Creel Eco No Metrics 2008

E
onometri s
Version 0.92, Jan 2008
January 18, 2008
Dept. of E onomi s and E onomi History, Universitat Autnoma de Bar elona, mi hael. reeluab.es,
http://pareto.uab.es/m reel
Contents
15
1 About this do ument

1.1
Li enses
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
15
1.2
Obtaining the materials
. . . . . . . . . . . . . . . . . . . . . . . . . . . . .
15
1.3
An easy way to use LYX and O tave today . . . . . . . . . . . . . . . . . . .
16
2 Introdu tion: E onomi and e onometri models
19
3 Ordinary Least Squares
21
3.1
The Linear Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
21
3.2
Estimation by least squares
22
3.3
Geometri interpretation of least squares estimation
X, Y
. . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . .
24
3.3.1
In
Spa e . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
24
3.3.2
In Observation Spa e . . . . . . . . . . . . . . . . . . . . . . . . . . .
24
3.3.3
Proje tion Matri es
. . . . . . . . . . . . . . . . . . . . . . . . . . .
25
3.4
Inuential observations and outliers . . . . . . . . . . . . . . . . . . . . . . .
26
3.5
Goodness of t
28
3.6
The lassi al linear regression model
3.7
Small sample statisti al properties of the least squares estimator
3.8
3.9
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . .
. . . . . .
31
3.7.1
Unbiasedness
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
31
3.7.2
Normality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
32
3.7.3
The varian e of the OLS estimator and the Gauss-Markov theorem .
33
Example: The Nerlove model
. . . . . . . . . . . . . . . . . . . . . . . . . .
35
3.8.1
Theoreti al ba kground
. . . . . . . . . . . . . . . . . . . . . . . . .
35
3.8.2
Cobb-Douglas fun tional form . . . . . . . . . . . . . . . . . . . . . .
36
3.8.3
The Nerlove data and OLS
. . . . . . . . . . . . . . . . . . . . . . .
37
Exer ises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
39
4 Maximum likelihood estimation

4.1
29
41
The likelihood fun tion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
41
4.1.1
42
Example: Bernoulli trial . . . . . . . . . . . . . . . . . . . . . . . . .
4.2
Consisten y of MLE
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
43
4.3
The s ore fun tion
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
45
4.4
Asymptoti normality of MLE . . . . . . . . . . . . . . . . . . . . . . . . . .
46
4.4.1
48
Coin ipping, again . . . . . . . . . . . . . . . . . . . . . . . . . . . .
4.5
The information matrix equality
. . . . . . . . . . . . . . . . . . . . . . . .
49
4.6
The Cramr-Rao lower bound . . . . . . . . . . . . . . . . . . . . . . . . . .
50
CONTENTS
4.7
Exer ises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
5 Asymptoti properties of the least squares estimator
52
53
5.1
Consisten y . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
53
5.2
Asymptoti normality
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
54
5.3
Asymptoti e ien y . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
55
5.4
Exer ises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
55
6 Restri tions and hypothesis tests

6.1
. . . . . . . . . . . . . . . . . . . . . . . . . . . . .
57
6.1.1
Imposition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
57
6.1.2
Properties of the restri ted estimator . . . . . . . . . . . . . . . . . .
60
Testing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
60
6.2.1
t-test . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
60
6.2.2
test . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
63
6.2.3
Wald-type tests . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
63
6.2.4
S ore-type tests (Rao tests, Lagrange multiplier tests)
. . . . . . . .
64
6.2.5
Likelihood ratio-type tests . . . . . . . . . . . . . . . . . . . . . . . .
65
6.3
The asymptoti equivalen e of the LR, Wald and s ore tests . . . . . . . . .
66
6.4
Interpretation of test statisti s
. . . . . . . . . . . . . . . . . . . . . . . . .
69
6.5
Conden e intervals
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
69
6.6
Bootstrapping . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
70
6.7
Testing nonlinear restri tions, and the Delta Method . . . . . . . . . . . . .
71
6.8
Example: the Nerlove data
. . . . . . . . . . . . . . . . . . . . . . . . . . .
74
6.9
Exer ises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
76
6.2
Exa t linear restri tions
57
7 Generalized least squares
79
7.1
Ee ts of nonspheri al disturban es on the OLS estimator . . . . . . . . . .
80
7.2
The GLS estimator . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
81
7.3
Feasible GLS
83
7.4
Heteros edasti ity
7.5
7.6
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
7.4.1
OLS with heteros edasti onsistent var ov estimation
7.4.2
Dete tion
84
. . . . . . . .
84
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
85
7.4.3
Corre tion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
86
7.4.4
Example: the Nerlove model (again!) . . . . . . . . . . . . . . . . . .
88
Auto orrelation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
91
7.5.1
Causes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
92
7.5.2
Ee ts on the OLS estimator
. . . . . . . . . . . . . . . . . . . . . .
92
7.5.3
AR(1) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
93
7.5.4
MA(1) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
95
7.5.5
Asymptoti ally valid inferen es with auto orrelation of unknown form 97
7.5.6
Testing for auto orrelation . . . . . . . . . . . . . . . . . . . . . . . .
7.5.7
Lagged dependent variables and auto orrelation . . . . . . . . . . . . 101
7.5.8
Examples
99
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101
Exer ises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104
CONTENTS
107
8 Sto hasti regressors

8.1
Case 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108
8.2
Case 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108
8.3
Case 3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109
8.4
When are the assumptions reasonable? . . . . . . . . . . . . . . . . . . . . . 110
8.5
Exer ises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111
9 Data problems
9.1
9.2
9.3
9.4
Collinearity
113
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113
9.1.1
A brief aside on dummy variables . . . . . . . . . . . . . . . . . . . . 114
9.1.2
Ba k to ollinearity . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114
9.1.3
Dete tion of ollinearity
9.1.4
Dealing with ollinearity . . . . . . . . . . . . . . . . . . . . . . . . . 117
Measurement error
. . . . . . . . . . . . . . . . . . . . . . . . . 116
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119
9.2.1
Error of measurement of the dependent variable . . . . . . . . . . . . 119
9.2.2
Error of measurement of the regressors . . . . . . . . . . . . . . . . . 120
Missing observations
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121
9.3.1
Missing observations on the dependent variable . . . . . . . . . . . . 121
9.3.2
The sample sele tion problem . . . . . . . . . . . . . . . . . . . . . . 123
9.3.3
Missing observations on the regressors
. . . . . . . . . . . . . . . . . 123
Exer ises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124
10 Fun tional form and nonnested tests
127
10.1 Flexible fun tional forms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128

10.1.1 The translog form
. . . . . . . . . . . . . . . . . . . . . . . . . . . . 129
10.1.2 FGLS estimation of a translog model . . . . . . . . . . . . . . . . . . 132

10.2 Testing nonnested hypotheses . . . . . . . . . . . . . . . . . . . . . . . . . . 134
11 Exogeneity and simultaneity

11.1 Simultaneous equations
11.2 Exogeneity
137
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 139
11.3 Redu ed form . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140

11.4 IV estimation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 142
11.5 Identi ation by ex lusion restri tions
. . . . . . . . . . . . . . . . . . . . . 146
11.5.1 Ne essary onditions . . . . . . . . . . . . . . . . . . . . . . . . . . . 146

11.5.2 Su ient onditions
. . . . . . . . . . . . . . . . . . . . . . . . . . . 148
11.5.3 Example: Klein's Model 1 . . . . . . . . . . . . . . . . . . . . . . . . 152

11.6 2SLS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153
11.7 Testing the overidentifying restri tions . . . . . . . . . . . . . . . . . . . . . 155
11.8 System methods of estimation . . . . . . . . . . . . . . . . . . . . . . . . . . 159
11.8.1 3SLS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159
11.8.2 FIML
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 163
11.9 Example: 2SLS and Klein's Model 1
12 Introdu tion to the se ond half
. . . . . . . . . . . . . . . . . . . . . . 164
167
CONTENTS
173
13 Numeri optimization methods
13.1 Sear h . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 173

13.2 Derivative-based methods
. . . . . . . . . . . . . . . . . . . . . . . . . . . . 174
13.2.1 Introdu tion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174

13.2.2 Steepest des ent
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175
13.2.3 Newton-Raphson . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175

13.3 Simulated Annealing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178
13.4 Examples
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178
13.4.1 Dis rete Choi e: The logit model . . . . . . . . . . . . . . . . . . . . 179

13.4.2 Count Data: The Poisson model
. . . . . . . . . . . . . . . . . . . . 180
13.4.3 Duration data and the Weibull model
. . . . . . . . . . . . . . . . . 181
13.5 Numeri optimization: pitfalls . . . . . . . . . . . . . . . . . . . . . . . . . . 184

13.5.1 Poor s aling of the data
13.5.2 Multiple optima
. . . . . . . . . . . . . . . . . . . . . . . . . 184
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 185
14 Asymptoti properties of extremum estimators
189
14.1 Extremum estimators . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 189

14.2 Consisten y . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 189
14.3 Example: Consisten y of Least Squares . . . . . . . . . . . . . . . . . . . . . 193
14.4 Asymptoti Normality
14.5 Examples
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 194
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 195
14.5.1 Coin ipping, yet again
. . . . . . . . . . . . . . . . . . . . . . . . . 195
14.5.2 Binary response models
. . . . . . . . . . . . . . . . . . . . . . . . . 196
14.5.3 Example: Linearization of a nonlinear model
15 Generalized method of moments (GMM)

15.1 Denition
. . . . . . . . . . . . . 199
203
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203
15.2 Consisten y . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 205

15.3 Asymptoti normality
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 205
15.4 Choosing the weighting matrix
. . . . . . . . . . . . . . . . . . . . . . . . . 207
15.5 Estimation of the varian e- ovarian e matrix
. . . . . . . . . . . . . . . . . 208
15.5.1 Newey-West ovarian e estimator . . . . . . . . . . . . . . . . . . . . 210

15.6 Estimation using onditional moments
. . . . . . . . . . . . . . . . . . . . . 210
15.7 Estimation using dynami moment onditions . . . . . . . . . . . . . . . . . 213

15.8 A spe i ation test . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 214
15.9 Other estimators interpreted as GMM estimators . . . . . . . . . . . . . . . 215
15.9.1 OLS with heteros edasti ity of unknown form . . . . . . . . . . . . . 215
15.9.2 Weighted Least Squares
. . . . . . . . . . . . . . . . . . . . . . . . . 217
15.9.3 2SLS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 217

15.9.4 Nonlinear simultaneous equations . . . . . . . . . . . . . . . . . . . . 218
15.9.5 Maximum likelihood
. . . . . . . . . . . . . . . . . . . . . . . . . . . 219
15.10Example: The Hausman Test
. . . . . . . . . . . . . . . . . . . . . . . . . . 221
15.11Appli ation: Nonlinear rational expe tations . . . . . . . . . . . . . . . . . . 226

15.12Empiri al example: a portfolio model . . . . . . . . . . . . . . . . . . . . . . 228
CONTENTS
231
16 Quasi-ML
16.1 Consistent Estimation of Varian e Components
. . . . . . . . . . . . . . . . 232
16.2 Example: the MEPS Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . 234

16.2.1 Innite mixture models: the negative binomial model . . . . . . . . . 234
16.2.2 Finite mixture models: the mixed negative binomial model
. . . . . 238
16.2.3 Information riteria . . . . . . . . . . . . . . . . . . . . . . . . . . . . 240
17 Nonlinear least squares (NLS)

17.1 Introdu tion and denition
17.2 Identi ation
243
. . . . . . . . . . . . . . . . . . . . . . . . . . . 243
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 244
17.3 Consisten y . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 245

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 246
17.5 Example: The Poisson model for ount data . . . . . . . . . . . . . . . . . . 247

17.6 The Gauss-Newton algorithm
. . . . . . . . . . . . . . . . . . . . . . . . . . 248
17.7 Appli ation: Limited dependent variables and sample sele tion
17.7.1 Example: Labor Supply
. . . . . . . 249
. . . . . . . . . . . . . . . . . . . . . . . . . 249
18 Nonparametri inferen e
253
18.1 Possible pitfalls of parametri inferen e: estimation . . . . . . . . . . . . . . 253

18.2 Possible pitfalls of parametri inferen e: hypothesis testing . . . . . . . . . . 257
18.3 The Fourier fun tional form . . . . . . . . . . . . . . . . . . . . . . . . . . . 257
18.3.1 Sobolev norm . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 260
18.3.2 Compa tness
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 260
18.3.3 The estimation spa e and the estimation subspa e
. . . . . . . . . . 261
18.3.4 Denseness . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 261

18.3.5 Uniform onvergen e . . . . . . . . . . . . . . . . . . . . . . . . . . . 262
18.3.6 Identi ation
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 263
18.3.7 Review of on epts . . . . . . . . . . . . . . . . . . . . . . . . . . . . 263

18.3.8 Dis ussion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 263
18.4 Kernel regression estimators . . . . . . . . . . . . . . . . . . . . . . . . . . . 264
18.4.1 Estimation of the denominator
18.4.2 Estimation of the numerator
. . . . . . . . . . . . . . . . . . . . . 265
. . . . . . . . . . . . . . . . . . . . . . 267
18.4.3 Dis ussion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 267

18.4.4 Choi e of the window width: Cross-validation
18.5 Kernel density estimation
. . . . . . . . . . . . . 268
. . . . . . . . . . . . . . . . . . . . . . . . . . . . 268
18.6 Semi-nonparametri maximum likelihood . . . . . . . . . . . . . . . . . . . . 269

18.7 Examples
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 271
18.7.1 Kernel regression estimation . . . . . . . . . . . . . . . . . . . . . . . 272

18.7.2 Seminonparametri ML estimation and the MEPS data
. . . . . . . 272
19 Simulation-based estimation
275
19.1 Motivation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 275

19.1.1 Example: Multinomial and/or dynami dis rete response models
19.1.2 Example: Marginalization of latent variables
. . 275
. . . . . . . . . . . . . 277
CONTENTS
19.1.3 Estimation of models spe ied in terms of sto hasti dierential

equations
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 278
19.2 Simulated maximum likelihood (SML)

19.2.1 Example: multinomial probit
. . . . . . . . . . . . . . . . . . . . . 279
. . . . . . . . . . . . . . . . . . . . . . 280
19.2.2 Properties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 281

19.3 Method of simulated moments (MSM)
. . . . . . . . . . . . . . . . . . . . . 281
19.3.1 Properties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 282

19.3.2 Comments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 283
19.4 E ient method of moments (EMM) . . . . . . . . . . . . . . . . . . . . . . 284
19.4.1 Optimal weighting matrix . . . . . . . . . . . . . . . . . . . . . . . . 285
19.4.2 Asymptoti distribution
. . . . . . . . . . . . . . . . . . . . . . . . . 287
19.4.3 Diagnoti testing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 287

19.5 Examples
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288
19.5.1 Estimation of sto hasti dierential equations . . . . . . . . . . . . . 288

19.5.2 EMM estimation of a dis rete hoi e model
. . . . . . . . . . . . . . 289
20 Parallel programming for e onometri s

20.1 Example problems
293
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 294
20.1.1 Monte Carlo
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 294
20.1.2 ML . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 294
20.1.3 GMM
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 295
20.1.4 Kernel regression . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 296
21 Final proje t: e onometri estimation of a RBC model
301
21.1 Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 301

21.2 An RBC Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 302
21.3 A redu ed form model
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 303
21.4 Results (I): The s ore generator . . . . . . . . . . . . . . . . . . . . . . . . . 304

21.5 Solving the stru tural model . . . . . . . . . . . . . . . . . . . . . . . . . . . 304
22 Introdu tion to O tave
309
22.1 Getting started . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 309

22.2 A short introdu tion
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 309
22.3 If you're running a Linux installation... . . . . . . . . . . . . . . . . . . . . . 310
23 Notation and Review
313
23.1 Notation for dierentiation of ve tors and matri es

23.2 Convergenge modes
. . . . . . . . . . . . . . 313
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 314
23.3 Rates of onvergen e and asymptoti equality . . . . . . . . . . . . . . . . . 316
24 Li enses
24.1 The GPL
319
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 319
24.2 Creative Commons . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 327
CONTENTS
333
25 The atti
25.1 Hurdle models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 333

25.1.1 Finite mixture models
25.2 Models for time series data
. . . . . . . . . . . . . . . . . . . . . . . . . . 337
. . . . . . . . . . . . . . . . . . . . . . . . . . . 340
25.2.1 Basi on epts
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 341
25.2.2 ARMA models
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 342
10
CONTENTS
List of Figures
1.1
LYX
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
16
1.2
O tave . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
17
3.1
Typi al data, Classi al Model . . . . . . . . . . . . . . . . . . . . . . . . . .
22
3.2
Example OLS Fit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
24
3.3
The t in observation spa e
25
3.4
Dete tion of inuential observations
3.5
2
Un entered R
. . . . . . . . . . . . . . . . . . . . . . . . . . .
. . . . . . . . . . . . . . . . . . . . . .
27
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
29
3.6
Unbiasedness of OLS under lassi al assumptions . . . . . . . . . . . . . . .
31
3.7
Biasedness of OLS when an assumption fails . . . . . . . . . . . . . . . . . .
32
3.8
Gauss-Markov Result: The OLS estimator . . . . . . . . . . . . . . . . . . .
34
3.9
Gauss-Markov Resul: The split sample estimator
. . . . . . . . . . . . . . .
35
6.1
Joint and Individual Conden e Regions . . . . . . . . . . . . . . . . . . . .
70
6.2
RTS as a fun tion of rm size . . . . . . . . . . . . . . . . . . . . . . . . . .
77
7.1
Residuals, Nerlove model, sorted by rm size
. . . . . . . . . . . . . . . . .
89
7.2
Auto orrelation indu ed by misspe i ation
. . . . . . . . . . . . . . . . . .
92
7.3
Residuals of simple Nerlove model
7.4
OLS residuals, Klein onsumption equation
9.1
s()
when there is no ollinearity . . . . . . . . . . . . . . . . . . . . . . . . 115
9.2
s()
when there is ollinearity . . . . . . . . . . . . . . . . . . . . . . . . . . 115
9.3
Sample sele tion bias . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124
. . . . . . . . . . . . . . . . . . . . . . . 102
. . . . . . . . . . . . . . . . . . 103
13.1 In reasing dire tions of sear h . . . . . . . . . . . . . . . . . . . . . . . . . . 175

13.2 Using MuPAD to get analyti derivatives
. . . . . . . . . . . . . . . . . . . 178
13.3 Life expe tan y of mongooses, Weibull model
. . . . . . . . . . . . . . . . . 183
13.4 Life expe tan y of mongooses, mixed Weibull model
. . . . . . . . . . . . . 185
13.5 A foggy mountain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 186

15.1 OLS
15.2 IV
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 222
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 222
18.1 True and simple approximating fun tions
. . . . . . . . . . . . . . . . . . . 254
18.2 True and approximating elasti ities . . . . . . . . . . . . . . . . . . . . . . . 255

18.3 True fun tion and more exible approximation
. . . . . . . . . . . . . . . . 256
18.4 True elasti ity and more exible approximation
. . . . . . . . . . . . . . . . 256
11
12
LIST OF FIGURES
18.5 Negative binomial raw moments . . . . . . . . . . . . . . . . . . . . . . . . . 271

18.6 Kernel tted OBDV usage versus AGE . . . . . . . . . . . . . . . . . . . . . 272
20.1 Speedups from parallelization
. . . . . . . . . . . . . . . . . . . . . . . . . . 297
21.1 Consumption and Investment, Levels . . . . . . . . . . . . . . . . . . . . . . 301

21.2 Consumption and Investment, Growth Rates
. . . . . . . . . . . . . . . . . 302
21.3 Consumption and Investment, Bandpass Filtered
. . . . . . . . . . . . . . . 302
22.1 Running an O tave program . . . . . . . . . . . . . . . . . . . . . . . . . . . 310
List of Tables
16.1 Marginal Varian es, Sample and Estimated (Poisson) . . . . . . . . . . . . . 234

16.2 Marginal Varian es, Sample and Estimated (NB-II) . . . . . . . . . . . . . . 238
16.3 Information Criteria, OBDV . . . . . . . . . . . . . . . . . . . . . . . . . . . 240
25.1 A tual and Poisson tted frequen ies . . . . . . . . . . . . . . . . . . . . . . 333
25.2 A tual and Hurdle Poisson tted frequen ies . . . . . . . . . . . . . . . . . . 337
13
14
LIST OF TABLES
Chapter 1
About this do ument
This do ument integrates le ture notes for a one year graduate level ourse with omputer
programs that illustrate and apply the methods that are studied. The immediate availability of exe utable (and modiable) example programs when using the PDF version of
the do ument is one of the advantages of the system that has been used. On the other
hand, when viewed in printed form, the do ument is a somewhat terse approximation to a
textbook. These notes are not intended to be a perfe t substitute for a printed textbook.
If you are a student of mine, please note that last senten e arefully. There are many good
textbooks available. A few of my favorites are listed in the bibliography.
With respe t to ontents, the emphasis is on estimation and inferen e within the world
of stationary data, with a bias toward mi roe onometri s. The se ond half is somewhat
more polished than the rst half, sin e I have taught that ourse more often. If you take
a moment to read the li ensing information in the next se tion, you'll see that you are
free to opy and modify the do ument. If anyone would like to ontribute material that
expands the ontents, it would be very wel ome. Error orre tions and other additions are
also wel ome.
1.1 Li enses
All materials are opyrighted by Mi hael Creel with the date that appears above. They are
provided under the terms of the GNU General Publi Li ense, ver. 2, whi h forms Se tion
24.1 of the notes, or, at your option, under the Creative Commons Attribution-Share Alike 2.5 li ense,
whi h forms Se tion 24.2 of the notes. The main thing you need to know is that you are
free to modify and distribute these materials in any way you like, as long as you share
your ontributions in the same way the materials are made available to you. In parti ular,
you must make available the sour e les, in editable form, for your modied version of the
materials.
1.2 Obtaining the materials

The materials are available on my web page, in a variety of forms in luding PDF and the
editable sour es, at pareto.uab.es/m reel/E onometri s/ . In addition to the nal produ t,
whi h you're probably looking at in some form now, you an obtain the editable sour es,
whi h will allow you to reate your own version, if you like, or send error orre tions
15
16
CHAPTER 1.
ABOUT THIS DOCUMENT
Figure 1.1: LYX
/home/mi hael/Mystuff/resear h/ParallelKnoppix/Examples/E onometri s/Examples/Figures/lyx.
and ontributions. The main do ument was prepared using LYX (www.lyx.org) and GNU
1
O tave (www.o tave.org). LYX is a free
what you see is what you mean word pro essor,
AT X. It (with help from other appli ations)

basi ally working as a graphi al frontend to L
E
AT X, HTML, PDF and several other forms. It will run on Linux,
an export your work in L
E
Windows, and Ma OS systems. Figure 1.1 shows LYX editing this do ument.
GNU O tave has been used for the example programs, whi h are s attered though
the do ument.
This hoi e is motivated by two fa tors.
The rst is the high quality of
the O tave environment for doing applied e onometri s. The fundamental tools exist and
are implemented in a way that make extending them fairly easy. The example programs
in luded here may onvin e you of this point. Se ondly, O tave's li ensing philosophy ts
in with the goals of this proje t. Thirdly, it runs on Linux, Windows and Ma OS. Figure
1.2 shows an O tave program being edited by NEdit, and the result of running the program
in a shell window.
1.3 An easy way to use LYX and O tave today

The example programs are available as links to les on my web page in the PDF version,
and here. Support les needed to run these are available here. The les won't run properly
from your browser, sin e there are dependen ies between les - they are only illustrative
when browsing. To see how to use these les (edit and run them), you should go to the
home page of this do ument, sin e you will probably want to download the pdf version
together with all the support les and examples. Then set the base URL of the PDF le
to point to wherever the O tave les are installed. Then you need to install O tave and
o tave-forge. All of this may sound a bit ompli ated, be ause it is. An easier solution is
available:
The Peli anHPC distribution of Linux is an ISO image le that may be burnt to
CDROM. It ontains a bootable-from-CD Gnu/Linux system. These notes, in sour e form
1
Free is used in the sense of freedom, but LYX is also free of harge.
1.3.
AN EASY WAY TO USE LYX AND OCTAVE TODAY
17
Figure 1.2: O tave
/home/mi hael/Mystuff/resear h/ParallelKnoppix/Examples/E onometri s/Examples/Figures/o ta
and as a PDF, together with all of the examples and the software needed to run them
are available on Peli anHPC. The reason why these notes are integrated into a Linux
distribution for parallel omputing will be apparent if you get to Chapter 20. If you don't
get that far or you're not interested in parallel omputing, please just ignore the stu
on the CD that's not related to e onometri s. If you happen to be interested in parallel
omputing but not e onometri s, just skip ahead to Chapter 20.
18
CHAPTER 1.
ABOUT THIS DOCUMENT
Chapter 2
Introdu tion: E onomi and
e onometri models
E onomi theory tells us that an individual's demand fun tion for a good is something
like:
x = x(p, m, z)
x
is the quantity demanded
is
G1
ve tor of pri es of the good and its substitutes and omplements
is in ome
z is a ve tor of other variables su h as individual hara teristi s that ae t preferen es

Suppose we have a sample onsisting of one observation on
period
t (this is a ross
n individuals' demands
at time
se tion , where i = 1, 2, ..., n indexes the individuals in the sample).
The individual demand fun tions are
xi = xi (pi , mi , zi )
The model is not estimable as it stands, sin e:
The form of the demand fun tion is dierent for all
Some omponents of
zi
i.
may not be observable to an outside modeler. For example,
people don't eat the same lun h every day, and you an't tell what they will order
just by looking at them. Suppose we an break
wi
and a single unobservable omponent
zi
into the observable omponents
i .
A step toward an estimable e onometri model is to suppose that the model may be written
as
xi = 1 + pi p + mi m + wi w + i
We have imposed a number of restri tions on the theoreti al model:
The fun tions
xi ()
whi h in prin iple may dier for all
belong to the same parametri family.
19
have been restri ted to all
20
CHAPTER 2.
INTRODUCTION: ECONOMIC AND ECONOMETRIC MODELS
Of all parametri families of fun tions, we have restri ted the model to the lass of
linear in the variables fun tions.
The parameters are onstant a ross individuals.
There is a single unobservable omponent, and we assume it is additive.
If we assume nothing about the error term

order for the
, we an always write the last equation.
But in
oe ients to exist in a sense that has e onomi meaning, and in order to
be able to use sample data to make reliable inferen es about their values, we need to make
additional assumptions. These additional assumptions have
no theoreti al basis,
they
are assumptions on top of those needed to prove the existen e of a demand fun tion. The
validity of any results we obtain using this model will be ontingent on these additional
restri tions being at least approximately orre t. For this reason,
spe i ation testing
will
be needed, to he k that the model seems to be reasonable. Only when we are onvin ed
that the model is at least approximately orre t should we use it for e onomi analysis.
When testing a hypothesis using an e onometri model, at least three fa tors an ause
a statisti al test to reje t the null hypothesis:
1. the hypothesis is false

2. a type I error has o ured
3. the e onometri model is not orre tly spe ied so the test does not have the assumed
distribution
To be able to make s ienti progress, we would like to ensure that the third reason is
not ontributing in a major way to reje tions, so that reje tion will be most likely due
to either the rst or se ond reasons.
Hopefully the above example makes it lear that
there are many possible sour es of misspe i ation of e onometri models. In the next few
se tions we will obtain results supposing that the e onometri model is entirely orre tly
spe ied. Later we will examine the onsequen es of misspe i ation and see some methods
for determining if a model is orre tly spe ied. Later on, e onometri methods that seek
to minimize maintained assumptions are introdu ed.
Chapter 3
Ordinary Least Squares
3.1 The Linear Model
y
Consider approximating a variable
using the variables
x1 , x2 , ..., xk .
We an onsider a
model that is a linear approximation:
Linearity:
the model is a linear fun tion of the parameter ve tor
0 :
y = 10 x1 + 20 x2 + ... + k0 xk +
or, using ve tor notation:
y = x 0 +
The dependent variable
x = ( x1 x2 xk ) is a k
k0 ) . The supers ript 0 in 0
is a s alar random variable,
ve tor of explanatory variables, and
0 = ( 10 20
means this is the true value of the unknown parameter. It will be dened more pre isely
later, and usually suppressed when it's not ne essary for larity.
Suppose that we want to use data to try to determine the best linear approximation
to
using the variables
x.
The data
{(yt , xt )} , t = 1, 2, ..., n
are obtained by some form of
sampling . An individual observation is
yt = xt + t
The
observations an be written in matrix form as
y = X + ,
where
y=
y1 y2 yn
is
n1
and
X=
(3.1)
x1 x2 xn
Linear models are more general than they might rst appear, sin e one an employ
nonlinear transformations of the variables:
0 (z) =
where the
1
1 (w) 2 (w) p (w)
i () are known fun tions.
Dening
y = 0 (z), x1 = 1 (w), et .
leads to a model
For example, ross-se tional data may be obtained by random sampling. Time series data a umulate
histori ally.
21
22
CHAPTER 3.
ORDINARY LEAST SQUARES
Figure 3.1: Typi al data, Classi al Model

10
data
true regression line
-5
-10
-15
0
10
X
12
14
16
18
20
in the form of equation 3.3. For example, the Cobb-Douglas model
z = Aw22 w33 exp()

an be transformed logarithmi ally to obtain
ln z = ln A + 2 ln w2 + 3 ln w3 + .
If we dene
y = ln z, 1 = ln A,
et .,
we an put the model in the form needed.
The
approximation is linear in the parameters, but not ne essarily linear in the variables.
3.2 Estimation by least squares

Figure 3.1, obtained by running Typi alData.m shows some data that follows the linear
model
yt = 1 + 2 xt2 + t .
The green line is the true regression line
the red rosses are the data points

and is independent of
xt2 .
(xt2 , yt ),
where
1 + 2 xt2 ,
and
is a random error that has mean zero
Exa tly how the green line is dened will be ome lear later.
In pra ti e, we only have the data, and we don't know where the green line lies. We need
to gain information about the straight line that best ts the data points.
The
ordinary least squares
(OLS) estimator is dened as the value that minimizes the
sum of the squared errors:
= arg min s()

where
3.2.
23
ESTIMATION BY LEAST SQUARES
n
X
s() =
t=1
yt xt
2
= (y X) (y X)
= y y 2y X + X X
= k y X k2
This last expression makes it lear how the OLS estimator is dened: it minimizes the
Eu lidean distan e between
best linear approximation to
and
X.
x
using
The tted OLS oe ients are those that give the
as basis fun tions, where best means minimum
Eu lidean distan e. One ould think of other estimators based upon other metri s. For
example, the
minimum absolute distan e
(MAD) minimizes
Pn
t=1 |yt
xt |.
Later, we
will see that whi h estimator is best in terms of their statisti al properties, rather than in
terms of the metri s that dene them, depends upon the properties of
about whi h we
have as yet made no assumptions.
To minimize the riterion
s(),
nd the derivative with respe t to
D s() = 2X y + 2X X
Then setting it to zeros gives
= 2X y + 2X X 0
D s()
so
= (X X)1 X y.
To verify that this is a minimum, he k the se ond order su ient ondition:
= 2X X
D2 s()
Sin e
(X) = K,
this matrix is positive denite, sin e it's a quadrati form in a p.d.
matrix (identity matrix of order
n),
so
The
tted values are the ve tor y = X.
The
residuals are the ve tor = y X
Note that
is in fa t a minimizer.
y = X +
= X +
24
CHAPTER 3.
Figure 3.2: Example OLS Fit

15
data points
fitted line
true line
10
-5
-10
-15
0
10
X
12
14
16
18
20
Also, the rst order onditions an be written as
X y X X = 0

X y X = 0
X = 0
whi h is to say, the OLS residuals are orthogonal to
X.
Let's look at this more
arefully.
3.3 Geometri interpretation of least squares estimation

3.3.1 In X, Y Spa e
Figure 3.2 shows a typi al t to data, along with the true regression line. Note that the true
line and the estimated line are dierent. This gure was reated by running the O tave
program OlsFit.m . You an experiment with hanging the parameter values to see how
this ae ts the t, and to see how the tted line will sometimes be lose to the true line,
and sometimes rather far away.
3.3.2 In Observation Spa e

If we want to plot in observation spa e, we'll need to use only two or three observations, or
we'll en ounter some limitations of the bla kboard. If we try to use 3, we'll en ounter the
limits of my artisti ability, so let's use two. With only two observations, we an't have
K > 1.
We an de ompose
into two omponents:
the orthogonal proje tion onto the
and the omponent

Kdimensional spa e spanned by X , X ,
that is the orthogonal
3.3.
GEOMETRIC INTERPRETATION OF LEAST SQUARES ESTIMATION
25
Figure 3.3: The t in observation spa e
Observation 2
e = M_xY
S(x)
x
x*beta=P_xY
Observation 1
proje tion onto the
Sin e
nK
is hosen to make
spanned by
X.
Sin e
subpa e that is orthogonal to the span of
as
short as possible,
=
is in this spa e, X
0.
will
X, .
be orthogonal to the spa e
Note that the f.o. . that dene the
least squares estimator imply that this is so.
3.3.3 Proje tion Matri es

X
is the proje tion of
onto the span of
X,
or
X = X X X
Therefore, the matrix that proje ts
1
X y
onto the span of
is
PX = X(X X)1 X
sin e
X = PX y.
is
of
the proje tion of
X.
We have that
onto the
N K
dimensional spa e that is orthogonal to the span
= y X
= y X(X X)1 X y

= In X(X X)1 X y.
26
CHAPTER 3.
So the matrix that proje ts
onto the spa e orthogonal to the span of
is
= In X(X X)1 X
MX
= In PX .
We have
= MX y.
Therefore
y = PX y + MX y
= X + .
These two proje tion matri es de ompose the
omponents - the portion that lies in the
nK
portion that lies in the orthogonal
Note that both
PX
and
MX
are
dimensional ve tor
into two orthogonal
dimensional spa e dened by
symmetri
and
idempotent.
A symmetri matrix
An idempotent matrix
The only nonsingular idempotent matrix is the identity matrix.
is one su h that
and the
dimensional spa e.
X,
A = A .
is one su h that
A = AA.
3.4 Inuential observations and outliers

The OLS estimator of the
ith
element of the ve tor
i =
(X X)1 X
= ci y
is simply
This is how we dene a linear estimator - it's a linear fun tion of the dependent variable.
Sin e it's a linear ombination of the observations on the dependent variable, where the
weights are determined by the observations on the regressors, some observations may have
more inuen e than others.
To investigate this, let
the
tth
et
olumn of the matrix
be an
In .
ve tor of zeros with a
in the t
Dene
ht = (PX )tt
= et PX et
so
ht
is the t
th element on the main diagonal of
PX .
Note that
ht = k PX et k2
so
ht k et k2 = 1
th position,
i.e., it's
3.4.
27
INFLUENTIAL OBSERVATIONS AND OUTLIERS
Figure 3.4: Dete tion of inuential observations

14
Data points
fitted
Leverage
Influence
12
10
-2
0
So
0.5
0 < ht < 1.
1.5
X
2.5
Also,
T rPX = K h = K/n.
So the average of the
ht is K/n.
The value
ht is referred to as the leverage of the observation.
If the leverage is mu h higher than average, the observation has the potential to ae t the
OLS t importantly. However, an observation may also be inuential due to the value of
yt ,
xt 's.
th
without using the t
observation (des-
rather than the weight it is multiplied by, whi h only depends on the
To a ount for this, onsider estimation of
ignate this estimator as
(t) ).
One an show (see Davidson and Ma Kinnon, pp. 32-5 for
proof ) that
(t) =
so the hange in the
tth
1
1 ht
(X X)1 Xt t
observations tted value is
xt
xt (t)
ht
1 ht
While an observation may be inuential if it doesn't ae t its own tted value, it ertainly
is

inuential if it does.
ht
1ht
A fast means of identifying inuential observations is to plot
(whi h I will refer to as the
own inuen e of the observation) as a fun tion of t.
Figure 3.4 gives an example plot of data, t, leverage and inuen e. The O tave program
is InuentialObservation.m . If you re-run the program you will see that the leverage of
the last observation (an outlying value of x) is always high, and the inuen e is sometimes
high.
After inuential observations are dete ted, one needs to determine
why
they are inu-
ential. Possible auses in lude:
data entry error, whi h an easily be orre ted on e dete ted. Data entry errors
very ommon.
are
28
CHAPTER 3.
spe ial e onomi fa tors that ae t some observations.
These would need to be
identied and in orporated in the model. This is the idea behind
stru tural hange :
the parameters may not be onstant a ross all observations.
pure randomness may have aused us to sample a low-probability observation.
There exist
robust
estimation methods that downweight outliers.
3.5 Goodness of t
The tted model is
y = X +
Take the inner produ t:
y y = X X + 2 X +
But the middle term of the RHS is zero sin e
X = 0,
so
y y = X X +
un entered Ru2
The
(3.2)
is dened as
Ru2 = 1

yy
X X
yy
k PX y k2
=
k y k2
= cos2 (),
where
is the angle between
The un entered
R2
and the span of
hanges if we add a onstant to
y, sin e this hanges (see Figure
3.5, the yellow ve tor is a onstant, sin e it's on the
45
degree line in observation
spa e). Another, more ommon denition measures the ontribution of the variables,
other than the onstant term, to explaining the variation in
ability of the model to explain the variation of
y.
Thus it measures the
about its un onditional sample
mean.
Let
= (1, 1, ..., 1) ,
-ve tor. So
M = In ( )1
= In /n
M y
just returns the ve tor of deviations from the mean. In terms of deviations from the
mean, equation 3.2 be omes
y M y = X M X + M
3.6.
29
THE CLASSICAL LINEAR REGRESSION MODEL
Figure 3.5: Un entered
R2
/home/mi hael/Mystuff/resear h/ParallelKnoppix/Examples/E onometri s/Examples/Figures
The
entered Rc2
is dened as
Rc2 = 1
where
ESS = and T SS = y M y =
Supposing that
ESS

=1
y M y
T SS
Pn
t=1 (yt
M = .
i.e., there is a onstant term),
ontains a olumn of ones (
X = 0
so
y)2 .
t = 0
In this ase
y M y = X M X +
So
Rc2 =
where
RSS
T SS
RSS = X M X
Supposing that a olumn of ones is in the spa e spanned by

an show that
Rc2
X (PX = ),
then one
1.
3.6 The lassi al linear regression model

Up to this point the model is empty of ontent beyond the denition of a best linear
approximation to
and some geometri al properties. There is no e onomi ontent to the
model, and the regression parameters have no e onomi interpretation. For example, what
30
CHAPTER 3.
is the partial derivative of
with respe t to
xj ?
The linear approximation is
y = 1 x1 + 2 x2 + ... + k xk +
The partial derivative is
= j +
xj
xj
Up to now, there's no guarantee that
xj =0. For the
to have an e onomi meaning,
we need to make additional assumptions. The assumptions that are appropriate to make
depend on the data under onsideration.
We'll start with the lassi al linear regression
model, whi h in orporates some assumptions that are learly not realisti for e onomi
data.
This is to be able to explain some on epts with a minimum of onfusion and
notational lutter.
Later we'll adapt the results to what we an get with more realisti
assumptions.
Linearity:
0 :
y = 10 x1 + 20 x2 + ... + k0 xk +
(3.3)
or, using ve tor notation:
y = x 0 +
Nonsto hasti linearly independent regressors: X is a xed matrix of onstants,

it has rank
K,
its number of olumns, and
1
lim X X = QX
n
where
QX
is a nite positive denite matrix.
(3.4)
This is needed to be able to identify the
individual ee ts of the explanatory variables.
Independently and identi ally distributed errors:

IID(0, 2 In )
(3.5)
is jointly distributed IID. This implies the following two properties:
Homos edasti errors:

V (t ) = 02 , t
(3.6)
E(t s ) = 0, t 6= s
(3.7)
Nonauto orrelated errors:
Optionally, we will sometimes assume that the errors are normally distributed.
Normally distributed errors:

N (0, 2 In )
(3.8)
3.7.
SMALL SAMPLE STATISTICAL PROPERTIES OF THE LEAST SQUARES ESTIMATOR31
Figure 3.6: Unbiasedness of OLS under lassi al assumptions

Beta hat - Beta true
0.12
0.1
0.08
0.06
0.04
0.02
0
-3
-2
-1
3.7 Small sample statisti al properties of the least squares

estimator
Up to now, we have only examined numeri properties of the OLS estimator, that always
hold. Now we will examine statisti al properties. The statisti al properties depend upon
the assumptions we make.
3.7.1 Unbiasedness
We have
= (X X)1 X y .
By linearity,
= (X X)1 X (X + )
= + (X X)1 X
By 3.4 and 3.5
E(X X)1 X = E(X X)1 X

= (X X)1 X E
= 0
so the OLS estimator is unbiased under the assumptions of the lassi al model.
Figure 3.6 shows the results of a small Monte Carlo experiment where the OLS estimator
was al ulated for 10000 samples from the lassi al model with
y = 1+2x+, where n = 20,
= 9,
and
is xed a ross samples. We an see that the
appears to be estimated
without bias. The program that generates the plot is Unbiased.m , if you would like to
experiment with this.
With time series data, the OLS estimator will often be biased. Figure 3.7 shows the
32
CHAPTER 3.
Figure 3.7: Biasedness of OLS when an assumption fails

Beta hat - Beta true
0.14
0.12
0.1
0.08
0.06
0.04
0.02
0
-1.2
-1
-0.8
-0.6
-0.4
-0.2
0.2
0.4
results of a small Monte Carlo experiment where the OLS estimator was al ulated for
1000 samples from the AR(1) model with
yt = 0 + 0.9yt1 + t ,
where
n = 20
and
2 = 1.
In this ase, assumption 3.4 does not hold: the regressors are sto hasti . We an see that
the bias in the estimation of
is about -0.2.
The program that generates the plot is Biased.m , if you would like to experiment with
this.
3.7.2 Normality
With the linearity assumption, we have
= + (X X)1 X .
This is a linear fun tion of
Adding the assumption of normality (3.8, whi h implies strong exogeneity), then
N , (X X)1 02
sin e a linear fun tion of a normal random ve tor is also normally distributed. In Figure
3.6 you an see that the estimator appears to be normally distributed. It in fa t is normally
distributed, sin e the DGP (see the O tave program) has normal errors. Even when the
data may be taken to be IID, the assumption of normality is often questionable or simply
untenable. For example, if the dependent variable is the number of automobile trips per
week, it is a ount variable with a dis rete distribution, and is thus not normally distributed.
Many variables in e onomi s an take on only nonnegative values, whi h, stri tly speaking,
2
rules out normality.
Normality may be a good model nonetheless, as long as the probability of a negative value o uring is
negligable under the model. This depends upon the mean being large enough in relation to the varian e.
3.7.
SMALL SAMPLE STATISTICAL PROPERTIES OF THE LEAST SQUARES ESTIMATOR33
3.7.3 The varian e of the OLS estimator and the Gauss-Markov theorem
Now let's make all the lassi al assumptions ex ept the assumption of normality. We have
= + (X X)1 X
and we know that
= .
E()
So

= E (X X)1 X X(X X)1
= E
V ar()
= (X X)1 02
The OLS estimator is a
the dependent variable,
linear estimator ,
whi h means that it is a linear fun tion of
y.

(X X)1 X y
= Cy
where
is also
unbiased
is a fun tion of the explanatory variables only, not the dependent variable.
other weights
under the present assumptions, as we proved above. One ould onsider
that are a fun tion of
still insist upon unbiasedness. Consider

fun tion of
It
X. Note that sin e W
is unbiased, then we must have
X that dene some other linear estimator. We'll

= W y, where W = W (X) is some k n matrix
is a fun tion of
X, it is nonsto hasti , too.
If the estimator
W X = IK :
E(W y)
E(W X0 + W )
W X0
WX
The varian e of
IK
is
= W W 2 .
V ()
0
Dene
D = W (X X)1 X
so
W = D + (X X)1 X
Sin e
W X = IK , DX = 0,
so

D + (X X)1 X D + (X X)1 X 02

1 2
0
=
DD + X X
=
V ()
So
V ()
V ()
The inequality is a shorthand means of expressing, more formally, that
V ()
V ()
is a
34
CHAPTER 3.
Figure 3.8: Gauss-Markov Result: The OLS estimator

Beta 2 hat, OLS
0.1
0.09
0.08
0.07
0.06
0.05
0.04
0.03
0.02
0.01
0
0
0.5
1.5
positive semi-denite matrix.
2.5
3.5
This is a proof of the Gauss-Markov Theorem.
The OLS
estimator is the best linear unbiased estimator (BLUE).
It is worth emphasizing again that we have not used the normality assumption in any
way to prove the Gauss-Markov theorem, so it is valid if the errors are not normally
distributed, as long as the other assumptions hold.
To illustrate the Gauss-Markov result, onsider the estimator that results from splitting
the sample into
equally-sized parts, estimating using ea h part of the data separately
by OLS, then averaging the
resulting estimators. You should be able to show that this
estimator is unbiased, but ine ient with respe t to the OLS estimator.
The program
E ien y.m illustrates this using a small Monte Carlo experiment, whi h ompares the
OLS estimator and a 3-way split sample estimator. The data generating pro ess follows
the lassi al model, with
n = 21.
The true parameter value is
= 2.
In Figures 3.8 and
3.9 we an see that the OLS estimator is more e ient, sin e the tails of its histogram are
more narrow.
We have that
=
E()
and
=
V ar()
1
XX
02 ,
but we still need to estimate
2
the varian e of , 0 , in order to have an idea of the pre ision of the estimates of
2
ommonly used estimator of 0 is
This estimator is unbiased:
c2 =
1

nK
3.8.
35
EXAMPLE: THE NERLOVE MODEL
Figure 3.9: Gauss-Markov Resul: The split sample estimator

Beta 2 hat, Split Sample Estimator
0.12
0.1
0.08
0.06
0.04
0.02
0
0
0.5
1.5
c2 =
0
=
c2 ) =
E(
0
=
=
=
=
=
where we use the fa t that
2.5
3.5
1

nK
1
M
nK
1
E(T r M )
nK
1
E(T rM )
nK
1
T rE(M )
nK
1
2 T rM
nK 0
1
2 (n k)
nK 0
02
T r(AB) = T r(BA) when both produ ts are onformable.
Thus,
this estimator is also unbiased under these assumptions.
3.8 Example: The Nerlove model

3.8.1 Theoreti al ba kground
For a rm that takes input pri es
and the output level
problem is to hoose the quantities of inputs
subje t to the restri tion
as given, the ost minimization
to solve the problem
min w x
x
36
CHAPTER 3.
f (x) = q.
x(w, q).
The solution is the ve tor of fa tor demands
The
ost fun tion
is obtained by
substituting the fa tor demands into the riterion fun tion:
Cw, q) = w x(w, q).

Monotoni ity
In reasing fa tor pri es annot de rease ost, so
C(w, q)
0
w
Remember that these derivatives give the onditional fa tor demands (Shephard's
Lemma).
Homogeneity The ost fun tion is homogeneous of degree 1 in input pri es: C(tw, q) =
tC(w, q)
where
is a s alar onstant. This is be ause the fa tor demands are homo-
geneous of degree zero in fa tor pri es - they only depend upon relative pri es.
Returns to s ale
The
returns to s ale
parameter
is dened as the inverse of the
elasti ity of ost with respe t to output:
Constant returns to s ale
C(w, q)
q
q
C(w, q)
1
is the ase where in reasing produ tion
in reases in the proportion 1:1. If this is the ase, then
implies that ost
= 1.
3.8.2 Cobb-Douglas fun tional form

The Cobb-Douglas fun tional form is linear in the logarithms of the regressors and the
dependent variable.
For a ost fun tion, if there are
fa tors, the Cobb-Douglas ost
fun tion has the form
C = Aw11 ...wg g q q e
What is the elasti ity of
eC
wj
C
=
wj ?
with respe t to
C
WJ

wj
C
= j Aw11 .wj j
..wg g q q e
wj
1
Aw1 ...wg g q q e
= j
This is one of the reasons the Cobb-Douglas form is popular - the oe ients are easy
to interpret, sin e they are the elasti ities of the dependent variable with respe t to the
3.8.
37
EXAMPLE: THE NERLOVE MODEL
explanatory variable. Not that in this ase,
eC
wj
C
WJ

= xj (w, q)
wj
C
wj
C
sj (w, q)
the
ost share
of the
j th
input. So with a Cobb-Douglas ost fun tion,
j = sj (w, q).
The
ost shares are onstants.

Note that after a logarithmi transformation we obtain
ln C = + 1 ln w1 + ... + g ln wg + q ln q +
where
= ln A
. So we see that the transformed model is linear in the logs of the data.
One an verify that the property of HOD1 implies that
g
X
g = 1
i=1
In other words, the ost shares add up to 1.

The hypothesis that the te hnology exhibits CRTS implies that
=
so
q = 1.
1
=1
q
Likewise, monotoni ity implies that the oe ients
i 0, i = 1, ..., g.
3.8.3 The Nerlove data and OLS

The le nerlove.data ontains data on 145 ele tri utility ompanies' ost of produ tion,
output and input pri es.
The data are for the U.S., and were olle ted by M. Nerlove.
COMPANY, COST (C), OUTPUT

(Q), PRICE OF LABOR (PL ), PRICE OF FUEL (PF ) and PRICE OF CAPITAL
The observations are by row, and the olumns are
(PK ).
Note that the data are sorted by output level (the third olumn).
We will estimate the Cobb-Douglas model
ln C = 1 + 2 ln Q + 3 ln PL + 4 ln PF + 5 ln PK +
(3.9)
using OLS. To do this yourself, you need the data le mentioned above, as well as Nerlove.m (the estimation pr
, and the library of O tave fun tions mentioned in the introdu tion to O tave that forms
3
se tion 22 of this do ument.

The results are
*********************************************************
OLS estimation results
Observations 145
R-squared 0.925955
3
If you are running the bootable CD, you have all of this installed and ready to run.
38
CHAPTER 3.
Sigma-squared 0.153943
Results (Ordinary var- ov estimator)
onstant
output
labor
fuel
apital
estimate
-3.527
0.720
0.436
0.427
-0.220
st.err.
1.774
0.017
0.291
0.100
0.339
t-stat.
-1.987
41.244
1.499
4.249
-0.648
p-value
0.049
0.000
0.136
0.000
0.518
*********************************************************
Do the theoreti al restri tions hold?
Does the model t well?
What do you think about RTS?
While we will use O tave programs as examples in this do ument, sin e following the
programming statements is a useful way of learning how theory is put into pra ti e, you
may be interested in a more user-friendly environment for doing e onometri s. I heartily
re ommend Gretl, the Gnu Regression, E onometri s, and Time-Series Library. This is an
easy to use program, available in English, Fren h, and Spanish, and it omes with a lot
AT X fragments, so that I
of data ready to use. It even has an option to save output as L
E
an just in lude the results into this do ument, no muss, no fuss. Here the results of the
Nerlove model from GRETL:
Model 2: OLS estimates using the 145 observations 1145

Dependent variable: l_ ost
Variable
onst
Coe ient
Std. Error
3.5265
t-statisti
1.77437
p-value
1.9875
0.0488
41.2445
0.0000
0.720394
0.0174664
l_labor
0.436341
0.291048
1.4992
0.1361
l_fuel
0.426517
0.100369
4.2495
0.0000
0.219888
0.339429
0.6478
0.5182
l_output
l_ apita
Mean of dependent variable
1.72466
S.D. of dependent variable
1.42172
Sum of squared residuals

Standard error of residuals (
)
Unadjusted
Adjusted
R2
2
R
21.5520
0.392356
0.925955
0.923840
F (4, 140)
437.686
Akaike information riterion
145.084
S hwarz Bayesian riterion
159.967
3.9.
39
EXERCISES
Fortunately, Gretl and my OLS program agree upon the results. Gretl is in luded in the
bootable CD mentioned in the introdu tion.
I re ommend using GRETL to repeat the
examples that are done using O tave.

The previous properties hold for nite sample sizes. Before onsidering the asymptoti
properties of the OLS estimator it is useful to review the MLE estimator, sin e under the
assumption of normal errors the two estimators oin ide.
3.9 Exer ises

Prove that the split sample estimator used to generate gure 3.9 is unbiased.
Cal ulate the OLS estimates of the Nerlove model using O tave and GRETL, and
provide printouts of the results. Interpret the results.
Do an analysis of whether or not there are inuential observations for OLS estimation
of the Nerlove model. Dis uss.
Using GRETL, examine the residuals after OLS estimation and tell me whether or not
you believe that the assumption of independent identi ally distributed normal errors is
warranted. No need to do formal tests, just look at the plots. Print out any that you think
are relevant, and interpret them.
For a random ve tor
X N (x , ),
what is the distribution of
where
and
and
are onformable matri es of onstants?

Using O tave, write a little program that veries that
AX + b,
T r(AB) = T r(BA)
for
tra e.
For the model with a onstant and a single regressor, yt = 1 + 2 xt + t , whi h satises
4x4 matri es of random numbers. Note: there is an O tave fun tion
the lassi al assumptions, prove that the varian e of the OLS estimator de lines to zero as
the sample size in reases.
40
CHAPTER 3.
Chapter 4
Maximum likelihood estimation
The maximum likelihood estimator is important sin e it is asymptoti ally e ient, as is
shown below. For the lassi al linear model with normal errors, the ML and OLS estimators
of
are the same, so the following theory is presented without examples. In the se ond
half of the ourse, nonlinear models with nonnormal errors are introdu ed, and examples
may be found there.
4.1 The likelihood fun tion

Suppose we have a sample of size
density of
ve tor
Y =
0 :
y1 . . . yn
and
of the random ve tors
Z=
z1 . . . zn
and
z.
Suppose the joint
is hara terized by a parameter
fY Z (Y, Z, 0 ).
This is the joint density of the sample. This density an be fa tored as
fY Z (Y, Z, 0 ) = fY |Z (Y |Z, 0 )fZ (Z, 0 )

The
likelihood fun tion
is just this density evaluated at other values
L(Y, Z, ) = f (Y, Z, ), ,
where
The
is a
parameter spa e.
maximum likelihood estimator
of
is the value of
that maximizes the likelihood
fun tion.
Note that if
hood fun tion
share no elements, then the maximizer of the onditional likeli-
fY |Z (Y |Z, )
likelihood fun tion

spond to
and
with respe t to
is the same as the maximizer of the overall
fY Z (Y, Z, ) = fY |Z (Y |Z, )fZ (Z, ),
In this ase, the variables
are said to be
for the elements of
exogenous
0 .
The maximum likelihood estimator of
0 = arg max fY |Z (Y |Z, )

41
that orre-
for estimation of
we may more onveniently work with the onditional likelihood fun tion
the purposes of estimating
and
fY |Z (Y |Z, )
for
42
CHAPTER 4.
If the
MAXIMUM LIKELIHOOD ESTIMATION
observations are independent, the likelihood fun tion an be written as
L(Y |Z, ) =
where the
ft
n
Y
t=1
f (yt |zt , )
are possibly of dierent form.
If this is not possible, we an always fa tor the likelihood into
ontributions of ob-
servations, by using the fa t that a joint density an be fa tored into the produ t of
a marginal and onditional (doing this iteratively)
L(Y, ) = f (y1 |z1 , )f (y2 |y1 , z2 , )f (y3 |y1 , y2 , z3 , ) f (yn |y1, y2 , . . . ytn , zn , )
To simplify notation, dene
xt = {y1 , y2 , ..., yt1 , zt }

so
x1 = z1 , x2 = {y1 , z2 },
et .
- it ontains exogenous and predetermined endogeous
variables. Now the likelihood fun tion an be written as
L(Y, ) =
n
Y
t=1
f (yt |xt , )
The riterion fun tion an be dened as the average log-likelihood fun tion:
1X
1
ln f (yt |xt , )
sn () = ln L(Y, ) =
n
n t=1
The maximum likelihood estimator may thus be dened equivalently as
= arg max sn (),

where the set maximized over is dened below.
fun tion,
ln L
and
Sin e
maximize at the same value of
ln()
is a monotoni in reasing
Dividing by
has no ee t on
4.1.1 Example: Bernoulli trial

Suppose that we are ipping a oin that may be biased, so that the probability of a heads
may not be 0.5.
y = 1(heads)
Maybe we're interested in estimating the probability of a heads.
Let
be a binary variable that indi ates whether or not a heads is observed. The
out ome of a toss is a Bernoulli random variable:
fY (y, p0 ) = py0 (1 p0 )1y , y {0, 1}

= 0, y
/ {0, 1}
So a representative term that enters the likelihood fun tion is
fY (y, p) = py (1 p)1y
4.2.
43
CONSISTENCY OF MLE
and
ln fY (y, p) = y ln p + (1 y) ln (1 p)
The derivative of this is
ln fY (y, p)
p
=
=
Averaging this over a sample of size
y (1 y)
p (1 p)
yp
p (1 p)
gives
1 X yi p
sn (p)
=
p
n
p (1 p)
i=1
Setting to zero and solving gives
p = y
So it's easy to al ulate the MLE of
p0 in
(4.1)
this ase.
Now imagine that we had a bag full of bent oins, ea h bent around a sphere of a
dierent radius (with the head pointing to the outside of the sphere). We might suspe t
that the probability of a heads ould depend upon the radius. Suppose that
(1 + exp(xi ))
where
xi =
1 ri
, so that
is a 21 ve tor. Now
pi p(xi , ) =
pi ()
= pi (1 pi ) xi
so
ln fY (y, )
y pi
pi (1 pi ) xi
pi (1 pi )
= (yi p(xi , )) xi
So the derivative of the average log lihelihood fun tion is now
sn ()
=
Pn
i=1 (yi
p(xi , )) xi
n
This is a set of 2 nonlinear equations in the two unknown elements in
There is no
expli it solution for the two elements that set the equations to zero. This is ommonly the
ase with ML estimators: they are often nonlinear, and nding the value of the estimate
often requires use of numeri methods to nd solutions to the rst order onditions. This
possibility is explored further in the se ond half of these notes (see se tion 14.5).
4.2 Consisten y of MLE

To show onsisten y of the MLE, we need to make expli it some assumptions.
Compa t parameter spa e , an open bounded subset of K . Maximixation

is over
whi h is ompa t.
This implies that
is an interior point of the
parameter spa e .
44
CHAPTER 4.
Uniform onvergen e
u.a.s
sn () lim E0 sn () s (, 0 ), .
n
We have suppressed
here for simpli ity.
This requires that almost sure onvergen e
holds for all possible parameter values. For a given parameter value, an ordinary Law of
Large Numbers will usually imply almost sure onvergen e to the limit of the expe tation.
Convergen e for a single element of the parameter spa e, ombined with the assumption
of a ompa t parameter spa e, ensures uniform onvergen e.
Continuity sn () is ontinuous in , . This implies that s (, 0 ) is ontinuous

in
Identi ation s (, 0 ) has a unique maximum

We will use these assumptions to show that
First,
in its rst argument.
a.s.
n 0 .
ertainly exists, sin e a ontinuous fun tion has a maximum on a ompa t
set.
Se ond, for any
6= 0
by Jensen's inequality (

L()
L()
E ln
ln E
L(0 )
L(0 )
ln ()
is a on ave fun tion).
Now, the expe tation on the RHS is
E
sin e
L(0 ) is
L()
L(0 )
L()
L(0 )dy = 1,
L(0 )
the density fun tion of the observations, and sin e the integral of any density
is 1. Therefore, sin e
ln(1) = 0,

E ln
L()
L(0 )

0,
or
E (sn ()) E (sn (0 )) 0.

Taking limits, this is (by the assumption on uniform onvergen e)
s (, 0 ) s (0 , 0 ) 0
ex ept on a set of zero probability.
By the identi ation assumption there is a unique maximizer, so the inequality is stri t
if
6= 0 :
Suppose that
s (, 0 ) s (0 , 0 ) < 0, 6= 0 , a.s.
is a limit point of
one limit point). Sin e
(any sequen e from a ompa t set has at least
is a maximizer, independent of
n,
s ( , 0 ) s (0 , 0 ) 0.
we must have
4.3.
45
THE SCORE FUNCTION
These last two inequalities imply that
= 0 , a.s.
Thus there is only one limit point, and it is equal to the true parameter value, with
probability one. In other words,
lim = 0 , a.s.
This ompletes the proof of strong onsisten y of the MLE. One an use weaker assumptions
to prove weak onsisten y ( onvergen e in probability to
0 )
of the MLE. This is omitted
here. Note that almost sure onvergen e implies onvergen e in probability.
4.3 The s ore fun tion

Dierentiability
borhood
N (0 )
of
sn () is twi e ontinuously
when n is large enough.
Assume that
0 ,
at least
dierentiable in a neigh-
To maximize the log-likelihood fun tion, take derivatives:
gn (Y, ) = D sn ()
n
1X
D ln f (yt |xx , )
=
n
t=1
This is the
s ore ve tor
(with dim
n
1X
gt ().
n t=1
K 1).
Note that the s ore fun tion has
argument, whi h implies that it is a random fun tion.
as an
(and any exogeneous variables)
will often be suppressed for larity, but one should not forget that they are still there.
The ML estimator
sets
the derivatives to zero:
X
= 1
0.
gn ()
gt ()
n
t=1
We will show that
E [gt ()] = 0, t.
density f (), not ne essarily f (0 ) .

E [gt ()] =
=
=
This is the expe tation taken with respe t to the
[D ln f (yt |xt , )]f (yt |x, )dyt
D f (yt |xt , )dyt .
1
[D f (yt |xt , )] f (yt |xt , )dyt
f (yt |xt , )
46
CHAPTER 4.
Given some regularity onditions on boundedness of
D f,
we an swit h the order of
integration and dierentiation, by the dominated onvergen e theorem. This gives
E [gt ()] = D
f (yt|xt , )dyt
= D 1
= 0
where we use the fa t that the integral of the density is 1.
So
E (gt () = 0 :
This hold for all
the expe tation of the s ore ve tor is zero.

t,
so it implies that
E gn (Y, ) = 0.
4.4 Asymptoti normality of MLE

Re all that we assume that
Taylor's series expansion of
sn () is twi e ontinuously dierentiable.

about the true value 0 :
g(Y, )
Take a rst order

= g(0 ) + (D g( )) 0
0 g()
or with appropriate denitions

H( ) 0 = g(0 ),
where
= + (1 )0 , 0 < < 1.
minute). So
Now onsider
H( ).
Assume
H( )
is invertible (we'll justify this in a

n 0 = H( )1 ng(0 )
This is
H( ) = D g( )
= D2 sn ( )
n
1X 2
=
D ln ft ( )
n
t=1
where the notation
D2 sn ()
2 sn ()
.

