Chapter 4 Econometrics Practice MC

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Chapter 4 Econometrics Practice MC
Introductory Econometrics (Wilfrid Laurier University)
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Introduction to Econometrics, 4e (Stock/Watson)

Chapter 4 Linear Regression with One Regressor
4.1 Multiple Choice Questions
1) When the estimated slope coefficient in the simple regression model, 1, is zero, then:
A) R2 = .
B) 0 < R2 < 1.
C) R2 = 0.
D) R2 > (SSR/TSS).
Answer: C
2) The regression R2 is defined as follows:

A)
B)
C)
D)
Answer: A
3) The standard error of the regression (SER) is defined as follows:
A)
B) SSR
C) 1-R2
D)
Answer: A
4) (Requires Appendix material) Which of the following statements is correct?

A) TSS = ESS + SSR
B) ESS = SSR + TSS
C) ESS > TSS
D) R2 = 1 - (ESS/TSS)
Answer: A

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5) Binary variables:
A) are generally used to control for outliers in your sample.
B) can take on more than two values.
C) exclude certain individuals from your sample.
D) can take on only two values.
Answer: D
6) The following are all least squares assumptions with the exception of:
A) The conditional distribution of ui given Xi has a mean of zero.
B) The explanatory variable in regression model is normally distributed.
C) (Xi, Yi), i = 1,..., n are independently and identically distributed.
D) Large outliers are unlikely.
Answer: B
7) The reason why estimators have a sampling distribution is that:

A) economics is not a precise science.
B) individuals respond differently to incentives.
C) in real life you typically get to sample many times.
D) the values of the explanatory variable and the error term differ across samples.
Answer: D
8) In the simple linear regression model, the regression slope:

A) indicates by how many percent Y increases, given a one percent increase in X.
B) when multiplied with the explanatory variable will give you the predicted Y.
C) indicates by how many units Y increases, given a one unit increase in X.
D) represents the elasticity of Y on X.
Answer: C
9) The OLS estimator is derived by:

A) connecting the Yi corresponding to the lowest Xi observation with the Yi corresponding to the
highest Xi observation.
B) making sure that the standard error of the regression equals the standard error of the slope
estimator.
C) minimizing the sum of absolute residuals.
D) minimizing the sum of squared residuals.
Answer: D
10) Interpreting the intercept in a sample regression function is:

A) not reasonable because you never observe values of the explanatory variables around the
origin.
B) reasonable because under certain conditions the estimator is BLUE.
C) reasonable if your sample contains values of Xi around the origin.
D) not reasonable because economists are interested in the effect of a change in X on the change
in Y.
Answer: C
11) Assume that the relationship between test scores and the student-teacher ratio can be

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modeled as a linear function with an intercept of 698.9 and a slope of (-2.28). A decrease in the
student-teacher ratio by 2 will:
A) reduce test scores by 2.28 on average
B) result in a test score of 698.9
C) reduce test scores by 2.56 on average
D) reduce test scores by 4.56 for every school district
Answer: C
12) (Requires Appendix) The sample average of the OLS residuals is:
A) a positive number since OLS uses squares.
B) zero.
C) unobservable since the population regression function is unknown.
D) dependent on whether the explanatory variable is mostly positive or negative.
Answer: B
13) The OLS residuals, i, are defined as follows:

A) i - 0 - 1Xi
B) Yi - β0 - β1Xi
C) Yi - i
D) (Yi - )2
Answer: C
14) The slope estimator, β1, has a smaller standard error, other things equal, if:
A) there is more variation in the explanatory variable, X.
B) there is a large variance of the error term, u.
C) the sample size is smaller.
D) the intercept, β0, is small.
Answer: A
15) The regression R2 is a measure of:

A) whether or not X causes Y.
B) the goodness of fit of your regression line.
C) whether or not ESS > TSS.
D) the square root of the correlation coefficient.
Answer: B
16) (Requires Appendix) The sample regression line estimated by OLS:

A) will always have a slope smaller than the intercept.
B) is exactly the same as the population regression line.
C) cannot have a slope of zero.
D) will always run through the point ( , ).
Answer: D

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17) The OLS residuals:

A) can be calculated using the errors from the regression function.
B) can be calculated by subtracting the fitted values from the actual values.
C) are unknown since we do not know the population regression function.
D) should not be used in practice since they indicate that your regression does not run through all
your observations.
Answer: B
18) The normal approximation to the sampling distribution of 1 is powerful because:

A) many explanatory variables in real life are normally distributed.
B) it allows econometricians to develop methods for statistical inference.
C) many other distributions are not symmetric.
D) is implies that OLS is the BLUE estimator for β1.
Answer: B
19) If the three least squares assumptions hold, then the large sample normal distribution of 1 is:
A) N(0, ).
B) N(β1, ).
C) N(β1, .
D) N(β1, ).
Answer: B
20) In the simple linear regression model Yi = β0 + β1Xi + ui:

A) the intercept is typically small and unimportant.
B) β0 + β1Xi represents the population regression function.
C) the absolute value of the slope is typically between 0 and 1.
D) β0 + β1Xi represents the sample regression function.
Answer: B
21) To obtain the slope estimator using the least squares principle, you divide the:
A) sample variance of X by the sample variance of Y.
B) sample covariance of X and Y by the sample variance of Y.
C) sample covariance of X and Y by the sample variance of X.
D) sample variance of X by the sample covariance of X and Y.
Answer: C

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22) To decide whether or not the slope coefficient is large or small:

A) you should analyze the economic importance of a given increase in X.
B) the slope coefficient must be larger than one.
C) the slope coefficient must be statistically significant.
D) you should change the scale of the X variable if the coefficient appears to be too small.
Answer: A
23) E(ui Xi) = 0 says that:

