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Contents
Preface xvi Summary and Conclusions 28
Acknowledgments xix Exercises 29

Introduction 1 CHAPTER 2
I.1 What Is Econometrics? 1 Two-Variable Regression Analysis: Some
I.2 Why a Separate Discipline? 2 Basic Ideas 34
I.3 Methodology of Econometrics 2 2.1 A Hypothetical Example 34
1. Statement of Theory or Hypothesis 3 2.2 The Concept of Population Regression
2. Specification of the Mathematical Model Function (PRF) 37
of Consumption 3 2.3 The Meaning of the Term Linear 38
3. Specification of the Econometric Model Linearity in the Variables 38
of Consumption 4 Linearity in the Parameters 38
4. Obtaining Data 5 2.4 Stochastic Specification of PRF 39
5. Estimation of the Econometric Model 5 2.5 The Significance of the Stochastic
6. Hypothesis Testing 7 Disturbance Term 41
7. Forecasting or Prediction 8 2.6 The Sample Regression Function (SRF) 42
8. Use of the Model for Control 2.7 Illustrative Examples 45
or Policy Purposes 9 Summary and Conclusions 48
Choosing among Competing Models 9 Exercises 48
I.4 Types of Econometrics 10
I.5 Mathematical and Statistical Prerequisites 11 CHAPTER 3
I.6 The Role of the Computer 11 Two-Variable Regression Model: The
I.7 Suggestions for Further Reading 12 Problem of Estimation 55
PART ONE 3.1 The Method of Ordinary Least Squares 55
3.2 The Classical Linear Regression Model: The
SINGLE-EQUATION REGRESSION
Assumptions Underlying the Method
MODELS 13 of Least Squares 61
CHAPTER 1 A Word about These Assumptions 68
3.3 Precision or Standard Errors
The Nature of Regression Analysis 15
of Least-Squares Estimates 69
1.1 Historical Origin of the Term Regression 15 3.4 Properties of Least-Squares Estimators:
1.2 The Modern Interpretation of Regression 15 The Gauss–Markov Theorem 71
Examples 16 3.5 The Coefficient of Determination r2:
1.3 Statistical versus Deterministic A Measure of “Goodness of Fit” 73
Relationships 19 3.6 A Numerical Example 78
1.4 Regression versus Causation 19 3.7 Illustrative Examples 81
1.5 Regression versus Correlation 20 3.8 A Note on Monte Carlo Experiments 83
1.6 Terminology and Notation 21 Summary and Conclusions 84
1.7 The Nature and Sources of Data for Economic Exercises 85
Analysis 22 Appendix 3A 92
Types of Data 22 3A.1 Derivation of Least-Squares Estimates 92
The Sources of Data 25 3A.2 Linearity and Unbiasedness Properties
The Accuracy of Data 27 of Least-Squares Estimators 92
A Note on the Measurement Scales 3A.3 Variances and Standard Errors
of Variables 27 of Least-Squares Estimators 93
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3A.4 Covariance Between β̂1 and β̂ 2 93 The “Zero” Null Hypothesis and the “2-t” Rule
3A.5 The Least-Squares Estimator of σ2 93 of Thumb 120
3A.6 Minimum-Variance Property Forming the Null and Alternative
of Least-Squares Estimators 95 Hypotheses 121
3A.7 Consistency of Least-Squares Estimators 96 Choosing α, the Level of Significance 121
The Exact Level of Significance:
CHAPTER 4 The p Value 122
Classical Normal Linear Regression Statistical Significance versus Practical
Model (CNLRM) 97 Significance 123
The Choice between Confidence-Interval
4.1 The Probability Distribution and Test-of-Significance Approaches
of Disturbances ui 97 to Hypothesis Testing 124
4.2 The Normality Assumption for ui 98 5.9 Regression Analysis and Analysis
Why the Normality Assumption? 99
of Variance 124
4.3 Properties of OLS Estimators under 5.10 Application of Regression Analysis:
the Normality Assumption 100 The Problem of Prediction 126
4.4 The Method of Maximum Mean Prediction 127
Likelihood (ML) 102 Individual Prediction 128
Summary and Conclusions 102 5.11 Reporting the Results of Regression
Appendix 4A 103 Analysis 129
4A.1 Maximum Likelihood Estimation 5.12 Evaluating the Results of Regression
of Two-Variable Regression Model 103 Analysis 130
4A.2 Maximum Likelihood Estimation Normality Tests 130
of Food Expenditure in India 105 Other Tests of Model Adequacy 132
Appendix 4A Exercises 105 Summary and Conclusions 134
Exercises 135
CHAPTER 5
Appendix 5A 143
Two-Variable Regression: Interval 5A.1 Probability Distributions Related
Estimation and Hypothesis Testing 107 to the Normal Distribution 143
5.1 Statistical Prerequisites 107 5A.2 Derivation of Equation (5.3.2) 145
5.2 Interval Estimation: Some Basic Ideas 108 5A.3 Derivation of Equation (5.9.1) 145
5.3 Confidence Intervals for Regression 5A.4 Derivations of Equations (5.10.2)
Coefficients β1 and β2 109 and (5.10.6) 145
Confidence Interval for β2 109 Variance of Mean Prediction 145
Confidence Interval for β1 and β2 Variance of Individual Prediction 146
Simultaneously 111
5.4 Confidence Interval for σ2 111 CHAPTER 6
5.5 Hypothesis Testing: General Comments 113 Extensions of the Two-Variable Linear
5.6 Hypothesis Testing:
Regression Model 147
The Confidence-Interval Approach 113
Two-Sided or Two-Tail Test 113 6.1 Regression through the Origin 147
One-Sided or One-Tail Test 115 r2 for Regression-through-Origin Model 150
5.7 Hypothesis Testing: 6.2 Scaling and Units of Measurement 154
The Test-of-Significance Approach 115 A Word about Interpretation 157
Testing the Significance of Regression 6.3 Regression on Standardized Variables 157
Coefficients: The t Test 115 6.4 Functional Forms of Regression Models 159
Testing the Significance of σ2: The χ2 Test 118 6.5 How to Measure Elasticity: The Log-Linear
5.8 Hypothesis Testing: Some Practical Aspects 119 Model 159
The Meaning of “Accepting” or “Rejecting” a 6.6 Semilog Models: Log–Lin and Lin–Log
Hypothesis 119 Models 162
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How to Measure the Growth Rate: Allocating R2 among Regressors 206