Given that this is an average of terms, it should usually be the ase that this satises a
strong law of large numbers (SLLN).
Regularity onditions
are a set of assumptions that
guarantee that this will happen. There are dierent sets of assumptions that an be used to
justify appeal to dierent SLLN's. For example, the
D2 ln ft ( )
must not be too strongly
dependent over time, and their varian es must not be ome innite. We don't assume any
parti ular set here, sin e the appropriate assumptions will depend upon the parti ularities
of a given model. However, we assume that a SLLN applies.
Also, sin e we know that
a.s.
0 .
is
onsistent, and sin e
= + (1 )0 ,
Also, by the above dierentiability assumtion,
H()
we have that
is ontinuous in
Given
4.4.
ASYMPTOTIC NORMALITY OF MLE
this,
H( )
47
onverges to the limit of it's expe tation:

a.s.
H( ) lim E D2 sn (0 ) = H (0 ) <
n
This matrix onverges to a nite limit.
Re-arranging orders of limits and dierentiation, whi h is legitimate given regularity

onditions, we get
H (0 ) = D2 lim E (sn (0 ))
n
2
D s (0 , 0 )
We've already seen that
s (, 0 ) < s (0 , 0 )
i.e., 0
maximizes the limiting obje tive fun tion. Sin e there is a unique maximizer, and
by the assumption that

then
H (0 )
sn () is twi e ontinuously dierentiable (whi h holds in the limit),
must be negative denite, and therefore of full rank. Therefore the previous
inversion is justied, asymptoti ally, and we have

a.s.
n 0 H (0 )1 ng(0 ).
Now onsider
ng(0 ).
(4.2)
This is
ngn (0 ) =
nD sn ()
X
n
n
D ln ft (yt |xt , 0 )
n
t=1
n
1 X
gt (0 )
n
t=1

applies.
Note that
a.s.
E [gt ()] = 0.
gn (0 ) 0,
As su h, it is reasonable to assume that a CLT
by onsisten y. To avoid this ollapse to a degenerate r.v. (a
onstant ve tor) we need to s ale by
n.
A generi CLT states that, for
Xn
a random
ve tor that satises ertain onditions,
Xn E(Xn ) N (0, lim V (Xn ))

The ertain onditions that
Xn
must satisfy depend on the ase at hand. Usually,
will be of the form of an average, s aled by
Xn =
This is the ase for
properties of the
Xt .
ng(0 )
for example.
For example, if the
Xt
Xn
n:
Pn
t=1 Xt
Then the properties of
Xn
depend on the
have nite varian es and are not too strongly
dependent, then a CLT for dependent pro esses will apply. Supposing that a CLT applies,
48
CHAPTER 4.
and noting that
E( ngn (0 ) = 0,
we get
d
I (0 )1/2 ngn (0 ) N [0, IK ]
where
I (0 ) =
=
This an also be written as
I (0 )
is known as the
lim E0 n [gn (0 )] [gn (0 )]

ngn (0 )
lim V0
ngn (0 ) N [0, I (0 )]
(4.3)
information matrix.
Combining [4.2 and [4.3, we get

a
n 0 N 0, H (0 )1 I (0 )H (0 )1 .
The MLE estimator is asymptoti ally normally distributed.
Denition 1 (CAN) An estimator of a parameter 0 is n- onsistent and asymptoti-
ally normally distributed if

d
n 0 N (0, V )
(4.4)
where V is a nite positive denite matrix.
There do exist, in spe ial ases, estimators that are onsistent su h that
0.
These are known as
super onsistent
estimators, sin e normally,
p

n 0
is the highest fa tor
that we an multiply by and still get onvergen e to a stable limiting distribution.
Denition 2 (Asymptoti unbiasedness) An estimator of a parameter 0 is asymp-
toti ally unbiased if
= .
lim E ()
(4.5)
Estimators that are CAN are asymptoti ally unbiased,
though not all onsistent esti-
mators are asymptoti ally unbiased. Su h ases are unusual, though. An example is
4.4.1 Coin ipping, again

In se tion 4.1.1 we saw that the MLE for the parameter of a Bernoulli trial, with i.i.d.
data, is the sample mean:
p = y
(equation 4.1). Now let's nd the limiting varian e of
4.5.
49
THE INFORMATION MATRIX EQUALITY
n (
p p).
lim V ar n (
p p) = lim nV ar (
p p)
= lim nV ar (
p)
= lim nV ar (
y)
P
yt
= lim nV ar
n
X
1
V ar(yt ) (by independen e of obs.)
= lim
n
1
= lim nV ar(y) (by identi ally distributed obs.)
n
= p (1 p)
4.5 The information matrix equality

We will show that
H () = I ().
1 =
Let
0 =
ft ()
f (yt |xt , )
be short for
ft ()dy,
so
D ft ()dy
(D ln ft ()) ft ()dy
Now dierentiate again:
D2 ln ft ()
ft ()dy + [D ln ft ()] D ft ()dy

Z

2
= E D ln ft () + [D ln ft ()] [D ln ft ()] ft ()dy

= E D2 ln ft () + E [D ln ft ()] [D ln ft ()]
0 =
= E [Ht ()] + E [gt ()] [gt ()]

Now sum over
and multiply by
(4.6)
1
n
#
" n
n
1X
1X
[Ht ()] = E
[gt ()] [gt ()]
E
n
n
t=1
The s ores
gt
and
gs
t=1
are un orrelated for
t 6= s,
sin e for
onditioned on prior information, so what was random in
t > s, ft (yt |y1 , ..., yt1 , )
is xed in
t.
has
(This forms the
basis for a spe i ation test proposed by White: if the s ores appear to be orrelated one
may question the spe i ation of the model). This allows us to write
E [H()] = E n [g()] [g()]
sin e all ross produ ts between dierent periods expe t to zero. Finally take limits, we
get
H () = I ().
(4.7)
50
CHAPTER 4.
This holds for all
in parti ular, for
0 .
Using this,

a.s.
n 0 N 0, H (0 )1 I (0 )H (0 )1
simplies to

a.s.
n 0 N 0, I (0 )1
To estimate the asymptoti varian e, we need estimators of
(4.8)
H (0 )
and
use
n
X
I\
(0 ) = n
I (0 ).
We an
t ()
gt ()g
t=1
H\
(0 ) = H().
Note, one an't use
h
ih
i
gn ()
I\
(0 ) = n gn ()
to estimate the information matrix. Why not?
From this we see that there are alternative ways to estimate
V (0 )
that are all valid.
These in lude
\
V\
(0 ) = H (0 )
\
V\
(0 ) = I (0 )
\
V\
(0 ) = H (0 )
These are known as the
\
I\
(0 )H (0 )
inverse Hessian, outer produ t of the gradient (OPG) and sandwi h
estimators, respe tively. The sandwi h form is the most robust, sin e it oin ides with the
ovarian e estimator of the
quasi-ML estimator.
4.6 The Cramr-Rao lower bound

The limiting varian e of a CAN estimator of 0 ,
say , minus the inverse of the information matrix is a positive semidenite matrix.
Theorem 3
[Cramer-Rao Lower Bound
Proof: Sin e the estimator is CAN, it is asymptoti ally unbiased, so
lim E ( ) = 0
n
Dierentiate wrt
lim E ( ) =
lim
= 0 (this
Noting that
D f (Y, ) = f ()D ln f (),
h

i
D f (Y, ) dy
is a
K K
matrix of zeros).
we an write
Z
Z

f (Y, )D dy = 0.
f ()D ln f ()dy + lim
lim
4.6.
51
THE CRAMR-RAO LOWER BOUND
Now note that

D = IK ,
and
f (Y, )(IK )dy = IK .
With this we have
Z

f ()D ln f ()dy = IK .
lim
n
Playing with powers of
lim
we get
1

n
n [D ln f ()] f ()dy = IK
{z
}
|n
Note that the bra keted part is just the transpose of the s ore ve tor,
lim E
g(), so we an write
h

i
n
ng() = IK

n , for any CAN

varian e of
n tends to
This means that the ovarian e of the s ore fun tion with
estimator, is an identity matrix. Using this, suppose the
V ().
Therefore,
# "
#
"
n
V ()
IK
.
=
V
IK
I ()
ng()
(4.9)
Sin e this is a ovarian e matrix, it is positive semi-denite. Therefore, for any
1 ()
I
This simplies to
Sin e
is arbitrary,
This means that

mator.
"
V ()
IK
IK
I ()
#"
I ()1
-ve tor
0.
h
i
I 1 () 0.
V ()
I 1 ()
V ()
1 ()
I
is a
is positive semidenite. This onludes the proof.
lower bound
for the asymptoti varian e of a CAN esti-
Asymptoti e ien y ) Given two CAN estimators of a parameter 0 , say and , is
asymptoti ally e ient with respe t to
if V ()V
() is a positive semidenite matrix.
A dire t proof of asymptoti e ien y of an estimator is infeasible, but if one an show

that the asymptoti varian e is equal to the inverse of the information matrix, then the
estimator is asymptoti ally e ient. In parti ular,
respe t to any other CAN estimator.
the MLE is asymptoti ally e ient with
Summary of MLE
Consistent
Asymptoti ally normal (CAN)
Asymptoti ally e ient
Asymptoti ally unbiased
This is for general MLE: we haven't spe ied the distribution or the linearity/nonlinearity of the estimator
52
CHAPTER 4.
4.7 Exer ises

Consider oin tossing with a single possibly biased oin.
random variable
y = 1(heads)
The density fun tion for the
is
fY (y, p0 ) = py0 (1 p0 )1y , y {0, 1}

= 0, y
/ {0, 1}
Suppose that we have a sample of size
pb0 = y.
n.
We know from above that the ML estimator is
We also know from the theory above that

a
n (
y p0 ) N 0, H (p0 )1 I (p0 )H (p0 )1
a) nd the analyti expression for gt () and show that E [gt ()] = 0
b) nd the analyti al expressions for H (p0 ) and I (p0 ) for this problem
) verify that the result for lim V ar n (

p p) found in se tion 4.4.1 is equal to H (p0 )1 I (p0 )H (p0 )1
d) Write an O tave program that does a Monte Carlo study that shows that n (y p0 ) is
approximately normally distributed when

the sampling frequen y of
Consider the model
yt =
n (
y p0 )
xt
+ t
is large. Please give me histograms that show
for several values of
n.
where the errors follow the Cau hy (Student-t with
1 degree of freedom) density. So
f (t ) =
1
, < t <
1 + 2t
The Cau hy density has a shape similar to a normal density, but with mu h thi ker tails.
Thus, extremely small and large errors o ur mu h more frequently with this density than
would happen if the errors were normally distributed. Find the s ore fun tion
gn () where
Consider the model lassi al linear regression model

Find the s ore fun tion
gn ()
where
yt = xt +t where t IIN (0, 2 ).
Compare the rst order onditions that dene the ML estimators of problems 2 and
3 and interpret the dieren es.
Why
estimator dierent in the two ases?
are the rst order onditions that dene an e ient
Chapter 5
Asymptoti properties of the least
squares estimator
1
The OLS estimator under the lassi al assumptions is BLUE , for all sample sizes. Now
let's see what happens when the sample size tends to innity.
5.1 Consisten y
= (X X)1 X y
= (X X)1 X (X + )
= 0 + (X X)1 X
1
XX
X
= 0 +
n
n
Consider the last two terms. By assumption
Q1
X ,
X X
n
= QX limn
xt t
X
n ,
X
1X
=
xt t
n
n t=1
has expe tation zero, so
X
n
=0
The varian e of ea h term is
V (xt t ) = xt xt 2 .
X X
n
1
sin e the inverse of a nonsingular matrix is a ontinuous fun tion of the elements of
the matrix. Considering
Ea h
limn
BLUE
best linear unbiased estimator if I haven't dened it before
53
54CHAPTER 5. ASYMPTOTIC PROPERTIES OF THE LEAST SQUARES ESTIMATOR
As long as these are nite, and given a te hni al ondition , the Kolmogorov SLLN applies,
so
1X
a.s.
xt t 0.
n t=1
This implies that
a.s.
0 .
This is the property of
strong onsisten y:
the estimator onverges in almost surely to the
true value.
The onsisten y proof does not use the normality assumption.
Remember that almost sure onvergen e implies onvergen e in probability.

We've seen that the OLS estimator is normally distributed
errors.
under the assumption of normal
If the error distribution is unknown, we of ourse don't know the distribution of
the estimator. However, we an get asymptoti results.
Assuming the distribution of is
unknown, but the the other lassi al assumptions hold:
= 0 + (X X)1 X
0 = (X X)1 X
1

X
XX
n 0
=
n
n
XX
n
1
Q1
X .
Now as before,
X
Considering , the limit of the varian e is
n
lim V
lim E
= 02 QX
X X
n
The mean is of ourse zero. To get asymptoti normality, we need to apply a CLT.
We assume one (for instan e, the Lindeberg-Feller CLT) holds, so

X d
N 0, 02 QX
n
Therefore,

d
n 0 N 0, 02 Q1
X
For appli ation of LLN's and CLT's, of whi h there are very many to hoose from, I'm going to avoid
the te hni alities. Basi ally, as long as terms that make up an average have nite varian es and are not
too strongly dependent, one will be able to nd a LLN or CLT to apply. Whi h one it is doesn't matter,
we only need the result.
5.3.
55
ASYMPTOTIC EFFICIENCY
In summary, the OLS estimator is normally distributed in small and large samples
if
is normally distributed.
If
is not normally distributed,
is asymptoti ally
normally distributed when a CLT an be applied.
5.3 Asymptoti e ien y

The least squares obje tive fun tion is
s() =
n
X
yt xt
t=1
Supposing that
2
is normally distributed, the model is
y = X0 + ,
N (0, 02 In ), so

n
Y
1
2t
f () =
exp 2
2
2 2
t=1
The joint density for
so
y
y an be onstru ted using a hange of variables.
In and | y
|
= 1,
so
n
Y
(yt xt )2
f (y) =
exp
2 2
2 2
t=1
Taking logs,
We have
= y X,
n
X
(yt xt )2
ln L(, ) = n ln 2 n ln
.
2 2
t=1
It's lear that the fon for the MLE of
are the same as the fon for OLS (up to mul-
the estimators are the same, under the present assumptions.

Therefore, their properties are the same. In parti ular, under the lassi al assumptions
with normality, the OLS estimator is asymptoti ally e ient.
tipli ation by a onstant), so
As we'll see later, it will be possible to use (iterated) linear estimation methods and still
a hieve asymptoti e ien y even if the assumption that
normally distributed. This is
not
the ase if
V ar() 6= 2 In , as long as is still
is nonnormal. In general with nonnormal
errors it will be ne essary to use nonlinear estimation methods to a hieve asymptoti ally
e ient estimation. That possibility is addressed in the se ond half of the notes.
5.4 Exer ises

1. Write an O tave program that generates a histogram for
of

n j j ,
rameters.
where
is the OLS estimator and
Monte Carlo repli ations
is one of the
slope pa-
should be a large number, at least 1000. The model used to generate
data should follow the lassi al assumptions, ex ept that the errors should not be
56CHAPTER 5. ASYMPTOTIC PROPERTIES OF THE LEAST SQUARES ESTIMATOR
normally distributed (try
n {20, 50, 100, 1000} .
ment.
U (a, a), t(p), 2 (p) p,
et ).
Generate histograms for
Do you observe eviden e of asymptoti normality?
Com-
Chapter 6
Restri tions and hypothesis tests
6.1 Exa t linear restri tions
In many ases, e onomi theory suggests restri tions on the parameters of a model. For
example, a demand fun tion is supposed to be homogeneous of degree zero in pri es and
in ome. If we have a Cobb-Douglas (log-linear) model,
ln q = 0 + 1 ln p1 + 2 ln p2 + 3 ln m + ,
then we need that
k0 ln q = 0 + 1 ln kp1 + 2 ln kp2 + 3 ln km + ,
so
1 ln p1 + 2 ln p2 + 3 ln m = 1 ln kp1 + 2 ln kp2 + 3 ln km
= (ln k) (1 + 2 + 3 ) + 1 ln p1 + 2 ln p2 + 3 ln m.
The only way to guarantee this for arbitrary
is to set
1 + 2 + 3 = 0,
whi h is a
parameter restri tion.
In parti ular, this is a linear equality restri tion, whi h
is probably the most ommonly en ountered ase.
6.1.1 Imposition
The general formulation of linear equality restri tions is the model
y = X +
R = r
where
is a
QK
R
matrix,
We assume
We also assume that
Q<K
is of rank
Q,
and
is a
Q1
ve tor of onstants.
so that there are no redundant restri tions.
that satises the restri tions: they aren't infeasible.
57
58
CHAPTER 6.
Let's onsider how to estimate
RESTRICTIONS AND HYPOTHESIS TESTS
R = r.
subje t to the restri tions
The most obvious
approa h is to set up the Lagrangean
min s() =
1
(y X) (y X) + 2 (R r).
n
The Lagrange multipliers are s aled by 2, whi h makes things less messy. The fon are
)
= 2X y + 2X X R + 2R
0
D s(,
)
= RR r 0,
D s(,
whi h an be written as
"
We get
"
X X R
R
#
"
#"
X X R
R
"
X y
#1 "
X y
r
For the maso hists: Stepwise Inversion
Note that
"
(X X)1
R (X X)1 IQ
#"
X X R
R
AB
=
"
"
IK
(X X)1 R
R (X X)1 R
#
(X X)1 R
IK
0
C,
and
"
IK
(X X)1 R P 1
P 1
#"
IK
(X X)1 R
DC
= IK+Q ,
so
DAB = IK+Q
DA = "
B 1
#
#"
(X X)1
0
IK (X X)1 R P 1
1
B
=
R (X X)1 IQ
0
P 1
#
"
(X X)1 (X X)1 R P 1 R (X X)1 (X X)1 R P 1
,
=
P 1 R (X X)1
P 1
6.1.
59
EXACT LINEAR RESTRICTIONS
so (everyone should start paying attention again, and please note that we have made the
denition
"
P = R (X X)1 R )
"
(X X)1 (X X)1 R P 1 R (X X)1 (X X)1 R P 1
P 1 R (X X)1
P 1

(X X)1 R P 1 R r

=
P 1 R r
#
"
"
#
X)1 R P 1 r
(X
IK (X X)1 R P 1 R
+
=
P 1 r
P 1 R
The fa t that
and
are linear fun tions of
tions, sin e the distribution of

for
and
is
makes
#"
X y
r
it easy to determine their distribu-
already known. Re all that for
a matrix and ve tor of onstants, respe tively,
a random ve tor, and
V ar (Ax + b) = AV ar(x)A .
Though this is the obvious way to go about nding the restri ted estimator, an easier
way, if the number of restri tions is small, is to impose them by substitution. Write
h
where
R1
is
R1 R2
Q Q nonsingular.
an always make
R1
"
1
2
y = X1 1 + X2 2 +
#
= r
Supposing the
Q restri tions are linearly independent,
nonsingular by reorganizing the olumns of
X.
one
Then
1 = R11 r R11 R2 2 .
Substitute this into the model
y = X1 R11 r X1 R11 R2 2 + X2 2 +

y X1 R11 r = X2 X1 R11 R2 2 +
or with the appropriate denitions,
yR = XR 2 + .
This model satises the lassi al assumptions,
estimate by OLS. The varian e of
supposing the restri tion is true.
is as before
V (2 ) = XR
XR
and the estimator is
V (2 ) = XR
XR
where one estimates
02
1
1
02
in the normal way, using the restri ted model,
c2 =

yR XR b2
yR XR b2
n (K Q)
i.e.,
One an
60
CHAPTER 6.
1 , use the restri tion.

2 , so
of
To re over
fun tion
To nd the varian e of
1 ,
use the fa t that it is a linear

V (1 ) = R11 R2 V (2 )R2 R11

1
= R11 R2 X2 X2
R2 R11 02
6.1.2 Properties of the restri ted estimator

We have that

R = (X X)1 R P 1 R r
= + (X X)1 R P 1 r (X X)1 R P 1 R(X X)1 X y
= + (X X)1 X + (X X)1 R P 1 [r R] (X X)1 R P 1 R(X X)1 X
R = (X X)1 X
+ (X X)1 R P 1 [r R]
(X X)1 R P 1 R(X X)1 X

Mean squared error is
M SE(R ) = E(R )(R )

Noting that the rosses between the se ond term and the other terms expe t to zero, and
that the ross of the rst and third has a an ellation with the square of the third, we
obtain
M SE(R ) = (X X)1 2
+ (X X)1 R P 1 [r R] [r R] P 1 R(X X)1
(X X)1 R P 1 R(X X)1 2
So, the rst term is the OLS ovarian e. The se ond term is PSD, and the third term is
NSD.
True restri tions
If the restri tion is true, the se ond term is 0, so we are better o.
If the restri tion is false, we may be better or worse o, in terms of MSE, depending
improve e ien y of estimation.

on the magnitudes of
r R
and
2 .
6.2 Testing
In many ases, one wishes to test e onomi theories. If theory suggests parameter restri tions, as in the above homogeneity example, one an test theory by testing parameter
restri tions. A number of tests are available.
6.2.1 t-test
Suppose one has the model
6.2.
61
TESTING
y = X +
and one wishes to test the
normality of the errors,
single restri tion H0 :R = r vs. HA :R 6= r .

R r N 0, R(X X)1 R 02
so
The problem is that
R r
R(X X)1 R 02
02
R r
R(X X)1 R
Under
N (0, 1) .
is unknown. One ould use the onsistent estimator
02 , but the test would only be valid asymptoti ally in this ase.
Proposition 4
H0 , with
N (0, 1)
q 2
t(q)
c2
in pla e of
(6.1)
(q)
q
as long as the N (0, 1) and the 2 (q) are independent.

We need a few results on the
distribution.
Proposition 5 If x N (, In ) is a ve tor of n independent r.v.'s., then

x x 2 (n, )
where =
When a
2
i i
r.v.
is the
(6.2)
non entrality parameter.
has the non entrality parameter equal to zero, it is referred to as
2
a entral r.v., and it's distribution is written as
2 (n),
suppressing the non entrality
parameter.
Proposition 6 If the n dimensional random ve tor x N (0, V ), then x V 1 x 2 (n).

We'll prove this one as an indi ation of how the following unproven propositions ould
be proved.
Proof: Fa tor
V 1
as
P P
(this is the Cholesky fa torization, where
upper triangular). Then onsider
y = P x.
We have
y N (0, P V P )
but
V P P
PV P P
so
P V P = In
and thus
y N (0, In ).
Thus
= In
= P
y y 2 (n)
y y = x P P x = xV 1 x
and we get the result we wanted.
but
is dened to be
62
CHAPTER 6.
A more general proposition whi h implies this result is
Proposition 7 If the n dimensional random ve tor x N (0, V ), then

x Bx 2 ((B))
(6.3)
if and only if BV is idempotent.

An immediate onsequen e is
Proposition 8 If the random ve tor (of dimension n) x N (0, I), and B is idempotent
with rank r, then
x Bx 2 (r).
(6.4)
Consider the random variable

=
02
MX
02

MX
=
0
0
2 (n K)
Proposition 9 If the random ve tor (of dimension n) x N (0, I), then Ax and x Bx are
independent if AB = 0.
Now onsider (remember that we have only one restri tion in this ase)
Rr
R(X X)1 R
q
=

(nK)02
This will have the
(X X)1 X
and
t(n K)
distribution if
0
c
R r
R(X X)1 R
and
are independent.
But
= +
(X X)1 X MX = 0,
so
0
c
R r
R(X X)1 R
In parti ular, for the ommonly en ountered

for whi h
H0 : i = 0
vs.
H0 : i 6= 0
R r
t(n K)
test of signi an e of an individual oe ient,
, the test statisti is
i
t(n K)
Note:
the
t test is stri tly valid only if the errors are a tually normally distributed.
If one has nonnormal errors, one ould use the above asymptoti result to justify
taking riti al values from the
n .
N (0, 1)
distribution, sin e
t(n K) N (0, 1)
as
In pra ti e, a onservative pro edure is to take riti al values from the
distribution if nonnormality is suspe ted. This will reje t

distribution is fatter-tailed than is the normal.
H0
less often sin e the
t
t
6.2.
63
TESTING
6.2.2
The
test
test allows testing multiple restri tions jointly.
Proposition 10 If x 2 (r) and y 2 (s), then

x/r
F (r, s)
y/s
(6.5)
provided that x and y are independent.

Proposition 11 If the random ve tor (of dimension n) x N (0, I), then x Ax and x Bx
are independent if AB = 0.
Using these results, and previous results on the

that the following statisti has the
F =
distribution, it is simple to show
distribution:
1

R r
R r
R (X X)1 R
q
2
F (q, n K).
A numeri ally equivalent expression is
(ESSR ESSU ) /q
F (q, n K).
ESSU /(n K)
Note:
The
test is stri tly valid only if the errors are truly normally distributed.
The following tests will be appropriate when one annot assume normally distributed
errors.
6.2.3 Wald-type tests

The Wald prin iple is based on the idea that if a restri tion is true, the unrestri ted model
should approximately satisfy the restri tion. Given that the least squares estimator is
asymptoti ally normally distributed:
then under
H0 : R0 = r,
so by Proposition [6
Note that
Q1
X
estimators.
or
Use
02

d
n 0 N 0, 02 Q1
X
we have

d
n R r N 0, 02 RQ1
X R

d
1
r
n R r
R
R
02 RQ1
2 (q)
X
are not observable. The test statisti we use substitutes the onsistent
(X X/n)1
as the onsistent estimator of
Q1
X .
With this, there is a
an ellation of n s, and the statisti to use is
R r

d
c2 R(X X)1 R 1 R r
2 (q)
0
64
CHAPTER 6.
The Wald test is a simple way to test restri tions without having to estimate the
Note that this formula is similar to one of the formulae provided for the
restri ted model.
test.
6.2.4 S ore-type tests (Rao tests, Lagrange multiplier tests)

In some ases, an unrestri ted model may be nonlinear in the parameters, but the model
is linear in the parameters under the null hypothesis. For example, the model
y = (X) +
is nonlinear in
and
, but is linear in
under
H0 : = 1. Estimation of nonlinear models
is a bit more ompli ated, so one might prefer to have a test based upon the restri ted,
linear model. The s ore test is useful in this situation.
S ore-type tests are based upon the general prin iple that the gradient ve tor of the
unrestri ted model, evaluated at the restri ted estimate, should be asymptoti ally
normally distributed with mean zero, if the restri tions are true.
The original de-
velopment was for ML estimation, but the prin iple is valid for a wide variety of
estimation methods.
We have seen that

1
R(X X)1 R
R r

= P 1 R r
so
Given that
nP =

n R r

d
n R r N 0, 02 RQ1
X R
under the null hypothesis, we obtain
So
Noting that

d
1
nP 02 RQ1
n
P
R
2 (q)
X
1
R,
lim nP = RQX
sin e the powers of
nP N 0, 02 RQ1
X R
n an el.
we obtain,
R(X X)1 R
02
2 (q)
To get a usable test statisti substitute a onsistent estimator
2
of 0 .
This makes it lear why the test is sometimes referred to as a Lagrange multiplier
test. It may seem that one needs the a tual Lagrange multipliers to al ulate this.
6.2.
65
TESTING
If we impose the restri tions by substitution, these are not available. Note that the
test an be written as

(X X)1 R
R
02
2 (q)
However, we an use the fon for the restri ted estimator:
X y + X X R + R
to get that
= X (y X R )
R
= X R
Substituting this into the above, we get
R X(X X)1 X R d 2
(q)
02
but this is simply
PX
d
R 2 (q).
02
To see why the test is also known as a s ore test, note that the fon for restri ted least
squares
X y + X X R + R
give us
= X y X X R
R
and the rhs is simply the gradient (s ore) of the unrestri ted model, evaluated at the
restri ted estimator.
The s ores evaluated at the unrestri ted estimate are identi ally
zero. The logi behind the s ore test is that the s ores evaluated at the restri ted estimate
should be approximately zero, if the restri tion is true. The test is also known as a Rao
test, sin e P. Rao rst proposed it in 1948.
6.2.5 Likelihood ratio-type tests

The Wald test an be al ulated using the unrestri ted model.
The s ore test an be
al ulated using only the restri ted model. The likelihood ratio test, on the other hand,
uses both the restri ted and the unrestri ted estimators. The test statisti is

ln L()
LR = 2 ln L()
where
is the unrestri ted estimate and
is the restri ted estimate. To show that it is
2
asymptoti ally , take a se ond order Taylor's series expansion of
ln L()
+
ln L()

n

H()
2
ln L()
about
66
CHAPTER 6.
(note, the rst order term drops out sin e

multiply the se ond-order term by
sin e
0
D ln L()
H()
by the fon and we need to
is dened in terms of
1
n
ln L())
so

LR n H()
As
H (0 ) = I(0 ),
n , H()
by the information matrix equality. So

a
LR = n I (0 )
?? that
We also have that, from [

a
n 0 = I (0 )1 n1/2 g(0 ).
An analogous result for the restri ted estimator is (this is unproven here, to prove this set
up the Lagrangean for MLE subje t to
:
R = r,
and manipulate the rst order onditions)

1

a
RI (0 )1 n1/2 g(0 ).
n 0 = I (0 )1 In R RI (0 )1 R
Combining the last two equations

1

a
n = n1/2 I (0 )1 R RI (0 )1 R
RI (0 )1 g(0 )
??
so, substituting into [
i
i
h
1 h
a
LR = n1/2 g(0 ) I (0 )1 R RI (0 )1 R
RI (0 )1 n1/2 g(0 )
But sin e
n1/2 g(0 ) N (0, I (0 ))

the linear fun tion
RI (0 )1 n1/2 g(0 ) N (0, RI (0 )1 R ).

We an see that LR is a quadrati form of this rv, with the inverse of its varian e in the
middle, so
LR 2 (q).
6.3 The asymptoti equivalen e of the LR, Wald and s ore

tests
We have seen that the three tests all onverge to
onverge to the
same
random variables. In fa t, they all
2 rv, under the null hypothesis. We'll show that the Wald and LR
tests are asymptoti ally equivalent.

equivalent to
We have seen that the Wald test is asymptoti ally

a
d
1
r
R
W = n R r
R
2 (q)
02 RQ1
X
6.3.
THE ASYMPTOTIC EQUIVALENCE OF THE LR, WALD AND SCORE TESTS67
Using
0 = (X X)1 X
and
R r = R( 0 )
we get
nR( 0 ) =
nR(X X)1 X
1
XX
= R
n1/2 X
n
?? to get
Substitute this into [
=
a
=
where
PR
1
RQ1
X X
1
a
= X(X X)1 R 02 R(X X)1 R
R(X X)1 X
2
1
= n1 XQ1
X R 0 RQX R
A(A A)1 A
02
PR
02
is the proje tion matrix formed by the matrix
Note that this matrix is idempotent and has

rank
X(X X)1 R .
olumns, so the proje tion matrix has
q.
Now onsider the likelihood ratio statisti
LR = n1/2 g(0 ) I(0 )1 R RI(0 )1 R
1
RI(0 )1 n1/2 g(0 )
Under normality, we have seen that the likelihood fun tion is
1 (y X) (y X)
.
ln L(, ) = n ln 2 n ln
2
2
Using this,
1
ln L(, )
n
X (y X0 )
n 2
X
n 2
g(0 ) D
=
=
68
CHAPTER 6.
Also, by the information matrix equality:
I(0 ) = H (0 )
= lim D g(0 )
X (y X0 )
= lim D
n 2
X X
= lim
n 2
QX
=
2
so
I(0 )1 = 2 Q1
X
??, we get
Substituting these last expressions into [
LR = X (X X)1 R 02 R(X X)1 R

PR
a
=
02
1
R(X X)1 X
= W
This ompletes the proof that the Wald and LR tests are asymptoti ally equivalent. Sim-
under the null hypothesis,
ilarly, one an show that,
qF = W = LM = LR
The proof for the statisti s ex ept for
LR
does not depend upon normality of the
errors, as an be veried by examining the expressions for the statisti s.
The
LR
statisti
is
based upon distributional assumptions, sin e one an't write the
likelihood fun tion without them.
However, due to the lose relationship between the statisti s

normality, the
qF
statisti an be thought of as a
qF
and
LR,
pseudo-LR statisti ,
supposing
in that it's
like a LR statisti in that it uses the value of the obje tive fun tions of the restri ted
and unrestri ted models, but it doesn't require distributional assumptions.
The presentation of the s ore and Wald tests has been done in the ontext of the linear
model.
This is readily generalizable to nonlinear models and/or other estimation
methods.
Though the four statisti s
are
asymptoti ally equivalent, they are numeri ally dierent in
small samples. The numeri values of the tests also depend upon how
is estimated, and
we've already seen than there are several ways to do this. For example all of the following
are onsistent for
under
H0
6.4.
69
INTERPRETATION OF TEST STATISTICS

nk

n
R R
nk+q
R R
n
and in general the denominator all be repla ed with any quantity
a su h that lim a/n = 1.
It an be shown, for linear regression models subje t to linear restri tions, and if
used to al ulate the Wald test and
R R
n

n is
is used for the s ore test, that
W > LR > LM.

For this reason, the Wald test will always reje t if the LR test reje ts, and in turn the LR
test reje ts if the LM test reje ts. This is a bit problemati : there is the possibility that by
areful hoi e of the statisti used, one an manipulate reported results to favor or disfavor
a hypothesis. A onservative/honest approa h would be to report all three test statisti s
when they are available. In the ase of linear models with normal errors the
test is to
be preferred, sin e asymptoti approximations are not an issue.

The small sample behavior of the tests an be quite dierent. The true size (probability
of reje tion of the null when the null is true) of the Wald test is often dramati ally higher
than the nominal size asso iated with the asymptoti distribution. Likewise, the true size
of the s ore test is often smaller than the nominal size.
6.4 Interpretation of test statisti s

Now that we have a menu of test statisti s, we need to know how to use them.
6.5 Conden e intervals

Conden e intervals for single oe ients are generated in the normal manner. Given the
statisti
t() =
a
100 (1 ) % onden e
t()
does not reje t
interval for
H0 : 0 = ,
using a
is dened by the bounds of the set of
is the interval
su h that
signi an e level:
C() = { : c/2 <

The set of su h

< c/2 }

cc/2
A onden e ellipse for two oe ients jointly would be, analogously, the set of {1 , 2 }
su h that the
(or some other test statisti ) doesn't reje t at the spe ied riti al value.
This generates an ellipse, if the estimators are orrelated.
70
CHAPTER 6.
Figure 6.1: Joint and Individual Conden e Regions
/home/mi hael/Mystuff/resear h/ParallelKnoppix/Examples/E onometri s/Examples/Figures/Join
The region is an ellipse, sin e the CI for an individual oe ient denes a (innitely
long) re tangle with total prob. mass
1, sin e the other oe ient is marginalized
(e.g., an take on any value). Sin e the ellipse is bounded in both dimensions but
also ontains mass
1 ,
it must extend beyond the bounds of the individual CI.
From the pi tue we an see that:
Reje tion of hypotheses individually does not imply that the joint test will
reje t.
Joint reje tion does not imply individal tests will reje t.
6.6 Bootstrapping
When we rely on asymptoti theory to use the normal distribution-based tests and onden e intervals, we're often at serious risk of making important errors. If the sample size is
small and errors are highly nonnormal, the small sample distribution of

n 0
may
be very dierent than its large sample distribution. Also, the distributions of test statisti s
may not resemble their limiting distributions at all. A means of trying to gain information
on the small sample distribution of test statisti s and estimators is the
bootstrap.
We'll
onsider a simple example, just to get the main idea.

Suppose that
X0 +
IID(0, 02 )
X
Given that the distribution of
is nonsto hasti
is unknown,
the distribution of
will be unknown
samples. However, sin e we have random sampling, we ould generate
in small
arti ial data.
The
steps are:
1. Draw
observations from
2. Then generate the data by
with repla ement.
Call this ve tor
yj = X + j
3. Now take this and estimate
j = (X X)1 X yj .
4. Save
(it's a
n 1).
6.7.
TESTING NONLINEAR RESTRICTIONS, AND THE DELTA METHOD
5. Repeat steps 1-4, until we have a large number,
J,
With this, we an use the repli ations to al ulate the

way to form a 100(1-)%
of
71
j .
empiri al distribution of j .
One
j from smallest
onden e interval for 0 would be to order the
J/2
to largest, and drop the rst and last
of the repli ations, and use the remaining
endpoints as the limits of the CI. Note that this will not give the shortest CI if the empiri al
distribution is skewed.
Suppose one was interested in the distribution of some fun tion of

test statisti . Simple: just al ulate the transformation for ea h
j,
for example a
and work with
the empiri al distribution of the transformation.
If the assumption of iid errors is too strong (for example if there is heteros edasti ity
or auto orrelation, see below) one an work with a bootstrap dened by sampling
from
(y, x)
with repla ement.
How to hoose
J: J
repetition of the entire bootstrap.

hange a lot, in rease
should be large enough that the results don't hange with
This is easy to he k.
If you nd the results
and try again.
The bootstrap is based fundamentally on the idea that the empiri al distribution of
the sample data onverges to the a tual sampling distribution as
be omes large,
so statisti s based on sampling from the empiri al distribution should onverge in

distribution to statisti s based on sampling from the a tual sampling distribution.
In nite samples, this doesn't hold. At a minimum, the bootstrap is a good way to
he k if asymptoti theory results oer a de ent approximation to the small sample
distribution.
Bootstrapping an be used to test hypotheses. Basi ally, use the bootstrap to get an
approximation to the empiri al distribution of the test statisti under the alternative
hypothesis, and use this to get riti al values. Compare the test statisti al ulated
using the real data, under the null, to the bootstrap riti al values. There are many
variations on this theme, whi h we won't go into here.
6.7 Testing nonlinear restri tions, and the Delta Method

Testing nonlinear restri tions of a linear model is not mu h more di ult, at least when
the model is linear. Sin e estimation subje t to nonlinear restri tions requires nonlinear
estimation methods, whi h are beyond the s ore of this ourse, we'll just onsider the Wald
test for nonlinear restri tions on a linear model.
Consider the
nonlinear restri tions
r(0 ) = 0.
where
at
r()
as
is a
q -ve tor
valued fun tion. Write the derivative of the restri tion evaluated

D r() = R()
72
CHAPTER 6.
We suppose that the restri tions are not redundant in a neighborhood of
0 ,
so that
(R()) = q
0 .
in a neighborhood of
Take a rst order Taylor's series expansion of
r()
about
0 :
= r(0 ) + R( )( 0 )
r()
where
is a onvex ombination of
and
0 .
Under the null hypothesis we have
= R( )( 0 )
r()
Due to onsisten y of
we an repla e
=
nr()
We've already seen the distribution of
by
0 ,
asymptoti ally, so
nR(0 )( 0 )
n( 0 ).
Using this we get

d
2

nr()
N 0, R(0 )Q1
X R(0 ) 0 .
Considering the quadrati form
R(0 )Q1 R(0 )

nr()
X
02
under the null hypothesis.
sulting statisti is
1
r()
Substituting onsistent estimators for
1

X)1 R()
R()(X
r()
r()
under the null hypothesis.
2 (q)
c2
0, QX
and
02 ,
the re-
2 (q)
Delta method, or as Klein's approximation.
This is known in the literature as the
Sin e this is a Wald test, it will tend to over-reje t in nite samples. The s ore and
LR tests are also possibilities, but they require estimation methods for nonlinear
models, whi h aren't in the s ope of this ourse.
Note that this also gives a onvenient way to estimate nonlinear fun tions and asso iated
asymptoti onden e intervals. If the nonlinear fun tion
r(0 )
is not hypothesized to be
zero, we just have

d
2
r(0 )
n r()
N 0, R(0 )Q1
X R(0 ) 0
so an approximation to the distribution of the fun tion of the estimator is
N (r(0 ), R(0 )(X X)1 R(0 ) 2 )

r()
0
6.7.
TESTING NONLINEAR RESTRICTIONS, AND THE DELTA METHOD
For example, the ve tor of elasti ities of a fun tion
(x) =
where
f (x)
73
is
x
f (x)
x
f (x)
means element-by-element multipli ation. Suppose we estimate a linear fun tion
y = x + .
The elasti ities of
w.r.t.
are
(x) =
x
x
(note that this is the entire ve tor of elasti ities). The estimated elasti ities are
b(x) =
x
x
To al ulate the estimated standard errors of all ve elasti ites, use
R() =
(x)

x1 0 0
.
0 x
.
.
2
.
.
..
..
0
0 0 xk
To get a onsistent estimator just substitute in

error are fun tions of
1 x21
2 x22
.
.
.
(x )2
..
0
.
.
.
k x2k
Note that the elasti ity and the standard
x. The program ExampleDeltaMethod.m shows how this an be done.
In many ases, nonlinear restri tions an also involve the data, not just the parameters.
For example, onsider a model of expenditure shares. Let
where
is pri es and
x(p, m)
be a demand fun ion,
is in ome. An expenditure share system for
si (p, m) =
goods is
pi xi (p, m)
, i = 1, 2, ..., G.
m
Now demand must be positive, and we assume that expenditures sum to in ome, so we
have the restri tions
G
X
0 si (p, m) 1, i
si (p, m)
i=1
Suppose we postulate a linear model for the expenditure shares:
i
si (p, m) = 1i + p pi + mm
+ i
It is fairly easy to write restri tions su h that the shares sum to one, but the restri tion
that the shares lie in the
[0, 1]
interval depends on both parameters and the values of
74
CHAPTER 6.
and
m.
It is impossible to impose the restri tion that
0 si (p, m) 1
and
m.
In su h ases, one might onsider whether or not a linear model is a reasonable
for all possible
spe i ation.
6.8 Example: the Nerlove data

Remember that we in a previous example (se tion 3.8.3) that the OLS results for the
Nerlove model are
*********************************************************
Observations 145
R-squared 0.925955
onstant
output
labor
fuel
apital
estimate
-3.527
0.720
0.436
0.427
-0.220
st.err.
1.774
0.017
0.291
0.100
0.339
t-stat.
-1.987
41.244
1.499
4.249
-0.648
p-value
0.049
0.000
0.136
0.000
0.518
*********************************************************
Note that
sK = K < 0,
and that
L + F + K 6= 1.
Remember that if we have onstant returns to s ale, then

homogeneity of degree 1 then
separately or jointly.
L + F + K = 1.
Q = 1,
We an test these hypotheses either
NerloveRestri tions.m imposes and tests CRTS and then HOD1.
From it we obtain the results that follow:
Imposing and testing HOD1

*******************************************************
Restri ted LS estimation results
Observations 145
R-squared 0.925652
onstant
output
labor
fuel
and if there is
estimate
-4.691
0.721
0.593
0.414
st.err.
0.891
0.018
0.206
0.100
t-stat.
-5.263
41.040
2.878
4.159
p-value
0.000
0.000
0.005
0.000
6.8.
75
EXAMPLE: THE NERLOVE DATA
apital
-0.007
0.192
-0.038
0.969
*******************************************************
Value
p-value
F
0.574
0.450
Wald
0.594
0.441
LR
0.593
0.441
S ore
0.592
0.442
Imposing and testing CRTS
*******************************************************
Restri ted LS estimation results
Observations 145
R-squared 0.790420
onstant
output
labor
fuel
apital
estimate
-7.530
1.000
0.020
0.715
0.076
st.err.
2.966
0.000
0.489
0.167
0.572
t-stat.
-2.539
Inf
0.040
4.289
0.132
p-value
0.012
0.000
0.968
0.000
0.895
*******************************************************
Value
p-value
F
256.262
0.000
Wald
265.414
0.000
LR
150.863
0.000
S ore
93.771
0.000
Noti e that the input pri e oe ients in fa t sum to 1 when HOD1 is imposed. HOD1
e.g., = 0.10).
is not reje ted at usual signi an e levels (
Also,
R2
does not drop mu h
when the restri tion is imposed, ompared to the unrestri ted results.
should note that
Q = 1
Q = 1,
For CRTS, you
so the restri tion is satised. Also note that the hypothesis that
is reje ted by the test statisti s at all reasonable signi an e levels. Note that
R2
drops quite a bit when imposing CRTS. If you look at the unrestri ted estimation results,
you an see that a t-test for
Q = 1 also reje ts,
and that a onden e interval for
does
not overlap 1.
From the point of view of neo lassi al e onomi theory, these results are not anomalous:
HOD1 is an impli ation of the theory, but CRTS is not.
Exer ise 12 Modify the NerloveRestri tions.m program to impose and test the restri tions
jointly.
76
CHAPTER 6.
The Chow test
Sin e CRTS is reje ted, let's examine the possibilities more arefully.
Re all that the data is sorted by output (the third olumn). Dene 5 subsamples of rms,
with the rst group being the 29 rms with the lowest output levels, then the next 29 rms,
et . The ve subsamples an be indexed by
j=2
for
t = 30, 31, ...58,
j = 1, 2, ..., 5,
where
j=1
for
t = 1, 2, ...29,
et . Dene a pie ewise linear model
ln Ct = 1j + 2j ln Qt + 3j ln PLt + 4j ln PF t + 5j ln PKt + t
where
(6.6)
is a supers ript (not a power) that ini ates that the oe ients may be dierent
a ording to the subsample in whi h the observation falls. That is, the oe ients depend
upon
whi h in turn depends upon
t.
Note that the rst olumn of nerlove.data indi ates
this way of breaking up the sample. The new model may be written as
y1
X1 0

y2 0

.. ..
. = .

0
y5
where
y1
is 291,
j
and is the
X1
29 1
is 295,
X2
X3
X4
is the
51
.
+
5
X5
5
ve tor of oe ient for the
(6.7)
j th
subsample,
th subsample.
ve tor of errors for the j
The O tave program Restri tions/ChowTest.m estimates the above model. It also tests
the hypothesis that the ve subsamples share the same parameter ve tor, or in other words,
that there is oe ient stability a ross the ve subsamples. The null to test is that the
parameter ve tors for the separate groups are all the same, that is,
1 = 2 = 3 = 4 = 5
This type of test, that parameters are onstant a ross dierent sets of data, is sometimes
referred to as a
Chow test.
There are 20 restri tions. If that's not lear to you, look at the O tave program.
The restri tions are reje ted at all onventional signi an e levels.
Sin e the restri tions are reje ted, we should probably use the unrestri ted model for
analysis. What is the pattern of RTS as a fun tion of the output group (small to large)?
Figure 6.2 plots RTS. We an see that there is in reasing RTS for small rms, but that
RTS is approximately onstant for large rms.
6.9 Exer ises

1. Using the Chow test on the Nerlove model, we reje t that there is oe ient stability
a ross the 5 groups. But perhaps we ould restri t the input pri e oe ients to be
the same but let the onstant and output oe ients vary by group size. This new
6.9.
77
EXERCISES
Figure 6.2: RTS as a fun tion of rm size

2.6
RTS
2.4
2.2
1.8
1.6
1.4
1.2
0.8
1
1.5
2.5
3
Output group
3.5
4.5
model is
ln Ci = 1j + 2j ln Qi + 3 ln PLi + 4 ln PF i + 5 ln PKi + i
(a) estimate this model by OLS, giving
(6.8)
R, estimated standard errors for oe ients,
t-statisti s for tests of signi an e, and the asso iated p-values. Interpret the
results in detail.
(b) Test the restri tions implied by this model (relative to the model that lets all
oe ients vary a ross groups) using the F, qF, Wald, s ore and likelihood ratio
tests. Comment on the results.
( ) Estimate this model but imposing the HOD1 restri tion,
mation program.
using an OLS
esti-
Don't use m _olsr or any other restri ted OLS estimation
program. Give estimated standard errors for all oe ients.

(d) Plot the estimated RTS parameters as a fun tion of rm size. Compare the plot
to that given in the notes for the unrestri ted model. Comment on the results.
2. For the simple Nerlove model, estimated returns to s ale is
[
RT
S =
1
cq . Apply the
delta method to al ulate the estimated standard error for estimated RTS. Dire tly
test
H0 : RT S = 1
HA : Q 6= 1.
versus
HA : RT S 6= 1
rather than testing
H0 : Q = 1
versus
Comment on the results.
3. Perform a Monte Carlo study that generates data from the model
y = 2 + 1x2 + 1x3 +
where the sample size is 30,
[0, 1]
and
IIN (0, 1)
x2
and
x3
are independently uniformly distributed on
78
CHAPTER 6.
(a) Compare the means and standard errors of the estimated oe ients using OLS
and restri ted OLS, imposing the restri tion that
2 + 3 = 2.
(b) Compare the means and standard errors of the estimated oe ients using OLS
and restri ted OLS, imposing the restri tion that
( ) Dis uss the results.
2 + 3 = 1.
Chapter 7
Generalized least squares
One of the assumptions we've made up to now is that
t IID(0, 2 ),
or o asionally
t IIN (0, 2 ).
Now we'll investigate the onsequen es of nonidenti ally and/or dependently distributed
errors. We'll assume xed regressors for now, relaxing this admittedly unrealisti assumption later. The model is
y = X +
E() = 0
V () =
where
is a general symmetri positive denite matrix (we'll write
in pla e of
to
simplify the typing of these notes).
The ase where
The ase where
is a diagonal matrix gives un orrelated, nonidenti ally distributed
errors. This is known as
heteros edasti ity.
has the same number on the main diagonal but nonzero elements
o the main diagonal gives identi ally (assuming higher moments are also the same)
dependently distributed errors. This is known as
auto orrelation.
The general ase ombines heteros edasti ity and auto orrelation. This is known as
nonspheri al disturban es, though why this term is used, I have no idea. Perhaps
it's be ause under the lassi al assumptions, a joint onden e region for
an
dimensional hypersphere.
79
would be
80
CHAPTER 7.
GENERALIZED LEAST SQUARES
7.1 Ee ts of nonspheri al disturban es on the OLS estimator

The least square estimator is
= (X X)1 X y
= + (X X)1 X
We have unbiasedness, as before.
The varian e of
is
i
h

E ( )( ) = E (X X)1 X X(X X)1
= (X X)1 X X(X X)1
Due to this, any test statisti that is based upon an estimator of

there
isn't
(7.1)
is invalid, sin e
2
any , it doesn't exist as a feature of the true d.g.p. In parti ular, the
formulas for the
t, F, 2
based tests given above do not lead to statisti s with these
distributions.
If
is still onsistent, following exa tly the same argument given before.
is normally distributed, then
N , (X X)1 X X(X X)1

The problem is that
is unknown in general, so this distribution won't be useful for
testing hypotheses.
Without normality, and un onditional on
we still have

n
n(X X)1 X
=
1
XX
=
n1/2 X
n
Dene the limiting varian e of
n1/2 X
lim E
so we obtain
Summary:
(supposing a CLT applies) as
X X
n

d
1
n N 0, Q1
X QX
OLS with heteros edasti ity and/or auto orrelation is:
unbiased in the same ir umstan es in whi h the estimator is unbiased with iid errors
has a dierent varian e than before, so the previous test statisti s aren't valid
is onsistent
7.2.
81
THE GLS ESTIMATOR
is asymptoti ally normally distributed, but with a dierent limiting ovarian e matrix. Previous test statisti s aren't valid in this ase for this reason.
is ine ient, as is shown below.
7.2 The GLS estimator

Suppose
were known. Then one ould form the Cholesky de omposition
P P = 1
Here,
is an upper triangular matrix. We have
P P = In
so
P P P = P ,
whi h implies that
P P = In
Consider the model
P y = P X + P ,
or, making the obvious denitions,
y = X + .
This varian e of
= P
is
E(P P ) = P P
= In
Therefore, the model
y = X +
E( ) = 0
V ( ) = In
satises the lassi al assumptions. The GLS estimator is simply OLS applied to the transformed model:
GLS
= (X X )1 X y
= (X P P X)1 X P P y
= (X 1 X)1 X 1 y
The GLS estimator is unbiased in the same ir umstan es under whi h the OLS esti-
82
CHAPTER 7.
mator is unbiased. For example, assuming
is nonsto hasti

E(GLS ) = E (X 1 X)1 X 1 y

= E (X 1 X)1 X 1 (X +
= .
The varian e of the estimator, onditional on
GLS
an be al ulated using
= (X X )1 X y
= (X X )1 X (X + )
= + (X X )1 X
so

GLS

GLS

= E (X X )1 X X (X X )1
= (X X )1 X X (X X )1
= (X X )1
= (X 1 X)1
Either of these last formulas an be used.
All the previous results regarding the desirable properties of the least squares estimator hold, when dealing with the transformed model, sin e the transformed model
satises the lassi al assumptions..
Tests are valid, using the previous formulas, as long as we substitute

of
X.
2
Furthermore, any test that involves an set it to
1.
in pla e
This is preferable to
re-deriving the appropriate formulas.
The GLS estimator is more e ient than the OLS estimator. This is a onsequen e
of the Gauss-Markov theorem, sin e the GLS estimator is based on a model that
satises the lassi al assumptions but the OLS estimator is not. To see this dire tly,
not that (the following needs to be ompleted)
V ar(GLS ) = (X X)1 X X(X X)1 (X 1 X)1

V ar()
= AA
where
i
h
A = (X X)1 X (X 1 X)1 X 1 .
This may not seem obvious, but it
is true, as you an verify for yourself. Then noting that

a positive denite matrix, we on lude that
AA
AA
is a quadrati form in
is positive semi-denite, and that
GLS is e ient relative to OLS.
As one an verify by al ulating fon , the GLS estimator is the solution to the
minimization problem
GLS = arg min(y X) 1 (y X)
7.3.
83
FEASIBLE GLS
metri 1
so the
is used to weight the residuals.
7.3 Feasible GLS

The problem is that
isn't known usually, so this estimator isn't available.

nn matrix with n2 n /2+n = n2 + n /2
Consider the dimension of
The number of parameters to estimate is larger than
it's an
unique elements.
and in reases faster than
n.
There's no way to devise an estimator that satises a LLN without adding restri tions.
The
feasible GLS estimator
the form of
Suppose that we
is based upon making su ient assumptions regarding
so that a onsistent estimator an be devised.
parameterize as a fun tion of X
and
where
may in lude
as well
as other parameters, so that
= (X, )
where
estimate
is of xed dimension.
as long as
(X, )
If we an onsistently estimate
is a ontinuous fun tion of
we an onsistently
(by the Slutsky theorem). In
this ase,
If we repla e
tor.
p

b = (X, )
(X, )
in the formulas for the GLS estimator with
b we obtain
,
the FGLS estima-
The FGLS estimator shares the same asymptoti properties as GLS. These
are
1. Consisten y
2. Asymptoti normality
3. Asymptoti e ien y
if
the errors are normally distributed. (Cramer-Rao).
4. Test pro edures are asymptoti ally valid.
In pra ti e, the usual way to pro eed is

1. Dene a onsistent estimator of
the parameterization
2. Form
().
b = (X, )
This is a ase-by- ase proposition, depending on
We'll see examples below.
3. Cal ulate the Cholesky fa torization

4. Transform the model using
1 ).
Pb = Chol(
P y = P X + P
5. Estimate using OLS on the transformed model.
84
CHAPTER 7.
7.4 Heteros edasti ity

Heteros edasti ity is the ase where
E( ) =
is a diagonal matrix, so that the errors are un orrelated, but have dierent varian es.
Heteros edasti ity is usually thought of as asso iated with ross se tional data, though
there is absolutely no reason why time series data annot also be heteros edasti . A tually,
the popular ARCH (autoregressive onditionally heteros edasti ) models expli itly assume
that a time series is heteros edasti .
Consider a supply fun tion
qi = 1 + p Pi + s Si + i
where
Pi
is pri e and
Si
is some measure of size of the
ith
rm. One might suppose that
unobservable fa tors (e.g., talent of managers, degree of oordination between produ tion
units,
et .)
a ount for the error term
large rms than for small rms, then
i .
If there is more variability in these fa tors for
may have a higher varian e when
Si
is high than
when it is low.
Another example, individual demand.
qi = 1 + p Pi + m Mi + i
where
is pri e and
is in ome. In this ase,
an ree t variations in preferen es.
There are more possibilities for expression of preferen es when one is ri h, so it is possible
that the varian e of
ould be higher when
is high.
Add example of group means.
7.4.1 OLS with heteros edasti onsistent var ov estimation

Ei ker (1967) and White (1980) showed how to modify test statisti s to a ount for heteros edasti ity of unknown form. The OLS estimator has asymptoti distribution

d
1
n N 0, Q1
X QX
as we've already seen. Re all that we dened
lim E
n
This matrix has dimension
estimate
KK
X X
n
and an be onsistently estimated, even if we an't
onsistently. The onsistent estimator, under heteros edasti ity but no auto-
orrelation is
X
b= 1
xt xt 2t
n
t=1
One an then modify the previous test statisti s to obtain tests that are valid when there
is heteros edasti ity of unknown form. For example, the Wald test for
H0 : R r = 0
7.4.
85
HETEROSCEDASTICITY
would be

n R r
X X
n
1
X X
n
1
!1

a
R r 2 (q)
7.4.2 Dete tion

There exist many tests for the presen e of heteros edasti ity. We'll dis uss three methods.
Goldfeld-Quandt
tions, where
The sample is divided in to three parts, with
n1 + n2 + n3 = n.
the sample, separately, so that
n1 , n2
and
n3
observa-
The model is estimated using the rst and third parts of
and
will be independent. Then we have
1 M 1 1 d 2
1 1
=
(n1 K)
2
2
and
3 M 3 3 d 2
3 3
(n3 K)
=
2
2
so
1 1 /(n1 K) d
F (n1 K, n3 K).
3 3 /(n3 K)
The distributional result is exa t if the errors are normally distributed. This test is a twotailed test. Alternatively, and probably more onventionally, if one has prior ideas about the
possible magnitudes of the varian es of the observations, one ould order the observations
a ordingly, from largest to smallest. In this ase, one would use a onventional one-tailed
F-test.
Draw pi ture.
Ordering the observations is an important step if the test is to have any power.
The motive for dropping the middle observations is to in rease the dieren e between
the average varian e in the subsamples, supposing that there exists heteros edasti ity.
This an in rease the power of the test.
On the other hand, dropping too many
observations will substantially in rease the varian e of the statisti s
1 1
and
3 3 .
A rule of thumb, based on Monte Carlo experiments is to drop around 25% of the
observations.
If one doesn't have any ideas about the form of the het. the test will probably have
low power sin e a sensible data ordering isn't available.
White's test
When one has little idea if there exists heteros edasti ity, and no idea of its
potential form, the White test is a possibility. The idea is that if there is homos edasti ity,
then
E(2t |xt ) = 2 , t
so that
xt
or fun tions of
1. Sin e
xt
shouldn't help to explain
E(2t ).
isn't available, use the onsistent estimator
The test works as follows:
instead.
86
CHAPTER 7.
2. Regress
2t = 2 + zt + vt
where
zt
is a
P -ve tor. zt
may in lude some or all of the variables in
other variables. White's original suggestion was to use

squares and ross produ ts of variables in
3. Test the hypothesis that
= 0.
The
qF =
Note that
ESSR = T SSU ,
qF
plus the set of all unique
statisti in this ase is
P (ESSR ESSU ) /P
ESSU / (n P 1)
so dividing both numerator and denominator by this we
qF = (n P 1)
R2
as well as
xt .
get
Note that this is the
xt ,
xt ,
R2
1 R2
or the arti ial regression used to test for heteros edasti ity,
2
not the R of the original model.
An asymptoti ally equivalent statisti , under the null of no heteros edasti ity (so that
R2
should tend to zero), is
nR2 2 (P ).
This doesn't require normality of the errors, though it does assume that the fourth moment
of
is onstant, under the null.
Question:
why is this ne essary?
The White test has the disadvantage that it may not be very powerful unless the
zt
ve tor is hosen well, and this is hard to do without knowledge of the form of
heteros edasti ity.
It also has the problem that spe i ation errors other than heteros edasti ity may
lead to reje tion.
Note: the null hypothesis of this test may be interpreted as
model
(2t )
h( + zt ), where
h()
=0
for the varian e
is an arbitrary fun tion of unknown form. The
test is more general than is may appear from the regression that is used.
Plotting the residuals

squares).
A very simple method is to simply plot the residuals (or their
Draw pi tures here.
Like the Goldfeld-Quandt test, this will be more informative
if the observations are ordered a ording to the suspe ted form of the heteros edasti ity.
7.4.3 Corre tion

Corre ting for heteros edasti ity requires that a parametri form for
that a means for estimating
spe i to the for supplied for
() be supplied, and
onsistently be determined. The estimation method will be
(). We'll onsider two examples.
the general nature of GLS when there is heteros edasti ity.

Multipli ative heteros edasti ity
Before this, let's onsider
7.4.
87
HETEROSCEDASTICITY
Suppose the model is
yt = xt + t
t2 = E(2t ) = zt
but the other lassi al assumptions hold. In this ase
2t = zt
and
vt
+ vt
has mean zero. Nonlinear least squares ould be used to estimate
tently, were
and
onsis-
observable. The solution is to substitute the squared OLS residuals
2
pla e of t , sin e it is onsistent by the Slutsky theorem. On e we have
2
estimate t onsistently using
p
t2 = zt t2 .
and
2t
in
we an
In the se ond step, we transform the model by dividing by the standard deviation:
x
t
yt
= t +
t
or
yt = x
t + t .
Asymptoti ally, this model satises the lassi al assumptions.
This model is a bit omplex in that NLS is required to estimate the model of the
varian e. A simpler version would be
yt
xt + t
t2 = E(2t ) = 2 zt
where
zt
is a single variable. There are still two parameters to be estimated, and the
model of the varian e is still nonlinear in the parameters. However, the
sear h method
an be used in this ase to redu e the estimation problem to repeated appli ations
of OLS.
First, we dene an interval of reasonable values for
Partition this interval into
For ea h of these values, al ulate the variable
The regression
e.g.,
equally spa ed values, e.g.,
[0, 3].
{0, .1, .2, ..., 2.9, 3}.
ztm .
2t = 2 ztm + vt
is linear in the parameters, onditional on
m ,
so one an estimate
Save the pairs (m , m ), and the orresponding

minimum
ESSm
ESSm .
by OLS.
Choose the pair with the
as the estimate.
Next, divide the model by the estimated standard deviations.
88
CHAPTER 7.
Draw pi ture.
Can rene.
Works well when the parameter to be sear hed over is low dimensional, as in this
ase.
Groupwise heteros edasti ity

A ommon ase is where we have repeated observations on ea h of a number of e onomi
agents: e.g., 10 years of ma roe onomi data on ea h of a set of ountries or regions, or
daily observations of transa tions of 200 banks. This sort of data is a
time-series model.
pooled ross-se tion
It may be reasonable to presume that the varian e is onstant over time
within the ross-se tional units, but that it diers a ross them (e.g., rms or ountries of
dierent sizes...). The model is
yit = xit + it
E(2it ) = i2 , t
where
i = 1, 2, ..., G
are the agents, and
t = 1, 2, ..., n
are the observations on ea h agent.
The other lassi al assumptions are presumed to hold.
In this ase, the varian e
In this model, we assume that
i2
is spe i to ea h agent, but onstant over the
obser-
vations for that agent.
relax later.
E(it is ) = 0.
This is a strong assumption that we'll
To orre t for heteros edasti ity, just estimate ea h
i2
using the natural estimator:
i2 =
1X 2
it
n
t=1
1/n
Note that we use
With ea h of these, transform the model as usual:
so
nK
here sin e it's possible that there are more than
regressors,
ould be negative. Asymptoti ally the dieren e is unimportant.
yit
x it
= it +
i
Do this for ea h ross-se tional group. This transformed model satises the lassi al
assumptions, asymptoti ally.
7.4.4 Example: the Nerlove model (again!)