A) dividing the error by the explanatory variable results in a zero (on average).
B) the sample regression function residuals are unrelated to the explanatory variable.
C) the sample mean of the Xs is much larger than the sample mean of the errors.
D) the conditional distribution of the error given the explanatory variable has a zero mean.
Answer: D
24) In the linear regression model, Yi = β0 + β1Xi + ui, β0 + β1Xi is referred to as:
A) the population regression function.
B) the sample regression function.
C) exogenous variation.
D) the right-hand variable or regressor.
Answer: A
25) Multiplying the dependent variable by 100 and the explanatory variable by 100,000 leaves
the:
A) OLS estimate of the slope the same.
B) OLS estimate of the intercept the same.
C) regression R2 the same.
D) variance of the OLS estimators the same.
Answer: C
26) Assume that you have collected a sample of observations from over 100 households and their
consumption and income patterns. Using these observations, you estimate the following
regression Ci = β0+β1Yi+ ui where C is consumption and Y is disposable income. The estimate
of β1 will tell you:
A)
B) The amount you need to consume to survive
C)
D)
Answer: D

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27) In which of the following relationships does the intercept have a real-world interpretation?
A) weight and height of adults where height is measured at 4 feet plus inches
B) the demand for coffee and its price
C) test scores and class-size
D) earnings and age
Answer: A
28) The OLS residuals, i, are sample counterparts of the population:

A) regression function slope.
B) errors.
C) regression function's predicted values.
D) regression function intercept.
Answer: B
29) Changing the units of measurement, e.g. measuring test scores in 100s, will do all of the
following EXCEPT for changing the:
A) residuals.
B) numerical value of the slope estimate.
C) interpretation of the effect that a change in X has on the change in Y.
D) numerical value of the intercept.
Answer: C
30) To decide whether the slope coefficient indicates a "large" effect of X on Y, you look at the:
A) economic importance implied by the slope coefficient.
B) regression R2 .
C) size of the slope coefficient.
D) value of the intercept.
Answer: A
31) The OLS estimator of the slope for the simple regression model is:
A)
B)
C)
D) - 1
Answer: A

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32) Using the example of a simple linear regression (population regression function) of test
scores and student-teacher ratio, a negative error mean:
A) the regression is useless for predicting test scores
B) the district did worse than predicted
C) the student-teacher ratio must be incorrect
D) the district did better than predicted
Answer: B
33) All of the following statements are TRUE with the exception of:
A) R2 = ESS/TSS.
B) R2 = 1 - (SSR/TSS).
C) R2 = .
D) SSR=
Answer: D
34) A low regression R2 means that:

A) the regression is bad.
B) tells you what the other factors influencing the left hand variable are.
C) there are other important factors that influence the left hand variable.
D) the SSR is low relative to the total variation in Y.
Answer: C
35) All of the following assumptions are required for the OLS estimate of the regression slope to
represent a causal effect, with the exception of:
A) the regression R2 is high.
B) E( | X) = 0.
C) ( , ), i = 1,...,n are i.i.d.
D) X and Y have a finite kurtosis.
Answer: A

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4.2 Essays and Longer Questions
1) Sir Francis Galton, a cousin of James Darwin, examined the relationship between the height of
children and their parents towards the end of the 19th century. It is from this study that the name
"regression" originated. You decide to update his findings by collecting data from 110 college
students, and estimate the following relationship:
= 19.6 + 0.73 × Midparh, R2 = 0.45, SER = 2.0
where Studenth is the height of students in inches, and Midparh is the average of the parental
heights. (Following Galton's methodology, both variables were adjusted so that the average
female height was equal to the average male height.)
(a) Interpret the estimated coefficients.
(b) What is the meaning of the regression R2 ?
(c) What is the prediction for the height of a child whose parents have an average height of
70.06 inches?
(d) What is the interpretation of the SER here?
(e) Given the positive intercept and the fact that the slope lies between zero and one, what
can you say about the height of students who have quite tall parents? Those who have quite short
parents?
(f) Galton was concerned about the height of the English aristocracy and referred to the
above result as "regression towards mediocrity." Can you figure out what his concern was? Why
do you think that we refer to this result today as "Galton's Fallacy"?
Answer:
(a) For every one inch increase in the average height of their parents, the student's height
increases by 0.73 of an inch. There is no reasonable interpretation for the intercept.
(b) The model explains 45 percent of the variation in the height of students.
(c) 19.6 + 0.73 × 70.06 = 70.74.
(d) The SER is a measure of the spread of the observations around the regression line. The
magnitude of the typical deviation from the regression line or the typical regression error here is
two inches.
(e) Tall parents will have, on average, tall students, but they will not be as tall as their parents.
Short parents will have short students, although on average, they will be somewhat taller than
their parents.
(f) This is an example of mean reversion. Since the aristocracy was, on average, taller, he was
concerned that their children would be shorter and resemble more the rest of the population. If
this conclusion were true, then eventually everyone would be of the same height. However, we
have not observed a decrease in the variance in height over time.

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2) (Requires Appendix material) At a recent county fair, you observed that at one stand people's
weight was forecasted, and were surprised by the accuracy (within a range). Thinking about how
the person could have predicted your weight fairly accurately (despite the fact that she did not
know about your "heavy bones"), you think about how this could have been accomplished. You
remember that medical charts for children contain 5%, 25%, 50%, 75% and 95% lines for a
weight/height relationship and decide to conduct an experiment with 110 of your peers. You
collect the data and calculate the following sums:
= 17,375, = 7,665.5,
= 94,228.8, = 1,248.9, = 7,625.9
where the height is measured in inches and weight in pounds. (Small letters refer to deviations
from means as in zi = Zi – .)
(a) Calculate the slope and intercept of the regression and interpret these.
(b) Find the regression R2 and explain its meaning. What other factors can you think of that
might have an influence on the weight of an individual?
Answer:
(a) 1 = = 6.11, 0 = 157.95 - 6.11 × 69.69 = -267.86. For every additional inch in height,
students weigh roughly 6 pounds more, on average.
(b) R2 = = = = 0.495. Roughly half of the weight variation in the 110
students is explained by the single explanatory variable, height. Answers will vary by student for
the other factors, but calorie intake and amount of exercise typically appear as part of the list.