–
The Log–Lin Model 162 The “Game’’ of Maximizing R2 206
The Lin–Log Model 164 7.9 The Cobb–Douglas Production Function:
6.7 Reciprocal Models 166 More on Functional Form 207
Log Hyperbola or Logarithmic Reciprocal 7.10 Polynomial Regression Models 210
Model 172 7.11 Partial Correlation Coefficients 213
6.8 Choice of Functional Form 172 Explanation of Simple and Partial
6.9 A Note on the Nature of the Stochastic Error Correlation Coefficients 213
Term: Additive versus Multiplicative Interpretation of Simple and Partial
Stochastic Error Term 174 Correlation Coefficients 214
Summary and Conclusions 175 Summary and Conclusions 215
Exercises 176 Exercises 216
Appendix 6A 182 Appendix 7A 227
6A.1 Derivation of Least-Squares Estimators 7A.1 Derivation of OLS Estimators
for Regression through the Origin 182 Given in Equations (7.4.3) to (7.4.5) 227
6A.2 Proof that a Standardized Variable 7A.2 Equality between the Coefficients of PGNP
Has Zero Mean and Unit Variance 183 in Equations (7.3.5) and (7.6.2) 229
6A.3 Logarithms 184 7A.3 Derivation of Equation (7.4.19) 229
6A.4 Growth Rate Formulas 186 7A.4 Maximum Likelihood Estimation
6A.5 Box-Cox Regression Model 187 of the Multiple Regression Model 230
7A.5 EViews Output of the Cobb–Douglas
CHAPTER 7 Production Function in
Equation (7.9.4) 231
Multiple Regression Analysis:
The Problem of Estimation 188
CHAPTER 8
7.1 The Three-Variable Model: Notation
Multiple Regression Analysis: The Problem
and Assumptions 188
7.2 Interpretation of Multiple Regression
of Inference 233
Equation 191 8.1 The Normality Assumption Once Again 233
7.3 The Meaning of Partial Regression 8.2 Hypothesis Testing in Multiple Regression:
Coefficients 191 General Comments 234
7.4 OLS and ML Estimation of the Partial 8.3 Hypothesis Testing about Individual
Regression Coefficients 192 Regression Coefficients 235
OLS Estimators 192 8.4 Testing the Overall Significance of the Sample
Variances and Standard Errors Regression 237
of OLS Estimators 194 The Analysis of Variance Approach to Testing the
Properties of OLS Estimators 195 Overall Significance of an Observed Multiple
Maximum Likelihood Estimators 196 Regression: The F Test 238
7.5 The Multiple Coefficient of Determination R2 Testing the Overall Significance of a Multiple
and the Multiple Coefficient Regression: The F Test 240
of Correlation R 196 An Important Relationship between R2 and F 241
7.6 An Illustrative Example 198 Testing the Overall Significance of a Multiple
Regression on Standardized Variables 199 Regression in Terms of R2 242
Impact on the Dependent Variable of a Unit The “Incremental” or “Marginal” Contribution
Change in More than One Regressor 199 of an Explanatory Variable 243
7.7 Simple Regression in the Context 8.5 Testing the Equality of Two Regression
of Multiple Regression: Introduction to Coefficients 246
Specification Bias 200 8.6 Restricted Least Squares: Testing Linear
7.8 R2 and the Adjusted R2 201 Equality Restrictions 248
Comparing Two R2 Values 203 The t-Test Approach 249
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The F-Test Approach: Restricted Least
Squares 249
General F Testing 252
8.7 Testing for Structural or Parameter Stability
of Regression Models: The Chow Test 254
8.8 Prediction with Multiple Regression 259
8.9 The Troika of Hypothesis Tests: The
Likelihood Ratio (LR), Wald (W), and
Lagrange Multiplier (LM) Tests 259
8.10 Testing the Functional Form of Regression:
Choosing between Linear and Log–Linear
Regression Models 260
Summary and Conclusions 262
Exercises 262
Appendix 8A: Likelihood
Ratio (LR) Test 274
CHAPTER 9
Dummy Variable Regression Models
9.1 The Nature of Dummy Variables 277
9.2 ANOVA Models 278
Caution in the Use of Dummy Variables
9.3 ANOVA Models with Two Qualitative
Variables 283
9.4 Regression with a Mixture of Quantitative
and Qualitative Regressors: The ANCOVA
Models 283
9.5 The Dummy Variable Alternative
to the Chow Test 285
9.6 Interaction Effects Using Dummy
Variables 288
9.7 The Use of Dummy Variables in Seasonal
Analysis 290
9.8 Piecewise Linear Regression 295
9.9 Panel Data Regression Models 297
9.10 Some Technical Aspects of the Dummy
Variable Technique 297
The Interpretation of Dummy Variables
in Semilogarithmic Regressions 297
Dummy Variables and Heteroscedasticity 298
Dummy Variables and Autocorrelation 299
What Happens If the Dependent Variable
Is a Dummy Variable? 299
9.11 Topics for Further Study 300
9.12 A Concluding Example 300
Summary and Conclusions 304
Exercises 305
Appendix 9A: Semilogarithmic Regression
with Dummy Regressor 314
Contents ix
PART TWO
RELAXING THE ASSUMPTIONS OF THE
CLASSICAL MODEL 315
CHAPTER 10
Multicollinearity: What Happens
If the Regressors Are Correlated? 320
10.1 The Nature of Multicollinearity 321
10.2 Estimation in the Presence of Perfect
Multicollinearity 324
10.3 Estimation in the Presence of “High”
but “Imperfect” Multicollinearity 325
10.4 Multicollinearity: Much Ado about Nothing?
Theoretical Consequences
of Multicollinearity 326
10.5 Practical Consequences
of Multicollinearity 327
277 Large Variances and Covariances
of OLS Estimators 328
Wider Confidence Intervals 330
“Insignificant” t Ratios 330
281 A High R2 but Few Significant t Ratios 331
Sensitivity of OLS Estimators and Their
Standard Errors to Small Changes in Data 331
Consequences of Micronumerosity 332
10.6 An Illustrative Example 332
10.7 Detection of Multicollinearity 337
10.8 Remedial Measures 342
Do Nothing 342
Rule-of-Thumb Procedures 342
10.9 Is Multicollinearity Necessarily Bad? Maybe
Not, If the Objective Is Prediction Only 347
10.10 An Extended Example: The Longley
Data 347
Summary and Conclusions 350
Exercises 351
CHAPTER 11
Heteroscedasticity: What Happens If
the Error Variance Is Nonconstant? 365
11.1 The Nature of Heteroscedasticity 365
11.2 OLS Estimation in the Presence
of Heteroscedasticity 370
11.3 The Method of Generalized Least
Squares (GLS) 371
Difference between OLS and GLS 373
11.4 Consequences of Using OLS in the Presence
of Heteroscedasticity 374
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OLS Estimation Allowing for 12.7 What to Do When You Find Autocorrelation:
Heteroscedasticity 374 Remedial Measures 440
OLS Estimation Disregarding 12.8 Model Mis-Specification versus Pure
Heteroscedasticity 374 Autocorrelation 441
A Technical Note 376 12.9 Correcting for (Pure) Autocorrelation:
11.5 Detection of Heteroscedasticity 376 The Method of Generalized Least
Informal Methods 376 Squares (GLS) 442
Formal Methods 378 When ρ Is Known 442
11.6 Remedial Measures 389 When ρ Is Not Known 443
When σ 2i Is Known: The Method of Weighted 12.10 The Newey–West Method of Correcting
Least Squares 389 the OLS Standard Errors 447
When σ 2i Is Not Known 391 12.11 OLS versus FGLS and HAC 448
11.7 Concluding Examples 395 12.12 Additional Aspects of Autocorrelation 449
11.8 A Caution about Overreacting Dummy Variables and Autocorrelation 449
to Heteroscedasticity 400 ARCH and GARCH Models 449
Summary and Conclusions 400 Coexistence of Autocorrelation
Exercises 401 and Heteroscedasticity 450