Let's he k the Nerlove data for eviden e of heteros edasti ity.
In what follows, we're
going to use the model with the onstant and output oe ient varying a ross 5 groups,
but with the input pri e oe ients xed (see Equation 6.8 for the rationale behind this).
Figure 7.1, whi h is generated by the O tave program GLS/NerloveResiduals.m plots the
residuals. We an see pretty learly that the error varian e is larger for small rms than
for larger rms.
7.4.
89
HETEROSCEDASTICITY
Figure 7.1: Residuals, Nerlove model, sorted by rm size

Regression residuals
1.5
Residuals
0.5
-0.5
-1
-1.5
0
20
40
60
80
100
120
140
160
Now let's try out some tests to formally he k for heteros edasti ity.
The O tave
program GLS/HetTests.m performs the White and Goldfeld-Quandt tests, using the above
model. The results are
Value
p-value
White's test
61.903
0.000
Value
p-value
GQ test
10.886
0.000
All in all, it is very lear that the data are heteros edasti . That means that OLS estimation
is not e ient, and tests of restri tions that ignore heteros edasti ity are not valid. The
previous tests (CRTS, HOD1 and the Chow test) were al ulated assuming homos edasti ity. The O tave program GLS/NerloveRestri tions-Het.m uses the Wald test to he k
1
for CRTS and HOD1, but using a heteros edasti - onsistent ovarian e estimator.
The
results are
Testing HOD1
Value
6.161
p-value
0.013
Value
20.169
p-value
0.001
Wald test
Testing CRTS
Wald test
1
By the way, noti e that GLS/NerloveResiduals.m and GLS/HetTests.m use the restri ted LS estimator
dire tly to restri t the fully general model with all oe ients varying to the model with only the onstant
and the output oe ient varying. But GLS/NerloveRestri tions-Het.m estimates the model by substituting the restri tions into the model. The methods are equivalent, but the se ond is more onvenient and
easier to understand.
90
CHAPTER 7.
We see that the previous on lusions are altered - both CRTS is and HOD1 are reje ted at
the 5% level. Maybe the reje tion of HOD1 is due to to Wald test's tenden y to over-reje t?
From the previous plot, it seems that the varian e of
is a de reasing fun tion of
output. Suppose that the 5 size groups have dierent error varian es (heteros edasti ity
by groups):
V ar(i ) = j2 ,
where
j =1
if
i = 1, 2, ..., 29,
et .,
as before. The O tave program GLS/NerloveGLS.m
estimates the model using GLS (through a transformation of the model so that OLS an
be applied). The estimation results are
*********************************************************
Observations 145
R-squared 0.958822
Results (Het. onsistent var- ov estimator)
onstant1
onstant2
onstant3
onstant4
onstant5
output1
output2
output3
output4
output5
labor
fuel
apital
estimate
-1.046
-1.977
-3.616
-4.052
-5.308
0.391
0.649
0.897
0.962
1.101
0.007
0.498
-0.460
st.err.
1.276
1.364
1.656
1.462
1.586
0.090
0.090
0.134
0.112
0.090
0.208
0.081
0.253
t-stat.
-0.820
-1.450
-2.184
-2.771
-3.346
4.363
7.184
6.688
8.612
12.237
0.032
6.149
-1.818
p-value
0.414
0.149
0.031
0.006
0.001
0.000
0.000
0.000
0.000
0.000
0.975
0.000
0.071
*********************************************************
*********************************************************
Observations 145
R-squared 0.987429
Results (Het. onsistent var- ov estimator)
estimate
st.err.
t-stat.
p-value
7.5.
91
AUTOCORRELATION
onstant1
onstant2
onstant3
onstant4
onstant5
output1
output2
output3
output4
output5
labor
fuel
apital
-1.580
-2.497
-4.108
-4.494
-5.765
0.392
0.648
0.892
0.951
1.093
0.103
0.492
-0.366
0.917
0.988
1.327
1.180
1.274
0.090
0.094
0.138
0.109
0.086
0.141
0.044
0.165
-1.723
-2.528
-3.097
-3.808
-4.525
4.346
6.917
6.474
8.755
12.684
0.733
11.294
-2.217
0.087
0.013
0.002
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.465
0.000
0.028
*********************************************************
Testing HOD1
Value
9.312
Wald test
p-value
0.002
The rst panel of output are the OLS estimation results, whi h are used to onsistently
estimate the
j2 .
The se ond panel of results are the GLS estimation results. Some om-
ments:
The
R2
measures are not omparable - the dependent variables are not the same.
The measure for the GLS results uses the transformed dependent variable. One ould
al ulate a omparable
R2
measure, but I have not done so.
The dieren es in estimated standard errors (smaller in general for GLS)
an
be
interpreted as eviden e of improved e ien y of GLS, sin e the OLS standard errors
are al ulated using the Huber-White estimator. They would not be omparable if
the ordinary (in onsistent) estimator had been used.
Note that the previously noted pattern in the output oe ients persists. The non onstant CRTS result is robust.
The oe ient on apital is now negative and signi ant at the 3% level. That seems
to indi ate some kind of problem with the model or the data, or e onomi theory.
Note that HOD1 is now reje ted. Problem of Wald test over-reje ting? Spe i ation
error in model?
7.5 Auto orrelation

Auto orrelation, whi h is the serial orrelation of the error term, is a problem that is
usually asso iated with time series data, but also an ae t ross-se tional data.
For
92
CHAPTER 7.
Figure 7.2: Auto orrelation indu ed by misspe i ation
/home/mi hael/Mystuff/resear h/ParallelKnoppix/Examples/E onometri s/Examples/Figures/Miss
example, a sho k to oil pri es will simultaneously ae t all ountries, so one ould expe t
ontemporaneous orrelation of ma roe onomi variables a ross ountries.
7.5.1 Causes
Auto orrelation is the existen e of orrelation a ross the error term:
E(t s ) 6= 0, t 6= s.
Why might this o ur? Plausible explanations in lude
1. Lags in adjustment to sho ks. In a model su h as
yt = xt + t ,
one ould interpret
xt
as the equilibrium value.
number of observations. One an interpret
Suppose
xt
is onstant over a
as a sho k that moves the system away
from equilibrium. If the time needed to return to equilibrium is long with respe t
to the observation frequen y, one ould expe t
t+1
to be positive, onditional on
positive, whi h indu es a orrelation.

2. Unobserved fa tors that are orrelated over time. The error term is often assumed
to orrespond to unobservable fa tors. If these fa tors are orrelated, there will be
auto orrelation.
3. Misspe i ation of the model. Suppose that the DGP is
yt = 0 + 1 xt + 2 x2t + t
but we estimate
yt = 0 + 1 xt + t
The ee ts are illustrated in Figure 7.2.
7.5.2 Ee ts on the OLS estimator

The varian e of the OLS estimator is the same as in the ase of heteros edasti ity - the
standard formula does not apply. The orre t formula is given in equation 7.1. Next we
dis uss two GLS orre tions for OLS. These will potentially indu e in onsisten y when
the regressors are nonsto hasti (see Chapter 8) and should either not be used in that
7.5.
93
AUTOCORRELATION
ase (whi h is usually the relevant ase) or used with aution.
The more re ommended
pro edure is dis ussed in se tion 7.5.5.
7.5.3 AR(1)
There are many types of auto orrelation.
We'll onsider two examples.
The rst is the
most ommonly en ountered ase: autoregressive order 1 (AR(1) errors. The model is
yt = xt + t
t = t1 + ut
ut iid(0, u2 )
E(t us ) = 0, t < s
We assume that the model satises the other lassi al assumptions.
We need a stationarity assumption:
By re ursive substitution we obtain
|| < 1.
Otherwise the varian e of
explodes as
in reases, so standard asymptoti s will not apply.
t = t1 + ut
= (t2 + ut1 ) + ut
= 2 t2 + ut1 + ut
= 2 (t3 + ut2 ) + ut1 + ut
In the limit the lagged
drops out, sin e
t =
m 0
as
m ,
so we obtain
m utm
m=0
With this, the varian e of
is found as
E(2t )
u2
If we had dire tly assumed that
2m
m=0
u2
2
were ovarian e stationary, we ould obtain this
using
V (t ) = 2 E(2t1 ) + 2E(t1 ut ) + E(u2t )

= 2 V (t ) + u2 ,
so
V (t ) =
The varian e is the
0th
u2
1 2
order auto ovarian e:
0 = V (t )
94
CHAPTER 7.
Note that the varian e does not depend on
Likewise, the rst order auto ovarian e
is
Cov(t , t1 ) = s = E((t1 + ut ) t1 )
=
V (t )
u2
1 2
Using the same method, we nd that for
s<t
Cov(t , ts ) = s =
The
t:
The auto ovarian es don't depend on
s u2
1 2
{t }
the pro ess
is
ovarian e stationary
orrelation ( in general, for r.v.'s x and y ) is dened as

orr(x, y)
ov(x, y)
se(x)se(y)
but in this ase, the two standard errors are the same, so the
s-order
auto orrelation
is
s = s
All this means that the overall matrix
u2
1 2
| {z }
this is the varian e

|
has the form
.
.
.
n1
..
{z
n1
n2
..
.

1
}
this is the orrelation matrix
So we have homos edasti ity, but elements o the main diagonal are not zero. All of
this depends only on two parameters,
and u2 . If we an estimate these onsistently,
we an apply FGLS.
It turns out that it's easy to estimate these onsistently. The steps are
1. Estimate the model
yt = xt + t
by OLS.
2. Take the residuals, and estimate the model
t =
t1 + ut
Sin e
t t ,
this regression is asymptoti ally equivalent to the regression
t = t1 + ut
7.5.
95
AUTOCORRELATION
whi h satises the lassi al assumptions. Therefore,
t =
t1 + ut is onsistent. Also, sin e ut
ut ,
obtained
by applying OLS to
the estimator
u2 =
1X 2 p 2
(
ut ) u
n
t=2
3. With the onsistent estimators

stru ture of
u2
and
, and estimate by FGLS.
form
= (
u2 , )
using the previous
A tually, one an omit the fa tor
sin e it an els out in the formula
u2 /(1 2 ),

1
1 X
1 y).
F GLS = X
(X
One an iterate the pro ess, by taking the rst FGLS estimator of
, re-estimating
2
and u , et . If one iterates to onvergen es it's equivalent to MLE (supposing normal
errors).
An asymptoti ally equivalent approa h is to simply estimate the transformed model
yt yt1 = (xt xt1 ) + ut

using
n1
observations (sin e
y0
and
x0
aren't available).
This is the method of
Co hrane and Or utt. Dropping the rst observation is asymptoti ally irrelevant, but
it an be very important in small samples.
One an re uperate the rst observation
by putting
y1 = y1
x1 = x1
1 2
1 2
This somewhat odd-looking result is related to the Cholesky fa torization of
1 . See
Davidson and Ma Kinnon, pg. 348-49 for more dis ussion. Note that the varian e of
y1
is
u2 , asymptoti ally,
so we see that the transformed model will be homos edasti
(and nonauto orrelated, sin e the
u s
are un orrelated with the
periods.
7.5.4 MA(1)
The linear regression model with moving average order 1 errors is
yt = xt + t
t = ut + ut1
ut iid(0, u2 )
E(t us ) = 0, t < s
y s,
in dierent time
96
CHAPTER 7.
In this ase,
i
h
V (t ) = 0 = E (ut + ut1 )2
=
u2 + 2 u2
u2 (1 + 2 )
Similarly
1 = E [(ut + ut1 ) (ut1 + ut2 )]

= u2
and
2 = [(ut + ut1 ) (ut2 + ut3 )]

= 0
so in this ase
= u2
1 + 2
1 + 2
..
.
.
.
.
.
.
..
1 + 2
Note that the rst order auto orrelation is
1 =
2
u
2 (1+2 )
u
This a hieves a maximum at
1
0
(1 + 2 )
= 1 and a minimum
at
= 1, and the maximal and
minimal auto orrelations are 1/2 and -1/2. Therefore, series that are more strongly
auto orrelated an't be MA(1) pro esses.
Again the ovarian e matrix has a simple stru ture that depends on only two parameters.
The problem in this ase is that one an't estimate
using OLS on
t = ut + ut1
be ause the
ut
are unobservable and they an't be estimated onsistently. However, there
is a simple way to estimate the parameters.
Sin e the model is homos edasti , we an estimate
V (t ) = 2 = u2 (1 + 2 )
7.5.
97
AUTOCORRELATION
using the typi al estimator:
1X 2
c2 = 2 (1
\
2) =
t
u
n
t=1
By the Slutsky theorem, we an interpret this as dening an (unidentied) estimator

of both
u2
and
e.g., use this as
X
c2 (1 + b2 ) = 1
2t
u
n
t=1
However, this isn't su ient to dene onsistent estimators of the parameters, sin e
it's unidentied.
To solve this problem, estimate the ovarian e of
and
t1
using
X
d2 = 1
d t , t1 ) =
t t1
Cov(
u
n
t=2
This is a onsistent estimator, following a LLN (and given that the epsilon hats
are onsistent for the epsilons).
unidentied estimator:
As above, this an be interpreted as dening an
X
c2 = 1
t t1
u
n
t=2
Now solve these two equations to obtain identied (and therefore onsistent) estimators of both
and
u2 .
Dene the onsistent estimator
c2 )

= (,
following the form we've seen above, and transform the model using the Cholesky
de omposition. The transformed model satises the lassi al assumptions asymptoti ally.
7.5.5 Asymptoti ally valid inferen es with auto orrelation of unknown

form
See Hamilton Ch. 10, pp. 261-2 and 280-84.
When the form of auto orrelation is unknown, one may de ide to use the OLS estimator,
without orre tion. We've seen that this estimator has the limiting distribution
where, as before,
is

d
1
n N 0, Q1
X QX
= lim E
n
We need a onsistent estimate of
Dene
X X
n
mt = xt t

(re all that
xt
is dened as a
K 1
98
CHAPTER 7.
ve tor). Note that
X =
t=1
n
X
i
2
xn .
..
n
x1 x2
n
X
xt t
mt
t=1
"
so that
1
= lim E
n n
We assume that
mt
does not depend on

Dene the
n
X
mt
t=1
n
X
mt
t=1
!#
is ovarian e stationary (so that the ovarian e between
mt
and
mts
t).
v th
mt
auto ovarian e of
as
v = E(mt mtv ).
Note that
mt
E(mt mt+v ) = v .
(show this with an example).
will be auto orrelated, sin e
In general, we expe t that:
is potentially auto orrelated:
v = E(mt mtv ) 6= 0
Note that this auto ovarian e does not depend on
ontemporaneously orrelated (
and heteros edasti (E(mit )
E(mit mjt ) 6= 0
t,
due to ovarian e stationarity.
), sin e the regressors in
xt
will in
general be orrelated (more on this later).
= i2
, whi h depends upon
i ), again sin e the regressors
will have dierent varian es.
While one ould estimate
parametri ally, we in general have little information upon whi h
to base a parametri spe i ation. Re ent resear h has fo used on onsistent nonparametri
estimators of
Now dene
1
n = E
n
We have (
"
n
X
mt
t=1
n
X
mt
t=1
!#
show that the following is true, by expanding sum and shifting rows to left)
n = 0 +
n2

n1
1
1 + 1 +
2 + 2 +
n1 + n1
n
n
n
The natural, onsistent estimator of
is
n
X
cv = 1
m
tm
tv .
n
t=v+1
7.5.
99
AUTOCORRELATION
where
m
t = xt t
(note:
one ould put
estimator of
1/(n v)
instead of
1/n
here).
So, a natural, but in onsistent,
would be

c + n 2
c + + 1
[
c1 +
c2 +
n =
c0 + n 1
[
+
n1
n1
1
2
n
n
n
n1

Xnv
c .
c0 +
cv +
=
v
n
v=1
This estimator is in onsistent in general, sin e the number of parameters to estimate is

more than the number of observations, and in reases more rapidly than
does not build up as
n .
On the other hand, supposing that
n,
so information
tends to zero su iently rapidly as
tends to
a modied estimator
where
q(n)
as
q(n)

X
c ,
cv +
n =
c0 +
v=1
will be onsistent, provided
q(n)
grows su iently slowly.
The assumption that auto orrelations die o is reasonable in many ases. For example, the AR(1) model with
|| < 1
has auto orrelations that die o.
nv
n an be dropped be ause it tends to one for
The term
A disadvantage of this estimator is that is may not be positive denite. This ould
in reases slowly relative to
v < q(n),
given that
q(n)
n.
ause one to al ulate a negative
statisti , for example!
E onometri a, 1987) that solves the prob-
Newey and West proposed and estimator (
lem of possible nonpositive deniteness of the above estimator. Their estimator is
n =
c0 +
q(n)
X
v=1

v
c .
cv +
1
v
q+1
This estimator is p.d. by onstru tion. The ondition for onsisten y is that
0.
Note that this is a very slow rate of growth for
q.
This estimator is nonparametri
- we've pla ed no parametri restri tions on the form of
kernel
n1/4 q(n)
It is an example of a
estimator.
Finally, sin e
has
p
n
as its limit,
. We an now
use
and
1
d
Q
X = nX X
to on-
sistently estimate the limiting distribution of the OLS estimator under heteros edasti ity
and auto orrelation of unknown form. With this, asymptoti ally valid tests are onstru ted
in the usual way.
7.5.6 Testing for auto orrelation

Durbin-Watson test
100
CHAPTER 7.
The Durbin-Watson test statisti is
DW
Pn
(
t t1 )2
t=2P
n
2t
t=1
Pn
t t1
2t 2
t=2
Pn 2
t
t=1
=
=
+ 2t1
The null hypothesis is that the rst order auto orrelation of the errors is zero:
1 = 0. The alternative
is of ourse
H0 :
HA : 1 6= 0. Note that the alternative is not that
the errors are AR(1), sin e many general patterns of auto orrelation will have the
rst order auto orrelation dierent than zero. For this reason the test is useful for
dete ting auto orrelation in general. For the same reason, one shouldn't just assume
that an AR(1) model is appropriate when the DW test reje ts the null.
Under the null, the middle term tends to zero, and the other two tend to one, so
Supposing that we had an AR(1) error pro ess with
Supposing that we had an AR(1) error pro ess with
DW 2.
term tends to
term tends to
2,
2,
so
so
= 1.
In this ase the middle
= 1.
In this ase the middle
DW 0
p
DW 4
These are the extremes:
The distribution of the test statisti depends on the matrix of regressors,
DW
always lies between 0 and 4.
X, so tables
an't give exa t riti al values. The give upper and lower bounds, whi h orrespond
to the extremes that are possible. See Figure
exa t riti al values onditional on
??.
There are means of determining
X.
Note that DW an be used to test for nonlinearity (add dis ussion).
The DW test is based upon the assumption that the matrix
is xed in repeated
samples. This is often unreasonable in the ontext of e onomi time series, whi h is
pre isely the ontext where the test would have appli ation. It is possible to relate
the DW test to other test statisti s whi h are valid without stri t exogeneity.
Breus h-Godfrey test

This test uses an auxiliary regression, as does the White test for heteros edasti ity.
The regression is
t = xt + 1 t1 + 2 t2 + + P tP + vt
and the test statisti is the
nR2 statisti , just as in the White test.
There are
restri tions,
2
so the test statisti is asymptoti ally distributed as a (P ).
The intuition is that the lagged errors shouldn't ontribute to explaining the urrent
error if there is no auto orrelation.
xt
is in luded as a regressor to a ount for the fa t that the
even if the
are not independent
are. This is a te hni ality that we won't go into here.
7.5.
101
AUTOCORRELATION
This test is valid even if the regressors are sto hasti and ontain lagged dependent
variables, so it is onsiderably more useful than the DW test for typi al time series
data.
The alternative is not that the model is an AR(P), following the argument above.
The alternative is simply that some or all of the rst
auto orrelations are dierent
from zero. This is ompatible with many spe i forms of auto orrelation.
7.5.7 Lagged dependent variables and auto orrelation
We've seen that the OLS estimator is onsistent under auto orrelation, as long as
0.
This will be the ase when
ase where
E(X ) = 0,
plim Xn =
following a LLN. An important ex eption is the
ontains lagged y s and the errors are auto orrelated. A simple example is
the ase of a single lag of the dependent variable with AR(1) errors. The model is
yt = xt + yt1 + t
t = t1 + ut
Now we an write

E(yt1 t ) = E (xt1 + yt2 + t1 )(t1 + ut )
6= 0
sin e one of the terms is

therefore
plim
X
n
6= 0.
E(2t1 )
whi h is learly nonzero. In this ase
Sin e
plim = + plim
the OLS estimator is in onsistent in this ase.
E(X ) 6= 0,
and
X
n
One needs to estimate by instrumental
variables (IV), whi h we'll get to later.
7.5.8 Examples
Nerlove model, yet again
The Nerlove model uses ross-se tional data, so one may
not think of performing tests for auto orrelation. However, spe i ation error an indu e
auto orrelated errors. Consider the simple Nerlove model
ln C = 1 + 2 ln Q + 3 ln PL + 4 ln PF + 5 ln PK +
and the extended Nerlove model
ln C = 1j + 2j ln Q + 3 ln PL + 4 ln PF + 5 ln PK + .
We have seen eviden e that the extended model is preferred. So if it is in fa t the proper
model, the simple model is misspe ied. Let's he k if this misspe i ation might indu e
auto orrelated errors.
The O tave program GLS/NerloveAR.m estimates the simple Nerlove model, and plots
the residuals as a fun tion of
ln Q,
and it al ulates a Breus h-Godfrey test statisti . The
102
CHAPTER 7.
Figure 7.3: Residuals of simple Nerlove model

Residuals
Quadratic fit to Residuals
1.5
0.5
-0.5
-1
1
residual plot is in Figure 7.3 , and the test results are:
Value
34.930
p-value
0.000
Clearly, there is a problem of auto orrelated residuals.

Repeat the auto orrelation tests using the extended Nerlove model (Equation
??)
to
see the problem is solved.
Klein model
Klein's Model I is a simple ma roe onometri model. One of the equations
in the model explains onsumption (C ) as a fun tion of prots (P ), both urrent and lagged,
as well as the sum of wages in the private se tor (W ) and wages in the government se tor
(W ). Have a look at the README le for this data set. This gives the variable names
and other information.
Consider the model
Ct = 0 + 1 Pt + 2 Pt1 + 3 (Wtp + Wtg ) + 1t

The O tave program GLS/Klein.m estimates this model by OLS, plots the residuals, and
performs the Breus h-Godfrey test, using 1 lag of the residuals. The estimation and test
results are:
*********************************************************
Observations 21
R-squared 0.981008
7.5.
103
AUTOCORRELATION
Figure 7.4: OLS residuals, Klein onsumption equation

Residuals
1.5
0.5
-0.5
-1
-1.5
-2
5
10
15
20
Constant
Profits
Lagged Profits
Wages
estimate
16.237
0.193
0.090
0.796
st.err.
1.303
0.091
0.091
0.040
t-stat.
12.464
2.115
0.992
19.933
p-value
0.000
0.049
0.335
0.000
*********************************************************
Value
p-value
1.539
0.215
and the residual plot is in Figure 7.4. The test does not reje t the null of nonauto orrelatetd
errors, but we should remember that we have only 21 observations, so power is likely to be
fairly low. The residual plot leads me to suspe t that there may be auto orrelation - there
are some signi ant runs below and above the x-axis. Your opinion may dier.
Sin e it seems that there
may
be auto orrelation, lets's try an AR(1) orre tion. The
O tave program GLS/KleinAR1.m estimates the Klein onsumption equation assuming

that the errors follow the AR(1) pattern. The results, with the Breus h-Godfrey test for
remaining auto orrelation are:
*********************************************************
Observations 21
R-squared 0.967090
104
CHAPTER 7.
Constant
Profits
Lagged Profits
Wages
estimate
16.992
0.215
0.076
0.774
st.err.
1.492
0.096
0.094
0.048
t-stat.
11.388
2.232
0.806
16.234
p-value
0.000
0.039
0.431
0.000
*********************************************************
Value
p-value
2.129
0.345
The test is farther away from the reje tion region than before, and the residual plot
is a bit more favorable for the hypothesis of nonauto orrelated residuals, IMHO. For
this reason, it seems that the AR(1) orre tion might have improved the estimation.
Nevertheless, there has not been mu h of an ee t on the estimated oe ients nor
on their estimated standard errors. This is probably be ause the estimated AR(1)
oe ient is not very large (around 0.2)
The existen e or not of auto orrelation in this model will be important later, in the
se tion on simultaneous equations.
7.6 Exer ises

Comparing the varian es of the OLS and GLS estimators, I laimed that the following
holds:
V ar(GLS ) = AA
V ar()
Verify that this is true.
Show that the GLS estimator an be dened as
GLS = arg min(y X) 1 (y X)

The limiting distribution of the OLS estimator with heteros edasti ity of unknown form
is
where

d
1
n N 0, Q1
X QX ,
lim E
n
Explain why
X X
n
n
X
b= 1
xt xt 2t
n
t=1
7.6.
105
EXERCISES
is a onsistent estimator of this matrix.

Dene the
vth auto ovarian e of a ovarian e stationary pro ess mt , where E(mt = 0)
as
v = E(mt mtv ).
Show that
E(mt mt+v ) = v .
For the Nerlove model
ln C = 1j + 2j ln Q + 3 ln PL + 4 ln PF + 5 ln PK +
assume that
V (t |xt ) = j2 , j = 1, 2, ..., 5.
That is, the varian e depends upon whi h of the
5 rm size groups the observation belongs to.
a) Apply White's test using the OLS residuals, to test for homos edasti ity
b) Cal ulate the FGLS estimator and interpret the estimation results.
) Test the transformed model to he k whether it appears to satisfy homos edasti ity.
106
CHAPTER 7.
Chapter 8
Sto hasti regressors
Up to now we have treated the regressors as xed, whi h is learly unrealisti . Now we will
assume they are random. There are several ways to think of the problem. First, if we are
interested in an analysis
onditional
on the explanatory variables, then it is irrelevant if
they are sto hasti or not, sin e onditional on the values of they regressors take on, they
are nonsto hasti , whi h is the ase already onsidered.
In ross-se tional analysis it is usually reasonable to make the analysis onditional

on the regressors.
In dynami models, where
yt
may depend on
yt1 ,
a onditional analysis is not
su iently general, sin e we may want to predi t into the future many periods out,
so we need to onsider the behavior of
on
and the relevant test statisti s un onditional
X.
The model we'll deal will involve a ombination of the following assumptions
Linearity:
0 :
yt = xt 0 + t ,
or in matrix form,
where
is
formable.
n 1, X =
x1 x2
y = X0 + ,

, where xt
xn
is
K 1,
and
and
are on-
Sto hasti , linearly independent regressors

X
has rank
is sto hasti
limn Pr
with probability 1
1
nX X

= QX = 1,
where
QX
is a nite positive denite matrix.
Central limit theorem

d
n1/2 X N (0, QX 02 )
Normality (Optional): |X N (0, 2 In ): is normally distributed

Strongly exogenous regressors:
E(t |X) = 0, t
107
(8.1)
108
CHAPTER 8.
STOCHASTIC REGRESSORS
Weakly exogenous regressors:

E(t |xt ) = 0, t
In both ases,
xt
is the onditional mean of
yt
(8.2)
given
xt : E(yt |xt ) = xt
8.1 Case 1
Normality of , strongly exogenous regressors
In this ase,
= 0 + (X X)1 X
E(|X)
= 0 + (X X)1 X E(|X)
= 0
and sin e this holds for all
= ,
X, E()
un onditional on
N , (X X)1 2
|X
0
If the density of
is
Likewise,
d(X), the marginal density of is obtained by multiplying the
onditional density by
density for
X.
d(X) and integrating over X. Doing this leads to a nonnormal
in small samples.
However, onditional on
X, the usual test statisti s have the t, F
and
2 distributions.
Importantly, these distributions don't depend on X, so when marginalizing to obtain

the un onditional distribution, nothing hanges. The tests are valid in small samples.
Summary:
When
is sto hasti but strongly exogenous and
is normally dis-
tributed:
1.
is unbiased
2.
is nonnormally distributed
3. The usual test statisti s have the same distribution as with nonsto hasti
4. The Gauss-Markov theorem still holds, sin e it holds onditionally on
this is true for all
X,
X.
and
X.
5. Asymptoti properties are treated in the next se tion.
8.2 Case 2
nonnormally distributed, strongly exogenous regressors

The unbiasedness of
arries through as before.
statisti s doesn't hold, due to nonnormality of
However, the argument regarding test
Still, we have
= 0 + (X X)1 X
1
XX
X
= 0 +
n
n
8.3.
109
CASE 3
Now
X X
n
1
Q1
X
by assumption, and
n1/2 X p
X
0
=
n
n
sin e the numerator onverges to a
N (0, QX 2 )
r.v. and the denominator still goes to in-
nity. We have unbiasedness and the varian e disappearing, so,
the estimator is onsistent :
p
0 .
Considering the asymptoti distribution
1

X
XX
n 0
=
n
n
n
1
XX
=
n1/2 X
n
so

d
2
n 0 N (0, Q1
X 0 )
dire tly following the assumptions.
Asymptoti normality of the estimator still holds.
Sin e
the asymptoti results on all test statisti s only require this, all the previous asymptoti
results on test statisti s are also valid in this ase.
Summary: Under strongly exogenous regressors, with
normal or nonnormal,
has
the properties:
1. Unbiasedness
2. Consisten y
3. Gauss-Markov theorem holds, sin e it holds in the previous ase and doesn't
depend on normality.
4. Asymptoti normality
5. Tests are asymptoti ally valid
6. Tests are not valid in small samples if the error is normally distributed
8.3 Case 3
Weakly exogenous regressors
An important lass of models are
dynami models,
where lagged dependent variables
have an impa t on the urrent value. A simple version of these models that aptures the
important points is
yt = zt +
p
X
s=1
= xt + t
s yts + t
110
CHAPTER 8.
where now
xt
ontains lagged dependent variables. Clearly, even with
are not un orrelated, so one an't show unbiasedness. For example,
E(t |xt ) = 0, X
and
E(t1 xt ) 6= 0
sin e
xt
ontains
yt1
(whi h is a fun tion of
t1 )
as an element.
This fa t implies that all of the small sample properties su h as unbiasedness, GaussMarkov theorem, and small sample validity of test statisti s
do not hold
in this ase.
Re all Figure 3.7. This is a ase of weakly exogenous regressors, and we see that the
OLS estimator is biased in this ase.
Nevertheless, under the above assumptions, all asymptoti properties ontinue to

hold, using the same arguments as before.
8.4 When are the assumptions reasonable?

The two assumptions we've added are
1
nX X

= QX = 1,
1.
limn Pr
2.
n1/2 X N (0, QX 02 )
QX
nite positive denite matrix.
The most ompli ated ase is that of dynami models, sin e the other ases an be treated
as nested in this ase.
There exist a number of entral limit theorems for dependent
pro esses, many of whi h are fairly te hni al. We won't enter into details (see Hamilton,
Chapter 7 if you're interested). A main requirement for use of standard asymptoti s for a
dependent sequen e
{st } = {
1X
zt }
n
t=1
to onverge in probability to a nite limit is that
zt
be
stationary, in some sense.
Strong stationarity requires that the joint distribution of the set
{zt , zt+s , ztq , ...}

not depend on
t.
Covarian e (weak) stationarity requires that the rst and se ond moments of this set
not depend on
t.
An example of a sequen e that doesn't satisfy this is an AR(1) pro ess with a unit
root (a
random walk):
xt = xt1 + t
t IIN (0, 2 )
One an show that the varian e of

stationary.
xt
depends upon
in this ase, so it's not weakly
8.5.
111
EXERCISES
The series
sin t + t
has a rst moment that depends upon
t,
so it's not weakly
stationary either.
Stationarity prevents the pro ess from trending o to plus or minus innity, and prevents
y li al behavior whi h would allow orrelations between far removed
zt
znd
zs
to be high.
Draw a pi ture here.
In summary, the assumptions are reasonable when the sto hasti onditioning variables have varian es that are nite, and are not too strongly dependent. The AR(1)
model with unit root is an example of a ase where the dependen e is too strong for
standard asymptoti s to apply.
The e onometri s of nonstationary pro esses has been an a tive area of resear h in
the last two de ades. The standard asymptoti s don't apply in this ase. This isn't
in the s ope of this ourse.
8.5 Exer ises

Show that for two random variables
and
B,
if
E(A|B) = 0,
then
E (Af (B)) = 0.
How
is this used in the proof of the Gauss-Markov theorem?

Is it possible for an AR(1) model for time series data,
weak exogeneity? Strong exogeneity? Dis uss.
e.g., yt = 0 + 0.9yt1 + t satisfy
112
CHAPTER 8.
Chapter 9
Data problems
In this se tion well onsider problems asso iated with the regressor matrix: ollinearity,
missing observation and measurement error.
9.1 Collinearity
Collinearity is the existen e of linear relationships amongst the regressors. We an always
write
1 x1 + 2 x2 + + K xK + v = 0
where
xi
is the
ith
olumn of the regressor matrix
ase that there exists ollinearity, the variation in
X,
and
is an
n1
ve tor.
In the
is relatively small, so that there is an
approximately exa t linear relation between the regressors.
relative and approximate are impre ise, so it's di ult to dene when ollinearilty
exists.
In the extreme, if there are exa t linear relationships (every element of
(X) < K,
so (X X)
< K,
equal) then
so X X is not invertible and the OLS estimator is not
uniquely dened. For example, if the model is
yt = 1 + 2 x2t + 3 x3t + t
x2t = 1 + 2 x3t
then we an write
yt = 1 + 2 (1 + 2 x3t ) + 3 x3t + t
= 1 + 2 1 + 2 2 x3t + 3 x3t + t
= (1 + 2 1 ) + (2 2 + 3 ) x3t
= 1 + 2 x3t + t
The
s an be onsistently estimated,
s,
the
but sin e the
s dene two equations in three
an't be onsistently estimated (there are multiple values of
the fon ). The s are
unidentied
in the ase of perfe t ollinearity.
113
that solve
114
CHAPTER 9.
DATA PROBLEMS
Perfe t ollinearity is unusual, ex ept in the ase of an error in onstru tion of the
regressor matrix, su h as in luding the same regressor twi e.
Another ase where perfe t ollinearity may be en ountered is with models with dummy
variables, if one is not areful. Consider a model of rental pri e
(yi ) of an
apartment. This
xi , as well as on the lo ation

th
if the i
apartment is in Bar elona, Bi = 0 otherwise.
ould depend fa tors su h as size, quality et ., olle ted in

of the apartment.
Similarly, dene
Let
Gi , Ti
Bi = 1
and
Li
for Girona, Tarragona and Lleida. One ould use a model
su h as
yi = 1 + 2 Bi + 3 Gi + 4 Ti + 5 Li + xi + i
In this model,
Bi + Gi + Ti + Li = 1, i,
so there is an exa t relationship between these
variables and the olumn of ones orresponding to the onstant. One must either drop the
onstant, or one of the qualitative variables.
9.1.1 A brief aside on dummy variables

Introdu e a brief dis ussion of dummy variables here.
9.1.2 Ba k to ollinearity
The more ommon ase, if one doesn't make mistakes su h as these, is the existen e of
inexa t linear relationships,
i.e., orrelations between the regressors that are less than one
in absolute value, but not zero. The basi problem is that when two (or more) variables
move together, it is di ult to determine their separate inuen es.
This is ree ted in
i.e., estimates with high varian es. With e onomi data, ollinearity
is ommonly en ountered, and is often a severe problem.
impre ise estimates,
When there is ollinearity, the minimizing point of the obje tive fun tion that denes
the OLS estimator (s(), the sum of squared errors) is relatively poorly dened. This is
seen in Figures 9.1 and 9.2.
To see the ee t of ollinearity on varian es, partition the regressor matrix as
X=
where
is the rst olumn of
x W
(note: we an inter hange the olumns of
isf we like,
so there's no loss of generality in onsidering the rst olumn). Now, the varian e of
under the lassi al assumptions, is
= X X
V ()
Using the partition,
X X =
"
x x
1
x W
W x W W
9.1.
115
COLLINEARITY
Figure 9.1:
s()
when there is no ollinearity
60
55
50
45
40
35
30
25
20
15
6
4
2
0
-2
-4
-6
-6
-4
-2
Figure 9.2:
s()
when there is ollinearity
6
4
2
0
-2
-4
-6
-6
-4
-2
100
90
80
70
60
50
40
30
20
116
CHAPTER 9.
DATA PROBLEMS
and following a rule for partitioned inversion,
X X
where by
ESSx|W
1
x x x W (W W )1 W x
1

=
x In W (W W ) 1 W x
1
= ESSx|W
1
1,1
we mean the error sum of squares obtained from the regression
x = W + v.
Sin e
R2 = 1 ESS/T SS,
we have
ESS = T SS(1 R2 )
so the varian e of the oe ient orresponding to
V (x ) =
is
2
2
T SSx (1 Rx|W
)
We see three fa tors inuen e the varian e of this oe ient. It will be high if
1.
is large
2. There is little variation in
x.
Draw a pi ture here.
3. There is a strong linear relationship between
an explain the movement in
2
Rx|W
and the other regressors, so that
well. In this ase,
2
Rx|W
will be lose to 1. As
1, V (x ) .
The last of these ases is ollinearity.

Intuitively, when there are strong linear relations between the regressors, it is di ult
to determine the separate inuen e of the regressors on the dependent variable. This an
be seen by omparing the OLS obje tive fun tion in the ase of no orrelation between
regressors with the obje tive fun tion with orrelation between the regressors.
See the
gures no ollin.ps (no orrelation) and ollin.ps ( orrelation), available on the web site.
9.1.3 Dete tion of ollinearity

The best way is simply to regress ea h explanatory variable in turn on the remaining
regressors.
If any of these auxiliary regressions has a high
R2 ,
there is a problem of
ollinearity. Furthermore, this pro edure identies whi h parameters are ae ted.
Sometimes, we're only interested in ertain parameters. Collinearity isn't a problem

if it doesn't ae t what we're interested in estimating.
An alternative is to examine the matrix of orrelations between the regressors.

orrelations are su ient but not ne essary for severe ollinearity.
High
9.1.
117
COLLINEARITY
Also indi ative of ollinearity is that the model ts well (high
R2 ),
but none of the
variables is signi antly dierent from zero (e.g., their separate inuen es aren't well determined).
In summary, the arti ial regressions are the best approa h if one wants to be areful.
9.1.4 Dealing with ollinearity

More information
Collinearity is a problem of an uninformative sample. The rst question is: is all the
available information being used? Is more data available? Are there oe ient restri tions
that have been negle ted?
ollinearity.
Pi ture illustrating how a restri tion an solve problem of perfe t
Sto hasti restri tions and ridge regression

Supposing that there is no more data or negle ted restri tions, one possibility is to
hange perspe tives, to Bayesian e onometri s. One an express prior beliefs regarding the
oe ients using sto hasti restri tions. A sto hasti linear restri tion would be something
of the form
R = r + v
where
and
are as in the ase of exa t linear restri tions, but
is a random ve tor. For
example, the model ould be
y = X +
R = r + v
!
!
0
,
N
0
v
2 In 0nq
v2 Iq
0qn
This sort of model isn't in line with the lassi al interpretation of parameters as onstants:
a ording to this interpretation the left hand side of
R = r + v
is onstant but the right
is random. This model does t the Bayesian perspe tive: we ombine information oming
from the model and the data, summarized in
y = X +
N (0, 2 In )
with prior beliefs regarding the distribution of the parameter, summarized in
R N (r, v2 Iq )
Sin e the sample is random it is reasonable to suppose that
pie e of information in the spe i ation.
E(v ) = 0,
whi h is the last
How an you estimate using this model?
The
solution is to treat the restri tions as arti ial data. Write
"
y
r
This model is heteros edasti , sin e
"
X
R
2 6= v2 .
"
Dene the
prior pre ision k = /v .
This
118
CHAPTER 9.
DATA PROBLEMS
expresses the degree of belief in the restri tion relative to the variability of the data.
Supposing that we spe ify
k,
then the model
"
y
kr
"
X
kR
"
kv
is homos edasti and an be estimated by OLS. Note that this estimator is biased. It is
onsistent, however, given that
is a xed onstant, even if the restri tion is false (this
is in ontrast to the ase of false exa t restri tions).

restri tions, where
To see this, note that there are
Q is the number of rows of R. As n , these Q arti ial observations
have no weight in the obje tive fun tion, so the estimator has the same limiting obje tive
fun tion as the OLS estimator, and is therefore onsistent.
To motivate the use of sto hasti restri tions, onsider the expe tation of the squared
length of
:

1
1
+ XX
X
+ XX
X

= + E X(X X)1 (X X)1 X
1 2
= + T r X X
= E
E( )
= + 2
K
X
i (the
tra e is the sum of eigenvalues)
i=1
> + max(X X 1 ) 2 (the
eigenvalues are all positive, sin eX
so
> +
E( )
where
min(X X)
eigenvalue of
is the minimum eigenvalue of
(X X)1 ).
is p.d.
2
min(X X)
X X
(whi h is the inverse of the maximum
As ollinearity be omes worse and worse,
min(X X) tends to zero (re all that the

)
tends to innite. On the other
and E(
X X
be omes more
nearly singular, so
determinant is the produ t of
the eigenvalues)
hand,
Now onsidering the restri tion
"
y
0
IK = 0 + v.
"
X
kIK
is nite.
With this restri tion the model be omes
"
kv
and the estimator is
ridge =
=
This is the ordinary
X kIK
X X + k2 IK
ridge regression
"
1
X
kIK
#!1
X y
X IK
"
y
0
estimator. The ridge regression estimator an be seen
2
to add k IK , whi h is nonsingular, to
X X,
ollinearity be omes worse and worse. As
whi h is more and more nearly singular as
k ,
the restri tions tend to
= 0,
that is,
9.2.
119
MEASUREMENT ERROR
the oe ients are shrunken toward zero. Also, the estimator tends to
ridge = X X + k2 IK
so
ridge
ridge 0.
1
X y k2 IK
1
X y =
X y
0
k2
This is learly a false restri tion in the limit, if our original model is
at al sensible.
There should be some amount of shrinkage that is in fa t a true restri tion. The problem
is to determine the
su h that the restri tion is orre t. The interest in ridge regression
enters on the fa t that it an be shown that there exists a
OLS .
The problem is that this
The ridge tra e method plots
depends on
ridge
ridge
and
2,
su h that
whi h are unknown.
as a fun tion of
k,
and hooses the value of
that artisti ally seems appropriate (e.g., where the ee t of in reasing
pi ture here.
This means of hoosing
the Bayesian perspe tive: the hoi e of
M SE(ridge ) <
dies o ).
Draw
is obviously subje tive. This is not a problem from
ree ts prior beliefs about the length of
In summary, the ridge estimator oers some hope, but it is impossible to guarantee
that it will outperform the OLS estimator. Collinearity is a fa t of life in e onometri s,
and there is no lear solution to the problem.
9.2 Measurement error

Measurement error is exa tly what it says, either the dependent variable or the regressors
are measured with error. Thinking about the way e onomi data are reported, measurement error is probably quite prevalent. For example, estimates of growth of GDP, ination,
et . are ommonly revised several times. Why should the last revision ne essarily be orre t?
9.2.1 Error of measurement of the dependent variable

Measurement errors in the dependent variable and the regressors have important dieren es. First onsider error in measurement of the dependent variable. The data generating
pro ess is presumed to be
y = X +
y = y + v
vt iid(0, v2 )
where
that
y is the unobservable true dependent variable, and y is what is observed.

and
are independent and that
y = X +
Given this, we have
y + v = X +
We assume
satises the lassi al assumptions.
120
CHAPTER 9.
DATA PROBLEMS
so
y = X + v
= X +
t iid(0, 2 + v2 )
As long as
is un orrelated with
X,
this model satises the lassi al assumptions
and an be estimated by OLS. This type of measurement error isn't a problem, then.
9.2.2 Error of measurement of the regressors

The situation isn't so good in this ase. The DGP is
yt = x
t + t
xt = xt + vt
vt iid(0, v )
where
is a
K K
matrix. Now
what is observed. Again assume that
ontains the true, unobserved regressors, and
v is independent of , and that the model y =
is
X +
satises the lassi al assumptions. Now we have
yt = (xt vt ) + t
= xt vt + t
= xt + t
The problem is that now there is a orrelation between
xt
and
E(xt t ) = E (xt + vt ) vt + t
= v
where
t ,
sin e

v = E vt vt .
Be ause of this orrelation, the OLS estimator is biased and in onsistent, just as in the
ase of auto orrelated errors with lagged dependent variables. In matrix notation, write
the estimated model as
y = X +
We have that
X X
n
1
X y
n
and
plim
X X
n
1
= plim
(X + V ) (X + V )
n
= (QX + v )1
9.3.
MISSING OBSERVATIONS
sin e
and
121
are independent, and
plim
V V
n
= lim E
= v
1X
vt vt
n
t=1
Likewise,
plim
X y
n
(X + V ) (X + )
n
= QX
= plim
so
plim = (QX + v )1 QX
So we see that the least squares estimator is in onsistent when the regressors are measured
with error.
A potential solution to this problem is the instrumental variables (IV) estimator,

whi h we'll dis uss shortly.
9.3 Missing observations

Missing observations o ur quite frequently: time series data may not be gathered in a
ertain year, or respondents to a survey may not answer all questions. We'll onsider two
ases: missing observations on the dependent variable and missing observations on the
regressors.
9.3.1 Missing observations on the dependent variable

In this ase, we have
y = X +
"
or
where
y2
y1
y2
"
X1
X2
"
1
2
is not observed. Otherwise, we assume the lassi al assumptions hold.
A lear alternative is to simply estimate using the ompete observations
y1 = X1 + 1
Sin e these observations satisfy the lassi al assumptions, one ould estimate by OLS.
The question remains whether or not one ould somehow repla e the unobserved
by a predi tor, and improve over OLS in some sense. Let
Now
y2
be the predi tor of
y2
y2 .
122
CHAPTER 9.
("
X1
# "
X1
#)1 "
X1
# "
y1
X2
X2
X2
y2

1
= X1 X1 + X2 X2
X1 y1 + X2 y2
DATA PROBLEMS
Re all that the OLS fon are
X X = X y
so if we regressed using only the rst ( omplete) observations, we would have
X1 X1 1 = X1 y1.
Likewise, an OLS regression using only the se ond (lled in) observations would give
X2 X2 2 = X2 y2 .
Substituting these into the equation for the overall ombined estimator gives
i

1 h
X1 X1 + X2 X2
X1 X1 1 + X2 X2 2

1
1
= X1 X1 + X2 X2
X1 X1 1 + X1 X1 + X2 X2
X2 X2 2
A1 + (IK A)2
where
1

X1 X1
A X1 X1 + X2 X2
and we use
X1 X1 + X2 X2

1
X1 X1 + X2 X2 X1 X1
X1 X1 + X2 X2
1

X1 X1
= IK X1 X1 + X2 X2
1
X2 X2 =
= IK A.
Now,
and this will be unbiased

= A + (IK A)E 2
E()

2 = .
only if E
The on lusion is the this lled in observations alone would need to dene an unbiased
estimator. This will be the ase only if
y2 = X2 + 2
where
has mean zero.
knowledge of
Clearly, it is di ult to satisfy this ondition without
Note that putting
y2 = y1
does not satisfy the ondition and therefore leads to a
biased estimator.
Exer ise 13 Formally prove this last statement.
9.3.
123
MISSING OBSERVATIONS
One possibility that has been suggested (see Greene, page 275) is to estimate
using
a rst round estimation using only the omplete observations
1 = (X1 X1 )1 X1 y1
then use this estimate,
1 ,to
predi t
y2
y2 = X2 1
= X2 (X1 X1 )1 X1 y1
Now, the overall estimate is a weighted average of
and
2 ,
just as above, but we
have
2 = (X2 X2 )1 X2 y2
= (X2 X2 )1 X2 X2 1
= 1
This shows that this suggestion is ompletely empty of ontent: the nal estimator
is the same as the OLS estimator using only the omplete observations.
9.3.2 The sample sele tion problem

In the above dis ussion we assumed that the missing observations are random. The sample
sele tion problem is a ase where the missing observations are not random. Consider the
model
yt = xt + t
whi h is assumed to satisfy the lassi al assumptions. However,
What is observed is
yt
yt
is not always observed.
dened as
yt = yt
Or, in other words,
yt
if
yt 0
is missing when it is less than zero.
The dieren e in this ase is that the missing values are not random: they are orrelated
with the
xt .
Consider the ase
y = x +
with
V () = 25,
but using only the observations for whi h
y > 0
to estimate. Figure 9.3
illustrates the bias. The O tave program is sampsel.m
9.3.3 Missing observations on the regressors

Again the model is
"
y1
y2
but we assume now that ea h row of
"
X1
X2
"
1
2
X2 has an unobserved omponent(s).
Again, one ould
just estimate using the omplete observations, but it may seem frustrating to have to drop
124
CHAPTER 9.
DATA PROBLEMS
Figure 9.3: Sample sele tion bias

25
Data
True Line
Fitted Line
20
15
10
-5
-10
0
observations simply be ause of a single missing variable.
10
In general, if the unobserved
X2 is repla ed by some predi tion, X2 , then we are in the ase of errors of observation.
As before, this means that the OLS estimator is biased when X2 is used instead of X2 .
Consisten y is salvaged, however, as long as the number of missing observations doesn't
in rease with
n.
In luding observations that have missing values repla ed by

interpreted as introdu ing false sto hasti restri tions.
ad ho
values an be
In general, this introdu es
bias. It is di ult to determine whether MSE in reases or de reases. Monte Carlo
studies suggest that it is dangerous to simply substitute the mean, for example.
In the ase that there is only one regressor other than the onstant, subtitution of
for the missing
xt
does not lead to bias.
This is a spe ial ase that doesn't hold for
K > 2.
Exer ise 14 Prove this last statement.
In summary, if one is strongly on erned with bias, it is best to drop observations

that have missing omponents.
There is potential for redu tion of MSE through
lling in missing elements with intelligent guesses, but this ould also in rease MSE.
9.4 Exer ises

Consider the Nerlove model
ln C = 1j + 2j ln Q + 3 ln PL + 4 ln PF + 5 ln PK +
When this model is estimated by OLS, some oe ients are not signi ant. This may be
due to ollinearity.
9.4.
125
EXERCISES
Cal ulate the orrelation matrix of the regressors.

Perform arti ial regressions to see if ollinearity is a problem.
Apply the ridge regression estimator.
Plot the ridge tra e diagram
Che k what happens as
goes to zero, and as
be omes very large.
126
CHAPTER 9.
DATA PROBLEMS
Chapter 10
Fun tional form and nonnested tests
Though theory often suggests whi h onditioning variables should be in luded, and suggests
the signs of ertain derivatives, it is usually silent regarding the fun tional form of the
relationship between the dependent variable and the regressors. For example, onsidering
a ost fun tion, one ould have a Cobb-Douglas model
c = Aw11 w22 q q e
This model, after taking logarithms, gives
ln c = 0 + 1 ln w1 + 2 ln w2 + q ln q +
where
0 = ln A.
Theory suggests that
A > 0, 1 > 0, 2 > 0, 3 > 0.
ompatible with a xed ost of produ tion sin e

one in input pri es suggests that
c=0
when
q = 0.
This model isn't
Homogeneity of degree
1 +2 = 1, while onstant returns to s ale implies q = 1.
While this model may be reasonable in some ases, an alternative
c = 0 + 1 w1 + 2 w2 + q q +
may be just as plausible. Note that
and
ln(x)
look quite alike, for ertain values of
the regressors, and up to a linear transformation, so it may be di ult to hoose between
these models.
The basi point is that many fun tional forms are ompatible with the linear-inparameters model, sin e this model an in orporate a wide variety of nonlinear transformations of the dependent variable and the regressors. For example, suppose that
a real valued fun tion and that
x()
is a
g()
is
ve tor-valued fun tion. The following model
is linear in the parameters but nonlinear in the variables:
xt = x(zt )
yt = xt + t
There may be
where
fundamental onditioning variables
zt ,
may be smaller than, equal to or larger than
but there may be
P.
squares and ross produ ts of the onditioning variables in
127
For example,
zt .
xt
regressors,
ould in lude
128
CHAPTER 10.
FUNCTIONAL FORM AND NONNESTED TESTS
10.1 Flexible fun tional forms

Given that the fun tional form of the relationship between the dependent variable and the
regressors is in general unknown, one might wonder if there exist parametri models that
an losely approximate a wide variety of fun tional relationships. A Diewert-Flexible
fun tional form is dened as one su h that the fun tion, the ve tor of rst derivatives and
the matrix of se ond derivatives an take on an arbitrary value
at a single data point.
Flexibility in this sense learly requires that there be at least

K = 1 + P + P 2 P /2 + P
free parameters: one for ea h independent ee t that we wish to model.

Suppose that the model is
y = g(x) +
A se ond-order Taylor's series expansion (with remainder term) of the fun tion
the point
x=0
is
g(x) = g(0) + x Dx g(0) +
g(x) about
x Dx2 g(0)x
+R
2
Use the approximation, whi h simply drops the remainder term, as an approximation to
g(x) :
g(x) gK (x) = g(0) + x Dx g(0) +
As
x 0,
x Dx2 g(0)x
2
the approximation be omes more and more exa t, in the sense that
g(x), Dx gK (x) Dx g(x)
2
and Dx gK (x)
Dx2 g(x). For
x = 0,
gK (x)
the approximation is exa t,
up to the se ond order. The idea behind many exible fun tional forms is to note that
Dx g(0)
and
Dx2 g(0)
g(0),
are all onstants. If we treat them as parameters, the approximation
will have exa tly enough free parameters to approximate the fun tion
unknown form, exa tly, up to se ond order, at the point
x = 0.
g(x),
whi h is of
The model is
gK (x) = + x + 1/2x x
so the regression model to t is
y = + x + 1/2x x +
While the regression model has enough free parameters to be Diewert-exible, the
The answer is no, in general. The reason is that if we treat the true values of the
question remains: is
plim
= g(0)?
Is
parameters as these derivatives, then

term, whi h is a fun tion of
x,
so that
plim = Dx g(0)?
Is
= D 2 g(0)?
plim
x
is for ed to play the part of the remainder
and
are orrelated in this ase. As before,
the estimator is biased in this ase.
A simpler example would be to onsider a rst-order T.S. approximation to a quadrati
The on lusion is that exible fun tional forms aren't really exible in a useful
fun tion.
Draw pi ture.
statisti al sense, in that neither the fun tion itself nor its derivatives are onsistently
10.1.
129
FLEXIBLE FUNCTIONAL FORMS
estimated, unless the fun tion belongs to the parametri family of the spe ied fun tional form. In order to lead to onsistent inferen es, the regression model must be
orre tly spe ied.
10.1.1 The translog form

In spite of the fa t that FFF's aren't really exible for the purposes of e onometri estimation and inferen e, they are useful, and they are ertainly subje t to less bias due to
misspe i ation of the fun tional form than are many popular forms, su h as the CobbDouglas or the simple linear in the variables model. The translog model is probably the
most widely used FFF. This model is as above, ex ept that the variables are subje ted to
a logarithmi tranformation. Also, the expansion point is usually taken to be the sample
mean of the data, after the logarithmi transformation. The model is dened by
y = ln(c)
z
x = ln
z
= ln(z) ln(
z)
y = + x + 1/2x x +
In this presentation, the
subs ript that distinguishes observations is suppressed for sim-
pli ity. Note that
y
x
= + x
=
=
whi h is the elasti ity of
ln(c)
ln(z)
c z
z c
(the other part of
z.
with respe t to
x is
onstant)
This is a onvenient feature of the translog
model. Note that at the means of the onditioning variables,
so the
z, x = 0,
so

y
=
x z=z
are the rst-order elasti ities, at the means of the data.
To illustrate, onsider that
is ost of produ tion:
y = c(w, q)
where
is a ve tor of input pri es and
extending
is output.
We ould add other variables by
in the obvious manner, but this is supressed for simpli ity.
lemma, the onditional fa tor demands are
x=
c(w, q)
w
By Shephard's
130
CHAPTER 10.
and the ost shares of the fa tors are therefore
s=
c(w, q) w
wx
=
c
w c
whi h is simply the ve tor of elasti ities of ost with respe t to input pri es. If the ost
fun tion is modeled using a translog fun tion, we have
ln(c) = + x + z + 1/2
"
11 12
12 22
#"
x
z
= + x + z + 1/2x 11 x + x 12 z + 1/2z 22
where
x = ln(w/w)
(element-by-element division) and
"
11 =
"
12 =
11 12
12 22
#
13
z = ln(q/
q ),
and
23
= 33 .
22
Note that symmetry of the se ond derivatives has been imposed.

Then the share equations are just
s=+
11 12
"
x
z
Therefore, the share equations and the ost equation have parameters in ommon.
By
pooling the equations together and imposing the (true) restri tion that the parameters of
the equations be the same, we an gain e ien y.
To illustrate in more detail, onsider the ase of two inputs, so
x=
"
x1
x2
In this ase the translog model of the logarithmi ost fun tion is
ln c = + 1 x1 + 2 x2 + z +
11 2 22 2 33 2
x +
x +
z + 12 x1 x2 + 13 x1 z + 23 x2 z
2 1
2 2
2
The two ost shares of the inputs are the derivatives of
ln c
with respe t to
x1
and
x2 :
s1 = 1 + 11 x1 + 12 x2 + 13 z
s2 = 2 + 12 x1 + 22 x2 + 13 z
Note that the share equations and the ost equation have parameters in ommon. One
an do a pooled estimation of the three equations at on e, imposing that the parameters
are the same. In this way we're using more observations and therefore more information,
whi h will lead to imporved e ien y. Note that this does assume that the ost equation
is orre tly spe ied (
i.e.,
not an approximation), sin e otherwise the derivatives would
10.1.
131
not be the true derivatives of the log ost fun tion, and would then be misspe ied for the
shares. To pool the equations, write the model in matrix form (adding in error terms)
ln c
s1
s2
This is
x21
2
1 x1 x2 z

= 0 1
0 0
x22
2
z2
2
x1 x2
x2
x2 0
x1
0 x1 0
0 0
one observation on the three equations.
x1 z x2 z
z
0
0
z
11
+ 2
22
3
33
12
13
23
With the appropriate notation, a single
observation an be written as
yt = Xt + t
The overall model would sta k
observations:
n
y1
observations on the three equations for a total of
X1
3n
y2 X2

. = .
+ .2
. .
.
. .
.
yn
Xn
n
Next we need to onsider the errors. For observation
1t
t the
errors an be pla ed in a ve tor
t = 2t
3t
First onsider the ovarian e matrix of this ve tor: the shares are ertainly orrelated
sin e they must sum to one.
(In fa t, with 2 shares the varian es are equal and the
ovarian e is -1 times the varian e. General notation is used to allow easy extension to the
ase of more than 2 inputs). Also, it's likely that the shares and the ost equation have
dierent varian es. Supposing that the model is ovarian e stationary, the varian e of
won t depend upon
t:
11 12 13
V art = 0 =
22 23
33
Note that this matrix is singular, sin e the shares sum to 1.

no auto orrelation, the overall ovarian e matrix has the
Assuming that there is
seemingly unrelated regressions
132
CHAPTER 10.
(SUR) stru ture.
V ar .
=
..
n
0 0
.
.
0
0 . . ..
= .
..
..
.
0
0
0
0
= In 0
where the symbol

matri es
and
indi ates the
is
Krone ker produ t.
The Krone ker produ t of two
a11 B a12 B a1q B
a B ...
21
AB = .
..
apq B
.
.
.
apq B
10.1.2 FGLS estimation of a translog model
So, this model has heteros edasti ity and auto orrelation, so OLS won't be e ient. The
next question is: how do we estimate e iently using FGLS? FGLS is based upon inverting
the estimated error ovarian e
So we need to estimate
An asymptoti ally e ient pro edure is (supposing normality of the errors)
1. Estimate ea h equation by OLS

2. Estimate
using
X
0 = 1
t t
n t=1
3. Next we need to a ount for the singularity of
0 .
It an be shown that
will be
singular when the shares sum to one, so FGLS won't work. The solution is to drop
one of the share equations, for example the se ond. The model be omes
"
ln c
s1
"
1 x1 x2 z
0 1
x21
2
x22
2
0 x1 0
z2
2
x1 x2
x2
#
x1 z x2 z
z
0

"
#
11
1
+
22
2
33
12
13
23
10.1.
133
or in matrix notation for the observation:
yt = Xt + t
and in sta ked notation for all observations we have the
y1
X1
2n
observations:

y2 X2

. = .
+ .2
. .
.
. .
yn
Xn
n
or, nally in matrix notation for all observations:
y = X +
Considering the error ovarian e, we an dene
Dene
as the leading
22
= V ar
"
= In
blo k of
1
2
, and form
= In
0 .
This is a onsistent estimator, following the onsisten y of OLS and applying a LLN.
4. Next ompute the Cholesky fa torization
1
0
P0 = Chol
(I am assuming this is dened as an upper triangular matrix, whi h is onsistent
with the way O tave does it) and the Cholesky fa torization of the overall ovarian e
matrix of the 2 equation model, whi h an be al ulated as
= In P0
P = Chol
5. Finally the FGLS estimator an be al ulated by applying OLS to the transformed
model
P y = P X + P
or by dire tly using the GLS formula
F GLS =
1
1
1
X 0
X
X
y
0
It is equivalent to transform ea h observation individually:
P0 yy = P0 Xt + P0
134
CHAPTER 10.
and then apply OLS. This is probably the simplest approa h.
A few last omments.
1. We have assumed no auto orrelation a ross time.
This is learly restri tive.
It is
relatively simple to relax this, but we won't go into it here.
2. Also, we have only imposed symmetry of the se ond derivatives. Another restri tion
that the model should satisfy is that the estimated shares should sum to 1. This an
be a omplished by imposing
1 + 2 = 1
3
X
ij = 0, j = 1, 2, 3.
i=1
These are linear parameter restri tions, so they are easy to impose and will improve
e ien y if they are true.
3. The estimation pro edure outlined above an be

as above, then re-estimate
iterated.
That is, estimate
F GLS
using errors al ulated as
= y X F GLS
These might be expe ted to lead to a better estimate than the estimator based on
OLS , sin e FGLS
is asymptoti ally more e ient. Then re-estimate
using the new
estimated error ovarian e. It an be shown that if this is repeated until the estimates
i.e., iterated to onvergen e) then the resulting estimator is the MLE.
don't hange (
At any rate, the asymptoti properties of the iterated and uniterated estimators are
the same, sin e both are based upon a onsistent estimator of the error ovarian e.
10.2 Testing nonnested hypotheses

Given that the hoi e of fun tional form isn't perfe tly lear, in that many possibilities
exist, how an one hoose between forms? When one form is a parametri restri tion of
another, the previously studied tests su h as Wald, LR, s ore or
qF
are all possibilities.
For example, the Cobb-Douglas model is a parametri restri tion of the translog:
The
translog is
yt = + xt + 1/2xt xt +
where the variables are in logarithms, while the Cobb-Douglas is
yt = + xt +
so a test of the Cobb-Douglas versus the translog is simply a test that
The situation is more ompli ated when we want to test
= 0.
non-nested hypotheses.
If the
two fun tional forms are linear in the parameters, and use the same transformation of the
10.2.
135
TESTING NONNESTED HYPOTHESES
dependent variable, then they may be written as
M1 : y = X +
t iid(0, 2 )
M2 : y = Z +
iid(0, 2 )
We wish to test hypotheses of the form:
H0 : Mi
misspe ied, for i = 1, 2.
is orre tly spe ied
versus
HA : Mi
One ould a ount for non-iid errors, but we'll suppress this for simpli ity.
There are a number of ways to pro eed.