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3) You have obtained a sub-sample of 1744 individuals from the Current Population Survey
(CPS) and are interested in the relationship between weekly earnings and age. The regression,
using heteroskedasticity-robust standard errors, yielded the following result:
= 239.16 + 5.20 × Age, R2 = 0.05, SER = 287.21.,
where Earn and Age are measured in dollars and years respectively.
(a) Interpret the results.
(b) Is the effect of age on earnings large?
(c) Why should age matter in the determination of earnings? Do the results suggest that there is a
guarantee for earnings to rise for everyone as they become older? Do you think that the
relationship between age and earnings is linear?
(d) The average age in this sample is 37.5 years. What is annual income in the sample?
(e) Interpret the measures of fit.
Answer:
(a) A person who is one year older increases her weekly earnings by $5.20. There is no meaning
attached to the intercept. The regression explains 5 percent of the variation in earnings.
(b) Assuming that people worked 52 weeks a year, the effect of being one year older translates
into an additional $270.40 a year. This does not seem particularly large in 2002 dollars, but may
have been earlier.
(c) In general, age-earnings profiles take on an inverted U-shape. Hence it is not linear and the
linear approximation may not be good at all. Age may be a proxy for "experience," which in
itself can approximate "on the job training." Hence the positive effect between age and earnings.
The results do not suggest that there is a guarantee for earnings to rise for everyone as they
become older since the regression R2 does not equal 1. Instead the result holds "on average."
(d) Since = - ⇒ = + . Substituting the estimates for the slope and the intercept
then results in average weekly earnings of $434.16 or annual average earnings of $22,576.32.
(e) The regression R2 indicates that five percent of the variation in earnings is explained by the
model. The typical error is $287.21.

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4) The baseball team nearest to your home town is, once again, not doing well. Given that your
knowledge of what it takes to win in baseball is vastly superior to that of management, you want
to find out what it takes to win in Major League Baseball (MLB). You therefore collect the
winning percentage of all 30 baseball teams in MLB for 1999 and regress the winning
percentage on what you consider the primary determinant for wins, which is quality pitching
(team earned run average). You find the following information on team performance:
Summary of the Distribution of Winning Percentage and

Team Earned Run Average for MLB in 1999
Average Standard Percentile
deviation
10% 25% 40% 50% 60% 75% 90%
(median)
Team 4.71 0.53 3.84 4.35 4.72 4.78 4.91 5.06 5.25
ERA
Winning 0.50 0.08 0.40 0.43 0.46 0.48 0.49 0.59 0.60
Percentage
(a) What is your expected sign for the regression slope? Will it make sense to interpret the
intercept? If not, should you omit it from your regression and force the regression line through
the origin?
(b) OLS estimation of the relationship between the winning percentage and the team ERA yield
the following:
= 0.9 – 0.10 × teamera , R2 = 0.49, SER = 0.06,
where winpct is measured as wins divided by games played, so for example a team that won half
of its games would have Winpct = 0.50. Interpret your regression results.
(c) It is typically sufficient to win 90 games to be in the playoffs and/or to win a division.
Winning over 100 games a season is exceptional: the Atlanta Braves had the most wins in 1999
with 103. Teams play a total of 162 games a year. Given this information, do you consider the
slope coefficient to be large or small?
(d) What would be the effect on the slope, the intercept, and the regression R2 if you measured
Winpct in percentage points, i.e., as (Wins/Games) × 100?
(e) Are you impressed with the size of the regression R2? Given that there is 51% of unexplained
variation in the winning percentage, what might some of these factors be?

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Answer:
(a) You expect a negative relationship, since a higher team ERA implies a lower quality of the
input. No team comes close to a zero team ERA, and therefore it does not make sense to interpret
the intercept. Forcing the regression through the origin is a false implication from this insight.
Instead the intercept fixes the level of the regression.
(b) For every one point increase in Team ERA, the winning percentage decreases by 10
percentage points, or 0.10. Roughly half of the variation in winning percentage is explained by
the quality of team pitching.
(c) The coefficient is large, since increasing the winning percentage by 0.10 is the equivalent of
winning 16 more games per year. Since it is typically sufficient to win 56 percent of the games to
qualify for the playoffs, this difference of 0.10 in winning percentage turns can easily turn a
loosing team into a winning team.
(d) Clearly the regression R2 will not be affected by a change in scale, since a descriptive
measure of the quality of the regression would depend on whim otherwise. The slope of the
regression will compensate in such a way that the interpretation of the result is unaffected, i.e., it
will become 10 in the above example. The intercept will also change to reflect the fact that if X
were 0, then the dependent variable would now be measured in percentage, i.e., it will become
94.0 in the above example.
(e) It is impressive that a single variable can explain roughly half of the variation in winning
percentage. Answers to the second question will vary by student, but will typically include the
quality of hitting, fielding, and management. Salaries could be included, but should be reflected
in the inputs.

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5) You have learned in one of your economics courses that one of the determinants of per capita
income (the "Wealth of Nations") is the population growth rate. Furthermore you also found out
that the Penn World Tables contain income and population data for 104 countries of the world.
To test this theory, you regress the GDP per worker (relative to the United States) in 1990
(RelPersInc) on the difference between the average population growth rate of that country (n) to
the U.S. average population growth rate (nus ) for the years 1980 to 1990. This results in the
following regression output:
= 0.518 – 18.831 × 18.831 × (n – nus), R2 = 0.522, SER = 0.197
(a) Interpret the results carefully. Is this relationship economically important?

(b) What would happen to the slope, intercept, and regression R2 if you ran another regression
where the above explanatory variable was replaced by n only, i.e., the average population growth
rate of the country? (The population growth rate of the United States from 1980 to 1990 was
0.009.) Should this have any effect on the t-statistic of the slope?
(c) 31 of the 104 countries have a dependent variable of less than 0.10. Does it therefore make
sense to interpret the intercept?
Answer:
(a) A relative increase in the population rate of one percentage point, from 0.01 to 0.02, say,
lowers relative per-capita income by almost 20 percentage points (0.188). This is a quantitatively
important and large effect. Nations which have the same population growth rate as the United
States have, on average, roughly half as much per capita income.
(b) The interpretation of the partial derivative is unaffected, in that the slope still indicates the
effect of a one percentage point increase in the population growth rate. The regression R2 will
remain the same since only a constant was removed from the explanatory variable. The intercept
will change as a result of the change in .
(c) To interpret the intercept, you must observe values of X close to zero, not Y.