Appendix 11A 409 12.13 A Concluding Example 450
11A.1 Proof of Equation (11.2.2) 409 Summary and Conclusions 452
11A.2 The Method of Weighted Least Exercises 453
Squares 409 Appendix 12A 466
11A.3 Proof that E(σ̂ 2 ) σ2 in the Presence 12A.1 Proof that the Error Term vt in
of Heteroscedasticity 410 Equation (12.1.11) Is Autocorrelated 466
11A.4 White’s Robust Standard Errors 411 12A.2 Proof of Equations (12.2.3), (12.2.4),
and (12.2.5) 466
CHAPTER 12
Autocorrelation: What Happens If the Error CHAPTER 13
Terms Are Correlated? 412 Econometric Modeling: Model Specification
and Diagnostic Testing 467
12.1 The Nature of the Problem 413
12.2 OLS Estimation in the Presence 13.1 Model Selection Criteria 468
of Autocorrelation 418 13.2 Types of Specification Errors 468
12.3 The BLUE Estimator in the Presence 13.3 Consequences of Model Specification
of Autocorrelation 422 Errors 470
12.4 Consequences of Using OLS Underfitting a Model (Omitting a Relevant
in the Presence of Autocorrelation 423 Variable) 471
OLS Estimation Allowing Inclusion of an Irrelevant Variable
for Autocorrelation 423 (Overfitting a Model) 473
OLS Estimation Disregarding 13.4 Tests of Specification Errors 474
Autocorrelation 423 Detecting the Presence of Unnecessary Variables
12.5 Relationship between Wages and Productivity (Overfitting a Model) 475
in the Business Sector of the United States, Tests for Omitted Variables and Incorrect
1960–2005 428 Functional Form 477
12.6 Detecting Autocorrelation 429 13.5 Errors of Measurement 482
I. Graphical Method 429 Errors of Measurement in the Dependent
II. The Runs Test 431 Variable Y 482
III. Durbin–Watson d Test 434 Errors of Measurement in the Explanatory
IV. A General Test of Autocorrelation: Variable X 483
The Breusch–Godfrey (BG) Test 438 13.6 Incorrect Specification of the Stochastic
Why So Many Tests of Autocorrelation? 440 Error Term 486
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13.7 Nested versus Non-Nested Models 487
13.8 Tests of Non-Nested Hypotheses 488
The Discrimination Approach 488
The Discerning Approach 488
13.9 Model Selection Criteria 493
The R2 Criterion 493
Adjusted R2 493
Akaike’s Information Criterion (AIC) 494
Schwarz’s Information Criterion (SIC) 494
Mallows’s Cp Criterion 494
A Word of Caution about Model
Selection Criteria 495
Forecast Chi-Square (χ2) 496
13.10 Additional Topics in Econometric
Modeling 496
Outliers, Leverage, and Influence 496
Recursive Least Squares 498
Chow’s Prediction Failure Test 498
Missing Data 499
13.11 Concluding Examples 500
1. A Model of Hourly Wage Determination 500
2. Real Consumption Function for the United
States, 1947–2000 505
13.12 Non-Normal Errors and Stochastic
Regressors 509
1. What Happens If the Error Term Is Not
Normally Distributed? 509
2. Stochastic Explanatory Variables 510
13.13 A Word to the Practitioner 511
Summary and Conclusions 512
Exercises 513
Appendix 13A 519
13A.1 The Proof that E(b1 2) = β2 + β3b3 2
[Equation (13.3.3)] 519
13A.2 The Consequences of Including an Irrelevant
Variable: The Unbiasedness Property 520
13A.3 The Proof of Equation (13.5.10) 521
13A.4 The Proof of Equation (13.6.2) 522
PART THREE
TOPICS IN ECONOMETRICS 523
CHAPTER 14
Nonlinear Regression Models 525
14.1 Intrinsically Linear and Intrinsically
Nonlinear Regression Models 525
14.2 Estimation of Linear and Nonlinear
Regression Models 527
Contents xi
14.3 Estimating Nonlinear Regression Models:
The Trial-and-Error Method 527
14.4 Approaches to Estimating Nonlinear
Regression Models 529
Direct Search or Trial-and-Error
or Derivative-Free Method 529
Direct Optimization 529
Iterative Linearization Method 530
14.5 Illustrative Examples 530
Summary and Conclusions 535
Exercises 535
Appendix 14A 537
14A.1 Derivation of Equations (14.2.4)
and (14.2.5) 537
14A.2 The Linearization Method 537
14A.3 Linear Approximation of the Exponential
Function Given in Equation (14.2.2) 538
CHAPTER 15
Qualitative Response Regression Models 541
15.1 The Nature of Qualitative Response
Models 541
15.2 The Linear Probability Model (LPM) 543
Non-Normality of the Disturbances ui 544
Heteroscedastic Variances
of the Disturbances 544
Nonfulfillment of 0 ≤ E(Yi | Xi) ≤ 1 545
Questionable Value of R2 as a Measure
of Goodness of Fit 546
15.3 Applications of LPM 549
15.4 Alternatives to LPM 552
15.5 The Logit Model 553
15.6 Estimation of the Logit Model 555
Data at the Individual Level 556
Grouped or Replicated Data 556
15.7 The Grouped Logit (Glogit) Model: A
Numerical Example 558
Interpretation of the Estimated Logit
Model 558
15.8 The Logit Model for Ungrouped
or Individual Data 561
15.9 The Probit Model 566
Probit Estimation with Grouped
Data: gprobit 567
The Probit Model for Ungrouped
or Individual Data 570
The Marginal Effect of a Unit Change
in the Value of a Regressor in the Various
Regression Models 571
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15.10 Logit and Probit Models 571 17.3 Estimation of Distributed-Lag Models 623
15.11 The Tobit Model 574 Ad Hoc Estimation of Distributed-Lag
Illustration of the Tobit Model: Ray Fair’s Model Models 623
of Extramarital Affairs 575 17.4 The Koyck Approach to Distributed-Lag
15.12 Modeling Count Data: The Poisson Models 624
Regression Model 576 The Median Lag 627
15.13 Further Topics in Qualitative Response The Mean Lag 627
Regression Models 579 17.5 Rationalization of the Koyck Model: The
Ordinal Logit and Probit Models 580 Adaptive Expectations Model 629
Multinomial Logit and Probit Models 580 17.6 Another Rationalization of the Koyck Model:
Duration Models 580 The Stock Adjustment, or Partial Adjustment,
Summary and Conclusions 581 Model 632
Exercises 582 17.7 Combination of Adaptive Expectations
Appendix 15A 589 and Partial Adjustment Models 634
15A.1 Maximum Likelihood Estimation of the Logit 17.8 Estimation of Autoregressive Models 634
and Probit Models for Individual (Ungrouped) 17.9 The Method of Instrumental
Data 589 Variables (IV) 636
17.10 Detecting Autocorrelation in Autoregressive
CHAPTER 16 Models: Durbin h Test 637
17.11 A Numerical Example: The Demand for
Panel Data Regression Models 591
Money in Canada, 1979–I to 1988–IV 639
16.1 Why Panel Data? 592 17.12 Illustrative Examples 642
16.2 Panel Data: An Illustrative Example 593 17.13 The Almon Approach to Distributed-Lag
16.3 Pooled OLS Regression or Constant Models: The Almon or Polynomial Distributed
Coefficients Model 594 Lag (PDL) 645
16.4 The Fixed Effect Least-Squares Dummy 17.14 Causality in Economics: The Granger
Variable (LSDV) Model 596 Causality Test 652
A Caution in the Use of the Fixed Effect The Granger Test 653
LSDV Model 598 A Note on Causality and Exogeneity 657
16.5 The Fixed-Effect Within-Group (WG) Summary and Conclusions 658
Estimator 599 Exercises 659
16.6 The Random Effects Model (REM) 602 Appendix 17A 669
Breusch and Pagan Lagrange 17A.1 The Sargan Test for the Validity
Multiplier Test 605 of Instruments 669
16.7 Properties of Various Estimators 605
16.8 Fixed Effects versus Random Effects Model:
Some Guidelines 606 PART FOUR
16.9 Panel Data Regressions: Some Concluding SIMULTANEOUS-EQUATION
