Advanced Econometrics: Based On The Textbook by Verbeek: A Guide To Modern Econometrics

Univariate time series Multivariate time series Panels
Advanced Econometrics
Based on the textbook by Verbeek:
A Guide to Modern Econometrics
Robert M. Kunst
robert.kunst@univie.ac.at
University of Vienna
and
Institute for Advanced Studies Vienna
May 16, 2013
Advanced Econometrics University of Vienna and Institute for Advanced Studies Vienna
Outline
Univariate time series
Multivariate time series
Panels
Basics
The static linear panel model
The dynamic linear panel model
Basics
Definition of a panel
A panel data set contains repeated observations for the same units,
collected over a number of periods. There is a cross-section
dimension (i = 1, . . . , N) and a time dimension (t = 1, . . . , T ).
If there is at least some constancy across time and individuals,
panels are certainly more informative than pure time series or pure
cross sections. Micro panels have N ≫ T , macro panels have N in
the same magnitude as T .
Basics
Linear regression in a panel
Consider the model
yit = β0 + xit′ β + εit ,
with an intercept β0 and a K –dimensional vector of regressors (or

covariates). Interest focuses on the K –dimensional coefficient
vector β = (β1 , . . . , βK )′ . There is an individual index i and a time
index t.
Basics
Random effects
In the random effects model, errors εit are assumed to be

systematically correlated over time. We write
εit = αi + uit ,
with αi representing individual though unobserved characteristics

(‘effects’) and uit the also unobserved (white-noise) idiosyncratic
errors. The random-effects model assumes that observed covariates
x and unobserved characteristics α are uncorrelated.
Basics
Fixed effects
In the fixed effects model, individual unspecific characteristics are

represented by individual dummies
yit = αi + xit′ β + uit ,
with αi treated as coefficients to be estimated, just like β, and uit

uncorrelated across time and individuals.
The fixed-effects estimator
The linear efficient estimator for the fixed-effects regression is the

fixed-effects (FE) estimator or least-squares dummy variables
estimator (LSDV). There are two ways to implement it.
The straightforward way to calculate FE is to run OLS on the
regression
N
αj δij + xit′ β + uit ,
X
yit =
j=1
with N individual dummy variables (δij = 1 if i = j and 0

otherwise). This is inconvenient if N is large.
FE estimates by mean correction
Denote time averages for individuals by ȳi , x̄i , ūi . Then,
ȳi = αi + x̄i′ β + ūi ,
and also
yit − ȳi = (xit − x̄i )′ β + uit − ūi ,
a regression model that satisfies the Gauss-Markov conditions and
is estimated by OLS. This estimate is numerically identical to the
first FE version. The second way is more convenient, but it does
not directly yield effect estimates α̂i .
Properties of the FE estimator
With strictly exogenous covariates (x uncorrelated with u) and

white-noise errors, the FE estimator is linear efficient (BLUE) and
consistent (for T → ∞ or N → ∞). Estimates of αi can only be
consistent for T → ∞.
If the covariates are not strictly exogenous—for example, lagged y
or variables depending on lagged y —all static-panels estimators
can be severely biased and are inconsistent for N → ∞ and T
fixed.
Covariance matrix of the FE estimator

Under the mentioned conditions, the FE estimator has the variance
matrix
( N T )−1
XX
varβ̂FE = σu2 (xit − x̄i )(xit − x̄i )′ .
i =1 t=1
An estimate for σu2 is provided by