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6) The neoclassical growth model predicts that for identical savings rates and population growth
rates, countries should converge to the per capita income level. This is referred to as the
convergence hypothesis. One way to test for the presence of convergence is to compare the
growth rates over time to the initial starting level.
(a) If you regressed the average growth rate over a time period (1960-1990) on the initial level of
per capita income, what would the sign of the slope have to be to indicate this type of
convergence? Explain. Would this result confirm or reject the prediction of the neoclassical
growth model?
(b) The results of the regression for 104 countries were as follows:
= 0.019 – 0.0006 × RelProd60 , R2 = 0.00007, SER = 0.016,
where g6090 is the average annual growth rate of GDP per worker for the 1960-1990 sample
period, and RelProd60 is GDP per worker relative to the United States in 1960.
Interpret the results. Is there any evidence of unconditional convergence between the countries of
the world? Is this result surprising? What other concept could you think about to test for
convergence between countries?
(c) You decide to restrict yourself to the 24 OECD countries in the sample. This changes your
regression output as follows:
= 0.048 – 0.0404 RelProd60 , R2 = 0.82 , SER = 0.0046
How does this result affect your conclusions from above?

Answer:
(a) You would require a negative sign. Countries that are far ahead of others at the beginning of
the period would have to grow relatively slower for the others to catch up. This represents
unconditional convergence, whereas the neoclassical growth model predicts conditional
convergence, i.e., there will only be convergence if countries have identical savings, population
growth rates, and production technology.
(b) An increase in 10 percentage points in RelProd60 results in a decrease of 0.00006 in the
growth rate from 1960 to 1990, i.e., countries that were further ahead in 1960 do grow by less.
There are some countries in the sample that have a value of RelProd60 close to zero (China,
Uganda, Togo, Guinea) and you would expect these countries to grow roughly by 2 percent per
year over the sample period. The regression R2 indicates that the regression has virtually no
explanatory power. The result is not surprising given that there are not many theories that predict
unconditional convergence between the countries of the world.
(c) Judging by the size of the slope coefficient, there is strong evidence of unconditional
convergence for the OECD countries. The regression R2 is quite high, given that there is only a
single explanatory variable in the regression. However, since we do not know the sampling
distribution of the estimator in this case, we cannot conduct inference.

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7) In 2001, the Arizona Diamondbacks defeated the New York Yankees in the Baseball World
Series in 7 games. Some players, such as Bautista and Finley for the Diamondbacks, had a
substantially higher batting average during the World Series than during the regular season.
Others, such as Brosius and Jeter for the Yankees, did substantially poorer. You set out to
investigate whether or not the regular season batting average is a good indicator for the World
Series batting average. The results for 11 players who had the most at bats for the two teams are:
= –0.347 + 2.290 AZSeasavg , R2 = 0.11, SER = 0.145,
= 0.134 + 0.136 NYSeasavg , R2 = 0.001, SER = 0.092,
where Wsavg and Seasavg indicate the batting average during the World Series and the regular
season respectively.
(a) Focusing on the coefficients first, what is your interpretation?
(b) What can you say about the explanatory power of your equation? What do you conclude from
this?
Answer:
(a) The two regressions are quite different. For the Diamondbacks, players who had a 10 point
higher batting average during the regular season had roughly a 23 point higher batting average
during the World Series. Hence top performers did relatively better. The opposite holds for the
Yankees.
(b) Both regressions have little explanatory power as seen from the regression R2. Hence
performance during the season is a poor forecast of World Series performance.
8) For the simple regression model of Chapter 4, you have been given the following data:
= 274, 745.75; = 8,248.979;
= 5,392, 705; = 163,513.03; = 179,878, 841.13
(a) Calculate the regression slope and the intercept.

(b) Calculate the regression R2
Answer:
(a) 1 = = -2.28; 0 = 654.2-2.28 × 19.6 = 698.9.
(This is the data set for Chapter 4).
(b) R2 = = 0.051

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9) Your textbook presented you with the following regression output:
= 698.9 – 2.28 × STR

n = 420, R2 = 0.051, SER = 18.6
(a) How would the slope coefficient change, if you decided one day to measure test scores in
100s, i.e., a test score of 650 became 6.5? Would this have an effect on your interpretation?
(b) Do you think the regression R2 will change? Why or why not?
(c) Although Chapter 4 in your textbook did not deal with hypothesis testing, it presented you
with the large sample distribution for the slope and the intercept estimator. Given the change in
the units of measurement in (a), do you think that the variance of the slope estimator will change
numerically? Why or why not?
Answer:
(a) The new regression line would be = 6.989 - 0.0228 × STR. Hence the decimal
point would simply move two digits to the left. The interpretation remains the same, since an
increase in the student-teacher ratio by 2, say, increases the new test score by 0.0456 points on
the new test score scale, which is 4.56 in the original test scores.
(b) The regression R2 should not change, since, if it did, an objective measure of fit would
depend on whim (the units of measurement). The SER will change (from 18.6 to 0.186). This is
to be expected, since the TSS obviously changes, and with the regression R2 unchanged, the SSR
(and hence SER) have to adjust accordingly.
(c) Since statistical inference will depend on the ratio of the estimator and its standard error, the
standard error must change in proportion to the estimator. If this was not true, then statistical
inference again would depend on the whim of the investigator.

