INTRODUCTION TO ECONOMETRICS James H. Stock Mark W. WatsonIntroduction to Econometrics THIRD EDITION James H. Stock Harvard University Mark W. Watson Princeton University Addison-Wesley Boston Columbus Indianapolis New York San Francisco Upper Saddle River Amsterdam Cape Town Dubai London Madrid Milan Munich Paris Montreal Toronto Delhi Mexico City Sao Paulo Sidney Hong Kong Seoul Singapore TaipeiEditorial Director: Sally Yagen Art Director: Anthony Gemmellaro Editor-in-Chief: Donna Battista Cover Designer: Anthony Gemmellaro Senior Acquisitions Editor: Adrienne D’Ambrosio Full-Service Project Management, Art Studio, and Assistant Editor: Jill Kolongowski Electronic Composition: Nesbitt Graphics, Inc. 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Copyright © 2011, 2007, 2003 Pearson Education, Inc., publishing as Addison-Wesley. All rights reserved. Manufactured in the United States of America. This publication is protected by Copyright, and permission should be obtained from the publisher prior to any prohibited reproduction, storage in a retrieval system. or transmission in any form or by any means, electronic, mechanical, photocopying, recording, or likewise. To obtain permission(s) to use material from this work, please submit a written request tc Pearson Education, Inc., Rights and Contracts Department, 501 Boylston Street, Suite 900, Boston, MA 02116, fax your request to 617-671-3447, or e-mail at http://www.pearsoned.com/legal/permissions.htm. Library of Congress Cataloging-in-Publication Data Stock, James H. Introduction to econometrics/James H. Stock, Mark W. Watson. — 3rd ed. p.cm. — (The Addison-Wesley series in economics) Includes bibliographical references and index. ISBN-13: 978-0-13-800900-7 (alk. paper) ISBN-10: 0-13-800900-7 (alk. paper) 1. Econometrics. I. Watson, Mark W. II. title. HB139.S765 2010 330.01°5195 —dc22 10987654321—EB—14 13 121110 Addison-Wesley is an imprint of PEARSON ISBN-13: 978- 0-13-800900-7 —_—_ www.pearsonhighered.com ISBN-10: 0-13-800900-7Brief Contents PART ONE Introduction and Review CHAPTER 1 Economic Questions and Data 1 CHAPTER 2 Review of Probability 14 CHAPTER 3 Review of Statistics 64 PART TWO Fundamentals of Regression Analysis 7 CHAPTER 4 Linear Regression with One Regressor 107 CHAPTER 5 Regression with a Single Regressor: Hypothesis Tests and Confidence Intervals 144 CHAPTER 6 Linear Regression with Multiple Regressors 179 CHAPTER 7 Hypothesis Tests and Confidence Intervals in Multiple Regression 214 CHAPTER 8 Nonlinear Regression Functions 252 CHAPTER 9 Assessing Studies Based on Multiple Regression 312 PART THREE Further Topics in Regression Analysis CHAPTER 10 Regression with Panel Data 347 CHAPTER 11 Regression with a Binary Dependent Variable 381 CHAPTER 12 Instrumental Variables Regression 419 CHAPTER 13 Experiments and Quasi-Experiments 469 PART FOUR Regression Analysis of Economic Time Series Data CHAPTER 14 introduction to Time Series Regression and Forecasting 516 CHAPTER 15 Estimation of Dynamic Causal Effects 583 CHAPTER 16 Additional Topics in Time Series Regression 631 PART FIVE The Econometric Theory of Regression Analysis CHAPTER 17 The Theory of Linear Regression with One Regressor 669 CHAPTER 18 The Theory of Multiple Regression 697Contents Preface xxix PART ONE CHAPTER 1 1 1.2 13 2.2 Introduction and Review Economic Questions and Data 1 Economic Questions We Examine 1 Question #1: Does Reducing Class Size Improve Elementary School Education? 2 Question #2: Is There Racial Discrimination in the Market for Home Loans? 3 Question #3: How Much Do Cigarette Taxes Reduce Smoking? 