Solutions of final exam Econometrics 1, 27 March 2018

Question 1 (50 points)

a. (10p) min e ' e =( y − Xb) '( y − Xb) =y ' y − 2 y ' Xb + b ' X ' Xb
∂e ' e
1st-order condition: 0 ⇒ 2 X ' Xb =
−2( y ' X ) '+ [ X ' X + ( X ' X ) ']b =
= 2X ' y
∂b
⇒b= ( X ' X ) −1 X ' y where the inverse exists, because rank(X)=k implies that X’X is pos.def. and
∂e ' e
therefore invertible. 2nd-order condition: = 2 X ' X is pos.def. so it is a minimum.
∂b∂b '

b. d
(15p) Multiplication with R gives √n (Rb–Rβ)  → N(0, σ2RQ-1R’)
Since {s2R[X’X]-1R’} is symmetric and positive definite its inverse {s2R[X’X]-1R’}-1 exists and has a
‘root matrix’ {s2R[X’X]-1R’}-1/2. Since plim(n-1X’X)=Q and plim(s2)=σ2, and making a continuous
mapping it follows that plim({s2R[n-1X’X]-1R’}-1/2) = {σ2RQ-1R’}-1/2.
Now Cramér’s theorem leads to
{s2R[n-1X’X]-1R’}-1/2 √n (Rb–Rβ)  d
→ N(0,{σ2RQ-1R’}-1/2 σ2RQ-1R’{σ2RQ-1R’}-1/2),
which can be simplified into {s2R[X’X]-1R’}-1/2 (Rb–Rβ)  d
→ N(0,Ig)
Taking a quadratic form leads to the “Wald statistic” (use continuous mapping theorem)
W = (Rb–Rβ)’{s2R[X’X]-1R’}-1(Rb–Rβ)  d
→ χ2(g)
The 95% confidence region for Rβ is given by (Rb–Rβ)’{s2R[X’X]-1R’}-1(Rb–Rβ) < χ20.05(g) (where
χ20.05(g) is the 95% quantile of χ2(g))

c. (4p) The OLS estimator is still unbiased and consistent, but not efficient. A more efficient estimator is
obtained by doing OLS after removing the variable xi2 from the regression.

d. (4p) Apply OLS to the model y=

i xi1β1 + ... + xik β k + xi 2 xi 3β k +1 + ε i i 1,..., n ). Then test H0: βk+1 =
(=
0 against H1: βk+1 ≠ 0 by doing a t-test.

e  My   M ( X be+ )  0  M 

e. (7p) =   =   =    +  e . This is normally
 b   ( X ' X ) X ' y   ( X ' X ) X '( X beb
−1 −1 −1
+ )   (X ' X ) X '
distributed, as it is a linear transformation of the normally distributed ε. Therefore independence is
equivalent to zero covariance. Hence we can look at:
) MCov (ee
Cov ( e, b= , )[( X ' X ) −1 X ']'= M ΩX ( X ' X ) −1 .
In the special case Ω = σ2 In we get M Ω
= X σ 2 MX
= 0 so that Cov ( e, b) = 0 as MX = 0.
But in the general case M ΩX ≠ 0 and thus Cov ( e, b) ≠ 0
 1 1 1 1
f. (10p) Transform the model to = yi xi1β1 + ... + xik β k + ε i and apply OLS to this
vi vi vi vi
 1 / v1 ... 0 
 
model. Defining the diagonal matrix P =  ... ... ...  this model can be written as
 
 0 ... 1 / vn 
Py PX β + Pε and the OLS-estimator of this model is
=
bWLS ) '( PX )]−1 ( PX ) '( Py ) [=
[( PX= X ' P ' PX ]−1 X ' P ' Py [ X 'WX ]−1 X 'Wy , where
 1 / v1 ... 0 
=  ... ... ...  . This estimator is BLUE (efficient), as the transformed model satisfies
W PP
= 
 0 ... 1 / vn 

the conditions for the Gauss-Markov theorem: rank(PX) = rank(X) = k (as multiplying with P only
changes the scale of every column in X),
 v1 ... 0 
2
( Pε ) PE
E= = (ε ) 0, Var= ( Pε ) PVar= ...  P σ 2 I n .
(ε ) P ' Pσ  ... ... =
 