T
N X
1 X
σ̂u2 = ûit2 ,
(T − 1)N
i =1 t=1
for the residuals ûit .
The first-difference estimator
A simple alternative way to remove the effects is to take first

differences ∆yit = yit − yi ,t−1 :
∆yit = ∆xit′ β + ∆uit .
If u are white noise, ∆u are autocorrelated MA(1), and GLS can

be applied to this equation. The first-differences (FD) estimator is
slightly less efficient than FE, though it works for some deviations
from exogeneity. Thus, strong discrepancies between FE and FD
indicate a violation of exogeneity.
Differences in differences
If the covariate is a treatment indicator (‘0’ for non-treated and ‘1’

for treated), the FD estimate β̂FD represents the response of those
individuals whose classification to treatment and control vary over
time. An extreme case is T = 2. This is why β̂FD is often called
the difference-in-difference (DID) estimator: differences in
treatment assignment and differences over time.
The random-effects estimator
The model
yit = β0 + xit′ β + αi + uit , αi ∼ IID(0, σα2 ), u ∼ IID(0, σu2 ),
is essentially a GLS model. Defining ui = (ui 1 , . . . , uiT )′ and ιT as

a T –vector of ones, one has
E(αi ιT + ui )(αi ιT + ui )′ = Ω = σα2 ιT ι′T + σu2 IT ,
which has a relatively simple inverse for the GLS calculation. Note
that ιT ι′T is a T × T –matrix of ones.
Implementing the RE estimator
The inverse Ω−1 has the representation
Ω−1 = σu−2 {(IT − ιT ι′T ) + ψιT ι′T },
with
1
ψ= .
1 + T σα2 /σu2
Estimates for σu2 and σα2 are obtained from the residuals in a
preliminary FE estimation. The so defined feasible GLS estimator
is called the random-effects (RE) estimator. Note that ψ = 1
defines OLS and that ψ = 0 yields FE.
Properties of the RE estimator
If covariates are exogenous and uncorrelated with the effects, the

RE estimator is linear efficient (BLUE).
If covariates are not exogenous, the RE estimator will be biased
and inconsistent.
If covariates are correlated with effects, the RE estimator will also
be biased and inconsistent. The RE estimator allowing for this
correlation will be identical to the FE estimator.
Covariance matrix of the RE estimator

Under the mentioned conditions, the RE estimator
( N T )−1
XX
β̂RE = (xit − x̄i )(xit − x̄i )′ + ψT (x̄i − x̄)(x̄i − x̄)′
i =1 t=1
( N T )
XX
× (xit − x̄i )(yit − ȳi ) + ψT (x̄i − x̄)(ȳi − ȳ)
i =1 t=1
has the variance matrix

( N T )−1
XX
varβ̂RE = σu2 (xit − x̄i )(xit − x̄i )′ + ψT (x̄i − x̄)(x̄i − x̄)′ ,
i =1 t=1
which is estimated by plugging in an estimate for σu2 .

Fixed effects or random effects ?

◮ FE works even in the RE model, while RE does not work in
the FE model. In doubtful cases, it makes sense to prefer FE;
◮ FE is usually preferred if N is small or heterogeneous by
definition. RE is often preferred if N is large or if individuals
can be seen as a random sample from a homogeneous
population;
◮ If T is large, RE approaches FE, FE will often be used;
◮ If the response to time-constant covariates is of interest, some
RE model must be used, as FE does not work;
◮ If by definition or by statistics some covariates and effects
correlate, FE should be used.
The Hausman test
The Hausman test principle applies to situations where

◮ There exist two estimators θ̂ and θ̃;
◮ θ̃ is efficient under the null and inconsistent under the
alternative;
◮ θ̂ is consistent under the null and under the alternative.
This describes β̂RE and β̂FE for the null of the RE model and the
alternative of a model with correlation of covariates and effects
that is equivalent to the FE model. The Hausman test rejects if
the RE model is invalid and FE should be used.
Some authors sound a warning that the test is not always reliable.
The Hausman test statistic
The Hausman test statistic is calculated as
ξH = (β̂FE − β̂RE )′ {var(β̂FE ) − var(β̂RE )}−1 (β̂FE − β̂RE ),
which is, under the null, asymptotically χ2 distributed with K

degrees of freedom, where K is the dimension of β.
Dynamic linear regression with panel data
Consider the simplest model of this type, with a first-order

autoregressive term
yit = xit′ β + γyi ,t−1 + αi + uit
Because yi ,t−1 depends on αi by definition, regressor and effects