3 Question #4:. What Will the Rate of Inflation Be Next Year? 4 Quantitative Questions, Quantitative Answers 5 Causal Effects and Idealized Experiments 5 Estimation of Causal Effects 6 Forecasting and Causality 7 Data: Sources and Types 7 Experimental Versus Observational Data 7 Cross-Sectional Data 8 Time Series Data 9 Panel Data 11 Review of Probabili 14 Random Variables and Probability Distributions 15 Probabilities, the Sample Space, and Random Variables 15 Probability Distribution of a Discrete Random Variable 16 Probability Distribution of a Continuous Random Variable 18 Expected Values, Mean, and Variance 18 The Expected Value of a Random Variable 18 The Standard Deviation and Variance 21 Mean and Variance of a Linear Function of a Random Variable 22 Other Measures of the Shape of a Distribution 23 viiviii Contents 23 2.4 25 2.6 CHAPTER 3 3.1 3.2 Two Random Variables 26 Joint and Marginal Distributions 26 Conditional Distributions 27 Independence 31 Covariance and Correlation 31 The Mean and Variance of Sums of Random Variables 32 The Normal, Chi-Squared, Student ¢, and F Distributions 36 The Normal Distribution 36 The Chi-Squared Distribution 41 The Student ¢ Distribution 41 The F Distribution 42 Random Sampling and the Distribution of the Sample Average 43 Random Sampling 43 The Sampling Distribution of the Sample Average 44 Large-Sample Approximations to Sampling Distributions 47 The Law of Large Numbers and Consistency 48 The Central Limit Theorem 50 APPENDIX 2.1 Derivation of Results in Key Concept 2.3 62 Review of Statistics Estimation of the Population Mean 65 Estimators and Their Properties 65 Properties of Y 67 The Importance of Random Sampling 69 Hypothesis Tests Concerning the Population Mean 70 Null and Alternative Hypotheses 70 The p-Value 71 Calculating the p-Value When oy Is Known = 72 The Sample Variance, Sample Standard Deviation, and Standard Error 73 Calculating the p-Value When oy Is Unknown = 75 The ¢-Statistic 75 Hypothesis Testing with a Prespecified Significance Level 76 One-Sided Alternatives 783.3 3.4 3.5 3.6 3.7 PART TWO CHAPTER 4 4] 4.2 43 Contents ix Confidence Intervals for the Population Mean 79 Comparing Means from Different Populations 81 Hypothesis Tests for the Difference Between Two Means _ 81 Confidence Intervals for the Difference Between Two Population Means 83 Differences-of-Means Estimation cf Causal Effects Using Experimental Data 83 The Causal Effect as a Difference of Conditional Expectations 84 Estimation of the Causal Effect Using Differences of Means 84 Using the ¢-Statistic When the Sample Size Is Small 86 The t-Statistic and the Student ¢ Distribution 86 Use of the Student f Distribution in Practice 90 Scatterplots, the Sample Covariance, and the Sample Correlation 91 Scatterplots 91 Sample Covariance and Correlation 91 APPENDIX 3.1 The U.S. Current Population Survey 104 APPENDIX 3.2 Two Proofs That Y Is the Least Squares Estimator of uy 104 APPENDIX 3.3 A Proof That the Sample Variance Is Consistent 105 Fundamentals of Regression Analysis Linear Regression with One Regressor 107 The Linear Regression Model 107 Estimating the Coefficients of the Linear Regression Model 112 The Ordinary Least Squares Estimator 114 OLS Estimates of the Relationship Between Test Scores and the Student—Teacher Ratio 115 Why Use the OLS Estimator? 117 Measures of Fit 119 The R2 119 The Standard Error of the Regression 120 Application to the Test Score Data 121x Contents 44 45 4.6 CHAPTER 5 54 5.5 The Least Squares Assumptions 122 Assumption #1: The Conditional Distribution of u; Given X; Has a Mean of Zero 122 Assumption #2: &, Yj), f= 1... , rn, Are Independently and Identically Distributed 124 Assumption #3: Large Outliers Are Unlikely 125 Use of the Least Squares Assumptions 126 Sampling Distribution of the OLS Estimators 127 The Sampling Distribution of the OLS Estimators 128 Conclusion 131 APPENDIX 4.1 The California Test Score Data Set 139 APPENDIX 4.2 Derivation of the OLS Estimators 139 APPENDIX 4.3 Sampling Distribution of the OLS Estimator 140 Regression with a Single Regressor: Hypothesis Tests and Confidence Intervals 144 Testing Hypotheses About One of the Regression Coefficients 144 Two-Sided Hypotheses Concerning B, 145 One-Sided Hypotheses Concerning B, 148 Testing Hypotheses About the Intercept By 150 Confidence Intervals for a Regression Coefficient 151 Regression When X Is a Binary Variable 153 Interpretation of the Regression Coeffidents 153 Heteroskedasticity and Homoskedasticity 155 What Are Heteroskedasticity and Homoskedasticity? 156 Mathematical Implications of Horoskedasticity 158 What Does This Mean in Practice? 159 The Theoretical Foundations of Ordinary Least Squares 161 Linear Conditionally Unbiased Estimators and the Gauss—Markov Theorem 162 Regression Estimators Other Than OLS 163