Introduction

to Econometrics (4th Edition)

by


James H. Stock and Mark W. Watson





Solutions to End-of-Chapter Exercises: Chapter 4*

(This version September 14, 2018)












*Limited distribution: For Instructors Only. Answers to all odd-numbered
questions are provided to students on the textbook website. If you find errors in
the solutions, please pass them along to us at mwatson@princeton.edu.

©2018 Pearson Education, Inc.

 Stock/Watson - Introduction to Econometrics 4th Edition - Answers to Exercises: Chapter 4 1
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4.1. (a) The predicted average test score is

! = 520.4 − 5.82 × 22 = 392.36

TestScore
(b) The predicted change in the classroom average test score is
The change is

! = (−5.82 × 23) − (−5.82 × 19) = −23.28

ΔTestScore

that is, the regression predicts that test scores will fall by 23.28 points.

(c) Using the formula for b̂ 0 in Equation (4.8), we know the sample average of the

test scores across the 100 classrooms is

TestScore = bˆ 0 + bˆ 1 ´ CS = 520.4 - 5.82 ´ 21.4 = 395.85.

(d) Use the formula for the standard error of the regression (SER) in Equation (4.19)
to get the sum of squared residuals:

SSR = (n - 2)SER2 = (100 - 2) ´11.52 = 12961.

Use the formula for R 2 in Equation (4.16) to get the total sum of squares:

SSR 12961
TSS = 2
= = 14088.
1− R 1− 0.08

The sample variance is sY2 = TSS

n−1
= 14088
99
= 142.3. Thus, standard deviation is

sY = sY2 = 11.9.

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 Stock/Watson - Introduction to Econometrics 4th Edition - Answers to Exercises: Chapter 4 2
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4.2. The sample size n = 200. The estimated regression equation is

! = (2.15) − 99.41+ (0.31) 3.94Height,

Weight R 2 = 0.81, SER = 10.2.

(a) Substituting Height = 70, 65, and 74 inches into the equation, the predicted
weights are 176.39, 156.69, and 192.15 pounds.

! = 3.94 × ΔHeight = 3.94 × 1.5 = 5.91.

(b) ΔWeight

(c) We have the following relations: 1 in = 2.54 cm and 1 lb = 0.4536 kg. Suppose
the regression equation in the centimeter-kilogram space is

! = ˆ + ˆ Height .
Weight γ0 γ1

The coefficients are gˆ 0 = -99.41´ 0.4536 = -45.092 kg;

gˆ1 = 3.94 ´ 0.24536

.54 = 0.7036 kg
per cm. The R 2 is unit free, so it remains at

R 2 = 0.81 . The standard error of the regression is

SER = 10.2 ´ 0.4536 = 4.6267 kg.

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 Stock/Watson - Introduction to Econometrics 4th Edition - Answers to Exercises: Chapter 4 3
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4.3. (a) The coefficient 9.6 shows the marginal effect of Age on AWE; that is, AWE is
expected to increase by $9.6 for each additional year of age. 696.7 is the intercept
of the regression line. It determines the overall level of the line.
(b) SER is in the same units as the dependent variable (Y, or AWE in this
example). Thus SER is measures in dollars per week.

(c) R2 is unit free.

(d) (i) 696.7 + 9.6 ´ 25 = $936.7;

(ii) 696.7 + 9.6 ´ 45 = $1,128.7

(e) No. The oldest worker in the sample is 65 years old. 99 years is far outside the
range of the sample data.

(f) No. The distribution of earning is positively skewed and has kurtosis larger
than the normal.

(g) bˆ0 = Y - bˆ1 X , so that Y = bˆ0 + bˆ1 X . Thus the sample mean of AWE is 696.7

9.6 ´ 41.6 $1,096.06.

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 Stock/Watson - Introduction to Econometrics 4th Edition - Answers to Exercises: Chapter 4 4
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4.4. (a) ( R - R f ) = b ( Rm - R f ) + u ,

so that var ( R - R f ) = b 2 ´ var( Rm - R f ) + var(u) + 2b ´ cov(u, Rm - R f ).

But cov(u , Rm - R f ) = 0, thus var( R - R f ) = b 2 ´ var( Rm - R f ) + var(u).

With b > 1, var(R - Rf) > var(Rm - Rf), because var(u) ³ 0.

(b) Yes. Using the expression in (a)

var ( R - R f ) - var ( Rm - R f ) = (b 2 - 1) ´ var ( Rm - R f ) + var(u), which will be

positive if var(u) > (1 - b 2 ) ´ var ( Rm - R f ).

