCTIONAL MISSPECIFICATION


. reg EARNINGS S FITTEDSQ
Source |
SS
df
MS
-------------+-----------------------------Model | 20372.4957
2 10186.2479
Residual | 91637.7353
537 170.647552
-------------+-----------------------------Total | 112010.231
539 207.811189

Number of obs
F( 2,
537)
Prob > F
R-squared
Adj R-squared
Root MSE

=
=
=
=
=
=

540
59.69
0.0000
0.1819
0.1788
13.063

-----------------------------------------------------------------------------EARNINGS |
Coef.
Std. Err.
t
P>|t|
[95% Conf. Interval]
-------------+---------------------------------------------------------------S | -.6956444
1.290509
-0.54
0.590
-3.230709
1.83942
FITTEDSQ |
.0303508
.0122302
2.48
0.013
.006326
.0543757
_cons |
16.35854
12.62009
1.30
0.195
-8.432256
41.14933
------------------------------------------------------------------------------

It may fail to detect some types of nonlinearity. However it does have the virtues of being
very easy to implement and consuming only one degree of freedom.
8

Copyright Christopher Dougherty 2011.


These slideshows may be downloaded by anyone, anywhere for personal use.
Subject to respect for copyright and, where appropriate, attribution, they may be
used as a resource for teaching an econometrics course. There is no need to
refer to the author.
The content of this slideshow comes from Section 4.3 of C. Dougherty,
Introduction to Econometrics, fourth edition 2011, Oxford University Press.
Additional (free) resources for both students and instructors may be
downloaded from the OUP Online Resource Centre
http://www.oup.com/uk/orc/bin/9780199567089/.
Individuals studying econometrics on their own and who feel that they might
benefit from participation in a formal course should consider the London School
of Economics summer school course
EC212 Introduction to Econometrics
http://www2.lse.ac.uk/study/summerSchools/summerSchool/Home.aspx
or the University of London International Programmes distance learning course
20 Elements of Econometrics
www.londoninternational.ac.uk/lse.

11.07.25