Davidson and Ma Kinnon,
E onometri a
We'll onsider the
is
test, proposed by
(1981). The idea is to arti ially nest the
two models, e.g.,
y = (1 )X + (Z) +
If the rst model is orre tly spe ied, then the true value of
hand, if the se ond model is orre tly spe ied then
is zero.
On the other
= 1.
The problem is that this model is not identied in general. For example, if the
models share some regressors, as in
M1 : yt = 1 + 2 x2t + 3 x3t + t
M2 : yt = 1 + 2 x2t + 3 x4t + t
then the omposite model is
yt = (1 )1 + (1 )2 x2t + (1 )3 x3t + 1 + 2 x2t + 3 x4t + t

Combining terms we get
yt = ((1 )1 + 1 ) + ((1 )2 + 2 ) x2t + (1 )3 x3t + 3 x4t + t

= 1 + 2 x2t + 3 x3t + 4 x4t + t
The four
are onsistently estimable, but
is not, sin e we have four equations in 7
unknowns, so one an't test the hypothesis that

The idea of the
test is to substitute
= 0.
in pla e of
This is a onsistent estimator
supposing that the se ond model is orre tly spe ied. It will tend to a nite probability
limit even if the se ond model is misspe ied. Then estimate the model
y = (1 )X + (Z ) +
= X +
y+
where
y = Z(Z Z)1 Z y = PZ y.
In this model,
is onsistently estimable, and one an
show that, under the hypothesis that the rst model is orre t,
0 and that the ordinary
136
CHAPTER 10.
-statisti for
=0
is asymptoti ally normal:
t=
a
N (0, 1)
If the se ond model is orre tly spe ied, then
t ,
sin e
to 1, while it's estimated standard error tends to zero.
tends in probability
Thus the test will always
reje t the false null model, asymptoti ally, sin e the statisti will eventually ex eed
any riti al value with probability one.
We an reverse the roles of the models, testing the se ond against the rst.
It may be the ase that
neither
model is orre tly spe ied. In this ase, the test
will still reje t the null hypothesis, asymptoti ally, if we use riti al values from
the
N (0, 1)
p
|t| .
distribution, sin e as long as
tends to something dierent from zero,
Of ourse, when we swit h the roles of the models the other will also be
reje ted asymptoti ally.
In summary, there are 4 possible out omes when we test two models, ea h against
the other. Both may be reje ted, neither may be reje ted, or one of the two may be
reje ted.
There are other tests available for non-nested models. The

when both models are linear in the parameters. The
apply when
M1
J test is simple to apply
P -test
is similar, but easier to
is nonlinear.
The above presentation assumes that the same transformation of the dependent variable is used by both models. Ma Kinnon, White and Davidson,
Journal of E ono-
metri s, (1983) shows how to deal with the ase of dierent transformations.
Monte-Carlo eviden e shows that these tests often over-reje t a orre tly spe ied
model. Can use bootstrap riti al values to get better-performing tests.
Chapter 11
Exogeneity and simultaneity
Several times we've en ountered ases where orrelation between regressors and the error
term lead to biasedness and in onsisten y of the OLS estimator. Cases in lude auto orrelation with lagged dependent variables and measurement error in the regressors. Another
important ase is that of simultaneous equations. The ause is dierent, but the ee t is
the same.
11.1 Simultaneous equations

Up until now our model is
y = X +
where, for purposes of estimation we an treat
we ondition
on
X,
on
as xed. This means that when estimating
X. When analyzing dynami models, we're not interested in onditioning
as we saw in the se tion on sto hasti regressors. Nevertheless, the OLS estimator
obtained by treating
as xed ontinues to have desirable asymptoti properties even in
that ase.
Simultaneous equations is a dierent prospe t. An example of a simultaneous equation
system is a simple supply-demand system:
qt = 1 + 2 pt + 3 yt + 1t
Demand:
"
1t
2t
The presumption is that
qt
Supply:
1t 2t
and
pt
q = 1 + 2 pt + 2t
#
!t
"
11 12
=
22
, t
are jointly determined at the same time by the inter-
se tion of these equations. We'll assume that
yt
is determined by some unrelated pro ess.
It's easy to see that we have orrelation between regressors and errors. Solving for
1 + 2 pt + 3 yt + 1t = 1 + 2 pt + 2t
2 pt 2 pt = 1 1 + 3 yt + 1t 2t
3 yt
1t 2t
1 1
+
+
pt =
2 2 2 2
2 2
137
pt
138
CHAPTER 11.
Now onsider whether
pt
EXOGENEITY AND SIMULTANEITY
1t :

1 1
3 yt
1t 2t
+
+
2 2 2 2
2 2
11 12
2 2
E(pt 1t ) = E
=
1t
Be ause of this orrelation, OLS estimation of the demand equation will be biased and
in onsistent. The same applies to the supply equation, for the same reason.
In this model,
qt
and
yt
within the system.
pt
is an
endogenous varibles (endogs), that are determined

exogenous variable (exogs). These on epts are a bit tri ky,
are the
and we'll return to it in a minute. First, some notation. Suppose we group together urrent
endogs in the ve tor
Yt . If there are G endogs, Yt
as well as lagged endogs in the ve tor

equations into the error ve tor
Et .
Xt
is
G 1. Group urrent and lagged exogs,
, whi h is
K 1.
Sta k the errors of the
The model, with additional assumtions, an be written
as
Yt = Xt B + Et
Et N (0, ), t
E(Et Es ) = 0, t 6= s
We an sta k all
observations and write the model as
Y = XB + E
E(X E) = 0(KG)
vec(E) N (0, )
where
is
n G, X
is
Y1
X1

X2
Y2
Y = . ,X =
..
.
..
Yn
Xn
n K,
and
is
n G.
E1
E
,E = . 2
.
En
omplete, in that there are as many equations as endogs.
This system is
There is a normality assumption. This isn't ne essary, but allows us to onsider the
relationship between least squares and ML estimators.

Sin e there is no auto orrelation of the
Et
's, and sin e the olumns of
vidually homos edasti , then
11 In 12 In 1G In
.
.
.
22 In
..
= In
.
.
.
GG In
are indi-
11.2.
139
EXOGENEITY
may ontain lagged endogenous and exogenous variables.
These variables are
predetermined.
We need to dene what is meant by endogenous and exogenous when lassifying

the urrent period variables.
11.2 Exogeneity
The model denes a
and
Xt ,
data generating pro ess.
The model involves two sets of variables,
Yt
as well as a parameter ve tor
vec() vec(B) vec ()

G2 + GK + G2 G /2 + G
In general, without additional restri tions,
In prin iple, there exists a joint density fun tion for
is a
di-
mensional ve tor. This is the parameter ve tor that were interested in estimating.
parameter ve tor
Yt
and
Xt ,
whi h depends on a
Write this density as
ft (Yt , Xt |, It )
where
It
is the information set in period
t.
's of ourse. This an be fa tored into the density of

marginal density of
Xt
Yt s
This in ludes lagged
Yt
and lagged
onditional on
Xt
Xt
times the
ft (Yt , Xt |, It ) = ft (Yt |Xt , , It )ft (Xt |, It )

This is a general fa torization, but is may very well be the ase that not all parameters
in
ae t both fa tors.
So use
onditional density and write

general,
and
to indi ate elements of
that enter into the
for parameters that enter into the marginal.
In
may share elements, of ourse. We have
ft (Yt , Xt |, It ) = ft (Yt |Xt , 1 , It )ft (Xt |2 , It )
Re all that the model is
Yt = Xt B + Et
Et N (0, ), t
E(Et Es ) = 0, t 6= s
Normality and la k of orrelation over time imply that the observations are independent
of one another, so we an write the log-likelihood fun tion as the sum of likelihood ontri-
140
CHAPTER 11.
butions of ea h observation:
ln L(Y |, It ) =
=
=
n
X
t=1
n
X
t=1
n
X
t=1
ln ft (Yt , Xt |, It )
ln (ft (Yt |Xt , 1 , It )ft (Xt |2 , It ))
ln ft (Yt |Xt , 1 , It ) +
n
X
ln ft (Xt |2 , It ) =
t=1
Denition 15 (Weak Exogeneity) Xt is weakly exogeneous for (the original param-
eter ve tor) if there is a mapping from to that is invariant to 2 . More formally, for
an arbitrary (1 , 2 ), () = (1 ).
This implies that
would hange as
and
Xt
annot share elements if
is weakly exogenous, sin e
hanges, whi h prevents onsideration of arbitrary ombinations of
(1 , 2 ).
Supposing that
Xt
is weakly exogenous, then the MLE of
using the joint density is
the same as the MLE using only the onditional density
ln L(Y |X, , It ) =
n
X
t=1
ln ft (Yt |Xt , 1 , It )
sin e the onditional likelihood doesn't depend on
2 .
tional log-likelihoods maximize at the same value of
In other words, the joint and ondi-
1 .
With weak exogeneity, knowledge of the DGP of

and knowledge of
DGP of
Xt
Xt
is irrelevant for inferen e on
is su ient to re over the parameter of interest,
is irrelevant, we an treat
Xt
1 ,
Sin e the
as xed in inferen e.
(1 ),and
By the invarian e property of MLE, the MLE of
Of ourse, we'll need to gure out just what this mapping is to re over
With la k of weak exogeneity, the joint and onditional likelihood fun tions maximize
is
this mapping is
assumed to exist in the denition of weak exogeneity.
This is the famous
from 1 .
identi ation problem.
in dierent pla es. For this reason, we an't treat
Xt
as xed in inferen e. The joint
MLE is valid, but the onditional MLE is not.
In resume, we require the variables in
Xt
to be weakly exogenous if we are to be able
to treat them as xed in estimation. Lagged

in the onditioning information set, e.g.,
Yt
satisfy the denition, sin e they are
Yt1 It .
Lagged
Yt
aren't exogenous in
are determined within the model,

just earlier on. Weakly exogenous variables in lude exogenous (in the normal sense)
variables as well as all predetermined variables.
the normal usage of the word, sin e their values
11.3 Redu ed form

Re all that the model is
11.3.
141
REDUCED FORM
Yt = Xt B + Et
V (Et ) =
This is the model in
stru tural form.
Denition 16 (Stru tural form) An equation is in stru tural form when more than one
urrent period endogenous variable is in luded.
The solution for the urrent period endogs is easy to nd. It is
Yt = Xt B1 + Et 1
= Xt + Vt =
Now only one urrent period endog appears in ea h equation. This is the
redu ed form.
Denition 17 (Redu ed form) An equation is in redu ed form if only one urrent pe-
riod endog is in luded.
An example is our supply/demand system. The redu ed form for quantity is obtained
by solving the supply equation for pri e and substituting into demand:

qt 1 2t
+ 3 yt + 1t
1 + 2
2
2 1 2 (1 + 2t ) + 2 3 yt + 2 1t
2 3 yt
2 1t 2 2t
2 1 2 1
+
+
2 2
2 2
2 2
11 + 21 yt + V1t

qt =
2 qt 2 qt =
qt =
=
Similarly, the rf for pri e is
1 + 2 pt + 2t = 1 + 2 pt + 3 yt + 1t
2 pt 2 pt = 1 1 + 3 yt + 1t 2t
3 yt
1t 2t
1 1
+
+
pt =
2 2 2 2
2 2
= 12 + 22 yt + V2t
The interesting thing about the rf is that the equations individually satisfy the lassi al assumptions, sin e
yt
E(yt Vit ) = 0,
The errors of the rf are
i=1,2,
t.
"
V1t
V2t
"
1t
and
2 1t 2 2t
2 2
1t 2t
2 2
2t
#
by assumption, and therefore
142
CHAPTER 11.
The varian e of
V1t
is

2 1t 2 2t
2 1t 2 2t
2 2
2 2
2
2 11 22 2 12 + 2 22
(2 2 )2
V (V1t ) = E
This is onstant over time, so the rst rf equation is homos edasti .
Likewise, sin e the
are independent over time, so are the
Vt .
The varian e of the se ond rf error is

1t 2t
1t 2t
V (V2t ) = E
2 2
2 2
11 212 + 22
=
(2 2 )2
and the ontemporaneous ovarian e of the errors a ross equations is

1t 2t
2 1t 2 2t
2 2
2 2
2 11 (2 + 2 ) 12 + 22
(2 2 )2
E(V1t V2t ) = E
=

In summary the rf equations individually satisfy the lassi al assumptions, under the
assumtions we've made, but they are ontemporaneously orrelated.
The general form of the rf is
Yt = Xt B1 + Et 1
= Xt + Vt
so we have that
and that the
Vt

Vt = 1 Et N 0, 1 1 , t
are timewise independent (note that this wouldn't be the ase if the
Et
were auto orrelated).
11.4 IV estimation
The IV estimator may appear a bit unusual at rst, but it will grow on you over time.
The simultaneous equations model is
Y = XB + E
Considering the rst equation (this is without loss of generality, sin e we an always reorder
the equations) we an partition the
matrix as
Y =
y Y1 Y2
11.4.
143
IV ESTIMATION
is the rst olumn
Y1
are the other endogenous variables that enter the rst equation
Y2
are endogs that are ex luded from this equation
Similarly, partition
as
X=
X1
X2
are the in luded exogs, and
X1 X2
are the ex luded exogs.
Finally, partition the error matrix as
E=
Assume that
E12
has ones on the main diagonal.
These are normalization restri tions
that simply s ale the remaining oe ients on ea h equation, and whi h s ale the varian es
of the error terms.
Given this s aling and our partitioning, the oe ient matri es an be written as
1
12
= 1 22
0
32
#
"
1 B12
B =
0 B22
With this, the rst equation an be written as
y = Y1 1 + X1 1 +
= Z +
The problem, as we've seen is that
is orrelated with
sin e
Y1
is formed of endogs.
Now, let's onsider the general problem of a linear regression model with orrelation
between regressors and the error term:
y = X +
iid(0, In 2 )
E(X ) 6= 0.
The present ase of a stru tural equation from a system of equations ts into this notation,
but so do other problems, su h as measurement error or lagged dependent variables with
auto orrelated errors. Consider some matrix
with
whi h is formed of variables un orrelated
This matrix denes a proje tion matrix
PW = W (W W )1 W
so that anything that is proje ted onto the spa e spanned by
will be un orrelated with
144
CHAPTER 11.
by the denition of
W.
Transforming the model with this proje tion matrix we get
PW y = PW X + PW
or
y = X +
Now we have that
and
are un orrelated, sin e this is simply
E(X ) = E(X PW
PW )
= E(X PW )
and
PW X = W (W W )1 W X
X
is the tted value from a regression of

of
W,
so it must be un orrelated with
on
W. This is a linear ombination
of the olumns
This implies that applying OLS to the model
y = X +
will lead to a onsistent estimator, given a few more assumptions. This is the
instrumental variables estimator. W
generalized
is known as the matrix of instruments. The estimator
is
IV = (X PW X)1 X PW y
from whi h we obtain
IV
= (X PW X)1 X PW (X + )
= + (X PW X)1 X PW
so
IV = (X PW X)1 X PW
=
X W (W W )1 W X
Now we an introdu e fa tors of
IV =
X W
n
to get
W W 1
n
!
Assuming that ea h of the terms with a
W W
n
QW W ,
X W
n
QXW ,
W p
n
W X
n
1
X W (W W )1 W
!1
X W
n

W W
n
1
W
n
in the denominator satises a LLN, so that
a nite pd matrix
a nite matrix with rank
(= ols(X) )
then the plim of the rhs is zero. This last term has plim 0 sin e we assume that
and
11.4.
145
IV ESTIMATION
are un orrelated, e.g.,
E(Wt t ) = 0,
Given these assumtions the IV estimator is onsistent
p
IV .
Furthermore, s aling by
n,
X W
n

n IV =
we have

W W
n
1
W X
n
!1
X W
n

W W
n
1
Assuming that the far right term saties a CLT, so that
d
W

n
N (0, QW W 2 )
then we get
The estimators for

d
1 2
n IV N 0, (QXW Q1
W W QXW )
QXW
and
QW W
are the obvious ones. An estimator for
is

2 = 1 y X
IV .
IV
d
y
IV
n
This estimator is onsistent following the proof of onsisten y of the OLS estimator of
2 ,
when the lassi al assumptions hold.

The formula used to estimate the varian e of
V (IV ) =
The IV estimator is
X W
W W
IV
1
is
W X
1 d
2
IV
1. Consistent
2. Asymptoti ally normally distributed
3. Biased in general, sin e even though
1 and
be zero, sin e (X PW X)
E(X PW ) = 0, E(X PW X)1 X PW
An important point is that the asymptoti distribution of
QW W ,
and these depend upon the hoi e of
When we have two sets of instruments,

estimator using
W1 .
W2
IV
depends upon
QXW
and
W.
The hoi e of instruments inuen es the
W1
and
e ien y of the estimator.
may not
X PW are not independent.
W2
su h that
W1 W2 ,
then the IV
is at least as e iently asymptoti ally as the estimator that used
More instruments leads to more asymptoti ally e ient estimation, in general.
There are spe ial ases where there is no gain (simultaneous equations is an example
The penalty for indis riminant use of instruments is that the small sample bias of the
of this, as we'll see).
IV estimator rises as the number of instruments in reases. The reason for this is that
PW X
be omes loser and loser to
itself as the number of instruments in reases.
146
CHAPTER 11.
IV estimation an learly be used in the ase of simultaneous equations. The only

issue is whi h instruments to use.
11.5 Identi ation by ex lusion restri tions

The identi ation problem in simultaneous equations is in fa t of the same nature as the
identi ation problem in any estimation setting: does the limiting obje tive fun tion have
the proper urvature so that there is a unique global minimum or maximum at the true
parameter value? In the ontext of IV estimation, this is the ase if the limiting ovarian e
of the IV estimator is positive denite and
plim n1 W = 0.
This matrix is
1 2
V (IV ) = (QXW Q1
W W QXW )
The ne essary and su ient ondition for identi ation is simply that this matrix be
For this matrix to be positive denite, we need that the onditions noted above hold:
These identi ation onditions are not that intuitive nor is it very obvious how to
positive denite, and that the instruments be (asymptoti ally) un orrelated with
QW W
must be positive denite and
QXW
must be of full rank (
).
he k them.
11.5.1 Ne essary onditions

If we use IV estimation for a single equation of the system, the equation an be written as
y = Z +
where
Z=
Notation:
Let
Let
K = cols(X1 )
Let
Y1 X1
be the total numer of weakly exogenous variables.
be the number of in luded exogs, and let
number of ex luded exogs (in this equation).
G = cols(Y1 ) + 1 be the
K = K K
total number of in luded endogs, and let
be the number of ex luded endogs.
be the
G = G G
Using this notation, onsider the sele tion of instruments.
Now the
It turns out that

in
X1
are weakly exogenous and an serve as their own instruments.
exhausts the set of possible instruments, in that if the variables
don't lead to an identied model then no other instruments will identify the
model either. Assuming this is true (we'll prove it in a moment), then a ne essary
11.5.
147
IDENTIFICATION BY EXCLUSION RESTRICTIONS
ondition for identi ation is that

instrument must be used twi e, so
cols(X2 ) cols(Y1 )
W
sin e if not then at least one
will not have full olumn rank:
(W ) < K + G 1 (QZW ) < K + G 1

This is the
order ondition for identi ation in a set of simultaneous equations.
When
the only identifying information is ex lusion restri tions on the variables that enter
an equation, then the number of ex luded exogs must be greater than or equal to
the number of in luded endogs, minus 1 (the normalized lhs endog), e.g.,
K G 1
To show that this is in fa t a ne essary ondition onsider some arbitrary set of

instruments
W.
A ne essary ondition for identi ation is that
1
plim W Z
n
where
Z=
= K + G 1
Y1 X1
Re all that we've partitioned the model
Y = XB + E
as
Y =
X=
Given the redu ed form
y Y1 Y2
X1 X2
Y = X + V
we an write the redu ed form using the same partition
y Y1 Y2
X1 X2
"
11 12 13
21 22 23
v V1 V2
so we have
Y1 = X1 12 + X2 22 + V1
so
Be ause the
and
V1
i
h
1
1
W Z = W X1 12 + X2 22 + V1 X1
n
n
's are un orrelated with the
V1
's, by assumption, the ross between
onverges in probability to zero, so
i
h
1
1
plim W Z = plim W X1 12 + X2 22 X1
n
n
Sin e the far rhs term is formed only of linear ombinations of olumns of
X,
the rank
148
CHAPTER 11.
of this matrix an never be greater than

has more than
K,
regardless of the hoi e of instruments. If
olumns, then it is not of full olumn rank.
When
has more than
olumns we have
G 1 + K > K
or noting that
K = K K ,
G 1 > K
In this ase, the limiting matrix is not of full olumn rank, and the identi ation ondition
fails.
11.5.2 Su ient onditions

Identi ation essentially requires that the stru tural parameters be re overable from the
data. This won't be the ase, in general, unless the stru tural model is subje t to some
restri tions. We've already identied ne essary onditions. Turning to su ient onditions
(again, we're only onsidering identi ation through zero restri itions on the parameters,
for the moment).
The model is
Yt = Xt B + Et
V (Et ) =
This leads to the redu ed form
Yt = Xt B1 + Et 1
= Xt + Vt

V (Vt ) = 1 1
=
The redu ed form parameters are onsistently estimable, but none of them are known
priori,
and there are no restri tions on their values. The problem is that more than one
stru tural form has the same redu ed form, so knowledge of the redu ed form parameters
alone isn't enough to determine the stru tural parameters. To see this, onsider the model
Yt F
= Xt BF + Et F
V (Et F ) = F F
where
is some arbirary nonsingular
GG
matrix. The rf of this new model is
Yt = Xt BF (F )1 + Et F (F )1
= Xt BF F 1 1 + Et F F 1 1
= Xt B1 + Et 1
= Xt + Vt
11.5.
149
Likewise, the ovarian e of the rf of the transformed model is
V (Et F (F )1 ) = V (Et 1 )
=
Sin e the two stru tural forms lead to the same rf, and the rf is all that is dire tly estimable,
the models are said to be
restri tions on
and
observationally equivalent.
What we need for identi ation are
su h that the only admissible
is an identity matrix (if all of the
equations are to be identied). Take the oe ient matri es as partitioned before:
"
12
=
0
1
0
22
32
B12
B22
The oe ients of the rst equation of the transformed model are simply these oe ients
multiplied by the rst olumn of
"
F.
#"
This gives
f11
F2
12
=
0
1
0
#
22 "
f11
32
F
2
B12
B22
For identi ation of the rst equation we need that there be enough restri tions so that
the only admissible
"
f11
F2
be the leading olumn of an identity matrix, so that
1
0
12
#
1
22 "
f11
=
32
0
F2
B12
1
0
B22
Note that the third and fth rows are
"
32
B22
F2 =
"
0
0
Supposing that the leading matrix is of full olumn rank, e.g.,
"
32
B22
#!
= cols
"
32
B22
#!
=G1
then the only way this an hold, without additional restri tions on the model's parameters,
150
CHAPTER 11.
is if
F2
F2
is a ve tor of zeros. Given that
1 12
Therefore, as long as
"
"
then
"
F2
is a ve tor of zeros, then the rst equation
f11
F2
B22
#!
"
32
f11
= 1 f11 = 1
=G1
1
0G1
The rst equation is identied in this ase, so the ondition is su ient for identi ation.
It is also ne essary, sin e the ondition implies that this submatrix must have at least
G1
rows. Sin e this matrix has
G + K = G G + K
rows, we obtain
G G + K G 1
or
K G 1
whi h is the previously derived ne essary ondition.
The above result is fairly intuitive (draw pi ture here). The ne essary ondition ensures
that there are enough variables not in the equation of interest to potentially move the other
equations, so as to tra e out the equation of interest. The su ient ondition ensures that
those other equations in fa t do move around as the variables hange their values. Some
points:
When an equation has
K = G 1,
is is
exa tly identied,
in that omission of an
identiying restri tion is not possible without loosing onsisten y.

When
K > G 1, the equation is overidentied,
sin e one ould drop a restri tion
and still retain onsisten y. Overidentifying restri tions are therefore testable. When
an equation is overidentied we have more instruments than are stri tly ne essary for
onsistent estimation. Sin e estimation by IV with more instruments is more e ient
asymptoti ally, one should employ overidentifying restri tions if one is ondent that
they're true.
We an repeat this partition for ea h equation in the system, to see whi h equations
These results are valid assuming that the only identifying information omes from
are identied and whi h aren't.
knowing whi h variables appear in whi h equations, e.g., by ex lusion restri tions,
and through the use of a normalization. There are other sorts of identifying information that an be used. These in lude
1. Cross equation restri tions
11.5.
151
2. Additional restri tions on parameters within equations (as in the Klein model
dis ussed below)
3. Restri tions on the ovarian e matrix of the errors
4. Nonlinearities in variables
When these sorts of information are available, the above onditions aren't ne essary
for identi ation, though they are of ourse still su ient.
To give an example of how other information an be used, onsider the model
Y = XB + E
where
system
is an upper triangular matrix with 1's on the main diagonal. This is a
triangular
of equations. In this ase, the rst equation is
y1 = XB1 + E1
Sin e only exogs appear on the rhs, this equation is identied.
The se ond equation is
y2 = 21 y1 + XB2 + E2
This equation has
K = 0
ex luded exogs, and
G = 2
in luded endogs, so it fails the
order (ne essary) ondition for identi ation.
However, suppose that we have the restri tion
21 = 0,
so that the rst and se ond
stru tural errors are un orrelated. In this ase

E(y1t 2t ) = E (Xt B1 + 1t )2t = 0
so there's no problem of simultaneity.
If the entire
matrix is diagonal, then fol-
lowing the same logi , all of the equations are identied.
re ursive
model.
This is known as a
fully
152
CHAPTER 11.
11.5.3 Example: Klein's Model 1

To give an example of determining identi ation status, onsider the following ma ro model
(this is the widely known Klein's Model 1)
Ct = 0 + 1 Pt + 2 Pt1 + 3 (Wtp + Wtg ) + 1t
Consumption:
Investment:
Wtp = 0 + 1 Xt + 2 Xt1 + 3 At + 3t
Private Wages:
Xt = Ct + It + Gt
Output:
Prots:
Capital Sto k:
It = 0 + 1 Pt + 2 Pt1 + 3 Kt1 + 2t
1t
Pt = Xt Tt Wtp
Kt = Kt1 + It

2t IID 0 ,
0
3t
The other variables are the government wage bill,
spending,
Gt ,and
a time trend,
At .
Yt =
11 12 13
22 23
33
Wtg ,
taxes,
Tt ,
government nonwage
The endogenous variables are the lhs variables,
Ct It Wtp Xt Pt Kt
and the predetermined variables are all others:
Xt =
1 Wtg Gt Tt At Pt1 Kt1 Xt1
The model assumes that the errors of the equations are ontemporaneously orrelated, by
nonauto orrelated. The model written as
Y = XB + E
3 0
B=
1 0
0
0
0 0 0 0 0
3 0
2 2 0
0
3 0
1
0
1 0
1
0
0
1
1 0
1 1
1 1 0
gives
1 0
0
0 1 0
0 0
0
0 0
0
0 0
1
0 0
0
0 0
To he k this identi ation of the onsumption equation, we need to extra t

the submatri es of oe ients of endogs and exogs that
don't
32
and
B22 ,
appear in this equation.
These are the rows that have zeros in the rst olumn, and we need to drop the rst
11.6.
153
2SLS
olumn. We get
"
32
B22
1 0
1 1
1 0
0
0
0
1
1
0
1 0
3 0
0
0
0
0
We need to nd a set of 5 rows of this matrix gives a full-rank 55 matrix. For example,
sele ting rows 3,4,5,6, and 7 we obtain the matrix
A=
0
0
3
0
0
3
0
0 0
0 1 0
0 0
0
0 0
1
1 0
This matrix is of full rank, so the su ient ondition for identi ation is met. Counting
in luded endogs,
G = 3,
and ounting ex luded exogs,
K = 5,
so
K L = G 1
5L
L
=31
=3
The equation is over-identied by three restri tions, a ording to the ounting rules,
whi h are orre t when the only identifying information are the ex lusion restri tions.
However, there is additional information in this ase. Both
Wtp
and
Wtg
enter the
onsumption equation, and their oe ients are restri ted to be the same. For this
reason the onsumption equation is in fa t overidentied by four restri tions.
11.6 2SLS
When we have no information regarding ross-equation restri tions or the stru ture of the
error ovarian e matrix, one an estimate the parameters of a single equation of the system
without regard to the other equations.
This isn't always e ient, as we'll see, but it has the advantage that misspe i ations
in other equations will not ae t the onsisten y of the estimator of the parameters
of the equation of interest.
Also, estimation of the equation won't be ae ted by identi ation problems in other
equations.
The 2SLS estimator is very simple: in the rst stage, ea h olumn of

the weakly exogenous variables in the system, e.g., the entire
Y1
is regressed on
all
matrix. The tted values
154
CHAPTER 11.
are
Y1 = X(X X)1 X Y1
= PX Y1
1
= X
Sin e these tted values are the proje tion of
any ve tor in this spa e is un orrelated with
Sin e
Y1
Y1
on the spa e spanned by
Y1
by assumption,
X,
and sin e
is simply the redu ed-form predi tion, it is orrelated with
Y1 ,
The only other
requirement is that the instruments be linearly independent. This should be the ase when
the order ondition is satised, sin e there are more olumns in
Y1
The se ond stage substitutes
in pla e of
Y1 ,
X2
than in
Y1
in this ase.
and estimates by OLS. This original
model is
y = Y1 1 + X1 1 +
= Z +
and the se ond stage model is
y = Y1 1 + X1 1 + .
Sin e
X1
is in the spa e spanned by
X, PX X1 = X1 ,
so we an write the se ond stage
model as
y = PX Y1 1 + PX X1 1 +
PX Z +
The OLS estimator applied to this model is
= (Z PX Z)1 Z PX y
whi h is exa tly what we get if we estimate using IV, with the redu ed form predi tions of
the endogs used as instruments. Note that if we dene
Z = PX Z
h
i
=
Y1 X1
so that
are the instruments for
Z,
then we an write
= (Z Z)1 Z y
Important note: OLS on the transformed model an be used to al ulate the 2SLS
estimate of
sin e we see that it's equivalent to IV using a parti ular set of instru-
ments. However
the OLS ovarian e formula is not valid.
ovarian e formula already seen above.
We need to apply the IV
11.7.
155
TESTING THE OVERIDENTIFYING RESTRICTIONS
A tually, there is also a simpli ation of the general IV varian e formula. Dene
Z = PX Z
h
i
=
Y X
The IV ovarian e estimator would ordinarily be

1

1
2
= Z Z
V ()
Z Z Z Z
IV
However, looking at the last term in bra kets
ZZ=
but sin e
PX
Y1 X1
i h
Y1 X1
is idempotent and sin e
Y1 X1
i h
"
PX X = X,
Y1 X1
"
Y1 (PX )Y1 Y1 (PX )X1

X1 Y1
X1 X1
we an write
Y1 PX PX Y1 Y1 PX X1
X1 X1
X1 PX Y1
h
i h
i
=
Y1 X1
Y1 X1
= Z Z
Therefore, the se ond and last term in the varian e formula an el, so the 2SLS var ov
estimator simplies to

1
2
= Z Z
V ()
IV
whi h, following some algebra similar to the above, an also be written as

1
2
= Z Z
V ()
IV
Finally, re all that though this is presented in terms of the rst equation, it is general sin e
any equation an be pla ed rst.
Properties of 2SLS:
1. Consistent
2. Asymptoti ally normal
3. Biased when the mean esists (the existen e of moments is a te hni al issue we won't
go into here).
4. Asymptoti ally ine ient, ex ept in spe ial ir umstan es (more on this later).
11.7 Testing the overidentifying restri tions

The sele tion of whi h variables are endogs and whi h are exogs
of the model.
is part of the spe i ation
As su h, there is room for error here: one might erroneously lassify a variable
as exog when it is in fa t orrelated with the error term. A general test for the spe i ation
on the model an be formulated as follows:
156
CHAPTER 11.
The IV estimator an be al ulated by applying OLS to the transformed model, so the

IV obje tive fun tion at the minimized value is

s(IV ) = y X IV PW y X IV ,
but
IV
= y X IV
= y X(X PW X)1 X PW y

= I X(X PW X)1 X PW y

= I X(X PW X)1 X PW (X + )
= A (X + )
where
A I X(X PW X)1 X PW
so
Moreover,
A PW A
A PW A =
=
=
Furthermore,

s(IV ) = + X A PW A (X + )
is idempotent, as an be veried by multipli ation:

I PW X(X PW X)1 X PW I X(X PW X)1 X PW

PW PW X(X PW X)1 X PW PW PW X(X PW X)1 X PW

I PW X(X PW X)1 X PW .
is orthogonal to
AX =

I X(X PW X)1 X PW X
= X X
= 0
so
s(IV ) = A PW A
Supposing the
are normally distributed, with varian e
2 ,
then the random variable
s(IV )
A PW A
=
2
2
is a quadrati form of a
so
N (0, 1)
random variable with an idempotent matrix in the middle,
s(IV )
2 ((A PW A))
2
This isn't available, sin e we need to estimate
2 .
Substituting a onsistent estimator,
s(IV ) a 2
((A PW A))
c
2
11.7.
157
TESTING THE OVERIDENTIFYING RESTRICTIONS
Even if the
aren't normally distributed, the asymptoti result still holds. The last
thing we need to determine is the rank of the idempotent matrix. We have
A PW A = PW PW X(X PW X)1 X PW
so
(A PW A) = T r PW PW X(X PW X)1 X PW
= T rPW T rX PW PW X(X PW X)1
= T rW (W W )1 W KX
= T rW W (W W )1 KX
= KW KX
where
KW
is the number of olumns of
and
KX
is the number of olumns of
X.
The degrees of freedom of the test is simply the number of overidentifying restri tions:
the number of instruments we have beyond the number that is stri tly ne essary for
onsistent estimation.
This test is an overall spe i ation test: the joint null hypothesis is that the model
is orre tly spe ied
and that the W
form valid instruments (e.g., that the variables
lassied as exogs really are un orrelated with

model
y = Z +
Reje tion an mean that either the
is misspe ied, or that there is orrelation between
and
This is a parti ular ase of the GMM riterion test, whi h is overed in the se ond
Note that sin e
half of the ourse. See Se tion 15.8.
IV = A
and
s(IV ) = A PW A
we an write
s(IV )
c2
where
Ru2

W (W W )1 W W (W W )1 W
=
/n
= n(RSSIV |W /T SSIV )
= nRu2
is the un entered
instruments
W.
R2
from a regression of the
IV
residuals on all of the
This is a onvenient way to al ulate the test statisti .
On an aside, onsider IV estimation of a just-identied model, using the standard notation
y = X +
and
is the matrix of instruments.
If we have exa t identi ation then
cols(W ) =
158
cols(X),
CHAPTER 11.
W X
so
is a square matrix. The transformed model is
PW y = PW X + PW
and the fon are
X PW (y X IV ) = 0
The IV estimator is
IV = X PW X
Considering the inverse here
X PW X
Now multiplying this by
IV
1
X PW y,
1
X PW y
X W (W W )1 W X
1
1
= (W X)1 X W (W W )1
1
= (W X)1 (W W ) X W
we obtain
= (W X)1 (W W ) X W
= (W X)1 (W W ) X W
= (W X)1 W y
1
1
X PW y
X W (W W )1 W y
The obje tive fun tion for the generalized IV estimator is

y X IV PW y X IV

X PW y X IV
y PW y X IV IV

X PW y + IV
X PW X IV
y PW y X IV IV

X PW y + X PW X IV
y PW y X IV IV

y PW y X IV
s(IV ) =
=
=
=
=
by the fon for generalized IV. However, when we're in the just indentied ase, this is

s(IV ) = y PW y X(W X)1 W y

= y PW I X(W X)1 W y

= y W (W W )1 W W (W W )1 W X(W X)1 W y
= 0
The value of the obje tive fun tion of the IV estimator is zero in the just identied ase.
This makes sense, sin e we've already shown that the obje tive fun tion after dividing by
is asymptoti ally
restri tions.
with degrees of freedom equal to the number of overidentifying
In the present ase, there are no overidentifying restri tions, so we have a
2 (0) rv, whi h has mean 0 and varian e 0, e.g., it's simply 0. This means we're not able
to test the identifying restri tions in the ase of exa t identi ation.
11.8.
159
SYSTEM METHODS OF ESTIMATION
11.8 System methods of estimation

2SLS is a single equation method of estimation, as noted above. The advantage of a single
equation method is that it's unae ted by the other equations of the system, so they don't
need to be spe ied (ex ept for dening what are the exogs, so 2SLS an use the omplete
set of instruments). The disadvantage of 2SLS is that it's ine ient, in general.
Re all that overidenti ation improves e ien y of estimation, sin e an overidentied

equation an use more instruments than are ne essary for onsistent estimation.
Se ondly, the assumption is that
Y = XB + E
E(X E) = 0(KG)
vec(E) N (0, )
Sin e there is no auto orrelation of the
Et
's, and sin e the olumns of
are indi-
vidually homos edasti , then
11 In 12 In 1G In
.
.
.
22 In
..
.
.
.
GG In
= In
This means that the stru tural equations are heteros edasti and orrelated with one
another
In general, ignoring this will lead to ine ient estimation, following the se tion on
GLS. When equations are orrelated with one another estimation should a ount for
the orrelation in order to obtain e ien y.
Also, sin e the equations are orrelated, information about one equation is impli itly
information about all equations.
equation improve e ien y for
all
Therefore, overidenti ation restri tions in any

equations, even the just identied equations.
Single equation methods an't use these types of information, and are therefore ine ient (in general).
11.8.1 3SLS
Note: It is easier and more pra ti al to treat the 3SLS estimator as a generalized method
of moments estimator (see Chapter 15). I no longer tea h the following se tion, but it is
retained for its possible histori al interest. Another alternative is to use FIML (Subse tion 11.8.2), if you are willing to make distributional assumptions on the errors. This is
omputationally feasible with modern omputers.
160
CHAPTER 11.
Following our above notation, ea h stru tural equation an be written as
yi = Yi 1 + Xi 1 + i
= Zi i + i
Grouping the
equations together we get
y1
y2
.
.
.
yG
or
Z1 0

0
=

.
..
0
0
.
.
.
Z2
..
ZG
.
..

2
+ .
.
.
G
y = Z +
where we already have that
E( ) =
= In
The 3SLS estimator is just 2SLS ombined with a GLS orre tion that takes advantage of
the stru ture of
Dene
as
X(X X)1 X Z1 0
Z = .
..
Y1 X1
= .
.
.
0
.
.
.
X(X X)1 X Z2
..
0
Y2 X2
0
0
.
.
.
..
These instruments are simply the
0
YG XG
unrestri ted
0
0
X(X X)1 X ZG
rf predi itions of the endogs, ombined
with the exogs. The distin tion is that if the model is overidentied, then
= B1
may be subje t to some zero restri tions, depending on the restri tions on
does not impose these restri tions. Also, note that
and
B,
and
is al ulated using OLS equation
by equation. More on this later.

The 2SLS estimator would be
= (Z Z)1 Z y
as an be veried by simple multipli ation, and noting that the inverse of a blo k-diagonal
matrix is just the matrix with the inverses of the blo ks on the main diagonal. This IV
11.8.
161
estimator still ignores the ovarian e information. The natural extension is to add the GLS
transformation, putting the inverse of the error ovarian e into the formula, whi h gives
the 3SLS estimator
3SLS
=
=
Z ( In )1 Z
Z ( In )1 y

1 1
Z In y
Z 1 In Z
This estimator requires knowledge of

a onsistent estimator of
1
. The solution is to dene a feasible estimator using
. The obvious
solution is to use an estimator based on the 2SLS
residuals:
i = yi Zi i,2SLS
(IMPORTANT NOTE: this is al ulated
using
is estimated by
ij =
Substitute
Zi ,
not
Zi ).
Then the element
i, j
of
i j
n
into the formula above to get the feasible 3SLS estimator.
Analogously to what we did in the ase of 2SLS, the asymptoti distribution of the
3SLS estimator an be shown to be
!
Z ( I )1 Z 1

a
n
n 3SLS N 0, lim E
n
A formula for estimating the varian e of the 3SLS estimator in nite samples ( an elling
out the powers of
n)
is

1
1 In Z
V 3SLS = Z
??),
This is analogous to the 2SLS formula in equation (
In the ase that all equations are just identied, 3SLS is numeri ally equivalent to
ombined with the GLS
orre tion.
2SLS. Proving this is easiest if we use a GMM interpretation of 2SLS and 3SLS.
GMM is presented in the next e onometri s ourse. For now, take it on faith.
The 3SLS estimator is based upon the rf parameter estimator
al ulated equation by
equation using OLS:
= (X X)1 X Y
whi h is simply
= (X X)1 X
that is, OLS equation by equation using
all
y1 y2 yG
the exogs in the estimation of ea h olumn of
.
It may seem odd that we use OLS on the redu ed form, sin e the rf equations are
162
CHAPTER 11.
orrelated:
Yt = Xt B1 + Et 1
= Xt + Vt
and

Vt = 1 Et N 0, 1 1 , t
Let this var- ov matrix be indi ated by

= 1 1
OLS equation by equation to get the rf is equivalent to
y1
y2
.
.
.
yG
where
yi
of exogs,
is the
n1
is the
ith
X 0

0
=

.
.

.
..
ve tor of observations of the

olumn of
and
vi
.
.
0
.
G
X
.
.
.
is the
ith
ith
v1

v2
+ .
.
.
vG
endog,
olumn of
is the entire
V.
nK
matrix
Use the notation
y = X + v
to indi ate the pooled model. Following this notation, the error ovarian e matrix is
V (v) = In
This is a spe ial ase of a type of model known as a set of
tions (SUR)
seemingly unrelated equa-
sin e the parameter ve tor of ea h equation is dierent. The equations
are ontemporanously orrelated, however. The general ase would have a dierent
Xi
for ea h equation.
Note that ea h equation of the system individually satises the lassi al assumptions.
However, pooled estimation using the GLS orre tion is more e ient, sin e equationby-equation estimation is equivalent to pooled estimation, sin e
is blo k diagonal,
but ignoring the ovarian e information.
The model is estimated by GLS, where
In the spe ial ase that all the
is estimated using the OLS residuals from
equation-by-equation estimation, whi h are onsistent.
Xi
are the same, whi h is true in the present ase
of estimation of the rf parameters, SUR
X = In X.
Using the rules
1.
(A B)1 = (A1 B 1 )
2.
(A B) = (A B )
and
OLS.
To show this note that in this ase
11.8.
3.
(A B)(C D) = (AC BD),
we get

1
(In X) ( In )1 (In X)
(In X) ( In )1 y

1 1

1 X (In X)
X y

(X X)1 1 X y

IG (X X)1 X y

.2
.
.
SU R =
=
=
=
163
So the unrestri ted rf oe ients an be estimated e iently (assuming normality)

by OLS, even if the equations are orrelated.
We have ignored any potential zeros in the matrix
Another example where SUROLS is in estimation of ve tor autoregressions.
whi h if they exist ould
potentially in rease the e ien y of estimation of the rf.
See
two se tions ahead.
11.8.2 FIML
Full information maximum likelihood is an alternative estimation method.
FIML will
be asymptoti ally e ient, sin e ML estimators based on a given information set are
asymptoti ally e ient w.r.t. all other estimators that use the same information set, and
in the ase of the full-information ML estimator we use the entire information set. The
2SLS and 3SLS estimators don't require distributional assumptions, while FIML of ourse
does. Our model is, re all
Yt = Xt B + Et
Et N (0, ), t
E(Et Es ) = 0, t 6= s
The joint normality of
Et
means that the density for
is
g/2
(2)
The transformation from
Et
to
det
Yt

1 1/2
G/2
(2)
Yt
is the multivariate normal, whi h
1
exp Et 1 Et
2
requires the Ja obian
| det
so the density for
Et
dEt
| = | det |
dYt
is
| det | det

1 1/2

1
exp Yt Xt B 1 Yt Xt B
2
164
CHAPTER 11.
Given the assumption of independen e over time, the joint log-likelihood fun tion is
ln L(B, , ) =

n
1X
nG
ln(2)+n ln(| det |) ln det 1
Yt Xt B 1 Yt Xt B
2
2
2
t=1
This is a nonlinear in the parameters obje tive fun tion. Maximixation of this an be
done using iterative numeri methods. We'll see how to do this in the next se tion.
It turns out that the asymptoti distribution of 3SLS and FIML are the same,
suming normality of the errors.
as-
One an al ulate the FIML estimator by iterating the 3SLS estimator, thus avoiding
the use of a nonlinear optimizer. The steps are
1. Cal ulate
3SLS
2. Cal ulate
= B
3SLS
1 .
3SLS
and
3SLS
B
as normal.
This is new, we didn't estimate
in this way
before. This estimator may have some zeros in it. When Greene says iterated
3SLS doesn't lead to FIML, he means this for a pro edure that doesn't update
but only updates

and B
,
3. Cal ulate the instruments
and
If you update
you do
.
Y = X
and al ulate
using
onverge to FIML.
and
to get the
estimated errors, applying the usual estimator.

4. Apply 3SLS using these new instruments and the estimate of
5. Repeat steps 2-4 until there is no hange in the parameters.
FIML is fully e ient, sin e it's an ML estimator that uses all information.
implies that 3SLS is fully e ient
when the errors are normally distributed.
This
Also,
if ea h equation is just identied and the errors are normal, then 2SLS will be fully
e ient, sin e in this ase 2SLS3SLS.
When the errors aren't normally distributed, the likelihood fun tion is of ourse
dierent than what's written above.
11.9 Example: 2SLS and Klein's Model 1

The O tave program Simeq/Klein.m performs 2SLS estimation for the 3 equations of
Klein's model 1, assuming nonauto orrelated errors, so that lagged endogenous variables
an be used as instruments. The results are:
CONSUMPTION EQUATION
*******************************************************
2SLS estimation results
Observations 21
R-squared 0.976711
estimate
st.err.
t-stat.
p-value
11.9.
165
EXAMPLE: 2SLS AND KLEIN'S MODEL 1
Constant
Profits
Lagged Profits
Wages
16.555
0.017
0.216
0.810
1.321
0.118
0.107
0.040
12.534
0.147
2.016
20.129
0.000
0.885
0.060
0.000
*******************************************************
INVESTMENT EQUATION
*******************************************************
Observations 21
R-squared 0.884884
Constant
Profits
Lagged Profits
Lagged Capital
estimate
20.278
0.150
0.616
-0.158
st.err.
7.543
0.173
0.163
0.036
t-stat.
2.688
0.867
3.784
-4.368
p-value
0.016
0.398
0.001
0.000
*******************************************************
WAGES EQUATION
*******************************************************
Observations 21
R-squared 0.987414
Constant
Output
Lagged Output
Trend
estimate
1.500
0.439
0.147
0.130
st.err.
1.148
0.036
0.039
0.029
t-stat.
1.307
12.316
3.777
4.475
p-value
0.209
0.000
0.002
0.000
*******************************************************
The above results are not valid (spe i ally, they are in onsistent) if the errors are
auto orrelated, sin e lagged endogenous variables will not be valid instruments in that
ase. You might onsider eliminating the lagged endogenous variables as instruments, and
re-estimating by 2SLS, to obtain onsistent parameter estimates in this more omplex
ase. Standard errors will still be estimated in onsistently, unless use a Newey-West type
ovarian e estimator. Food for thought...
166
CHAPTER 11.
Chapter 12
Introdu tion to the se ond half
We'll begin with study of
based on a sample of size
extremum estimators
in general. Let
sn (Zn , )
be the available data,
n.
[Extremum estimator An extremum estimator

tive fun tion
Zn
over a set
is the optimizing
element of an obje -
We'll usually write the obje tive fun tion suppressing the dependen e on
Zn .
Example: Least squares, linear model

Let the d.g.p. be
yt = xt 0+ t , t = 1, 2, ..., n, 0 . Sta king observations verti ally,
yn = Xn 0 + n , where Xn =
as
x1 x2 xn
. The least squares estimator is dened
arg min sn () = (1/n) [yn Xn ] [yn Xn ]
We readily nd that
= (X X)1 X y.
Example: Maximum likelihood

Suppose that the ontinuous random variable
estimator is dened as
arg max Ln () =
n
Y
t=1
yt IIN ( 0 , 1). The maximum likelihood
(yt )2
(2)1/2 exp
2
Be ause the logarithmi fun tion is stri tly in reasing on
(0, ),
average logarithm of the likelihood fun tion is a hieved at the same
maximization of the
as
for the likelihood
fun tion:
arg max sn () = (1/n) ln Ln () = 1/2 ln 2 (1/n)
Solution of the f.o. . leads to the familiar result that
n
X
(yt )2
t=1
.
= y
MLE estimators are asymptoti ally e ient (Cramr-Rao lower bound, Theorem3),
One an investigate the properties of an ML estimator supposing that the distribu-
supposing the strong distributional assumptions upon whi h they are based are true.
tional assumptions are in orre t. This gives a

later.
167
quasi-ML estimator, whi h we'll study
168
CHAPTER 12.
INTRODUCTION TO THE SECOND HALF
The strong distributional assumptions of MLE may be questionable in many ases.

It is possible to estimate using weaker distributional assumptions based only on some
of the moments of a random variable(s).
Example: Method of moments

Suppose we draw a random sample of
parameter of interest.
yt
from the
2 ( 0 )
1 ,
The rst moment (expe tation),
general be a fun tion of the parameters of the distribution,
1 = 1 ( 0 )
is a
distribution. Here,
is the
of a random variable will in
i.e., 1 ( 0 ) .
moment-parameter equation.
In this example, the relationship is the identity fun tion
1 ( 0 ) = 0 ,
though in
general the relationship may be more ompli ated. The sample rst moment is
c1 =
n
X
yt /n.
t=1
Dene
The method of moments prin iple is to hoose the estimator of the parameter to set
m1 () = 1 ()
c1
0.
, i.e., m1 ()
the estimate of the population moment equal to the sample moment
Then the moment-parameter equation is inverted to solve for the parameter estimate.
In this ase,
=
m1 ()
Sin e
Pn
t=1 yt /n
n
X
yt /n = 0.
t=1
by the LLN, the estimator is onsistent.
More on the method of moments

Continuing with the above example, the varian e of a
V (yt ) = E yt 0
Dene
m2 () = 2
2
2 ( 0 )
r.v. is
= 2 0 .
Pn
t=1 (yt
y)2
The MM estimator would set
= 2
m2 ()
Pn
t=1 (yt
y)2
0.
Again, by the LLN, the sample varian e is onsistent for the true varian e, that is,
Pn
t=1 (yt
So,
n
Pn
y)2
t=1 (yt
2n
2 0 .
y)2
whi h is obtained by inverting the moment-parameter equation, is onsistent.
169
Example: Generalized method of moments (GMM)

The previous two examples give two estimators of
whi h are both onsistent. With
a given sample, the estimators will be dierent in general.
With two moment-parameter equations and only one parameter, we have
overiden-
ti ation, whi h means that we have more information than is stri tly ne essary for
onsistent estimation of the parameter.
The GMM ombines information from the two moment-parameter equations to form
a new estimator whi h will be
From the rst example, dene

average of
m1t (),
i.e.,
more e ient, in general (proof of this below).
m1t () = yt .
m1 () = 1/n
=
We already have that
n
X
t=1
n
X
m1 ()
is the sample
m1t ()
yt /n.
t=1
Clearly, when evaluated at the true parameter value
0.

0 , both E m1t ( 0 ) = 0 and E m1 ( 0 ) =
From the se ond example we dene additional moment onditions
m2t () = 2 (yt y)2

and
m2 () = 2
Again, it is lear from the LLN that
either
=0
m1 ()
or
Pn
t=1 (yt
a.s.
m2 ( 0 ) 0.
= 0. In general,
m2 ()
y)2
The MM estimator would hose
no single value of
to
set
will solve the two equations
simultaneously.
The GMM estimator is based on dening a measure of distan e
m() = (m1 (), m2 ()) ,
d(m()),
where
and hoosing
= arg min sn () = d (m()) .
An example would be to hoose
d(m) = m Am,
where
is a positive denite matrix.
While it's lear that the MM gives onsistent estimates if there is a one-to-one relationship
between parameters and moments, it's not immediately obvious that the GMM estimator
is onsistent. (We'll see later that it is.)
These examples show that these widely used estimators may all be interpreted as the
solution of an optimization problem. For this reason, the study of extremum estimators is
useful for its generality. We will see that the general results extend smoothly to the more
spe ialized results available for spe i estimators. After studying extremum estimators
in general, we will study the GMM estimator, then QML and NLS. The reason we study
GMM rst is that LS, IV, NLS, MLE, QML and other well-known parametri estimators
170
CHAPTER 12.
may all be interpreted as spe ial ases of the GMM estimator, so the general results on
GMM an simplify and unify the treatment of these other estimators. Nevertheless, there
are some spe ial results on QML and NLS, and both are important in empiri al resear h,
whi h makes fo us on them useful.
One of the fo al points of the ourse will be nonlinear models.

that linear models aren't useful.
This is not to suggest
Linear models are more general than they might rst
appear, sin e one an employ nonlinear transformations of the variables:
0 (yt ) =
For example,
1 (xt ) 2 (xt ) p (xt )
0 + t
ln yt = + x1t + x21t + x1t x2t + t

ts this form.
The important point is that the model is
linear in the variables.
linear in the parameters
but not ne essarily
In spite of this generality, situations often arise whi h simply an not be onvin ingly
represented by linear in the parameters models.
Also, theory that applies to nonlinear
models also applies to linear models, so one may as well start o with the general ase.
Example: Expenditure shares

Roy's Identity states that the quantity demanded of the
xi =
ith
of
goods is
v(p, y)/pi
.
v(p, y)/y
An expenditure share is
so ne essarily
si [0, 1],
and
si pi xi /y,
PG
i=1 si
= 1.
No linear in the parameters model for
xi
or
si
with a parameter spa e that is dened independent of the data an guarantee that either of
these onditions holds. These onstraints will often be violated by estimated linear models,
whi h alls into question their appropriateness in ases of this sort.
Example: Binary limited dependent variable

The referendum ontingent valuation (CV) method of infering the so ial value of a
proje t provides a simple example. This example is a spe ial ase of more general dis rete
hoi e (or binary response) models. Individuals are asked if they would pay an amount
0
0
for provision of a proje t. Indire t utility in the base ase (no proje t) is v (m, z)+ , where
m is in ome and z is a ve tor of other variables su h as pri es, personal hara teristi s,
1
1
After provision, utility is v (m, z) + . The random terms
= 1, 2,
ree t variations of
to pay
preferen es in the population. With this, an individual agrees
0
1}
| {z
<
et .
i , i
if
v 1 (m A, z) v 0 (m, z)
|
{z
}
v(w, A)
We assume here that responses are truthful, that is there is no strategi behavior and that individuals
are able to order their preferen es in this hypotheti al situation.
171
= 0 1 ,
Dene
y = 1
Dene
let
olle t
and
z,
and let
if the onsumer agrees to pay
v(w, A) = v 1 (m A, z) v 0 (m, z).
for the hange,
y = 0
otherwise.
The
probability of agreement is
Pr(y = 1) = F [v(w, A)] .

To simplify notation, dene
pose that
p(w, A) F [v(w, A)] .
(12.1)
To make the example spe i , sup-
v 1 (m, z) = m
v 0 (m, z) = m
and
and
are i.i.d. extreme value random variables. That is, utility depends only on
in ome, preferen es in both states are homotheti , and a spe i distributional assumption
is made on the distribution of preferen es in the population. With these assumptions (the
details are unimportant here, see arti les by D. M Fadden if you're interested) it an be
shown that
p(A, ) = ( + A) ,
where
(z) is
the logisti distribution fun tion
(z) = (1 + exp(z))1 .
This is the simple logit model: the hoi e probability is the logit fun tion of a linear in
parameters fun tion.
Now,
is either
or 1, and the expe ted value of
is
( + A)
. Thus, we an write
y = ( + A) +
E() = 0.
One ould estimate this by (nonlinear) least squares

1X
(y ( + A))2
,
= arg min
n t
The main point is that it is impossible that
( + A)
parameters model, in the sense that, for arbitrary
A,
an be written as a linear in the
there are no
, (A)
su h that
( + A) = (A) , A
where
(A)
is a
p-ve tor
is be ause for any

than
valued fun tion of
we an always nd a
1, whi h is illogi al,
and
is a
su h that
dimensional parameter. This
(A)
will be negative or greater
sin e it is the expe tation of a 0/1 binary random variable. Sin e
this sort of problem o urs often in empiri al work, it is useful to study NLS and other
nonlinear models.
After dis ussing these estimation methods for parametri models we'll briey introdu e
172
CHAPTER 12.
nonparametri estimation methods.

f (xt )
These methods allow one, for example, to estimate
onsistently when we are not willing to assume that a model of the form
yt = f (xt ) + t
an be restri ted to a parametri form
yt = f (xt , ) + t
Pr(t < z) = F (z|, xt )
,
where
f ()
and perhaps
F (z|, xt )
are of known fun tional form. This is important sin e
e onomi theory gives us general information about fun tions and the signs of their derivatives, but not about their spe i form.
Then we'll look at simulation-based methods in e onometri s.
us to substitute omputer power for mental power.
These methods allow
Sin e omputer power is be oming
relatively heap ompared to mental eort, any e onometri ian who lives by the prin iples
of e onomi theory should be interested in these te hniques.
Finally, we'll look at how e onometri omputations an be done in parallel on a luster
of omputers.
This allows us to harness more omputational power to work with more
omplex models that an be dealt with using a desktop omputer.
Chapter 13
Numeri optimization methods
Readings:
; Gourieroux and Monfort, Vol. 1,
Hamilton, h. 5, se tion 7 (pp. 133-139)
h. 13, pp. 443-60 ; Goe, et. al. (1994).