Comments 607 MODELS AND TIME SERIES
16.10 Some Illustrative Examples 607 ECONOMETRICS 671
Summary and Conclusions 612
Exercises 613
CHAPTER 18
Simultaneous-Equation Models 673
CHAPTER 17
Dynamic Econometric Models: Autoregressive 18.1 The Nature of Simultaneous-Equation
and Distributed-Lag Models 617 Models 673
18.2 Examples of Simultaneous-Equation
17.1 The Role of “Time,’’ or “Lag,’’ Models 674
in Economics 618 18.3 The Simultaneous-Equation Bias:
17.2 The Reasons for Lags 622 Inconsistency of OLS Estimators 679
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18.4 The Simultaneous-Equation Bias: A Numerical
Example 682
Summary and Conclusions 684
Exercises 684
CHAPTER 19
The Identification Problem 689
19.1 Notations and Definitions 689
19.2 The Identification Problem 692
Underidentification 692
Just, or Exact, Identification 694
Overidentification 697
19.3 Rules for Identification 699
The Order Condition of Identifiability 699
The Rank Condition of Identifiability 700
19.4 A Test of Simultaneity 703
Hausman Specification Test 703
19.5 Tests for Exogeneity 705
Summary and Conclusions 706
Exercises 706
CHAPTER 20
Simultaneous-Equation Methods 711
20.1 Approaches to Estimation 711
20.2 Recursive Models and Ordinary
Least Squares 712
20.3 Estimation of a Just Identified Equation: The
Method of Indirect Least Squares (ILS) 715
An Illustrative Example 715
Properties of ILS Estimators 718
20.4 Estimation of an Overidentified Equation:
The Method of Two-Stage Least Squares
(2SLS) 718
20.5 2SLS: A Numerical Example 721
20.6 Illustrative Examples 724
Summary and Conclusions 730
Exercises 730
Appendix 20A 735
20A.1 Bias in the Indirect Least-Squares
Estimators 735
20A.2 Estimation of Standard Errors of 2SLS
Estimators 736
CHAPTER 21
Time Series Econometrics:
Some Basic Concepts 737
21.1 A Look at Selected U.S. Economic Time
Series 738
Contents xiii
21.2 Key Concepts 739
21.3 Stochastic Processes 740
Stationary Stochastic Processes 740
Nonstationary Stochastic Processes 741
21.4 Unit Root Stochastic Process 744
21.5 Trend Stationary (TS) and Difference
Stationary (DS) Stochastic Processes 745
21.6 Integrated Stochastic Processes 746
Properties of Integrated Series 747
21.7 The Phenomenon of Spurious
Regression 747
21.8 Tests of Stationarity 748
1. Graphical Analysis 749
2. Autocorrelation Function (ACF)
and Correlogram 749
Statistical Significance of Autocorrelation
Coefficients 753
21.9 The Unit Root Test 754
The Augmented Dickey–Fuller (ADF)
Test 757
Testing the Significance of More than One
Coefficient: The F Test 758
The Phillips–Perron (PP) Unit
Root Tests 758
Testing for Structural Changes 758
A Critique of the Unit Root Tests 759
21.10 Transforming Nonstationary Time Series 760
Difference-Stationary Processes 760
Trend-Stationary Processes 761
21.11 Cointegration: Regression of a Unit
Root Time Series on Another Unit Root
Time Series 762
Testing for Cointegration 763
Cointegration and Error Correction
Mechanism (ECM) 764
21.12 Some Economic Applications 765
Summary and Conclusions 768
Exercises 769
CHAPTER 22
Time Series Econometrics:
Forecasting 773
22.1 Approaches to Economic Forecasting 773
Exponential Smoothing Methods 774
Single-Equation Regression Models 774
Simultaneous-Equation Regression
Models 774
ARIMA Models 774
VAR Models 775
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22.2 AR, MA, and ARIMA Modeling of Time Expected Value 808
Series Data 775 Properties of Expected Values 809
An Autoregressive (AR) Process 775 Variance 810
A Moving Average (MA) Process 776 Properties of Variance 811
An Autoregressive and Moving Average (ARMA) Covariance 811
Process 776 Properties of Covariance 812
An Autoregressive Integrated Moving Correlation Coefficient 812
Average (ARIMA) Process 776 Conditional Expectation and Conditional
22.3 The Box–Jenkins (BJ) Methodology 777 Variance 813
22.4 Identification 778 Properties of Conditional Expectation
22.5 Estimation of the ARIMA Model 782 and Conditional Variance 814
22.6 Diagnostic Checking 782 Higher Moments of Probability
22.7 Forecasting 782 Distributions 815
22.8 Further Aspects of the BJ Methodology 784 A.6 Some Important Theoretical Probability
22.9 Vector Autoregression (VAR) 784 Distributions 816
Estimation or VAR 785 Normal Distribution 816
Forecasting with VAR 786 The χ2 (Chi-Square) Distribution 819
VAR and Causality 787 Student’s t Distribution 820
Some Problems with VAR Modeling 788 The F Distribution 821
An Application of VAR: A VAR Model of the Texas The Bernoulli Binomial Distribution 822
Economy 789 Binomial Distribution 822
22.10 Measuring Volatility in Financial Time Series: The Poisson Distribution 823
The ARCH and GARCH Models 791 A.7 Statistical Inference: Estimation 823
What to Do If ARCH Is Present 795 Point Estimation 823
A Word on the Durbin–Watson d and the ARCH Interval Estimation 824
Effect 796 Methods of Estimation 825
A Note on the GARCH Model 796 Small-Sample Properties 826
22.11 Concluding Examples 796 Large-Sample Properties 828
Summary and Conclusions 798 A.8 Statistical Inference: Hypothesis Testing 831
Exercises 799 The Confidence Interval Approach 832
The Test of Significance Approach 836
References 837
APPENDIX A
A Review of Some Statistical Concepts 801 APPENDIX B
A.1 Summation and Product Operators 801
Rudiments of Matrix Algebra 838
A.2 Sample Space, Sample Points, B.1 Definitions 838
and Events 802 Matrix 838
A.3 Probability and Random Variables 802 Column Vector 838
Probability 802 Row Vector 839
Random Variables 803 Transposition 839
A.4 Probability Density Function (PDF) 803 Submatrix 839
Probability Density Function of a Discrete B.2 Types of Matrices 839
Random Variable 803 Square Matrix 839
Probability Density Function of a Continuous Diagonal Matrix 839
Random Variable 804 Scalar Matrix 840
Joint Probability Density Functions 805 Identity, or Unit, Matrix 840
Marginal Probability Density Function 805 Symmetric Matrix 840
Statistical Independence 806 Null Matrix 840
A.5 Characteristics of Probability Null Vector 840
Distributions 808 Equal Matrices 840
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B.3 Matrix Operations 840
Matrix Addition 840
Matrix Subtraction 841
Scalar Multiplication 841
Matrix Multiplication 841
Properties of Matrix Multiplication
Matrix Transposition 843
Matrix Inversion 843
B.4 Determinants 843
Evaluation of a Determinant 844
Properties of Determinants 844
Rank of a Matrix 845
Minor 846
Cofactor 846
B.5 Finding the Inverse of a Square Matrix 847
B.6 Matrix Differentiation 848
References 848
C.9 Prediction Using Multiple Regression: Matrix
Formulation 861
Mean Prediction 861
Variance of Mean Prediction 862
Individual Prediction 862
842 Variance of Individual Prediction 862
C.10 Summary of the Matrix Approach: An
Illustrative Example 863
C.11 Generalized Least Squares (GLS) 867
C.12 Summary and Conclusions 868
Exercises 869
Appendix CA 874
CA.1 Derivation of k Normal or Simultaneous
Equations 874
CA.2 Matrix Derivation of Normal Equations 875
ˆ 875
CA.3 Variance–Covariance Matrix of 
CA.4 BLUE Property of OLS Estimators 875