will always be correlated. OLS assumes an error εit = αi + uit and
is clearly
P biased. FE will also be biased, as the correction term
T −1 T t=1 yit = ȳi is correlated with uit .
The Nickell bias
The Nickell bias is the bias of the FE estimator in a dynamic panel

model for finite T . For small T , the bias is substantial. For
T → ∞, the bias disappears. However, for N → ∞, it does not
disappear. FE is inconsistent for N → ∞.
The solution suggested in the literature is using instrumental
variables (IV) estimation. The instrument must be correlated with
the lag yi ,t−1 but uncorrelated with uit . Skilfully designed IV
estimators have a small bias but they are consistent under
reasonable assumptions.
The Arellano-Bond estimator: the idea
The Arellano-Bond estimator is a particular IV estimator. It

considers the model in differences
∆yit = ∆xit′ β + γ∆yi ,t−1 + ∆uit , t = 3, . . . , T ,
thus eliminating the effects αi . yi ,1 can be an instrument for ∆yi ,3 ;

yi ,1 and yi ,2 for ∆yi ,4 ; . . .; yi ,1 , . . . , yi ,T −3 for ∆yi ,T . The special
structure of the residual covariance matrix for ∆uit is exploited in
a GLS step. This IV-GLS method is the most popular estimator in
dynamic panel regressions.

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Univariate time series Multivariate time series Panels

May 16, 2013

Univariate time series

Multivariate time series

Linear regression in a panel

Consider the model

yit = β0 + xit′ β + εit ,

with an intercept β0 and a K –dimensional vector of regressors (or

In the random effects model, errors εit are assumed to be

with αi representing individual though unobserved characteristics

In the fixed effects model, individual unspecific characteristics are

yit = αi + xit′ β + uit ,

with αi treated as coefficients to be estimated, just like β, and uit

The static linear panel model

The fixed-effects estimator

The linear efficient estimator for the fixed-effects regression is the

with N individual dummy variables (δij = 1 if i = j and 0

The static linear panel model

FE estimates by mean correction

Denote time averages for individuals by ȳi , x̄i , ūi . Then,

ȳi = αi + x̄i′ β + ūi ,

The static linear panel model

Properties of the FE estimator

With strictly exogenous covariates (x uncorrelated with u) and

The static linear panel model

Covariance matrix of the FE estimator

An estimate for σu2 is provided by

for the residuals ûit .

The static linear panel model

The first-difference estimator

A simple alternative way to remove the effects is to take first

∆yit = ∆xit′ β + ∆uit .

If u are white noise, ∆u are autocorrelated MA(1), and GLS can

The static linear panel model

If the covariate is a treatment indicator (‘0’ for non-treated and ‘1’

The static linear panel model

The random-effects estimator

yit = β0 + xit′ β + αi + uit , αi ∼ IID(0, σα2 ), u ∼ IID(0, σu2 ),

is essentially a GLS model. Defining ui = (ui 1 , . . . , uiT )′ and ιT as

E(αi ιT + ui )(αi ιT + ui )′ = Ω = σα2 ιT ι′T + σu2 IT ,

The static linear panel model

Implementing the RE estimator

The inverse Ω−1 has the representation

Ω−1 = σu−2 {(IT − ιT ι′T ) + ψιT ι′T },

The static linear panel model

Properties of the RE estimator

If covariates are exogenous and uncorrelated with the effects, the

The static linear panel model

Covariance matrix of the RE estimator

has the variance matrix

which is estimated by plugging in an estimate for σu2 .

The static linear panel model

Fixed effects or random effects ?

The static linear panel model

The Hausman test

The Hausman test principle applies to situations where

The static linear panel model

The Hausman test statistic

The Hausman test statistic is calculated as

ξH = (β̂FE − β̂RE )′ {var(β̂FE ) − var(β̂RE )}−1 (β̂FE − β̂RE ),

which is, under the null, asymptotically χ2 distributed with K

The dynamic linear panel model

Dynamic linear regression with panel data