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Simon Jackman

Stanford University

Consider the linear regression model, y = Xb+u, where y is a n-by-1 vector of observations

on a dependent variable, X is a n-by-k matrix of independent variables of full column rank, b

is a k-by-1 vector of parameters to be estimated, and u is a n-by-1 vector of disturbances. Via

the Gauss-Markov Theorem, if

A1 E(u|X) = 0 (i.e., the disturbances have conditional mean zero), and

the disturbances are independent and identically distributed or ‘‘iid’’ with conditional

variance r2 ),

then the ordinary least squares estimator b̂OLS = (X0 X)-1 X0 y with variance-covariance matrix

V(b̂OLS ) = r2 (X0 X)-1 is (1) the best linear unbiased estimator (BLUE) of b, in the sense of having

smallest sampling variability in the class of linear unbiased estimators; (2) a consistent

estimator of b (i.e., as n → ∞, Pr[|b̂OLS - b| < e] = 1, for any e > 0, or plim b̂OLS = b).

If A2 fails to hold (i.e., X is a positive definite matrix but not equal to In ), then b̂OLS remains

unbiased, but no longer ‘‘best’’, and remains consistent. Relying on b̂OLS when A2 doesn’t hold

risks faulty inferences; without A2, r̂2 (X0 X)-1 is a biased and inconsistent estimator of V(b̂OLS ),

meaning that the estimated standard errors for b̂OLS are wrong, invalidating inferences and

the results of hypothesis tests. Assumption A2 often fails to hold in practice: e.g., (1) when

pooling across disparate units generates disturbances with different conditional variances

(heteroskedasticity); (2) an analysis of time series data generates disturbances that are not

conditionally independent (serially correlated disturbances).

When A2 does not hold, it may be possible to implement a generalized least squares (GLS)

estimator that is BLUE (at least asymptotically). For instance, if the researcher knows the

exact form of the departure from A2 (i.e., the researcher knows X) then the GLS estimator

b̂GLS = (X0 X-1 X)-1 X0 X-1 y is BLUE, with variance-covariance matrix r2 (X0 X-1 X)-1 . Note that when

A2 holds, X = In and b̂GLS = b̂OLS (i.e., OLS is a special case of the more general estimator).

Typically, researchers suspecting that assumption A2 does not hold do not possess

exact knowledge of X, meaning that b̂GLS is non-operational, and a estimated or feasible

generalized least squares (FGLS) estimator is utilized. FGLS estimators are often implemented

in multiple steps: (1) a OLS analysis to yield estimated residuals û; (2) analysis of the û to

form an estimate of X, denoted X̂ (3) computing the FGLS estimator b̂FGLS = (X0 X̂-1 X)-1 X0 X̂-1 y.

Step (3) is often performed by noting that X̂ can be decomposed as X̂ = P-1 (P0 )-1 , and b̂FGLS is

obtained by running the weighted least squares (WLS) regression of y* = Py on X* = PX; i.e.,

0 0

b̂FGLS = (X* X* )-1 X* y* .

The properties of FGLS estimators vary depending on the form of X (i.e., the nature of

the departure from the conditional iid assumption in A2) and the quality of X̂ and so can

not be neatly summarized. Finite sample properties of the FGLS estimator are often dervied

case-by-case via Monte Carlo experiments; in fact, it is possible to find cases where b̂OLS is

more efficient than b̂FGLS , say, when the violation of A2 is mild (e.g., Rao and Griliches, 1969;

Chipman, 1979). Asymptotic results are more plentiful, and usually rely on showing that

b̂FGLS and b̂GLS are asymptotically equivalent, so that b̂FGLS is a consistent and asymptotically

efficient estimator of b: e.g., Judge et al. (1980, 117-8), Amemiya (1985, 186-222).

In social-science settings, FGLS is most commonly encountered in dealing with sim-

ple forms of residual autocorrelation and heteroskedasticity. For instance, the popular

Cochrane-Orcutt (1949) and Prais-Winsten (1954) procedures for AR(1) disturbances yield

FGLS estimators. The use of FGLS to deal with heteroskedasticity appears in many econo-

metrics texts: Judge et al. (1980, 128-145) and Amemiya (1985, 198-207) provide rigorous

treatments of FGLS estimators of b for commonly encountered forms of heteroskedasticity.

Group-wise heteroskedasticity arises from pooling across disparate units, yielding distur-

bances that are conditionally iid within groups of observations; this model is actually a

special case of Zellner’s (1962) seemingly unrelated regression (SUR) model. FGLS applied

to Zellner’s SUR model results in a cross-equation weighting scheme that is also used as the

the third-stage of three-stage least squares estimators (Zellner and Theil, 1962).

FGLS is also used to estimate models for panel data with unit and/or period specific

heterogeneity not captured by the independent variables: e.g., yit = xit0 b + mi + gt + eit where

mi and gt are error components (or random effects) specific to units i and time periods t,

respectively. The composite error term uit = mi + gt + eit is generally not iid, but its variance-

covariance matrix X can be estimated with the sum of the estimated variances of the error

components; provided that E(uit |xit ) = 0 and E(X0 X-1 X) is of full rank, then FGLS provides a

consistent estimator of b. See Wooldridge (2002, Chapter 10).

Finally, FGLS estimators can often be obtained as maximum likelihood estimates (MLEs),

generating consistent estimates of b in ‘‘one shot’’. While the iid assumption (A2) often

greatly simplifies deriving and computating MLEs, the more common (and hence more simple)

departures from assumption A2 are often tapped via a small number of auxiliary parameters

that determine the content and structure of X (e.g., consider the relatively simple form of X

implied by first-order residual autocorrelation, group-wise heteroskedasticity, or simple error

components structures). Thus the parameters of substantive interest (b) and parameters

tapping the assumed error process can be estimated simulataneously via MLE, yielding

estimates that are asymptotically equivalent to FGLS estimates.

References

Amemiya, Takeshi. 1985. Advanced Econometrics. Cambridge: Harvard University Press.

Chipman, J.S. 1979. ‘‘Efficiency of least squares estimation of linear trend when residuals

are autocorrelated.’’ Econometrica 47:115--128.

Cochrane, D. and G.H. Orcutt. 1949. ‘‘Application of Least Squares Relationships Containing

Autocorrelated Error Terms.’’ Journal of the American Statistical Association 44:32--61.

Judge, George G., William E. Griffiths, R. Carter Hill and Tsoung-Chao Lee. 1980. The Theory

and Practice of Econometrics. Wiley Series in Probability and Mathemetical Statistics New

York: Wiley.

2

Prais, S. J. and C. B. Winsten. 1954. Trend estimators and serial correlation. Chicago: Cowles

Commission.

Rao, Potluri and Zvi Griliches. 1969. ‘‘Small-Sample Properties of Several Two-Stage

Regression Methods in the Context of Auto-Correlated Errors.’’ Journal of the American

Statistical Association 64:253--272.

Wooldridge, Jeffrey M. 2002. Econometric Analysis of Cross-Section and Panel Data. Cam-

bridge, Massachusetts: MIT Press.

Zellner, A. 1962. ‘‘An Efficient Method of Estimating Seemingly Unrelated Regressions and

Tests for Aggregation Bias.’’ Journal of the American Statistical Association 57:348--368.

Simultaneous Equations.’’ Econometrica 30:54--78.

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