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10) The news-magazine The Economist regularly publishes data on the so called Big Mac index
and exchange rates between countries. The data for 30 countries from the April 29, 2000 issue is
listed below:
Price of Actual Exchange Rate

Country Currency Big Macper U.S. dollar
Indonesia Rupiah 14,500 7,945

Italy Lira 4,500 2,088
South Korea Won 3,000 1,108
Chile Peso 1,260 514
Spain Peseta 375 179
Hungary Forint 339 279
Japan Yen 294 106
Taiwan Dollar 70 30.6
Thailand Baht 55 38.0
Czech Rep. Crown 54.37 39.1
Russia Ruble 39.50 28.5
Denmark Crown 24.75 8.04
Sweden Crown 24.0 8.84
Mexico Peso 20.9 9.41
France Franc 18.5 .07
Israel Shekel 14.5 4.05
China Yuan 9.90 8.28
South Africa Rand 9.0 6.72
Switzerland Franc 5.90 1.70
Poland Zloty 5.50 4.30
Germany Mark 4.99 2.11
Malaysia Dollar 4.52 3.80
New Zealand Dollar 3.40 2.01
Singapore Dollar 3.20 1.70
Brazil Real 2.95 1.79
Canada Dollar 2.85 1.47
Australia Dollar 2.59 1.68
Argentina Peso 2.50 1.00
Britain Pound 1.90 0.63
United States Dollar 2.51
The concept of purchasing power parity or PPP ("the idea that similar foreign and domestic
goods … should have the same price in terms of the same currency," Abel, A. and B. Bernanke,
Macroeconomics, 4th edition, Boston: Addison Wesley, 476) suggests that the ratio of the Big
Mac priced in the local currency to the U.S. dollar price should equal the exchange rate between
the two countries.
(a) Enter the data into your regression analysis program (EViews, Stata, Excel, SAS, etc.).
Calculate the predicted exchange rate per U.S. dollar by dividing the price of a Big Mac in local
currency by the U.S. price of a Big Mac ($2.51).

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(b) Run a regression of the actual exchange rate on the predicted exchange rate. If purchasing
power parity held, what would you expect the slope and the intercept of the regression to be? Is
the value of the slope and the intercept "far" from the values you would expect to hold under
PPP?
(c) Plot the actual exchange rate against the predicted exchange rate. Include the 45 degree line
in your graph. Which observations might cause the slope and the intercept to differ from zero and
one?
Answer:
(a)
Country Predicted Exchange Rate
per U.S. dollar
Indonesia 5777
Italy 1793
South Korea 1195
Chile 502
Spain 149
Hungary 135
Japan 117
Taiwan 27.9
Thailand 21.9
Czech Rep. 21.7
Russia 15.7
Denmark 9.86
Sweden 9.56
Mexico 8.33
France 7.37
Israel 5.78
China 3.94
South Africa 3.59
Switzerland 2.35
Poland 2.19
Germany 1.99
Malaysia 1.80
New Zealand 1.35
Singapore 1.27
Brazil 1.18
Canada 1.14
Australia 1.03
Argentina 1.00
Britain 0.76

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(b) The estimated regression is as follows:
= -27.05 + 1.35 × Pr edExRate

R2 = 0.994, n = 29, SER = 122.15
For PPP to hold exactly, you would expect an intercept of zero and a slope of unity. Since we do
not know the standard error of the slope and the intercept, and since Chapter 4 has not dealt with
hypothesis testing, it is hard to judge how "far" 27.05 and 1.35 are away from zero and one
respectively.
(c) The regression is represented by the solid line, while the dashed one is the 45 degree line.
Most of the observations are bunched towards the origin, making it hard to judge from this graph
which observations cause the regression line to differ from the 45 degree line. However, the
Indonesian Rupiah is certainly a possible candidate.

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11) At the Stock and Watson (http://www.pearsonhighered.com/stock_watson) website go to

Student Resources and select the option "Datasets for Replicating Empirical Results." Then
select the "California Test Score Data Used in Chapters 4-9" (caschool.xls) and open it in a
spreadsheet program such as Excel.
In this exercise you will estimate various statistics of the Linear Regression Model with One
Regressor through construction of various sums and ratio within a spreadsheet program.
Throughout this exercise, let Y correspond to Test Scores (testscore) and X to the Student
Teacher Ratio (str). To generate answers to all exercises here, you will have to create seven
columns and the sums of five of these. They are
(i) Yi, (ii) Xi, (iii) (Yi- ), (iv) (Xi- ), (v) (Yi- )×(Xi- ), (vi) (Xi- )2, (vii) (Yi- )2
Although neither the sum of (iii) or (iv) will be required for further calculations, you may
want to generate these as a check (both have to sum to zero).
a. Use equation (4.7) and the sums of columns (v) and (vi) to generate the slope of the
regression.
b. Use equation (4.8) to generate the intercept.
c. Display the regression line (4.9) and interpret the coefficients.
d. Use equation (4.16) and the sum of column (vii) to calculate the regression R2.
e. Use equation (4.19) to calculate the SER.
f. Use the "Regression" function in Excel to verify the results.
Answer:
Column (i): 654.156548
Column (ii): 19.64043
Column (iii): 1.27329E-11
Column (iv): 1.13E-12
Column (v): -3418.76
Column (vi): 1499.58
Column (vii): 152109.6
a. 1= = - 2.27981
b. 0 = 274745.75-(-2.27981)×8248.979 = 698.933
c. i= 698.9 - 2.28 × Xi. A decrease in the student-teacher ratio of one results in an increase in
test scores of 2.28. It is best not to interpret the intercept; it simply determines the height of the
regression line.

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d. To calculate the regression R2, you need the TSS given from the sum in column (vii) and
either the ESS or SSR. In principle, you could use equation (4.10) to generate the residuals,
square these and sum them up to get SSR. However, the textbook suggests a shortcut at the
bottom of p. 142:
= (the cross-product vanishes due to the orthogonality
conditions (4.32) and (4.36)). The various terms on the RHS of the equation have been
calculated and equation (4.35) implies that = ESS = 7794.11. Hence the
regression R2 = = 0.051
e. The answer in (d) can be used to calculate the SSR, which are 144325.5. Hence the SEE
must be 18.6.
f.
SUMMARY OUTPUT
Regression Statistics
Multiple R 0.226
R Square 0.051
Adjusted R Square 0.049
Standard Error 18.581
Observations 420
ANOVA
df SS
Regression 1 7794.11
Residual 418 144315.5
Total 419 152109.6
Coefficients
Intercept 698.93
str -2.28

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12) You have obtained a sample of 14,925 individuals from the Current Population Survey (CPS)
and are interested in the relationship between average hourly earnings and years of education.
The regression yields the following result:
= -4.58 + 1.71×educ , R2 = 0.182, SER = 9.30
where ahe and educ are measured in dollars and years respectively.
a. Interpret the coefficients and the regression R2.