If we're going to be applying extremum estimators, we'll need to know how to nd
an extremum.
This se tion gives a very brief introdu tion to what is a large literature
on numeri optimization methods. We'll onsider a few well-known te hniques, and one
fairly new te hnique that may allow one to solve di ult problems. The main obje tive
is to be ome familiar with the issues, and to learn how to use the BFGS algorithm at the
pra ti al level.
The general problem we onsider is how to nd the maximizing element
of a fun tion
s().
(a K
-ve tor)
This fun tion may not be ontinuous, and it may not be dierentiable.
Even if it is twi e ontinuously dierentiable, it may not be globally on ave, so lo al

maxima, minima and saddlepoints may all exist. Supposing
of
e.g.,
s() were a quadrati fun tion
1
s() = a + b + C,
2
the rst order onditions would be linear:
D s() = b + C
so the maximizing (minimizing) element would be
= C 1 b.
This is the sort of problem
we have with linear models estimated by OLS. It's also the ase for feasible GLS, sin e
onditional on the estimate of the var ov matrix, we have a quadrati obje tive fun tion
in the remaining parameters.
More general problems will not have linear f.o. ., and we will not be able to solve for
the maximizer analyti ally. This is when we need a numeri optimization method.
13.1 Sear h
The idea is to reate a grid over the parameter spa e and evaluate the fun tion at ea h
point on the grid. Sele t the best point. Then rene the grid in the neighborhood of the
best point, and ontinue until the a ura y is good enough. See Figure
??.
One has to
be areful that the grid is ne enough in relationship to the irregularity of the fun tion to
ensure that sharp peaks are not missed entirely.
173
174
CHAPTER 13.
To he k
he k
qK
values in ea h dimension of a
points.
q = 100
For example, if
NUMERIC OPTIMIZATION METHODS
dimensional parameter spa e, we need to
and
K = 10,
there would be
10010
points to
9
he k. If 1000 points an be he ked in a se ond, it would take 3. 17110 years to perform
the al ulations, whi h is approximately the age of the earth. The sear h method is a very
reasonable hoi e if
is small, but it qui kly be omes infeasible if
is moderate or large.
13.2 Derivative-based methods

13.2.1 Introdu tion
Derivative-based methods are dened by
1. the method for hoosing the initial value,

2. the iteration method for hoosing
k+1
given
(based upon derivatives)
3. the stopping riterion.
The iteration method an be broken into two problems: hoosing the stepsize
and hoosing the dire tion of movement,
dk ,
ak
whi h is of the same dimension of
(a s alar)
so that
(k+1) = (k) + ak dk .
A lo ally in reasing dire tion of sear h d is a dire tion su h that

a :
for
s( + ad)
>0
a
d,
positive but small. That is, if we go in dire tion
we will improve on the obje tive
fun tion, at least if we don't go too far in that dire tion.
As long as the gradient at
is not zero there exist in reasing dire tions, and they an
k
k
all be represented as Q g( ) where
Qk
is a symmetri pd matrix and
0
is the gradient at . To see this, take a T.S. expansion around a
g () = D s()
=0
s( + ad) = s( + 0d) + (a 0) g( + 0d) d + o(1)

= s() + ag() d + o(1)
For small enough
we need g() d
a the o(1) term an be ignored.
> 0.
Dening
d = Qg(),
where
If
d is to be an in reasing dire tion,

is positive denite, we guarantee
that
g() d = g() Qg() > 0

unless
g() = 0.
Every in reasing dire tion an be represented in this way (p.d.
matri es are those su h that the angle between
and
Qg()
See Figure 13.1.
With this, the iteration rule be omes
(k+1) = (k) + ak Qk g( k )
is less that 90 degrees).
13.2.
175
DERIVATIVE-BASED METHODS
Figure 13.1: In reasing dire tions of sear h
/home/mi hael/Mystuff/resear h/ParallelKnoppix/Examples/E onometri s/Examples/NonlinearOpt
and we keep going until the gradient be omes zero, so that there is no in reasing dire tion.
The problem is how to hoose
Conditional on Q,
and
hoosing
attra tive possibility, sin e
Q.
is fairly straightforward. A simple line sear h is an
is a s alar.
The remaining problem is how to hoose
Q.
Note also that this gives no guarantees to nd a global maximum.
13.2.2 Steepest des ent

Steepest des ent (as ent if we're maximizing) just sets
to and identity matrix, sin e the
gradient provides the dire tion of maximum rate of hange of the obje tive fun tion.
Advantages: fast - doesn't require anything more than rst derivatives.
Disadvantages: This doesn't always work too well however (draw pi ture of banana
fun tion).
13.2.3 Newton-Raphson
The Newton-Raphson method uses information about the slope and urvature of the obje tive fun tion to determine whi h dire tion and how far to move from an initial point.
sn (). Take a se ond order Taylor's series approximak

about (an initial guess).
Supposing we're trying to maximize

tion of
sn ()

sn () sn ( k ) + g( k ) k + 1/2 k H( k ) k
To attempt to maximize
depends on
sn (),
we an maximize the portion of the right-hand side that
i.e., we an maximize

s() = g( k ) + 1/2 k H( k ) k
176
CHAPTER 13.
with respe t to
This is a mu h easier problem, sin e it is a quadrati fun tion in
so it
has linear rst order onditions. These are

D s() = g( k ) + H( k ) k
So the solution for the next round estimate is
k+1 = k H( k )1 g( k )
This is illustrated in Figure
??.
However, it's good to in lude a stepsize, sin e the approximation to

far away from the maximizer
sn ()
may be bad
so the a tual iteration formula is
k+1 = k ak H( k )1 g( k )
A potential problem is that the Hessian may not be negative denite when we're
far from the maximizing point.
So
H( k )1
may not be positive denite, and
H( k )1 g( k ) may not dene an in reasing dire tion of sear h. This an happen
when the obje tive fun tion has at regions, in whi h ase the Hessian matrix is
very ill- onditioned (e.g., is nearly singular), or when we're in the vi inity of a lo al
minimum,
H( k )
is positive denite, and our dire tion is a
de reasing
dire tion of
sear h. Matrix inverses by omputers are subje t to large errors when the matrix is
ill- onditioned. Also, we ertainly don't want to go in the dire tion of a minimum
when we're maximizing. To solve this problem,
H()
a positive denite omponent to

denite,
e.g., Q = H() + bI,
methods simply add
to ensure that the resulting matrix is positive
where
onditioned and positive denite.
Quasi-Newton
is hosen large enough so that
is well-
This has the benet that improvement in the
obje tive fun tion is guaranteed.
Another variation of quasi-Newton methods is to approximate the Hessian by using

su essive gradient evaluations. This avoids a tual al ulation of the Hessian, whi h
is an order of magnitude (in the dimension of the parameter ve tor) more ostly than
al ulation of the gradient. They an be done to ensure that the approximation is
p.d. DFP and BFGS are two well-known examples.
Stopping riteria
The last thing we need is to de ide when to stop.
limited ma hine pre ision and round-o errors.
hope that a program an
exa tly
A digital omputer is subje t to
For these reasons, it is unreasonable to
nd the point that maximizes a fun tion. We need to
dene a eptable toleran es. Some stopping riteria are:
Negligable hange in parameters:
|jk jk1 | < 1 , j
Negligable relative hange:
jk jk1
jk1
| < 2 , j
13.2.
177
DERIVATIVE-BASED METHODS
Negligable hange of fun tion:
|s( k ) s( k1 )| < 3
Gradient negligibly dierent from zero:
|gj ( k )| < 4 , j
Or, even better, he k all of these.
Also, if we're maximizing, it's good to he k that the last round (real, not approximate) Hessian is negative denite.
Starting values
The Newton-Raphson and related algorithms work well if the obje tive fun tion is
on ave (when maximizing), but not so well if there are onvex regions and lo al minima
or multiple lo al maxima. The algorithm may onverge to a lo al minimum or to a lo al
maximum that is not optimal. The algorithm may also have di ulties onverging at all.
The usual way to ensure that a global maximum has been found is to use many
dierent starting values, and hoose the solution that returns the highest obje tive
fun tion value.
THIS IS IMPORTANT in pra ti e.
More on this later.
Cal ulating derivatives

The Newton-Raphson algorithm requires rst and se ond derivatives. It is often dif ult to al ulate derivatives (espe ially the Hessian) analyti ally if the fun tion
sn ()
is
ompli ated. Possible solutions are to al ulate derivatives numeri ally, or to use programs
su h as MuPAD or Mathemati a to al ulate analyti derivatives. For example, Figure 13.2
1
shows MuPAD
al ulating a derivative that I didn't know o the top of my head, and one
that I did know.
Numeri derivatives are less a urate than analyti derivatives, and are usually more
ostly to evaluate.
Both fa tors usually ause optimization programs to be less
su essful when numeri derivatives are used.
One advantage of numeri derivatives is that you don't have to worry about having
made an error in al ulating the analyti derivative.
When programming analyti
derivatives it's a good idea to he k that they are orre t by using numeri derivatives.
This is a lesson I learned the hard way when writing my thesis.
Numeri se ond derivatives are mu h more a urate if the data are s aled so that the
elements of the gradient are of the same order of magnitude. Example: if the model
is
yt = h(xt + zt ) + t ,
and
D sn () = 0.001.
zt /1000.
1
and estimation is by NLS, suppose that
One ould dene
In this ase, the gradients
D sn () = 1000
= /1000; xt = 1000xt ; = 1000; zt =
D sn ()
and
D sn ()
will both be 1.
MuPAD is not a freely distributable program, so it's not on the CD. You an download it from
http://www.mupad.de/download.shtml
178
CHAPTER 13.
Figure 13.2: Using MuPAD to get analyti derivatives
In general, estimation programs always work better if data is s aled in this way, sin e
roundo errors are less likely to be ome important.
This is important in pra ti e.
There are algorithms (su h as BFGS and DFP) that use the sequential gradient
evaluations to build up an approximation to the Hessian. The iterations are faster
for this reason sin e the a tual Hessian isn't al ulated, but more iterations usually
are required for onvergen e.
Swit hing between algorithms during iterations is sometimes useful.
13.3 Simulated Annealing

Simulated annealing is an algorithm whi h an nd an optimum in the presen e of non on avities, dis ontinuities and multiple lo al minima/maxima.
Basi ally, the algorithm
randomly sele ts evaluation points, a epts all points that yield an in rease in the obje tive
fun tion, but also a epts some points that de rease the obje tive fun tion. This allows the
algorithm to es ape from lo al minima. As more and more points are tried, periodi ally
the algorithm fo uses on the best point so far, and redu es the range over whi h random
points are generated. Also, the probability that a negative move is a epted redu es. The
algorithm relies on many evaluations, as in the sear h method, but fo uses in on promising
areas, whi h redu es fun tion evaluations with respe t to the sear h method. It does not
require derivatives to be evaluated. I have a program to do this if you're interested.
13.4 Examples
This se tion gives a few examples of how some nonlinear models may be estimated using
maximum likelihood.
13.4.
179
EXAMPLES
13.4.1 Dis rete Choi e: The logit model

In this se tion we will onsider maximum likelihood estimation of the logit model for binary
0/1 dependent variables. We will use the BFGS algotithm to nd the MLE.
We saw an example of a binary hoi e model in equation 12.1. A more general representation is
y = g(x)
y = 1(y > 0)
P r(y = 1) = F [g(x)]
p(x, )
The log-likelihood fun tion is
sn () =
1X
(yi ln p(xi , ) + (1 yi ) ln [1 p(xi , )])
n
i=1
For the logit model (see the ontingent valuation example above), the probability has
the spe i form
p(x, ) =
1
1 + exp(x)
You should download and examine LogitDGP.m , whi h generates data a ording to
the logit model, logit.m , whi h al ulates the loglikelihood, and EstimateLogit.m , whi h
sets things up and alls the estimation routine, whi h uses the BFGS algorithm.
Here are some estimation results with
n = 100,
and the true
= (0, 1) .
***********************************************
Trial of MLE estimation of Logit model
MLE Estimation Results
BFGS onvergen e: Normal onvergen e
Average Log-L: 0.607063
Observations: 100
estimate
onstant
0.5400
slope
0.7566
st. err
0.2229
0.2374
t-stat
2.4224
3.1863
p-value
0.0154
0.0014
Information Criteria
CAIC : 132.6230
BIC : 130.6230
AIC : 125.4127
***********************************************
The estimation program is alling
mle_results(),
whi h in turn alls a number of
180
CHAPTER 13.
other routines. These fun tions are part of the
o tave-forge
repository.
13.4.2 Count Data: The Poisson model

Demand for health are is usually thought of a a derived demand: health are is an input
to a home produ tion fun tion that produ es health, and health is an argument of the
utility fun tion. Grossman (1972), for example, models health as a apital sto k that is
subje t to depre iation (e.g., the ee ts of ageing).
Health are visits restore the sto k.
Under the home produ tion framework, individuals de ide when to make health are visits
to maintain their health sto k, or to deal with negative sho ks to the sto k in the form of
a idents or illnesses. As su h, individual demand will be a fun tion of the parameters of
the individuals' utility fun tions.
The MEPS health data le ,
meps1996.data,
ontains 4564 observations on six mea-
sures of health are usage. The data is from the 1996 Medi al Expenditure Panel Survey
(MEPS). You an get more information at
http://www.meps.ahrq.gov/.
The six mea-
sures of use are are o e-based visits (OBDV), outpatient visits (OPV), inpatient visits
(IPV), emergen y room visits (ERV), dental visits (VDV), and number of pres ription
drugs taken (PRESCR). These form olumns 1 - 6 of
meps1996.data.
The ondition-
ing variables are publi insuran e (PUBLIC), private insuran e (PRIV), sex (SEX), age
(AGE), years of edu ation (EDUC), and in ome (INCOME). These form olumns 7 - 12
of the le, in the order given here. PRIV and PUBLIC are 0/1 binary variables, where a
1 indi ates that the person has a ess to publi or private insuran e overage. SEX is also
0/1, where 1 indi ates that the person is female. This data will be used in examples fairly
extensively in what follows.
The program ExploreMEPS.m shows how the data may be read in, and gives some
des riptive information about variables, whi h follows:
All of the measures of use are ount data, whi h means that they take on the values
0, 1, 2, ....
It might be reasonable to try to use this information by spe ifying the density
as a ount data density. One of the simplest ount data densities is the Poisson density,
whi h is
fY (y) =
exp()y
.
y!
The Poisson average log-likelihood fun tion is
1X
(i + yi ln i ln yi !)
sn () =
n
i=1
We will parameterize the model as
i = exp(xi )
xi = [1 P U BLIC P RIV SEX AGE EDU C IN C] .
This ensures that the mean is positive, as is required for the Poisson model. Note that for
this parameterization
j =
/j
13.4.
181
EXAMPLES
so
j xj = xj ,
the elasti ity of the onditional mean of
with respe t to the
j th
onditioning variable.
The program EstimatePoisson.m estimates a Poisson model using the full data set.
The results of the estimation, using OBDV as the dependent variable are here:
MPITB extensions found

OBDV
******************************************************
Poisson model, MEPS 1996 full data set
Average Log-L: -3.671090
Observations: 4564
onstant
pub. ins.
priv. ins.
sex
age
edu
in
estimate
-0.791
0.848
0.294
0.487
0.024
0.029
-0.000
st. err
0.149
0.076
0.071
0.055
0.002
0.010
0.000
t-stat
-5.290
11.093
4.137
8.797
11.471
3.061
-0.978
p-value
0.000
0.000
0.000
0.000
0.000
0.002
0.328
CAIC : 33575.6881
Avg. CAIC: 7.3566
BIC : 33568.6881
Avg. BIC:
7.3551
AIC : 33523.7064
Avg. AIC:
7.3452
******************************************************
13.4.3 Duration data and the Weibull model

In some ases the dependent variable may be the time that passes between the o uren e
of two events. For example, it may be the duration of a strike, or the time needed to nd
a job on e one is unemployed. Su h variables take on values on the positive real line, and
are referred to as duration data.
A
spell
is the period of time between the o uren e of initial event and the on luding
event. For example, the initial event ould be the loss of a job, and the nal event is the
182
CHAPTER 13.
nding of a new job. The spell is the period of unemployment.

Let
o urs.
t0
be the time the initial event o urs, and
t1
be the time the on luding event
For simpli ity, assume that time is measured in years.
D = t1 t0 .
FD (t) = Pr(D < t).
is the duration of the spell,

distribution fun tion
The random variable
Dene the density fun tion of
D, fD (t),
with
Several questions may be of interest. For example, one might wish to know the expe ted
time one has to wait to nd a job given that one has already waited
that a spell lasts
s years.
The probability
years is
Pr(D > s) = 1 Pr(D s) = 1 FD (s).

The density of
onditional on the spell already having lasted
years is
fD (t)
.
1 FD (s)
fD (t|D > s) =
The expe tan ed additional time required for the spell to end given that is has already
lasted
years is the expe tation of
with respe t to this density, minus
E = E(D|D > s) s =
Z
fD (z)
z
dz
1 FD (s)
To estimate this fun tion, one needs to spe ify the density
s.
fD (t) as a parametri density,
then estimate by maximum likelihood. There are a number of possibilities in luding the
exponential density, the lognormal,
et .
A reasonably exible model that is a generalization
of the exponential density is the Weibull density
fD (t|) = e(t) (t)1 .

A ording to this model,
densities.
E(D) = .
The log-likelihood is just the produ t of the log
To illustrate appli ation of this model, 402 observations on the lifespan of mongooses
in Serengeti National Park (Tanzania) were used to t a Weibull model.
The spell in
this ase is the lifetime of an individual mongoose. The parameter estimates and standard
errors are
= 0.559 (0.034)
and
= 0.867 (0.033)
and the log-likelihood value is -659.3.
Figure 13.3 presents tted life expe tan y (expe ted additional years of life) as a fun tion
of age, with 95% onden e bands. The plot is a ompanied by a nonparametri KaplanMeier estimate of life-expe tan y. This nonparametri estimator simply averages all spell
lengths greater than age, and then subtra ts age. This is onsistent by the LLN.
In the gure one an see that the model doesn't t the data well, in that it predi ts
life expe tan y quite dierently than does the nonparametri model.
For ages 4-6, the
nonparametri estimate is outside the onden e interval that results from the parametri
model, whi h asts doubt upon the parametri model. Mongooses that are between 2-6
years old seem to have a lower life expe tan y than is predi ted by the Weibull model,
whereas young mongooses that survive beyond infan y have a higher life expe tan y, up
to a bit beyond 2 years. Due to the dramati hange in the death rate as a fun tion of
t,
13.4.
EXAMPLES
Figure 13.3: Life expe tan y of mongooses, Weibull model
183
184
CHAPTER 13.
one might spe ify
fD (t)
as a mixture of two Weibull densities,

2
1
fD (t|) = e(1 t) 1 1 (1 t)1 1 + (1 ) e(2 t) 2 2 (2 t)2 1 .
The parameters
and
i , i = 1, 2
are the parameters of the two Weibull densities, and
is the parameter that mixes the two.

With the same data,
log-likelihood = -623.17.
an be estimated using the mixed model.
Note that a standard likelihood ratio test annot be used to
hose between the two models, sin e under the null that
parameters
and
The results are a
=1
(single density), the two
are not identied. It is possible to take this into a ount, but this
topi is out of the s ope of this ourse. Nevertheless, the improvement in the likelihood
fun tion is onsiderable. The parameter estimates are
Parameter
Estimate
St. Error
0.233
0.016
1.722
0.166
1.731
0.101
1.522
0.096
0.428
0.035
Note that the mixture parameter is highly signi ant. This model leads to the t in Figure
13.4. Note that the parametri and nonparametri ts are quite lose to one another, up to
around
6 years.
The disagreement after this point is not too important, sin e less than 5%
of mongooses live more than 6 years, whi h implies that the Kaplan-Meier nonparametri
estimate has a high varian e (sin e it's an average of a small number of observations).
Mixture models are often an ee tive way to model omplex responses, though they
an suer from overparameterization. Alternatives will be dis ussed later.
13.5 Numeri optimization: pitfalls

In this se tion we'll examine two ommon problems that an be en ountered when doing
numeri optimization of nonlinear models, and some solutions.
13.5.1 Poor s aling of the data

When the data is s aled so that the magnitudes of the rst and se ond derivatives are
of dierent orders, problems an easily result. If we un omment the appropriate line in
EstimatePoisson.m, the data will not be s aled, and the estimation program will have
di ulty onverging (it seems to take an innite amount of time). With uns aled data,
the elements of the s ore ve tor have very dierent magnitudes at the initial value of
(all
zeros). To see this run Che kS ore.m. With uns aled data, one element of the gradient is
very large, and the maximum and minimum elements are 5 orders of magnitude apart. This
auses onvergen e problems due to serious numeri al ina ura y when doing inversions
to al ulate the BFGS dire tion of sear h.
With s aled data, none of the elements of
the gradient are very large, and the maximum dieren e in orders of magnitude is 3.
Convergen e is qui k.
13.5.
185
NUMERIC OPTIMIZATION: PITFALLS
Figure 13.4: Life expe tan y of mongooses, mixed Weibull model
13.5.2 Multiple optima

Multiple optima (one global, others lo al) an ompli ate life, sin e we have limited means
of determining if there is a higher maximum the the one we're at.
Think of limbing a
mountain in an unknown range, in a very foggy pla e (Figure 13.5). You an go up until
there's nowhere else to go up, but sin e you're in the fog you don't know if the true summit
is a ross the gap that's at your feet. Do you laim vi tory and go home, or do you trudge
down the gap and explore the other side?
The best way to avoid stopping at a lo al maximum is to use many starting values,
for example on a grid, or randomly generated. Or perhaps one might have priors about
e.g., from previous studies of similar data).
possible values for the parameters (
Let's try to nd the true minimizer of minus 1 times the foggy mountain fun tion (sin e
the algoritms are set up to minimize). From the pi ture, you an see it's lose to
(0, 0),
but
let's pretend there is fog, and that we don't know that. The program FoggyMountain.m
shows that poor start values an lead to problems. It uses SA, whi h nds the true global
minimum, and it shows that BFGS using a battery of random start values an also nd
the global minimum help. The output of one run is here:

======================================================
BFGSMIN final results
186
CHAPTER 13.
Figure 13.5: A foggy mountain
Used numeri gradient

-----------------------------------------------------STRONG CONVERGENCE
Fun tion onv 1 Param onv 1 Gradient onv 1
-----------------------------------------------------Obje tive fun tion value -0.0130329
Stepsize 0.102833
43 iterations
-----------------------------------------------------param
gradient hange
15.9999 -0.0000
0.0000
-28.8119 0.0000
0.0000
The result with poor start values
ans =
16.000 -28.812
================================================
SAMIN final results
NORMAL CONVERGENCE
Fun . tol. 1.000000e-10 Param. tol. 1.000000e-03
Obj. fn. value -0.100023
parameter
sear h width
13.5.
NUMERIC OPTIMIZATION: PITFALLS
187
0.037419
0.000018
-0.000000
0.000051
================================================
Now try a battery of random start values and
a short BFGS on ea h, then iterate to onvergen e
The result using 20 randoms start values
ans =
3.7417e-02
2.7628e-07
The true maximizer is near (0.037,0)
In that run, the single BFGS run with bad start values onverged to a point far from
the true minimizer, whi h simulated annealing and BFGS using a battery of random start
values both found the true maximizaer. battery of random start values managed to nd
the global max. The moral of the story is be autious and don't publish your results too
qui kly.
188
CHAPTER 13.
In o tave, type help

le to
In
le to
bfgsmin_example, to nd out the lo ation of the le. Edit

examine it and learn how to all bfgsmin. Run it, and examine the output.
o tave, type help samin_example, to nd out the lo ation of the le. Edit
examine it and learn how to all samin. Run it, and examine the output.
the
the
Using logit.m and EstimateLogit.m as templates, write a fun tion to al ulate the
probit loglikelihood, and a s ript to estimate a probit model.
Run it using data that
a tually follows a logit model (you an generate it in the same way that is done in the logit
example).
Study
mle_results.m to see what it does.
Examine the fun tions that
mle_results.m
alls, and in turn the fun tions that those fun tions all. Write a omplete des ription of
how the whole hain works.
Look at the Poisson estimation results for the OBDV measure of health are use and
give an e onomi interpretation.
health are usage.
Estimate Poisson models for the other 5 measures of
Chapter 14
Asymptoti properties of extremum
estimators
Readings:
Gourieroux and Monfort (1995), Vol.
2, Ch.
24
; Amemiya, Ch. 4 se tion
4.1 ; Davidson and Ma Kinnon, pp. 591-96; Gallant, Ch. 3; Newey and M Fadden (1994),
Large Sample Estimation and Hypothesis Testing, in
Handbook of E onometri s, Vol. 4,
Ch. 36.
14.1 Extremum estimators

In Denition 12 we dened an extremum estimator
obje tive fun tion
np
sn ()
random matrix
over a set
Zn =
as the optimizing element of an
Let the obje tive fun tion
z1 z2 zn
where the
zt
are
sn (Zn , )
p-ve tors
depend upon a
and
is nite.
Example 18 Given the model yi = xi + i , with n observations, dene zi = (yi , xi ) . The
OLS estimator minimizes
sn (Zn , ) = 1/n
n
X
i=1
yi xi
= 1/n k Y X k2
2
where Y and X are dened similarly to Z.
14.2 Consisten y
The following theorem is patterned on a proof in Gallant (1987) (the arti le, ref. later),
whi h we'll see in its original form later in the ourse.
It is interesting to ompare the
following proof with Amemiya's Theorem 4.1.1, whi h is done in terms of onvergen e in
probability.
Theorem 19
[Consisten y of e.e.
Suppose that n is obtained by maximizing sn () over
Assume
1. Compa tness: The parameter spa e is an open bounded subset of Eu lidean spa e
K . So the losure of , , is ompa t.
189
190
CHAPTER 14.
ASYMPTOTIC PROPERTIES OF EXTREMUM ESTIMATORS
2. Uniform Convergen e: There is a nonsto hasti fun tion s () that is ontinuous in

on su h that
lim sup |sn () s ()| = 0, a.s.
n
3. Identi ation: s () has a unique global maximum at 0 , i.e., s ( 0 ) > s (),

6= 0 ,
0.
Then n a.s.
Proof:

that is
Sele t a
fun tions. Suppose
and hold it xed.

su h that
sn ()
{sn (, )}
Then
is a xed sequen e of
onverges uniformly to
with probability one by assumption (b). The sequen e
{n }
assumption (1) and the fa t that maximixation is over
s ().
lies in the ompa t set
of
with
There is a subsequen e
limm nm = .
{nm } ({nm }
by
Sin e every sequen e from a
ompa t set has at least one limit point (Davidson, Thm. 2.12), say that
{n }.
This happens
is
a limit point
is simply a sequen e of in reasing integers)
By uniform onvergen e and ontinuity
lim snm (nm ) = s ().
To see this, rst of all, sele t an element
from the sequen e
onvergen e implies
o
nm .
Then uniform
lim snm (t ) = s (t ).
m
Continuity of
s ()
implies that
lim s (t ) = s ()
t
sin e the limit as
of
Next, by maximization
n o
t
is
So the above laim is true.
snm (nm ) snm ( 0 )

whi h holds in the limit, so
lim snm (nm ) lim snm ( 0 ).
However,
lim snm (nm ) = s (),
m
as seen above, and
lim snm ( 0 ) = s ( 0 )
m
by uniform onvergen e, so
s ( 0 ).
s ()
But by assumption (3), there is a unique global maximum of
= s ( 0 ),
s ()
far we have held
and
= 0 .
s () at 0 , so we
must have
Finally, all of the above limits hold almost surely, sin e so
xed, but now we need to onsider all
0
one limit point, , ex ept on a set
with
P (C) = 0.
Therefore
{n }
has only
14.2.
191
CONSISTENCY
Dis ussion of the proof:
(2)
This proof relies on the identi ation assumption of a unique global maximum at
0.
An equivalent way to state this is
Identi ation:
Any point
in
with s () s ( 0 ) must be su h that k 0 k= 0,
whi h mat hes the way we will write the assumption in the se tion on nonparametri
inferen e.
We assume that
unique for
is in fa t a global maximum of
sn () .
It is not required to be
nite, though the identi ation assumption requires that the limiting
obje tive fun tion have a unique maximizing argument.
The previous se tion on
numeri optimization methods showed that a tually nding the global maximum of
sn ()
may be a non-trivial problem.
See Amemiya's Example 4.1.4 for a ase where dis ontinuity leads to breakdown of
The assumption that
onsisten y.
is in the interior of
(part of the identi ation
has not been used to prove onsisten y, so we ould dire tly assume that
an element of a ompa t set
assumption)
is simply
The reason that we assume it's in the interior here
is that this is ne essary for subsequent proof of asymptoti normality, and I'd like
to maintain a minimal set of simple assumptions, for larity.
Parameters on the
boundary of the parameter set ause theoreti al di ulties that we will not deal
with in this ourse. Just note that onventional hypothesis testing methods do not
apply in this ase.
Note that
sn ()
The following gures illustrate why uniform onvergen e is important. In the se ond
is not required to be ontinuous, though
s ()
is.
gure, if the fun tion is not onverging around the lower of the two maxima, there is
no guarantee that the maximizer will be in the neighborhood of the global maximizer.
With uniform convergence, the maximum of the sample

objective function eventually must be in the neighborhood
of the maximum of the limiting objective function
192
CHAPTER 14.
With pointwise convergence, the sample objective function

may have its maximum far away from that of the limiting
objective function
We need a uniform strong law of large numbers in order to verify assumption (2) of
Theorem 19. The following theorem is from Davidson, pg. 337.
Let {Gn ()} be a sequen e of sto hasti real-valued

fun tions on a totally-bounded metri spa e (, ). Then
Theorem 20
[Uniform Strong LLN
a.s.
sup |Gn ()| 0
if and only if
(a) Gn () a.s.
0 for ea h 0 , where 0 is a dense subset of and
(b) {Gn ()} is strongly sto hasti ally equi ontinuous..
The metri spa e we are interested in now is simply

norm.
K ,
using the Eu lidean
The pointwise almost sure onvergen e needed for assuption (a) omes from one of
Stronger assumptions that imply those of the theorem are:
the usual SLLN's.
the parameter spa e is ompa t (this has already been assumed)
the obje tive fun tion is ontinuous and bounded with probability one on the
entire parameter spa e
a standard SLLN an be shown to apply to some point in the parameter spa e
These are reasonable onditions in many ases, and hen eforth when dealing with
spe i estimators we'll simply assume that pointwise almost sure onvergen e an
be extended to uniform almost sure onvergen e in this way.
14.3.
193
EXAMPLE: CONSISTENCY OF LEAST SQUARES
The more general theorem is useful in the ase that the limiting obje tive fun tion
an be ontinuous in
sn ()
even if
is dis ontinuous.
This an happen be ause
dis ontinuities may be smoothed out as we take expe tations over the data. In the
se tion on simlation-based estimation we will se a ase of a dis ontinuous obje tive
fun tion.
14.3 Example: Consisten y of Least Squares

We suppose that data is generated by random sampling of
+t . (wt , t )
(y, w),
where
yt = 0 + 0 wt
w (w and are independent) with

2
2
0
0
0
support W E. Suppose that the varian es w and are nite. Let = ( , ) ,
0
for whi h is ompa t. Let xt = (1, wt ) , so we an write yt = xt + t . The sample
has the ommon distribution fun tion
obje tive fun tion for a sample size
sn () = 1/n
= 1/n
n
X
t=1
n
X
t=1
is
yt xt
2
xt 0
= 1/n
n
X
xt 0 + t xt
i=1
2
n
X
+ 2/n
t=1
2
n
X

xt 0 t + 1/n
2t
t=1
Considering the last term, by the SLLN,
1/n
n
X
t=1
a.s.
2t
Considering the se ond term, sin e
Finally, for the rst term, for a given
2 dW dE = 2 .
E() = 0 and w and are independent,
the SLLN
implies that it onverges to zero.
1/n
n
X
xt
t=1
=
=
2
a.s.
,
Z
we assume that a SLLN applies so that
x 0
2

+ 2 0 0
0
2
dW
(14.1)
wdW +
2
2

2

0 + 2 0 0 E(w) + 0 E w2
w2 dW
Finally, the obje tive fun tion is learly ontinuous, and the parameter spa e is assumed
to be ompa t, so the onvergen e is also uniform. Thus,
2

2

s () = 0 + 2 0 0 E(w) + 0 E w2 + 2
A minimizer of this is learly
= 0 , = 0 .
Exer ise 21 Show that in order for the above solution to be unique it is ne essary that
Dis uss the relationship between this ondition and the problem of olinearity
of regressors.
E(w2 ) 6= 0.
This example shows that Theorem 19 an be used to prove strong onsisten y of the
OLS estimator. There are easier ways to show this, of ourse - this is only an example of
194
CHAPTER 14.
appli ation of the theorem.
14.4 Asymptoti Normality

A onsistent estimator is oftentimes not very useful unless we know how fast it is likely
to be onverging to the true value, and the probability that it is far away from the true
value. Establishment of asymptoti normality with a known s aling fa tor solves these two
problems. The following theorem is similar to Amemiya's Theorem 4.1.3 (pg. 111).
Theorem 22
[Asymptoti normality of e.e.
In addition to the assumptions of Theorem
19, assume
(a) Jn () D2 sn() exists and is ontinuous in an open, onvex neighborhood of 0 .
(b) {Jn (n )} a.s.
J ( 0 ), a nite negative denite matrix, for any sequen e {n } that
onverges almost surely to 0.

d
( ) nDsn ( 0 )
N 0, I ( 0 ) , where I ( 0 ) = limn V ar nD sn ( 0 )

d
Then n 0
N 0, J ( 0 )1 I ( 0 )J ( 0 )1
Proof:
By Taylor expansion:

D sn (n ) = D sn ( 0 ) + D2 sn ( ) 0
where
= + (1 ) 0 , 0 1.
will
D2 sn ()
Note that
Now the l.h.s. of this equation is zero, at least asymptoti ally, sin e
as
be in the neighborhood where
be omes large, by onsisten y.
and the f.o. .
Also, sin e
is a maximizer
must hold exa tly sin e the limiting obje tive fun tion is stri tly
on ave in a neighborhood of
exists with probability one
is between
0.
and
0,
and sin e
a.s.
n 0
, assumption (b) gives
a.s.
D2 sn ( ) J ( 0 )
So

0 = D sn ( 0 ) + J ( 0 ) + op (1) 0
And
0=
Now
J ( 0 )
vant next to

nD sn ( 0 ) + J ( 0 ) + op (1) n 0
is a nite negative denite matrix, so the
J ( 0 ),
op (1)
term is asymptoti ally irrele-
so we an write
0=

nD sn ( 0 ) + J ( 0 ) n 0

a
n 0 = J ( 0 )1 nD sn ( 0 )
14.5.
195
EXAMPLES
Be ause of assumption ( ), and the formula for the varian e of a linear ombination of
r.v.'s,

d
n 0 N 0, J ( 0 )1 I ( 0 )J ( 0 )1
Assumption (b) is not implied by the Slutsky theorem. The Slutsky theorem says
that
a.s.
g(xn ) g(x)
an't depend on
if
xn x and g()
x.
is ontinuous at
to use this theorem.
In our ase
theorem whi h applies (Amemiya, Ch. 4) is
However, the fun tion
Jn (n )
is
a fun tion of
g()
n.
Theorem 23 If gn () onverges uniformly almost surely to a nonsto hasti fun tion g ()
a.s.
uniformly on an open neighborhood of 0 , then gn ()
g ( 0 ) if g ( 0 ) is ontinuous at
a.s.
0 and 0 .
To apply this to the se ond derivatives, su ient onditions would be that the se ond
derivatives be strongly sto hasti ally equi ontinuous on a neighborhood of
that an ordinary LLN applies to the derivatives when evaluated at
0,
and
N ( 0 ).
Stronger onditions that imply this are as above: ontinuous and bounded se ond
derivatives in a neighborhood of
Skip this in le ture.
0.
A note on the order of these matri es: Supposing that
is representable as an average of
sn ()
terms, whi h is the ase for all estimators we
2
onsider, D sn () is also an average of
matri es, the elements of whi h are not
entered (they do not have zero expe tation). Supposing a SLLN applies, the almost
D2 sn ( 0 ), J ( 0 ) = O(1), as we saw in Example

0 d
0
assumption ( ): nD sn ( ) N 0, I ( ) means that
sure limit of
hand,
51.
On the other
nD sn ( 0 ) = Op ()
where we use the result of Example 49. If we were to omit the
n,
we'd have
D sn ( 0 ) = n 2 Op (1)
1
= Op n 2
Op (nr )Op (nq ) = Op (nr+q ). The sequen e D sn ( 0 )
n to avoid onvergen e to zero.

s ale by

entered, so we need to
is
14.5 Examples
14.5.1 Coin ipping, yet again
Remember that in se tion 4.4.1 we saw that the asymptoti varian e of the MLE of the
parameter of a Bernoulli trial, using i.i.d. data, was
lim V ar n (
p p) = p (1 p).
verify this using the methods of this Chapter. The log-likelihood fun tion is
sn (p) =
1X
{yt ln p + (1 yt ) (1 ln p)}
n
t=1
Let's
196
CHAPTER 14.
so

Esn (p) = p0 ln p + 1 p0 (1 ln p)
by the fa t that the observations are i.i.d. Thus,

bit of al ulation shows that

s (p) = p0 ln p + 1 p0 (1 ln p).

D2 sn (p)p=p0 Jn () =
p0 (1 p0 )
whi h doesn't depend upon
n.
1 (p0 ).
J
1 (p0 ) = p0 1 p0
J
And in this ase,
By results we've seen on MLE,
the same result we got in se tion 4.4.1.
lim V ar n p p0 =
. It's omforting to see that this is
14.5.2 Binary response models

Extending the Bernoulli trial model to binary response models with onditioning variables,
su h models arise in a variety of ontexts. We've already seen a logit model. Another simple
example is a probit threshold- rossing model. Assume that
y = x
y = 1(y > 0)
N (0, 1)
Here,
is an unobserved (latent) ontinuous variable, and
indi ates whether y is negative or positive.

where
() =
Then
is a binary variable that
P r(y = 1) = P r( < x) = (x),
(2)1/2 exp(
2
)d
2
is the standard normal distribution fun tion.

In general, a binary response model will require that the hoi e probability be parameterized in some form. For a ve tor of explanatory variables
x,
the response probability
will be parameterized in some manner
P r(y = 1|x) = p(x, )

If
p(x, ) = (x ),
we have a logit model. If
p(x, ) = (x ),
where
()
is the standard
normal distribution fun tion, then we have a probit model.

Regardless of the parameterization, we are dealing with a Bernoulli density,
fYi (yi |xi ) = p(xi , )yi (1 p(x, ))1yi

so as long as the observations are independent, the maximum likelihood (ML) estimator,
is the maximizer of
sn () =
1X
(yi ln p(xi , ) + (1 yi ) ln [1 p(xi , )])
n
i=1
n
1X
s(yi , xi , ).
n
i=1
(14.2)
14.5.
197
EXAMPLES
Following the above theoreti al results,

uniform almost sure limit of
i.i.d. pro esses,
s(y, x, ).
sn ()
sn ().
tends in probability to the 0
Noting that
Eyi = p(xi , 0 ),
that maximizes the
and following a SLLN for
onverges almost surely to the expe tation of a representative term
First one an take the expe tation onditional on
to get

Ey|x {y ln p(x, ) + (1 y) ln [1 p(x, )]} = p(x, 0 ) ln p(x, )+ 1 p(x, 0 ) ln [1 p(x, )] .
Next taking expe tation over
s () =
where
we get the limiting obje tive fun tion

p(x, 0 ) ln p(x, ) + 1 p(x, 0 ) ln [1 p(x, )] (x)dx,
(x) is the (joint - the integral is understood to be multiple,
x)
density fun tion of the explanatory variables
as
p(x, )
x.
and
(14.3)
is the support of
This is learly ontinuous in
as long
is ontinuous, and if the parameter spa e is ompa t we therefore have uniform
almost sure onvergen e. Note that
p(x, )
for example. The maximizing element of
Z
X
is ontinous for the logit and probit models,
s (), ,
solves the rst order onditions

1 p(x, 0 )
p(x, 0 )
p(x, )
p(x, ) (x)dx = 0
p(x, )
1 p(x, )
This is learly solved by
= 0 . Provided the solution is unique, is onsistent.
Question:
what's needed to ensure that the solution is unique?

The asymptoti normality theorem tells us that

d
n 0 N 0, J ( 0 )1 I ( 0 )J ( 0 )1 .
In the ase of i.i.d. observations
I ( 0 ) = limn V ar nD sn ( 0 )
is simply the expe -
tation of a typi al element of the outer produ t of the gradient.
There's no need to subtra t the mean, sin e it's zero, following the f.o. .
The terms in
onsisten y proof above and the fa t that observations are i.i.d.
also drop out by the same argument:
1X
lim V ar nD
s( 0 )
n
n t
X
1
s( 0 )
= lim V ar D
n
n
t
X
1
D s( 0 )
= lim V ar
n n
t
lim V ar nD sn ( 0 ) =
lim V arD s( 0 )
= V arD s( 0 )
So we get
I ( ) = E
0
0
s(y, x, ) s(y, x, ) .
in the
198
CHAPTER 14.
Likewise,
J ( 0 ) = E
Expe tations are jointly over
over
x.
and
x,
2
s(y, x, 0 ).

or equivalently, rst over
onditional on
x,
then
From above, a typi al element of the obje tive fun tion is

s(y, x, 0 ) = y ln p(x, 0 ) + (1 y) ln 1 p(x, 0 ) .
Now suppose that we are dealing with a orre tly spe ied logit model:
1
p(x, ) = 1 + exp(x )
.
We an simplify the above results in this ase. We have that
2
1 + exp(x )
exp(x )x
p(x, ) =
exp(x )
x
1 + exp(x )
= p(x, ) (1 p(x, )) x

= p(x, ) p(x, )2 x.
1
1 + exp(x )
So

s(y, x, 0 ) = y p(x, 0 ) x

2
s( 0 ) = p(x, 0 ) p(x, 0 )2 xx .
Taking expe tations over
I ( ) =
=
then
gives

EY y 2 2p(x, 0 )p(x, 0 ) + p(x, 0 )2 xx (x)dx

p(x, 0 ) p(x, 0 )2 xx (x)dx.
EY (y) = EY (y 2 ) = p(x, 0 ).
0
J ( ) =
(14.4)
(14.5)
(14.6)
Likewise,

p(x, 0 ) p(x, 0 )2 xx (x)dx.
(14.7)
Note that we arrive at the expe ted result: the information matrix equality holds (that is,
J ( 0 ) = I( 0 )).
simplies to
With this,

d
n 0 N 0, J ( 0 )1 I ( 0 )J ( 0 )1

d
n 0 N 0, J ( 0 )1
whi h an also be expressed as

d
n 0 N 0, I ( 0 )1 .
14.5.
199
EXAMPLES
On a nal note, the logit and standard normal CDF's are very similar - the logit
distribution is a bit more fat-tailed.
While oe ients will vary slightly between the
two models, fun tions of interest su h as estimated probabilities
p(x, )
will be virtually
identi al for the two models.
14.5.3 Example: Linearization of a nonlinear model

Ref. Gourieroux and Monfort, se tion 8.3.4. White,
Intn'l E on. Rev.
1980 is an earlier
referen e.
Suppose we have a nonlinear model
yi = h(xi , 0 ) + i
where
i iid(0, 2 )
The
nonlinear least squares
estimator solves
1X
(yi h(xi , ))2
n = arg min
n
i=1
We'll study this more later, but for now it is lear that the fo for minimization will require
solving a set of nonlinear equations. A ommon approa h to the problem seeks to avoid
this di ulty by
x0
point
linearizing
the model. A rst order Taylor's series expansion about the
with remainder gives
yi = h(x0 , 0 ) + (xi x0 )
where
en ompasses both
h(x0 , 0 )
+ i
x
and the Taylor's series remainder. Note that
is no longer
a lassi al error - its mean is not zero. We should expe t problems.

Dene
= h(x0 , 0 ) x0
=
h(x0 , 0 )
x
h(x0 , 0 )
x
Given this, one might try to estimate
and
by applying OLS to
yi = + xi + i
Question, will
The answer is no, as one an see by interpreting

Let
and
be onsistent for
and
and
as extremum estimators.
(, ) .
n
1X
(yi xi )2
= arg min sn () =
n
i=1
200
CHAPTER 14.
The obje tive fun tion onverges to its expe tation
u.a.s.
sn () s () = EX EY |X (y x)2
and
onverges
a.s.
to the
that minimizes
s ():
0 = arg min EX EY |X (y x)2

Noting that
EX EY |X y x
sin e ross produ ts involving
2
2
= EX EY |X h(x, 0 ) + x
2
= 2 + EX h(x, 0 ) x
drop out.
and
orrespond to the hyperplane that is
0
losest to the true regression fun tion h(x, ) a ording to the mean squared error riterion. This depends on both the shape of
h()
and the density fun tion of the onditioning
variables.
Inconsistency of the linear approximation, even at

the approximation point
x
h(x,)
x
Tangent line
Fitted line
x
x
x_0
It is lear that the tangent line does not minimize MSE, sin e, for example, if
Note that the true underlying parameter
h(x, 0 )
is on ave, all errors between the tangent line and the true fun tion are negative.
is not estimated onsistently, either
(it may be of a dierent dimension than the dimension of the parameter of the
approximating model, whi h is 2 in this example).
Se ond order and higher-order approximations suer from exa tly the same problem,
though to a less severe degree, of ourse. For this reason, translog, Generalized Leontiev and other exible fun tional forms based upon se ond-order approximations
in general suer from bias and in onsisten y. The bias may not be too important for
analysis of onditional means, but it an be very important for analyzing rst and
14.5.
201
EXAMPLES
se ond derivatives. In produ tion and onsumer analysis, rst and se ond derivatives
e.g., elasti ities of substitution)
are often of interest, so in this ase, one should be
autious of unthinking appli ation of models that impose stong restri tions on se ond
derivatives.
This sort of linearization about a long run equilibrium is a ommon pra ti e in

dynami ma roe onomi models. It is justied for the purposes of theoreti al analysis
of a model
given
the model's parameters, but it is not justiable for the estimation
of the parameters of the model using data. The se tion on simulation-based methods
oers a means of obtaining onsistent estimators of the parameters of dynami ma ro
models that are too omplex for standard methods of analysis.
202
CHAPTER 14.
Chapter Exer ises

1. Suppose that
xi
uniform(0,1), and
yi = + xi +
0
that are the probability limits of
we estimate the misspe ied model
0
values of and
yi = 1 x2i + i ,
where
is iid(0,
2 ). Suppose
by OLS. Find the numeri

and
2. Verify your results using O tave by generating data that follows the above model,
and al ulating the OLS estimator. When the sample size is very large the estimator
should be very lose to the analyti al results you obtained in question 1.
3. Use the asymptoti normality theorem to nd the asymptoti distribution of the ML
estimator of
x.
y = x 0 + , where N (0, 1) and is independent of

sn ()
0
0
sn (), J ( ),
, and I( ). The expressions may
for the model
This means nding
involve the unspe ied density of
x.
4. Assume a d.g.p. follows the logit model:
(a) Assume that

estimator of
uniform(-a,a).
1
Pr(y = 1|x) = 1 + exp( 0 x) .
Find the asymptoti distribution of the ML
(this is a s alar parameter).
(b) Now assume that
uniform(-2a,2a). Again nd the asymptoti distribution
of the ML estimator of
0.
( ) Comment on the results
Chapter 15
Generalized method of moments
(GMM)
Readings:
Hamilton Ch. 14 ; Davidson and Ma Kinnon, Ch. 17 (see pg. 587 for refs.
to appli ations); Newey and M Fadden (1994), Large Sample Estimation and Hypothesis
Testing, in
Handbook of E onometri s, Vol. 4, Ch.
36.
15.1 Denition
We've already seen one example of GMM in the introdu tion, based upon the
distribu-
tion. Consider the following example based upon the t-distribution. The density fun tion
of a t-distributed r.v.
Yt
is

(0 +1)/2
0 + 1 /2
1 + yt2 / 0
fYt (yt , ) =
1/2
( 0 ) ( 0 /2)
Given an iid sample of size
n,
one ould estimate
by maximizing the log-likelihood
fun tion
arg max ln Ln () =
n
X
ln fYt (yt , )
t=1
This approa h is attra tive sin e ML estimators are asymptoti ally e ient.
This
is be ause the ML estimator uses all of the available information (e.g., the distribution is fully spe ied up to a parameter). Re alling that a distribution is ompletely
hara terized by its moments, the ML estimator is interpretable as a GMM estimator that uses
all
of the moments. The method of moments estimator uses only
moments to estimate a
dimensional parameter. Sin e information is dis arded,
in general, by the MM estimator, e ien y is lost relative to the ML estimator.
fYt (yt , 0 )
Continuing with the example, a t-distributed r.v. with density
Using the notation introdu ed previously, dene a moment ondition
zero and varian e
/ ( 2)

V (yt ) = 0 / 0 2
yt2 and
m1 () = 1/n
0
(for
Pn
> 2).
203
Pn
m1t () =
= / ( 2) 1/n t=1 yt2 . As be

0
0
value , both E 0 m1t ( ) = 0 and
t=1 m1t ()
fore, when evaluated at the true parameter
has mean
204
CHAPTER 15.

E0 m1 ( 0 ) = 0.
Choosing
to
set
0
m1 ()
GENERALIZED METHOD OF MOMENTS (GMM)
yields a MM estimator:
(15.1)
Pn 2
i yi
This estimator is based on only one moment of the distribution - it uses less information
than the ML estimator, so it is intuitively lear that the MM estimator will be ine ient
relative to the ML estimator.
An alternative MM estimator ould be based upon the fourth moment of the tdistribution. The fourth moment of a t-distributed r.v. is
4
provided
0 > 4.
E(yt4 )
2
3 0
= 0
,
( 2) ( 0 4)
We an dene a se ond moment ondition
m2 () =
1X 4
3 ()2
yt
( 2) ( 4) n
t=1
A se ond, dierent MM estimator hooses
to
set
0.
m2 ()
If you solve this you'll
see that the estimate is dierent from that in equation 15.1.
This estimator isn't e ient either, sin e it uses only one moment.
A GMM estimator
would use the two moment onditions together to estimate the single parameter.
The
GMM estimator is overidentied, whi h leads to an estimator whi h is e ient relative to

the just identied MM estimators (more on e ien y later).
As before, set
mn () = (m1 (), m2 ()) .
0
sample size. Note that m( )
variables, whereas
The
subs ript is used to indi ate the
Op (n1/2 ), sin e it is an average of entered random
m() = Op (1), 6= 0 ,
true distribution with parameter
0.
where expe tations are taken using the
This is the fundamental reason that GMM is
onsistent.
hoi e (for reasons noted below) is to set
sn () =
d (m()).
A GMM estimator requires dening a measure of distan e,
m() W
n m(). We assume
In general, assume we have
gg
Wn
d (m()) =
m W
A popular
n m, and we minimize
onverges to a nite positive denite matrix.
moment onditions, so
m()
is a
-ve tor and
is a
matrix.
For the purposes of this ourse, the following denition of the GMM estimator is su iently
general:
Denition 24 The GMM estimator of the K -dimensional parameter ve tor 0 ,

P
where mn () = n1 nt=1 mt () is a g-ve tor, g K,

with E m() = 0, and Wn onverges almost surely to a nite g g symmetri positive
denite matrix W .
arg min sn () mn () Wn mn (),
15.2.
205
CONSISTENCY
What's the reason for using GMM if MLE is asymptoti ally e ient?
Robustness: GMM is based upon a limited set of moment onditions. For onsisten y,
only these moment onditions need to be orre tly spe ied, whereas MLE in ee t
every on eivable moment ondition. GMM is robust

with respe t to distributional misspe i ation. The pri e for robustness is loss of
requires orre t spe i ation of
e ien y with respe t to the MLE estimator. Keep in mind that the true distribution
is not known so if we erroneously spe ify a distribution and estimate by MLE, the
estimator will be in onsistent in general (not always).
Feasibility: in some ases the MLE estimator is not available, be ause we are
not able to dedu e the likelihood fun tion.
simulation-based estimation.
More on this in the se tion on
The GMM estimator may still be feasible even
though MLE is not possible.
15.2 Consisten y
We simply assume that the assumptions of Theorem 19 hold, so the GMM estimator is
strongly onsistent.
The only assumption that warrants additional omments is that of
identi ation. In Theorem 19, the third assumption reads: ( )
0
a unique global maximum at ,
quadrati obje tive fun tion
i.e., s
( 0 )
> s (), 6=
sn () = mn () Wn mn (),
Applying a uniform law of large numbers, we get
Sin e
E mn ( 0 ) = 0
Sin e
s ( 0 ) = m ( 0 ) W m ( 0 ) = 0,
need that
m () 6= 0 for 6=
assumption that
a.s.
mn ().
a.s.
mn () m ().
m ( 0 ) = 0.
in order for asymptoti identi ation, we
0 , for at least some element of the ve tor. This and the
Wn W ,
a nite positive
0
that is asymptoti ally identied.
has
0 . Taking the ase of a
rst onsider
by assumption,
Identi ation: s ()
gg
denite
gg
matrix guarantee
Note that asymptoti identi ation does not rule out the possibility of la k of identi ation for a given data set - there may be multiple minimizing solutions in nite
samples.

We also simply assume that the onditions of Theorem 22 hold, so we will have asymptoti
normality. However, we do need to nd the stru ture of the asymptoti varian e- ovarian e
matrix of the estimator. From Theorem 22, we have

d
0
n N 0, J ( 0 )1 I ( 0 )J ( 0 )1
where
J ( 0 ) is the almost sure limit of
2
sn () and

sn ( 0 ).
I ( 0 ) = limn V ar n
We need to determine the form of these matri es given the obje tive fun tion
mn
() W
n mn ().
sn () =
206
CHAPTER 15.
Now using the produ t rule from the introdu tion,

sn () = 2
mn () Wn mn ()
Dene the
K g
matrix

m () ,
n
Dn ()
so:
s() = 2D()W m () .
(Note that
sn (), Dn (), Wn
mn ()
and
(15.2)
all depend on the sample size
n,
but it is omitted
to un lutter the notation).
To take se ond derivatives, let
Di
be the
th row of
D().
Using the produ t rule,
2
s() =
i
2Di ()Wn m ()

= 2Di W D + 2m W
D
i
When evaluating the term
D()i
2m() W

at
0,
assume that
D()i satises a LLN, so that it onverges almost surely to a nite
limit. In this ase, we have
0 a.s.
D( )i 0,
2m( ) W

0
sin e
a.s.
m( 0 ) = op (1), W W .
Sta king these results over the
lim
where we dene
I ( 0 ),
Em( 0 )
rows of
D,
we get
sn ( 0 ) = J ( 0 ) = 2D W D
, a.s.,

lim D = D , a.s.,
With regard to
0
zero at (sin e
and
lim W = W ,
a.s. (we assume a LLN holds).
following equation 15.2, and noting that the s ores have mean
=0
by assumption), we have

lim V ar n sn ( 0 )
n
= lim E4nDn Wn m( 0 )m() Wn Dn

n

nm( 0 )
nm() Wn Dn
= lim E4Dn Wn
I ( 0 ) =
Now, given that
m( 0 )
is an average of entered (mean-zero) quantities, it is reasonable to
expe t a CLT to apply, after multipli ation by
n.
Assuming this,
nm( 0 ) N (0, ),
15.4.
207
CHOOSING THE WEIGHTING MATRIX
where

= lim E nm( 0 )m( 0 ) .
n
Using this, and the last equation, we get
I ( 0 ) = 4D W W D
Using these results, the asymptoti normality theorem gives us

h

i

d
1
1
n 0 N 0, D W D
D W W D
D W D
,
the asymptoti distribution of the GMM estimator for arbitrary weighting matrix
Note that for
to be positive denite,
must have full row rank,
Wn .
(D ) = k.
15.4 Choosing the weighting matrix

W
is a
weighting matrix,
whi h determines the relative importan e of violations of the
individual moment onditions. For example, if we are mu h more sure of the rst moment
ondition, whi h is based upon the varian e, than of the se ond, whi h is based upon the
fourth moment, we ould set
"
W =
with
mu h larger than
b.
a 0
0 b
In this ase, errors in the se ond moment ondition have less
weight in the obje tive fun tion.
Sin e moments are not independent, in general, we should expe t that there be a
orrelation between the moment onditions, so it may not be desirable to set the
o-diagonal elements to 0.
may be a random, data dependent matrix.
We have already seen that the hoi e of
will inuen e the asymptoti distribution
of the GMM estimator. Sin e the GMM estimator is already ine ient w.r.t. MLE,
we might like to hoose the
the lass of GMM estimators
matrix to make the GMM estimator e ient
dened by
within
mn ().
To provide a little intuition, onsider the linear model
Let
Then the model
y = x +, where N (0, ).
That is, he have heteros edasti ity and auto orrelation.
be the Cholesky fa torization of
P y = P X + P
1 ,
e.g,
P P = 1 .
satises the lassi al assumptions of homos edas-
ti ity and nonauto orrelation, sin e
V (P ) = P V ()P = P P = P (P P )1 P =
P P 1 (P )1 P = In . (Note:
(AB)1 = B 1 A1
we use
for
A, B
both nonsingular).
This means that the transformed model is e ient.
The OLS estimator of the model
(y X) 1 (y X).
P y = P X + P
Interpreting
minimizes the obje tive fun tion
(y X) = ()
that they do have zero expe tation when evaluated at
as moment onditions (note
0 ),
the optimal weighting
matrix is seen to be the inverse of the ovarian e matrix of the moment onditions.
208
CHAPTER 15.
This result arries over to GMM estimation. (Note: this presentation of GLS is not
a GMM estimator, be ause the number of moment onditions here is equal to the
sample size,
n. Later we'll see that GLS an be put into the GMM framework dened
above).
Theorem 25 If is a GMM estimator that minimizes mn () Wn mn (), the asymptoti

W = 1
varian e of will be minimized by hoosing Wn so that Wn a.s
, where =

limn E nm( 0 )m( 0 ) .
Proof:
For
W = 1
,
the asymptoti varian e
D W D
simplies to
D 1
D
1
1
D W W D
D W D
Now, for any hoi e su h that
dieren e of the inverses of the varian es when
W =
1
W 6= 1
,
1 versus when
onsider the
is some arbitrary
positive denite matrix:

D 1
D W D
D D W D D W W D
h
i

1/2
1/2
1
1/2
I
W
D
D
W
W
D
= D 1/2
D
W
as an be veried by multipli ation. The term in bra kets is idempotent, whi h is also easy
to he k by multipli ation, and is therefore positive semidenite. A quadrati form in a
positive semidenite matrix is also positive semidenite. The dieren e of the inverses of
the varian es is positive semidenite, whi h implies that the dieren e of the varian es is
negative semidenite, whi h proves the theorem.
The result
allows us to treat

h
i

d
1
n 0 N 0, D 1
D

N
where the
tors of
means approximately
and
D 1
D
,
n
0
d
D
distributed as. To operationalize this we need estima-
The obvious estimator of
1 !
(15.3)
is simply
mn

, whi h
is onsistent by the onsis-
mn is ontinuous in . Sto hasti equi ontinuity results
an give us this result even if

mn is not ontinuous. We now turn to estimation of
ten y of
assuming that
15.5 Estimation of the varian e- ovarian e matrix

(See Hamilton Ch. 10, pp. 261-2 and 280-84) .
In the ase that we wish to use the optimal weighting matrix, we need an estimate
of
the limiting varian e- ovarian e matrix of
nmn ( 0 ).
While one ould estimate
parametri ally, we in general have little information upon whi h to base a parametri
spe i ation. In general, we expe t that:
15.5.
mt
will be auto orrelated (ts
not depend on
209
ESTIMATION OF THE VARIANCE-COVARIANCE MATRIX
= E(mt mts ) 6= 0).
Note that this auto ovarian e will
if the moment onditions are ovarian e stationary.
ontemporaneously orrelated, sin e the individual moment onditions will not in

general be independent of one another (E(mit mjt )
and have dierent varian es (E(mit )
2
= it
6= 0).
).
Sin e we need to estimate so many omponents if we are to take the parametri approa h,
it is unlikely that we would arrive at a orre t parametri spe i ation. For this reason,
resear h has fo used on onsistent nonparametri estimators of
Hen eforth we assume that
mts
does not depend on
v =
E(mt mts ). Note that
t).
mt
is ovarian e stationary (the ovarian e between
Dene the
E(mt mt+s )
v th
mt
and
auto ovarian e of the moment onditions
v . Re all that
mt
and
are fun tions of
0
for now assume that we have some onsistent estimator of , so that
m
t = mt ().
so
Now
!#
!
"
n
n
X
X

mt
1/n
mt
= E nm( 0 )m( 0 ) = E n 1/n
"
= E 1/n
n
X
t=1
mt
n
X
mt
t=1
t=1
t=1
!#
n2

n1
1
= 0 +
1 + 1 +
2 + 2 +
n1 + n1
n
n
n
A natural, onsistent estimator of
is
cv = 1/n
(you might use

of
n
X
m
tm
tv .
t=v+1
nv in the denominator instead).
So, a natural, but in onsistent, estimator
would be

c + n 2
c + +
[
c1 +
c2 +
=
c0 + n 1
[
n1
1
2
n1
n
n
n1

X nv
c .
cv +
c0 +
=
v
n
v=1
This estimator is in onsistent in general, sin e the number of parameters to estimate is

more than the number of observations, and in reases more rapidly than
does not build up as
n .
On the other hand, supposing that
n,
so information
tends to zero su iently rapidly as
tends to
a modied estimator
where
q(n)
as
=
c0 +
q(n)

X
c ,
cv +
v
v=1
will be onsistent, provided
nv
The term
n an be dropped be ause
q(n)
must be
q(n)
op (n).
grows su iently slowly.
This allows information to
a umulate at a rate that satises a LLN. A disadvantage of this estimator is that it may
not be positive denite.
example!
This ould ause one to al ulate a negative
statisti , for
210
CHAPTER 15.
Note: the formula for

estimate of
requires an estimate of
whi h is based upon an estimate of
is to set the weighting matrix
whi h in turn requires an
The solution to this ir ularity
arbitrarily (for example to an identity matrix),
obtain a rst onsistent but ine ient estimate of
m( 0 ),
0,
then use this estimate to form
0
then re-estimate . The pro ess an be iterated until neither
nor
hange
appre iably between iterations.
15.5.1 Newey-West ovarian e estimator

E onometri a, 1987) solves the problem of possible nonpositive
The Newey-West estimator (
deniteness of the above estimator. Their estimator is
=
c0 +
q(n)
X
1
v=1

v
c .
cv +
v
q+1
This estimator is p.d. by onstru tion. The ondition for onsisten y is that
Note that this is a very slow rate of growth for
q.
pla ed no parametri restri tions on the form of

In a more re ent paper, Newey and West
pre-whitening
n1/4 q 0.
This estimator is nonparametri - we've
kernel
(Review of E onomi Studies,
.
It is an example of a
estimator.
1994) use
before applying the kernel estimator. The idea is to t a VAR model to the
moment onditions. It is expe ted that the residuals of the VAR model will be more nearly
white noise, so that the Newey-West ovarian e estimator might perform better with short
lag lengths..
The VAR model is
m
t = 1 m
t1 + + p m
tp + ut
This is estimated, giving the residuals
u
t .
Then the Newey-West ovarian e estimator is
applied to these pre-whitened residuals, and the ovarian e
is estimated ombining the
tted VAR
c
c1 m
cp m
m
t =
t1 + +
tp
with the kernel estimate of the ovarian e of the
ut .
See Newey-West for details.
I have a program that does this if you're interested.
15.6 Estimation using onditional moments

So far, the moment onditions have been presented as un onditional expe tations.
One
ommon way of dening un onditional moment onditions is based upon onditional moment onditions.
Suppose that a random variable
variable
X
EY |X Y =
has zero expe tation onditional on the random
Y f (Y |X)dY = 0
Then the un onditional expe tation of the produ t of
and a fun tion
g(X)
of
is also
15.6.
211
ESTIMATION USING CONDITIONAL MOMENTS
zero. The un onditional expe tation is
EY g(X) =
Z Z
X
Y g(X)f (Y, X)dY
dX.
This an be fa tored into a onditional expe tation and an expe tation w.r.t. the marginal
density of
X:
EY g(X) =
g(X)
Sin e
doesn't depend on
Z Z
X
EY g(X) =
Y g(X)f (Y |X)dY
f (X)dX.
it an be pulled out of the integral
Z Z
Y f (Y |X)dY
g(X)f (X)dX.
But the term in parentheses on the rhs is zero by assumption, so
EY g(X) = 0
as laimed.
This is important e onometri ally, sin e models often imply restri tions on onditional
moments. Suppose a model tells us that the fun tion
on the information set
It ,
equal to
K(yt , xt ) has expe tation, onditional
k(xt , ),
E K(yt , xt )|It = k(xt , ).
For example, in the ontext of the lassi al linear model
K(yt , xt ) = yt
so that
k(xt , ) =
yt = xt + t ,
we an set
xt .
With this, the fun tion
ht () = K(yt , xt ) k(xt , )
has onditional expe tation equal to zero
E ht ()|It = 0.
This is a s alar moment ondition, whi h isn't su ient to identify a
parameter
(K > 1).
-dimensional
However, the above result allows us to form various un onditional
expe tations
mt () = Z(wt )ht ()
where
Z(wt ) is a g 1-ve tor
the information set
It .
The
onditions, so as long as
valued fun tion of
Z(wt )
g>K
are
wt
and
wt
is a set of variables drawn from
instrumental variables.
We now have
the ne essary ondition for identi ation holds.
moment
212
CHAPTER 15.
One an form the
ng
Zn
With this we an form the
matrix
Z1 (w1 ) Z2 (w1 ) Zg (w1 )
Zg (w2 )
Z1 (w2 ) Z2 (w2 )
=
.
..
.
.
.
Z1 (wn ) Z2 (wn ) Zg (wn )
Z1

Z2
Zn
g
h1 ()
h2 ()
1
Zn
n ...
hn ()
=
=
=
Z(t,)
is the
tth
row of
moment onditions
mn () =
where
Zn .
1
Z hn ()
n n
n
1X
Zt ht ()
n
1
n
t=1
n
X
mt ()
t=1
This ts the previous treatment. An interesting question
that arises is how one should hoose the instrumental variables
Z(wt ) to a hieve maximum
e ien y.
Note that with this hoi e of moment onditions, we have that
matrix) is
Dn () =
=
Dn () =
Hn
is a
K n
m () (a
K g

1
Zn hn ()
n

1
h () Zn
n n
whi h we an dene to be
where
Dn
1
Hn Zn .
n
matrix that has the derivatives of the individual moment onditions
as its olumns. Likewise, dene the var- ov. of the moment onditions

n = E nmn ( 0 )mn ( 0 )

1
Zn hn ( 0 )hn ( 0 ) Zn
= E
n

1
0
0
hn ( )hn ( ) Zn
= Zn E
n
n
Zn
Zn
n
15.7.
213
ESTIMATION USING DYNAMIC MOMENT CONDITIONS
where we have dened
n = V arhn ( 0 ). Note that the dimension of this matrix is growing
with the sample size, so it is not onsistently estimable without additional assumptions.
The asymptoti normality theorem above says that the GMM estimator using the
optimal weighting matrix is distributed as

d
n 0 N (0, V )
where
V = lim
Hn Zn
n

Zn n Zn
n
1
Using an argument similar to that used to prove that

we an show that putting
Zn Hn
n
!1
(15.4)
is the e ient weighting matrix,
Zn = 1
n Hn
auses the above var- ov matrix to simplify to
V = lim
Hn 1
n Hn
n
1
(15.5)
and furthermore, this matrix is smaller that the limiting var- ov for any other hoi e of
instrumental variables. (To prove this, examine the dieren e of the inverses of the var- ov
matri es with the optimal intruments and with non-optimal instruments. As above, you
an show that the dieren e is positive semi-denite).
Note that both

on
0,
must be onsistently estimated to apply this.
Usually, estimation of
where
and
Hn , whi h we should write more properly as Hn ( 0 ), sin e it depends
is
Hn
is straightforward - one just uses

b = hn ,
H
some initial onsistent estimator based on non-optimal instruments.
Estimation of
may not be possible. It is an
nn
elements than
n,
the sample size, so without restri tions on the parameters it an't
matrix, so it has more unique
be estimated onsistently. Basi ally, you need to provide a parametri spe i ation of
ht () in order to be able to use optimal instruments.
A solution
is to approximate this matrix parametri ally to dene the instruments.
Note that
the ovarian es of the
the simplied var- ov matrix in equation 15.5 will not apply if approximately optimal
instruments are used - it will be ne essary to use an estimator based upon equation
15.4, where the term
Z
Zn
n n
must be estimated onsistently apart, for example by
n
the Newey-West pro edure.
15.7 Estimation using dynami moment onditions

Note that dynami moment onditions simplify the var- ov matrix, but are often harder
to formulate. The will be added in future editions. For now, the Hansen appli ation below
is enough.
214
CHAPTER 15.
15.8 A spe i ation test

The rst order onditions for minimization, using the an estimate of the optimal weighting
matrix, are

1

s() = 2
mn mn 0
or
0
1 mn ()
D()
Consider a Taylor expansion of
Multiplying by
:
m()

= mn ( 0 ) + D ( 0 ) 0 + op (1).
m()
n
1
D()
(15.6)
we obtain

= D()
1 m()
1 mn ( 0 ) + D()
1 D( 0 ) 0 + op (1)
D()
The lhs is zero, and sin e
tends
to
and
tends to
we an write

0
0 a
1
D 1
mn ( ) = D D
or

a
1
0
n 0 = n D 1
D 1
D
mn ( )
With this, and taking into a ount the original expansion (equation 15.6), we get
=
D 1
nm()
nmn ( 0 ) nD
D
This last an be written as
=
nm()
Or
0
D 1
mn ( ).

