## Are you sure?

This action might not be possible to undo. Are you sure you want to continue?

Bruce E. Hansen c °2000, 20061 University of Wisconsin www.ssc.wisc.edu/~bhansen Revised: January 2006 Comments Welcome

This manuscript may be printed and reproduced for individual or instructional use, but may not be printed for commercial purposes.

1

Contents

1 Introduction 1.1 Economic Data . . 1.2 Observational Data 1.3 Random Sample . 1.4 Economic Data . . 1 1 1 2 2 4 4 5 6 7 8 8 9 9 10 11 11 12 14 15 15 20 21 21 22 25 26 27 28 30 32 33 34 35

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

2 Matrix Algebra 2.1 Terminology . . . . . . . . . . . . . . . . . 2.2 Matrix Multiplication . . . . . . . . . . . 2.3 Trace . . . . . . . . . . . . . . . . . . . . . 2.4 Inverse . . . . . . . . . . . . . . . . . . . . 2.5 Eigenvalues . . . . . . . . . . . . . . . . . 2.6 Rank and Positive Deﬁniteness . . . . . . 2.7 Matrix Calculus . . . . . . . . . . . . . . . 2.8 Determinant . . . . . . . . . . . . . . . . . 2.9 Kronecker Products and the Vec Operator 3 Regression and Projection 3.1 Conditional Mean . . . . . 3.2 Regression Equation . . . 3.3 Conditional Variance . . . 3.4 Linear Regression . . . . . 3.5 Best Linear Predictor . . 3.6 Exercises . . . . . . . . . 4 Least Squares Estimation 4.1 Estimation . . . . . . . . 4.2 Least Squares . . . . . . . 4.3 Normal Regression Model 4.4 Model in Matrix Notation 4.5 Projection Matrices . . . . 4.6 Residual Regression . . . 4.7 Bias and Variance . . . . 4.8 Gauss-Markov Theorem . 4.9 Semiparametric Eﬃciency 4.10 Omitted Variables . . . . 4.11 Multicollinearity . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

i

4.12 Inﬂuential Observations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.13 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 Asymptotic Theory 5.1 Inequalities . . . . . . . . . . 5.2 Weak Law of Large Numbers 5.3 Convergence in Distribution . 5.4 Asymptotic Transformations .

36 38 41 41 42 43 45 46 46 47 48 50 52 53 54 55 56 57 58 60 62 65 67 70 74 74 77 77 78 80 83 84 85 86 89 92 92 93 94 94 96 97 98 99

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

6 Inference 6.1 Sampling Distribution . . . . . . . . . . . . . . . . . . 6.2 Consistency . . . . . . . . . . . . . . . . . . . . . . . . 6.3 Asymptotic Normality . . . . . . . . . . . . . . . . . . 6.4 Covariance Matrix Estimation . . . . . . . . . . . . . . 6.5 Consistency of the White Covariance Matrix Estimate 6.6 Alternative Covariance Matrix Estimators . . . . . . . 6.7 Functions of Parameters . . . . . . . . . . . . . . . . . 6.8 t tests . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.9 Conﬁdence Intervals . . . . . . . . . . . . . . . . . . . 6.10 Wald Tests . . . . . . . . . . . . . . . . . . . . . . . . 6.11 F Tests . . . . . . . . . . . . . . . . . . . . . . . . . . 6.12 Normal Regression Model . . . . . . . . . . . . . . . . 6.13 Problems with Tests of NonLinear Hypotheses . . . . 6.14 Monte Carlo Simulation . . . . . . . . . . . . . . . . . 6.15 Estimating a Wage Equation . . . . . . . . . . . . . . 6.16 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . 7 Additional Regression Topics 7.1 Generalized Least Squares . . . . . 7.2 Testing for Heteroskedasticity . . . 7.3 Forecast Intervals . . . . . . . . . . 7.4 NonLinear Least Squares . . . . . 7.5 Least Absolute Deviations . . . . . 7.6 Quantile Regression . . . . . . . . 7.7 Testing for Omitted NonLinearity . 7.8 Irrelevant Variables . . . . . . . . . 7.9 Model Selection . . . . . . . . . . . 7.10 Exercises . . . . . . . . . . . . . . 8 The 8.1 8.2 8.3 8.4 8.5 8.6 8.7 8.8

. . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

Bootstrap Deﬁnition of the Bootstrap . . . . . . . . . The Empirical Distribution Function . . . . Nonparametric Bootstrap . . . . . . . . . . Bootstrap Estimation of Bias and Variance Percentile Intervals . . . . . . . . . . . . . . Percentile-t Equal-Tailed Interval . . . . . . Symmetric Percentile-t Intervals . . . . . . Asymptotic Expansions . . . . . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

ii

. . . . . 100 101 102 103 104 106 106 107 107 108 109 110 111 112 113 114 117 117 119 120 121 121 124 125 126 127 127 128 129 130 133 135 135 137 137 138 138 139 140 140 141 142 142 143 9 Generalized Method of Moments 9. . . . . . . . . .10 8. 10. . . . . . . . . 9. . . . . . . 12 Univariate Time Series 12. . . . . . . . . . . . . . . . . . . . . . 12. . .8 Bootstrap for Autoregressions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9 8. . . . .10Testing for Omitted Serial Correlation 12. . . . . . . . . . .3 Overidentifying Restrictions . . . . . .5 Special Cases: IV and 2SLS 11. . . . . . . . . . .4 Testing . . . . . . . . . . . . . . 12. . . . . . . .11 8. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . .7 Hypothesis Testing: The Distance Statistic 9. . . . . . . . . . . . . .5 GMM: The General Case . . . . . . . .2 Reduced Form . . . 11. . . . . . . . . . 12. . . . . . . . . . . . . 9. . . . . . . . . . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2 GMM Estimator . . . . . . . . . . . . . .6 Estimation . . . . .2 Asymptotic Distribution of EL Estimator 10. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9. . . . . . . . . . . . . . . . .12 8. . . . . . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . . . . .6 Over-Identiﬁcation Test . . . . . . . . . 11. . .5 Numerical Computation . . . . . . . 11 Endogeneity 11. . .7 Identiﬁcation Failure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Non-Parametric Likelihood . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .13 One-Sided Tests . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 Empirical Likelihood 10. . . Bootstrap Methods for Regression Models Exercises . . . . . . . . . .8. . . . . . . . . . . . . . . . 9. . . . . . . . . . . . 11. . . . . Percentile Conﬁdence Intervals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3 Identiﬁcation . . . . . . . . . . . . . . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . . . . .8 Exercises . . . . . . . . . .2 Autoregressions . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Instrumental Variables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .12Autoregressive Unit Roots . . . . . . . . . . . . .1 Stationarity and Ergodicity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . .1 Overidentiﬁed Linear Model . . . . . . . . . . . iii . . . . . . . . . . . .3 Distribution of GMM Estimator . . . . . . . . . . . . . . . Symmetric Two-Sided Tests . . . . 9. . .9 Bootstrap GMM Inference . . . . . . .3 Stationarity of AR(1) Process . . . . . . . . . . . 11. . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . . . 10. . .7 Asymptotic Distribution . . . . . . . . . . . . . . . . . .8 Conditional Moment Restrictions .9 Trend Stationarity . . . . . . . . . . . .10 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11. . 10. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . .4 Lag Operator . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4 Estimation . . . . . . . . .4 Estimation of the Eﬃcient Weight Matrix . . . . . . . . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11. . . . . . . .6 Bekker Asymptotics . . . . . .11Model Selection . . .5 Stationarity of AR(k) . . . . . . . . . . .

. iv . . . . . . . A. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A. . . .1 Binary Choice . . . . . . . . . A. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14. . . . . . . . .3 Censored Data . . . . . . . . . . . . . . . 157 15. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4 Sample Selection . . . 15 Panel Data 157 15. . . . . . . . . . . . . . . . . . . . . . . . . . . .3 Derivative-Free Methods . . . . . . . . . . . . . . . . . . . . . . . 13. . . . .3 Restricted VARs . . . . . . . . . . . . 13. . . . . . . . . . . . . . . . . . . . . . . . . . A. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Grid Search . . . . . . . . . . . . .2 Gradient Methods . . . 14 Limited Dependent Variables 14. . . . . . . . . . . . . . . . . . . . . . . . . . . . B Numerical Optimization B. . . . . . . . . . . . . . . . . . . . . . . .2 Asymptotic MSE for Kernel Estimates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5 Multivariate Random Variables . . . . . . . . . . . . . . .6 Conditional Distributions and Expectation . . .1 Kernel Density Estimation . . . . . . . . . . 162 A Probability A. . . . . . . . . . . . . 145 145 146 146 147 147 148 148 149 149 151 151 153 153 154 . . . . . . . . .7 Granger Causality . . . . . . . . B. . . . . A. . . . . . . . . . 13. . . . .1 Vector Autoregressions (VARs) . . . . . . . . . . . . . . . .3 Dynamic Panel Regression . . . . 159 16 Nonparametrics 160 16. . . . . . . . . . . . 13. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . B. . . . . . .2 Estimation . . . . . . . . . . . . . . . . . . . . . . . . . 14. . . . . . . .3 Expectation . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8 Cointegration . . . . . . . . 165 165 167 168 169 171 173 175 175 178 183 183 184 185 . . . . . . . . . . . . . . . . . . . . . . . . . . .2 Random Variables . . . . . . . .8 Normal and Related Distributions . . . . . . . . . . . . 160 16. . . . . . . . . . . . . . 14. . . . . . . . . . . . . . . . . . . . . . . . . . . . .2 Count Data . . . . . . . . . . . 13. . . . . . . . .4 Single Equation from a VAR . . . . . . . . . . . . . . . . . 13. . A. . . . . . . . . . .9 Cointegrated VARs . . . . . . . . . . . . . . . . . . . . . . . . . .9 Maximum Likelihood . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A. . . . . . . . . . . . . . .13 Multivariate Time Series 13. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .7 Transformations . . . . . . . . 13. . . . . . . . . . . . . . . . . . . . . . .6 Selection of Lag Length in an VAR .1 Individual-Eﬀects Model . . . . . . . . . . . . . . . . . .5 Testing for Omitted Serial Correlation 13. A. . . . . . . . . . . . . . .4 Common Distributions . . . . . . . . . . . . . . . . . . . . . . 157 15. . . . . . .1 Foundations .2 Fixed Eﬀects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

The quality of the study will be largely determined by the data available. households. They are distinguished by the dependence structure across observations.2 Observational Data A common econometric question is to quantify the impact of one set of variables on another variable. and then follow the children’s wage path as they mature and enter the labor force. Each individual (person. Typical examples include macroeconomic aggregates. This type of data is characterized by serial dependence. Ideally. These data sets consist surveys of a set of individuals. Another issue of interest is the earnings gap between men and women. Panel data combines elements of cross-section and time-series. The individuals surveyed may be persons. a concern in labor economics is the returns to schooling — the change in earnings induced by increasing a worker’s education. an experiment might randomly divide children into groups. what we observe (through data collection) is the level of a person’s education and their wage. we would use experimental data to answer these questions. Econometric theory concerns the study and development of tools and methods for applied econometric applications. For example. repeated over time. timeseries. or corporations. most economic data is observational.Chapter 1 Introduction Econometrics is the study of estimation and inference for economic models using economic data. Cross-sectional data sets are characterized by mutually independent observations. 1 . Surveys are a typical source for cross-sectional data. and assess the joint dependence. To measure the returns to schooling. household or corporation) is surveyed on multiple occasions. Applied econometrics concerns the application of these tools to economic data. as we are not able to manipulate one variable to see the direct eﬀect on the other. mandate diﬀerent levels of education to the diﬀerent groups. experiments such as this are infeasible. We can measure the joint distribution of these variables. However. and panel. There are three major types of economic data sets: cross-sectional. even immoral! Instead. prices and interest rates. To continue the above example. Time-series data is indexed by time. The diﬀerences between the groups could be attributed to the diﬀerent levels of education. holding other variables constant. 1. 1.1 Economic Data An econometric study requires data for analysis. But we cannot infer causality.

xi ) : i = 1. We call these observations the sample. xi } ∈ R × Rk is an observation on an individual (e. This discussion means that causality cannot be infered from observational data alone. the development of the internet has provided a convenient forum for dissemination of economic data. n} where each pair {yi . High ability individuals do better in school. This “population” is inﬁnitely large.org/ US Census: http://www. it is reasonable to model each observation as a random draw from the same probability distribution. The random variables (yi . Bureau of Labor Statistics: http://www. This abstraction can a source of confusion as it does not correspond to a physical population in the real world.bls. an econometrician has data {(y1 . . (yn . and their high ability is the fundamental reason for their high wages. x2 ) . An excellent starting point is the Resources for Economists Data Links. xi ) is independent of the pair (yj . For example. The distribution F is unknown. (y2 ..3 Random Sample Typically. xi ) . x1 ) . and this is based on strong assumptions. or iid. a person’s level of education is (at least partially) determined by that person’s choices and their achievement in education.edu/Data/index... Sometimes the independent part of the label iid is misconstrued.4 Economic Data Fortunately for economists. household or ﬁrm). Some other excellent data sources are listed below. many regressors in econometric practice are binary. taking on only the values 0 and 1. Rather it means that the pair (yi ..gov/releases/ National Bureau of Economic Research: http://www. 1. Louis: http://research.stlouisfed.org/fred2/ Board of Governors of the Federal Reserve System: http://www. Causal inference requires identiﬁcation.federalreserve...wustl.census.. Many large-scale economic datasets are available without charge from governmental agencies.gov/econ/www/ 2 . In this case the data are independent and identically distributed. Knowledge of the joint distibution cannot distinguish between these explanations. and are typically called dummy variables. (yi . xj ) for i 6= j. It is not a statement about the relationship between yi and xi . We will return to a discussion of some of these issues in Chapter 11. If the data is randomly gathered. These factors are likely to be aﬀected by their personal abilities and attitudes towards work. . The fact that a person is highly educated suggests a high level of ability. xi ) have a distribution F which we call the population.gov/ Federal Reserve Bank of St. 1.html.nber. available at http://rfe..g. . and therefore choose to attain higher levels of education.For example. If the data is cross-sectional (each observation is a diﬀerent individual) it is often reasonable to assume they are mutually independent. xn )} = {(yi . At this point in our analysis it is unimportant whether the observations yi and xi come from continuous or discrete distributions. and the goal of statistical inference is to learn about features of F from the sample. We call this a random sample. The point is that multiple explanations are consistent with a positive correlation between schooling levels and education.. This is an alternative explanation for an observed positive correlation between educational levels and wages..

sipp.apdi.gov/ CompuStat: http://www.gov/cps/cpsmain.bls.gov/sipp/ Panel Study of Income Dynamics (PSID): http://psidonline.com/www/ International Financial Statistics (IFS): http://ifs.S.Current Population Survey (CPS): http://www.doc. Bureau of Economic Analysis: http://www.census.net/imf/ 3 .compustat.htm Survey of Income and Program Participation (SIPP): http://www.census.bea.edu/ U.umich.isr.