(c) Rm − R f = 5.3% − 2.0% = 3.3%. Thus, the predicted returns are

R̂ = R f + β̂ (Rm − R f ) = 2.0% + β̂ × 3.3%

Wal-Mart: 2.0% + 0.1×3.3% = 2.3%

Coca-Cola 2.0% + 0.6×3.3% = 4.0%
Verizon: 2.0% + 0.7×3.3% = 4.3%
Google: 2.0% + 1.0×3.3% = 5.3%
Boeing: 2.0% + 1.3×3.3% = 6.3%
Bank of America: 2.0% + 1.7×3.3% = 7.6%

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 Stock/Watson - Introduction to Econometrics 4th Edition - Answers to Exercises: Chapter 4 5
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4.5. (a) ui represents factors other than time that influence the student’s performance
on the exam including amount of time studying, aptitude for the material, and so
forth. Some students will have studied more than average, other less; some
students will have higher than average aptitude for the subject, others lower, and
so forth.

(b) Because of random assignment ui is independent of Xi. Since ui represents

deviations from average E(ui) = 0. Because u and X are independent E(ui|Xi) =
E(ui) = 0.

(c) (2) is satisfied if this year’s class is typical of other classes, that is, students in
this year’s class can be viewed as random draws from the population of students
that enroll in the class. (3) is satisfied because 0 £ Yi £ 100 and Xi can take on
only two values (90 and 120).

(d) (i) 49 + 0.24 ´ 90 = 70.6; 49 + 0.24 ´120 = 77.8; 49 + 0.24 ´150 = 85.0

(ii) 0.24 ´10 = 2.4.

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 Stock/Watson - Introduction to Econometrics 4th Edition - Answers to Exercises: Chapter 4 6
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4.6. Using E (ui |X i ) = 0, we have

E (Yi |X i ) = E ( b0 + b1 X i + ui |X i ) = b0 + b1E ( X i |X i ) + E (ui |X i ) = b0 + b1 X i .

©2018 Pearson Education, Inc.

 Stock/Watson - Introduction to Econometrics 4th Edition - Answers to Exercises: Chapter 4 7
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4.7. The expectation of bˆ0 is obtained by taking expectations of both sides of Equation
(4.8):

é æç 1 n ö÷ ù
E ( bˆ0 ) = E (Y - bˆ1 X ) = E ê ç b 0 + b1 X + å ui ÷ - bˆ1 X ú
ë çè n i =1 ÷ø û
n
1
= b 0 + E ( b1 - bˆ1 ) X + å E (ui )
n i =1
= b0
where the third equality in the above equation has used the facts that E(ui) = 0 and
E[( b̂1 −b1) X ] = E[ X × (E( b̂1 −b1)| X )] = 0 because E[( b1 - bˆ1 ) | X ] = 0 (see text
equation (4.31).)

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 Stock/Watson - Introduction to Econometrics 4th Edition - Answers to Exercises: Chapter 4 8
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4.8. The only change is that the mean of bˆ0 is now b0 + 2. An easy way to see this is

this is to write the regression model as

Yi = (b0 + 2) + b1 X i + (ui - 2).

The new regression error is (ui - 2) and the new intercept is (b0 + 2). All of the
assumptions of Key Concept 4.3 hold for this regression model.

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 Stock/Watson - Introduction to Econometrics 4th Edition - Answers to Exercises: Chapter 4 9
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4.9. (a) With bˆ1 = 0, bˆ0 = Y , and Yˆi = bˆ0 = Y . Thus ESS = 0 and R2 = 0.

(b) If R2 = 0, then ESS = 0, so that Ŷi = Y for all i. But, using the formula for β̂0 ,

Ŷi = β̂0 + β̂1 X i = Y − β̂1 ( X i − X ) , Thus Yˆi = Y for all i implies that bˆ1 = 0, or that

å
n
Xi is constant for all i. If Xi is constant for all i, then i -1
( X i - X )2 = 0 and b̂1
is undefined (see equation (4.7)).

©2018 Pearson Education, Inc.

 Stock/Watson - Introduction to Econometrics 4th Edition - Answers to Exercises: Chapter 4 10
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4.10. (a) E(ui|X = 0) = 0 and E(ui|X = 1) = 0. (Xi, ui) are i.i.d. so that (Xi, Yi) are i.i.d.
(because Yi is a function of Xi and ui). Xi is bounded and so has finite fourth
moment; the fourth moment is non-zero because Pr(Xi = 0) and Pr(Xi = 1) are both
non-zero. Following calculations like those exercise 2.13, ui also has nonzero
finite fourth moment.

(b) var( X i ) = 0.2 ´ (1 - 0.2) = 0.16 and µ X = 0.2. Also

var[( X i - µ X )ui ] = E[( X i - µ X )ui ]2

= E[( X i - µ X )ui |X i = 0]2 ´ Pr( X i = 0) + E[( X i - µ X )ui |X i = 1]2 ´ Pr( X i = 1)

where the first equality follows because E[(Xi - µX)ui] = 0, and the second
equality follows from the law of iterated expectations.