APPENDIX C APPENDIX D
The Matrix Approach to Linear Regression Statistical Tables 877
Model 849
C.1 The k-Variable Linear Regression APPENDIX E
Model 849 Computer Output of EViews, MINITAB,
C.2 Assumptions of the Classical Linear Excel, and STATA 894
Regression Model in Matrix Notation 851
C.3 OLS Estimation 853 E.1 EViews 894
An Illustration 855 E.2 MINITAB 896
Variance-Covariance Matrix of β̂ 856 E.3 Excel 897
Properties of OLS Vector β̂ 858 E.4 STATA 898
C.4 The Coefficient of Determination R2 in Matrix E.5 Concluding Comments 898
Notation 858 References 899
C.5 The Correlation Matrix 859
C.6 Hypothesis Testing about Individual APPENDIX F
Regression Coefficients in Matrix Economic Data on the World Wide Web 900
Notation 859
C.7 Testing the Overall Significance of
Regression: Analysis of Variance in Matrix Selected Bibliography 902
Notation 860 Name Index 905
C.8 Testing Linear Restrictions: General F Testing
Using Matrix Notation 861 Subject Index 909
guj75772_fm.qxd 05/09/2008 11:15 AM Page xvi

Preface
Objective of the Book
The first edition of Basic Econometrics was published thirty years ago. Over the years,
there have been important developments in the theory and practice of econometrics. In
each of the subsequent editions, I have tried to incorporate the major developments in the
field. The fifth edition continues that tradition.
What has not changed, however, over all these years is my firm belief that econometrics
can be taught to the beginner in an intuitive and informative way without resorting to
matrix algebra, calculus, or statistics beyond the introductory level. Some subject material
is inherently technical. In that case I have put the material in the appropriate appendix or
refer the reader to the appropriate sources. Even then, I have tried to simplify the technical
material so that the reader can get an intuitive understanding of this material.
I am pleasantly surprised not only by the longevity of this book but also by the fact that
the book is widely used not only by students of economics and finance but also by students
and researchers in the fields of politics, international relations, agriculture, and health
sciences. All these students will find the new edition with its expanded topics and concrete
applications very useful. In this edition I have paid even more attention to the relevance and
timeliness of the real data used in the text. In fact, I have added about fifteen new illustra-
tive examples and more than thirty new end-of-chapter exercises. Also, I have updated
the data for about two dozen of the previous edition’s examples and more than twenty
exercises.
Although I am in the eighth decade of my life, I have not lost my love for econometrics,
and I strive to keep up with the major developments in the field. To assist me in this
endeavor, I am now happy to have Dr. Dawn Porter, Assistant Professor of Statistics at the
Marshall School of Business at the University of Southern California in Los Angeles, as
my co-author. Both of us have been deeply involved in bringing the fifth edition of Basic
Econometrics to fruition.