A matrix can be written as a set of column vectors or as a set of row vectors. . α0 k where ⎢ ⎢ ai = ⎢ ⎣ 4 ⎡ a1i a2i . If k = 1 then a is a scalar. A matrix A is a k × r rectangular array of numbers. ⎡ 0 ⎤ α1 ⎢ α0 ⎥ ¤ ⎢ 2 ⎥ £ A = a1 a2 · · · ar = ⎢ . a vector a is an element of Euclidean k space. typically arranged in a column. ak1 ak2 · · · akr By convention aij refers to the i0 th row and j 0 th column of A. If r = k = 1. 2.1 Terminology Equivalently. ⎦ . ⎠ . ⎦ ⎣ . . . then A is a scalar. written as ⎤ ⎡ a11 a12 · · · a1r ⎢ a21 a22 · · · a2r ⎥ ⎥ ⎢ A=⎢ . . A vector a is a k × 1 list of numbers. . ak . ⎥ ⎣ . . ⎟ ⎝ . hence a ∈ Rk . aki ⎤ ⎥ ⎥ ⎥ ⎦ A scalar a is a single number. If r = 1 or k = 1 then A is a vector. . We write this as ⎞ ⎛ a1 ⎜ a2 ⎟ ⎟ ⎜ a=⎜ . ⎥ = [aij ] . That is.Chapter 2 Matrix Algebra This chapter reviews the essential components of matrix algebra. .

⎦ ⎣ . Then ⎡ 0 ⎤ a1 ⎢ a0 ⎥ £ ¤ ⎢ 2 ⎥ AB = ⎢ .are column vectors and α0 = j are row vectors. Ak1 Ak2 · · · Akr where the Aij denote matrices. vectors and/or scalars. ⎦ ⎣ . or the product AB. . ⎦ ⎣ . . and this is the only case where this product is deﬁned. we say that A and B. .2 Matrix Multiplication k X j=1 If a and b are both k × 1. . denoted B = A0 . . . a0 b1 a0 b2 · · · k k a0 bs k . . The transpose of a matrix. 5 Note that a0 b = b0 a. A square matrix is symmetric if A = A0 . A matrix is square if k = r. . . A square matrix is diagonal if the only non-zero elements appear on the diagonal. . Note that if A is k × r. a0 k ⎡ 0 ⎤ a1 b1 a0 b2 · · · a0 bs 1 1 ⎢ a0 b1 a0 b2 · · · a0 bs ⎥ 2 2 ⎢ 2 ⎥ = ⎢ . so that aij = 0 if i 6= j. then a0 is a 1 × k row vector. ⎥ . ⎥ . then we deﬁne their product AB by writing A as a set of row vectors and B as a set of column vectors (each of length r). If a is a k × 1 vector. then A0 is r × k. ⎥ . . A partitioned matrix takes the form ⎤ ⎡ A11 A12 · · · A1r ⎢ A21 A22 · · · A2r ⎥ ⎥ ⎢ A=⎢ . are conformable. If A is k × r and B is r × s. . . . A square matrix is upper (lower) diagonal if all elements below (above) the diagonal equal zero. a1r a2r · · · akr £ aj1 aj2 · · · ajr ¤ Thus bij = aji for all i and j. . . ⎥ b1 b2 · · · bs ⎣ . 2. is obtained by ﬂipping the matrix on its diagonal. ⎤ ⎡ a11 a21 · · · ak1 ⎢ a12 a22 · · · ak2 ⎥ ⎥ ⎢ B = A0 = ⎢ . which implies aij = aji . . ⎦ . . then their inner product is a0 b = a1 b1 + a2 b2 + · · · + ak bk = aj bj When the number of columns of A equals the number of rows of B.

. . then AIr = A and Ik A = A.3 Trace The trace of a k × k square matrix A is the sum of its diagonal elements tr (A) = k X i=1 aii Some straightforward properties for square matrices A and B are tr (cA) = c tr (A) ¡ ¢ tr A0 = tr (A) tr (Ik ) = k. . A square matrix A is called orthogonal if A0 A = Ik . . ⎤ ⎥ ⎥ ⎥ ⎦ AB = A1 A2 · · · Ar Br = A1 B1 + A2 B2 + · · · + Ar Br r X = Ar Br j=1 ¤⎢ ⎢ ⎢ ⎣ Important properties are that if A is k × r. Also. . ⎥ . . We say that two vectors a and b are orthogonal if a0 b = 0. The columns of a k × r matrix A. An important diagonal matrix is the identity matrix. A k × k identity matrix is denoted as ⎡ ⎤ 1 0 ··· 0 ⎢ 0 1 ··· 0 ⎥ ⎢ ⎥ Ik = ⎢ . . r ≤ k. for k × r A and r × k B we have tr (AB) = tr (BA) tr (A + B) = tr (A) + tr (B) 6 . ⎦ ⎣ . . which has ones on the diagonal. 0 0 ··· 1 2. ¸ B12 B22 ¸ A11 B12 + A12 B22 A21 B12 + A22 B22 ⎡ B1 B2 . For example. are said to be orthogonal if A0 A = Ir .An alternative way to write the matrix product is ∙ ¸∙ A11 A12 B11 AB = A21 A22 B21 ∙ A11 B11 + A12 B21 = A21 B11 + A22 B21 and £ to use matrix partitions.

3) The matrix A− is not necessarily unique.The can be seen since ⎢ ⎢ tr (AB) = tr ⎢ ⎣ = k X i=1 k X i=1 ⎡ a0 b1 a0 b2 · · · 1 1 a0 b1 a0 b2 · · · 2 2 . For non-singular A and C. 7 Also.3) plus the following three conditions A− AA− = A− AA− is symmetric A− A is symmetric For any matrix A. The following fact about inverting partitioned matrices is sometimes useful. or is nonsingular. This matrix is called the inverse of A and is denoted by A−1 . . the Moore-Penrose generalized inverse A− exists and is unique.4 Inverse A k × k matrix A has full rank. some properties include AA−1 = A−1 A = Ik ¡ ¢−1 ¡ −1 ¢0 = A0 A Even if a matrix A does not possess an inverse. we can still deﬁne a generalized inverse A− as a matrix which satisﬁes AA− A = A. The Moore-Penrose generalized inverse A− satisﬁes (2. . if there is no c 6= 0 such that Ac = 0. . 2. . then # ¡ ¢−1 ¡ ¢−1 ∙ ¸−1 " A − BD−1 C A B − A − BD−1 C BD−1 ¡ ¡ ¢−1 ¢−1 = . a0 bk k ⎤ ⎥ ⎥ ⎥ ⎦ a0 bi i b0 ai i = = tr (BA) .2) C D D − CA−1 B − D − CA−1 B CA−1 (AC)−1 = C −1 A−1 ¡ ¢−1 −1 (A + C)−1 = A−1 A−1 + C −1 C ¡ −1 ¢ −1 −1 −1 −1 −1 A − (A + C) = A A +C A ¡ ¢ −1 (A + BCD) = A−1 − A−1 BC C + CDA−1 BC CDA−1 (2. then A−1 = A. (2. if A is an orthogonal matrix. 0b 0b ak 1 ak 2 · · · a0 bk 1 a0 bk 2 . (2. In this case there exists a unique matrix B such that AB = BA = Ik . . If A − BD−1 C and D − CA−1 B are non-singular. .1) . .

6 Rank and Positive Deﬁniteness The rank of a square matrix is the number of its non-zero characteristic roots.. and the characteristic roots are all real. If A = G0 G.) If A is positive deﬁnite.. A square matrix A is idempotent if AA = A. then A is non-singular and A−1 exists. . 2.. c0 Ac > 0. λ−1 . which are not necessarily distinct and may be real or complex.. note that we can write A = HΛH 0 where H is orthogonal and Λ contains the (real) characteristic roots. Then A = AA = HΛH 0 HΛH 0 = HΛ2 H 0 . If A is also symmetric (most idempotent matrices are) then all its characteristic roots equal either zero or one. and then set B = HΛ1/2 . We call B a matrix square root of A. k denote the k eigenvalues and eigenvectors of a square matrix A. X 0 X is symmetric and positive deﬁnite.5 Eigenvalues det (A − λIk ) = 0. 8 . then A > 0 if and only if all its characteristic roots are positive. • If A has distinct characteristic roots. If A > 0 we can ﬁnd a matrix B such that A = BB 0 . i = 1. c0 Ac ≥ 0. We say that a square matrix A is positive semi-deﬁnite if for all non-zero c. In this case. λ−1 . Let λi and hi . Let Λ be a diagonal matrix with the characteristic roots in the diagonal. We say that A is positive deﬁnite if for all non-zero c. Furthermore. then A is positive semi-deﬁnite. We say that X is n × k. This is written as A ≥ 0. • If A is symmetric. c0 Ac = α0 a ≥ 0 where α = Gc. then A = HΛH 0 and H 0 AH = Λ. They are called the latent roots or characteristic roots or eigenvalues of A. and let H = [h1 · · · hk ]. (For any c 6= 0. then A − λi Ik is singular so there exists a non-zero vector hi such that (A − λi Ik ) hi = 0 The vector hi is called a latent vector or characteristic vector or eigenvector of A corresponding to λi . • The characteristic roots of A−1 are λ−1 . We now state some useful properties. The characteristic equation of a square matrix A is The left side is a polynomial of degree k in λ so it has exactly k roots. The matrix B need not be unique. there exists a nonsingular matrix P such that A = P −1 ΛP and P AP −1 = Λ. To see this. k < n.. Q • det(A) = k λi i=1 Pk • tr(A) = i=1 λi • A is non-singular if and only if all its characteristic roots are non-zero.. If A is symmetric.2. has full rank k if there is no non-zero c such that Xc = 0. A−1 > 0. 1 2 k The decomposition A = HΛH 0 is called the spectral decomposition of a matrix. . This is written as A > 0. One way to construct B is to use the spectral decomposition A = HΛH 0 where Λ is diagonal. If λi is an eigenvalue of A.

.7 Matrix Calculus ⎛ ∂ ∂x1 g(x) Let x = (x1 .8 Determinant The determinant is deﬁned for square matrices. Let π = (j1 . The vector derivative is ∂ ⎜ g(x) = ⎝ ∂x ∂ ∂x1 g(x) and ⎟ .. . k)). ... . Then X det A = επ a1j1 a2j2 · · · akjk π Some properties include • det A = det A0 • det (αA) = αk det A • det(AB) = (det A) (det B) ¢ ¡ • det A−1 = (det A)−1 9 . i Hence they must equal either 0 or 1.By the uniqueness of the characteristic roots. If A is 2 × 2. (a0 x) = ∂ ∂x (x0 a) = a (Ax) = A (x0 Ax) = (A + A0 ) x (x0 Ax) = A + A0 ∂2 ∂x∂x0 2.. • • • • ∂ ∂x ∂ ∂x0 ∂ ∂x ´ . and let επ = +1 if this count is even and επ = −1 if the count is odd... 2. . . we deduce that Λ2 = Λ and λ2 = λi for i = 1.. . It follows that the spectral decomposition of A takes the form ¸ ∙ In−k 0 (2...4) H0 M =H 0 0 with H 0 H = In . tr(A) = rank(A). For a general k × k matrix A = [aij ] .. xk ) be k × 1 and g(x) = g(x1 . k) .. . jk ) denote a permutation of (1. There is a unique count of the number of inversions of the indices of such permutations (relative to the natural order (1.. then its determinant is det A = a11 a22 − a12 a21 ... Additionally. ⎠ . ∂ g(x) ∂xk ··· ∂ ∂xk g(x) ⎞ ³ ∂ g(x) = ∂x0 Some properties are now summarized. xk ) : Rk → R... k.. There are k! such permutations. we can deﬁne the determinant as follows.

The Kronecker product of A and B. an Let B be any matrix. • If A is orthogonal.9 Kronecker Products and the Vec Operator Let A = [a1 a2 · · · an ] = [aij ] be m × n. . . . ⎟ . . denoted by vec (A) . . denoted A ⊗ B. . is the mn × 1 vector ⎞ ⎛ a1 ⎜ a2 ⎟ ⎟ ⎜ vec (A) = ⎜ . ⎣ ⎦ . is the matrix ⎡ ⎤ a11 B a12 B a1n B ⎢ a21 B a22 B · · · a2n B ⎥ ⎢ ⎥ A⊗B =⎢ ⎥. . .• det ∙ A B C D ¸ • det A 6= 0 if and only if A is nonsingular. These results hold for matrices for which all matrix multiplications are conformable. • (A + B) ⊗ C = A ⊗ C + B ⊗ C • (A ⊗ B) (C ⊗ D) = AC ⊗ BD • A ⊗ (B ⊗ C) = (A ⊗ B) ⊗ C • (A ⊗ B)0 = A0 ⊗ B 0 • tr (A ⊗ B) = tr (A) tr (B) • If A is m × m and B is n × n. ⎠ ⎝ . am1 B am2 B · · · amn B Some important properties are now summarized. then det A = ±1 ¢ ¡ = (det D) det A − BD−1 C if det D 6= 0 Qk i=1 aii • If A is triangular (upper or lower). . det(A ⊗ B) = (det (A))n (det (B))m • (A ⊗ B)−1 = A−1 ⊗ B −1 • If A > 0 and B > 0 then A ⊗ B > 0 • vec (ABC) = (C 0 ⊗ A) vec (B) • tr (ABCD) = vec (D0 )0 (C 0 ⊗ A) vec (B) 10 . The vec of A. then det A = 2.

holding the other variables constant.1. ⎟ . which is a common feature of wage distributions. education and experience. These are asymmetric (skewed) densities.2) m(x) = E (yi | xi = x) = −∞ In general.73. You can see that the right tail of then density is much thicker than the left tail. the conditioning variable.1) xi = ⎜ . See Chapter 16. ⎠ ⎝ . The data are from the 2004 Current Population Survey 1 11 .1. This is used when the goal is to quantify the impact of one set of variables on another variable. and exists so long as E |yi | < ∞. The two density curves show the eﬀect of gender on the distribution of wages. xki 3.1 Conditional Mean To study how the distribution of yi varies with the variables xi in the population. or the covariates. These are indicated in Figure 3.Chapter 3 Regression and Projection The most commonly applied econometric tool is regression. (3. gender. m(x) can take any form. Figure 3.1 displays the density1 of hourly wages for men and women. the mean is not necessarily a good summary of the central tendency. it is useful to have numerical measures of the diﬀerence. we can focus on f (y | x) . Take a closer look at the density functions displayed in Figure 3. An important summary measure is the conditional mean Z ∞ yf (y | x) dy. We list the elements of xi in the vector ⎞ ⎛ x1i ⎜ x2i ⎟ ⎟ ⎜ (3. In the example presented in Figure 3. the conditional density of yi given xi . . We call yi the dependent variable. and that for women is $20. xi ) where yi is a scalar (real-valued) and xi is a vector.1 by the arrows drawn to the x-axis. the mean wage for men is $27. In this context it is often convenient These are nonparametric density estimates using a Gaussian kernel with the bandwidth selected by crossvalidation. In this context we partition the observations into the pair (yi . While it is easy to observe that the two densities are unequal. When a distribution is skewed. We call xi alternatively the regressor. These are conditional density functions — the density of hourly wages conditional on race. To illustrate.22. from the population of white non-military wage earners with a college degree and 10-15 years of potential work experience.