b. Is the effect of education on earnings large?
c. Why should education matter in the determination of earnings? Do the results suggest that
there is a guarantee for average hourly earnings to rise for everyone as they receive an additional
year of education? Do you think that the relationship between education and average hourly
earnings is linear?
d. The average years of education in this sample is 13.5 years. What is mean of average hourly
earnings in the sample?
e. Interpret the measure SER. What is its unit of measurement.
Answer:
a. A person with one more year of education increases her earnings by $1.71. There is no
meaning attached to the intercept, it just determines the height of the regression. The model
explains 5 percent of the variation in average hourly earnings.
b. The difference between a high school graduate and a college graduate is four years of
education. Hence a college graduate will earn almost $7 more per hour, on average ($6.84 to be
precise). If you assume that there are 2,000 working hours per year, then the average salary
difference would be close to $14,000 (actually $13,680). Depending on how much you have
spent for an additional year of education and how much income you have forgone, this does not
seem particularly large.
c. In general, you would expect to find a positive relationship between years of education and
average hourly earnings. Education is considered investment in human capital. If this were not
the case, then it would be a puzzle as to why there are students in the econometrics course —
surely they are not there to just "find themselves" (which would be quite expensive in most
cases). However, if you consider education as an investment and you wanted to see a return on it,
then the relationship will most likely not be linear. For example, a constant percent return would
imply an exponential relationship whereby the additional year of education would bring a larger
increase in average hourly earnings at higher levels of education. The results do not suggest that
there is a guarantee for earnings to rise for everyone as they become more educated since the
regression R2 does not equal 1. Instead the result holds "on average."
d. Since 0 = - 1 ⇒ = 0 + 1 Substituting the estimates for the slope and the intercept
then results in a mean of average hourly earnings of roughly $18.50.
e. The typical prediction error is $9.30. Since the measure is related to the deviation of the actual
and fitted values, the unit of measurement must be the same as that of the dependent variable,
which is in dollars here.

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4.3 Mathematical and Graphical Problems
1) Prove that the regression R2 is identical to the square of the correlation coefficient between
two variables Y and X. Regression functions are written in a form that suggests causation running
from X to Y. Given your proof, does a high regression R2 present supportive evidence of a causal
relationship? Can you think of some regression examples where the direction of causality is not
clear? Is without a doubt?
Answer: The regression R2 = , where ESS is given by - )2. But i = 0 + 1Xi and
= 0 + 1 . Hence ( i - )2 = (Xi - )2 and therefore ESS = . Using small
letters to indicate deviations from mean, i.e., zi = Zi - , we get that the regression R2 =
. The square of the correlation coefficient is r2 = =
= . Hence the two are the same. Correlation does not imply
causation. Income is a regressor in the consumption function, yet consumption enters on the
right-hand side of the GDP identity. Regressing the weight of individuals on the height is a
situation where causality is without doubt, since the author of this test bank should be seven feet
tall otherwise. The authors of the textbook use weather data to forecast orange juice prices later
in the text.
2) You have analyzed the relationship between the weight and height of individuals. Although
you are quite confident about the accuracy of your measurements, you feel that some of the
observations are extreme, say, two standard deviations above and below the mean. Your therefore
decide to disregard these individuals. What consequence will this have on the standard deviation
of the OLS estimator of the slope?
Answer: Other things being equal, the standard error of the slope coefficient will decrease the
larger the variation in X. Hence you prefer more variation rather than less. This can be seen from
formula (4.20) in the text. Intuitively it is easier for OLS to detect a response to a unit change in
X if the data varies more.

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3) In order to calculate the regression R2 you need the TSS and either the SSR or the ESS. The
TSS is fairly straightforward to calculate, being just the variation of Y. However, if you had to
calculate the SSR or ESS by hand (or in a spreadsheet), you would need all fitted values from the
regression function and their deviations from the sample mean, or the residuals. Can you think of
a quicker way to calculate the ESS simply using terms you have already used to calculate the
slope coefficient?
Answer: The ESS is given by . But i = 0 + 1Xi and = 0 + 1 . Hence ( i - )2
= (Xi - )2, and therefore ESS = . The right-hand side contains the estimated
slope squared and the denominator of the slope, i.e., all values that have already been calculated.
4) (Requires Appendix material) In deriving the OLS estimator, you minimize the sum of
squared residuals with respect to the two parameters 0 and 1. The resulting two equations
imply two restrictions that OLS places on the data, namely that = 0 and Xi = 0. Show
that you get the same formula for the regression slope and the intercept if you impose these two
conditions on the sample regression function.
Answer: The sample regression function is Yi = o + 1Xi + i. Summing both sides results in
+ 1 + . Imposing the first restriction, namely that the sum of the
residuals is zero, dividing both sides of the equation by n, and solving for o gives the OLS
formula for the intercept.
For the second restriction, multiply both sides of the sample regression function by Xi and then
sum both sides to get = o + 1 After imposing the restriction
= 0 and substituting the formula for the intercept, you get
= ( - 1 )n + 1 or -n = 1 , which, after isolating 1
and dividing by the variation in ,X results in the OLS estimator for the slope.

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5) (Requires Appendix material) Show that the two alternative formulae for the slope given in
your textbook are identical.
Answer: Let's start with the first equality. The numerator of the right-hand side expression can
be written as follows:
= = -
= -n +n = n . (Note that .)
Multiplying out the terms in the denominator and moving the summation sign into the expression
in parentheses similarly yields . Dividing both of these expressions by n then results
in the left-hand side fraction.
6) (Requires Calculus) Consider the following model:
Yi = β0 + ui.
Derive the OLS estimator for β0.

Answer: To derive the OLS estimator, minimize the sum of squared prediction mistakes
. Taking the derivative with respect to b0 results in =
= (-2) . Setting the derivative to zero then results in the OLS
estimator:
(-2) .

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7) (Requires Calculus) Consider the following model:
Yi = β1Xi + ui.
Derive the OLS estimator for β1.