Major Features of the Fifth Edition

Before discussing the specific changes in the various chapters, the following features of the
new edition are worth noting:
1. Practically all of the data used in the illustrative examples have been updated.
2. Several new examples have been added.
3. In several chapters, we have included extended concluding examples that illustrate the
various points made in the text.
4. Concrete computer printouts of several examples are included in the book. Most of these
results are based on EViews (version 6) and STATA (version 10), as well as MINITAB
(version 15).
5. Several new diagrams and graphs are included in various chapters.
6. Several new data-based exercises are included in the various chapters.
7. Small-sized data are included in the book, but large sample data are posted on the book’s
website, thereby minimizing the size of the text. The website will also publish all of the
data used in the book and will be periodically updated.
xvi
guj75772_fm.qxd 05/09/2008 11:15 AM Page xvii

Preface xvii

8. In a few chapters, we have included class exercises in which students are encouraged to
obtain their own data and implement the various techniques discussed in the book. Some
Monte Carlo simulations are also included in the book.

Specific Changes to the Fifth Edition

Some chapter-specific changes are as follows:
1. The assumptions underlying the classical linear regression model (CLRM) introduced
in Chapter 3 now make a careful distinction between fixed regressors (explanatory
variables) and random regressors. We discuss the importance of the distinction.
2. The appendix to Chapter 6 discusses the properties of logarithms, the Box-Cox trans-
formations, and various growth formulas.
3. Chapter 7 now discusses not only the marginal impact of a single regressor on the
dependent variable but also the impacts of simultaneous changes of all the explanatory
variables on the dependent variable. This chapter has also been reorganized in the same
structure as the assumptions from Chapter 3.
4. A comparison of the various tests of heteroscedasticity is given in Chapter 11.
5. There is a new discussion of the impact of structural breaks on autocorrelation in
Chapter 12.
6. New topics included in Chapter 13 are missing data, non-normal error term, and
stochastic, or random, regressors.
7. A non-linear regression model discussed in Chapter 14 has a concrete application of
the Box-Cox transformation.
8. Chapter 15 contains several new examples that illustrate the use of logit and probit
models in various fields.
9. Chapter 16 on panel data regression models has been thoroughly revised and illus-
trated with several applications.
10. An extended discussion of Sims and Granger causality tests is now included in Chap-
ter 17.
11. Stationary and non-stationary time series, as well as some of the problems associated
with various tests of stationarity, are now thoroughly discussed in Chapter 21.
12. Chapter 22 includes a discussion on why taking the first differences of a time series
for the purpose of making it stationary may not be the appropriate strategy in some
situations.
Besides these specific changes, errors and misprints in the previous editions have been cor-
rected and the discussions of several topics in the various chapters have been streamlined.