The diﬀerence in the log mean wage between men and women is 0.30. 3. Of particular interest to graduate students may be the observation that diﬀerence between a B.Figure 3. The main point to be learned from Figure 3. The conditional expectation function is close to linear. then comparisons become more complicated.3) White non-military male wage earners with 10-15 years of potential work experience.1: Wage Densities for White College Grads with 10-15 Years Work Experience to transform the data by taking the (natural) logarithm. Figure 3. The comparison in Figure 3.3 is how the conditional expectation describes an important feature of the conditional distribution. When the distribution of the control variable is continuous. which implies a 30% average wage diﬀerence for this population. implying an average 36% diﬀerence in wage levels. wage regressions typically use log wages as a dependent variable rather than the level of wages. By construction.36. and a Ph.1 is facilitated by the fact that the control variable (gender) is discrete. Assuming for simplicity that this is the true joint distribution. 2 (3.D. with mean log hourly wages drawn in with the arrows. the solid line displays the conditional expectation of log wages varying with education.5. To illustrate. the dashed line is a linear projection approximation which will be discussed in the Section 3.2 Regression Equation The regression error ei is deﬁned to be the diﬀerence between yi and its conditional mean (3. this yields the formula yi = m(xi ) + ei .3 displays a scatter plot2 of log wages against education levels. For this reason. 12 . This is a more robust measure of the typical wage gap between men and women than the diﬀerence in the untransformed wage means.2) evaluated at the observed value of xi : ei = yi − m(xi ).A. degree in mean log hourly wages is 0. Figure 3.2 shows the density of log hourly wages for the same population.

A regression model imposes further restrictions on the joint distribution. most typically. To show the ﬁrst statement. These equations hold true by deﬁnition. 13 . are often stated jointly as the regression framework.Figure 3. 4. E (ei | xi ) = E ((yi − m(xi )) | xi ) = m(xi ) − m(xi ) = E (yi | xi ) − E (m(xi ) | xi ) = 0.2: Log Wage Densities Theorem 3. because no restrictions have been placed on the joint distribution of the data.1 Properties of the regression error ei 1. E(ei ) = 0. The equations yi = m(xi ) + ei E (ei | xi ) = 0. The remaining parts of the Theorem are left as an exercise. restrictions on the permissible class of regression functions m(x). not a model. 2. by the deﬁnition of ei and the linearity of conditional expectations. E (h(xi )ei ) = 0 for any function h (·) . E (ei | xi ) = 0. E(xi ei ) = 0.2. It is important to understand that this is a framework. 3.

A common measure of the dispersion is the conditional variance ¡ ¢ σ 2 (x) = V ar (yi | xi = x) = E e2 | xi = x . The right-hand-side is minimized by setting g(x) = m(x). In the general case i where σ 2 (x) depends on x we say that the error ei is heteroskedastic.3 Conditional Variance Generally. in the sense of achieving the lowest mean squared error. when σ 2 (x) is a constant so that ¢ ¡ (3. i . Given the random variable xi . the conditional variance of yi is σ 2 = σ 2 (xi ). Thus the mean squared error is minimized by the conditional mean. The conditional standard deviation is its square root σ(x) = σ 2 (x). subject to the restriction p that it is non-negative. 3.3.1. let g(x) be an arbitrary predictor of yi given xi = x. In contrast. To see this.Figure 3.4) E e2 | xi = σ 2 i 14 While the conditional mean is a good measure of the location of a conditional distribution. σ 2 (x) is a non-trivial function of x. The expected squared error using this prediction function is E (yi − g(xi ))2 = E (ei + m(xi ) − g(xi ))2 = Ee2 + 2E (ei (m(xi ) − g(xi ))) + E (m(xi ) − g(xi ))2 i = Ee2 + E (m(xi ) − g(xi ))2 i ≥ Ee2 i where the second equality uses Theorem 3. it does not provide information about the spread of the distribution. and can take any form.2.3: Conditional Mean of Wages Given Education The conditional mean also has the property of being the the best predictor of yi .

i (3.8) is called the linear regression model. We call this the “constant” or “intercept”. In this case (3.1. Some textbooks inappropriately describe heteroskedasticity as the case where “the variance of ei varies across observation i”. ⎠ . its functional form is typically unknown.3) can be writen as yi = x0 β + ei i E (ei | xi ) = 0.3) is when the conditional mean function m(x) is linear in x (or linear in functions of x). it is convenient to augment the regressor vector xi by listing the number “1” as an element.we say that the error ei is homoskedastic. Notationally.9) 3. take the conditional wage densities displayed in Figure 3. This concept is less helpful than deﬁning heteroskedasticity as the dependence of the conditional variance on the observables xi . Thus (3.7) is a k × 1 parameter vector. ⎟ β=⎝ . ⎝ . xki When m(x) is linear in x. βk ⎛ (3.8) (3. and the linear assumption of the previous section is empirically unlikely to accurate.4 Linear Regression An important special case of (3. Equivalently. So while men have higher average wages.1). Equation (3. As an example. it is more realistic to view the linear speciﬁcation (3. they are also somewhat more dispersed. An important special case is homoskedastic linear regression model yi = x0 β + ei i E (ei | xi ) = 0 ¢ ¡ E e2 | xi = σ 2 . we assume that x1i = 1. where x1i is the ﬁrst element of the vector xi deﬁned in (3. which we derive in this section. 15 . The conditional standard deviation for men is 12. ⎟ . 3.6) as an approximation. Instead.1) has been redeﬁned as the k × 1 vector ⎛ ⎞ 1 ⎜ x2i ⎟ ⎜ ⎟ (3.5. we can write it as m(x) = x0 β = β 1 + x2i β 2 + · · · + xki β k where ⎞ β1 ⎜ .1 and that for women is 10.6) (3.5) xi = ⎜ . ⎠ .5 Best Linear Predictor While the conditional mean m(x) = E (yi | xi = x) is the best predictor of yi among all functions of xi .

x0 β is the best linear predictor for yi . This occurs when redundant variables are included in xi . Equivalently.10). 2 2. written E (xi x0 ) > 0. E (x0 xi ) < ∞. It is invertible if and only if it is positive deﬁnite. i 4. Rewriting.1 1. Assumption 3. E (xi x0 ) is invertible. The error is i ei = yi − x0 β.5. We now summarize the assumptions necessary for its derivation and list the implications in Theorem 3. As before. β = E xi x0 i In the linear projection model the coeﬃcient β is deﬁned so that the function x0 β is the i best linear predictor of yi .10) exists and is unique as long as the k ×k matrix E (xi x0 ) is invertible.10) It is worth taking the time to understand the notation involved in this expression.11) Notice that the error from the linear prediction equation ei is equal to the error from the regression equation when (and only when) the conditional mean is linear in xi . there cannot i exist a non-zero vector α such that α0 xi = 0 identically.12) This completes the derivation of the linear projection model. For any β ∈ Rk a linear predictor for yi is x0 β with expected squared prediction i error ¢2 ¡ S(β) = E yi − x0 β i ¢ ¢ ¡ ¡ 2 = Eyi − 2E yi x0 β + β 0 E xi x0 β. Eyi < ∞. The vector (3. Observe i that for any non-zero α ∈ Rk . Therefore. by “best” we mean the predictor function with lowest mean squared error. i ∂β ¢¢−1 ¡ ¡ E (xi yi ) . i 16 . i (3. Given the deﬁnition of β in (3. i i (3.1. The ﬁrst-order condition for minimization (from Section 2. i (3. we obtain a decomposition of yi into linear predictor and error yi = x0 β + ei . The best linear predictor is obtained by selecting β to minimize S(β). α0 E (xi x0 ) α = E (α0 xi )2 ≥ 0 so the matrix E (xi x0 ) is by construction i i positive semi-deﬁnite. otherwise they are distinct. alternative expressions such as E xixi ) or E (xi yi ) (E (xi x0 ))−1 i ( i 0i ) are incoherent and incorrect.7) is 0= Solving for β we ﬁnd ¡ ¢ ∂ S(β) = −2E (xi yi ) + 2E xi x0 β. 3. this situation must be excluded.which is quadratic in β. In order for β to be uniquely deﬁned. xi contains an intercept. α0 E (xi x0 ) α = E (α0 xi )2 > 0. i which requires that for all non-zero α.5. E (xi x0 ) is a mai E(x y trix and E (xi yi ) is a vector.

13) and Assumption 3.10) ¡ ¡ ¢¢ E (xi ei ) = E xi yi − x0 β i ¡ ¢¡ ¡ ¢¢−1 E (xi yi ) = E (xi yi ) − E xi x0 E xi x0 i i = 0.2 and 3.8)-(3.2.9). Assumption 3.11) are well deﬁned.3 ensure that the moments in (3. Assumption 3.14) holds. Assumption 3.5.3 are called regularity conditions.4 guarantees that the solution β exits.4 is required to ensure that β is uniquely deﬁned. 17 .1.13) summarize the linear projection model. By deﬁnition. Let’s compare it with the linear regression model (3.1 Under Assumption 3. suppose that for xi ∈ R that Ex3 = 0 and ei = x2 .11) and (3.4 we know that the regression error has the property E (xi ei ) = 0.5.1.5.10) and (3.1 are weak.1.1.2 and 3. Equation (3.14) follows from (3. it follows that linear regression is a special case of the projection model.5.5.1.13) implies that xi and ei are uncorrelated. The ﬁnite variance Assumptions 3.1.1. (3. For example. E (xi ei ) = 0 and E (ei ) = 0. Since ei is mean zero by (3.1. This means that the equation (3.14) Proof.13) The two equations (3. x0 β is the i projection of yi on xi since the error ei is orthogonal with xi .12) can be alternatively interpreted as a projection decomposition. the converse is not true as the projection error does not necessarily satisfy E (ei | xi ) = 0. (3.10) are deﬁned.1 is employed to guarantee that (3. ¥ (3.1. Furthermore.5. Figure 3. the orthogonality restriction (3.1.Theorem 3.4: Hourly Wage as a Function of Experience The conditions listed in Assumption 3.14). Assumption 3.5. However.5.12) and (3.1. Since from Theorem 3.5. Then i i Exi e2 = Ex3 = 0 yet E (ei | xi ) = x2 6= 0. Using the deﬁnitions (3.5. i i i Since E (xi ei ) = 0 we say that xi and ei are orthogonal.5.

12) with the properties listed in Theorem 3. In this example the linear projection is a close approximation to the conditional mean. However. and under-predicts for the rest.10) may not hold and the implications of Theorem 3.5.4 displays the relationship3 between mean log hourly wages and labor market experience. there are no changes in our methods or analysis.1. the dashed line is the linear projection of log wages on eduction. The solid line is the conditional mean. in many economic models the parameter β may be deﬁned within the model. In the example just presented.12) is deﬁned by projection and the associated coeﬃcient deﬁnition (3. xi ) we can deﬁne a linear projection equation (3. and are discussed in Chapter 11.4 we display as well this quadratic projection. since the resulting function is quadratic in experience. and the straight dashed line is the linear projection. for any pair (yi . for those over 53 in age). Most importantly.1 may be false. This defect in linear projection can be partially corrected through a careful selection of regressors.3. Figure 3. it misses the strong downturn in expected wages for those above 35 years work experience (equivalently. 18 . In this case (3. it is important to not misinterpret the generality of this statement. Other than the redeﬁnition of the regressor vector. In this example it is a much better approximation to the conditional mean than the linear projection. In this case the linear projection is a poor approximation to the conditional mean.5 for a 3 In the population of Caucasian non-military male wage earners with 12 years of education. The linear equation (3.5: Conditional Mean and Two Linear Projections Another defect of linear projection is that it is sensitive to the marginal distribution of the regressors when the conditional mean is non-linear. A projection of log wages on these two variables can be called a quadratic projection. Returning to the joint distribution displayed in Figure 3. It over-predicts wages for young and old workers. We illustrate the issue in Figure 3.We have shown that under mild regularity conditions.5. In contrast. we can augment the regressor vector xi to include both experience and experience2 . In other cases the two may be quite diﬀerent. Figure 3. In Figure 1. No additional assumptions are required.10). These structural models require alternative estimation methods.

combined with diﬀerent marginal distributions for the conditioning variables. The separate linear projections of yi on xi for these two groups is displayed in the Figure with the dashed lines.constructed4 joint distribution of yi and xi . and the conditional distriubtion of yi given xi is N(m(xi ). The xi in Group 1 are N(2. 4 19 . The solid line is the non-linear conditional mean of yi given xi . These two projections are distinct approximations to the conditional mean. and Group 1 has a lower mean value of xi than Group 2. A defect with linear projection is that it leads to the incorrect conclusion that the eﬀect of xi on yi is diﬀerent for individuals in the two Groups. The apparant diﬀerence is a by-product of a linear approximation to a non-linear mean. The data are divided in two — Group 1 and Group 2 — which have diﬀerent marginal distributions for the regressor xi . 1) and those in Group 2 are N(4. This conclusion is incorrect because is fact there is no diﬀerence in the conditional mean between the two groups. 1). 1) where m(x) = 2x − x2 /6.

and E(e2 | xi ) = σ 2 . . If yi = x0 β + ei . True or False. m. σ 2 = V ar(yi ) and σ xy = Cov(xi . True or False. e−λ λj j! .2 Y =1 .3 Find E(Y | X = x).4 . E(ei | xi ) = 0. 2. Compute the conditional mean m(x) = E (yi | xi = x) . If yi = x0 β + ei and E(xi ei ) = 0. ¡ ¢ 4. If yi = x0 β + ei and E(ei | xi ) = 0. Compute 2 the coeﬃcients of the linear projection yi = β 0 + β 1 xi + ei . and have the following joint probability distribution X=0 X=1 Y =0 .1. 1. then E(x2 ei ) = 0.3. Suppose that yi is discrete-valued. i 10. then ei is independent of xi .2. True or False. True or False. σ 2 = V ar(xi ). i 11. Let X be a random variable with µ = EX and σ 2 = V ar(X). and E(ei | xi ) = 0. yi ). s) = 0 if and only if m = µ and s = σ 2 . 20 .1 . If yi = xi β + ei . j! 0 j = 0. Are they diﬀerent? Hint: If P (Y = j) = 5. y) = 3 x2 + y 2 on 0 ≤ x ≤ 1. Does this justify a linear regression model of the form yi = x0 β + εi ? i then EY = λ and V ar(Y ) = λ. E(Y 2 | X = x) and V ar(Y | X = x). (x − µ)2 − σ 2 Show that Eg (X. i 8. taking values only on the non-negative integers. True or False. 3 and 4 of Theorem 3. then ei is i i independent of xi . 9. Take the bivariate linear projection model yi = β 0 + β 1 xi + ei E (ei ) = 0 E (xi ei ) = 0 Deﬁne µy = Eyi . 0 ≤ y ≤ 1. µx = Exi . 2. x 6. Show that x y β 1 = σ xy /σ 2 and β 0 = µy − β 1 µx . Let xi and yi have the joint density f (x. σ = . a constant.. µ. xi ∈ R. Suppose that Y and X only take the values 0 and 1. and the conditional distribution of yi given xi is Poisson: P (yi = k | xi = x) = e−x β (x0 β)j . Compute E(yi | xi = x) and V ar(yi | xi = x).. xi ∈ R. Prove parts 2. then E(ei | xi ) = 0. Deﬁne µ ¶ ¢ ¡ x−µ 2 g x. i 7. and E(xi ei ) = 0. 3.6 Exercises 1. If yi = xi β + ei . then E(x2 ei ) = 0.