E[( X i - µ X )ui |X i = 0]2 = 0.22 ´1, and E[( X i - µ X )ui |X i = 1]2 = (1 - 0.2) 2 ´ 4.

Putting these results together

1 (0.22 ´1´ 0.8) + ((1 - 0.2) 2 ´ 4 ´ 0.2) 1

s =2
bˆ
= 21.25
1
n 0.162 n

©2018 Pearson Education, Inc.

 Stock/Watson - Introduction to Econometrics 4th Edition - Answers to Exercises: Chapter 4 11
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å
n
4.11. (a) The least squares objective function is i =1
(Yi - b1 X i )2. Differentiating with

= -2åi =1 X i (Yi - b1 X i ). Setting this zero, and

¶ åin=1 (Yi -b1 X i )2 n
respect to b1 yields ¶b1

solving for the least squares estimator yields bˆ1 =

åin=1 X iYi
åin=1 X i2
.

(b) Following the same steps in (a) yields bˆ1 = åin=1 X i (Yi - 4)
åin=1 X i2

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 Stock/Watson - Introduction to Econometrics 4th Edition - Answers to Exercises: Chapter 4 12
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4.12. (a) Write

n n n
ESS = å (Yˆi - Y ) 2 = å ( bˆ0 + bˆ1 X i - Y ) 2 = å [ bˆ1 ( X i - X )]2
i =1 i =1 i =1
2
n éë åin=1 ( X i - X )(Yi - Y ) ùû
= b å(Xi - X ) =
ˆ
1
2 2
.
i =1 åin=1 ( X i - X )2
This implies
2
ESS éë åin=1 ( X i - X )(Yi - Y ) ùû
R = n
2
=
åi =1 (Yi - Y ) 2 åin=1 ( X i - X ) 2 åin=1 (Yi - Y ) 2
2
é 1
åin=1 ( X i - X )(Yi - Y ) ù
=ê n -1
ú
êë 1
n -1 åin=1 ( X i - X ) 2 n -1 å i =1 (Yi - Y ) û
1 n 2
ú
2
és ù
= ê XY ú = rXY
2

ë s X sY û

(b) This follows from part (a) because rXY = rYX.

s XY s
(c) Because rXY = , rXY Y =
s X sY sX
n
1 n

s XY å
(n - 1) i =1
( X i - X )(Yi - Y ) å ( X i - X )(Yi - Y )
= n
= i =1 n = bˆ1
sX2 1
å(Xi - X )
(n - 1) i =1
2
åi =1
(Xi - X ) 2

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 Stock/Watson - Introduction to Econometrics 4th Edition - Answers to Exercises: Chapter 4 13
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4.13. The answer follows the derivations in Appendix 4.3 in “Large-Sample Normal
Distribution of the OLS Estimator.” In particular, the expression for ni is now ni =
(Xi − µX)kui, so that var(ni) = k3var[(Xi − µX)ui], and the term k2 carry through the rest
of the calculations.

©2018 Pearson Education, Inc.

 Stock/Watson - Introduction to Econometrics 4th Edition - Answers to Exercises: Chapter 4 14
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4.14. Because bˆ0 = Y - bˆ1 X , Y = bˆ0 + b1 X . The sample regression line is y = β̂0 + β̂1x ,

so that the sample regression line passes through ( X , Y ).

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 Stock/Watson - Introduction to Econometrics 4th Edition - Answers to Exercises: Chapter 4 15
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4.15

(a.i) Because (Yoos, Xoos) are from some population as the in-sample observation,

E(Yoos|Xoos = xoos) = E(Y|X = xoos) = b0 + b1xoos.

(a.ii)

E(Ŷ oos | X oos = x oos ) = E( β̂0 + β̂1x oos | X oos = x oos )

= E( β̂0 + β̂1x oos ) = E( β̂0 ) + E( β̂1 )x oos
= β0 + β1x oos

where the second line follows because Xoos is independent of ( β̂0 , β̂1 ) because they
depend only on the in-sample observations.

(a.iii) From appendix 4.4:

( ) ( )
û oos = u oos − ⎡⎢ β̂0 − β0 + β̂1 − β1 x oos ⎤⎥
⎣ ⎦

and the result follows by noting that the two terms on the right hand side of the equation
are independent, and therefore uncorrelated with each other.

(b.i) No. Because (Yoos, Xoos) are drawn from distribution different that the sample data,
then in general E(Yoos|Xoos = xoos) ≠ E(Y|X = xoos) = b0 + b1xoos.

(b.ii) Yes. Same reason as (a.ii).

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