1/2
1/2
1
1/2
mn ( 0 )
n D
D 1
D
D
a
n1/2
m() =
Now
1

1/2
1 1
1/2
n Ig 1/2
D
mn ( 0 )
D
D
D
0
n1/2
mn ( ) N (0, Ig )
and one an easily verify that

1 1
1/2
P = Ig 1/2
D
D
D
D
is idempotent of rank
tra e) so
g K,
(re all that the rank of an idempotent matrix is equal to its

d
1/2
= nm()
1 m()

n1/2
m(
)
n
m(
)
2 (g K)
15.9.
215
OTHER ESTIMATORS INTERPRETED AS GMM ESTIMATORS
Sin e
onverges to
we also have
d

1 m()
nm()
2 (g K)
or
2 (g K)
n sn ()
supposing the model is orre tly spe ied. This is a onvenient test sin e we just multiply
n,
the optimized value of the obje tive fun tion by

value.
and ompare with a
2 (g K)
riti al
The test is a general test of whether or not the moments used to estimate are
orre tly spe ied.
This won't work when the estimator is just identied. The f.o. . are
0.
1 m()
D sn () = D
But with exa t identi ation, both
and
are square and invertible (at least
asymptoti ally, assuming that asymptoti normality hold), so
0.
m()
So the moment onditions are zero
regardless
of the weighting matrix used. As su h,
we might as well use an identity matrix and save trouble. Also
= 0,
sn ()
so the test
breaks down.
A note: this sort of test often over-reje ts in nite samples. One should be autious
in reje ting a model when this test reje ts.
15.9 Other estimators interpreted as GMM estimators

15.9.1 OLS with heteros edasti ity of unknown form
Example 26 White's heteros edasti onsistent var ov estimator for OLS.
Suppose
y = X 0 + ,
where
The typi al approa h is to parameterize

parameter ve tor, and to estimate
if the parameterization of
N (0, ),
and
a diagonal matrix.
= (),
where
is a nite dimensional
jointly (feasible GLS). This will work well
is orre t.
, we an still estimate onsistently by

= (X X)1
2 will be biased
estimator V ()
If we're not ondent about parameterizing

OLS. However, the typi al ovarian e
and in onsistent, and will lead to invalid inferen es.
By exogeneity of the regressors

suggests the moment ondition
xt
(a
K1
olumn ve tor) we have

mt () = xt yt xt .
E(xt t ) = 0,whi h
216
CHAPTER 15.
In this ase, we have exa t identi ation (

have
m() = 1/n
mt = 1/n
For any hoi e of
W, m()
parameters and
X
t
xt yt 1/n
moment onditions). We
xt xt .
will be identi ally zero at the minimum, due to exa t iden-
ti ation. That is, sin e the number of moment onditions is identi al to the number of
parameters, the fo imply that
0
m()
regardless of
W.
There is no need to use the op-
timal weighting matrix in this ase, an identity matrix works just as well for the purpose
of estimation. Therefore
xt xt
!1
xt yt = (X X)1 X y,
whi h is the usual OLS estimator.
The GMM estimator of the asymptoti var ov matrix is
d
D
is simply

.
m
In this ase
d
D
= 1/n
Re all that a possible estimator of
X
t
d
b 1 d
D
D
1
. Re all that
xt xt = X X/n.
is
=
c0 +
n1

X
c .
cv +
v
v=1
This is in general in onsistent, but in the present ase of nonauto orrelation, it simplies
to
=
c0
whi h has a onstant number of elements to estimate, so information

onsisten y obtains. In the present ase
b =
c0 = 1/n
= 1/n
" n
X
= 1/n
=
where
is an
nn
m
tm
t
t=1
xt xt
t=1
" n
X
n
X

2
yt xt
xt xt 2t
t=1
X EX
diagonal matrix with
2t
in the position
t, t.
will a umulate, and
15.9.
217
Therefore, the GMM var ov. estimator, whi h is onsistent, is
!
)1

1 X X
X EX
X X
n
n
n
!
1

XX
X X 1
X EX
=
n
n
n
(

V
n
=
This is the var ov estimator that White (1980) arrived at in an inuential arti le. This
estimator is onsistent under heteros edasti ity of an unknown form. If there is auto orrelation, the Newey-West estimator an be used to estimate
- the rest is the same.
15.9.2 Weighted Least Squares

Consider the previous example of a linear model with heteros edasti ity of unknown form:
y = X 0 +
N (0, )
where
is a diagonal matrix.
Now, suppose that the form of
is known, so that
spe i ation (whi h may also depend upon
X).
= X 1 X
is a orre t parametri
In this ase, the GLS estimator is
1
X 1 y)
This estimator an be interpreted as the solution to the
= 1/n
m()
( 0 )
moment onditions
X xt yt
X xt x
t
1/n
0.
0)
0)
(
t
t
t
t
That is, the GLS estimator in this ase has an obvious representation as a GMM estimator.
With auto orrelation, the representation exists but it is a little more ompli ated.
Nevertheless, the idea is the same. There are a few points:
The (feasible) GLS estimator is known to be asymptoti ally e ient in the lass of
This means that it is more e ient than the above example of OLS with White's
linear asymptoti ally unbiased estimators (Gauss-Markov).
heteros edasti onsistent ovarian e, whi h is an alternative GMM estimator.

This means that the hoi e of the moment onditions is important to a hieve e ien y.
15.9.3 2SLS
Consider the linear model
yt = zt + t ,
or
y = Z +
218
CHAPTER 15.
using the usual onstru tion, where
is
K 1
and
is i.i.d. Suppose that this equation
is one of a system of simultaneous equations, so that
zt
ontains both endogenous and
Suppose that
xt
is the ve tor of all exogenous and predetermined
variables that are un orrelated with
(suppose that
exogenous variables.
Dene
as the ve tor of predi tions of
X (X X)1 X Z
= X X X
Z
Sin e
is a linear ombination
Z
with
This suggests the
K -dimensional
m() = 1/n
parameters and
when regressed upon
1
t zt
z
X,
e.g.,
=
Z
X Z
x, zt
must be un orrelated
mt () = zt (yt zt )

t yt zt .
z
moment onditions, the GMM estimator will set
identi ally equal to zero, regardless of
r 1).
moment ondition
X
t
Sin e we have
is
of the exogenous variables
and so
xt
!1
W,
X
t
so we have

1
Z
y
(zt yt ) = Z
Z
This is the standard formula for 2SLS. We use the exogenous variables and the redu ed
form predi tions of the endogenous variables as instruments, and apply IV estimation. See
Hamilton pp. 420-21 for the var ov formula (whi h is the standard formula for 2SLS), and
for how to deal with
heterogeneous and dependent (basi ally, just use the Newey-West or
some other onsistent estimator of
, and apply the usual formula).
Note that
t dependent
auses lagged endogenous variables to loose their status as legitimate instruments.
15.9.4 Nonlinear simultaneous equations

GMM provides a onvenient way to estimate nonlinear systems of simultaneous equations.
We have a system of equations of the form
y1t = f1 (zt , 10 ) + 1t
y2t = f2 (zt , 20 ) + 2t
.
.
.
0
yGt = fG (zt , G
) + Gt ,
or in ompa t notation
yt = f (zt , 0 ) + t ,
where
f ()
is a
-ve tor valued fun tion, and
We need to nd an
orrelated with
variables in
zt ,
it .
Ai 1
0 ) .
0 = (10 , 20 , , G
ve tor of instruments
xit ,
for ea h equation, that are un-
Typi al instruments would be low order monomials in the exogenous
with their lagged values. Then we an dene the
P
G

A
i=1 i 1
orthogo-
15.9.
nality onditions
(y1t f1 (zt , 1 )) x1t
(y2t f2 (zt , 2 )) x2t

mt () =
.
.
.
(yGt fG (zt , G )) xGt
219
A note on identi ation: sele tion of instruments that ensure identi ation is a nontrivial problem.
A note on e ien y: the sele ted set of instruments has important ee ts on the
e ien y of estimation.
Unfortunately there is little theory oering guidan e on
what is the optimal set. More on this later.
15.9.5 Maximum likelihood

In the introdu tion we argued that ML will in general be more e ient than GMM sin e
ML impli itly uses all of the moments of the distribution while GMM uses a limited number
of moments. A tually, a distribution with
moment onditions.
parameters an be uniquely hara terized by
However, some sets of
moment onditions may ontain more
information than others, sin e the moment onditions ould be highly orrelated. A GMM
estimator that hose an optimal set of
moment onditions would be fully e ient. Here
we'll see that the optimal moment onditions are simply the s ores of the ML estimator.
Let
yt
be a
-ve tor of variables, and let
Yt = (y1 , y2 , ..., yt ) .
Then at time
t, Yt1
has been observed (refer to it as the information set, sin e we assume the onditioning
variables have been sele ted to take advantage of all useful information). The likelihood
fun tion is the joint density of the sample:
L() = f (y1 , y2 , ..., yn , )

whi h an be fa tored as
L() = f (yn |Yn1 , ) f (Yn1 , )

and we an repeat this to get
L() = f (yn |Yn1 , ) f (yn1 |Yn2 , ) ... f (y1 ).

The log-likelihood fun tion is therefore
ln L() =
n
X
t=1
ln f (yt |Yt1 , ).
Dene
mt (Yt , ) D ln f (yt |Yt1 , )

as the
s ore
of the
tth
observation. It an be shown that, under the regularity onditions,
that the s ores have onditional mean zero when evaluated at

to E onometri s):
E{mt (Yt , 0 )|Yt1 } = 0
(see notes to Introdu tion
220
CHAPTER 15.
so one ould interpret these as moment onditions to use to dene a just-identied GMM
estimator ( if there are
sets
1/n
parameters there are
n
X
= 1/n
mt (Yt , )
n
X
t=1
t=1
s ore equations). The GMM estimator
= 0,
D ln f (yt |Yt1 , )
whi h are pre isely the rst order onditions of MLE. Therefore, MLE an be interpreted
as a GMM estimator. The GMM var ov formula is
V = D 1 D
Consistent estimates of varian e omponents are as follows
1
= 1/n
d
D
D2 ln f (yt |Yt1 , )
m(Yt , )
=
t=1
It is important to note that
mt
and
mts , s > 0
are both onditionally and un on-
ditionally un orrelated. Conditional un orrelation follows from the fa t that

a fun tion of
Yts ,
whi h is in the information set at time
t.
mts
is
Un onditional un or-
relation follows from the fa t that onditional un orrelation hold regardless of the
realization of
Yt1 , so marginalizing
with respe t to
Yt1
preserves un orrelation (see
the se tion on ML estimation, above). The fa t that the s ores are serially un orrelated implies that
an be estimated by the estimator of the 0
th auto ovarian e of
the moment onditions:
b = 1/n
n
X
t (Yt , )
= 1/n
mt (Yt , )m
n h
X
t=1
t=1
ih
i
D ln f (yt |Yt1 , )
D ln f (yt |Yt1 , )
Re all from study of ML estimation that the information matrix equality (equation
??)
states that
n

o
= E D2 ln f (yt |Yt1 , 0 ) .
D ln f (yt |Yt1 , 0 ) D ln f (yt|Yt1 , 0 )
This result implies the well known (and already seeen) result that we an estimate
in
any of three ways:
The sandwi h version:
nP
o
n
2 ln f (y |Y

,
)
D
t
t1
t=1
P h
ih
i 1
n
c
V = n
D ln f (yt |Yt1 , )
t=1 D ln f (yt |Yt1 , )
n
o
Pn
t=1
or the inverse of the negative of the Hessian (sin e the middle and last term an el,
ex ept for a minus sign):
"
Vc
= 1/n
n
X
t=1
#1
15.10.
221
EXAMPLE: THE HAUSMAN TEST
or the inverse of the outer produ t of the gradient (sin e the middle and last an el
ex ept for a minus sign, and the rst term onverges to minus the inverse of the
middle term, whi h is still inside the overall inverse)
Vc
=
1/n
n h
X
t=1
ih
i
D ln f (yt |Yt1 , )
D ln f (yt |Yt1 , )
)1
This simpli ation is a spe ial result for the MLE estimator - it doesn't apply to GMM
estimators in general.
Asymptoti ally, if the model is orre tly spe ied, all of these forms onverge to the
same limit.
In small samples they will dier.
In parti ular, there is eviden e that the
outer produ t of the gradient formula does not perform very well in small samples (see
Davidson and Ma Kinnon, pg.
477).
White's
Information matrix test
(E onometri a,
1982) is based upon omparing the two ways to estimate the information matrix: outer
produ t of gradient or negative of the Hessian. If they dier by too mu h, this is eviden e
of misspe i ation of the model.
15.10 Example: The Hausman Test

This se tion dis usses the Hausman test, whi h was originally presented in Hausman, J.A.
(1978), Spe i ation tests in e onometri s,
E onometri a, 46, 1251-71.
Consider the simple linear regression model
yt = xt +t . We assume that the fun tional
form and the hoi e of regressors is orre t, but that the some of the regressors may be
orrelated with the error term, whi h as you know will produ e in onsisten y of
For
example, this will be a problem if
if some regressors are endogeneous
some regressors are measured with error
lagged values of the dependent variable are used as regressors and t is auto orrelated.
To illustrate, the O tave program biased.m performs a Monte Carlo experiment where
errors are orrelated with regressors, and estimation is by OLS and IV. The true value of
the slope oe ient used to generate the data is
= 2.
Figure 15.1 shows that the OLS
estimator is quite biased, while Figure 15.2 shows that the IV estimator is on average mu h
loser to the true value. If you play with the program, in reasing the sample size, you an
see eviden e that the OLS estimator is asymptoti ally biased, while the IV estimator is
onsistent.
We have seen that in onsistent and the onsistent estimators onverge to dierent
probability limits. This is the idea behind the Hausman test - a pair of onsistent estimators
onverge to the same probability limit, while if one is onsistent and the other is not they
e.g.,
onverge to dierent limits. If we a ept that one is onsistent (
e.g.,
but we are doubting if the other is onsistent (
the IV estimator),
the OLS estimator), we might try to
he k if the dieren e between the estimators is signi antly dierent from zero.
If we're doubting about the onsisten y of OLS (or QML,
et .),
why should we be
interested in testing - why not just use the IV estimator? Be ause the OLS estimator
222
CHAPTER 15.
Figure 15.1: OLS

OLS estimates
0.12
0.1
0.08
0.06
0.04
0.02
0
2.3
2.31
2.32
2.33
2.34
2.35
2.36
2.37
Figure 15.2: IV
IV estimates
0.16
0.14
0.12
0.1
0.08
0.06
0.04
0.02
0
1.9
1.92
1.94
1.96
1.98
2.02
2.04
2.06
2.08
15.10.
223
is more e ient when the regressors are exogenous and the other lassi al assumptions
(in luding normality of the errors) hold. When we have a more e ient estimator
that relies on stronger assumptions (su h as exogeneity) than the IV estimator, we
might prefer to use it, unless we have eviden e that the assumptions are false.
So, let's onsider the ovarian e between the MLE estimator
.
estimator) and some other CAN estimator, say
(or
any other fully e ient
Now, let's re all some results from MLE.
Equation 4.2 is:

a.s.
n 0 H (0 )1 ng(0 ).
Equation 4.7 is
H () = I ().
Combining these two equations, we get

a.s.
n 0 I (0 )1 ng(0 ).
Also, equation 4.9 tells us that the asymptoti ovarian e between any CAN estimator
and the MLE s ore ve tor is
# "
"
#
n
V ()
IK
V
.
=
IK
I ()
ng()
Now, onsider
"
IK
0K

#
#"
n
n
0K
a.s.
.

I ()
n
ng()
The asymptoti ovarian e of this is

#"
"
#"
n
IK
I
0
V
(
)
I
K
K
K
=
V
0K
0K I ()1
IK
I ()
n
#
"
V ()
I ()1
,
=
I ()1 I ()1
0K
I ()1
whi h, for larity in what follows, we might write as
"

#
1
n
V
(
)
I
()
=
V
.
I ()1 V ()
n
So, the asymptoti ovarian e between the MLE and any other CAN estimator is equal to
the MLE asymptoti varian e (the inverse of the information matrix).
Now, suppose we with to test whether the the two estimators are in fa t both onverging
to
0 ,
versus the alternative hypothesis that the MLE estimator is not in fa t onsistent
(the onsisten y of
is a maintained
hypothesis). Under the null hypothesis that they are,
224
CHAPTER 15.
we have
IK
IK

n 0

= n ,
n 0
will be asymptoti ally normally distributed as

d
V ()
.
n N 0, V ()
So,
where

1

d
V ()
n
V ()
2 (),
is the rank of the dieren e of the asymptoti varian es. A statisti that has the
same asymptoti distribution is

1

d
V ()

V ()
2 ().
This is the Hausman test statisti , in its original form. The reason that this test has power
under the alternative hypothesis is that in that ase the MLE estimator will not be
A , say, where A 6= 0 . Then the mean of the asymptoti

n will be 0 A , a non-zero ve tor, so the test statisti
onsistent, and will onverge to

distribution of ve tor
will eventually reje t, regardless of how small a signi an e level is used.
Note: if the test is based on a sub-ve tor of the entire parameter ve tor of the MLE,
it is possible that the in onsisten y of the MLE will not show up in the portion of the
ve tor that has been used. If this is the ase, the test may not have power to dete t
the in onsisten y. This may o ur, for example, when the onsistent but ine ient
estimator is not identied for all the parameters of the model.
Some things to note:
The rank,
of the dieren e of the asymptoti varian es is often less than the
dimension of the matri es, and it may be di ult to determine what the true rank
is. If the true rank is lower than what is taken to be true, the test will be biased
against reje tion of the null hypothesis. The ontrary holds if we underestimate the
rank.
A solution to this problem is to use a rank 1 test, by omparing only a single oe ient. For example, if a variable is suspe ted of possibly being endogenous, that
variable's oe ients may be ompared.
This simple formula only holds when the estimator that is being tested for onsisten y
is
fully e ient under the null hypothesis.
This means that it must be a ML estimator
or a fully e ient estimator that has the same asymptoti distribution as the ML
estimator. This is quite restri tive sin e modern estimators su h as GMM and QML
are not in general fully e ient.
Following up on this last point, let's think of two not ne essarily e ient estimators,
and
2 ,
where one is assumed to be onsistent, but the other may not be.
We assume
15.10.
225
for expositional simpli ity that both
and
belong to the same parameter spa e, and
that they an be expressed as generalized method of moments (GMM) estimators. The

estimators are dened (suppressing the dependen e upon data) by
i = arg min mi (i ) Wi mi (i )
i
where
mi (i )
is a
weighting matrix,
gi 1
ve tor of moment onditions, and
i = 1, 2.
1 , 2 = arg min
Wi
is a
Consider the omnibus GMM estimator
m1 (1 ) m2 (2 )
"
W1
#"
0(g1 g2 )
W2
0(g2 g1 )
gi gi
positive denite
m1 (1 )
m2 (2 )
(15.7)
Suppose that the asymptoti ovarian e of the omnibus moment ve tor is
#)
(
"
m1 (1 )
= lim V ar
n
n
m2 (2 )
!
1 12
(15.8)
The standard Hausman test is equivalent to a Wald test of the equality of
and
(or
subve tors of the two) applied to the omnibus GMM estimator, but with the ovarian e of
the moment onditions estimated as
b=
c1
0(g2 g1 )
0(g1 g2 )
c2
While this is learly an in onsistent estimator in general, the omitted
12
term an els out
of the test statisti when one of the estimators is asymptoti ally e ient, as we have seen
above, and thus it need not be estimated.
The general solution when neither of the estimators is e ient is lear: the entire
matrix must be estimated onsistently, sin e the
12
term will not an el out. Methods
for onsistently estimating the asymptoti ovarian e of a ve tor of moment onditions
, e.g.,
are well-known
the Newey-West estimator dis ussed previously. The Hausman test
using a proper estimator of the overall ovarian e matrix will now have an asymptoti
distribution when neither estimator is e ient. This is

However, the test suers from a loss of power due to the fa t that the omnibus GMM
estimator of equation 15.7 is dened using an ine ient weight matrix. A new test an be
dened by using an alternative omnibus GMM estimator
i 1

h
e
1 , 2 = arg min m1 (1 ) m2 (2 )
where
"
m1 (1 )
m2 (2 )
is a onsistent estimator of the overall ovarian e matrix
(15.9)
of equation 15.8. By
standard arguments, this is a more e ient estimator than that dened by equation 15.7,
so the Wald test using this alternative is more powerful. See my arti le in
nomi s, 2004, for more details, in luding simulation results.
Applied E o-
The O tave s ript hausman.m
al ulates the Wald test orresponding to the e ient joint GMM estimator (the H2 test
226
CHAPTER 15.
in my paper), for a simple linear model.
15.11 Appli ation: Nonlinear rational expe tations

Readings:
Hansen and Singleton, 1982
; Tau hen, 1986
Though GMM estimation has many appli ations, appli ation to rational expe tations
models is elegant, sin e theory dire tly suggests the moment onditions. Hansen and Singleton's 1982 paper is also a lassi worth studying in itself. Though I strongly re ommend
reading the paper, I'll use a simplied model with similar notation to Hamilton's.
We assume a representative onsumer maximizes expe ted dis ounted utility over an
innite horizon. Utility is temporally additive, and the expe ted utility hypothesis holds.
The future onsumption stream is the sto hasti sequen e
at time
is the dis ounted expe ted utility
X
s=0
The parameter
s E (u(ct+s )|It ) .
at time
and earlier.
The hoi e variable is
ct
- urrent onsumption, whi h is onstained to be less than
or equal to urrent wealth
wt .
Suppose the onsumer an invest in a risky asset. A dollar invested in the asset yields
a gross return
where
to
pt
is the pri e and
dt
pt+1 + dt+1
pt
is the dividend in period
t.
The pri e of
ct
is normalized
1.
Current wealth
wt = (1 + rt )it1 ,
where
it1
is investment in period
t 1.
So the
problem is to allo ate urrent wealth between urrent onsumption and investment
to nan e future onsumption:
(15.10)
t, and in ludes the all realizations of random variables
(1 + rt+1 ) =
The obje tive fun tion
is between 0 and 1, and ree ts dis ounting.
It is the information set

indexed
{ct }
t=0 .
Future net rates of return
wt = ct + it .
rt+s , s > 0
are
not known
in period
t:
the asset is risky.
A partial set of ne essary onditions for utility maximization have the form:

u (ct ) = E (1 + rt+1 ) u (ct+1 )|It .
(15.11)
To see that the ondition is ne essary, suppose that the lhs < rhs. Then by redu ing urrent
onsumption marginally would ause equation 15.10 to drop by
u (ct ),
sin e there is no
dis ounting of the urrent period. At the same time, the marginal redu tion in onsumption
nan es investment, whi h has gross return
period
(1 + rt+1 ) , whi h ould nan e onsumption in
t+1. This in rease in onsumption would ause the obje tive fun tion to in rease by
E {(1 + rt+1 ) u (ct+1 )|It } .
Therefore, unless the ondition holds, the expe ted dis ounted
utility fun tion is not maximized.
15.11.
227
APPLICATION: NONLINEAR RATIONAL EXPECTATIONS
To use this we need to hoose the fun tional form of utility. A onstant relative risk
aversion form is
u(ct ) =
where
c1
1
t
1
is the oe ient of relative risk aversion. With this form,
u (ct ) = c
t
so the fo are
o
n
c
t = E (1 + rt+1 ) ct+1 |It
While it is true that

n
o
E c
(1
+
r
)
c
|It = 0
t+1
t
t+1
so that we ould use this to dene moment onditions, it is unlikely that
ct
is stationary,
even though it is in real terms, and our theory requires stationarity. To solve this, divide
though by
c
t
E
(note that
ct
1-
(1 + rt+1 )
ct+1
ct
)!
an be passed though the onditional expe tation sin e
only upon information available in time

Now
1-
is analogous to
ht () dened
from the information set
It .

represents
and
ct
is hosen based
t).
(1 + rt+1 )
ct+1
ct
)
above: it's a s alar moment ondition. To get a ve tor of mo-
ment onditions we need some instruments. Suppose that
|It = 0
zt
is a ve tor of variables drawn
We an use the ne essary onditions to form the expressions
1 (1 + rt+1 )
ct+1
ct

zt mt ()
Therefore, the above expression may be interpreted as a moment ondition whi h

an be used for GMM estimation of the parameters
Note that at time
t, mts
0.
has been observed, and is therefore an element of the information
set. By rational expe tations, the auto ovarian es of the moment onditions other than
should be zero. The optimal weighting matrix is therefore the inverse of the varian e
of the moment onditions:

= lim E nm( 0 )m( 0 )
whi h an be onsistently estimated by
= 1/n
n
X
t ()
mt ()m
t=1
As before, this estimate depends on an initial onsistent estimate of
whi h an be
228
CHAPTER 15.
obtained by setting the weighting matrix

After obtaining
arbitrarily (to an identity matrix, for example).
we then minimize
1 m().
s() = m()
This pro ess an be iterated, e.g., use the new estimate to re-estimate
estimate
0,
use this to
and repeat until the estimates don't hange.
In prin iple, we ould use a very large number of moment onditions in estimation,
sin e
any urrent or lagged variable
ould be used in
xt .
Sin e use of more moment
onditions will lead to a more (asymptoti ally) e ient estimator, one might be
tempted to use many instrumental variables. We will do a omputer lab that will
show that this may not be a good idea with nite samples. This issue has been studied
using Monte Carlos (Tau hen,
JBES, 1986).
The reason for poor performan e when
using many instruments is that the estimate of
be omes very impre ise.
Empiri al papers that use this approa h often have serious problems in obtaining
pre ise estimates of the parameters. Note that we are basing everything on a single
parial rst order ondition. Probably this f.o. . is simply not informative enough.
Simulation-based estimation methods (dis ussed below) are one means of trying to
use more informative moment onditions to estimate this sort of model.
15.12 Empiri al example: a portfolio model

The O tave program portfolio.m performs GMM estimation of a portfolio model, using the
data le tau hen.data. The olumns of this data le are
are 95 observations (sour e: Tau hen,
r,
JBES,
c, p,
and
******************************************************
Example of GMM estimation of rational expe tations model
GMM Estimation Results
Obje tive fun tion value: 0.000014
Observations: 94
X^2 test
beta
estimate
0.915
df
1.000
st. err
0.009
in that order. There
1986). As instruments we use lags of
as well as a onstant. For a single lag the estimation results are
Value
0.001
p-value
0.971
t-stat
97.271
p-value
0.000
and
15.12.
229
EMPIRICAL EXAMPLE: A PORTFOLIO MODEL
gamma
0.569
0.319
1.783
0.075
******************************************************
For two lags the estimation results are
******************************************************
Example of GMM estimation of rational expe tations model
Observations: 93
X^2 test
Value
3.523
df
3.000
p-value
0.318
estimate
st. err
t-stat
p-value
beta
0.857
0.024
35.636
0.000
gamma
-2.351
0.315
-7.462
0.000
******************************************************
Pretty learly, the results are sensitive to the hoi e of instruments. Maybe there is some
problem here: poor instruments, or possibly a onditional moment that is not very informative. Moment onditions formed from Euler onditions sometimes do not identify the
parameter of a model. See Hansen, Heaton and Yarron, (1996)
problem here, (I haven't he ked it arefully)?
JBES
V14, N3. Is that a
230
CHAPTER 15.
Exer ises
1. Show how to ast the generalized IV estimator presented in se tion 11.4 as a GMM
estimator.
Identify what are the moment onditions,
the the matrix
Dn ,
mt (),
what is the form of
what is the e ient weight matrix, and show that the ovarian e
matrix formula given previously orresponds to the GMM ovarian e matrix formula.
2. Using O tave, generate data from the logit dgp . Re all that
[1 + exp(xt
)]1 .
E(yt |xt ) = p(xt , ) =
Consider the moment ondtions (exa tly identied)
mt () =
[yt p(xt , )]xt
(a) Estimate by GMM, using these moments.

(b) Estimate by MLE.
( ) The two estimators should oin ide.
Prove analyti ally that the estimators
oi ide.
3. Verify the missing steps needed to show that

distribution.
equal to
1 m()
n m()
has a
2 (g K)
That is, show that the monster matrix is idempotent and has tra e
g K.
4. For the portfolio example, experiment with the program using lags of 3 and 4 periods
to dene instruments
(a) Iterate the estimation of
= (, )
and
to onvergen e.
(b) Comment on the results. Are the results sensitive to the set of instruments used?
(Look at
Are these good instruments?

as well as .
orrelated with one another?
Are the instruments highly
Chapter 16
Quasi-ML
Quasi-ML is the estimator one obtains when a misspe ied probability model is used to
al ulate an ML estimator.
n of a random

yand a ve tor of onditioning

variables x,

suppose the joint density of Y =
y1 . . . yn onditional on X = x1 . . . xn is
a member of the parametri family pY (Y|X, ), . The true joint density is asso iated
Given a sample of size
ve tor
0 :
with the ve tor
pY (Y|X, 0 ).
As long as the marginal density of
doesn't depend on
0 ,
this onditional density fully
hara terizes the random hara teristi s of samples: i.e., it fully des ribes the probabilisti ally important features of the d.g.p. The
at other values
Let
likelihood fun tion
is just this density evaluated
Yt1 =
y1
L(Y|X, ) = pY (Y|X, ), .

. . . yt1 , Y0 = 0, and let Xt = x1 . . . xt
The like-
lihood fun tion, taking into a ount possible dependen e of observations, an be

written as
L(Y|X, ) =
n
Y
t=1
n
Y
pt (yt |Yt1 , Xt , )
pt ()
t=1
The average log-likelihood fun tion is:
sn () =
Suppose that we do not have knowledge of the family of densities
pt ().
Mistak-
yt is a member of the fam0

0
where there is no su h that ft (yt |Yt1 , Xt , ) =
enly, we may assume that the onditional density of

ily
ft (yt |Yt1 , Xt , ), ,
pt (yt |Yt1 , Xt , 0 ), t
1
1X
ln L(Y|X, ) =
ln pt ()
n
n t=1
(this is what we mean by misspe ied).
This setup allows for heterogeneous time series data, with dynami misspe i ation.
231
232
CHAPTER 16.
The QML estimator is the argument that maximizes the
misspe ied
lihood, whi h we refer to as the quasi-log likelihood fun tion.
QUASI-ML
average log like-
This obje tive fun tion
is
1X
ln ft (yt |Yt1 , Xt , 0 )
n
sn () =
t=1
n
1X
ln ft ()
n
t=1
and the QML is
n = arg max sn ()
A SLLN for dependent sequen es applies (we assume), so that
a.s.
sn () lim E
n
1X
ln ft () s ()
n
t=1
We assume that this an be strengthened to uniform onvergen e, a.s., following the previous arguments. The pseudo-true value of
is the value that maximizes
s():
0 = arg max s ()
Given assumptions so that theorem 19 is appli able, we obtain
lim n = 0 , a.s.
Applying the asymptoti normality theorem,

d
n 0 N 0, J ( 0 )1 I ( 0 )J ( 0 )1
where
J ( 0 ) = lim ED2 sn ( 0 )
n
and
I ( 0 ) = lim V ar nD sn ( 0 ).
n
Note that asymptoti normality only requires that the additional assumptions regarding
and
hold in a neighborhood of
for
and at
In this sense, asymptoti normality is a lo al property.
0 , for I, not throughout
16.1 Consistent Estimation of Varian e Components

Consistent estimation of
that
Jn (n ) =
J ( 0 ) is straightforward.
Assumption (b) of Theorem 22 implies
t=1
t=1
1X 2
1X 2
a.s.
D ln ft (n ) lim E
D ln ft ( 0 ) = J ( 0 ).
n n
n
That is, just al ulate the Hessian using the estimate

Consistent estimation of
I ( 0 )
in pla e of
0.
is more di ult, and may be impossible.
16.1.
233
CONSISTENT ESTIMATION OF VARIANCE COMPONENTS
Notation:
Let
gt D ft ( 0 )
We need to estimate
I ( 0 ) =
=
lim V ar nD sn ( 0 )
n
1X
lim V ar n
D ln ft ( 0 )
n
n t=1
n
X
1
gt
V ar
n n
t=1
! )
! n
( n
X
X
1
= lim E
(gt Egt )
(gt Egt )
n n
=
lim
t=1
t=1
This is going to ontain a term
1X
(Egt ) (Egt )
n n
lim
t=1
whi h will not tend to zero, in general. This term is not onsistently estimable in general,
sin e it requires al ulating an expe tation using the true density under the d.g.p., whi h
is unknown.
There are important ases where
I ( 0 )
is
onsistently estimable.
i.e., they
suppose that the data ome from a random sample (
For example,
are iid). This would
be the ase with ross se tional data, for example. (Note: under i.i.d. sampling, the
joint distribution of
density
f (yt |xt )
(yt , xt )
is identi al.
This does not imply that the onditional
is identi al).
With random sampling, the limiting obje tive fun tion is simply
s ( 0 ) = EX E0 ln f (y|x, 0 )
where
E0 means expe tation of y|x and EX
density of
means expe tation respe t to the marginal
x.
By the requirement that the limiting obje tive fun tion be maximized at
we have
D EX E0 ln f (y|x, 0 ) = D s ( 0 ) = 0
The dominated onvergen e theorem allows swit hing the order of expe tation and
dierentiation, so
D EX E0 ln f (y|x, 0 ) = EX E0 D ln f (y|x, 0 ) = 0
The CLT implies that
1 X
d
D ln f (y|x, 0 ) N (0, I ( 0 )).

n t=1
234
CHAPTER 16.
QUASI-ML
That is, it's not ne essary to subtra t the individual means, sin e they are zero.
Given this, and due to independent observations, a onsistent estimator is
1X
ln ft ()
D ln ft ()D
Ib =
n
t=1
This is an important ase where onsistent estimation of the ovarian e matrix is possible.
Other ases exist, even for dynami ally misspe ied time series models.
16.2 Example: the MEPS Data

To he k the plausibility of the Poisson model for the MEPS data, we an ompare the
sample un onditional varian e with the estimated un onditional varian e a ording to the
Poisson model:
V[
(y) =
Pn
t=1
Using the program PoissonVarian e.m, for OBDV and
ERV, we get We see that even after onditioning, the overdispersion is not aptured in
Table 16.1: Marginal Varian es, Sample and Estimated (Poisson)

OBDV
ERV
Sample
38.09
0.151
Estimated
3.28
0.086
either ase. There is huge problem with OBDV, and a signi ant problem with ERV. In
both ases the Poisson model does not appear to be plausible. You an he k this for the
other use measures if you like.
16.2.1 Innite mixture models: the negative binomial model

Regression analysis of ount data, hapter 4.
Referen e: Cameron and Trivedi (1998)
The two measures seem to exhibit extra-Poisson variation.

heterogeneity, a possibility is the
random parameters
To apture unobserved
approa h. Consider the possibility
that the onstant term in a Poisson model were random:
exp() y
y!
= exp(x + )
fY (y|x, ) =
= exp(x) exp()
=
where
= exp(x )
and
= exp().
Now
The problem is that we don't observe
density
fY (y|x) =
This density
an
aptures the randomness in the onstant.
so we will need to marginalize it to get a usable
exp[] y
fv (z)dz
y!
be used dire tly, perhaps using numeri al integration to evaluate the
likelihood fun tion. In some ases, though, the integral will have an analyti solution. For
16.2.
235
EXAMPLE: THE MEPS DATA
example, if
follows a ertain one parameter gamma density, then
(y + )
fY (y|x, ) =
(y + 1)()
where
= (, ).
For this density,
The varian e depends upon how

y
(16.1)
appears sin e it is the parameter of the gamma density.
E(y|x) = ,
whi h we have parameterized

is parameterized.
If
= /,
x,
so that the varian e is too. This is referred to as the NB-I model.
If
= 1/,
where
where
> 0,
= exp(x )
> 0,
then
then
V (y|x) = + .
Note that
V (y|x) = + 2 .
is a fun tion of
This is referred to as the
NB-II model.
So both forms of the NB model allow for overdispersion, with the NB-II model allowing
for a more radi al form.
Testing redu tion of a NB model to a Poisson model annot be done by testing
=0
using standard Wald or LR pro edures. The riti al values need to be adjusted to a ount
for the fa t that
=0
is on the boundary of the parameter spa e. Without getting into
details, suppose that the data were in fa t Poisson, so there is equidispersion and the true
= 0.
Then about half the time the sample data will be underdispersed, and about half
the time overdispersed. When the data is underdispersed, the MLE of
will be
= 0.
Thus, under the null, there will be a probability spike in the asymptoti distribution of
n(
) =
at 0, so standard testing methods will not be valid.
This program will do estimation using the NB model. Note how modelargs is used to
sele t a NB-I or NB-II density. Here are NB-I estimation results for OBDV:

OBDV
======================================================
Used analyti gradient
-----------------------------------------------------Obje tive fun tion value 2.18573
Stepsize 0.0007
17 iterations
-----------------------------------------------------param
gradient hange
1.0965 0.0000 -0.0000
236
CHAPTER 16.
0.2551
0.2024
0.2289
0.1969
0.0769
0.0000
1.7146
QUASI-ML
-0.0000
0.0000
-0.0000
0.0000
0.0000 -0.0000
0.0000 -0.0000
0.0000 -0.0000
-0.0000
0.0000
-0.0000
0.0000
******************************************************
Negative Binomial model, MEPS 1996 full data set
Observations: 4564
onstant
pub. ins.
priv. ins.
sex
age
edu
in
alpha
estimate
-0.523
0.765
0.451
0.458
0.016
0.027
0.000
5.555
st. err
0.104
0.054
0.049
0.034
0.001
0.007
0.000
0.296
t-stat
-5.005
14.198
9.196
13.512
11.869
3.979
0.000
18.752
p-value
0.000
0.000
0.000
0.000
0.000
0.000
1.000
0.000
CAIC : 20026.7513
Avg. CAIC: 4.3880
BIC : 20018.7513
Avg. BIC:
4.3862
AIC : 19967.3437
Avg. AIC:
4.3750
******************************************************
Note that the parameter values of the last BFGS iteration are dierent that those
reported in the nal results. This ree ts two things - rst, the data were s aled before
doing the BFGS minimization, but the
mle_results
s ript takes this into a ount and
reports the results using the original s aling. But also, the parameterization
is used to enfor e the restri tion that
> 0.
The unrestri ted parameter
= exp( )
= log
is
used to dene the log-likelihood fun tion, sin e the BFGS minimization algorithm does
not do ontrained minimization. To get the standard error and t-statisti of the estimate
of
we need to use the delta method. This is done inside
mle_results,
the fun tion parameterize.m .

Likewise, here are NB-II results:

OBDV
======================================================
making use of
16.2.
237

Stepsize 0.0104394
13 iterations
-----------------------------------------------------param
1.0375
0.3673
0.2136
0.2816
0.3027
0.0843
-0.0048
0.4780
gradient
0.0000
-0.0000
0.0000
0.0000
0.0000
-0.0000
0.0000
-0.0000
hange
-0.0000
0.0000
-0.0000
-0.0000
0.0000
0.0000
-0.0000
0.0000
******************************************************
Negative Binomial model, MEPS 1996 full data set
Observations: 4564
onstant
pub. ins.
priv. ins.
sex
age
edu
in
alpha
estimate
-1.068
1.101
0.476
0.564
0.025
0.029
-0.000
1.613
st. err
0.161
0.095
0.081
0.050
0.002
0.009
0.000
0.055
t-stat
-6.622
11.611
5.880
11.166
12.240
3.106
-0.176
29.099
p-value
0.000
0.000
0.000
0.000
0.000
0.002
0.861
0.000
CAIC : 20019.7439
Avg. CAIC: 4.3864
BIC : 20011.7439
Avg. BIC:
4.3847
AIC : 19960.3362
Avg. AIC:
4.3734
******************************************************
For the OBDV usage measurel, the NB-II model does a slightly better job than the
NB-I model, in terms of the average log-likelihood and the information riteria (more
on this last in a moment).
238
CHAPTER 16.
QUASI-ML
Note that both versions of the NB model t mu h better than does the Poisson model
(see 13.4.2).
The estimated
is highly signi ant.
To he k the plausibility of the NB-II model, we an ompare the sample un onditional

varian e with the estimated un onditional varian e a ording to the NB-II model:
Pn
V[
(y) =
t )2
(
t=1 t +
. For OBDV and ERV (estimation results not reported), we get For OBDV,
n
Table 16.2: Marginal Varian es, Sample and Estimated (NB-II)

OBDV
ERV
Sample
38.09
0.151
Estimated
30.58
0.182
the overdispersion problem is signi antly better than in the Poisson ase, but there is still
some that is not aptured. For ERV, the negative binomial model seems to apture the
overdispersion adequately.
16.2.2 Finite mixture models: the mixed negative binomial model

The nite mixture approa h to tting health are demand was introdu ed by Deb and
Trivedi (1997). The mixture approa h has the intuitive appeal of allowing for subgroups
of the population with dierent health status. If individuals are lassied as healthy or
unhealthy then two subgroups are dened.
A ner lassi ation s heme would lead to
more subgroups. Many studies have in orporated obje tive and/or subje tive indi ators of
health status in an eort to apture this heterogeneity. The available obje tive measures,
su h as limitations on a tivity, are not ne essarily very informative about a person's overall
health status. Subje tive, self-reported measures may suer from the same problem, and
may also not be exogenous
Finite mixture models are on eptually simple. The density is
fY (y, 1 , ..., p , 1 , ..., p1 ) =
p1
X
(i)
i fY (y, i ) + p fYp (y, p ),
i=1
where
i > 0, i = 1, 2, ..., p, p = 1
that the
Pp1
i=1
i ,
and
are ordered in some way, for example,
Pp
i=1 i
= 1.
Identi ation requires
1 2 p
and
i 6= j , i 6= j .
This is simple to a omplish post-estimation by rearrangement and possible elimination of

redundant omponent densities.
The properties of the mixture density follow in a straightforward way from those of
the omponents. In parti ular, the moment generating fun tion is the same mixture
of the moment generating fun tions of the omponent densities, so, for example,
E(Y |x) =
Pp
i=1 i i (x), where
i (x)
is the mean of the
ith
omponent density.
Mixture densities may suer from overparameterization, sin e the total number of
parameters grows rapidly with the number of omponent densities. It is possible to
onstrained parameters a ross the mixtures.
16.2.
239
Testing for the number of omponent densities is a tri ky issue. For example, testing
for
p=1
(a single omponent, whi h is to say, no mixture) versus
of two omponents) involves the restri tion

parameter spa e. Not that when
1 = 1,
1 = 1,
p=2
(a mixture
whi h is on the boundary of the
the parameters of the se ond omponent
an take on any value without ae ting the density.
Usual methods su h as the
likelihood ratio test are not appli able when parameters are on the boundary under
the null hypothesis. Information riteria means of hoosing the model (see below)
are valid.
The following results are for a mixture of 2 NB-II models, for the OBDV data, whi h you
an repli ate using this program .
OBDV
******************************************************
Mixed Negative Binomial model, MEPS 1996 full data set
Observations: 4564
onstant
pub. ins.
priv. ins.
sex
age
edu
in
alpha
onstant
pub. ins.
priv. ins.
sex
age
edu
in
alpha
Mix
estimate
0.127
0.861
0.146
0.346
0.024
0.025
-0.000
1.351
0.525
0.422
0.377
0.400
0.296
0.111
0.014
1.034
0.257
st. err
0.512
0.174
0.193
0.115
0.004
0.016
0.000
0.168
0.196
0.048
0.087
0.059
0.036
0.042
0.051
0.187
0.162
t-stat
0.247
4.962
0.755
3.017
6.117
1.590
-0.214
8.061
2.678
8.752
4.349
6.773
8.178
2.634
0.274
5.518
1.582
p-value
0.805
0.000
0.450
0.003
0.000
0.112
0.831
0.000
0.007
0.000
0.000
0.000
0.000
0.008
0.784
0.000
0.114
CAIC : 19920.3807
Avg. CAIC: 4.3647
BIC : 19903.3807
Avg. BIC:
4.3610
AIC : 19794.1395
Avg. AIC:
4.3370
******************************************************
It is worth noting that the mixture parameter is not signi antly dierent from zero,
240
CHAPTER 16.
QUASI-ML
but also not that the oe ients of publi insuran e and age, for example, dier quite a
bit between the two latent lasses.
16.2.3 Information riteria

As seen above, a Poisson model an't be tested (using standard methods) as a restri tion of
a negative binomial model. But it seems, based upon the values of the likelihood fun tions
and the fa t that the NB model ts the varian e mu h better, that the NB model is more
appropriate. How an we determine whi h of a set of ompeting models is the best?
The information riteria approa h is one possibility. Information riteria are fun tions
of the log-likelihood, with a penalty for the number of parameters used. Three popular
information riteria are the Akaike (AIC), Bayes (BIC) and onsistent Akaike (CAIC). The
formulae are
+ k(ln n + 1)
CAIC = 2 ln L()
+ k ln n
BIC = 2 ln L()
+ 2k
AIC = 2 ln L()
It an be shown that the CAIC and BIC will sele t the orre tly spe ied model from
a group of models, asymptoti ally. This doesn't mean, of ourse, that the orre t model
is ne esarily in the group.
The AIC is not onsistent, and will asymptoti ally favor an
over-parameterized model over the orre tly spe ied model. Here are information riteria
values for the models we've seen, for OBDV. Pretty learly, the NB models are better
Table 16.3: Information Criteria, OBDV

Model
AIC
BIC
CAIC
Poisson
7.345
7.355
7.357
NB-I
4.375
4.386
4.388
NB-II
4.373
4.385
4.386
MNB-II
4.337
4.361
4.365
than the Poisson. The one additional parameter gives a very signi ant improvement in
the likelihood fun tion value. Between the NB-I and NB-II models, the NB-II is slightly
favored.
But one should remember that information riteria values are statisti s, with
varian es. With another sample, it may well be that the NB-I model would be favored,
sin e the dieren es are so small. The MNB-II model is favored over the others, by all 3
information riteria.
Why is all of this in the hapter on QML? Let's suppose that the orre t model for
OBDV is in fa t the NB-II model. It turns out in this ase that the Poisson model will
give onsistent estimates of the slope parameters (if a model is a member of the linearexponential family and the onditional mean is orre tly spe ied, then the parameters of
the onditional mean will be onsistently estimated). So the Poisson estimator would be
a QML estimator that is onsistent for some parameters of the true model. The ordinary
OPG or inverse Hessinan ML ovarian e estimators are however biased and in onsistent,
sin e the information matrix equality does not hold for QML estimators. But for i.i.d. data
(whi h is the ase for the MEPS data) the QML asymptoti ovarian e an be onsistently
16.2.
estimated, as dis ussed above, using the sandwi h form for the ML estimator.
241
mle_results
in fa t reports sandwi h results, so the Poisson estimation results would be reliable for
inferen e even if the true model is the NB-I or NB-II. Not that they are in fa t similar to
the results for the NB models.
However, if we assume that the orre t model is the MNB-II model, as is favored by
the information riteria, then both the Poisson and NB-x models will have misspe ied
mean fun tions, so the parameters that inuen e the means would be estimated with bias
and in onsistently.
242
CHAPTER 16.
QUASI-ML
Exer ises
Considering the MEPS data (the des ription is in Se tion 13.4.2), for the OBDV (y )
measure, let
suspe t that
be a latent index of health status that has expe tation equal to unity.
and
P RIV
may be orrelated, but we assume that
We
the other regressors. We assume that
E(y|P U B, P RIV, AGE, EDU C, IN C, )

= exp(1 + 2 P U B + 3 P RIV + 4 AGE + 5 EDU C + 6 IN C).
We use the Poisson QML estimator of the model
Poisson()
= exp(1 + 2 P U B + 3 P RIV +
(16.2)
4 AGE + 5 EDU C + 6 IN C).

2
Sin e mu h previous eviden e indi ates that health are servi es usage is overdispersed ,
this is almost ertainly not an ML estimator, and thus is not e ient. However, when
and
P RIV
are un orrelated, this estimator is onsistent for the
onditional mean is orre tly spe ied in that ase.
When
and
parameters, sin e the
P RIV
are orrelated,
Mullahy's (1997) NLIV estimator that uses the residual fun tion
=
where
is dened
y
1,
in equation 16.2, with appropriate instruments, is onsistent. As instru-
ments we use all the exogenous regressors, as well as the ross produ ts of
variables in
Z = {AGE, EDU C, IN C}.
PUB
with the
That is, the full set of instruments is
W = {1 P U B Z P U B Z }.
1. Cal ulate the Poisson QML estimates.
(a) Cal ulate the generalized IV estimates (do it using a GMM formulation - see
the portfolio example for hints how to do this).
(b) Cal ulate the Hausman test statisti to test the exogeneity of PRIV.
( ) omment on the results
1
2
A restri tion of this sort is ne essary for identi ation.

Overdispersion exists when the onditional varian e is greater than the onditional mean. If this is
the ase, the Poisson spe i ation is not orre t.
Chapter 17
Nonlinear least squares (NLS)
Readings:
and 5 ; Gallant, Ch. 1
Davidson and Ma Kinnon, Ch. 2
17.1 Introdu tion and denition

Nonlinear least squares (NLS) is a means of estimating the parameter of the model
yt = f (xt , 0 ) + t .
In general,
will be heteros edasti and auto orrelated, and possibly nonnormally
distributed. However, dealing with this is exa tly as in the ase of linear models, so
we'll just treat the iid ase here,
t iid(0, 2 )
If we sta k the observations verti ally, dening
y = (y1 , y2 , ..., yn )
f = (f (x1 , ), f (x1 , ), ..., f (x1 , ))
and
= (1 , 2 , ..., n )
we an write the
observations as
y = f () +
Using this notation, the NLS estimator an be dened as
1
1
arg min sn () = [y f ()] [y f ()] = k y f () k2
n
n
The estimator minimizes the weighted sum of squared errors, whi h is the same as
minimizing the Eu lidean distan e between
The obje tive fun tion an be written as
243
and
f ().
244
CHAPTER 17.
sn () =
NONLINEAR LEAST SQUARES (NLS)

1
y y 2y f () + f () f () ,
n
whi h gives the rst order onditions

0.
f () y +
f () f ()
Dene the
nK
matrix
D f ().
F()
In shorthand, use
in pla e of
F().
(17.1)
Using this, the rst order onditions an be written
as
0,
y + F
f ()
F
or
h
i
0.
y f ()
F
(17.2)
This bears a good deal of similarity to the f.o. . for the linear model - the derivative of
the predi tion is orthogonal to the predi tion error. If
f () = X,
then
is simply
X,
so
the f.o. . (with spheri al errors) simplify to
X y X X = 0,
the usual 0LS f.o. .
INSERT drawings of geometri al depi tion of OLS

and NLS (see Davidson and Ma Kinnon, pgs. 8,13 and 46).
We an interpret this geometri ally:
Note that the nonlinearity of the manifold leads to potential multiple lo al maxima,
minima and saddlepoints: the obje tive fun tion
sn () is not ne essarily well-behaved
and may be di ult to minimize.
17.2 Identi ation

As before, identi ation an be onsidered onditional on the sample, and asymptoti ally.
sn () tend to a limiting fun tion s ()

0
. This will be the ase if s ( 0 ) is stri tly onvex at 0 ,
The ondition for asymptoti identi ation is that

su h that
( 0 )
< s (), 6=
whi h requires that
D2 s ( 0 )
be positive denite. Consider the obje tive fun tion:
sn () =
1X
[yt f (xt , )]2
n
t=1
=
=
n
2
1 X
f (xt , 0 ) + t ft (xt , )
n t=1
n
n
2 1 X
1 X
0
(t )2
ft ( ) ft () +
n
n
t=1
t=1
n

2 X
ft ( 0 ) ft () t
n
t=1
As in example 14.3, whi h illustrated the onsisten y of extremum estimators using
17.3.
245
CONSISTENCY
OLS, we on lude that the se ond term will onverge to a onstant whi h does not
depend upon
A LLN an be applied to the third term to on lude that it onverges pointwise to

0, as long as
f () and
are un orrelated.
Next, pointwise onvergen e needs to be stregnthened to uniform almost sure onvergen e. There are a number of possible assumptions one ould use. Here, we'll just
assume it holds.
Turning to the rst term, we'll assume a pointwise law of large numbers applies, so
n
2 a.s.
1 X
ft ( 0 ) ft ()
n
t=1
where
(x)
is the distribution fun tion of
and ontinuous, for all

x.
2
f (z, 0 ) f (z, ) d(z),
In many ases,
f (x, )
will
(17.3)
be bounded
, so strengthening to uniform almost sure onvergen e
immediate. For example if
f (x, ) = [1 + exp(x)]
range, and the fun tion is ontinuous in
Given these results, it is lear that a minimizer is
0.
, f : K (0, 1) ,
is
a bounded
When onsidering identi ation
(asymptoti ), the question is whether or not there may be some other minimizer. A lo al
ondition for identi ation is that
2
2
s () =

be positive denite at
0.
2
f (x, 0 ) f (x, ) d(x)
Evaluating this derivative, we obtain (after a little work)

2
f (x, ) f (x, ) d(x)
0
=2
0
D f (z, 0 )

D f (z, 0 ) d(z)
the expe tation of the outer produ t of the gradient of the regression fun tion evaluated at
0 . (Note: the uniform boundedness we have already assumed allows passing the derivative
through the integral, by the dominated onvergen e theorem.) This matrix will be positive
denite (wp1) as long as the gradient ve tor is of full rank (wp1). The tangent spa e to the
regression manifold must span a
-dimensional spa e if we are to onsistently estimate a
-dimensional parameter ve tor. This is analogous to the requirement that there be no
perfe t olinearity in a linear model. This is a ne essary ondition for identi ation. Note
that the LLN implies that the above expe tation is equal to
J ( 0 ) = 2 lim E
F F
n
17.3 Consisten y
We simply assume that the onditions of Theorem 19 hold, so the estimator is onsistent.
Given that the strong sto hasti equi ontinuity onditions hold, as dis ussed above, and
given the above identi ation onditions an a ompa t estimation spa e (the losure of the
parameter spa e
),
the onsisten y proof 's assumptions are satised.
246
CHAPTER 17.
As in the ase of GMM, we also simply assume that the onditions for asymptoti normality
as in Theorem 22 hold.
The only remaining problem is to determine the form of the
asymptoti varian e- ovarian e matrix. Re all that the result of the asymptoti normality
theorem is
where
J ( 0 )

d
n 0 N 0, J ( 0 )1 I ( 0 )J ( 0 )1 ,
2
sn () evaluated at
is the almost sure limit of
0,
and
I ( 0 ) = lim V ar nD sn ( 0 )
The obje tive fun tion is
sn () =
1X
[yt f (xt , )]2
n
t=1
So
2X
D sn () =
[yt f (xt , )] D f (xt , ).
n
t=1
Evaluating at
0,
D sn ( 0 ) =
2X
t D f (xt , 0 ).
n
t=1
Note that the expe tation of this is zero, sin e
and
xt
are assumed to be un orrelated.
So to al ulate the varian e, we an simply al ulate the se ond moment about zero. Also
note that
n
X
t D f (xt , 0 ) =
t=1
0
f ( )
= F
With this we obtain
I ( 0 ) = lim V ar nD sn ( 0 )
4
= lim nE 2 F ' F
n
F F
= 4 2 lim E
n
J ( 0 ) = 2 lim E
F F
,
n
where the expe tation is with respe t to the joint density of
0
expressions for J ( ) and
we get
and
Combining these
I ( 0 ), and the result of the asymptoti normality theorem,

d
n 0 N
F F
0, lim E
n
1
17.5.
247
EXAMPLE: THE POISSON MODEL FOR COUNT DATA
We an onsistently estimate the varian e ovarian e matrix using
F
n
where
!1
2,
(17.4)
is dened as in equation 17.1 and
2 =
i h
i
y f ()
y f ()
n
the obvious estimator. Note the lose orresponden e to the results for the linear model.
17.5 Example: The Poisson model for ount data

Suppose that
yt
onditional on
ount data
variable is a
xt
is independently distributed Poisson. A Poisson random
variable, whi h means it an take the values {0,1,2,...}. This sort
of model has been used to study visits to do tors per year, number of patents registered
by businesses per year,
et .
The Poisson density is
f (yt ) =
The mean of
yt
is
t ,
exp(t )yt t
, yt {0, 1, 2, ...}.
yt !
as is the varian e. Note that
must be positive. Suppose that the
true mean is
0t = exp(xt 0 ),
whi h enfor es the positivity of
t .
Suppose we estimate
by nonlinear least squares:
n
2
1X
= arg min sn () =
yt exp(xt )
T t=1
We an write
sn () =
=
n
2
1X
exp(xt 0 + t exp(xt )
T t=1
n
n
n

2 1 X
1X
1X
2t + 2
t exp(xt 0 exp(xt )
exp(xt 0 exp(xt ) +
T
T
T
t=1
t=1
t=1
The last term has expe tation zero sin e the assumption that
that
E (t |xt ) = 0,
whi h in turn implies that fun tions of
E(yt |xt ) = exp(xt 0 ) implies
xt
are un orrelated with
t .
Applying a strong LLN, and noting that the obje tive fun tion is ontinuous on a ompa t
parameter spa e, we get
2
s () = Ex exp(x 0 exp(x ) + Ex exp(x 0 )
where the last term omes from the fa t that the onditional varian e of
the varian e of
y.
This fun tion is learly minimized at
onsistent as long as identi ation holds.
is the same as
0 , so the NLS estimator is
248
CHAPTER 17.

n 0 .
Exer ise 27 Determine the limiting distribution of

n ()
of sn (), J ( 0 ), s
,
the spe i forms

no need to verify that it an be applied.
2
This means nding the
and I( 0 ). Again, use a CLT as needed,
17.6 The Gauss-Newton algorithm

Readings: Davidson and Ma Kinnon,
Chapter 6, pgs. 201-207 .
The Gauss-Newton optimization te hnique is spe i ally designed for nonlinear least
squares. The idea is to linearize the nonlinear model, rather than the obje tive fun tion.
The model is
y = f ( 0 ) + .
At some
in the parameter spa e, not equal to
0,
we have
y = f () +
where
is a ombination of the fundamental error term
the regression fun tion at
approximation around a point
Dene
and the error due to evaluating
0
rather than the true value . Take a rst order Taylor's series
1 :

y = f ( 1 ) + D f 1
1 + + approximation
z y f ( 1 )
and
b ( 1 ).
error.
Then the last equation an be written as
z = F( 1 )b + ,
where, as above,
F( 1 ) D f ( 1 )
1
fun tion, evaluated at , and
is
is the
nK
matrix of derivatives of the regression
plus approximation error from the trun ated Taylor's
series.
1.
Note that
Note that one ould estimate
Given
b,
is known, given
simply by performing OLS on the above equation.
we al ulate a new round estimate of
as
2 = b + 1 .
With this, take a
2
new Taylor's series expansion around and repeat the pro ess. Stop when
b = 0
(to within a spe ied toleran e).
To see why this might work, onsider the above approximation, but evaluated at the NLS
estimator:
The OLS estimate of

+ F()
+
y = f ()
b is

1 h
i
b = F
.
F
y f ()
F
This must be zero, sin e
h
i
0
y f ()
F
17.7.
APPLICATION: LIMITED DEPENDENT VARIABLES AND SAMPLE SELECTION249
by denition of the NLS estimator (these are the normal equations as in equation 17.2,
Sin e
b 0
when we evaluate at
updating would stop.
The Gauss-Newton method doesn't require se ond derivatives, as does the Newton-
The var ov estimator, as in equation 17.4 is simple to al ulate, sin e we have
Raphson method, so it's faster.
as a
F
i.e., it's just the last round regressor matrix).
by-produ t of the estimation pro ess (
In fa t, a normal OLS program will give the NLS var ov estimator dire tly, sin e it's
just the OLS var ov estimator from the last iteration.
The method an suer from onvergen e problems sin e
F() F(),
may be very
nearly singular, even with an asymptoti ally identied model, espe ially if
far from
is very
Consider the example
y = 1 + 2 xt 3 + t
When evaluated at
so
2 0, 3
has virtually no ee t on the NLS obje tive fun tion,
will have rank that is essentially 2, rather than 3. In this ase,
F F
will be
1 will be subje t to large roundo errors.

nearly singular, so (F F)
17.7 Appli ation: Limited dependent variables and sample

sele tion
Readings:
Davidson and Ma Kinnon, Ch. 15
(a qui k reading is su ient), J. He kman,
Sample Sele tion Bias as a Spe i ation Error,
E onometri a,
arti le, not required for reading, and whi h is a bit out-dated.
1979 (This is a lassi

Nevertheless it's a good
pla e to start if you en ounter sample sele tion problems in your resear h).
Sample sele tion is a ommon problem in applied resear h. The problem o urs when
observations used in estimation are sampled non-randomly, a ording to some sele tion
s heme.
17.7.1 Example: Labor Supply

Labor supply of a person is a positive number of hours per unit time supposing the oer
wage is higher than the reservation wage, whi h is the wage at whi h the person prefers
not to work. The model (very simple, with
Chara teristi s of individual:
Latent labor supply:
Oer wage:
Reservation wage:
subs ripts suppressed):
s = x +
wo = z +
wr = q +
Write the wage dierential as
w =

z + q +
r +
250
CHAPTER 17.
We have the set of equations
s = x +
w = r + .
"
Assume that
"
0
0
# "
,
#!
We assume that the oer wage and the reservation wage, as well as the latent variable
are unobservable. What is observed is
w = 1 [w > 0]
s = ws .
In other words, we observe whether or not a person is working. If the person is working,
we observe labor supply, whi h is equal to latent labor supply,
s .
Otherwise,
s = 0 6= s .
Note that we are using a simplifying assumption that individuals an freely hoose their
weekly hours of work.
Suppose we estimated the model
s = x + residual
using only observations for whi h
for whi h
sin e
w > 0,
and
or equivalently,
s > 0.
The problem is that these observations are those
< r
and

E | < r 6= 0,
are dependent. Furthermore, this expe tation will in general depend on
sin e elements of
an enter in
r.
Be ause of these two fa ts, least squares estimation is
biased and in onsistent.
Consider more arefully
E [| < r ] .
write (see for example Spanos
Given the joint normality of
and
we an
Statisti al Foundations of E onometri Modelling, pg.