Chapter 4 Least Squares Estimation This chapter explores estimation and inference in the linear projection model yi = x0 β + ei i E (xi ei ) = 0 ¡ ¡ ¢¢−1 E (xi yi ) β = E xi x0 i (4. we narrow the focus to the linear regression model.3) In Sections 4.1 Estimation Equation (4.2) can be written in the parametric 0 β)) = 0.8.1) (4.3) with the sample moments: ³ ¡ ¢´−1 ˆ ˆ ˆ β = E xi x0 E (xi yi ) i Ã n !−1 n 1X 1X 0 xi xi xi yi = n n i=1 i=1 Ã n !−1 n X X = xi x0 xi yi . The function g(β) can be estimated by form g(β) = E (xi (yi − xi g (β) = ˆ ¢ 1X ¡ xi yi − x0 β . Their moment estimators are the sample moments i ˆ E (xi yi ) = ¢ ¡ ˆ E xi x0 = i 1X xi yi n 1 n i=1 n X i=1 n xi x0 .2) (4. but for most of the chapter we retain the broader focus on the projection model. (4.7 and 4. Observe that (4.4) i i=1 i=1 ˆ Another way to derive β is as follows. 4. i It follows that the moment estimator of β replaces the population moments in (4.3) writes the projection coeﬃcient β as an explicit function of population moments E (xi yi ) and E (xi x0 ) . i n i=1 n 21 .

0.4).14 205.5) = n n 1X 1X ˆ xi yi − xi x0 β i n n i=1 i=1 whose solution is (4.94 −2.ˆ This is a set of k equations which are linear in β.14 14. Let yi be log wages and xi be an intercept and years of education.3.14 14. n X i=1 2 yi − 2β 0 n X i=1 xi yi + β 0 n X i=1 xi x0 β.40 µ ¶µ ¶ 34. 30 = . excluding military. Then µ ¶ n 1X 2.83 ¶−1 µ ¶ . i 22 .4).40 n i=1 1 n Thus ˆ β = n X i=1 xi x0 i = µ 1 14. 40 0.117 1 14.71 = −2. consider the data used to generate Figure 3.14 205.37 µ ¶ 1.117 Educationi .95 xi yi = 42.2 Least Squares There is another classic motivation for the estimator (4. This sample has 988 observations. To illustrate. The estimator β is the value which jointly sets these equations equal to zero: 0 = g (β) ˆ ˆ n ´ 1X ³ ˆ xi yi − x0 β = i n i=1 (4. ¶ 2.7% increase in mean wages.83 µ We often write the estimated equation using the format \ log(W agei ) = 1.95 42. Deﬁne the sum-of-squared errors (SSE) function n X¡ ¢2 yi − x0 β Sn (β) = i i=1 = This is a quadratic function of β. 4. These are white male wage earners from the March 2004 Current Population Survey.30 + 0. An interpretation of the estimated equation is that each year of education is associated with an 11. with 10-15 years of potential work experience.170 37. 40 2.

we deﬁne the predicted value ˆ yi = x0 β ˆ i and the residual ˆ ei = yi − yi ˆ ˆ = yi − x0 β.1: Sum-of-Squared Errors Function As a by-product of OLS estimation. 23 .1 displays an example sum—of-squared errors function Sn (β) for the case k = 2.2 displays the contour lines of the same function — horizontal slices at equally spaced heights. i ˆ ˆ Note that yi = yi + ei . while the residual is a by-product of estimation. The error is unobservable. Figure 4. Figure 4. Following convention we will call β the OLS estimator of β. Matrix calculus (see Appendix 2. It is important to understand the distinction between the error ei and the residual ei .7) gives the ﬁrst-order conditions for minimization: 0 = ∂ ˆ Sn (β) ∂β n n X X ˆ = −2 xi yi + 2 xi x0 β i i=1 i=1 ˆ whose solution is (4. which can cause confusion.The Ordinary Least Squares (OLS) estimator is the value of β which minimizes Sn (β).4). Since the function Sn (β) is a quadratic function of β. These two ˆ variables are frequently mislabeled. the contour lines are ellipses. Figure 4. To visualize the sum-of-squared errors function.

5) implies that 1X xi ei = 0. ˆ n i=1 n Since xi contains a constant. ˆ n i=1 Thus the residuals have a sample mean of zero and the sample correlation between the regressors and the residual is zero. 24 . Its method of moments estimator is the sample average 1X 2 ei . ˆ n−k 2 i=1 (4.6) An alternative estimator uses the formula n 1 X 2 s = ei . The error variance σ 2 = Ee2 is also a parameter of interest. It measures the variation in the i “unexplained” part of the regression.Figure 4.7. one implication is that n 1X ei = 0. These are algebraic results. and hold true for all linear regression estimates.2: Sum-of-Squared Error Function Contours Equation (4. ˆ σ = ˆ n 2 i=1 n (4.7) A justiﬁcation for the latter choice will be provided in Section 4.

σ 2 ). σ 2 ) is a function of β only through the sum of squared errors Sn (β). This is a parametric model. Pn y2 ˆ σ2 ˆ R2 = Pn i=1 i 2 = 1 − 2 σy ˆ i=1 (yi − y) σ2 = ˆy 1X (yi − y)2 n i=1 n is the sample variance of yi . This is the linear regression model with the additional assumption that the error ei is independent of xi and has the distribution N (0. σ 2 ). The log-likelihood function for the normal regression model is Ã ¶! µ n X ¢2 1 1 ¡ 2 0 log exp − 2 yi − xi β Ln (β. The R2 is frequently mislabeled as a measure of “ﬁt”. and distribution theory. σ 2 ) maximize Ln (β. testing. it should be viewed as an estimator of the population parameter ρ2 = σ2 V ar (x0 β) i =1− 2 V ar(yi ) σy where σ 2 = V ar(yi ).where A measure of the explained variation relative to the total variation is the coeﬃcient of determination or R-squared. n−1 i=1 Theil’s estimator R is a ratio of adjusted variance estimators. Instead. σ 2 ) = − log 2πσ 2 − 2 2 2σ i=1 25 . Hence the MLE for β equals the OLS estimator. ˆ Plugging β into the log-likelihood we obtain n ¡ ¢ n 1 X 2 ˆ ei ˆ Ln (β.3 Normal Regression Model Another motivation for the least-squares estimator can be obtained from the normal regression model. maximizing the likelihood is identical to minimizing Sn (β). and therefore is expected to be a better estimator of ρ2 than the unadjusted estimator R2 . An alternative estimator of ρ2 proposed by Theil called “R-bar-squared” is y R =1− where σ2 = ˜y 2 n 2 s2 σ2 ˜y 1 X (yi − y)2 . It is an ˆ inappropriate label as the value of R2 does not help interpret the parameter estimates β or test statistics concerning β. where likelihood methods can be used for estimation. 4. Since Ln (β. σ ) = 2σ (2πσ 2 )1/2 i=1 ¡ ¢ n 1 = − log 2πσ 2 − 2 Sn (β) 2 2σ ˆ ˆ The MLE (β.

Thus the MLE (β. and X is an n × k matrix.4). ⎟. Due to this equivalence. one for each observation.Maximization with respect to σ 2 yields the ﬁrst-order condition n X ∂ n 1 ˆ ˆ Ln (β. and sample error variance can be written as ¢−1 ¡ 0 ¢ ¡ ˆ β = X 0X XY ˆ e = Y − Xβ ˆ σ 2 = n−1 e0 e. the ˆ OLS estimator β is frequently referred to as the Gaussian MLE. yn ⎟ ⎟ ⎟. For example n X i=1 For many purposes. . ⎠ . including computation.8) . σ 2 ) = − 2 + ¡ ¢2 e2 = 0. We can stack these n equations together as y1 = x0 β + e1 1 y2 = x0 β + e2 2 .12) is a system of n equations. x0 n ⎞ ⎛ e1 e2 . . 4. The linear equation (3. Sample sums can also be written in matrix notation. . n X i=1 Thus the estimator (4. n or equivalently Y = Xβ + e.6). ⎝ ⎝ . yn = x0 β + en . . ˆ ˆˆ ˆ A useful result is obtained by inserting Y = Xβ + e into the formula for β to obtain ¢ ¡ 0 ¢−1 ¡ 0 ˆ X (Xβ + e) β = XX ¡ ¢−1 ¡ 0 ¢ ¡ 0 ¢−1 0 Xe X Xβ + X 0 X = XX ¡ 0 ¢−1 0 X e. σ 2 ) for the normal ˆ regression model are identical to the method of moment estimators. ⎠ ⎜ ⎜ e=⎜ ⎝ ⎟ ⎟ ⎟. en ⎞ Observe that Y and e are n × 1 vectors.4 Model in Matrix Notation convenient to write the model and statistics in x0 1 x0 2 . ˆi 2 ∂σ 2 2ˆ σ 2 σ ˆ i=1 ˆ ˆ Solving for σ 2 yields the method of moments estimator (4. . it is matrix notation. = β+ XX 26 (4. We deﬁne ⎛ ⎞ ⎛ y1 ⎜ ⎜ y2 ⎟ ⎜ ⎟ ⎜ X=⎜ Y = ⎜ . . ⎠ xi x0 = X 0 X i xi yi = X 0 Y. residual vector.

4.5

Projection Matrices

¢−1 0 ¡ X P = X X 0X M ¡ ¢−1 0 = In − X X 0 X X = In − P

Deﬁne the matrices and

where In is the n × n identity matrix. They are called projection matrices due to the property that for any matrix Z which can be written as Z = XΓ for some matrix Γ, (we say that Z lies in the range space of X) then ¢−1 0 ¡ X XΓ = XΓ = Z P Z = P XΓ = X X 0 X M Z = (In − P ) Z = Z − P Z = Z − Z = 0. As an important example of this property, partition the matrix X into two matrices X1 and X2 , so that X = [X1 X2 ] . Then P X1 = X1 and M X1 = 0. It follows that M X = 0 and M P = 0, so M and P are orthogonal. The matrices P and M are symmetric and idempotent1 . To see that P is symmetric, ³ ¡ ¢−1 0 ´0 P 0 = X X 0X X ³¡ ¡ ¢0 ¢−1 ´0 X 0X = X0 (X)0 ³¡ ¢0 ´−1 0 = X X 0X X ³ ¡ ¢0 ´−1 0 = X (X)0 X 0 X = P. To establish that it is idempotent, ³ ¡ ¢−1 0 ´ ³ ¡ 0 ¢−1 0 ´ X X 0X X XX X X ¡ 0 ¢−1 0 ¡ 0 ¢−1 0 = X XX XX XX X ¡ 0 ¢−1 0 = X XX X = P, and MM = M (In − P )

and

PP

=

= M − MP = M

1

A matrix A is idempotent if AA = A.

27

**since M P = 0. Another useful property is that tr P tr M where the trace operator tr A = = k = n−k
**

r X j=1

(4.9) (4.10)

ajj

is the sum of the diagonal elements of the matrix A. To show (4.9) and (4.10), ³ ¡ ¢−1 0 ´ X tr P = tr X X 0 X ³¡ ¢−1 0 ´ = tr X 0 X XX = tr (Ik ) = k, and tr M = tr (In − P ) = tr (In ) − tr (P ) = n − k. Given the deﬁnitions of P and M, observe that ¢−1 0 ¡ ˆ ˆ X Y = PY Y = X β = X X 0X ˆ e = Y − X β = Y − P Y = M Y. ˆ Furthermore, since Y = Xβ + e and M X = 0, then e = M (Xβ + e) = M e. ˆ Another way of writing (4.11) is ˆ ˆ Y = (P + M ) Y = P Y + M Y = Y + e. This decomposition is orthogonal, that is ˆ ˆ Y 0 e = (P Y )0 (M Y ) = Y 0 P M Y = 0. (4.12) (4.11)

and

4.6

Residual Regression

X = [X1 X2 ] ¶ .

Partition and β= µ

β1 β2

Then the regression model can be rewritten as Y = X1 β 1 + X2 β 2 + e. 28 (4.13)

Observe that the OLS estimator of β = (β 0 , β 0 )0 can be obtained by regression of Y on X = [X1 1 2 X2 ]. OLS estimation can be written as ˆ ˆ Y = X1 β 1 + X2 β 2 + e. ˆ (4.14)

Suppose that we are primarily interested in β 2 , not in β 1 , so are only interested in obtaining ˆ ˆ the OLS sub-component β 2 . In this section we derive an alternative expression for β 2 which does not involve estimation of the full model. Deﬁne ¡ 0 ¢−1 0 X1 . M1 = In − X1 X1 X1

0 Recalling the deﬁnition M = I − X (X 0 X)−1 X 0 , observe that X1 M1 = 0 and thus ¡ 0 ¢−1 0 M1 M = M − X1 X1 X1 X1 M = M

It follows that

**M1 e = M1 M e = M e = e. ˆ ˆ Using this result, if we premultiply (4.14) by M1 we obtain M1 Y ˆ ˆ = M1 X1 β 1 + M1 X2 β 2 + M1 e ˆ ˆ = M1 X2 β + e ˆ
**

2

(4.15)

0 0ˆ the second equality since M1 X1 = 0. Premultiplying by X2 and recalling that X2 e = 0, we obtain 0 0 0 0 ˆ ˆ X2 M1 Y = X2 M1 X2 β 2 + X2 e = X2 M1 X2 β 2 . ˆ

Solving, ˆ an alternative expression for β 2 . Now, deﬁne

¡ 0 ¢ ¢−1 ¡ 0 ˆ β 2 = X2 M1 X2 X2 M1 Y ˜ X2 = M1 X2 ˜ Y = M1 Y, (4.16) (4.17)

ˆ ˜ ˜ This shows that β 2 can be calculated by the OLS regression of Y on X2 . This technique is called residual regression. Furthermore, using the deﬁnitions (4.16) and (4.17), expression (4.15) can be equivalently written as ˜ ˜ ˆ ˆ Y = X2 β 2 + e. ˆ ˜ ˜ Since β 2 is precisely the OLS coeﬃcient from a regression of Y on X2 , this shows that the residual from this regression is e, numerically the same residual as from the joint regression (4.14). We ˆ have proven the following theorem. 29

the least-squares residuals from the regression of X2 and Y, respectively, on the matrix X1 only. Since the matrix M1 is idempotent, M1 = M1 M1 and thus ¢−1 ¡ 0 ¡ 0 ¢ ˆ X2 M1 Y β 2 = X2 M1 X2 ¢ ¢−1 ¡ 0 ¡ 0 X2 M1 M1 Y = X2 M1 M1 X2 ´−1 ³ ³ ´ ˜0 ˜ ˜0 ˜ = X2 X2 X2 Y