Organization and Options

The extensive coverage in this edition gives the instructor substantial flexibility in choos-
ing topics that are appropriate to the intended audience. Here are suggestions about how
this book may be used.
One-semester course for the nonspecialist: Appendix A, Chapters 1 through 9, an
overview of Chapters 10, 11, 12 (omitting all the proofs).
One-semester course for economics majors: Appendix A, Chapters 1 through 13.
guj75772_fm.qxd 05/09/2008 11:15 AM Page xviii

xviii Preface

Two-semester course for economics majors: Appendices A, B, C, Chapters 1 to 22.

Chapters 14 and 16 may be covered on an optional basis. Some of the technical appen-
dices may be omitted.
Graduate and postgraduate students and researchers: This book is a handy refer-
ence book on the major themes in econometrics.

Supplements
A comprehensive website contains the following supplementary material:
–Data from the text, as well as additional large set data referenced in the book; the data
will be periodically updated by the authors.
–A Solutions Manual, written by Dawn Porter, providing answers to all of the
questions and problems throughout the text.
–A digital image library containing all of the graphs and figures from the text.
For more information, please go to www.mhhe.com/gujarati5e
guj75772_fm.qxd 05/09/2008 11:15 AM Page xix

Acknowledgments
Since the publication of the first edition of this book in 1978, we have received valuable
advice, comments, criticism, and suggestions from a variety of people. In particular, we
would like to acknowledge the help we have received from Michael McAleer of the
University of Western Australia, Peter Kennedy of Simon Frazer University in Canada,
Kenneth White, of the University of British Columbia, George K. Zestos, of Christopher
Newport University, Virginia, and Paul Offner, of Georgetown University, Washington, D.C.
We are also grateful to several people who have influenced us by their scholarship. We
especially want to thank Arthur Goldberger of the University of Wisconsin, William
Greene of New York University, and the late G. S. Maddala. We continue to be grateful to
the following reviewers who provided valuable insight, criticism, and suggestions for
previous editions of this text: Michael A. Grove at the University of Oregon, Harumi Ito
at Brown University, Han Kim at South Dakota University, Phanindra V. Wunnava at
Middlebury College, and Andrew Paizis of the City University of New York.
Several authors have influenced the writing of this text. In particular, we are grateful to
these authors: Chandan Mukherjee, director of the Centre for Development Studies,
Trivandrum, India; Howard White and Marc Wuyts, both at the Institute of Social Studies
in the Netherlands; Badi H. Baltagi, Texas A&M University; B. Bhaskara Rao, University
of New South Wales, Australia; R. Carter Hill, Louisiana University; William E. Griffiths,
University of New England; George G. Judge, University of California at Berkeley; Marno
Verbeek, Center for Economic Studies, KU Leuven; Jeffrey Wooldridge, Michigan State
University; Kerry Patterson, University of Reading, U.K.; Francis X. Diebold, Wharton
School, University of Pennsylvania; Wojciech W. Charemza and Derek F. Deadman, both of
the University of Leicester, U.K.; and Gary Koop, University of Glasgow.
A number of very valuable comments and suggestions given by reviewers of the fourth
edition have greatly improved this edition. We would like to thank the following:
Valerie Bencivenga Gary Krueger
University of Texas–Austin Macalester College
Andrew Economopoulos Subal Kumbhakar
Ursinus College Binghamton University
Eric Eide Tae-Hwy Lee
Brigham Young University University of California–Riverside
Gary Ferrier Solaiman Miah
University of Arkansas–Fayetteville West Virginia State University
David Garman Fabio Milani
Tufts University University of California–Irvine
David Harris Helen Naughton
Benedictine College University of Oregon
Don Holley Solomon Smith
Boise State University Langston University
George Jakubson Kay Strong
Cornell University Bowling Green State University
Bruce Johnson Derek Tittle
Centre College of Kentucky Georgia Institute of Technology
Duke Kao Tiemen Woutersen
Syracuse University Johns Hopkins University
xix
guj75772_fm.qxd 05/09/2008 11:15 AM Page xx

xx Acknowledgments

We would like to thank students and teachers all over the world who have not only used
this book but have communicated with us about various aspects of the book.
For their behind-the-scenes help at McGraw-Hill, we are grateful to Douglas Reiner,
Noelle Fox, and Anne Hilbert.
Finally, but not least important, Dr. Gujarati would like to thank his daughters, Joan and
Diane, for their constant support and encouragement in the preparation of this and the pre-
vious editions.
Damodar N. Gujarati
Dawn C. Porter
guj75772_intro.qxd 23/08/2008 10:29 AM Page 1

Introduction
I.1 What Is Econometrics?
Literally interpreted, econometrics means “economic measurement.” Although measure-
ment is an important part of econometrics, the scope of econometrics is much broader, as
can be seen from the following quotations:
Econometrics, the result of a certain outlook on the role of economics, consists of the applica-
tion of mathematical statistics to economic data to lend empirical support to the models
constructed by mathematical economics and to obtain numerical results.1

. . . econometrics may be defined as the quantitative analysis of actual economic phenomena

based on the concurrent development of theory and observation, related by appropriate
methods of inference.2

Econometrics may be defined as the social science in which the tools of economic theory,
mathematics, and statistical inference are applied to the analysis of economic phenomena.3

Econometrics is concerned with the empirical determination of economic laws.4

The art of the econometrician consists in finding the set of assumptions that are both suffi-
ciently specific and sufficiently realistic to allow him to take the best possible advantage of the
data available to him.5
Econometricians . . . are a positive help in trying to dispel the poor public image of economics
(quantitative or otherwise) as a subject in which empty boxes are opened by assuming the
existence of can-openers to reveal contents which any ten economists will interpret in
11 ways.6
The method of econometric research aims, essentially, at a conjunction of economic theory
and actual measurements, using the theory and technique of statistical inference as a bridge
pier.7

1
Gerhard Tintner, Methodology of Mathematical Economics and Econometrics, The University of Chicago
Press, Chicago, 1968, p. 74.
2
P. A. Samuelson, T. C. Koopmans, and J. R. N. Stone, “Report of the Evaluative Committee for Econo-
metrica,” Econometrica, vol. 22, no. 2, April 1954, pp. 141–146.
3
Arthur S. Goldberger, Econometric Theory, John Wiley & Sons, New York, 1964, p. 1.
4
H. Theil, Principles of Econometrics, John Wiley & Sons, New York, 1971, p. 1.
5
E. Malinvaud, Statistical Methods of Econometrics, Rand McNally, Chicago, 1966, p. 514.
6
Adrian C. Darnell and J. Lynne Evans, The Limits of Econometrics, Edward Elgar Publishing, Hants,
England, 1990, p. 54.
7
T. Haavelmo, “The Probability Approach in Econometrics,” Supplement to Econometrica, vol. 12,
1944, preface p. iii.