= + ,
where
has mean zero and is independent of
With this we an write
s = x + + .
If we ondition this equation on
< r
we get
s = x + E(| < r ) +
whi h may be written as
s = x + E(| > r ) +
122)
APPLICATION: LIMITED DEPENDENT VARIABLES AND SAMPLE SELECTION251
17.7.
A useful result is that for
z N (0, 1)
E(z|z > z ) =
where
()
()
and
(z )
,
(z )
are the standard normal density and distribution fun tion,
respe tively. The quantity on the RHS above is known as the
IM R(z ) =
inverse Mill's ratio:
(z )
(z )
With this we an write (making use of the fa t that the standard normal density is
symmetri about zero, so that
(a) = (a)):
(r )
+
(r )
#
"
i
(r )
s = x +
where
= .
regressors
The error term
(r )
(r )
(r )
(17.5)
+ .
(17.6)
has onditional mean zero, and is un orrelated with the
At this point, we an estimate the equation by NLS.
He kman showed how one an estimate this in a two step pro edure where rst
is
estimated, then equation 17.6 is estimated by least squares using the estimated value
of
to form the regressors. This is ine ient and estimation of the ovarian e is a
tri ky issue. It is probably easier (and more e ient) just to do MLE.
The model presented above depends strongly on joint normality. There exist many
alternative models whi h weaken the maintained assumptions. It is possible to estimate onsistently without distributional assumptions. See Ahn and Powell,
of E onometri s, 1994.
Journal
252
CHAPTER 17.
Chapter 18
Nonparametri inferen e
18.1 Possible pitfalls of parametri inferen e: estimation
Readings:
Fun tions,
H. White (1980) Using Least Squares to Approximate Unknown Regression
International E onomi Review, pp.
149-70.
In this se tion we onsider a simple example, whi h illustrates both why nonparametri
methods may in some ases be preferred to parametri methods.
We suppose that data is generated by random sampling of
is uniformly distributed on
(0, 2),
and
y = f (x) +,
where
is a lassi al error. Suppose that
f (x) = 1 +
3x x 2
2
2
The problem of interest is to estimate the elasti ity of

the range of
(y, x),
f (x)
with respe t to
x,
throughout
x.
In general, the fun tional form of

series approximation to
f (x)
f (x)
is unknown.
about some point
x0 .
One idea is to take a Taylor's
Flexible fun tional forms su h as the
trans endental logarithmi (usually know as the translog) an be interpreted as se ond

order Taylor's series approximations.
simpli ity. Approximating about
We'll work with a rst order approximation, for
x0 :
h(x) = f (x0 ) + Dx f (x0 ) (x x0 )

If the approximation point is
x0 = 0,
we an write
h(x) = a + bx
The oe ient
derivative at
is the value of the fun tion at
x = 0.
x = 0,
and the slope is the value of the
These are of ourse not known. One might try estimation by ordinary
least squares. The obje tive fun tion is
s(a, b) = 1/n
n
X
t=1
(yt h(xt ))2 .
The limiting obje tive fun tion, following the argument we used to get equations 14.1 and
253
254
CHAPTER 18.
NONPARAMETRIC INFERENCE
Figure 18.1: True and simple approximating fun tions
3.5
approx
true
3.0
2.5
2.0
1.5
1.0
0
17.3 is
s (a, b) =
2
0
(f (x) h(x))2 dx.
The theorem regarding the onsisten y of extremum estimators (Theorem 19) tells us that
and
fun tion.
at
will onverge almost surely to the values that minimize the limiting obje tive
Solving the rst order onditions

0 7 0
a = 6 , b = 1 .
s (a, b) obtains
fun tion h(x)

therefore
reveals that
The estimated approximating
its minimum
tends almost
surely to
h (x) = 7/6 + x/
In Figure 18.1 we see the true fun tion and the limit of the approximation to see the
asymptoti bias as a fun tion of
x.
(The approximating model is the straight line, the true model has urvature.)
Note
that the approximating model is in general in onsistent, even at the approximation point.
This shows that exible fun tional forms based upon Taylor's series approximations do
not in general lead to onsistent estimation of fun tions.
The approximating model seems to t the true model fairly well, asymptoti ally. However, we are interested in the elasti ity of the fun tion.
Re all that an elasti ity is the
marginal fun tion divided by the average fun tion:
(x) = x (x)/(x)
Good approximation of the elasti ity over the range of
of both
f (x)
and f (x) over the range of
x.
x will require a good approximation
The approximating elasti ity is
(x) = xh (x)/h(x)
1
maxima -b fff.ma You an

http://pareto.uab.es/m reel/E onometri s/Examples/Nonparametri /fff.ma .
The following results were obtained using the ommand
le at
get the sour e
18.1.
POSSIBLE PITFALLS OF PARAMETRIC INFERENCE: ESTIMATION
255
Figure 18.2: True and approximating elasti ities
0.7
approx
true
0.6
0.5
0.4
0.3
0.2
0.1
0.0
0
In Figure 18.2 we see the true elasti ity and the elasti ity obtained from the limiting
approximating model.
The true elasti ity is the line that has negative slope for large
x.
Visually we see that
the elasti ity is not approximated so well. Root mean squared error in the approximation
of the elasti ity is
Z
((x) (x)) dx
1/2
= . 31546
Now suppose we use the leading terms of a trigonometri series as the approximating
model. The reason for using a trigonometri series as an approximating model is motivated
by the asymptoti properties of the Fourier exible fun tional form (Gallant, 1981, 1982),
whi h we will study in more detail below. Normally with this type of model the number
of basis fun tions is an in reasing fun tion of the sample size.
Here we hold the set of
basis fun tion xed. We will onsider the asymptoti behavior of a xed model, whi h we
interpret as an approximation to the estimator's behavior in nite samples. Consider the
set of basis fun tions:
Z(x) =
1 x cos(x) sin(x) cos(2x) sin(2x)
The approximating model is
gK (x) = Z(x).
Maintaining these basis fun tions as the sample size in reases, we nd that the limiting
obje tive fun tion is minimized at

7
1
1
1
a1 = , a2 = , a3 = 2 , a4 = 0, a5 = 2 , a6 = 0 .
6
4
Substituting these values into
gK (x)

we obtain the almost sure limit of the approximation
1
g (x) = 7/6 + x/ + (cos x) 2
1
+ (sin x) 0 + (cos 2x) 2
4
+ (sin 2x) 0
(18.1)
256
CHAPTER 18.
Figure 18.3: True fun tion and more exible approximation
3.5
approx
true
3.0
2.5
2.0
1.5
1.0
0
Figure 18.4: True elasti ity and more exible approximation
0.7
approx
true
0.6
0.5
0.4
0.3
0.2
0.1
0.0
0
In Figure 18.3 we have the approximation and the true fun tion: Clearly the trun ated
trigonometri series model oers a better approximation, asymptoti ally, than does the
linear model.
In Figure 18.4 we have the more exible approximation's elasti ity and
that of the true fun tion: On average, the t is better, though there is some implausible
wavyness in the estimate. Root mean squared error in the approximation of the elasti ity
is
g (x)x
(x)
g (x)
2
dx
!1/2
= . 16213,
about half that of the RMSE when the rst order approximation is used. If the trigonometri series ontained innite terms, this error measure would be driven to zero, as we
shall see.
18.2.
POSSIBLE PITFALLS OF PARAMETRIC INFERENCE: HYPOTHESIS TESTING257
18.2 Possible pitfalls of parametri inferen e: hypothesis testing

What do we mean by the term nonparametri inferen e? Simply, this means inferen es
that are possible without restri ting the fun tions of interest to belong to a parametri
family.
Consider means of testing for the hypothesis that onsumers maximize utility.
2
onsequen e of utility maximization is that the Slutsky matrix Dp h(p, U ), where
h(p, U )
are the a set of ompensated demand fun tions, must be negative semi-
denite. One approa h to testing for utility maximization would estimate a set of
normal demand fun tions
x(p, m).
Estimation of these fun tions by normal parametri methods requires spe i ation
of the fun tional form of demand, for example
x(p, m) = x(p, m, 0 ) + , 0 0 ,
where
x(p, m, 0 )
is a fun tion of known form and
is a nite dimensional param-
eter.
to al ulate (by solving the integrability

x
= x(p, m, )
b 2 h(p, U ). If we an statisti ally reje t that the matrix
problem, whi h is non-trivial) D
After estimation, we ould use
is negative semi-denite, we might on lude that onsumers don't maximize utility.
The problem with this is that the reason for reje tion of the theoreti al proposition
may be that our hoi e of fun tional form is in orre t. In the introdu tory se tion
we saw that fun tional form misspe i ation leads to in onsistent estimation of the
fun tion and its derivatives.
Testing using parametri models always means we are testing a ompound hypothesis.
The hypothesis that is tested is 1) the e onomi proposition we wish to test, and 2)
the model is orre tly spe ied. Failure of either 1) or 2) an lead to reje tion. This
is known as the model-indu ed augmenting hypothesis.
Varian's WARP allows one to test for utility maximization without spe ifying the
form of the demand fun tions.
The only assumptions used in the test are those
dire tly implied by theory, so reje tion of the hypothesis alls into question the theory.
Nonparametri inferen e allows dire t testing of e onomi propositions, without the

model-indu ed augmenting hypothesis.
18.3 The Fourier fun tional form

Readings:
sion, in
Gallant, 1987, Identi ation and onsisten y in semi-nonparametri regres-
Advan es in E onometri s, Fifth World Congress,
Cambridge.
V. 1, Truman Bewley, ed.,
258
CHAPTER 18.
Suppose we have a multivariate model
y = f (x) + ,
where
f (x)
is of unknown form and
assume that
is a lassi al error.
is a
P dimensional
ve tor.
For simpli ity,
Let us take the estimation of the ve tor of elasti ities
with typi al element
x i =
at an arbitrary point
xi f (x)
,
f (x) xi f (x)
xi .
The Fourier form, following Gallant (1982), but with a somewhat dierent parameterization, may be written as
A X
J
X
gK (x | K ) = + x + 1/2x Cx +
where the
K -dimensional
=1 j=1

uj cos(jk x) vj sin(jk x) .
parameter ve tor
K = {, , vec (C) , u11 , v11 , . . . , uJA , vJA } .
(18.2)
We assume that the onditioning variables

an interval that is shorter than
2.
(18.3)
have ea h been transformed to lie in
This is required to avoid periodi behavior of
the approximation, whi h is desirable sin e e onomi fun tions aren't periodi . For
example, subtra t sample means, divide by the maxima of the onditioning variables,
and multiply by
The
2 eps,
eps
where
k are elementary multi-indi es
(negative, positive and zero).
The
is some positive number less than

whi h are simply
in value.
P ve tors formed of integers
k , = 1, 2, ..., A
are required to be linearly
independent, and we follow the onvention that the rst non-zero element be positive.
For example
0 1 1 0 1
is a potential multi-index to be used, but
0 1 1 0 1
i
i
is not sin e its rst nonzero element is negative. Nor is
0 2 2 0 2
a multi-index we would use, sin e it is a s alar multiple of the original multi-index.
We parameterize the matrix
dierently than does Gallant be ause it simplies
things in pra ti e. The ost of this is that we are no longer able to test a quadrati
spe i ation using nested testing.
The ve tor of rst partial derivatives is
18.3.
259
THE FOURIER FUNCTIONAL FORM
Dx gK (x | K ) = + Cx +
A X
J
X
=1 j=1

uj sin(jk x) vj cos(jk x) jk
(18.4)
and the matrix of se ond partial derivatives is
Dx2 gK (x|K ) = C +
A X
J
X
=1 j=1

uj cos(jk x) + vj sin(jk x) j 2 k k
To dene a ompa t notation for partial derivatives, let

index with no negative elements. Dene
arguments
be an
N -dimensional
| as the sum of the elements of
multi-
If we have
of the (arbitrary) fun tion h(x), use D h(x) to indi ate a ertain partial
derivative:
||
D h(x)
When
(18.5)
x1 1 x2 2 xNN
is the zero ve tor, D h(x) h(x).
h(x)
Taking this denition and the last few equations
into a ount, we see that it is possible to dene
(1 K)
ve tor
Z (x)
so that
D gK (x|K ) = z (x) K .
(18.6)
Both the approximating model and the derivatives of the approximating model are
For the approximating model to the fun tion (not derivatives), write
linear in the parameters.
gK (x|K ) =
K for simpli ity.
The following theorem an be used to prove the onsisten y of the Fourier form.
Theorem 28 [Gallant and Ny hka, 1987 Suppose that h n is obtained by maximizing a
sample obje tive fun tion sn(h) over HKn where HK is a subset of some fun tion spa e H
on whi h is dened a norm k h k. Consider the following onditions:
(a) Compa tness: The losure of H with respe t to k h k is ompa t in the relative
topology dened by k h k.
(b) Denseness: K HK , K = 1, 2, 3, ... is a dense subset of the losure of H with respe t
to k h k and HK HK+1.
( ) Uniform onvergen e: There is a point h in H and there is a fun tion s (h, h )
that is ontinuous in h with respe t to k h k su h that
lim sup | sn (h) s (h, h ) |= 0
almost surely.
(d) Identi ation: Any point h in the losure of H with s (h, h ) s (h , h ) must
have k h h k= 0.
Under these onditions limn k h h n k= 0 almost surely, provided that limn Kn =
almost surely.
260
CHAPTER 18.
The modi ation of the original statement of the theorem that has been made is to set
the parameter spa e
in Gallant and Ny hka's (1987) Theorem 0 to a single point and to
state the theorem in terms of maximization rather than minimization.

This theorem is very similar in form to Theorem 19. The main dieren es are:
1. A generi norm
k h k
is used in pla e of the Eu lidean norm.
This norm may be
stronger than the Eu lidean norm, so that onvergen e with respe t to
khk
implies
onvergen e w.r.t the Eu lidean norm. Typi ally we will want to make sure that the
norm is strong enough to imply onvergen e of all fun tions of interest.
2. The estimation spa e
in
H is a fun tion spa e.
It plays the role of the parameter spa e
our dis ussion of parametri estimators. There is no restri tion to a parametri
family, only a restri tion to a spa e of fun tions that satisfy ertain onditions. This
formulation is mu h less restri tive than the restri tion to a parametri family.
3. There is a denseness assumption that was not present in the other theorem.
We will not prove this theorem (the proof is quite similar to the proof of theorem [19, see
Gallant, 1987) but we will dis uss its assumptions, in relation to the Fourier form as the
approximating model.
18.3.1 Sobolev norm

Sin e all of the assumptions involve the norm
we wish to use.
khk
, we need to make expli it what norm
We need a norm that guarantees that the errors in approximation of
the fun tions we are interested in are a ounted for. Sin e we are interested in rst-order
elasti ities in the present ase, we need lose approximation of both the fun tion
its rst derivative f (x), throughout the range of

all values of
x.
Let
f (x)
and
be an open set that ontains
that we're interested in. The Sobolev norm is appropriate in this ase. It is
dened, making use of our notation for partial derivatives, as:

k h km,X = max sup D h(x)
| |m X
To see whether or not the fun tion
gK (x | K ),
f (x)
is well approximated by an approximating model
we would evaluate
k f (x) gK (x | K ) km,X .
We see that this norm takes into a ount errors in approximating the fun tion and partial
derivatives up to order
m.
this example, the relevant

over
X,
onvergen e w.r.t.
If we want to estimate rst order elasti ities, as is the ase in
would be
m = 1.
the Sobolev means
onsistent estimates for all values of
Furthermore, sin e we examine the
uniform
sup
onvergen e, so that we obtain
x.
18.3.2 Compa tness

Verifying ompa tness with respe t to this norm is quite te hni al and unenlightening. It
is proven by Elbadawi, Gallant and Souza,
E onometri a,
1983. The basi requirement is
18.3.
261
that if we need onsisten y w.r.t.
k h km,X ,
then the fun tions of interest must belong to
a Sobolev spa e whi h takes into a ount derivatives of order
m + 1.
A Sobolev spa e is
the set of fun tions
Wm,X (D) = {h(x) :k h(x) km,X < D},

where
is a nite onstant.
In plain words, the fun tions must have bounded partial
derivatives of one order higher than the derivatives we seek to estimate.
18.3.3 The estimation spa e and the estimation subspa e

Sin e in our ase we're interested in onsistent estimation of rst-order elasti ities, we'll
dene the estimation spa e as follows:
Denition 29 [Estimation spa e The estimation spa e H = W2,X (D). The estimation
spa e is an open set, and we presume that h H.
So we are assuming that the fun tion to be estimated has bounded se ond derivatives
throughout
X.
With seminonparametri estimators, we don't a tually optimize over the estimation

spa e. Rather, we optimize over a subspa e,
HK n ,
dened as:
Denition 30 [Estimation subspa e The estimation subspa e HK is dened as

HK = {gK (x|K ) : gK (x|K ) W2,Z (D), K K },
where gK (x, K ) is the Fourier form approximation as dened in Equation 18.2.
18.3.4 Denseness
The important point here is that
dimensional parameter (K has
n > K,
HK
is a spa e of fun tions that is indexed by a nite
elements, as in equation 18.3).
element of
HK ,
so optimization over
for optimization over

we need that:
HK
HK
observations,
may not lead to a onsistent estimator. In order
to be equivalent to optimization over
1. The dimension of the parameter ve tor,

by making
lear that
and
H, at
as
be dense subsets of
HK ,
. A set of subsets
Aa
n.
least asymptoti ally,
n .
in equation 18.2 in reasing fun tions of
HK
The estimation subspa e
dim Kn
will have to grow more slowly than
2. We need that the
spa e,
With
this parameter is estimable. Note that the true fun tion h is not ne essarily an
n,
This is a hieved
the sample size. It is
The se ond requirement is:
H.
dened above, is a subset of the losure of the estimation

of a set
of the subsets is equal to the losure of
is dense if the losure of the ountable union
A:
a=1 Aa = A
Use a pi ture here. The rest of the dis ussion of denseness is provided just for ompleteness:
there's no need to study it in detail. To show that HK is a dense subset of H with respe t
262
to
CHAPTER 18.
k h k1,X ,
it is useful to apply Theorem 1 of Gallant (1982), who in turn ites Edmunds
and Mos atelli (1977).
We reprodu e the theorem as presented by Gallant, with minor
notational hanges, for onvenien e of referen e:
Theorem 31 [Edmunds and Mos atelli, 1977 Let the real-valued fun tion h (x) be on-
tinuously dierentiable up to order m on an open set ontaining the losure of X . Then it

is possible to hoose a triangular array of oe ients 1 , 2 , . . . K , . . . , su h that for every
q with 0 q < m, and every > 0, k h (x) hK (x|K ) kq,X = o(K m+q+ ) as K .
In the present appli ation,
elements of
losure of
HK
X,
q = 1, and m = 2.
By denition of the estimation spa e, the
are on e ontinuously dierentiable on
X,
whi h is open and ontains the
so the theorem is appli able. Closely following Gallant and Ny hka (1987),
HK .
is the ountable union of the
a sequen e of {hK } from
HK
The impli ation of Theorem 31 is that there is
su h that
lim k h hK k1,X = 0,
K
for all
h H.
Therefore,
H HK .
However,
HK H,
so
HK H.
Therefore
H = HK ,
so
HK
is a dense subset of
H,
with respe t to the norm
k h k1,X .
18.3.5 Uniform onvergen e

We now turn to the limiting obje tive fun tion. We estimate by OLS. The sample obje tive
fun tion stated in terms of maximization is
sn (K ) =
1X
(yt gK (xt | K ))2
n
t=1
With random sampling, as in the ase of Equations 14.1 and 17.3, the limiting obje tive
fun tion is
s (g, f ) =
where the true fun tion
of the theorem. Both
f (x)
g(x)
(f (x) g(x))2 dx 2 .
takes the pla e of the generi fun tion
and
f (x)
are elements of
(18.7)
in the presentation
HK .
The pointwise onvergen e of the obje tive fun tion needs to be strengthened to uniform
onvergen e. We will simply assume that this holds, sin e the way to verify this depends
upon the spe i appli ation. We also have ontinuity of the obje tive fun tion in
g,
with
18.3.
263
respe t to the norm
k h k1,X
sin e
lim
kg 1 g 0 k1,X 0
lim

s g 1 , f ) s g 0 , f )
Z h
2
2 i
dx.
g1 (x) f (x) g0 (x) f (x)
kg 1 g 0 k1,X 0 X
By the dominated onvergen e theorem (whi h applies sin e the nite bound
dene
W2,Z (D)
used to
is dominated by an integrable fun tion), the limit and the integral an be
inter hanged, so by inspe tion, the limit is zero.
18.3.6 Identi ation

The identi ation ondition requires that for any point
k g f k1,X = 0.
(g, f ) in HH, s (g, f ) s (f, f )
This ondition is learly satised given that
and
are on e
ontinuously dierentiable (by the assumption that denes the estimation spa e).
18.3.7 Review of on epts

For the example of estimation of rst-order elasti ities, the relevant on epts are:
Estimation spa e
fun tion must lie.
H = W2,X (D):
Consisten y norm
k h k1,X .
Estimation subspa e
HK .
The losure of
is ompa t with respe t to this norm.
The estimation subspa e is the subset of
sentable by a Fourier form with parameter
sn (K ),
Sample obje tive fun tion
Limiting obje tive fun tion
K .
that is repre-
These are dense subsets of
H.
the negative of the sum of squares. By standard
arguments this onverges uniformly to the
s ( g, f ),
whi h is ontinuous in
and has a global
maximum in its rst argument, over the losure of the innite union of the estimation
subpa es, at
the fun tion spa e in the losure of whi h the true
g = f.
As a result of this, rst order elasti ities
xi f (x)
f (x) xi f (x)
are onsistently estimated for all
x X.
18.3.8 Dis ussion

Consisten y requires that the number of parameters used in the expansion in rease with
the sample size, tending to innity. If parameters are added at a high rate, the bias tends
relatively rapidly to zero. A basi problem is that a high rate of in lusion of additional
parameters auses the varian e to tend more slowly to zero. The issue of how to hose the
rate at whi h parameters are added and whi h to add rst is fairly omplex. A problem
is that the allowable rates for asymptoti normality to obtain (Andrews 1991; Gallant and
264
CHAPTER 18.
Souza, 1991) are very stri t. Supposing we sti k to these rates, our approximating model
is:
gK (x|K ) = z K .
Dene
ZK
as the
LS estimator is
nK
matrix of regressors obtained by sta king observations. The
K = ZK ZK
where
()+
+
ZK y,
is the Moore-Penrose generalized inverse.
This is used sin e
ZK ZK
may be singular, as would be the ase for
K(n)
large
enough when some dummy variables are in luded.
The predi tion,
z K ,
distributed:
f (x)
of the unknown fun tion
is asymptoti ally normally

d
n z K f (x) N (0, AV ),
#
"
+
2
ZK ZK
z
.
AV = lim E z
n
n
where
Formally, this is exa tly the same as if we were dealing with a parametri linear model.
I emphasize, though, that this is only valid if
grows very slowly as
grows.
If
we an't sti k to a eptable rates, we should probably use some other method of
approximating the small sample distribution. Bootstrapping is a possibility. We'll
dis uss this in the se tion on simulation.
18.4 Kernel regression estimators

Readings:
Bierens, 1987, Kernel estimators of regression fun tions, in
E onometri s, Fifth World Congress, V. 1, Truman Bewley, ed., Cambridge.
Advan es in
An alternative method to the semi-nonparametri method is a fully nonparametri

method of estimation.
Kernel regression estimation is an example (others are splines,
nearest neighbor, et .). We'll onsider the Nadaraya-Watson kernel regression estimator
in a simple ase.
Suppose we have an iid sample from the joint density
f (x, y), where x is k -dimensional.
The model is
yt = g(xt ) + t ,
where
E(t |xt ) = 0.
The onditional expe tation of
given
is
g(x).
By denition of the onditional
expe tation, we have
g(x) =
=
f (x, y)
dy
h(x)
Z
1
yf (x, y)dy,
h(x)
y
18.4.
where
h(x)
is the marginal density of
x:
Z
h(x) =
265
KERNEL REGRESSION ESTIMATORS
f (x, y)dy.
g(x)
This suggests that we ould estimate
by estimating
h(x)
and
yf (x, y)dy.
18.4.1 Estimation of the denominator

A kernel estimator for
h(x)
has the form
1 X K [(x xt ) /n ]
h(x)
=
,
n t=1
nk
where
is the sample size and
The fun tion
K()
is the dimension of
(the kernel) is absolutely integrable:
Z
and
K()
integrates to
In this respe t,
x.
1:
|K(x)|dx < ,
K(x)dx = 1.
K() is like a density fun tion,
but we do not ne essarily restri t
K()
to be nonnegative.
The
window width
parameter,
is a sequen e of positive numbers that satises
lim n = 0
lim nnk =
So, the window width must tend to zero, but not too qui kly.
To show pointwise onsisten y of
h(x)
for
h(x),
rst onsider the expe tation of the
estimator (sin e the estimator is an average of iid terms we only need to onsider the
expe tation of a representative term):
i Z
E h(x) = nk K [(x z) /n ] h(z)dz.

h
Change variables as
z = (x z)/n ,
so
z = x n z
and
| dzdz | = nk ,
Z
i
E h(x) =
nk K (z ) h(x n z )nk dz
Z
=
K (z ) h(x n z )dz .
h
we obtain
266
CHAPTER 18.
Now, asymptoti ally,
Z
lim
K (z ) h(x n z )dz
n
Z
=
lim K (z ) h(x n z )dz
n
Z
=
K (z ) h(x)dz
Z
= h(x) K (z ) dz
h
i
lim E h(x)
=
= h(x),
sin e
n 0
and
K (z ) dz = 1
by assumption. (Note: that we an pass the limit
through the integral is a result of the dominated onvergen e theorem.. For this to
hold we need that
h()
be dominated by an absolutely integrable fun tion.
Next, onsidering the varian e of
nnk V
h(x),
we have, due to the iid assumption

n
i
X
1
K
[(x
x
)
/
]
t
n
k
h(x)
= nn 2
V
n t=1
nk
n
= nk
1X
V {K [(x xt ) /n ]}
n
t=1
By the representative term argument, this is
h
i
nnk V h(x)
= nk V {K [(x z) /n ]}
Also, sin e
V (x) = E(x2 ) E(x)2
we have
h
o
i
n
nnk V h(x)
= nk E (K [(x z) /n ])2 nk {E (K [(x z) /n ])}2
Z
2
Z
2
k
k
k
=
n K [(x z) /n ] h(z)dz n
n K [(x z) /n ] h(z)dz
Z
h
i2
=
nk K [(x z) /n ]2 h(z)dz nk E b
h(x)
The se ond term onverges to zero:
nk E
h
i2
b
h(x) 0,
by the previous result regarding the expe tation and the fa t that
lim nnk V
n
n 0. Therefore,
Z
i
nk K [(x z) /n ]2 h(z)dz.
h(x) = lim
n
Using exa tly the same hange of variables as before, this an be shown to be
Z
h
i
lim nnk V h(x)

= h(x) [K(z )]2 dz .
n
Sin e both
[K(z )]2 dz
and
h(x) are bounded, this is bounded, and sin e nnk
18.4.
by assumption, we have that
267
KERNEL REGRESSION ESTIMATORS
h
i
V h(x) 0.
Sin e the bias and the varian e both go to zero, we have pointwise onsisten y ( onvergen e in quadrati mean implies onvergen e in probability).
18.4.2 Estimation of the numerator

To estimate
yf (x, y)dy,
form as the estimator for
we need an estimator of
h(x),
f (x, y).
The estimator has the same
only with one dimension more:
1 X K [(y yt ) /n , (x xt ) /n ]
f(x, y) =
n
nk+1
t=1
The kernel
K ()
is required to have mean zero:
yK (y, x) dy = 0
and to marginalize to the previous kernel for
h(x) :
K (y, x) dy = K(x).
With this kernel, we have
1 X K [(x xt ) /n ]
y f(y, x)dy =
yt
n
nk
t=1
by marginalization of the kernel, so we obtain
g(x) =
=
=
h(x)
1 Pn
y f(y, x)dy
K[(xxt )/n ]
k
n
K[(xxt )/n ]
1 Pn
k
t=1
n
n
Pn
yt K [(x xt ) /n ]
Pt=1
.
n
t=1 K [(x xt ) /n ]
n
t=1 yt
This is the Nadaraya-Watson kernel regression estimator.
18.4.3 Dis ussion
The kernel regression estimator for
g(xt ) is a weighted average of the yj , j = 1, 2, ..., n,
where higher weights are asso iated with points that are loser to
xt .
The weights
sum to 1.
The window width parameter
A large window width redu es the varian e (strong imposition of atness), but in-
at as
n ,
reases the bias.
imposes smoothness. The estimator is in reasingly
sin e in this ase ea h weight tends to
1/n.
268
CHAPTER 18.
A small window width redu es the bias, but makes very little use of information
ex ept points that are in a small neighborhood of
xt . Sin e relatively little information
is used, the varian e is large when the window width is small.
The standard normal density is a popular hoi e for
K(.)
and
K (y, x), though there
are possibly better alternatives.
18.4.4 Choi e of the window width: Cross-validation

The sele tion of an appropriate window width is important. One popular method is ross
validation. This onsists of splitting the sample into two parts (e.g., 50%-50%). The rst
part is the in sample data, whi h is used for estimation, and the se ond part is the out
of sample data, used for evaluation of the t though RMSE or some other riterion. The
steps are:
1. Split the data. The out of sample data is

2. Choose a window width
y out
and
xout .
3. With the in sample data, t
ytout
orresponding to ea h
xout
t .
This tted value is a
fun tion of the in sample data, as well as the evaluation point
xout
t ,
but it does not
out
involve yt .
4. Repeat for all out of sample points.
5. Cal ulate RMSE()
2,
6. Go to step
7. Sele t the
or to the next step if enough window widths have been tried.
that minimizes RMSE() (Verify that a minimum has been found, for
example by plotting RMSE as a fun tion of

8. Re-estimate using the best
).
and all of the data.
This same prin iple an be used to hoose
and
in a Fourier form model.
18.5 Kernel density estimation

The previous dis ussion suggests that a kernel density estimator may easily be onstru ted.
We have already seen how joint densities may be estimated. If were interested in a onditional density, for example of
y onditional on x, then the kernel estimate of the onditional
density is simply
fby|x =
=
=
f(x, y)
h(x)
1 Pn
K [(yyt )/n ,(xxt )/n ]

k+1
n
P
K[(xxt )/n ]
n
1
k
t=1
n
n
Pn
1
[(y yt ) /n , (x xt ) /n ]
t=1 K
P
n
n
t=1 K [(x xt ) /n ]
n
t=1
18.6.
269
SEMI-NONPARAMETRIC MAXIMUM LIKELIHOOD
where we obtain the expressions for the joint and marginal densities from the se tion on
kernel regression.
18.6 Semi-nonparametri maximum likelihood

Readings:
Gallant and Ny hka,
E onometri a,
1987. For a Fortran program to do this
and a useful dis ussion in the user's guide, see
Journal of Applied E onometri s,
this link . See also Cameron and Johansson,
V. 12,
1997.
MLE is the estimation method of hoi e when we are ondent about spe ifying the
density. Is is possible to obtain the benets of MLE when we're not so ondent about the
spe i ation? In part, yes.
Suppose we're interested in the density of
Suppose that the density
f (y|x, )
onditional on
(both may be ve tors).
is a reasonable starting approximation to the true
density. This density an be reshaped by multiplying it by a squared polynomial. The new

density is
h2p (y|)f (y|x, )

gp (y|x, , ) =
p (x, , )
where
hp (y|) =
p
X
k y k
k=0
p (x, , ) is a normalizing fa tor to make the density integrate (sum) to one. Be ause
2
hp (y|)/p (x, , ) is a homogenous fun tion of it is ne essary to impose a normalization:
and
is set to 1.
The normalization fa tor
p (, )
is al ulated (following Cameron and
Johansson) using
E(Y r ) =
y r fY (y|, )
y=0
yr
[hp (y|)]2
fY (y|)
p (, )
y=0
p X
p
X
X
y r fY (y|)k l y k y l /p (, )
y=0 k=0 l=0
p X
p
X
k l
k=0 l=0
p X
p
X
y=0
y r+k+l fY (y|) /p (, )
k l mk+l+r /p (, ).
k=0 l=0
By setting
r=0
we get that the normalizing fa tor is
18.8
p (, ) =
p X
p
X
k l mk+l
(18.8)
k=0 l=0
Re all that
is set to 1 to a hieve identi ation. The
mr
in equation 18.8 are the raw
moments of the baseline density. Gallant and Ny hka (1987) give onditions under whi h
270
CHAPTER 18.
su h a density may be treated as orre tly spe ied, asymptoti ally. Basi ally, the order of
the polynomial must in rease as the sample size in reases. However, there are te hni alities.
Similarly to Cameron and Johannson (1997), we may develop a negative binomial
polynomial (NBP) density for ount data. The negative binomial baseline density may be
written (see equation as
fY (y|) =
where
= {, }, > 0
variables
and
> 0.
is the parameterization
binomial-I model (NB-I). When

For the NB-I density,
(y + )
(y + 1)()

y
The usual means of in orporating onditioning
= ex .
= 1/
V (Y ) = + .
2 . For both forms,
When
= /
we have the negative
we have the negative binomial-II (NP-II) model.
In the ase of the NB-II model, we have
V (Y ) =
E(Y ) = .
The reshaped density, with normalization to sum to one, is
fY (y|, ) =
[hp (y|)]2 (y + )
p (, ) (y + 1)()

y
(18.9)
To get the normalization fa tor, we need the moment generating fun tion:
MY (t) = et +
(18.10)
To illustrate, Figure 18.5 shows al ulation of the rst four raw moments of the NB density,
al ulated using MuPAD, whi h is a Computer Algebra System that (use to be?) free for
personal use. These are the moments you would need to use a se ond order polynomial
(p = 2).
MuPAD will output these results in the form of C ode, whi h is relatively easy to
edit to write the likelihood fun tion for the model. This has been done in NegBinSNP. ,
whi h is a C++ version of this model that an be ompiled to use with o tave using the
mko tfile
ommand. Note the impressive length of the expressions when the degree of
the expansion is 4 or 5! This is an example of a model that would be di ult to formulate
without the help of a program like
MuPAD.
It is possible that there is onditional heterogeneity su h that the appropriate reshaping

should be more lo al. This an be a omodated by allowing the
parameters to depend
upon the onditioning variables, for example using polynomials.

Gallant and Ny hka,
E onometri a, 1987 prove that this sort of density an approximate
a wide variety of densities arbitrarily well as the degree of the polynomial in reases with
the sample size. This approa h is not without its drawba ks: the sample obje tive fun tion
an have an
extremely
large number of lo al maxima that an lead to numeri di ulties.
If someone ould gure out how to do in a way su h that the sample obje tive fun tion
was ni e and smooth, they would probably get the paper published in a good journal. Any
ideas?
Here's a plot of true and the limiting SNP approximations (with the order of the
polynomial xed) to four dierent ount data densities, whi h variously exhibit over and
underdispersion, as well as ex ess zeros. The baseline model is a negative binomial density.
18.7.
271
EXAMPLES
Figure 18.5: Negative binomial raw moments
Case 1
Case 2
.5
.4
.1
.3
.2
.05
.1
0
Case 3
10
15
20
.25
.2
.2
.15
.15
Case 4
10
15
20
25
.1
.1
.05
.05
1
2.5
7.5
10
12.5
15
18.7 Examples
We'll use the MEPS OBDV data to illustrate kernel regression and semi-nonparametri
maximum likelihood.
272
CHAPTER 18.
Figure 18.6: Kernel tted OBDV usage versus AGE

Kernel fit, OBDV visits versus AGE
7
2
20
25
30
35
40
Age
45
50
55
60
65
18.7.1 Kernel regression estimation

Let's try a kernel regression t for the OBDV data. The program OBDVkernel.m loads
the MEPS OBDV data, s ans over a range of window widths and al ulates leave-one-out
CV s ores, and plots the tted OBDV usage versus AGE, using the best window width.
The plot is in Figure 18.6. Note that usage in reases with age, just as we've seen with the
parametri models. On e ould use bootstrapping to generate a onden e interval to the
t.
18.7.2 Seminonparametri ML estimation and the MEPS data

Now let's estimate a seminonparametri density for the OBDV data.
We'll reshape a
negative binomial density, as dis ussed above. The program EstimateNBSNP.m loads the
MEPS OBDV data and estimates the model, using a NB-I baseline density and a 2nd order
polynomial expansion. The output is:
OBDV
======================================================
Used numeri gradient
Stepsize 0.0065
18.7.
273
EXAMPLES
24 iterations
-----------------------------------------------------param
gradient hange
1.3826 0.0000 -0.0000
0.2317 -0.0000
0.0000
0.1839 0.0000
0.0000
0.2214 0.0000 -0.0000
0.1898 0.0000 -0.0000
0.0722 0.0000 -0.0000
-0.0002 0.0000 -0.0000
1.7853 -0.0000 -0.0000
-0.4358 0.0000 -0.0000
0.1129 0.0000
0.0000
******************************************************
NegBin SNP model, MEPS full data set
Observations: 4564
onstant
pub. ins.
priv. ins.
sex
age
edu
in
gam1
gam2
lnalpha
estimate
-0.147
0.695
0.409
0.443
0.016
0.025
-0.000
1.785
-0.436
0.113
st. err
0.126
0.050
0.046
0.034
0.001
0.006
0.000
0.141
0.029
0.027
t-stat
-1.173
13.936
8.833
13.148
11.880
3.903
-0.011
12.629
-14.786
4.166
p-value
0.241
0.000
0.000
0.000
0.000
0.000
0.991
0.000
0.000
0.000
CAIC : 19907.6244
Avg. CAIC: 4.3619
BIC : 19897.6244
Avg. BIC:
4.3597
AIC : 19833.3649
Avg. AIC:
4.3456
******************************************************
Note that the CAIC and BIC are lower for this model than for the models presented in
Table 16.3. This model ts well, still being parsimonious. You an play around trying other
use measures, using a NP-II baseline density, and using other orders of expansions. Density
fun tions formed in this way may have
MANY
lo al maxima, so you need to be areful
before a epting the results of a asual run. To guard against having onverged to a lo al
maximum, one an try using multiple starting values, or one ould try simulated annealing
as an optimization method. If you un omment the relevant lines in the program, you an
use SA to do the minimization. This will take a
lot
of time, ompared to the default BFGS
274
CHAPTER 18.
minimization. The hapter on parallel omputations might be interesting to read before

trying this.
Chapter 19
Simulation-based estimation
Readings:
In addition to the book mentioned previously, arti les in lude Gallant and
Tau hen (1996), Whi h Moments to Mat h?, ECONOMETRIC THEORY, Vol. 12, 1996,
J. Apl.
E onometri s; Pakes and Pollard (1989) E onometri a ; M Fadden (1989) E onometri a.
pages 657-681; Gourieroux, Monfort and Renault (1993), Indire t Inferen e,
19.1 Motivation
Simulation methods are of interest when the DGP is fully hara terized by a parameter
ve tor, but the likelihood fun tion is not al ulable. If it were available, we would simply
estimate by MLE, whi h is asymptoti ally fully e ient.
19.1.1 Example: Multinomial and/or dynami dis rete response models

Let
yi
be a latent random ve tor of dimension
m.
Suppose that
yi = Xi + i
where
Xi
is
m K.
Suppose that
Hen eforth drop the
i N (0, )
i
(19.1)
subs ript when it is not needed for larity.
is not observed. Rather, we observe a many-to-one mapping
y = (y )
This mapping is su h that ea h element of
is either zero or one (in some ases only
one element will be one).
Dene
Ai = A(yi ) = {y |yi = (y )}
Suppose random sampling of
(yi , Xi ).
In this ase the elements of
independent of one another (and learly are not if

independent of
yj , i 6= j.
275
yi
may not be
is not diagonal). However,
yi
is
276
CHAPTER 19.
Let
= ( , (vec ) )
of the
ith
SIMULATION-BASED ESTIMATION
be the ve tor of parameters of the model. The ontribution
observation to the likelihood fun tion is
pi () =
Ai
n(yi Xi , )dyi
where
M/2
n(, ) = (2)
1/2
||
is the multivariate normal density of an

likelihood fun tion is
1
exp
2
-dimensional random ve tor.
The log-
ln L() =
and the MLE
solves
1X
ln pi ()
n
i=1
the s ore equations
n
n
1 X D pi ()
1X
gi () =
0.
n
n
pi ()
i=1
i=1
The problem is that evaluation of
Li ()
and its derivative w.r.t.
by standard
methods of numeri integration su h as quadrature is omputationally infeasible when
(the dimension of
y)
is higher than 3 or 4 (as long as there are no restri tions on
).
The mapping
(y ) has not been made spe i so far.
This setup is quite general: for
dierent hoi es of (y ) it nests the ase of dynami binary dis rete hoi e models
as well as the ase of multinomial dis rete hoi e (the hoi e of one out of a nite set
of alternatives).
Multinomial dis rete hoi e is illustrated by a (very simple) job sear h model.
We have ross se tional data on individuals' mat hing to a set of
jobs that
are available (one of whi h is unemployment). The utility of alternative
is
uj = Xj + j
Utilities of jobs, sta ked in the ve tor
ui
are not observed. Rather, we observe
the ve tor formed of elements
yj = 1 [uj > uk , k m, k 6= j]
Only one of these elements is dierent than zero.
Dynami dis rete hoi e is illustrated by repeated hoi es over time between
two alternatives. Let alternative
have utility
ujt = Wjt jt ,
j
{1, 2}
t {1, 2, ..., m}
19.1.
277
MOTIVATION
Then
y = u2 u1
= (W2 W1 ) + 2 1
X +
Now the mapping is (element-by-element)
y = 1 [y > 0] ,
that is
yit = 1
if individual
hooses the se ond alternative in period
t,
zero
otherwise.
19.1.2 Example: Marginalization of latent variables

E onomi data often presents substantial heterogeneity that may be di ult to model. A
possibility is to introdu e latent random variables. This an ause the problem that there
may be no known losed form for the distribution of observable variables after marginalizing out the unobservable latent variables.
0, 1, 2, 3, ...)
For example, ount data (that takes values
is often modeled using the Poisson distribution
Pr(y = i) =
exp()i
i!
The mean and varian e of the Poisson distribution are both equal to
E(y) = V (y) = .
Often, one parameterizes the onditional mean as
i = exp(Xi ).
This ensures that the mean is positive (as it must be). Estimation by ML is straightforward.
Often, ount data exhibits overdispersion whi h simply means that
V (y) > E(y).

If this is the ase, a solution is to use the negative binomial distribution rather than the
Poisson.
An alternative is to introdu e a latent variable that ree ts heterogeneity into
the spe i ation:
i = exp(Xi + i )
where
has some spe ied density with support
parameters). Let
d(i )
be the density of
Pr(y = yi ) =
i .
(this density may depend on additional
In some ases, the marginal density of
exp [ exp(Xi + i )] [exp(Xi + i )]yi

d(i )
yi !
will have a losed-form solution (one an derive the negative binomial distribution in the
278
CHAPTER 19.
way if
has an exponential distribution), but often this will not be possible. In this ase,
simulation is a means of al ulating
Pr(y = i),
whi h is then used to do ML estimation.
This would be an example of the Simulated Maximum Likelihood (SML) estimation.
In this ase, sin e there is only one latent variable, quadrature is probably a better
hoi e. However, a more exible model with heterogeneity would allow all parameters
(not just the onstant) to vary. For example
Pr(y = yi ) =
entails a
when
exp [ exp(Xi i )] [exp(Xi i )]yi

d(i )
yi !
K = dim i -dimensional integral,
whi h will not be evaluable by quadrature
gets large.
19.1.3 Estimation of models spe ied in terms of sto hasti dierential

equations
It is often onvenient to formulate models in terms of ontinuous time using dierential
equations. A realisti model should a ount for exogenous sho ks to the system, whi h an
be done by assuming a random omponent. This leads to a model that is expressed as a
system of sto hasti dierential equations. Consider the pro ess
dyt = g(, yt )dt + h(, yt )dWt

whi h is assumed to be stationary.
su h that
{Wt }
W (T ) =
is a standard Brownian motion (Weiner pro ess),
dWt N (0, T )
Brownian motion is a ontinuous-time sto hasti pro ess su h that
W (0) = 0
[W (s) W (t)] N (0, s t)
[W (s) W (t)]
and
[W (j) W (k)]
are independent for
s > t > j > k.
That is,
non-overlapping segments are independent.
One an think of Brownian motion the a umulation of independent normally distributed

sho ks with innitesimal varian e.
The fun tion
h(, yt )
g(, yt )
is the deterministi part.
determines the varian e of the sho ks.
To estimate a model of this sort, we typi ally have data that are assumed to be observations
of
yt
in dis rete points
y1 , y2 , ...yT . That is, though yt
is a ontinuous pro ess it is observed
in dis rete time.

To perform inferen e on
, dire t ML or GMM estimation is not usually feasible, be ause
one annot, in general, dedu e the transition density
f (yt |yt1 , ). This density is ne essary
to evaluate the likelihood fun tion or to evaluate moment onditions (whi h are based upon
expe tations with respe t to this density).
19.2.
279
SIMULATED MAXIMUM LIKELIHOOD (SML)
A typi al solution is to dis retize the model, by whi h we mean to nd a dis rete
time approximation to the model. The dis retized version of the model is
yt yt1 = g(, yt1 ) + h(, yt1 )t

t N (0, 1)
The dis retization indu es a new parameter,
(that is, the 0
whi h denes the best
approximation of the dis retization to the a tual (unknown) dis rete time version
of the model is not equal to
whi h is the true parameter value).
approximation, and as su h ML estimation of
This is an
(whi h is a tually quasi-maximum
likelihood, QML) based upon this equation is in general biased and in onsistent for
the original parameter,
Nevertheless, the approximation shouldn't be too bad,
whi h will be useful, as we will see.
The important point about these three examples is that omputational di ulties
prevent dire t appli ation of ML, GMM, et . Nevertheless the model is fully spe ied
in probabilisti terms up to a parameter ve tor.
This means that the model is
simulable, onditional on the parameter ve tor.
19.2 Simulated maximum likelihood (SML)

For simpli ity, onsider ross-se tional data. An ML estimator solves
1X
M L = arg max sn () =
ln p(yt |Xt , )
n t=1
where
p(yt |Xt , )
is the density fun tion of the
have a known losed form,
M L
tth
p(yt |Xt , )
observation. When
does not
is an infeasible estimator. However, it may be possible to
dene a random fun tion su h that
E f (, yt , Xt , ) = p(yt |Xt , )
where the density of
is known. If this is the ase, the simulator
p (yt , Xt , ) =
H
1 X
f (ts , yt , Xt , )
H
s=1
is unbiased for
p(yt |Xt , ).
The SML simply substitutes
p (yt , Xt , )
in pla e of
fun tion, that is
p(yt |Xt , )
in the log-likelihood
1X
SM L = arg max sn () =
ln p (yt , Xt , )
n
i=1
280
CHAPTER 19.
19.2.1 Example: multinomial probit

Re all that the utility of alternative
is
uj = Xj + j
and the ve tor
is formed of elements
yj = 1 [uj > uk , k m, k 6= j]
The problem is that
Pr(yj = 1|) an't be al ulated when m is larger than 4 or 5.
However,
it is easy to simulate this probability.
Draw
Cal ulate
Dene
Repeat this
Dene
from the distribution
u
i = Xi + i
N (0, )
(where
Xi
is the matrix formed by sta king the
Xij )
yij = 1 [uij > uik , k m, k 6= j]
ei
times and dene
as the
eij =
m-ve tor
formed of the
and the elements sum to one.
PH
ijh
h=1 y
H
eij .
Ea h element of
ei
is between 0 and 1,
p (yi , Xi , ) = yi
ei
Now
The SML multinomial probit log-likelihood fun tion is
1X
yi ln p (yi , Xi , )
n
ln L(, ) =
This is to be maximized w.r.t.
and
i=1
Notes:
The
draws of
used to nd
and
are draw
only on e
and are used repeatedly during the iterations
The draws are dierent for ea h
i.
If the
are re-drawn at
every iteration the estimator will not onverge.
The log-likelihood fun tion with this simulator is a dis ontinuous fun tion of
and .
This does not ause problems from a theoreti al point of view sin e it an be shown
that
ln L(, )
is sto hasti ally equi ontinuous. However, it does ause problems if
one attempts to use a gradient-based optimization method su h as Newton-Raphson.
It may be the ase, parti ularly if few simulations,

of
ei
are zero. If the orresponding element of
problem.
Solutions to dis ontinuity:
yi
H,
are used, that some elements
is equal to 1, there will be a
log(0)
19.3.
281
METHOD OF SIMULATED MOMENTS (MSM)
1) use an estimation method that doesn't require a ontinuous and dierentiable

obje tive fun tion, for example, simulated annealing. This is omputationally
ostly.
2) Smooth the simulated probabilities so that they are ontinuous fun tions of
the parameters. For example, apply a kernel transformation su h as

m
m
yij = A uij max uik
+ .5 1 uij = max uik
k=1
where
that
yij
is a large positive number.

is very lose to zero if
is the maximum.
pij
k=1
and therefore
requires that
This makes
ln L(, )
p
A(n) ,
uij
yij
This approximates a step fun tion su h

is not the maximum, and
a ontinuous fun tion of
uij = 1
and
if it
so that
will be ontinuous and dierentiable. Consisten y
so that the approximation to a step fun tion be omes
arbitrarily lose as the sample size in reases.
There are alternative methods
(e.g., Gibbs sampling) that may work better, but this is too te hni al to dis uss
here.
To solve to log(0) problem, one possibility is to sear h the web for the slog fun tion.
Also, in rease
if this is a serious problem.
19.2.2 Properties
The properties of the SML estimator depend on how
is set. The following is taken from
Lee (1995) Asymptoti Bias in Simulated Maximum Likelihood Estimation of Dis rete
Choi e Models,
E onometri Theory, 11, pp.
437-83.
Theorem 32 [Lee 1) if limn n1/2 /H = 0, then

d
n SM L 0 N (0, I 1 ( 0 ))
2) if limn n1/2 /H = , a nite onstant, then

d
n SM L 0 N (B, I 1 ( 0 ))
where B is a nite ve tor of onstants.
This means that the SML estimator is asymptoti ally biased if
The var ov is the typi al inverse of the information matrix, so that as long as
than
doesn't grow faster
n1/2 .
H
grows fast enough the estimator is onsistent and fully asymptoti ally e ient.
19.3 Method of simulated moments (MSM)

Suppose we have a DGP(y|x, ) whi h is simulable given
is not al ulable.
but is su h that the density of
282
CHAPTER 19.
On e ould, in prin iple, base a GMM estimator upon the moment onditions
mt () = [K(yt , xt ) k(xt , )] zt
where
k(xt , ) =
zt
K(yt , xt )p(y|xt , )dy,
is a ve tor of instruments in the information set and
onditional on
However
xt .
p(y|xt , )
is the density of
The problem is that this density is not available.
k(xt , )
is readily simulated using
H
1 X
e
k (xt , ) =
K(e
yth , xt )
H
h=1
By the law of large numbers,
a.s.
e
k (xt , ) k (xt , ) , as H , whi h provides a lear
intuitive basis for the estimator, though in fa t we obtain onsisten y even for
nite, sin e a law of large numbers is also operating a ross the
observations of real
data, so errors introdu ed by simulation an el themselves out.
This allows us to form the moment onditions
where
zt
h
i
m
ft () = K(yt , xt ) e
k (xt , ) zt
(19.2)
is drawn from the information set. As before, form
m()
e
=
=
1X
m
ft ()
n
i=1
"
#
n
H
1 X
1X
h
K(yt , xt )
k(e
yt , xt ) zt
n
H
i=1
(19.3)
h=1
with whi h we form the GMM riterion and estimate as usual. Note that the unbiased
simulator
k(e
yth , xt )
appears linearly within the sums.
19.3.1 Properties
Suppose that the optimal weighting matrix is used. M Fadden (ref. above) and Pakes and
Pollard (refs. above) show that the asymptoti distribution of the MSM estimator is very
similar to that of the infeasible GMM estimator. In parti ular, assuming that the optimal
weighting matrix is used, and for
nite,

1
d
0
1 1
n M SM N 0, 1 +
D D
H
where
D 1 D
1
(19.4)
is the asymptoti varian e of the infeasible GMM estimator.
That is, the asymptoti varian e is inated by a fa tor
1 + 1/H.
For this reason the
MSM estimator is not fully asymptoti ally e ient relative to the infeasible GMM
19.3.
283
METHOD OF SIMULATED MOMENTS (MSM)
estimator, for
nite, but the e ien y loss is small and ontrollable, by setting
reasonably large.
The estimator is asymptoti ally unbiased even for
H = 1.
If one doesn't use the optimal weighting matrix, the asymptoti var ov is just the
The above presentation is in terms of a spe i moment ondition based upon the
This is an advantage
relative to SML.
ordinary GMM var ov, inated by
onditional mean.
1 + 1/H.
Simulated GMM an be applied to moment onditions of any
form.
19.3.2 Comments
Why is SML in onsistent if
upon an average of
is nite, while MSM is? The reason is that SML is based
logarithms of an unbiased simulator (the densities of the observations).
To use the multinomial probit model as an example, the log-likelihood fun tion is
ln L(, ) =
The SML version is
1X
yi ln pi (, )
n
i=1
1X
ln L(, ) =
yi ln pi (, )
n
i=1
The problem is that
E ln(
pi (, )) 6= ln(E pi (, ))
in spite of the fa t that
E pi (, ) = pi (, )
due to the fa t that
ln()
equal (in the limit) is if
is a nonlinear transformation. The only way for the two to be

tends to innite so that
p ()
tends to
p ().
The reason that MSM does not suer from this problem is that in this ase the unbiased
simulator appears
linearly
within every sum of terms, and it appears within a sum over
(see equation [19.3). Therefore the SLLN applies to an el out simulation errors, from
whi h we get onsisten y. That is, using simple notation for the random sampling ase,
the moment onditions
m()
"
#
n
H
1 X
1X
h
K(yt , xt )
k(e
yt , xt ) zt
n
H
i=1
h=1
"
#
n
H
X
X
1
1
k(xt , 0 ) + t
[k(xt , ) + ht ] zt
n
H
i=1
h=1
onverge almost surely to
m
() =

k(x, 0 ) k(x, ) z(x)d(x).
(19.5)
(19.6)
284
CHAPTER 19.
(note:
zt
is assume to be made up of fun tions of
xt ).
The obje tive fun tion onverges to
s () = m
() 1
()
m
whi h obviously has a minimum at
0,
hen eforth onsisten y.
If you look at equation 19.6 a bit, you will see why the varian e ination fa tor is
(1 +
1
H ).
19.4 E ient method of moments (EMM)

The hoi e of whi h moments upon whi h to base a GMM estimator an have very pronoun ed ee ts upon the e ien y of the estimator.
A poor hoi e of moment onditions may lead to very ine ient estimators, and an
even ause identi ation problems (as we've seen with the GMM problem set).
The drawba k of the above approa h MSM is that the moment onditions used in
estimation are sele ted arbitrarily. The asymptoti e ien y of the estimator may
be low.
The asymptoti ally optimal hoi e of moments would be the s ore ve tor of the
likelihood fun tion,
mt () = D ln pt ( | It )
As before, this hoi e is unavailable.
The e ient method of moments (EMM) (see Gallant and Tau hen (1996), Whi h Moments to Mat h?, ECONOMETRIC THEORY, Vol.
12, 1996, pages 657-681) seeks to
provide moment onditions that losely mimi the s ore ve tor.
If the approximation is
very good, the resulting estimator will be very nearly fully e ient.
The DGP is hara terized by random sampling from the density
p(yt |xt , 0 ) pt ( 0 )
We an dene an auxiliary model, alled the s ore generator, whi h simply provides
a (misspe ied) parametri density
f (y|xt , ) ft ()
This density is known up to a parameter
We assume that this density fun tion
al ulable. Therefore quasi-ML estimation is possible. Spe i ally,
X
= arg max sn () = 1
ln ft ().
n
t=1
After determining
we an al ulate the s ore fun tions
.
D ln f (yt |xt , )
is
19.4.
The important point is that even if the density is misspe ied, there is a pseudotrue
for whi h the true expe tation, taken with respe t to the true but unknown
density of
y, p(y|xt , 0 ),
: EX EY |X
and then marginalized over

D ln f (y|x, ) =
0
Z Z
X
onditions
1X
n t=1
is zero:
D ln f (y|x, 0 )p(y|x, 0 )dyd(x) = 0

Y |X
We have seen in the se tion on QML that
=
mn (, )
285
EFFICIENT METHOD OF MOMENTS (EMM)
0 ;
this suggests using the moment
t ()dy
D ln ft ()p
These moment onditions are not al ulable, sin e
pt ()
is not available, but they
are simulable using
n
H
1X 1 X
m
fn (, ) =
D ln f (e
yth |xt , )
n
H
t=1
where
yth
is a draw from
onverges to
DGP (),
h=1
holding
xt
xed. By the LLN and the fa t that
This is not the ase for other values of
The advantage of this pro edure is that if

then
0 ,
m
e ( 0 , 0 ) = 0.
(19.7)
m
e n (, )
assuming that
f (yt|xt , )
is identied.
losely approximates
p(y|xt , ),
will losely approximate the optimal moment onditions whi h har-
a terize maximum likelihood estimation, whi h is fully e ient.
If one has prior information that a ertain density approximates the data well, it
would be a good hoi e for
f ().
If one has no density in mind, there exist good ways of approximating unknown
E onometri a,
distributions parametri ally: Philips' ERA's (
E onometri a, 1987)
Ny hka's (
1983) and Gallant and
SNP density estimator whi h we saw before. Sin e
the SNP density is onsistent, the e ien y of the indire t estimator is the same as
the infeasible ML estimator.
19.4.1 Optimal weighting matrix

I will present the theory for
nite, and possibly small.
sometimes impra ti al to estimate with

for the ase of
This is done be ause it is
very large. Gallant and Tau hen give the theory
so large that it may be treated as innite (the dieren e being irrelevant
given the numeri al pre ision of a omputer). The theory for the ase of
innite follows
dire tly from the results presented here.

The moment ondition
m(,
e )
depends on the pseudo-ML estimate
We an apply
Theorem 22 to on lude that

d
0
n
N 0, J (0 )1 I(0 )J (0 )1
(19.8)
286
CHAPTER 19.
f (yt |xt , )
If the density
were in fa t the true density
maximum likelihood estimator, and

information matrix equality.
p(y|xt , ),
then
J (0 )1 I(0 ) would be an identity
would be the
matrix, due to the
However, in the present ase we assume that
p(y|xt , ), so there is no an ellation.

2

0 ) . Comparing the denition

J (0 ) p lim
s
(
n
only an approximation to
Re all that
of
f (yt|xt , )
sn ()
is
with the
denition of the moment ondition in Equation 19.7, we see that
J (0 ) = D m( 0 , 0 ).
As in Theorem 22,

sn () sn ()
I( ) = lim E n
.
n
0 0
0
In this ase, this is simply the asymptoti varian e ovarian e matrix of the moment
onditions,
Now take a rst order Taylor's series approximation to
nmn ( 0 , )
about
0 :
=
nm
n ( 0 , )
First onsider
nm
n ( 0 , 0 ) +
nm
n ( 0 , 0 ).
Next onsider the se ond term
so we have

0 + op (1)
0 , 0 )
nD m(
It is straightforward but somewhat tedious to show that
the asymptoti varian e of this term is
J (0 ),
1
0
H I ( ).

0 .
0 , 0 )
nD m(
Note that
a.s.
n ( 0 , 0 )
D m

0 = nJ (0 )
0 , a.s.
0 , 0 )
nD m(
But noting equation 19.8

a
0
nJ (0 )
N 0, I(0 )
Now, ombining the results for the rst and se ond terms,
Suppose that
\
0)
I(

1
0
N 0, 1 +
nm
n ( , )
I( )
H
0
is a onsistent estimator of the asymptoti varian e- ovarian e matrix
of the moment onditions.
This may be ompli ated if the s ore generator is a poor
approximator, sin e the individual s ore ontributions may not have mean zero in this ase
(see the se tion on QML) . Even if this is the ase, the individuals means an be al ulated
by simulation, so it is always possible to onsistently estimate
I(0 )
when the model is
simulable. On the other hand, if the s ore generator is taken to be orre tly spe ied, the
ordinary estimator of the information matrix is onsistent. Combining this with the result
on the e ient GMM weighting matrix in Theorem 25, we see that dening

= arg min mn (, )

1
1+
H
\
0)
I(
1
mn (, )
is the GMM estimator with the e ient hoi e of weighting matrix.
as
19.4.
EFFICIENT METHOD OF MOMENTS (EMM)
287
If one has used the Gallant-Ny hka ML estimator as the auxiliary model, the appropriate weighting matrix is simply the information matrix of the auxiliary model,
sin e the s ores are un orrelated.
(e.g., it really is ML estimation asymptoti ally,
sin e the s ore generator an approximate the unknown density arbitrarily well).
19.4.2 Asymptoti distribution

Sin e we use the optimal weighting matrix, the asymptoti distribution is as in Equation
15.3, so we have (using the result in Equation 19.8):
!1

1

1
d
,
D
I(0 )
n 0 N 0, D 1 +
H
where

D = lim E D mn ( 0 , 0 ) .
n
This an be onsistently estimated using
= D mn (,
D
19.4.3 Diagnoti testing

The fa t that

1
a
0
nmn ( , ) N 0, 1 +
I( )
H
0
implies that
)

nmn (,
where
is
dim() dim(),

1
1+
H
1
a 2
)

mn (,
(q)
I()
sin e without
dim()
moment onditions the model is not
identied, so testing is impossible. One test of the model is simply based on this statisti : if
it ex eeds the
2 (q) riti al point, something may be wrong (the small sample performan e
of this sort of test would be a topi worth investigating).
Information about what is wrong an be gotten from the pseudo-t-statisti s:
diag

1
1+
H
1/2 !1
nmn (,
I()
an be used to test whi h moments are not well modeled. Sin e these moments are
related to parameters of the s ore generator, whi h are usually related to ertain
features of the model, this information an be used to revise the model. These aren't
and nmn (,
)
have dierent
N (0, 1), sin e nmn ( 0 , )
)
is somewhat more ompli ated). It an be shown
nmn (,
a tually distributed as
distributions (that of
that the pseudo-t statisti s are biased toward nonreje tion. See Gourieroux
or Gallant and Long, 1995, for more details.
et. al.
288
CHAPTER 19.
19.5 Examples
19.5.1 Estimation of sto hasti dierential equations
It is often onvenient to formulate theoreti al models in terms of dierential equations,
and when the observation frequen y is high (e.g., weekly, daily, hourly or real-time) it may
be more natural to adopt this framework for e onometri models of time series.
The most ommon approa h to estimation of sto hasti dierential equations is to
dis retize the model, as above, and estimate using the dis retized version. However, sin e
the dis retization is only an approximation to the true dis rete-time version of the model
(whi h is not al ulable), the resulting estimator is in general biased and in onsistent.
An alternative is to use indire t inferen e: The dis retized model is used as the s ore
generator. That is, one estimates by QML to obtain the s ores of the dis retized approximation:
yt yt1 = g(, yt1 ) + h(, yt1 )t

t N (0, 1)
Indi ate these s ores by
mn (, ).
Then the system of sto hasti dierential equations
dyt = g(, yt )dt + h(, yt )dWt

is simulated over
and the s ores are al ulated and averaged over the simulations
N
1 X
min (, )
m
n (, ) =
N
i=1
is
hosen to set the simulated s ores to zero
)
0
m
n (,
(sin e
and
are of the same dimension).
This method requires simulating the sto hasti dierential equation. There are many
ways of doing this. Basi ally, they involve doing very ne dis retizations:
yt+
= yt + g(, yt ) + h(, yt )t
t N (0, )
By setting
very small, the sequen e of
approximates a Brownian motion fairly well.
This is only one method of using indire t inferen e for estimation of dierential equations. There are others (see Gallant and Long, 1995 and Gourieroux
et. al.).
Use of a series
approximation to the transitional density as in Gallant and Long is an interesting possibility sin e the s ore generator may have a higher dimensional parameter than the model,
whi h allows for diagnosti testing. In the method des ribed above the s ore generator's
parameter
is of the same dimension as is
so diagnosti testing is not possible.
19.5.
289
EXAMPLES
19.5.2 EMM estimation of a dis rete hoi e model

In this se tion onsider EMM estimation. There is a sophisti ated pa kage by Gallant and
Tau hen for this, but here we'll look at some simple, but hopefully dida ti ode.
The
le probitdgp.m generates data that follows the probit model. The le emm_moments.m
denes EMM moment onditions, where the DGP and s ore generator an be passed as
arguments. Thus, it is a general purpose moment ondition for EMM estimation. This le
is interesting enough to warrant some dis ussion. A listing appears in Listing 19.1. Line
3 denes the DGP, and the arguments needed to evaluate it are dened in line 4.
s ore generator is dened in line 5, and its arguments are dened in line 6.
estimate of the parameter of the s ore generator is read in line 7.
The
The QML
Note in line 10 how
the random draws needed to simulate data are passed with the data, and are thus xed
during estimation, to avoid hattering. The simulated data is generated in line 16, and
the derivative of the s ore generator using the simulated data is al ulated in line 18. In
line 20 we average the s ores of the s ore generator, whi h are the moment onditions that
the fun tion returns.
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
fun tion s ores = emm_moments(theta, data, momentargs)

k = momentargs{1};
dgp = momentargs{2}; # the data generating pro ess (DGP)
dgpargs = momentargs{3}; # its arguments ( ell array)
sg = momentargs{4}; # the s ore generator (SG)
sgargs = momentargs{5}; # SG arguments ( ell array)
phi = momentargs{6}; # QML estimate of SG parameter
y = data(:,1);
x = data(:,2:k+1);
rand_draws = data(:,k+2: olumns(data)); # passed with data to ensure fixed
a ross iterations
n = rows(y);
s ores = zeros(n,rows(phi)); # ontainer for moment ontributions
reps = olumns(rand_draws); # how many simulations?
for i = 1:reps
e = rand_draws(:,i);
y = feval(dgp, theta, x, e, dgpargs); # simulated data
sgdata = [y x; # simulated data for SG
s ores = s ores + numgradient(sg, {phi, sgdata, sgargs}); # gradient of SG
endfor
s ores = s ores / reps; # average over number of simulations
endfun tion
Listing 19.1: emm_moments.m
The le emm_example.m performs EMM estimation of the probit model, using a logit
model as the s ore generator. The results we obtain are
S ore generator results:

=====================================================
290
CHAPTER 19.