! Thus the OLS estimator for the slope coeﬃcients is a regression with demeaned data. 4.Theorem 4. . . ¡ ¢−1 0 ι. By the independence of the observations and (3. ˆ which are “demeaned”. ⎟ ⎜ ⎟ ⎜ (4. . The FWL theorem says that β 2 is the OLS estimate from a regression of ˜ ˜ Y on X2 . which you may have seen in an introductory econometrics course. or yi − y on x2i − x2 : ˆ β2 = Ã n X i=1 (x2i − x2 ) (x2i − x2 ) 0 !−1 Ã n X i=1 (x2i − x2 ) (yi − y) . In some contexts. In this section we derive the small sample conditional mean and variance of the OLS estimator. ⎠ ⎝ ⎠ ⎝ . Regress Y on X1 . In the model (4. .1 (Frisch-Waugh-Lovell). In this case. and X2 is the vector of observed regressors. .9). but in most cases there is little computational advantage to using the two-step algorithm.9).13). Rather.18) E (e | X) = ⎜ E (ei | X) ⎟ = ⎜ E (ei | xi ) ⎟ = 0. A common application of the FWL theorem. is the demeaning formula for regression. obtain OLS estimates β 2 and residuals e. 30 . the primary use is theoretical. .7 Bias and Variance In this and the following section we consider the special case of the linear regression model (3. Regress Y on X2 . obtain residuals X2 . the FWL theorem can be used to speed computation. . observe that ⎞ ⎛ ⎞ ⎛ . ˆ ˜ ˜ ˆ 3.8)(3. the OLS estimator of β 2 and the OLS residuals e may be equivalently computed by either the OLS regression (4.14) or via the ˆ following algorithm: ˜ 1.6. M1 = I − ι ι0 ι Observe that ¡ ¢−1 0 ˜ ι X2 X2 = M1 X2 = X2 − ι ι0 ι = X2 − X 2 and ˜ Y ¡ ¢−1 0 = M1 Y = Y − ι ι0 ι ιY = Y −Y. Regress X2 on X1 . Partition X = [X1 X2 ] where X1 = ι is a vector of ones. obtain residuals Y . . . . ˜ 2.

for any random vector Z deﬁne the covariance materix V ar(Z) = E (Z − EZ) (Z − EZ)0 = EZZ 0 − (EZ) (EZ)0 .. under the of ˆ ¢ 2 | x = σ 2 . . .. V ar β | X = X 0 X ⎟ ⎟ ⎟. From (4. 0 0 ··· 0 0 . X 0 DX = X 0 Xσ 2 . ⎝ . 1 n . σ 2 = σ 2 and we have the simplii ﬁcations D = In σ 2 . σ 2 } = ⎜ . Next.18). we can calculate ³ ´ ³¡ ´ ¢−1 0 ˆ E β−β |X = E X 0X Xe|X ¢−1 0 ¡ X E (e | X) = X 0X = 0. and (4. .. ⎠ (4. σ2 = ˆ ¢ 1 ¡ ¢ 1 0 1 1 1 ¡ e e = e0 M M e = e0 M e = tr e0 M e = tr M ee0 ˆˆ n n n n n 31 In the special case of the linear homoskedastic regression model.20) . the properties of conditional expectations. and the trace operator observe that. ..8). . the properties additional assumption of conditional homoskedasticity E ei i of projection matrices. Thus D is a diagonal matrix with i’th diagonal element σ 2 : i ⎛ 2 σ1 0 · · · ⎜ 0 σ2 · · · 2 ⎜ D = diag{σ 2 .Using (4. . ¡ X 0X ¢−1 ¡ ¢−1 X 0 DX X 0 X while the ij 0 th oﬀ-diagonal element of D is ¢ ¢ ¡ ¡ E e2 | X = E e2 | xi = σ 2 i i i E (ei ej | X) = E (ei | xi ) E (ej | xj ) = 0. Then given (4. . σ2 n ⎞ We now calculate the ﬁnite sample bias of the method ¡ moments estimator σ 2 for σ 2 . and ³ ´ ¡ ¢−1 2 ˆ σ .19) we see that ¶ µ³ ³ ´ ´³ ´0 ˆ ˆ ˆ V ar β | X = E β−β β−β |X = where The i’th diagonal element of D is ¡ ¢ D = E ee0 | X . We have shown that which implies ³ ´ ˆ E β|X =β ³ ´ ˆ E β =β (4.12).19) ˆ and thus the OLS estimator β is unbiased for β. .

10).1 Gauss-Markov. known as the Gauss-Markov theorem.7) is unbiased for σ 2 by this calculation. ³ ´ ˜ E β | X = A0 Xβ. It is important to remember. Thus since V ar (e | X) = In σ 2 under homoskedasticity. It is not unbiased in the absence of homoskedasticity. ˜ β L = A0 Y = A (Xβ + e) = β + Ae. that this estimator is only unbiased in the special case of the homoskedastic linear regression model. as it yields the smallest variance among all unbiased linear estimators. ³ ´ ˜ V ar β | X = A0 V ar (e | X) A = A0 Aσ 2 . = σ2 n the ﬁnal equality by (4. The following result. which is (3. is a famous statement of the solution. Now consider the class of estimators of β which are linear functions of i the vector Y. we can write The “best” linear estimator is obtained by ﬁnding the matrix A for which this variance is the smallest in the positive deﬁnite sense. the estimator ˆ 2 deﬁned (4. Thus σ 2 is biased towards zero. Theorem 4. 32 . By a calculation similar to those of the previous section. or in the projection model. ˜ so β is unbiased if (and only if) A0 X = Ik . As an alternative.8 Gauss-Markov Theorem In this section we restrict attention to the homoskedastic linear regression model. says that the least-squares estimator is the best choice. the best (minimumvariance) unbiased linear estimator is OLS. 4. and thus can be written as ˜ β = A0 Y where A is an n × k function of X.8. however.Then ¢ ¡ E σ2 | X = ˆ ¢¤ 1 £ ¡ tr E M ee0 | X n ¡ ¢¤ 1 £ = tr M E ee0 | X n ¤ 1 £ tr M σ 2 = n n−k . This is the justiﬁcation for the common s ˆ preference of s2 over σ 2 in empirical practice.8)¢ ¡ (3. What is the best choice of A? The Gauss-Markov theorem. which we now present.9) plus E e2 | xi = σ 2 . The least-squares estimator is the special case obtained by setting A = X(X 0 X)−1 . In this case. In the homoskedastic linear regression model.

xi = ξ j = π j . as the theorem leaves open the possibility that a non-linear or biased estimator could have lower mean squared error than the least-squares estimator. As the data are multinomial.. but the π j are unknown.. j = 1.. ¥ The Gauss-Markov theorem is an eﬃciency justiﬁcation for the least-squares estimator. Then we calculate that ³ ¡ ¡ ¢−1 ¡ ¢−1 ´0 ³ ¢−1∗ ´ ¡ 0 ¢−1 C + X X 0X − XX = C + X X 0X A0 A − X 0 X ¡ 0 ¢−1 ¡ 0 ¢−1 0 ¡ ¢−1 0 ¡ 0 ¢−1 ¡ 0 ¢−1 = C 0C + C 0X X X + XX X C + X 0X XX XX − XX = C 0C The matrix C 0 C is positive semi-deﬁnite (see Appendix 2. . but it is quite limited in scope. xi ) is discrete. the maximum likelihood estimator (MLE) is ¡ ¢ 1X 1 (yi = τ j ) 1 xi = ξ j πj = ˆ n i=1 n for j = 1. The variance of the least-squares estimator is (X 0 X)−1 σ 2 and that of A0 Y is A0 Aσ 2 .5) as required. This property is called semiparametric eﬃciency. r for some constant vectors τ j ... It is suﬃcient to show that the diﬀerence A0 A − (X 0 X)−1 is positive semi-deﬁnite.. . who established that in the projection model the OLS estimator has the smallest asymptotic meansquared error among feasible estimators. Let A be any n×k function of X such that A0 X = Ik . π j is the percentage of the observations ˆ ˆ which fall in each category. Assume that the τ j and ξ j are known. That is.3) can be rewritten as ⎞−1 ⎛ ⎞ ⎛ r r X X β=⎝ πj ξ j ξ 0 ⎠ ⎝ πj ξ j τ j ⎠ (4.. 4. Note that X 0 C = 0.21) with the parameters ˆ π j replaced by the estimates π j : ⎞−1 ⎛ ⎞ ⎛ r r X X ˆ πj ξj ξ0 ⎠ ⎝ ˆ πj ξ j τ j ⎠ . Set C = A − X (X 0 X)−1 .. π r ) . and is a strong justiﬁcation for the least-squares estimator.21) j j=1 j=1 Thus β is a function of (π 1 .. but we don’t know the probabilities. r. ¡ ¢ P yi = τ j .Proof.) In this discrete setting. The MLE β mle for β is then the analog of (4. Not only has the class of models has been restricted to homoskedastic linear regressions. ξ j . where 1 (·) is the indicator function. and π j . the class of potential estimators has been restricted to linear unbiased estimators. Suppose that the joint distribution of (yi .9 Semiparametric Eﬃciency In the previous section we presented the Gauss-Markov theorem as a limited eﬃciency justiﬁcation for the least-squares estimator. A broader justiﬁcation is provided in Chamberlain (1987). This latter restriction is particularly unsatisfactory. (We know the values yi and xi can take. That is. We discuss the intuition behind his result in this section. the deﬁnition (4. . ˆ β mle = ⎝ j j=1 j=1 33 . for ﬁnite r.

Let the regressors be partitioned as Suppose we are interested in the coeﬃcient on x1i alone in the regression of yi on the full set xi . ˆ r X j=1 πj ξ j ξ 0 ˆ j r n X1X ¡ ¢ = 1 (yi = τ j ) 1 xi = ξ j ξ j ξ 0 j n j=1 = 1 n 1 n i=1 n X X r i=1 j=1 n X i=1 ¡ ¢ 1 (yi = τ j ) 1 xi = ξ j xi x0 i = and r X j=1 xi x0 i πj ξ j τ j ˆ r n X1X ¡ ¢ = 1 (yi = τ j ) 1 xi = ξ j ξ j τ j n j=1 i=1 = r n ¡ ¢ 1 XX 1 (yi = τ j ) 1 xi = ξ j xi yi n = Thus ˆ β mle = Ã 1 n n i=1 j=1 n X i=1 xi yi !−1 Ã ! In other words. He proves that generically the OLS estimator (4.Substituting in the expressions for π j .4) is an asymptotically eﬃcient estimator for the parameter β deﬁned in (3. Chamberlain (1987) extends this argument to the case of continuously-distributed data. Since this is a regular parametric model the MLE is asymptotically eﬃcient (see Appendix A.10 Omitted Variables xi = µ x1i x2i ¶ .22) 34 .5.9). 1X xi x0 i n i=1 1X xi yi n i=1 n ˆ = β ols 4. the maximum likelihood estimator is identical to the OLS estimator. and thus so is the OLS estimator. and any continuous distribution can be arbitrarily well approximated by a multinomial distribution. We can write the model as yi = x0 β 1 + x0 β 2 + ei 1i 2i E (xi ei ) = 0 where the parameter of interest is β 1 . if the data have a discrete distribution. (4.10) for the class of models satisfying Assumption 3.1. He observes that the above argument holds for all multinomial distributions.

log(p2 ) and log(p1 /p2 ). To see this. Typically.e. Observe that γ 1 6= β 1 unless Γ = 0 or β 2 = 0.23) is an estimate of γ 1 = β 1 + Γβ 2 rather than β 1 . This is one diﬃculty with the deﬁnition and interpretation of multicollinearity. This deﬁnition is not precise. First.Now suppose that instead of estimating equation (4. This is the situation when the X 0 X matrix is near singular. Goldberger (1991) calls (4. then β is not deﬁned. In this case.22). this is rarely a problem for applied econometric practice.11 Multicollinearity ˆ If rank(X 0 X) < k + 1. The more relevant issue is near multicollinearity.22) is zero. the coeﬃcient on x2i in (4.22) by least-squares.. i. To avoid omitted variables bias the standard advice is to include potentially relevant variables in the estimated model. In general. least-squares estimation of (4. log(p1 ). β 1 6= γ 1 . 4. Thus the short and long regressions have the same coeﬃcient on x1i only under one of two conditions. or second. and the error as ui rather than ei .22) the long regression and (4. 35 . when the columns of X are close to linearly dependent. except in special cases. Since the error is discovered quickly. Typically there are limits. the regression of x2i on x1i yields a set of zero coeﬃcients (they are uncorrelated). we calculate γ1 = ¡ ¡ ¢¢−1 E x1i x0 E (x1i yi ) 1i ¡ ¡ ¢¢−1 ¡ ¡ 0 ¢¢ 0 E x1i x1i β 1 + x0 β 2 + ei = E x1i x1i 2i ¢¢−1 ¡ ¢ ¡ ¡ E x1i x0 β 2 = β 1 + E x1i x0 1i 2i = β 1 + Γβ 2 ¢¢−1 ¡ ¢ ¡ ¡ E x1i x0 Γ = E x1i x0 1i 2i (4. By construction. This is because the model being estimated is diﬀerent than (4. When this happens. This is called strict multicollinearity. Most commonly. the general model will be free of the omitted variables problem. This happens when the columns of X are linearly dependent. the applied researcher quickly discovers the error as the statistical software will be unable to construct (X 0 X)−1 . if X includes both the logs of two prices and the log of the relative prices. we regress yi on x1i only. The diﬀerence Γβ 2 is known as omitted variable bias. this arises when sets of regressors are included which are identically related. which is often called “multicollinearity” for brevity. This is estimation of the equation yi = x0 γ 1 + ui 1i E (x1i ui ) = 0 Notice that we have written the coeﬃcient on x1i as γ 1 rather than β 1 . For example. because we have not said what it means for a matrix to be “near singular”.23) the short regression to emphasize the distinction. the possibility of omitted variables bias should be acknowledged and discussed in the course of an empirical investigation. It is the consequence of omission of a relevant correlated variable. as many desired variables are not available in a given dataset.23) where is the coeﬃcient from a regression of x2i on x1i . there is some α such that Xα = 0.