1
guj75772_intro.qxd 23/08/2008 10:29 AM Page 2

2 Basic Econometrics

I.2 Why a Separate Discipline?

As the preceding definitions suggest, econometrics is an amalgam of economic theory,
mathematical economics, economic statistics, and mathematical statistics. Yet the subject
deserves to be studied in its own right for the following reasons.
Economic theory makes statements or hypotheses that are mostly qualitative in nature.
For example, microeconomic theory states that, other things remaining the same, a reduc-
tion in the price of a commodity is expected to increase the quantity demanded of that com-
modity. Thus, economic theory postulates a negative or inverse relationship between the
price and quantity demanded of a commodity. But the theory itself does not provide any
numerical measure of the relationship between the two; that is, it does not tell by how much
the quantity will go up or down as a result of a certain change in the price of the commod-
ity. It is the job of the econometrician to provide such numerical estimates. Stated differ-
ently, econometrics gives empirical content to most economic theory.
The main concern of mathematical economics is to express economic theory in mathe-
matical form (equations) without regard to measurability or empirical verification of the
theory. Econometrics, as noted previously, is mainly interested in the empirical verification
of economic theory. As we shall see, the econometrician often uses the mathematical
equations proposed by the mathematical economist but puts these equations in such a form
that they lend themselves to empirical testing. And this conversion of mathematical into
econometric equations requires a great deal of ingenuity and practical skill.
Economic statistics is mainly concerned with collecting, processing, and presenting
economic data in the form of charts and tables. These are the jobs of the economic statisti-
cian. It is he or she who is primarily responsible for collecting data on gross national
product (GNP), employment, unemployment, prices, and so on. The data thus collected
constitute the raw data for econometric work. But the economic statistician does not go any
further, not being concerned with using the collected data to test economic theories. Of
course, one who does that becomes an econometrician.
Although mathematical statistics provides many tools used in the trade, the econometri-
cian often needs special methods in view of the unique nature of most economic data,
namely, that the data are not generated as the result of a controlled experiment. The econo-
metrician, like the meteorologist, generally depends on data that cannot be controlled
directly. As Spanos correctly observes:
In econometrics the modeler is often faced with observational as opposed to experimental
data. This has two important implications for empirical modeling in econometrics. First, the
modeler is required to master very different skills than those needed for analyzing experimen-
tal data. . . . Second, the separation of the data collector and the data analyst requires the mod-
eler to familiarize himself/herself thoroughly with the nature and structure of data in question.8

I.3 Methodology of Econometrics

How do econometricians proceed in their analysis of an economic problem? That is, what
is their methodology? Although there are several schools of thought on econometric
methodology, we present here the traditional or classical methodology, which still domi-
nates empirical research in economics and other social and behavioral sciences.9

8
Aris Spanos, Probability Theory and Statistical Inference: Econometric Modeling with Observational Data,
Cambridge University Press, United Kingdom, 1999, p. 21.
9
For an enlightening, if advanced, discussion on econometric methodology, see David F. Hendry,
Dynamic Econometrics, Oxford University Press, New York, 1995. See also Aris Spanos, op. cit.
guj75772_intro.qxd 23/08/2008 10:29 AM Page 3

Introduction 3

Broadly speaking, traditional econometric methodology proceeds along the following

lines:
1. Statement of theory or hypothesis.
2. Specification of the mathematical model of the theory.
3. Specification of the statistical, or econometric, model.
4. Obtaining the data.
5. Estimation of the parameters of the econometric model.
6. Hypothesis testing.
7. Forecasting or prediction.
8. Using the model for control or policy purposes.
To illustrate the preceding steps, let us consider the well-known Keynesian theory of
consumption.

1. Statement of Theory or Hypothesis

Keynes stated:
The fundamental psychological law . . . is that men [women] are disposed, as a rule and on
average, to increase their consumption as their income increases, but not as much as the
increase in their income.10
In short, Keynes postulated that the marginal propensity to consume (MPC), the rate of
change of consumption for a unit (say, a dollar) change in income, is greater than zero but
less than 1.

2. Specification of the Mathematical Model of Consumption

Although Keynes postulated a positive relationship between consumption and income,
he did not specify the precise form of the functional relationship between the two. For
simplicity, a mathematical economist might suggest the following form of the Keynesian
consumption function:

Y = β1 + β2 X 0 < β2 < 1 (I.3.1)

where Y = consumption expenditure and X = income, and where β1 and β2 , known as the
parameters of the model, are, respectively, the intercept and slope coefficients.
The slope coefficient β2 measures the MPC. Geometrically, Equation I.3.1 is as shown
in Figure I.1. This equation, which states that consumption is linearly related to income, is
an example of a mathematical model of the relationship between consumption and income
that is called the consumption function in economics. A model is simply a set of mathe-
matical equations. If the model has only one equation, as in the preceding example, it is
called a single-equation model, whereas if it has more than one equation, it is known as a
multiple-equation model (the latter will be considered later in the book).
In Eq. (I.3.1) the variable appearing on the left side of the equality sign is called the
dependent variable and the variable(s) on the right side is called the independent, or
explanatory, variable(s). Thus, in the Keynesian consumption function, Eq. (I.3.1), con-
sumption (expenditure) is the dependent variable and income is the explanatory variable.

10
John Maynard Keynes, The General Theory of Employment, Interest and Money, Harcourt Brace
Jovanovich, New York, 1936, p. 96.
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