Answer: To derive the OLS estimator, minimize the sum of squared prediction mistakes
. Taking the derivative with respect to b1 results in =
= (-2) Setting the derivative to zero then results in the
OLS estimator:
(-2)(

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8) Show first that the regression R2 is the square of the sample correlation coefficient. Next,
show that the slope of a simple regression of Y on X is only identical to the inverse of the
regression slope of X on Y if the regression R2 equals one.
Answer: The regression R2 = , where ESS is given by . But i = 0 + 1Xi and
= 0 + 1 . Hence ( i - )2 = (Xi - )2, and therefore ESS = Using small
letters to indicate deviations from mean, i.e., zi = Zi - , we get that the regression R2 =
. The square of the correlation coefficient is r2 = =
= . Hence the two are the same.
Now 1 = r2 = ⇒ = . But = 1 and therefore 1= ,
which is the inverse of the regression slope of X on Y.

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9) Consider the sample regression function
Yi = 0 + 1Xi + i.
First, take averages on both sides of the equation. Second, subtract the resulting equation from
the above equation to write the sample regression function in deviations from means. (For
simplicity, you may want to use small letters to indicate deviations from the mean, i.e., zi = Zi –
.) Finally, illustrate in a two-dimensional diagram with SSR on the vertical axis and the
regression slope on the horizontal axis how you could find the least squares estimator for the
slope by varying its values through trial and error.
Answer: Taking averages results in the following equation: = 0 + 1 . Subtracting this
equation from the above one, we get yi = 1xi + i.
SSR = = )2 is a quadratic which takes on different values for different choices
of (the y and x are given in this case, i.e., different from the usual calculus problems, they
cannot vary here). You could choose a starting value of the slope and calculate SSR. Next you
could choose a different value for the slope and calculate the new SSR. There are two choices for
the new slope value for you to make: first, in which direction you want to move, and second,
how large a distance you want to choose the new slope value from the old one. (In essence, this
is what sophisticated search algorithms do.) You continue with this procedure until you find the
smallest SSR. The slope coefficient which has generated this SSR is the OLS estimator.

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10) Given the amount of money and effort that you have spent on your education, you wonder if
it was (is) all worth it. You therefore collect data from the Current Population Survey (CPS) and
estimate a linear relationship between earnings and the years of education of individuals. What
would be the effect on your regression slope and intercept if you measured earnings in thousands
of dollars rather than in dollars? Would the regression R2 be affected? Should statistical
inference be dependent on the scale of variables? Discuss.
Answer: It should be clear that interpretation of estimated relationships and statistical inference
should not depend on the units of measurement. Otherwise whim could dictate conclusions.
Hence the regression R2 and statistical inference cannot be effected. It is easy but tedious to
show this mathematically. Next, the intercept indicates the value of Y when X is zero. The change
in the units of measurement have no effect on this, since the change in is cancelled by the
change in 1. The slope coefficient will change to compensate for the change in the units of
measurement of X. In the above case, the decimal point will move 3 digits to the left.

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11) (Requires Appendix material) Consider the sample regression function
= 0+ 1 + i,
where * indicates that the variable has been standardized. What are the units of measurement for
the dependent and explanatory variable? Why would you want to transform both variables in this
way? Show that the OLS estimator for the intercept equals zero. Next prove that the OLS
estimator for the slope in this case is identical to the formula for the least squares estimator
where the variables have not been standardized, times the ratio of the sample standard deviation
of X and Y, i.e., 1 = 1 * .
Answer: The units of measurement are in standard deviations. Standardizing the variables
allows conversion into common units and allows comparison of the size of coefficients. The
mean of standardized variables is zero, and hence the OLS intercept must also be zero. The slope
coefficient is given by the formula 1= , where small letters indicate deviations from
mean, i.e., z = Z - .
Note that means of standardized variables are zero, and hence we get 1= . Writing
this expression in terms of originally observed variables results in 1 = , which is
the same as the sought after expression after simplification.

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12) The OLS slope estimator is not defined if there is no variation in the data for the explanatory
variable. You are interested in estimating a regression relating earnings to years of schooling.
Imagine that you had collected data on earnings for different individuals, but that all these
individuals had completed a college education (16 years of education). Sketch what the data
would look like and explain intuitively why the OLS coefficient does not exist in this situation.
Answer: There is no variation in X in this case, and it is therefore unreasonable to ask by how
much Y would change if X changed by one unit. Regression analysis cannot figure out the answer
to this question, because a change in X never happens in the sample.
13) Indicate in a scatterplot what the data for your dependent variable and your explanatory
variable would look like in a regression with an R2 equal to zero. How would this change if the
regression R2 was equal to one?
Answer: For the zero regression R2, the data would look something like this:
In the case of the regression R2 being one, all observations would lie on a straight line.

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14) Imagine that you had discovered a relationship that would generate a scatterplot very similar
to the relationship Yi = , and that you would try to fit a linear regression through your data
points. What do you expect the slope coefficient to be? What do you think the value of your
regression R2 is in this situation? What are the implications from your answers in terms of fitting
a linear regression through a non-linear relationship?
Answer: You would expect the slope to be a straight line (= 0) and the regression R2 to be zero
in this situation. The implication is that although there may be a relationship between two
variables, you may not detect it if you use the wrong functional form.
15) (Requires Appendix material) A necessary and sufficient condition to derive the OLS
estimator is that the following two conditions hold: = 0 and = 0. Show that these
conditions imply that = 0.
Answer: = + Xi) = +
16) The help function for a commonly used spreadsheet program gives the following definition
for the regression slope it estimates:
Prove that this formula is the same as the one given in the textbook.
Answer: = = .
Dividing both numerator and denominator by n then gives you the desired result.