ˆ i A simple comparison yields that ˆ ei − ei. µ ¶−1 µ ¶ ³ ´ 2 σ2 1 ρ 1 −ρ ˆ|X = σ .25) β (−i) = β − (1 − hi )−1 X 0 X where ¢−1 ¡ xi hi = x0 X 0 X i The i’th observation is inﬂuential on the least-squares estimate if the deletion of the observation ˆ from the sample results in a meaningful change in β. To investigate the possibility of inﬂuential observations. If the i’th observation 36 . We can see this most simply in a homoskedastic linear regression model with two regressors yi = x1i β 1 + x2i β 2 + ei . A more relevant implication of near multicollinearity is that individual coeﬃcient estimates will be imprecise. and 1 0 XX= n µ 1 ρ ρ 1 ¶ In this case The correlation ρ indexes collinearity. We derive expression (4. We can also deﬁne the leave-one-out residual ˆ ˆ ei. deﬁne the leave-one-out least-squares estimator of β. = V ar β ρ 1 n n (1 − ρ2 ) −ρ 1 4.−i = yi − x0 β (−i) = (1 − hi )−1 ei . that is.One implication of near singularity of matrices is that the numerical reliability of the calculations is reduced. the change in the coeﬃcient estimate by deletion of the i’th observation depends critically on the magnitude of hi .25) below. since as ρ approaches 1 the matrix becomes singular. the precision of individual estimates are reduced. Thus the more “collinear” are the estimate σ 2 1 − ρ2 regressors.27) (4. 1] and sum to k. This equals ´−1 ³ 0 ˆ X(−i) Y(−i) (4. In extreme cases it is possible that the reported calculations will be in error due to ﬂoating-point calculation diﬃculties.12 Inﬂuential Observations where X(−i) and Y(−i) are the data matrices omitting the i’th row. As a consequence.−i = (1 − hi )−1 hi ei . the OLS estimator based on the sample excluding the i’th observation.26) As we can see. ˆ ˆ (4. We can see the eﬀect of collinearity on precision by observing that the asymptotic variance of a coeﬃcient ¡ ¢−1 approaches inﬁnity as ρ approaches 1. What is happening is that when the regressors are highly dependent.24) β (−i) = X(−i) X(−i) is the i’th diagonal element of the projection matrix X (X 0 X)−1 X 0 . A convenient alternative expression is ¡ ¢−1 ˆ ˆ xi ei ˆ (4. the worse the precision of the individual coeﬃcient estimates. it is statistically diﬃcult to disentangle the impact of β 1 from that of β 2 . The hi take values in [0.

Investigations into the presence of inﬂuential observations can plot the values of (4. ¢−1 ¡ 0 ¢−1 ¡ 0 ¢−1 ¡ 0 ¢−1 ¡ = XX + XX xi (1 − hi )−1 x0 X 0 X X X − xi x0 i i ¡ 0 ¢−1 ¡ 0 ¢ X X − xi x0 X Y − xi yi i ¢ ¡ ¡ ¢ ¡ ¢−1 ¡ 0 ¢−1 ¢−1 ¡ 0 X Y − xi yi + (1 − hi )−1 X 0 X X Y − xi yi = X 0X xi x0 X 0 X i ¢−1 ¡ ˆ xi ei .1) in Section 2.27). ˆ = β − (1 − hi )−1 X 0 X and thus ˆ β (−i) = 37 . which is considerably more informative than plots of the uncorrected residuals ei .25). ˆ We now derive equation (4. then this observation is a leverage point and has the potential to be an inﬂuential observation.This implies has a large value of hi . The key is equation (2.4 which states that ¡ ¢ (A + BCD)−1 = A−1 − A−1 BC C + CDA−1 BC CDA−1 .

4.13

Exercises

1. Let X be a random variable with µ = EX and σ 2 = V ar(X). Deﬁne µ ¶ ¢ ¡ x−µ 2 . g x, µ, σ = (x − µ)2 − σ 2

µ ˆ Let (ˆ , σ 2 ) be the values such that g n (ˆ , σ 2 ) = 0 where g n (m, s) = n−1 µ ˆ 2 Show that µ and σ are the sample mean and variance. ˆ ˆ

Pn

i=1 g

¡ ¢ Xi , µ, σ 2 .

2. Consider the OLS regression of the n × 1 vector y on the n × k matrix X. Consider an alternative set of regressors Z = XC, where C is a k × k non-singular matrix. Thus, each column of Z is a mixture of some of the columns of X. Compare the OLS estimates and residuals from the regression of Y on X to the OLS estimates from the regression of Y on Z.

0ˆ 3. Let e be the OLS residual from a regression of Y on X = [X1 X2 ]. Find X2 e. ˆ

4. Let e be the OLS residual from a regression of Y on X. Find the OLS coeﬃcient estimate ˆ from a regression of e on X. ˆ ˆ 5. Let y = X(X 0 X)−1 X 0 y. Find the OLS coeﬃcient estimate from a regression of y on X. ˆ ˆ 6. Prove that R2 is the square of the simple correlation between y and y. Pn 1 7. Explain the diﬀerence between n i=1 xi x0 and E (xi x0 ) . i i

0 0 ˆ 8. Let β n = (Xn Xn )−1 Xn Yn denote the OLS estimate when Yn is n × 1 and Xn is n × k. A new observation (yn+1 , xn+1 ) becomes available. Prove that the OLS estimate computed using this additional observation is ³ ´ ¡ 0 ¢−1 1 ˆ ˆ ˆ xn+1 yn+1 − x0 β n . β n+1 = β n + Xn Xn n+1 0 1 + x0 (Xn Xn )−1 xn+1 n+1

9. True or False. If yi = xi β + ei , xi ∈ R, E(ei | xi ) = 0, and ei is the OLS residual from the ˆ P ˆ regression of yi on xi , then n x2 ei = 0. i=1 i 10. A dummy variable takes on only the values 0 and 1. It is used for categorical data, such as an individual’s gender. Let D1 and D2 be vectors of 1’s and 0’s, with the i0 th element of D1 equaling 1 and that of D2 equaling 0 if the person is a man, and the reverse if the person is a woman. Suppose that there are n1 men and n2 women in the sample. Consider the three regressions Y Y Y = µ + D1 α1 + D2 α2 + e = D1 α1 + D2 α2 + e = µ + D1 φ + e (4.28) (4.29) (4.30)

(a) Can all three regressions (4.28), (4.29), and (4.30) be estimated by OLS? Explain if not. (b) Compare regressions (4.29) and (4.30). Is one more general than the other? Explain the relationship between the parameters in (4.29) and (4.30). 38

(d) Letting α = (α0 α0 )0 , write equation (4.29) as Y = Xα + e. Consider the assumption 1 2 E(xi ei ) = 0. Is there any content to this assumption in this setting? 11. Let D1 and D2 be deﬁned as in the previous exercise. (a) In the OLS regression Y = D1 γ 1 + D2 γ 2 + u, ˆ ˆ ˆ show that γ 1 is sample mean of the dependent variable among the men of the sample ˆ (Y 1 ), and that γ 2 is the sample mean among the women (Y 2 ). ˆ (b) Describe in words the transformations Y ∗ = Y − D1 Y 1 + D2 Y 2

(c) Compute ι0 D1 and ι0 D2 , where ι is an n × 1 is a vector of ones.

X ∗ = X − D1 X 1 + D2 X 2 . ˜ (c) Compare β from the OLS regresion ˜ ˜ Y ∗ = X ∗β + e ˆ with β from the OLS regression ˆ ˆ Y = D1 α1 + D2 α2 + X β + e. ˆ ˆ 12. The data ﬁle cps85.dat contains a random sample of 528 individuals from the 1985 Current Population Survey by the U.S. Census Bureau. The ﬁle contains observations on nine variables, listed in the ﬁle cps85.pdf. V1 V2 V3 V4 V5 V6 V7 V8 V9 = = = = = = = = = education (in years) region of residence (coded 1 if South, 0 otherwise) (coded 1 if nonwhite and non-Hispanic, 0 otherwise) (coded 1 if Hispanic, 0 otherwise) gender (coded 1 if female, 0 otherwise) marital status (coded 1 if married, 0 otherwise) potential labor market experience (in years) union status (coded 1 if in union job, 0 otherwise) hourly wage (in dollars)

Estimate a regression of wage yi on education x1i , experience x2i , and experienced-squared x3i = x2 (and a constant). Report the OLS estimates. 2i ˆ Let ei be the OLS residual and yi the predicted value from the regression. Numerically ˆ calculate the following: (a) (b) (c) (d) (e) Pn Pn Pn Pn ˆ i=1 ei ˆ i=1 x1i ei

ˆ i=1 x2i ei 2 ˆ i=1 x1i ei Pn 2 ˆ i=1 x2i ei

39

(f) (g) (h)

Pn

Pn

ˆˆ i=1 yi ei ˆ2 i=1 ei R2

Are the calculations (i)-(vi) consistent with the theoretical properties of OLS? Explain. 13. Use the data from the previous problem, restimate the slope on education using the residual regression approach. Regress yi on (1, x2i , x2 ), regress x1i on (1, x2i , x2 ), and regress the 2i 2i residuals on the residuals. Report the estimate from this regression. Does it equal the value from the ﬁrst OLS regression? Explain. In the second-stage residual regression, (the regression of the residuals on the residuals), calculate the equation R2 and sum of squared errors. Do they equal the values from the initial OLS regression? Explain.

40

We list here some of the most critical deﬁnitions and inequalities. then g(E(X)) ≤ E(g(X)). then its Euclidean norm is The following are an important set of inequalities which are used in asymptotic distribution theory. ´1/2 ³ ´1/2 ³ E |Y |2 E |XY | ≤ E |X|2 Holder’s Inequality. The Euclidean norm of an m × 1 vector a is Ã m !1/2 X ¡ 0 ¢1/2 = a2 .2) + 1 q = 1. |a| = a a i i=1 If A is a m × n matrix.Chapter 5 Asymptotic Theory This chapter reviews the essential components of asymptotic theory. ij i=1 j=1 (5. If p > 1 and q > 1 and 1 p ⎞1/2 ⎛ m n XX ¡ 0 ¢1/2 |A| = tr A A =⎝ a2 ⎠ . These approximations are bounded through the use of mathematical inequalities. then (5. 5.1 Inequalities Asymptotic theory is based on a set of approximations.3) E |XY | ≤ (E |X|p )1/p (E |Y |q )1/q . 41 . Cauchy-Schwarz Inequality. Jensen’s Inequality. Triangle inequality |X + Y | ≤ |X| + |Y | . If g(·) : R → R is convex.1) (5.

denoted Zn →p Z as n → ∞.1 Weak Law of Large Numbers (WLLN). Applying expectations. (5. Then Z ∞ −1 P (Y > α) = α αf (y)dy Zα∞ ≤ α−1 yf (y)dy α Z ∞ ≤ α−1 yf (y)dy = α−1 E(Y ) −∞ the second-to-last inequality using the region of integration {y > α}. n→∞ lim P (|Zn − Z| > δ) = 0. tangent lines lie below it. P (g(X) > α) ≤ α−1 Eg(X). Since 1 + 1 = 1 an application of Jensen’s inequality shows that p q U Then 1/p V 1/q 1 1 ln U + ln V = exp p q E |XY | ∙ ¸ ≤ 1 1 U V exp (ln U ) + exp (ln V ) = + . This is a probabilistic way of generalizing the mathematical deﬁnition of a limit. Let a + bx be the tangent line to g(x) at x = EX.2.3). ¥ 5. Let U = |X|p /E |X|p and V = |Y |q /E |Y |q . Note EU = EV = 1. then as n → ∞ n 1X Xn = Xi →p E(X). We say that Zn converges in probability to Z as n → ∞.2 Weak Law of Large Numbers Let Zn ∈ Rk be a random vector. n i=1 42 . If Xi ∈ Rk is iid and E |Xi | < ∞. Theorem 5. =E U V p q p q Proof of Markov’s Inequality. Set Y = g(X) and let f denote the density function of Y. g(x) ≥ a + bx yet g(EX) = a + bEX since the curve is tangent at EX. The WLLN shows that sample averages converge in probability to the population average. Eg(X) ≥ a + bEX = g(EX). (E |X|p )1/p (E |Y |q )1/q ¥ µ ¶ ´ ³ U V 1 1 1/p 1/q ≤E + = + = 1.4) Proof of Jensen’s Inequality. For any strictly increasing function g(X) ≥ 0. ¥ Proof of Holder’s Inequality. Since g(x) is convex. p p p q which is (5.Markov’s Inequality. as stated. So for all x. if for all δ > 0.

5) (where 1 (·) is the indicator function) which is possible since E |X| < ∞. 5. 43 . by Markov’s inequality (5. We say that Zn converges in distribution to Z as n → ∞.1) and (5. ≤ 2E |Xi | 1 (|Xi | > C) Zi = Xi 1 (|Xi | > C) − E (Xi 1 (|Xi | > C)) . n i=1 0 where µ = EX and V = E (X − µ) (X − µ) . then as n→∞ n ¢ √ ¡ 1 X n Xn − µ = √ (Xi − µ) →d N (0. we can set E(X) = 0 (by recentering Xi on its expectation).4). If Xi ∈ Rk is iid and E |Xi |2 < ∞. Deﬁne the random vectors Wi = Xi 1 (|Xi | ≤ C) − E (Xi 1 (|Xi | ≤ C)) By the triangle inequality. ¯¢2 ¡ ¯ 2 ≤ EW n E ¯W n ¯ = EWi2 n 4C 2 ≤ n ≤ ε2 (5. the fact that X n = W n + Z n .5).7) the ﬁnal inequality holding for n ≥ 4C 2 /ε2 = 36C 2 /δ 2 η 2 . Fn (x) → F (x) as n → ∞. Fix δ and η. if for all x at which F (x) is continuous. Jensen’s inequality (5. V ) .6) and (5. Pick C < ∞ large enough so that E (|X| 1 (|X| > C)) ≤ ε (5. as needed. P ¯X n ¯ > δ ≤ η. ¯ ¯ E ¯Z n ¯ ≤ E |Zi | ≤ 2ε.3. We have shown that for any δ > 0 and η > 0 then for all ¢ ¡¯ ¯ ¥ n ≥ 36C 2 /δ 2 η 2 . (5. We need to ¢show that for all δ > 0 and η > 0 there is some N < ∞ so that for all n ≥ N. ≤ E |Xi | 1 (|Xi | > C) + |E (Xi 1 (|Xi | > C))| (5.7). denoted Zn →d Z.1). Set ε = δη/3.Proof: Without loss of generality. ¯ ¯ ¯ ¯ ¯ ¯ ¢ E ¯X n ¯ ¡¯ ¯ E ¯W n ¯ + E ¯Z n ¯ 3ε ≤ ≤ = η. Finally.3 Convergence in Distribution Let Zn be a random variable with distribution Fn (x) = P (Zn ≤ x) . the fact that the Wi are iid and mean zero. Theorem 5.1 Central Limit Theorem (CLT). ¡¯ ¯ P ¯X n ¯ > δ ≤ η. P ¯X n ¯ > δ ≤ δ δ δ the equality by the deﬁnition of ε. and the bound |Wi | ≤ 2C.6) By Jensen’s inequality (5. where Z has distribution F (x) = P (Z ≤ x) . the triangle inequality.

the independence of the Xi . 1 1 c(λ) = c(0) + cλ (0)0 λ + λ0 cλλ (λ∗ )λ = λ0 cλλ (λ∗ )λ 2 2 (5. By the properties of the exponential function. Then observe ¡ ¡ ¢¢ ∂ C(λ) = iE X exp iλ0 X ∂λ ¡ ¡ 0 ¢¢ ∂2 2 0 0 C(λ) = i E XX exp iλ X ∂λ∂λ C(0) = 1 ∂ C(0) = iE (X) = 0 ∂λ ¡ ¢ ∂2 0 0 C(0) = −E XX = −Ik . ∂λ∂λ cλ (λ) = cλλ (λ) = ∂ ∂ c(λ) = C(λ)−1 C(λ) ∂λ ∂λ ∂ ∂2 ∂2 −2 ∂ C(λ) 0 C(λ) c(λ) = C(λ)−1 0 0 C(λ) − C(λ) ∂λ ∂λ∂λ ∂λ∂λ ∂λ so when evaluated at λ = 0 Furthermore.Proof: Without loss of generality. the deﬁnition of c(λ) and (5.8) ⎞ ⎛ nλ0 X 1 Xj ⎠ ln Cn (λ) = log E exp ⎝i √ n j=1 µ ¶ n Y 1 exp i √ λ0 Xj = log E n j=1 µ ¶ n Y 1 0 E exp i √ λ Xj = log n i=1 ¶ µ λ = nc √ n 1 0 λ cλλ (λn )λ = 2 44 . For ¡ ¢ λ ∈ Rk . let C(λ) = E exp iλ0 X denote the characteristic function of X and set c(λ) = ln C(λ). ¢ ¡ √ √ We now compute Cn (λ) = E exp iλ0 nX n the characteristic function of nX n . it is suﬃcient to consider the case µ = 0 and V = Ik . so when evaluated at λ = 0 c(0) = 0 cλ (0) = 0 cλλ (0) = −Ik . By a second-order Taylor series expansion of c(λ) about λ = 0.8) where λ∗ lies on the line segment joining 0 and λ.