Stepsize 0.0279
15 iterations
-----------------------------------------------------param
1.8979
1.6648
1.9125
1.8875
1.7433
gradient
0.0000
-0.0000
-0.0000
-0.0000
-0.0000
hange
0.0000
0.0000
0.0000
0.0000
0.0000
======================================================
Model results:
******************************************************
EMM example
Observations: 1000
Exa tly identified, no spe . test
estimate
st. err
t-stat
p-value
p1
1.069
0.022
47.618
0.000
p2
0.935
0.022
42.240
0.000
p3
1.085
0.022
49.630
0.000
p4
1.080
0.022
49.047
0.000
p5
0.978
0.023
41.643
0.000
******************************************************
It might be interesting to ompare the standard errors with those obtained from ML
estimation, to he k e ien y of the EMM estimator. One ould even do a Monte Carlo
study.
19.5.
EXAMPLES
291
Exer ises
1. Do SML estimation of the probit model.
2. Do a little Monte Carlo study to ompare ML, SML and EMM estimation of the
probit model. Investigate how the number of simulations ae t the two simulationbased estimators.
292
CHAPTER 19.
Chapter 20
Parallel programming for
e onometri s
The following borrows heavily from Creel (2005).
Parallel omputing an oer an important redu tion in the time to omplete omputations. This is well-known, but it bears emphasis sin e it is the main reason that parallel
omputing may be attra tive to users. To illustrate, the Intel Pentium IV (Willamette)
pro essor, running at 1.5GHz, was introdu ed in November of 2000.
The Pentium IV
(Northwood-HT) pro essor, running at 3.06GHz, was introdu ed in November of 2002. An

approximate doubling of the performan e of a ommodity CPU took pla e in two years.
Extrapolating this admittedly rough snapshot of the evolution of the performan e of ommodity pro essors, one would need to wait more than 6.6 years and then pur hase a new
omputer to obtain a 10-fold improvement in omputational performan e. The examples in
this hapter show that a 10-fold improvement in performan e an be a hieved immediately,
using distributed parallel omputing on available omputers.
Re ent (this is written in 2005) developments that may make parallel omputing attra tive to a broader spe trum of resear hers who do omputations. The rst is the fa t
that setting up a luster of omputers for distributed parallel omputing is not di ult. If
you are using the ParallelKnoppix bootable CD that a ompanies these notes, you are less
than 10 minutes away from reating a luster, supposing you have a se ond omputer at
hand and a rossover ethernet able. See the ParallelKnoppix tutorial. A se ond development is the existen e of extensions to some of the high-level matrix programming (HLMP)
1
languages
that allow the in orporation of parallelism into programs written in these lan-
guages. A third is the spread of dual and quad- ore CPUs, so that an ordinary desktop or
laptop omputer an be made into a mini- luster. Those ores won't work together on a
single problem unless they are told how to.
Following are examples of parallel implementations of several mainstream problems
in e onometri s.
A fo us of the examples is on the possibility of hiding parallelization
from end users of programs.
If programs that run in parallel have an interfa e that is
nearly identi al to the interfa e of equivalent serial versions, end users will nd it easy to
take advantage of parallel omputing's performan e. We ontinue to use O tave, taking
1
By high-level matrix programming language I mean languages su h as MATLAB (TM the Mathworks,
In .), Ox (TM OxMetri s Te hnologies, Ltd.), and GNU O tave (www.o tave.org ), for example.
293
294
CHAPTER 20.
PARALLEL PROGRAMMING FOR ECONOMETRICS
advantage of the MPI Toolbox (MPITB) for O tave, by by Fernndez Baldomero
et al.
(2004). There are also parallel pa kages for Ox, R, and Python whi h may be of interest
to e onometri ians, but as of this writing, the following examples are the most a essible
introdu tion to parallel programming for e onometri ians.
20.1 Example problems

This se tion introdu es example problems from e onometri s, and shows how they an be
parallelized in a natural way.
20.1.1 Monte Carlo

A Monte Carlo study involves repeating a random experiment many times under identi al
onditions. Several authors have noted that Monte Carlo studies are obvious andidates
for parallelization (Doornik
et al.
2002; Bru he, 2003) sin e blo ks of repli ations an be
done independently on dierent omputers.
To illustrate the parallelization of a Monte
Carlo study, we use same tra e test example as do Doornik,
et. al.
(2002). tra etest.m is
a fun tion that al ulates the tra e test statisti for the la k of ointegration of integrated
time series.
This fun tion is illustrative of the format that we adopt for Monte Carlo
simulation of a fun tion: it re eives a single argument of ell type, and it returns a row
ve tor that holds the results of one random simulation. The single argument in this ase is
a ell array that holds the length of the series in its rst position, and the number of series
in the se ond position. It generates a random result though a pro ess that is internal to
the fun tion, and it reports some output in a row ve tor (in this ase the result is a s alar).
m _example1.m is an O tave s ript that exe utes a Monte Carlo study of the tra e
test by repeatedly evaluating the
tra etest.m
fun tion. The main thing to noti e about
this s ript is that lines 7 and 10 all the fun tion

arguments, as in line 7,
monte arlo.m
monte arlo.m.
When alled with 3
exe utes serially on the omputer it is alled from.
In line 10, there is a fourth argument. When alled with four arguments, the last argument
is the number of slave hosts to use. We see that running the Monte Carlo study on one
or more pro essors is transparent to the user - he or she must only indi ate the number of
slave omputers to be used.
20.1.2 ML
For a sample
{(yt , xt )}n
of
observations of a set of dependent and explanatory variables,
the maximum likelihood estimator of the parameter
an be dened as
= arg max sn ()
where
sn () =
1X
ln f (yt |xt , )
n
t=1
Here,
yt
may be a ve tor of random variables, and the model may be dynami sin e
ontain lags of
yt .
xt
may
As Swann (2002) points out, this an be broken into sums over blo ks
20.1.
295
EXAMPLE PROBLEMS
of observations, for example two blo ks:
1
sn () =
n
n1
X
t=1
Analogously, we an dene up to
ln f (yt |xt , )
n
n
X
t=n1 +1
!)
ln f (yt |xt , )
blo ks. Again following Swann, parallelization an be
done by al ulating ea h blo k on separate omputers.

mle_example1.m is an O tave s ript that al ulates the maximum likelihood estimator
of the parameter ve tor of a model that assumes that the dependent variable is distributed
as a Poisson random variable, onditional on some explanatory variables. In lines 1-3 the
model, and the

mle_estimate performs
data is read, the name of the density fun tion is provided in the variable
initial value of the parameter ve tor is set. In line 5, the fun tion
ordinary serial al ulation of the ML estimator, while in line 7 the same fun tion is alled
with 6 arguments. The fourth and fth arguments are empty pla eholders where options
to
mle_estimate may be set, while the sixth argument is the number of slave omputers to
use for parallel exe ution, 1 in this ase. A person who runs the program sees no parallel
programming ode - the parallelization is transparent to the end user, beyond having to
sele t the number of slave omputers. When exe uted, this s ript prints out the estimates
theta_s
and
theta_p,
whi h are identi al.
It is worth noting that a dierent likelihood fun tion may be used by making the
model
variable point to a dierent fun tion. The likelihood fun tion itself is an ordinary O tave
fun tion that is not parallelized. The
mle_estimate fun tion is a generi fun tion that an
all any likelihood fun tion that has the appropriate input/output syntax for evaluation
either serially or in parallel.
Users need only learn how to write the likelihood fun tion
using the O tave language.
20.1.3 GMM
For a sample as above, the GMM estimator of the parameter
an be dened as
arg min sn ()
where
sn () = mn () Wn mn ()
and
mn () =
1X
mt (yt |xt , )
n
t=1
Sin e
mn ()
is an average, it an obviously be omputed blo kwise, using for example 2
blo ks:
1
mn () =
n
Likewise, we may dene up to
n1
X
t=1
mt (yt |xt , )
n
X
t=n1 +1
!)
mt (yt |xt , )
(20.1)
blo ks, ea h of whi h ould potentially be omputed on a
dierent ma hine.
gmm_example1.m is a s ript that illustrates how GMM estimation may be done serially
or in parallel. When this is run,
theta_s and theta_p are identi al
up to the toleran e for
296
CHAPTER 20.
onvergen e of the minimization routine. The point to noti e here is that an end user an
perform the estimation in parallel in virtually the same way as it is done serially. Again,
gmm_estimate,
used in lines 8 and 10, is a generi fun tion that will estimate any model
moments variable - a dierent model an be estimated by hanging the

moments variable. The fun tion that moments points to is an ordinary O tave
spe ied by the

value of the
fun tion that uses no parallel programming, so users an write their models using the
simple and intuitive HLMP syntax of O tave. Whether estimation is done in parallel or
serially depends only the seventh argument to
gmm_estimate
- when it is missing or zero,
estimation is by default done serially with one pro essor. When it is positive, it spe ies
the number of slave nodes to use.
20.1.4 Kernel regression

The Nadaraya-Watson kernel regression estimator of a fun tion
g(x)
at a point
is
Pn
yt K [(x xt ) /n ]
g(x) = Pt=1
n
t=1 K [(x xt ) /n ]
n
X
wt yy
t=1
We see that the weight depends upon every data point in the sample. To al ulate the t
at every point in a sample of size
n, on the order of n2 k
is the dimension of the ve tor of explanatory variables,
al ulations must be done, where
x.
Ra ine (2002) demonstrates that
MPI parallelization an be used to speed up al ulation of the kernel regression estimator

by al ulating the ts for portions of the sample on dierent omputers. We follow this
implementation here. kernel_example1.m is a s ript for serial and parallel kernel regression. Serial exe ution is obtained by setting the number of slaves equal to zero, in line 15.
In line 17, a single slave is spe ied, so exe ution is in parallel on the master and slave
nodes.
The example programs show that parallelization may be mostly hidden from end users.
Users an benet from parallelization without having to write or understand parallel ode.
The speedups one an obtain are highly dependent upon the spe i problem at hand, as
well as the size of the luster, the e ien y of the network,
are presented in Creel (2005).
et .
Some examples of speedups
Figure 20.1 reprodu es speedups for some e onometri
problems on a luster of 12 desktop omputers. The speedup for
nodes is the time to
nish the problem on a single node divided by the time to nish the problem on
nodes.
Note that you an get 10X speedups, as laimed in the introdu tion. It's pretty obvious
that mu h greater speedups ould be obtained using a larger luster, for the embarrassingly
parallel problems.
20.1.
297
EXAMPLE PROBLEMS
Figure 20.1: Speedups from parallelization

11
10
MONTECARLO
BOOTSTRAP
MLE
GMM
KERNEL
9
8
7
6
5
4
3
2
1
2
8
nodes
10
12
298
CHAPTER 20.
Bibliography
[1 Bru he, M. (2003) A note on embarassingly parallel omputation using OpenMosix
and Ox, working paper, Finan ial Markets Group, London S hool of E onomi s.
[2 Creel, M. (2005) User-friendly parallel omputations with e onometri examples,
Computational E onomi s, V. 26, pp. 107-128.

[3 Doornik, J.A., D.F. Hendry and N. Shephard (2002) Computationally-intensive e onometri s using a distributed matrix-programming language,
of the Royal So iety of London, Series A, 360, 1245-1266.
Philosophi al Transa tions
[4 Fernndez Baldomero, J. (2004) LAM/MPI parallel omputing under GNU O tave,
at .ugr.es/javier-bin/mpitb.
[5 Ra ine, Je (2002) Parallel distributed kernel estimation,
Data Analysis, 40, 293-302.
Computational Statisti s &
[6 Swann, C.A. (2002) Maximum likelihood estimation using parallel omputing:

introdu tion to MPI,
Computational E onomi s, 19, 145-178.
299
an
300
BIBLIOGRAPHY
Chapter 21
Final proje t: e onometri
estimation of a RBC model
THIS IS NOT FINISHED - IGNORE IT FOR NOW
In this last hapter we'll go through a worked example that ombines a number of the
topi s we've seen.
We'll do simulated method of moments estimation of a real business
y le model, similar to what Valderrama (2002) does.
21.1 Data
We'll develop a model for private onsumption and real gross private investment.
The
data are obtained from the US Bureau of E onomi Analysis (BEA) National In ome and
Produ t A ounts (NIPA), Table 11.1.5, Lines 2 and 6 (you an download quarterly data
from 1947-I to the present). The data we use are in the le rb _data.m. This data is real
( onstant dollars).
The program plots.m will make a few plots, in luding Figures 21.1 though 21.3. First
looking at the plot for levels, we an see that real onsumption and investment are learly
nonstationary (surprise, surprise). There appears to be somewhat of a stru tural hange
in the mid-1970's.
Looking at growth rates, the series for onsumption has an extended period of high growth
in the 1970's, be oming more moderate in the 90's. The volatility of growth of onsumption
has de lined somewhat, over time. Looking at investment, there are some notable periods
of high volatility in the mid-1970's and early 1980's, for example. Sin e 1990 or so, volatility
seems to have de lined.
E onomi models for growth often imply that there is no long term growth (!) - the
Figure 21.1: Consumption and Investment, Levels
Examples/RBC/levels.eps
301
302CHAPTER 21. FINAL PROJECT: ECONOMETRIC ESTIMATION OF A RBC MODEL
Figure 21.2: Consumption and Investment, Growth Rates
Examples/RBC/growth.eps
Figure 21.3: Consumption and Investment, Bandpass Filtered
Examples/RBC/filtered.eps
data that the models generate is stationary and ergodi .
Or, the data that the models
generate needs to be passed through the inverse of a lter. We'll follow this, and generate
stationary business y le data by applying the bandpass lter of Christiano and Fitzgerald
(1999). The ltered data is in Figure 21.3. We'll try to spe ify an e onomi model that an
generate similar data. To get data that look like the levels for onsumption and investment,
we'd need to apply the inverse of the bandpass lter.
21.2 An RBC Model

Consider a very simple sto hasti growth model (the same used by Maliar and Maliar
(2003), with minor notational dieren e):
max{ct ,kt }
E0
t=0
t=0
t U (c )
t
(1 ) kt1 + t kt1
ct + kt
log t
log t1 + t
IIN (0, 2 )
Assume that the utility fun tion is
U (ct ) =
c1
1
t
1
is the dis ount rate
is the depre iation rate of apital
is the elasti ity of output with respe t to apital
is a te hnology sho k that is positive.
is observed in period
t.
21.3.
303
A REDUCED FORM MODEL
is the oe ient of relative risk aversion.
When
= 1,
the utility fun tion is
logarithmi .
gross investment,
it ,
is the hange in the apital sto k:
it = kt (1 ) kt1
we assume that the initial ondition
(k0 , 0 )
We would like to estimate the parameters
is given.
= , , , , , 2
using the data that we
have on onsumption and investment. This problem is very similar to the GMM estimation
of the portfolio model dis ussed in Se tions 15.11 and 15.12. On e an derive the Euler
ondition in the same way we did there, and use it to dene a GMM estimator.
approa h was not very su essful, re all.
That
Now we'll try to use some more informative
moment onditions to see if we get better results.
21.3 A redu ed form model

Ma roe onomi time series data are often modeled using ve tor autoregressions. A ve tor
autogression is just the ve tor version of an autoregressive model. Let
yt
be a
G-ve tor
of
jointly dependent variables. A VAR(p) model is
yt = c + A1 yt1 + A2 yt2 + ... + Ap ytp + vt

where
c is a G-ve tor
of parameters, and
Aj ,
j=1,2,...,p, are
G G matri es of parameters.
vt = Rt t , where t IIN (0, I2 ), and Rt is upper triangular. So V (vt |yt1 , ...ytp ) =
Rt Rt . You an think of a VAR model as the redu ed form of a dynami linear simultaneous
Let
equations model where all of the variables are treated as endogenous. Clearly, if all of the
variables are endogenous, one would need some form of additional information to identify
a stru tural model. But we already have a stru tural model, and we're only going to use
the VAR to help us estimate the parameters. A well-tting redu ed form model will be
adequate for the purpose.
We're seen that our data seems to have episodes where the varian e of growth rates
and ltered data is non- onstant. This brings us to the general area of sto hasti volatility.
Without going into details, we'll just onsider the exponential GARCH model of Nelson
(1991) as presented in Hamilton (1994, pg. 668-669).
Dene
this is a
ht = vec (Rt ),
31
the ve tor of elements in the upper triangle of
Rt
(in our ase
ve tor). We assume that the elements follow
o
n
p
log hjt = j + P(j,.) |vt1 | 2/ + (j,.)vt1 + G(j,.) log ht1
The varian e of the VAR error depends upon its own past, as well as upon the past
realizations of the sho ks.
This is an EGARCH(1,1) spe i ation. The obvious generalization is the EGARCH(r, m)

spe i ation, with longer lags (r for lags of
v, m
for lags of
h).
The advantage of the EGARCH formulation is that the varian e is assuredly positive
without parameter restri tions
The matrix
has dimension
3 2.
The matrix
has dimension
3 3.
The matrix
The parameter matrix
We will probably want to restri t these parameter matri es in some way. For instan e,
(reminder to self: this is an aleph) has dimension
allows
for
2 2.
leverage, so that positive and negative sho ks an
have asymmetri ee ts upon volatility.
ould plausibly be diagonal.
With the above spe i ation, we have
t IIN (0, I2 )
t = R1
t vt
and we know how to al ulate
Rt
and
vt ,
given the data and the parameters. Thus, it is
straighforward to do estimation by maximum likelihood. This will be the s ore generator.
21.4 Results (I): The s ore generator

21.5 Solving the stru tural model
The rst order ondition for the stru tural model is

1
c
t = Et ct+1 1 + t+1 kt
or
h
n
io 1
1
ct = Et ct+1 1 + t+1 kt
The problem is that we annot solve for
ct
sin e we do not know the solution for the
expe tation in the previous equation.

The parameterized expe tations algorithm (PEA: den Haan and Mar et, 1990), is a
means of solving the problem. The expe tations term is repla ed by a parametri fun tion.
As long as the parametri fun tion is a exible enough fun tion of variables that have been
realized in period
t,
there exist parameter values that make the approximation as lose to
the true expe tation as is desired. We will write the approximation
h
i
1
exp (0 + 1 log t + 2 log kt1 )
1
k
Et c
t+1
t
t+1
For given values of the parameters of this approximating fun tion, we an solve for
then for
kt
using the restri tion that
ct + kt = (1 ) kt1 + t kt1
ct ,
and
21.5.
305
SOLVING THE STRUCTURAL MODEL
This allows us to generate a series

updated by tting
{(ct , kt )}.
Then the expe tations approximation is

1
= exp (0 + 1 log t + 2 log kt1 ) + t
c
t+1 1 + t+1 kt
by nonlinear least squares.
The 2 step pro edure of generating data and updating the
parameters of the approximation to expe tations is iterated until the parameters no longer
hange. When this is the ase, the expe tations fun tion is the best t to the generated
data. As long it is a ri h enough parametri model to en ompass the true expe tations
fun tion, it an be made to be equal to the true expe tations fun tion by using a long
enough simulation.
Thus, given the parameters of the stru tural model,
generate data
{(ct , kt )}
it = kt (1 ) kt1 .
= , , , , , 2
using the PEA. From this we an get the series
, we an
{(ct , it )}
using
This an be used to do EMM estimation using the s ores of the
redu ed form model to dene moments, using the simulated data from the stru tural model.
Bibliography
[1 Creel. M (2005) A Note on Parallelizing the Parameterized Expe tations Algorithm.
[2 den Haan, W. and Mar et, A. (1990) Solving the sto hasti growth model by parameterized expe tations,
[3 Hamilton, J. (1994)
Journal of Business and E onomi s Statisti s, 8, 31-34.
Time Series Analysis, Prin eton Univ. Press
[4 Maliar, L. and Maliar, S. (2003) Matlab ode for Solving a Neo lassi al Growh Model with a Parametriz
[5 Nelson, D. (1991) Conditional heteros edasti ity is asset returns: a new approa h,
E onometri a, 59, 347-70.

[6 Valderrama, D. (2002) Statisti al nonlinearities in the business y le: a hallenge for
the anoni al RBC model, E onomi Resear h, Federal Reserve Bank of San Fran is o.
http://ideas.repe .org/p/fip/fedfap/2002-13.html
307
308
BIBLIOGRAPHY
Chapter 22
Introdu tion to O tave
Why is O tave being used here, sin e it's not that well-known by e onometri ians? Well,
be ause it is a high quality environment that is easily extensible, uses well-tested and high
performan e numeri al libraries, it is li ensed under the GNU GPL, so you an get it for
free and modify it if you like, and it runs on both GNU/Linux, Ma OSX and Windows
systems. It's also quite easy to learn.
22.1 Getting started

Get the ParallelKnoppix CD, as was des ribed in Se tion 1.3. Then burn the image, and
boot your omputer with it.
This will give you this same PDF le, but with all of the
example programs ready to run.
The editor is ongure with a ma ro to exe ute the
programs using O tave, whi h is of ourse installed.
From this point, I assume you are
running the CD (or sitting in the omputer room a ross the hall from my o e), or that
you have ongured your omputer to be able to run the
*.m
les mentioned below.
22.2 A short introdu tion

The obje tive of this introdu tion is to learn just the basi s of O tave. There are other
ways to use O tave, whi h I en ourage you to explore.
These are just some rudiments.
After this, you an look at the example programs s attered throughout the do ument (and
edit them, and run them) to learn more about how O tave an be used to do e onometri s.
Students of mine: your problem sets will in lude exer ises that an be done by modifying
the example programs in relatively minor ways. So study the examples!
O tave an be used intera tively, or it an be used to run programs that are written using a text editor. We'll use this se ond method, preparing programs with NEdit, and alling
O tave from within the editor. The program rst.m gets us started. To run this, open it up
with NEdit (by nding the orre t le inside the
/home/knoppix/Desktop/E onometri s
folder and li king on the i on) and then type CTRL-ALT-o, or use the O tave item in
the Shell menu (see Figure 22.1).
printf()
Edit first.m so that the 8th line reads printf(hello
Note that the output is not formatted in a pleasing way.

doesn't automati ally start a new line.
world\n);
and re-run the program.
309
That's be ause
310
CHAPTER 22.
INTRODUCTION TO OCTAVE
Figure 22.1: Running an O tave program
/home/mi hael/Mystuff/resear h/ParallelKnoppix/Examples/E onometri s/Examples/O taveIntro/
We need to know how to load and save data. The program se ond.m shows how. On e
you have run this, you will nd the le x in the dire tory
E onometri s/Examples/O taveIntro/
You might have a look at it with NEdit to see O tave's default format for saving data.
Basi ally, if you have data in an ASCII text le, named for example myfile.data, formed
of numbers separated by spa es, just use the ommand load
myfile.data.
After having
done so, the matrix myfile (without extension) will ontain the data.
Please have a look at CommonOperations.m for examples of how to do some basi
things in O tave. Now that we're done with the basi s, have a look at the O tave programs
that are in luded as examples.
If you are looking at the browsable PDF version of this
do ument, then you should be able to li k on links to open them.
If not, the example
programs are available here and the support les needed to run these are available here.
Those pages will allow you to examine individual les, out of ontext.
To a tually use
these les (edit and run them), you should go to the home page of this do ument, sin e
you will probably want to download the pdf version together with all the support les and
examples. Or get the bootable CD.
There are some other resour es for doing e onometri s with O tave. You might like to
he k the arti le E onometri s with O tave
and the E onometri s Toolbox , whi h is for
Matlab, but mu h of whi h ould be easily used with O tave.
22.3 If you're running a Linux installation...

Then to get the same behavior as found on the CD, you need to:
Get the olle tion of support programs and the examples, from the do ument home page.
Put them somewhere, and tell O tave how to nd them, e.g., by putting a link to
the MyO taveFiles dire tory in
/usr/lo al/share/o tave/site-m
Make sure nedit is installed and ongured to run O tave and use syntax highlighting.
Copy the le
/home/e onometri s/.nedit
from the CD to do this. Or, get the le
22.3.
IF YOU'RE RUNNING A LINUX INSTALLATION...
311
NeditConguration and save it in your $HOME dire tory with the name .nedit.
Not to put too ne a point on it, please note that there is a period in that name.
Asso iate
*.m
les with NEdit so that they open up in the editor when you li k on
them. That should do it.
312
CHAPTER 22.
INTRODUCTION TO OCTAVE
Chapter 23
Notation and Review
All ve tors will be olumn ve tors, unless they have a transpose symbol (or I forget
to apply this rule - your help at hing typos and er0rors is mu h appre iated). For
example, if
xt
is a
p1
ve tor,
xt
1p
is a
mean a olumn ve tor.
ve tor. When I refer to a
p-ve tor,
23.1 Notation for dierentiation of ve tors and matri es

[3, Chapter 1
Let
as a
s() : p
be a real valued fun tion of the
p-ve tor,
Following this onvention,
s()
is a
s()
=
1p

2 s()
=
s()
1
s()
2
.
.
.
s()
p
ve tor, and
s()

Let
1n
f ():p n
be a
valued transpose of
Produ t rule:
the
Let
p-ve tor .
n-ve tor
. Then
f ():p n
and
Then
has dimension
1 p.
s()
a x
x
= a.
pp
p-ve tor .
313
Let
f ()
be the
f ().
+f
be
n-ve tor

f h+
h f
p 1.
matrix. Also,
Applying the transposition rule we get
h() f () =
whi h has dimension
2 s()
is a
h():p n
h() f () = h

s()
is organized
valued fun tion of the
=
f ()
Then
Exer ise 33 For a and x both p-ve tors, show that
p-ve tor .
valued fun tions of
314
CHAPTER 23.
NOTATION AND REVIEW
Exer ise 34 For A a p p matrix and x a p 1 ve tor, show that
Chain rule :
Let
r
and let g():
Then
has dimension
f ():p n
p be a
p-ve tor
n-ve tor
x Ax
x
valued fun tion of a
valued fun tion of an
r -ve tor
= A + A .
p-ve tor
argument,
valued argument
f [g ()] =
f ()
g()
=g()
n r.
Exer ise 35 For x and both p 1 ve tors, show that
exp(x )
= exp(x )x.
23.2 Convergenge modes

Readings:
[1, Chapter 4;[4, Chapter 4.
We will onsider several modes of onvergen e.

simply for ba kground.
The rst three modes dis ussed are
The sto hasti modes are those whi h will be used later in the
ourse.
Denition 36 A sequen e is a mapping from the natural numbers {1, 2, ...} = {n}
n=1 =
{n} to some other set,
with its elements.
so that the set is ordered a ording to the natural numbers asso iated
Real-valued sequen es:

A real-valued sequen e of ve tors {an } onverges to the ve tor a if for any > 0 there exists an integer N su h that for all n > N , k an a k< .
a is the limit of an , written an a.
Denition 37
[Convergen e
Deterministi real-valued fun tions

Consider a sequen e of fun tions
{fn ()}
where
fn : T .
may be an arbitrary set.
A sequen e of fun tions {fn ()} onverges pointwise on to the fun tion f () if for all > 0 and there exists an integer N su h
that
Denition 38
[Pointwise onvergen e
|fn () f ()| < , n > N .

It's important to note that
rapid for ertain
gen e throughout
depends upon
so that onverge may be mu h more
than for others. Uniform onvergen e requires a similar rate of onver-
A sequen e of fun tions {fn ()} onverges uniformly on to the fun tion f () if for any > 0 there exists an integer N su h that
Denition 39
[Uniform onvergen e
sup |fn () f ()| < , n > N.
23.2.
315
CONVERGENGE MODES
(insert a diagram here showing the envelope around f () in whi h fn() must lie)
Sto hasti sequen es

In e onometri s, we typi ally deal with sto hasti sequen es.
(, F, P ) ,
Given a probability spa e
re all that a random variable maps the sample spa e to the real line
X() : .
A sequen e of random variables
{Xn ()}
i.e.
is a olle tion of su h mappings,
i.e., ea h Xn () is a random variable with respe t to the probability spa e (, F, P ) . For

example, given the model
Y = X 0 + ,
n = (X X)1 X Y, where n
n }. A number of
random ve tors {
the OLS estimator
is the sample size, an be used to form a sequen e of
modes of onvergen e are in use when dealing with sequen es of random variables. Several
su h modes of onvergen e should already be familiar:
Let Xn () be a sequen e of random variables,

and let X() be a random variable. Let An = { : |Xn () X()| > }. Then {Xn ()}
onverges in probability to X() if
Denition 40
[Convergen e in probability
lim P (An ) = 0, > 0.
Xn X,
Convergen e in probability is written as
or plim
Xn = X.
Let Xn () be a sequen e of random variables,

and let X() be a random variable. Let A = { : limn Xn () = X()}. Then {Xn ()}
onverges almost surely to X() if
Denition 41
[Almost sure onvergen e
P (A) = 1.
In other words,
set
C = A
Xn X, a.s.
Xn () X()
su h that
(ordinary onvergen e of the two fun tions) ex ept on a
P (C) = 0.
Almost sure onvergen e is written as
One an show that
a.s.
Xn X,
or
a.s.
Xn X Xn X.
Let the r.v. Xn have distribution fun tion

Fn and the r.v. Xn have distribution fun tion F. If Fn F at every ontinuity point of
F, then Xn onverges in distribution to X.
Denition 42
[Convergen e in distribution
Convergen e in distribution is written as
Xn X.
It an be shown that onvergen e in
probability implies onvergen e in distribution.
Sto hasti fun tions

Simple laws of large numbers (LLN's) allow us to dire tly on lude that
OLS example, sin e
n = 0 +
and
X
n
X X
n
1
X
n
a.s.
n 0
a.s.
in the
by a SLLN. Note that this term is not a fun tion of the parameter
This
easy proof is a result of the linearity of the model, whi h allows us to express the estimator
316
CHAPTER 23.
NOTATION AND REVIEW
in a way that separates parameters from random fun tions. In general, this is not possible.
We often deal with the more ompli ated situation where the sto hasti sequen e depends
on parameters in a manner that is not redu ible to a simple sequen e of random variables.
In this ase, we have a sequen e of random fun tions that depend on
ea h
Xn (, )
parameter
: {Xn (, )},
is a random variable with respe t to a probability spa e
belongs to a parameter spa e
Denition 43
[Uniform almost sure onvergen e
surely in to X(, ) if
{Xn (, )}
(, F, P )
where
and the
onverges uniformly almost
lim sup |Xn (, ) X(, )| = 0, (a.s.)
Impli it is the assumption that all
Xn (, )
and
X(, )
are random variables w.r.t.
u.a.s.
(, F, P ) for all . We'll indi ate uniform almost sure onvergen e by

onvergen e in probability by
and uniform
u.p.
An equivalent denition, based on the fa t that almost sure means with probability
one is
Pr

lim sup |Xn (, ) X(, )| = 0 = 1
This has a form similar to that of the denition of a.s. onvergen e - the essential
dieren e is the addition of the
sup.
23.3 Rates of onvergen e and asymptoti equality

It's often useful to have notation for the relative magnitudes of quantities. Quantities that
are small relative to others an often be ignored, whi h simplies analysis.
Denition 44
f (n) = o(g(n))
[Little-o
Let f (n) and g(n) be two real-valued fun tions. The notation
(n)
means limn fg(n)
= 0.
Let f (n) and g(n) be two real-valued fun tions.

The notation

f (n)
f (n) = O(g(n)) means there exists some N su h that for n > N, g(n) < K, where K
is a nite onstant.
Denition 45
[Big-O
This denition doesn't require that

If
{fn }
and
{gn }
f (n)
g(n) have a limit (it may u tuate boundedly).
are sequen es of random variables analogous denitions are
Denition 46 The notation f (n) = op (g(n)) means
f (n) p
g(n)
0.

Example 47 The least squares estimator = (X X)1 X Y = (X X)1 X X 0 + =
0 + (X X)1 X . Sin e plim (X X)1 X = 0,

= 0 + op (1). Asymptoti ally, the term op (1) is
that the LS estimator is onsistent.
we an write (X X)1 X = op (1) and

negligible. This is just a way of indi ating
Denition 48 The notation f (n) = Op (g(n)) means there exists some N su h that for
>0
and all n > N ,
where K is a nite onstant.

f (n)

< K > 1 ,
P
g(n)
23.3.
RATES OF CONVERGENCE AND ASYMPTOTIC EQUALITY
317
Example 49 If Xn N (0, 1) then Xn = Op (1), sin e, given , there is always some K
su h that P (|Xn | < K ) > 1 .

Useful rules:
Op (np )Op (nq ) = Op (np+q )

op (np )op (nq ) = op (np+q )
Example 50 Consider a random sample of iid r.v.'s with mean 0 and varian e 2 . The
P
A
estimator of the mean = 1/n ni=1 xi is asymptoti ally normally distributed, e.g., n1/2
N (0, 2 ). So n1/2 = Op (1), so = Op (n1/2 ). Before we had = op (1), now we have have
the stronger result that relates the rate of onvergen e to the sample size.
Example 51 Now onsider a random sample of iid r.v.'s with mean and varian e 2 .
P
The estimator
i=1

of the mean = 1/n
xi is asymptoti ally normally distributed, e.g.,
A
1/2
2
1/2
N (0, ). So n
= Op (1), so = Op (n1/2 ), so = Op (1).
n
These two examples show that averages of entered (mean zero) quantities typi ally
have plim 0, while averages of un entered quantities have nite nonzero plims. Note that
the denition of
Op
does not mean that
f (n)
and
g(n)
are of the same order. Asymptoti
equality ensures that this is the ase.
Denition 52 Two sequen es of random variables {fn } and {gn } are asymptoti ally equal
(written fn =a gn ) if
plim
f (n)
g(n)
Finally, analogous almost sure versions of
op
=1
and
Op
are dened in the obvious way.
318
CHAPTER 23.
For
For
For
and
both
For
and
both
and
both
pp
p1
ve tors, show that
p1
ve tors, show that
matrix and
p1
p1
NOTATION AND REVIEW
Dx a x = a.
ve tor, show that
Dx2 x Ax = A + A .
D exp x = exp(x )x.
ve tors, nd the analyti expression for
D2 exp x .
Write an O tave program that veries ea h of the previous results by taking numeri
derivatives. For a hint, type
help numgradient
and
help numhessian
inside o tave.
Chapter 24
Li enses
This do ument and the asso iated examples and materials are opyright Mi hael Creel,
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Creative Commons Attribution-Share Alike Li ense, Version 2.5. The li enses follow.
24.1 The GPL

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CHAPTER 24.
LICENSES
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CHAPTER 24.
LICENSES
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Chapter 25
The atti
This holds material that is not really ready to be in orporated into the main body, but
that I don't want to lose.
Basi ally, ignore it, unless you'd like to help get it ready for
in lusion.
25.1 Hurdle models

Returning to the Poisson model, lets look at a tual and tted ount probabilities. A tual
relative frequen ies are
Pn
f (y = j) =
i 1(yi
= j)/n
and tted frequen ies are
f(y = j) =
i=1 fY (j|xi , )/n We see that for the OBDV measure, there are many more a tual zeros
Table 25.1: A tual and Poisson tted frequen ies
Count
than predi ted.
OBDV
ERV
Count
A tual
Fitted
A tual
Fitted
0.32
0.06
0.86
0.83
0.18
0.15
0.10
0.14
0.11
0.19
0.02
0.02
0.10
0.18
0.004
0.002
0.052
0.15
0.002
0.0002
0.032
0.10
2.4e-5
For ERV, there are somewhat more a tual zeros than tted, but the
dieren e is not too important.

Why might OBDV not t the zeros well? What if people made the de ision to onta t
the do tor for a rst visit, they are si k, then the
do tor de ides on whether or not follow-up
visits are needed. This is a prin ipal/agent type situation, where the total number of visits
depends upon the de ision of both the patient and the do tor. Sin e dierent parameters
may govern the two de ision-makers hoi es, we might expe t that dierent parameters
govern the probability of zeros versus the other ounts. Let
patient's demand for visits, and let
be the parameters of the
be the paramter of the do tor's demand for visits.
The patient will initiate visits a ording to a dis rete hoi e model, for example, a logit
model:
333
334
CHAPTER 25.
THE ATTIC
Pr(Y = 0) = fY (0, p ) = 1 1/ [1 + exp(p )]

Pr(Y > 0)
1/ [1 + exp(p )] ,
The above probabilities are used to estimate the binary 0/1 hurdle pro ess.
Then, for
the observations where visits are positive, a trun ated Poisson density is estimated. This
density is
fY (y, d |y > 0) =
=
fY (y, d )
Pr(y > 0)
fY (y, d )
1 exp(d )
sin e a ording to the Poisson model with the do tor's paramaters,
Pr(y = 0) =
exp(d )0d
.
0!
Sin e the hurdle and trun ated omponents of the overall density for
share no parameters,
they may be estimated separately, whi h is omputationally more e ient than estimating
the overall model. (Re all that the BFGS algorithm, for example, will have to invert the
approximated Hessian. The omputational overhead is of order
of parameters to be estimated) . The expe tation of
K2
where
is
E(Y |x) = Pr(Y > 0|x)E(Y |Y > 0, x)

1
d
=
1 + exp(p )
1 exp(d )
is the number
25.1.
HURDLE MODELS
335
Here are hurdle Poisson estimation results for OBDV, obtained from this estimation program
**************************************************************************
MEPS data, OBDV
logit results
Strong onvergen e
Observations = 500
Fun tion value
-0.58939
t-Stats
params
t(OPG)
t(Sand.)
t(Hess)
onstant
-1.5502
-2.5709
-2.5269
-2.5560
pub_ins
1.0519
3.0520
3.0027
3.0384
priv_ins
0.45867
1.7289
1.6924
1.7166
sex
0.63570
3.0873
3.1677
3.1366
age
0.018614
2.1547
2.1969
2.1807
edu
0.039606
1.0467
0.98710
1.0222
in
0.077446
1.7655
2.1672
1.9601
Consistent Akaike
639.89
S hwartz
632.89
Hannan-Quinn
614.96
Akaike
603.39
**************************************************************************
336
CHAPTER 25.
THE ATTIC
The results for the trun ated part:
**************************************************************************
MEPS data, OBDV
tpoisson results
Strong onvergen e
Observations = 500
Fun tion value
-2.7042
t-Stats
params
t(OPG)
t(Sand.)
t(Hess)
onstant
0.54254
7.4291
1.1747
3.2323
pub_ins
0.31001
6.5708
1.7573
3.7183
priv_ins
0.014382
0.29433
0.10438
0.18112
sex
0.19075
10.293
1.1890
3.6942
age
0.016683
16.148
3.5262
7.9814
edu
0.016286
4.2144
0.56547
1.6353
in
-0.0079016
-2.3186
-0.35309
-0.96078
Consistent Akaike
2754.7
S hwartz
2747.7
Hannan-Quinn
2729.8
Akaike
2718.2
**************************************************************************
25.1.
337
HURDLE MODELS
Fitted and a tual probabilites (NB-II ts are provided as well) are:
Table 25.2: A tual and Hurdle Poisson tted frequen ies

Count
OBDV
Count
A tual
0
1
ERV
Fitted HP
Fitted NB-II
A tual
Fitted HP
Fitted NB-II
0.32
0.32
0.34
0.86
0.86
0.86
0.18
0.035
0.16
0.10
0.10
0.10
0.11
0.071
0.11
0.02
0.02
0.02
0.10
0.10
0.08
0.004
0.006
0.006
0.052
0.11
0.06
0.002
0.002
0.002
0.032
0.10
0.05
0.0005
0.001
For the Hurdle Poisson models, the ERV t is very a urate.

so good.
The OBDV t is not
Zeros are exa t, but 1's and 2's are underestimated, and higher ounts are
overestimated. For the NB-II ts, performan e is at least as good as the hurdle Poisson
model, and one should re all that many fewer parameters are used. Hurdle version of the
negative binomial model are also widely used.
25.1.1 Finite mixture models

The following are results for a mixture of 2 negative binomial (NB-I) models, for the OBDV
data, whi h you an repli ate using this estimation program
338
CHAPTER 25.
THE ATTIC
**************************************************************************
MEPS data, OBDV
mixnegbin results
Strong onvergen e
Observations = 500
Fun tion value
-2.2312
t-Stats
params
t(OPG)
t(Sand.)
t(Hess)
onstant
0.64852
1.3851
1.3226
1.4358
pub_ins
-0.062139
-0.23188
-0.13802
-0.18729
priv_ins
0.093396
0.46948
0.33046
0.40854
sex
0.39785
2.6121
2.2148
2.4882
age
0.015969
2.5173
2.5475
2.7151
edu
-0.049175
-1.8013
-1.7061
-1.8036
in
0.015880
0.58386
0.76782
0.73281
ln_alpha
0.69961
2.3456
2.0396
2.4029
onstant
-3.6130
-1.6126
-1.7365
-1.8411
pub_ins
2.3456
1.7527
3.7677
2.6519
priv_ins
0.77431
0.73854
1.1366
0.97338
sex
0.34886
0.80035
0.74016
0.81892
age
0.021425
1.1354
1.3032
1.3387
edu
0.22461
2.0922
1.7826
2.1470
in
0.019227
0.20453
0.40854
0.36313
ln_alpha
2.8419
6.2497
6.8702
7.6182
logit_inv_mix
0.85186
1.7096
1.4827
1.7883
Consistent Akaike
2353.8
S hwartz
2336.8
Hannan-Quinn
2293.3
Akaike
2265.2
**************************************************************************
Delta method for mix parameter st. err.
mix
se_mix
0.70096
0.12043
The 95% onden e interval for the mix parameter is perilously lose to 1, whi h
suggests that there may really be only one omponent density, rather than a mixture.
Again, this is
not
the way to test this - it is merely suggestive.
Edu ation is interesting.
For the subpopulation that is healthy, i.e., that makes
relatively few visits, edu ation seems to have a positive ee t on visits.
For the
25.1.
339
HURDLE MODELS
unhealthy group, edu ation has a negative ee t on visits. The other results are
more mixed. A larger sample ould help larify things.
The following are results for a 2 omponent onstrained mixture negative binomial model
where all the slope parameters in
j = exj
are the same a ross the two omponents.
The onstants and the overdispersion parameters

omponents.
are allowed to dier for the two
340
CHAPTER 25.
THE ATTIC
**************************************************************************
MEPS data, OBDV
mixnegbin results
Strong onvergen e
Observations = 500
Fun tion value
t-Stats
-2.2441
onstant
pub_ins
priv_ins
sex
params
-0.34153
0.45320
0.20663
0.37714
t(OPG)
-0.94203
2.6206
1.4258
3.1948
t(Sand.)
-0.91456
2.5088
1.3105
3.4929
t(Hess)
-0.97943
2.7067
1.3895
3.5319
age
edu
in
ln_alpha
onst_2
lnalpha_2
0.015822
0.011784
0.014088
1.1798
1.2621
2.7769
3.1212
0.65887
0.69088
4.6140
0.47525
1.5539
3.7806
0.50362
0.96831
7.2462
2.5219
6.4918
3.7042
0.58331
0.83408
6.4293
1.5060
4.2243
2.4888
0.60073
3.7224
1.9693
logit_inv_mix
Consistent Akaike
2323.5
S hwartz
2312.5
Hannan-Quinn
2284.3
Akaike
2266.1
**************************************************************************
Delta method for mix parameter st.
mix
se_mix
0.92335
0.047318
err.
Now the mixture parameter is even loser to 1.
The slope parameter estimates are pretty lose to what we got with the NB-I model.
25.2 Models for time series data

This se tion an be ignored in its present form. Just left in to form a basis for ompletion
(by someone else ?!) at some point.
Hamilton,
Time Series Analysis
is a good referen e for this se tion.
in omplete and ontributions would be very wel ome.
This is very
25.2.
341
MODELS FOR TIME SERIES DATA
Up to now we've onsidered the behavior of the dependent variable

of other variables
e.g.,
xt .
yt
as a fun tion
These variables an of ourse ontain lagged dependent variables,
xt = (wt , yt1 , ..., ytj ).
Pure time series methods onsider the behavior of
yt
as a
fun tion only of its own lagged values, un onditional on other observable variables. One
an think of this as modeling the behavior of
yt
after marginalizing out all other variables.
While it's not immediately lear why a model that has other explanatory variables should
marginalize to a linear in the parameters time series model, most time series work is done
with linear models, though nonlinear time series is also a large and growing eld. We'll
sti k with linear time series models.
25.2.1 Basi on epts

Denition 53 (Sto hasti pro ess) A sto hasti pro ess is a sequen e of random vari-
ables, indexed by time:
{Yt }
t=
(25.1)
Denition 54 (Time series) A time series is one observation of a sto hasti pro ess,
over a spe i interval:
{yt }nt=1
So a time series is a sample of size
(25.2)
from a sto hasti pro ess. It's important to keep
in mind that on eptually, one ould draw another sample, and that the values would be
dierent.
Denition 55 (Auto ovarian e) The j th auto ovarian e of a sto hasti pro ess is
jt = E(yt t )(ytj tj )
(25.3)
where t = E (yt ) .
Denition 56 (Covarian e (weak) stationarity) A sto hasti pro ess is ovarian e sta-
tionary if it has time onstant mean and auto ovarian es of all orders:
t
= , t
jt = j , t
As we've seen, this implies that
j = j :
the auto ovarian es depend only one the
interval between observations, but not the time of the observations.
Denition 57 (Strong stationarity) A sto hasti pro ess is strongly stationary if the
joint distribution of an arbitrary olle tion of the {Yt } doesn't depend on t.
Sin e moments are determined by the distribution, strong stationarityweak station-
arity.
What is the mean of

One ould think of
Yt ?
The time series is one sample from the sto hasti pro ess.
repeated samples from the sto h. pro ., e.g.,
would expe t that
M
1 X
p
lim
ytm E(Yt )
M M
m=1
{ytm }
By a LLN, we
342
CHAPTER 25.
THE ATTIC
The problem is, we have only one sample to work with, sin e we an't go ba k in time
and olle t another. How an
needed property.
E(Yt )
be estimated then? It turns out that
ergodi ity
is the
Denition 58 (Ergodi ity) A stationary sto hasti pro ess is ergodi (for the mean) if
the time average onverges to the mean
1X
p
yt
n t=1
(25.4)
A su ient ondition for ergodi ity is that the auto ovarian es be absolutely summable:
X
j=0
|j | <
This implies that the auto ovarian es die o, so that the
yt
are not so strongly dependent
that they don't satisfy a LLN.
Denition 59 (Auto orrelation) The j th auto orrelation, j is just the j th auto ovari-
an e divided by the varian e:
j =
j
0
(25.5)
Denition 60 (White noise) White noise is just the time series literature term for a
lassi al error. t is white noise if i) E(t ) = 0, t, ii) V (t ) = 2 , t, and iii) t and s are
independent, t 6= s. Gaussian white noise just adds a normality assumption.
25.2.2 ARMA models

With these on epts, we an dis uss ARMA models. These are losely related to the AR
and MA error pro esses that we've already dis ussed. The main dieren e is that the lhs
variable is observed dire tly now.
MA(q) pro esses

A
q th
order moving average (MA) pro ess is
yt = + t + 1 t1 + 2 t2 + + q tq
where
is white noise. The varian e is
= E (yt )2
= E (t + 1 t1 + 2 t2 + + q tq )2

= 2 1 + 12 + 22 + + q2
Similarly, the auto ovarian es are
= j + j+1 1 + j+2 2 + + q qj , j q
= 0, j > q
25.2.
343
Therefore an MA(q) pro ess is ne essarily ovarian e stationary and ergodi , as long as
and all of the
are nite.
AR(p) pro esses

An AR(p) pro ess an be represented as
yt = c + 1 yt1 + 2 yt2 + + p ytp + t

The dynami behavior of an AR(p) pro ess an be studied by writing this
pth
order dier-
en e equation as a ve tor rst order dieren e equation:
yt
yt1
.
.
.
ytp+1
1 2
1

0
= . 0
.
. .
..
0
0
c
1
..
0
..
..
..
yt1
0
yt2
0
.
..
0
ytp
0
0
+ .
.
.
0
or
Yt = C + F Yt1 + Et
With this, we an re ursively work forward in time:
Yt+1
= C + F Yt + Et+1
= C + F (C + F Yt1 + Et ) + Et+1
= C + F C + F 2 Yt1 + F Et + Et+1
and
Yt+2
= C + F Yt+1 + Et+2

= C + F C + F C + F 2 Yt1 + F Et + Et+1 + Et+2
= C + F C + F 2 C + F 3 Yt1 + F 2 Et + F Et+1 + Et+2

or in general
Yt+j = C + F C + + F j C + F j+1 Yt1 + F j Et + F j1 Et+1 + + F Et+j1 + Et+j

Consider the impa t of a sho k in period
on
yt+j .
This is simply
Yt+j
j
= F(1,1)
Et (1,1)
If the system is to be stationary, then as we move forward in time this impa t must die o.
Otherwise a sho k auses a permanent hange in the mean of
requires that
j
=0
lim F(1,1)
Save this result, we'll need it in a minute.
yt .
Therefore, stationarity
344
CHAPTER 25.
Consider the eigenvalues of the matrix
F.
These are the for
THE ATTIC
su h that
|F IP | = 0
The determinant here an be expressed as a polynomial. for example, for
p = 1, the matrix
is simply
F = 1
so
|1 | = 0
an be written as
1 = 0
When
p = 2,
the matrix
is
F =
"
so
F IP =
"
1 2
1
1 2
and
|F IP | = 2 1 2
So the eigenvalues are the roots of the polynomial
2 1 2
whi h an be found using the quadrati equation. This generalizes. For a
pth
order AR
pro ess, the eigenvalues are the roots of
p p1 1 p2 2 p1 p = 0
Supposing that all of the roots of this polynomial are distin t, then the matrix
an be
fa tored as
F = T T 1
where
is the matrix whi h has as its olumns the eigenve tors of
F,
and
is a diagonal
matrix with the eigenvalues on the main diagonal. Using this de omposition, we an write
F j = T T 1
where
T T 1
is repeated

T T 1 T T 1
times. This gives
F j = T j T 1
25.2.
345
and
0
=
0
j
Supposing that the
j1 0
i i = 1, 2, ..., p
j2
..
jp
are all real valued, it is lear that
j
=0
lim F(1,1)
j
requires that
|i | < 1, i = 1, 2, ..., p
e.g., the eigenvalues must be less than one in absolute value.
It may be the ase that some eigenvalues are omplex-valued. The previous result
generalizes to the requirement that the eigenvalues be less than one in
the modulus of a omplex number
a + bi
modulus, where
is
mod(a + bi) =
a2 + b2
This leads to the famous statement that stationarity requires the roots of the determinantal polynomial to lie inside the omplex unit ir le.
When there are roots on
Dynami multipliers:
draw pi ture here.
the unit ir le (unit roots) or outside the unit ir le, we
leave the world of stationary pro esses.
response
fun tion.
j
yt+j /t = F(1,1)
is a
dynami multiplier
or an
impulse-
Real eigenvalues lead to steady movements, whereas omlpex
eigenvalue lead to o illatory behavior. Of ourse, when there are multiple eigenvalues
the overall ee t an be a mixture.
pi tures
Invertibility of AR pro ess

To begin with, dene the lag operator
Lyt = yt1
The lag operator is dened to behave just as an algebrai quantity, e.g.,
L2 yt = L(Lyt )
= Lyt1
= yt2
or
(1 L)(1 + L)yt = 1 Lyt + Lyt L2 yt

= 1 yt2
346
CHAPTER 25.
THE ATTIC
A mean-zero AR(p) pro ess an be written as
yt 1 yt1 2 yt2 p ytp = t

or
yt (1 1 L 2 L2 p Lp ) = t
Fa tor this polynomial as
1 1 L 2 L2 p Lp = (1 1 L)(1 2 L) (1 p L)
For the moment, just assume that the
are oe ients to be determined.
dened to operate as an algebrai quantitiy, determination of the

mination of the
Sin e
is
is the same as deter-
su h that the following two expressions are the same for all
z:
1 1 z 2 z 2 p z p = (1 1 z)(1 2 z) (1 p z)
Multiply both sides by
z p
z p 1 z 1p 2 z 2p p1 z 1 p = (z 1 1 )(z 1 2 ) (z 1 p )
and now dene
= z 1
so we get
p 1 p1 2 p2 p1 p = ( 1 )( 2 ) ( p )
The LHS is pre isely the determinantal polynomial that gives the eigenvalues of
fore, the
matrix
F.
that are the oe ients of the fa torization are simply the eigenvalues of the
F.
Now onsider a dierent stationary pro ess
(1 L)yt = t
Stationarity, as above, implies that
Multiply both sides by
|| < 1.
1 + L + 2 L2 + ... + j Lj
to get

1 + L + 2 L2 + ... + j Lj (1 L)yt = 1 + L + 2 L2 + ... + j Lj t
or, multiplying the polynomials on th LHS, we get

1 + L + 2 L2 + ... + j Lj L 2 L2 ... j Lj j+1 Lj+1 yt

== 1 + L + 2 L2 + ... + j Lj t
and with an ellations we have
so
There-

1 j+1 Lj+1 yt = 1 + L + 2 L2 + ... + j Lj t

yt = j+1 Lj+1 yt + 1 + L + 2 L2 + ... + j Lj t
25.2.
347
Now as
j , j+1 Lj+1 yt 0,
sin e
|| < 1,
so

yt
= 1 + L + 2 L2 + ... + j Lj t
and the approximation be omes better and better as
in reases. However, we started with
(1 L)yt = t
Substituting this into the above equation we have

yt
= 1 + L + 2 L2 + ... + j Lj (1 L)yt
so

1 + L + 2 L2 + ... + j Lj (1 L)
=1
and the approximation be omes arbitrarily good as
|| < 1,
dene
(1 L)
in reases arbitrarily. Therefore, for
j Lj
j=0
Re all that our mean zero AR(p) pro ess
yt (1 1 L 2 L2 p Lp ) = t
an be written using the fa torization
yt (1 1 L)(1 2 L) (1 p L) = t
where the
are the eigenvalues of
F, and
given stationarity, all the
an invert ea h rst order polynomial on the LHS to get
|i | < 1.
Therefore, we
X
X
X
jp Lj t
j1 Lj
j2 Lj
yt =
j=0
j=0
j=0
The RHS is a produ t of innite-order polynomials in
L,
whi h an be represented as
yt = (1 + 1 L + 2 L2 + )t
where the
The
The
are real-valued and absolutely summable.
are formed of produ ts of powers of the
i ,
whi h are in turn fun tions of the
i .
i are real-valued be ause any omplex-valued i always o ur in onjugate pairs.
This means that if
a + bi
is an eigenvalue of
F,
then so is
a bi.
(a + bi) (a bi) = a2 abi + abi b2 i2

= a2 + b2
In multipli ation
348
CHAPTER 25.
THE ATTIC
whi h is real-valued.
This shows that an AR(p) pro ess is representable as an innite-order MA(q) pro ess.
Re all before that by re ursive substitution, an AR(p) pro ess an be written as
Yt+j = C + F C + + F j C + F j+1 Yt1 + F j Et + F j1 Et+1 + + F Et+j1 + Et+j

If the pro ess is mean zero, then everything with a
it by
drops out. Take this and lag
periods to get
Yt = F j+1 Ytj1 + F j Etj + F j1 Etj+1 + + F Et1 + Et

As
j , the lagged Y
on the RHS drops out. The
Ets
are ve tors of zeros ex ept
for their rst element, so we see that the rst equation here, in the limit, is just
yt =
Fj
j=0
1,1 tj
whi h makes expli it the relationship between the
and the
(and the
j
re alling the previous fa torization of F ).
Moments of AR(p) pro ess
The AR(p) pro ess is
yt = c + 1 yt1 + 2 yt2 + + p ytp + t

Assuming stationarity,
E(yt ) = , t,
so
= c + 1 + 2 + ... + p
so
c
1 1 2 ... p
and
c = 1 ... p
so
yt = 1 ... p + 1 yt1 + 2 yt2 + + p ytp + t

= 1 (yt1 ) + 2 (yt2 ) + ... + p (ytp ) + t
With this, the se ond moments are easy to nd: The varian e is
0 = 1 1 + 2 2 + ... + p p + 2
as well,
25.2.
349
The auto ovarian es of orders
j1
follow the rule
= E [(yt ) (ytj ))]

= E [(1 (yt1 ) + 2 (yt2 ) + ... + p (ytp ) + t ) (ytj )]
= 1 j1 + 2 j2 + ... + p jp
Using the fa t that

have
p+1
j>p
j = j ,
2
unknowns ( ,
one an take the
0 , 1 , ..., p )
p+1
equations for
j = 0, 1, ..., p,
and solve for the unknowns. With these, the
whi h
for
an be solved for re ursively.
Invertibility of MA(q) pro ess

An MA(q) an be written as
yt = (1 + 1 L + ... + q Lq )t
As before, the polynomial on the RHS an be fa tored as
(1 + 1 L + ... + q Lq ) = (1 1 L)(1 2 L)...(1 q L)

and ea h of the
an write
(1 i L)
an be inverted as long as
|i | < 1.
If this is the ase, then we
(1 + 1 L + ... + q Lq )1 (yt ) = t
where
(1 + 1 L + ... + q Lq )1
will be an innite-order polynomial in
X
j=0
with
0 = 1,
L,
so we get
j Lj (ytj ) = t
or
(yt ) 1 (yt1 ) 2 (yt2 ) + ... = t

or
yt = c + 1 yt1 + 2 yt2 + ... + t

where
c = + 1 + 2 + ...
So we see that an MA(q) has an innite AR representation, as long as the
i = 1, 2, ..., q.
|i | < 1,
It turns out that one an always manipulate the parameters of an MA(q) pro ess to
nd an invertible representation. For example, the two MA(1) pro esses
yt = (1 L)t
350
CHAPTER 25.
THE ATTIC
and
yt = (1 1 L)t
have exa tly the same moments if
2 = 2 2
For example, we've seen that
0 = 2 (1 + 2 ).
Given the above relationships amongst the parameters,
0 = 2 2 (1 + 2 ) = 2 (1 + 2 )
so the varian es are the same.
It turns out that
all
the auto ovarian es will be
the same, as is easily he ked. This means that the two MA pro esses are
tionally equivalent.
observa-
As before, it's impossible to distinguish between observationally
equivalent pro esses on the basis of data.
For a given MA(q) pro ess, it's always possible to manipulate the parameters to nd
an invertible representation (whi h is unique).
It's important to nd an invertible representation, sin e it's the only representation
that allows one to represent
as a fun tion of past
y s.
The other representations
express
Why is invertibility important?
The most important reason is that it provides a
justi ation for the use of parsimonious models.
Sin e an AR(1) pro ess has an
MA() representation, one an reverse the argument and note that at least some
MA() pro esses have an AR(1) representation.
At the time of estimation, it's a
lot easier to estimate the single AR(1) oe ient rather than the innite number of
oe ients asso iated with the MA representation.
This is the reason that ARMA models are popular. Combining low-order AR and
MA models an usually oer a satisfa tory representation of univariate time series
data with a reasonable number of parameters.
Stationarity and invertibility of ARMA models is similar to what we've seen - we

won't go into the details. Likewise, al ulating moments is similar.
Exer ise 61 Cal ulate the auto ovarian es of an ARMA(1,1) model: (1 + L)yt = c +
(1 + L)t
Bibliography
[1 Davidson, R. and J.G. Ma Kinnon (1993)
Estimation and Inferen e in E onometri s,
Oxford Univ. Press.

[2 Davidson, R. and J.G. Ma Kinnon (2004)
E onometri Theory and Methods, Oxford
Univ. Press.
[3 Gallant, A.R. (1985)
Nonlinear Statisti al Models, Wiley.
[4 Gallant, A.R. (1997)
An Introdu tion to E onometri Theory, Prin eton Univ. Press.
[5 Hamilton, J. (1994)
[6 Hayashi, F. (2000)
Time Series Analysis, Prin eton Univ. Press
E onometri s, Prin eton Univ. Press.
[7 Wooldridge (2003),
Introdu tory E onometri s,
supplementary use only).
351
Thomson. (undergraduate level, for
Index
asymptoti equality, 317
Chain rule, 314
Cobb-Douglas model, 22
onvergen e, almost sure, 315
onvergen e, in distribution, 315
onvergen e, in probability, 315
Convergen e, ordinary, 314
onvergen e, pointwise, 314
onvergen e, uniform, 314
onvergen e, uniform almost sure, 316
ross se tion, 19
estimator, linear, 26, 33
estimator, OLS, 23
extremum estimator, 167
tted values, 23
leverage, 27
likelihood fun tion, 41
matrix, idempotent, 26
matrix, proje tion, 25
matrix, symmetri , 26
observations, inuential, 26
outliers, 26
own inuen e, 27
parameter spa e, 41
Produ t rule, 313
R- squared, un entered, 28
R-squared, entered, 29
residuals, 23
352

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E

January 18, 2008

1 About this do ument

Obtaining the materials

An easy way to use LYX and O tave today . . . . . . . . . . . . . . . . . . .

2 Introdu tion: E onomi and e onometri models

3 Ordinary Least Squares

The Linear Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Estimation by least squares

Geometri interpretation of least squares estimation

Proje tion Matri es

Inuential observations and outliers . . . . . . . . . . . . . . . . . . . . . . .

The lassi al linear regression model

Small sample statisti al properties of the least squares estimator

The varian e of the OLS estimator and the Gauss-Markov theorem .

Example: The Nerlove model

Cobb-Douglas fun tional form . . . . . . . . . . . . . . . . . . . . . .

The Nerlove data and OLS

4 Maximum likelihood estimation

The likelihood fun tion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Example: Bernoulli trial . . . . . . . . . . . . . . . . . . . . . . . . .

The s ore fun tion

Asymptoti normality of MLE . . . . . . . . . . . . . . . . . . . . . . . . . .

Coin ipping, again . . . . . . . . . . . . . . . . . . . . . . . . . . . .

The information matrix equality

The Cramr-Rao lower bound . . . . . . . . . . . . . . . . . . . . . . . . . .

5 Asymptoti properties of the least squares estimator

6 Restri tions and hypothesis tests

Properties of the restri ted estimator . . . . . . . . . . . . . . . . . .

S ore-type tests (Rao tests, Lagrange multiplier tests)

Likelihood ratio-type tests . . . . . . . . . . . . . . . . . . . . . . . .

The asymptoti equivalen e of the LR, Wald and s ore tests . . . . . . . . .

Interpretation of test statisti s

Testing nonlinear restri tions, and the Delta Method . . . . . . . . . . . . .

Example: the Nerlove data

Exa t linear restri tions

7 Generalized least squares

Ee ts of nonspheri al disturban es on the OLS estimator . . . . . . . . . .

The GLS estimator . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Heteros edasti ity

OLS with heteros edasti onsistent var ov estimation

Example: the Nerlove model (again!) . . . . . . . . . . . . . . . . . .

Ee ts on the OLS estimator

Asymptoti ally valid inferen es with auto orrelation of unknown form 97

Testing for auto orrelation . . . . . . . . . . . . . . . . . . . . . . . .

Lagged dependent variables and auto orrelation . . . . . . . . . . . . 101

Exer ises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104

8 Sto hasti regressors

When are the assumptions reasonable? . . . . . . . . . . . . . . . . . . . . . 110

Exer ises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111

A brief aside on dummy variables . . . . . . . . . . . . . . . . . . . . 114

Dete tion of ollinearity

Dealing with ollinearity . . . . . . . . . . . . . . . . . . . . . . . . . 117

Error of measurement of the dependent variable . . . . . . . . . . . . 119

Error of measurement of the regressors . . . . . . . . . . . . . . . . . 120

Missing observations on the dependent variable . . . . . . . . . . . . 121

The sample sele tion problem . . . . . . . . . . . . . . . . . . . . . . 123

Missing observations on the regressors

Exer ises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124

10 Fun tional form and nonnested tests

10.1 Flexible fun tional forms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 128

10.1.2 FGLS estimation of a translog model . . . . . . . . . . . . . . . . . . 132

11 Exogeneity and simultaneity

Inuential observations and outliers . . . . . . . . . . . . . . . . . . . . . . .

Coin ipping, again . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Ee ts of nonspheri al disturban es on the OLS estimator . . . . . . . . . .

Ee ts on the OLS estimator

14.5.1 Coin ipping, yet again

19.1.3 Estimation of models spe ied in terms of sto hasti dierential

19.5.1 Estimation of sto hasti dierential equations . . . . . . . . . . . . . 288

23.1 Notation for dierentiation of ve tors and matri es

The t in observation spa e

Dete tion of inuential observations

Joint and Individual Conden e Regions . . . . . . . . . . . . . . . . . . . .