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exo ass

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The model:

yi = 0 + 1 xi + ui

We omit the i subscripts from now.

The exogeneity assumptions are the following.

E (u) = 0

(1)

This is a technical assumption; not meeting the assumption has a consequence on the regression

constant only (see the first homework).

The important assumption is exogeneity of x. Consistency of the OLS estimator for 1 requires

the following exogeneity assumption:

Cov (u, x) = 0

(2)

Note that technical assumption (1) implies that Cov (u, x) = E (ux) E (x) E (u) = E (ux) ,

and so Cov (u, x) = 0 implies that E (ux) = 0.

1.1

Mean-independence

E (u|x) = E (u) = 0

where the last equality follows from technical assumption (1).

1.1.1

Intuitively: a (population) regression of u on x is the linear approximation to E (u|x). The regression would yield a slope coefficient of Cov (u, x) /V (x). If E (u|x) = E (u), the conditional

expectation function is a constant. Therefore, a linear approximation to it would yield a slope of

zero, which implies that Cov (u, x) = 0.

Formally,

ux 1

|x = E (ux|x)

x

x

and therefore E (ux|x) = xE (u|x). But the law of iterated expectations implies that E (ux) =

E [E (ux|x)] . Therefore,

E (u|x) = E

If E (u|x) = E (u), we have that

E (ux) = E [xE (u|x)] = E [xE (u)] = E (x) E (u)

Because Cov (u, x) = E (ux) E (x) E (u), we have shown that E (u|x) = E (u) implies that

Cov (u, x) = 0.

1.1.2

Intuition: it may be that E (u|x) is nonconstant but its shape is such that when averaged over x,

it becomes zero. Such cases are, of course, more of text book examples than real-life cases.

One such example: E (u|x) = x2 , x N (0, 1). E (x) = 0, E (u) = E [E (u|x)] = E x2 =

V (x) = 1. E (ux) = E [xE (u|x)] = E x3 = 0. Cov (u, x) = E (xu) E (x) E (u) = 0 0 = 0. But

E (u|x) = x2 = E (u) in general.

1.2

Independence

u is said to be independent of x if the joint density of u and x is the same as the product of the

marginal densities:

f (u, x) = f (u) f (x)

1.2.1

Intuitively: if x and u are independent, then any moment of each cannot be a function of the other.

Formally: independence implies that the conditional density of u given x is equal to the marginal

(unconditional) density of u:

f (u|x) =

f (u, x)

f (u) f (x)

=

= f (u)

f (x)

f (x)

E (u|x) = uf (u|x) du = uf (u) du = E (u) .

1.2.2

One such case is mean-independence with conditional heteroskedasticity. Here V (u|x) is a nonconstant function of x, and therefore there is some dependence between u and x. At the same time,

we may have mean independence such that E (u|x) is a constant function. An example:

u N 0, x2

Setup is as before, iid sample of n observations (i = 1, 2, ..., n), and we omit i subscripts.

The model is as before, but the RHS variable is a dummy (is either zero or one):

y = 0 + 1D + u

D {0, 1}

In this case the exogeneity assumption is usually stated as mean-independence:

E (u|D = 0) = E (u|D = 1) = E (u) = 0

(3)

Of course, mean independence implies zero covariance here as well, because in the derivation

above we did not use the fact that the RHS variable (or, for that matter, u) is continuos. But here

mean-independence is not stricter than the zero covariance, for the following reason.

2.1

Intuitively: E (u|D) is a two-valued function: E (u|D = 0) and E (u|D = 1). The two are the same

if and only if the line that connects them has zero slope.

Formally:

E (Du) =

=

E (D) =

Cov (u, D) =

=

=

Pr (D = 0) E (Du|D = 0) + Pr (D = 1) E (Du|D = 1)

Pr (D = 1) E (u|D = 1) = Pr (D = 1) E (u)

Pr (D = 1)

E (Du) E (D) E (u)

Pr (D = 1) E (u) Pr (D = 1) E (u)

0

where in the second line we used assumption (3) above, i.e. that E (u|D = 1) = E (u) .

2.2

Independence

2.2.1

Intuitively: if D and u are independent, then any moment of u must be the same for any value of

D.

Formally: E (u|D = j) = uf (u|D = j) du so if f (u|D = j) = f (u), we trivially have that

E (u|D = j) = E (u) whether j = 0 or 1.

2.2.2

u N (0, 1) if D = 0

u N (0, 2) if D = 1

So that E (u|D = 0) = E (u|D = 1) = 0 but V (u|D = 0) = 1 = V (u|D = 1) = 2.

3

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