 0 ... vn 
 Question 2 (50 points)

a. (4p) The estimated income elasticity of the gasoline consumption is 0.866. So a 1% increase of
real income (ceteris paribus) leads to a predicted 0.866% increase of real expenditure on gasoline.

b. (4p) Testing X6: p-value = 0.1238/2 = 0.0619

Testing X5: p-value = 1 – 0.1281/2 = 1 – 0.06405 = 0.93595.

c. (7p) Cause of multicollinearity:

Variable: X2 X3 X4 X5 X6
R-squared: 0.986 0.887 0.845 0.984 0.487
Variance Inflation Factor (VIF) 71.4 8.85 6.45 62.5 1.95
The VIF is very high for X2 and X5, so their coefficients are subject to multicollinearity.
Consequences for the coefficient estimators of X2 and X5: Their standard deviations are pushed up
(making them less accurate), and as a result their t-values are pushed towards 0 (possibly making them
insignificant). Actually, we see only a low t-value for the coefficient of X5, and even the sign seems
wrong. The big t-value of the coefficient of X2 can be attributed to the big estimated coefficient.

d.
(7p) Do the Chow forecast test, as there are too few years of the oil crisis to do the Chow break test.
( SSRr − SSRu ) / q (0.012512 − SSRu ) / 7 (0.012512 − SSRu ) / 7
= F = = .
SSRu / ( n − k − q) SSRu / (30 − 6 − 7) SSRu / 17
SSRu is obtained by applying OLS to the model, while leaving out the seven years of the oil crises,
which makes only 17 observations.

e. (5p) The OLS-estimators are still unbiased and consistent, and can therefore be used. Valid testing can
be done by using the heteroscedasticity and autocorrelation consistent (HAC) estimate of Var(b).

(10p) b = ( X ' X ) −1 X ' y = ( X ' X ) −1 X '( X b + ε ) = b + ( X ' X ) −1 X ' ε= β + ( n −1 X ' X ) −1 ( n −1 X ' ε ) .

f.
When X would be completely exogenous, then we could assume that
=E ( xi'ε ) E X [=
E ( xi'ε | X )] E X [=
xi' E (ε | X )] =
E X [ xi' × 0] 0 and = plim( n −1 X ' ε ) plim(
= n −1 ∑ xi'ε ) 0 ,
and assuming also that p lim( n −1 X ' X ) −1 = Q pos.def., it would follow that
plim(b) = b + (plim[n −1 X ' X ]) −1 plim( n −1 X ' ε ) = bb
+ Q −1 × 0 = so that b would be consistent.
But when X is (partly) endogenous, then E ( xi'ε ) ≠ 0 and plim( n −1 X ' ε ) ≠ 0 (in general), so that
plim(b) ≠ bb
+ Q −1 × 0 = so that b is inconsistent.

g. (13p) (i) bIV = ( Xˆ ' Xˆ ) −1 Xˆ ' y , where

= Xˆ P=
ZX, PZ Z ( Z ' Z ) −1 Z ' , X has as columns the observations
of (C X1 X2 X3 X4 X5 X6), and Z has as columns the observations of (C X1 X2 X7 X4 X5 X6).
(ii) X7 must be exogenous (X7 not correlated with the error) and X7 must be a relevant instrument for
X3, which means that when you do the first stage regression X3 on C X1 X2 X7 X4 X5 X6, then the
square of the t-statistic of X7 should be sufficiently high (>10).
(iii) The IV-estimator is biased, but consistent and asymptotically normal.