4. Σ) = N 0. then g(Zn ) →d g(Z) as n → ∞.4. If Zn →p c as n → ∞ and g (·) is continuous at c. k ≤ m. gθ Σgθ . where θ is m × 1 and Σ is m × m. √ Theorem 5. gj (θn ) = gj (θ0 ) + gjθ (θ∗ ) (θn − θ0 ) jn where θnj lies on the line segment between θn and θ0 and therefore converges in probability to θ0 . Stacking across elements of g. Recall that A ⊂ B implies P (A) ≤ P (B).4 Asymptotic Transformations Theorem 5. ¥ 5. for each element of g. for all ε > 0 we can ﬁnd a δ > 0 such that if |Zn − c| < δ then |g (Zn ) − g (c)| ≤ ε. 45 . then ¡ ¢ √ 0 n (g (θn ) − g(θ0 )) →d N 0.4. Ik ) distribution. and g(θ) : Rm → Rk . gθ Σgθ where gθ (θ) = ∂ g(θ) ∂θ0 and gθ = gθ (θ0 ).3 Delta Method: If n (θn − θ0 ) →d N (0. Since cλλ (λn ) → cλλ (0) = −Ik . Σ) . Thus P (|g (Zn ) − g (c)| ≤ ε) ≥ P (|Zn − c| < δ) → 1 as n → ∞ by the assumption that Zn →p c.1 Continuous Mapping Theorem 1 (CMT). µ ¶ 1 Cn (λ) → exp − λ0 λ 2 the characteristic function of the N (0. Proof: Since g is continuous at c.√ where λn → 0 lies on the line segment joining 0 and λ/ n. It follows that ajn = gjθ (θ∗ ) − gjθ →p 0. we ﬁnd jn ¢ ¡ √ √ 0 n (g (θn ) − g(θ0 )) = (gθ + an ) n (θn − θ0 ) →d gθ N (0. This is suﬃcient to establish the theorem. we see that as n → ∞. then g(Zn ) →p g(c) as n → ∞.2 Continuous Mapping Theorem 2. Hence g(Zn ) →p g(c) as n → ∞. Proof : By a vector Taylor series expansion. If Zn →d Z as n → ∞ and g (·) is continuous. Theorem 5.

The verticle line marks the true value of the projection coeﬃcient.Chapter 6 Inference 6. 46 . let yi and xi be drawn from the joint density µ ¶ µ ¶ 1 1 1 2 2 exp − (ln y − ln x) exp − (ln x) f (x. xi ) and the sample size n. ˆ Figure 6. n = 100 and n = 800. its distribution is a complicated function of the joint distribution of (yi .1 Sampling Distribution The least-squares estimator is a random vector. the density function of β 2 was computed and plotted in Figure 6. Using ˆ simulation methods. y) = 2πxy 2 2 ˆ and let β 2 be the slope coeﬃcient estimate computed on observations from this joint density.1 for sample sizes of n = 25. and therefore has a sampling distribution.1: Sampling Density of β 2 To illustrate the possibilities in one example. since it is a function of the random data. In general.

Equation (4.1).2 Consistency ˆ As discussed in Section 6. 6.1). As the sample size increases the density becomes more concentrated about the population coeﬃcient.2). Assumption 3. we can conclude ˆ that β →p β. we can write !−1 Ã n ! n 1X 1X 0 ˆ β−β = xi xi xi ei n n i=1 i=1 Ã n ! n X X 1 1 xi x0 . (6.3). the OLS estimator β is has a statistical distribution which is unknown.1. Ã n ! n X 1X 0 1 ˆ xi xi .4.1 and the WLLN (Theorem 5. ˆ 47 . ˆ Theorem 6.1 by the fact that the sampling densities become more concentrated as n gets larger.2. we will use the methods of asymptotic approximation. (6.1. xi ei = g i n n i=1 i=1 1X xi ei →p E (xi ei ) = 0. Asymptotic (large sample) methods approximate sampling distributions based on the limiting experiment that the sample size n tends to inﬁnity.3) Ã where g(A. ¥ We can similarly show that the estimators σ 2 and s2 are consistent for σ 2 . A preliminary step in this approach is the demonstration that estimators are consistent — that they converge in probability to the true parameters as the sample size gets large. xi ei →p g (Q. Hence by the continuous mapping theorem (Theorem 5.5.5.1).1) imply that n ¡ ¢ 1X xi x0 →p E xi x0 = Q (6.1. β →p β as n → ∞.4. Proof. n i=1 (6.8) implies that ˆ β−β = Ã n X i=1 xi x0 i !−1 n X i=1 xi ei .5.2. (6.4 implies that Q−1 exists and thus g(·. To characterize the sampling distribution more fully. 0).2) i i n i=1 n From (6.1 Under Assumption 3. 0) = Q−1 0 = 0 β−β =g n n i=1 i=1 ˆ which implies β →p β as stated. using (6.From the ﬁgure we can see that the density functions are dispersed and highly non-normal. b) = A−1 b is a continuous function of A and b at all values of the arguments such that A−1 exist. This is illustrated in Figure 6. For a complete argument. First.1). ·) is continuous at (Q. Assumption 3. and the continuous mapping theorem (Theorem 5.1) and ˆ We now deduce the consistency of β.

Ω) .1 guarantees that the elements of Ω are ﬁnite. (6. (6. it follows that s2 = ¥ n σ 2 →p σ 2 .6) n i=1 48 .1). Note that ˆ ei = yi − x0 β ˆ i i Thus and n ˆ = ei + x0 β − x0 β i i ³ ´ ˆ = ei − x0 β − β . Thus σ 2 is consistent for σ 2 . We need a strengthening of the moment conditions. Assumption 6. since n/(n − k) → 1 as n → ∞.4) ³ ´ ³ ´0 ³ ´ ˆ ˆ ˆ e2 = e2 − 2ei x0 β − β + β − β xi x0 β − β ˆi i i i σ2 = ˆ 1X 2 ei ˆ n i=1 i=1 →p σ 2 n 1X 2 = ei − 2 n Ã ! Ã n ! n ´ ³ ´0 1 X ³ ´ 1 X 0 ³ˆ 0 ˆ ˆ β−β + β−β β−β ei xi xi xi n n i=1 i=1 the last line using the WLLN.Theorem 6. E ¯ei ¯ E ¯e4 ¯ i i i i (6. σ 2 →p σ 2 and s2 →p σ 2 as n → ∞.2.2). (6. ´1/2 ¡ ¯ ¯¢ ¯ ³ ¯ ¯2 ´1/2 ¡ ¯ 4 ¯¢1/2 ³ ¯ 1/2 E ¯xi x0 e2 ¯ ≤ E ¯xi x0 ¯ = E |xi |4 < ∞. Ee4 < ∞ and E |xi |4 < ∞. by the Cauchy-Schwarz inequality (5. By the central limit theorem (Theorem 5.2. ˆ n−k 6.5.3.3) and Theorem (6.2 Under Assumption 3. To see this. n 1 X √ xi ei →d N (0.3.3.1 In addition to Assumption 3.1.1.2).5. (6.5) Thus xi ei is iid with mean zero and has covariance matrix Ω. i Now deﬁne ¡ ¢ Ω = E xi x0 e2 .3 Asymptotic Normality ˆ We now establish the asymptotic distribution of β after normalization. i i Assumption 6. ˆ Finally.1). ˆ Proof.

e2 ) = 0. 1) asymptotic distibution.8) Ω = E xi x0 E e2 = Qσ 2 i i V = Q−1 ΩQ−1 = Q−1 σ 2 ≡ V 0 (6. V ) where V = Q−1 ΩQ−1 . its variance diverges q ³ ´ ˆ to inﬁnity. The trouble is that no matter how large is the sample size.1. ´ √ ³ ˆ n β−β = Ã 1X xi x0 i n i=1 n !−1 Ã Theorem 6.3. For α 49 .Then using (6. Under (6.2 we display the ﬁnite sample densities of the q ³ ˆ normalized estimator n α−2 β 2 − β 2 .1 states that the sampling distribution of the least-squares estimator.3. If α > 2 the 2 error εi has zero mean and variance α/(α − 2).1.3. In this context the normalized least-squares slope estimator n α−2 β 2 − β 2 has α →d Q−1 N (0. for any ˆ ﬁxed n the sampling distribution of β can be arbitrarily far from the normal distribution. ´ √ ³ˆ As V is the variance of the asymptotic distribution of n β − β . The asymptotic distribution ´ Theorem 6. the normal approximation is arbitrarily poor for some data distribution satisfying the assumptions. We call V 0 the homoskedastic covariance matrix. and (6. however. The expression V = Q−1 ΩQ−1 is called a sandwich form. 1). for example. there is no simple answer to this reasonable question. When (6. V is often referred to as ˆ the asymptotic covariance matrix of β.3.9) we deﬁne V 0 = Q−1 σ 2 whether (6. Ω) ¡ ¢ = N 0.7) holds. but this is not a necessary condition. (6. We say that ei is a Homoskedastic Projection Error when (6.6). 1 X √ xi ei n i=1 n ! the N (0. as n → ∞ ´ √ ³ ˆ n β − β →d N (0. Q−1 ΩQ−1 .2).7) is true or false. i i Condition (6.9) In (6. when xi and ei are independent. As α approaches 2. However. xi ) which satisfy the conditions of Assumption 6. after rescaling. This holds true for all joint distibutions of (yi .3.7) Cov(xi x0 .1).1 Under Assumption 6. The approximation may be poor when n is small. In Figure 6. and εi is independent of xi with the Double Pareto density f (ε) = α |ε|−α−1 . is approximately normal when the sample size n is suﬃciently large.7) is true then V = V 0 . setting n = 100 and varying the parameter α. Let yi = β 0 + β 1 xi + εi where xi is N (0. How large should n be in order for the approximation to be useful? Unfortunately. There is a special case where Ω and V simplify. Theorem 6. In´Figure 6. otherwise V 6= V 0 .1 we have already seen a simple example where the least-squares estimate is quite asymmetric and non-normal even for reasonably large sample sizes. We illustrate this problem using a simulation. |ε| ≥ 1.1 is commonly used to approximate the ﬁnite of √ ³ˆ sample distribution of n β − β .7) the asymptotic variance formulas simplify as ¡ ¢ ¡ ¢ (6.

6 and 8.2: Density of Normalized OLS estimator α = 3.10) V 0 = Q−1 s2 . ˆ ˆ Since Q →p Q and s2 →p σ 2 (see (6.Figure 6. 1) asymptotic approximation is never guaranteed to be accurate. 1) density.4 Let Covariance Matrix Estimation 1X ˆ xi x0 Q= i n i=1 n be the method of moments estimator for Q.10) without changing this result. 6. As k increases. 1). The homoskedastic covariance matrix V 0 = Q−1 σ 2 is typically estimated by ˆ ˆ (6.2. σ may also be substituted for s ˆ ¡ ¢ To estimate V = Q−1 ΩQ−1 .2) and Theorem 6. The lesson from Figures 6.11) 50 . we need an estimate of Ω = E xi x0 e2 . for k = 1.0 the density is very close to the N (0. The estimator 2 2 in (6.3.3 is that the N (0. As α diminishes the density changes signiﬁcantly. concentrating most of the probability mass around zero. 4. The MME estimator is i i 1X ˆ xi x0 e2 Ω= i ˆi n i=1 n (6. Here the model is yi = β 1 + εi where uk − Euk i i εi = ³ ¡ k ¢2 ´1/2 Eu2k − Eui i ´ √ ³ˆ and ui ∼ N (0. Another example is shown in Figure 6. We show the sampling distribution of n β 1 − β 1 setting n = 100.2 and 6. the sampling distribution becomes highly skewed and non-normal.1) it is clear that V 0 →p V 0 .

so that by the late 1990s White estimate V emerged as the standard covariance matrix estimator. these all mean the same thing. as it is not always clear which has been computed. A more easily interpretable measure of spread is its square root — the standard deviation. The estimator of V is then ˆ ˆ ˆ ˆˆ V = Q−1 ΩQ−1 This estimator was introduced to the econometrics literature by White (1980).1 A standard error s(β) for an estimator β is an estimate of the standard ˆ deviation of the distribution of β. Thus q ˆ ˆ s(β j ) = n−1/2 Vjj . ˆ ˆ Deﬁnition 6. j = 0. the “Huber formula”. It is therefore important to understand what formula and method is 51 . When β is a vector. When reading and reporting applied work. the “Eicker-White formula”. This motivates the deﬁnition of a standard error.Figure 6. β j . 1. standard errors are not unique. The methods switched during ˆ the late 1980s and early 1990s.. ´ p √ ³ˆ ˆ ˆ ˆ When β is scalar.. the “Huber-White formula” or the “GMM covariance matrix”. it is important to pay ˆ ˆ attention to the distinction between V 0 and V . k. ˆ ˆ When V is used rather than the traditional choice V 0 .3: Sampling distribution where ei are the OLS residuals.4. .. vis. ˆ ˆ The variance estimator V is an estimate of the variance of the asymptotic distribution of β. many authors will state that their “standard errors have been corrected for heteroskedasticity”. and V is an estimator of the variance of n β − β . and was still the standard choice for much empirical work done in the early 1980s. we set s(β) = n−1/2 V . we focus on individual elements of β one-at-a-time. ˆ The estimator V 0 was the dominate covariance estimator used before 1980.. or that they use the “White formula”. or that they use a “heteroskedasticity-robust covariance matrix estimator”. as there may be more than one estimator of the variance of the estimator. Generically. In most cases.