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17) In order to calculate the slope, the intercept, and the regression R2 for a simple sample
regression function, list the five sums of data that you need.
Answer: Depending whether or not the data is in deviations from means or not (zi = Zi - or Zi,
say), you need the following sums:
(data in deviation form) or
. Using these five columns, you can calculate the slope
= , the intercept 0 = - 1 , and the regression R2 = = .
Alternatively, if the data is not given in deviation form, the formulae are as follows: =
, and for the regression R2 = = .
18) A peer of yours, who is a major in another social science, says he is not interested in the
regression slope and/or intercept. Instead he only cares about correlations. For example, in the
test score/student-teacher ratio regression, he claims to get all the information he needs from the
negative correlation coefficient corr(X,Y)=-0.226. What response might you have for your peer?
Answer: First of all, the regression slope is related to the regression R2, and hence its square
root, the correlation coefficient, since
R2 = = .
However, while the correlation coefficient tells you something about the direction and strength of
the relationship between two variables, it does not inform you about the effect a one unit increase
in the explanatory variable. Hence it cannot answer the question whether or not the relationship
is important (although even with the knowledge of the slope coefficient, this requires further
information). Your friend would not be able to answer the question which policy makers and
researchers are typically interested in, such as, what would be the effect on test scores of a
reduction in the student-teacher ratio by one?

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19) Assume that there is a change in the units of measurement on both Y and X. The new
variables are Y*= aY and X* = bX. What effect will this change have on the regression slope?
Answer: We now have the following sample regression function = + X*. The formula
for the slope will be
= = = = 1.
20) Assume that there is a change in the units of measurement on X. The new variables X* = bX.
Prove that this change in the units of measurement on the explanatory variable has no effect on
the intercept in the resulting regression.
Answer: Consider the sample regression function = + X*. The formula for the intercept
will be = - b . But = = = = 1. Hence = -
1b = 0.

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21) At the Stock and Watson (http://www.pearsonhighered.com/stock_watson) website, go to

select the "California Test Score Data Used in Chapters 4-9" and read the data either into Excel
or STATA (or another statistical program). First run a regression where the dependent variable is
test scores and the independent variable is the student-teacher ratio. Record the regression R2.
Then run a regression where the dependent variable is the student-teacher ratio and the
independent variable is test scores. Record the regression R2 from this regression. How do they
compare?
Answer: The regression R2 is 0.051, confirming the idea that the regression R2 is only the
square of the correlation coefficient between two variables. This can also be shown formally as
follows:
The regression R2 = where ESS is given by . But i= 0 + 1Xi and = 0 + 1
. Hence ( i- )2 = (Xi- )2 and therefore ESS = (Xi- )2. Using small letters to indicate
deviations from mean, i.e., : zi = Zi- , we get that the regression R2 = . The square
of the correlation coefficient is r2 = = = . Hence
the two are the same.

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22) At the Stock and Watson (http://www.pearsonhighered.com/stock_watson) website, go to

select the "California Test Score Data Used in Chapters 4-9" and read the data either into Excel
or STATA (or another statistical program).
Run a regression of the average reading score (read_scr) on the average math score (math_scr).
What values for the slope and the intercept would you expect? Interpret the coefficients in the
resulting regression output and the regression R2.
Answer: On average, it would seem plausible, a priori, that schools which score high on the
math score would also do well in the reading score. Perhaps an underlying variable, such as
genes, parental interest, or the quality of teachers, is driving results in both. The relationship is
close to the 45 degree line, where the intercept would be zero and the slope would be one.
Interpreted literally, 85 percent of the variation in the reading score is explained by our model.

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23) In a simple regression with an intercept and a single explanatory variable, the variation in Y
(TSS = ) can be decomposed into the explained sums of squares ( ESS = )
and the sum of squared residuals (SSR = = ) (see, for example, equation (4.35)
in the textbook).
Consider any regression line, positively or negatively sloped in {X,Y} space. Draw a horizontal
line where, hypothetically, you consider the sample mean of Y ( ) to be. Next add a single
actual observation of Y.
In this graph, indicate where you find the following distances: the
(i) residual
(ii) actual minus the mean of Y
(iii) fitted value minus the mean of Y
Answer:

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Chapter 4 Econometrics Practice MC

Introductory Econometrics (Wilfrid Laurier University)

Studocu is not sponsored or endorsed by any college or university

Introduction to Econometrics, 4e (Stock/Watson)

4.1 Multiple Choice Questions

2) The regression R2 is defined as follows:

3) The standard error of the regression (SER) is defined as follows:

4) (Requires Appendix material) Which of the following statements is correct?

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7) The reason why estimators have a sampling distribution is that:

8) In the simple linear regression model, the regression slope:

9) The OLS estimator is derived by:

10) Interpreting the intercept in a sample regression function is:

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13) The OLS residuals, i, are defined as follows:

15) The regression R2 is a measure of:

16) (Requires Appendix) The sample regression line estimated by OLS:

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17) The OLS residuals:

18) The normal approximation to the sampling distribution of 1 is powerful because:

20) In the simple linear regression model Yi = β0 + β1Xi + ui:

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22) To decide whether or not the slope coefficient is large or small:

23) E(ui Xi) = 0 says that:

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28) The OLS residuals, i, are sample counterparts of the population:

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34) A low regression R2 means that:

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4.2 Essays and Longer Questions

= 19.6 + 0.73 × Midparh, R2 = 0.45, SER = 2.0

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= 94,228.8, = 1,248.9, = 7,625.9

(b) R2 = = = = 0.495. Roughly half of the weight variation in the 110

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= 239.16 + 5.20 × Age, R2 = 0.05, SER = 287.21.,

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Summary of the Distribution of Winning Percentage and

= 0.9 – 0.10 × teamera , R2 = 0.49, SER = 0.06,

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= 0.518 – 18.831 × 18.831 × (n – nus), R2 = 0.522, SER = 0.197

(a) Interpret the results carefully. Is this relationship economically important?

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= 0.019 – 0.0006 × RelProd60 , R2 = 0.00007, SER = 0.016,

= 0.048 – 0.0404 RelProd60 , R2 = 0.82 , SER = 0.0046

How does this result affect your conclusions from above?

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= –0.347 + 2.290 AZSeasavg , R2 = 0.11, SER = 0.145,

= 0.134 + 0.136 NYSeasavg , R2 = 0.001, SER = 0.092,

= 274, 745.75; = 8,248.979;

= 5,392, 705; = 163,513.03; = 179,878, 841.13

(a) Calculate the regression slope and the intercept.

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9) Your textbook presented you with the following regression output:

= 698.9 – 2.28 × STR

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Price of Actual Exchange Rate

Indonesia Rupiah 14,500 7,945

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(b) The estimated regression is as follows: