C29IE DEC 2021 OPEN BOOK EXAM - ANSWER GUIDE

Important: this answer guide is for a 24-hour open book exam. Questions are therefore
longer, and suggested answers more detailed, than would be expected for a timed in-person
exam.

SECTION A – Answer BOTH questions

Q1.
(a) Most will answer using an example of how to construct a CI using the SEs reported
with OLS. Good answers will refer how the sampling distribution relates to the SEs
and to the coverage property of the CI construction procedure, and be clear e.g. that
the interval is random and 95% coverage refers to the interval containing the true
value of the parameter in 95% of repeated samples.

(b) Answers should mention the two conditions for OVB, OV determines Y and corr (OV,
X) ≠ 0. Good answers might link this discussion to the direction of the bias by
introducing the OVB formula. They should mention that the failure of LSA #1 can be
addressed by either including the OV in the regression (as another X, when
observed) or by including, other variables that “control” (are correlated with the OV)
for the OV. They should present the model with controls and explain how this
addresses LSA#1 (Conditional mean independence). A good answer will detail the
differences between conditional mean independence and LSA#1. They should note
that the coefficient on the controls in general cannot be interpreted as causal.

SECTION B – Answer any FOUR questions

Q2: Basic idea is that if LSA #1 for Prediction fails, the “rules have changed”. Students
should be clear on the meaning of “out-of-sample observation”.
Q3: Answers should note that we include robust standard errors when we suspect there
might be evidence of heteroskedasticity in the data (some might explain what is
heteroskedasticity). They can include the formula and highlight the difference with the
regular “unrobust” standard error formula.
Q4: Prediction of the outcome variable based on estimated parameters from the sample.
In a time-series context, POOS is a common way of estimating MSFE. It’s “pseudo”
because the sample is split into two parts: one to estimate the coefficients and one to
evaluate the forecast performance.
Q5: Most will define the Lasso using the objective function with a penalty term. Basic
answer would be that it’s suitable for the setting with many predictors; better answers
will e.g. refer to sparsity, cross-validation, etc.

Q6: Stationarity implies that the probability distribution of the series does not change over
time (some students may point out that mean and variance stay the same). The book
talks about stationarity as homoskedasticity in the time series context, so some
students may mention this. Extra marks for answers that discuss how to transform
series (i.e., use first differences) to deal with non-stationarity.
Q7: The formal definition of AIC should appear here along with the statement that AIC
(and BIC) is (are) a formal way of determining lag length. Good answers will compare
AIC to BIC and point out that AIC chooses more lags than BIC. Even better answers
may point out that in some cases, the number of lags included should be determined
using the AIC information criterion, rather than the BIC, since it results in a better
performance – especially in finite samples of the ADF statistic.

Q8: Answers should explain what is a directed acyclic graph (dot and arrow pictures that
summarise existing scientific knowledge). They should detail the role of dots and
arrows in a DAG and detail that a DAG describes ALL causal relationships between
the variables presented (if a relation is not depicted in a DAG it is assumed to be
absent). They should provide a simple example (DAG).

Q9: Most answers will probably use one of the examples in the lecture notes (Snow or
Card-Krueger) to illustrated diff-in-diff. Good answers will go beyond this.

Q10: Either RMSE or R2 acceptable. Standard definitions and interpretations.

SECTION C – Answer only ONE question

Q11:
(a) All the variables in the table are “time-varying”, except educ, which is the variable
measuring maximum years of schooling for each individual and it makes good sense
to think of this variable as something that doesn’t change over time. Most individuals
in the sample are working professionals (reporting wages!) so this variable should be
fixed over time.

A very good answer might mention that the within variation (Std. Dev.) reported in the
table for education is zero, highlighting the lack of time variation for this variable.

(b) We have a log-linear specification in which our dependent variable is log hourly wage
and our explanatory variables include years of schooling, experience, experience
squared and a dummy for union membership. We use “unrobust” standard errors,
hence we do not account for the possibility of heteroskedasticity.

We expect students to go over each of the reported coefficients and minimum do 3

things:
(1) Detail how to read it (for an additional year of schooling hourly wage increases by
10.3%).
(2) Comment on the precision of the estimate (narrow/wide confidence interval and
relative magnitude of the SE.).
(3) For experience, they should at least mention that marginal effects have to be taken
into account, to correctly interpret the effect of experience in wages.
(4) They should be careful when dealing with dummies, “on average, those in a union
earn x% more than those who are not in a union, keeping other covariates
constant”.
 Finally, answers should briefly comment on the shortcomings of using OLS on this
data, The pooled OLS SEs are the usual SEs and are an underestimate of the true
standard errors, because they ignore the positive serial correlation between
unobserved individual ability and wages (entity).

(c) Here answers should present, in written text, the partial derivative w.r.t. experience. In
addition, they should do the previous exercise (1) to (4) for experience.

(d) Answers can approach this question in a few ways, but a good answer should introduce
the fixed effects regression (n-1 binary regressor model or fixed effects regression
model, either accepted) and then specify how to do the estimation, again they can
choose from any of the three options presented in class:
 the “n-1 binary” regression form,
 the “entity-demeaned” regression form
 or the “changes” specification (for T=2)
They should note that since years of schooling do not change over time, once we take
deviations from “entity-averages” this variable drops out.
This new formula is needed because observations for the same entity are not
independent (it is the same entity!). A very good answer might go into the details of the
LS assumption that breaks and how μit might be serially correlated.
(e) Interpretation of the results as in (b). Does this mean that union causes the increase
in salaries? A: Maybe, also maybe getting union membership is correlated with other
things that do, but when using FE we do control for the time invariant unobserved
effects. Alternative causal explanations may include:

a) Union increases bargaining power of workers.

b) Some other causal explanation.

The union premium decreases because part of that premium might be explained by
unobserved ability too; it might be the case that union members with high ability would
still get a higher wage even if they did not belong to a union.

Q12:
(a) In simple terms, seasonality is the regular (possibly predictable) changes that recur
at certain time intervals. It is a good idea to remove seasonality in time series
analysis for various reasons. Here are two examples: (1) when dealing with multiple
time series, each of them may have their own seasonality. It is, therefore, much
easier to deal with de-seasonalised series in multivariate models; and (2)
seasonality effectively introduces noise into the model. For example, house prices
tend to be higher in the summer not because of an underlying fundamental reason
but simply because of its seasonal pattern. In this case, e-commerce sales display
significant seasonality and GDP does not. This is to be expected because sales are
a small proportion of overall GDP and not every component of GDP has the same
seasonal patterns.
 (b)
i. The high autocorrelation coefficient and a time series plot that displays a clear trend
suggest that a stochastic trend may exist. To test for a stochastic trend using more
formal methods requires use of the Dickey-Fuller test, or better yet, the augmented
Dickey-Fuller test.

ii. Since the level of log GDP appears to have a unit root, forecasting using levels is
problematic because the series is not stationary. We heavily rely on stationarity
when forecasting because we effectively assume that the future distribution of the
series is the same as its past distribution. A good answer would identify this as the
Augmented Dickey-Fuller test. Using the equation given, we can calculate the test
statistic and compare it to the given critical values. In this case, we fail to reject the
null hypothesis that a unit root exists. Hence, the series appears to be non-
stationary and using the first difference is appropriate. A good answer would point
out here that we should conduct ADF on the first difference as well to make sure we
are now working with a stationary series.

(c)
i. Model 1 predicts a GDP growth rate of -0.008 (approximately -1%). Model 2
predicts 0.016 (approximately 1.6%). Good students may also catch that some of
the coefficients look a little strange. For example, the positive sign on 𝑑𝑢𝑛𝑒𝑚𝑝 is
not what we might expect.

ii. Using formula

 SSR
SER  suˆ 
2
MSFE
T  p 1

for the MSFE and taking the square root, we can use

YˆT 1|T  1.96  RMSFE



to calculate the CI. The RSS is available in the output table given to the students
(along with a hint). This yields the CIs below:

Model 1
quarter CI1l xb1 CI1u
01-Jul-21 -0.040718 -0.00881 0.023102

Model 2
quarter CI2l xb2 CI2u
01-Jul-21 -0.01159 0.015861 0.043311

iii. The predictions are quite different in this case. However, model 2 has a slightly
narrower CI. There could be various reasons for the difference between the
forecasts. The obvious reason is that 2020 was an extraordinary year and the
outliers observed in 2020 could be driving some of the results. As above, good
students may also catch that some of the coefficients look a little strange. For
example, the positive sign on 𝑑𝑢𝑛𝑒𝑚𝑝 is not what we might expect.