035 ¶ .2/988 = .085) (.14 205.039 and ˆ V = µ 1 14.493 −0. (.used by an author when studying their work.83 ¶−1 µ . We can write the estimated equation with standards errors using the format \ log(W agei ) = 1.5) and the WLLN (Theorem 5.4) ˆ Ω = = n n n ³ ´0 ³ ´0 ³ ´ 1X 2X 1X 0 2 0 ˆ ˆ ˆ xi xi ei − xi xi β − β xi ei + xi x0 β − β xi x0 β − β .12) in turn. We calculate that s2 = 0. Ω 2.1. then take the diagonal elements.80 40.35/988 = . (6.020) 6.085 p ˆ and that for β 1 is .1) show that n ¡ ¢ 1X xi x0 e2 →p E xi x0 e2 = Ω.199 2. just as any other estimator.80 2. we return to the log wage regression of Section 4.83 −0.480 . To illustrate. Using (6.12) i i n n n i=1 i=1 We now examine each sum on the right-hand-side of (6.14 205.80 .98 −0.117 Educationi .6 Therefore the two covariance matrix estimates are µ ¶−1 µ ¶ 1 14. by Holder’s inequality (5.5 Consistency of the White Covariance Matrix Estimate 1X xi x0 e2 i ˆi n i=1 i=1 n ˆ ˆ We now show Ω →p Ω. n n i=1 52 .3) so by the WLLN ³ ´ ³ ´3/4 ¡ ¯ ¯¢ 1/4 E |xi |3 |ei | ≤ E |xi |4 < ∞.199 2.30 + 0. i i i i n i=1 Second. and then the square roots.20 −0. the standard method to calculate the standard errors is to ˆ ﬁrst calculate n−1 V .20 = V 14. p ˆ In this case the two estimates are quite similar.80 40.020.14 205.6 ¶µ 1 14.20 and µ ¶ ˆ = 0. It is also important to understand that a particular standard error may be relevant under one set of model assumptions. from which it follows that V →p V as n → ∞.14 14.2. From a computational standpoint. but not under another set of assumptions.14 6. The standard errors for β 0 are 7.83 ¶−1 = µ 7. E ¯e4 ¯ i ³ ´ 1X |xi |3 |ei | →p E |xi |3 |ei | .493 0.480 ˆ0 = 0. First. (6.14 14.

Andrews’ proposed estimator is ˆ ˆ ˆ ˆ V ∗∗ = Q−1 Ω∗∗ Q−1 53 .5. Recall from Section 4.−i = (1 − hi )−1 ei ˆ presented in (4. these establish consistency. n i=1 n − 1 ˆ −1 ˆ ∗ ˆ −1 ˆ V∗ = Q Ω Q n where 1X ˆ (1 − hi )−2 xi x0 e2 − Ω∗ = i ˆi n i=1 n (6. ¯ n ¯ n ¯2 X ¯1 X ³ ´0 ³ ´¯ ¯ ¯ 0 ˆ ˆ ˆ − β ¯ ≤ ¯β − β ¯ 1 xi xi β − β xi xi β |xi |4 →p 0.13) of Efron (1982). Andrews (1991) suggested an similar estimator based on cross-validation. They also suggest that the scaling factor (n − 1)/n in (??) can be omitted. which. Using this substitution. ¯ ¯ ¯ ¯ ¯n ¯ n i=1 i=1 1X |xi |4 →p E |xi |4 .12 the deﬁnition of β (−i) as the least-squares estimator with the i’th observation deleted. Ω →p Ω and V →p V. by the WLLN ¯ n ¯ Ã n ! ¯ 1X ¯1 X ¯ ¯ ³ ´0 ¯ ¯ ¯ ¯ˆ 3 0 ˆ xi xi β − β xi ei ¯ ≤ ¯β − β ¯ |xi | |ei | →p 0. 6.1 As n → ∞.25).26). i=1 Third.11) with the leave-one-out estimator ei. ¯ ¯n ¯ n i=1 so Together.¯ ¯ ¯ ¯ˆ and thus since ¯β − β ¯ →p 0. is deﬁned ˆ ˆ by replacing the OLS residual ei in (6.6 Alternative Covariance Matrix Estimators ˆ MacKinnon and White (1985) suggested a small-sample corrected version of V based on the jackˆ knife principle. MacKinnon and White (1985) present numerical (simulation) evidence i ˆ ˆ that V ∗ works better than V as an estimator of V . From equation (3.14) Ã 1X (1 − hi )−1 xi ei ˆ n i=1 n !Ã 1X (1 − hi )−1 xi ei ˆ n i=1 n !0 and hi = x0 (X 0 X)−1 xi . you can show that 1 Xˆ ¯ β= β (−i) .13) Using formula (4. n i=1 n ˆ ˆ Theorem 6. the jackknife estimator of the ˆ variance matrix for β is ˆ V ∗ = (n − 1) where n X³ ˆ β i=1 ¯ (−i) − β n ´³ ˆ β ¯ (−i) − β ´0 (6.

we may be interested in a single coeﬃcient β j or a ratio β j /β l . Hβ = ∂β In many cases. β k+1 ). Ω∗∗ = i ˆi n i=1 n 6. ˆ ˆ If V is the estimated covariance matrix for β. Let h : Rk → Rq denote this function and let θ = h(β) denote the parameter of interest. In this case. ˆ θ What is an appropriate standard error for ˆ Assume that h(β) is diﬀerentiable at the true θ? value of β. so Vθ = R0 V R. Hβ = Thus ´ √ ³ ´ √ ³ ˆ n ˆ − θ = n h(β) − h(β) θ ³ ´ 0√ ˆ ' Hβ n β − β 0 →d Hβ N (0. For example. Andrews ˆ ˆ (1991) argues that simulation evidence indicates that V ∗∗ is an improvement on V ∗ .. but omits the mean correction. In these cases we can write the parameter of interest as a function of β. 1X ˆ (1 − hi )−2 xi x0 e2 . (6. The estimate of θ is ˆ = h(β). = N (0. then the natural estimate for the variance of ˆ is θ ˆ0 ˆ ˆ ˆ Vθ = Hβ V Hβ where ∂ ˆ ˆ h(β). 54 . . By a ﬁrst-order Taylor series approximation: ³ ´ 0 ˆ ˆ h(β) ' h(β) + Hβ β − β . V ) where ∂ h(β) ∂β (k + 1) × q.15) where 0 Vθ = Hβ V Hβ .where ˆ It is similar to the MacKinnon-White estimator V ∗ .. Vθ ).. Hβ = R and Hβ = R.7 Functions of Parameters Sometimes we are interested in some lower-dimensional function of the parameter vector β = (β 1 . the function h(β) is linear: h(β) = R0 β ˆ ˆ ˆ for some k × q matrix R.

and is therefore exactly free of unknowns.8 t tests Let θ = h(β) : Rk → R be any parameter of interest. then θ = R0 β = β 1 and ˆ Vθ = ¡ I 0 ¢ ˆ V µ I 0 ¶ ˆ = V11 . Since the standard normal distribution does not depend on the parameters. 1) Proof.For example. Vθ ) √ Vθ = N (0. s(ˆ θ) (6. that (so θ ˆ ˆ ˆ is. however. if R is a “selector matrix” R= so that if β = (β 1 . pivotal statistics are unavailable and so we must rely on asymptotically pivotal statistics. s(ˆ = n−1/2 H 0 V Hβ . ˆ its estimate and s(ˆ its asymptotic θ θ) standard error. θ could be a single element of β). In this case.16) ¥ Thus the asymptotic distribution of the t-ratio tn (θ) is the standard normal. β 2 ). we say that tn is an exactly pivotal statistic.15) tn (θ) = ˆ−θ θ s(ˆ θ) ´ √ ³ˆ n θ−θ q = ˆ Vθ N (0. θ) β 6. 55 . the standard error for ˆ is the square root of n−1 Vθ . In special cases (such as the normal regression model. see Section X). and θ = h(β) is some function of the parameter vector. ˆ When q = 1q h(β) is real-valued). (For example.1 tn (θ) →d N (0. Consider the studentized statistic tn (θ) = Theorem 6. In general. A simple null and composite hypothesis takes the form H0 : θ = θ0 H1 : θ 6= θ0 where θ0 is some pre-speciﬁed value. µ I 0 ¶ ˆ the upper-left block of V .8. the statistic tn has an exact t distribution. we say that tn (θ) is asymptotically pivotal. 1) →d ˆ−θ θ . By (6.

p-values and hypothesis tests are equivalent since pn < α if and only if |tn | > zα/2 .The standard test for H0 against H1 is the t-statistic (or studentized statistic) tn = tn (θ0 ) = ˆ − θ0 θ . or “accepts” H0 . 6. regardless of the complication of the distribution of the original test statistic. In a sense. pn →d U [0. z. For example. If the p-value pn is small (close to zero) then the evidence against H0 is strong. This is because ¡ ¢ P (reject H0 | H0 true) = P |tn | > zα/2 | θ = θ0 ¢ ¡ → P |Z| > zα/2 = α. The p-value is more general. then P (Z > zα/2 ) = α/2 and P (|Z| > zα/2 ) = α.96 and z. associated with Fisher. 1). and is a function of the data and hence is / random.05 = 1. P (1 − p(tn ) ≤ u) establishing that 1 − pn →d U [0. Either θ ∈ Cn or θ ∈ Cn . 1]. The rejection/acceptance dichotomy is associated with the Neyman-Pearson approach to hypothesis testing. An alternative approach. To see this fact. 56 . Thus an equivalent statement of a Neyman-Pearson test is to reject at the α% level if and only if pn < α. That is. That is. s(ˆ θ) Under H0 . Otherwise the test does not reject. under H0 . Another helpful observation is that the p-value function has simply made a unit-free transformation of the test statistic. Thus P (1 − pn ≤ u) = = P (F (tn ) ≤ u) ¡ ¢ = P |tn | ≤ F −1 (u) ¡ ¢ → F F −1 (u) = u. It is designed to cover θ with high probability. 1].645.9 Conﬁdence Intervals A conﬁdence interval Cn is an interval estimate of θ. Deﬁne the tail probability. The asymptotic p-value for the above statistic is constructed as follows. Let zα/2 is the upper α/2 quantile of the standard normal distribution. tn →d N (0. is to report an asymptotic p-value. in that the reader is allowed to pick the level of signiﬁcance α. however. in contrast to Neyman-Pearson rejection/acceptance reporting where the researcher picks the level.025 = 1. if Z ∼ N (0. 1). 1]. so the “unusualness” of the test statistic can be compared to the easy-to-understand uniform distribution. from which it follows that pn →d U [0. A test of asymptotic signiﬁcance α rejects H0 if |tn | > zα/2 . The coverage probability is P (θ ∈ Cn ). or asymptotic p-value function p(t) = P (|Z| > |t|) = 2 (1 − Φ(|t|)) . Then the asymptotic p-value of the statistic tn is pn = p(tn ). note that the asymptotic distribution of |tn | is F (x) = 1 − p(x).

We typically cannot calculate the exact coverage probability P (θ ∈ Cn ).05. Thus values of θ within two standard errors of the estimated interval θ θ) θ θ) ˆ are considered “reasonable” candidates for the true value θ. ˆ The natural estimate of θ is ˆ = h(β) and has asymptotic covariance matrix estimate θ ˆ0 ˆ ˆ ˆ Vθ = Hβ V Hβ where ∂ ˆ ˆ h(β). A conﬁdence interval is then constructed as the values of θ for which this test does not reject: © ª Cn = θ : |tn (θ)| ≤ zα/2 ( ) ˆ−θ θ = θ : −zα/2 ≤ ≤ zα/2 s(ˆ θ) i h θ). θ The interval has been constructed so that as n → ∞. or α = . ˆ + zα/2 s(ˆ .17) = ˆ − zα/2 s(ˆ θ and Cn is an asymptotic (1 − α)% conﬁdence interval. the most common professional choice isi95%. and values of θ outside two standard θ errors of the estimated ˆ are considered unlikely or unreasonable candidates for the true value. θ θ) (6. While there is no hard-and-fast guideline for choosing the coverage probability 1 − α. 6. A good method for construction of a conﬁdence interval is the collection of parameter values which are not rejected by a statistical test. and it is desired to test the joint restrictions simultaneously.16) and zα/2 is the upper α/2 quantile of the standard normal distribution. We say that Cn has asymptotic (1 − α)% coverage for θ if P (θ ∈ Cn ) → 1 − α as n → ∞. = n h(β) − θ0 Hβ V Hβ 57 (6. In this case the t-statistic approach does not work. We have the null and alternative H0 : θ = θ0 H1 : θ 6= θ0 .96s(ˆ ≈ ˆ ± 2s(ˆ . Hβ = ∂β The Wald statistic for H0 against H1 is ´0 ³ ´ ³ ˆ θ θ Wn = n ˆ − θ0 Vθ−1 ˆ − θ0 ´0 ³ ´−1 ³ ´ ³ ˆ ˆ ˆ0 ˆ ˆ h(β) − θ0 .10 Wald Tests Sometimes θ = h(β) is a q × 1 vector. The t-test of the previous setion rejects H0 : θ0 = θ if |tn (θ)| > zα/2 where tn (θ) is the t-statistic (6. However we often can calculate the asymptotic coverage probability limn→∞ P (θ ∈ Cn ). ¢ ¡ ¢ ¡ P (θ ∈ Cn ) = P |tn (θ)| ≤ zα/2 → P |Z| ≤ zα/2 = 1 − α. This corresponds to selecting the conﬁdence h i h ˆ ± 1.18) .

χ2 (. the upper-α quantile q 2 of the χ2 distribution.84 = z. ˆ Wn = n θ θ q θ θ Theorem 6. the covariance What we will show in this section is that if V is replaced with V 0 = σ 2 n−1 X 0 X matrix estimator valid under homoskedasticity.3. Hβ (β) →p Hβ . In this case.8.1 showed θ ˆ that V →p V.025 . a chiq square random variable with q degrees of freedom. Vθ ).1 Under H0 and Assumption 6.11 F Tests Y = X1 β 1 + X2 β 2 + e Take the linear model where X1 is n × k1 and X2 is n × k2 and k + 1 = k1 + k2 . h(β) = R0 β. θ = β 2 . The asymptotic p-value for Wn is pn = p(Wn ). if rank(Hβ ) = q. = nβ 2 R0 V R R0 β is linear with R = µ 0 I ¶ ¢−1 ¡ ˆ ˆ ˆ . 1] under H0 . where p(x) = P χ2 ≥ x is the tail q q probability function of the χ2 distribution.19) σ2 ˆ where σ2 = ˜ 1 0 e e. then Wn →d χ2 . Wn = n R0 β − θ0 ´ √ ³ The delta method (6. The null hypothesis is H0 : β 2 = 0. Hβ (β) is a continuous function of β. then the Wald statistic takes the form ´0 ³ ´ ³ ´−1 ³ ˆ ˆ ˆ R0 V R R0 β − θ 0 . the test rejects at the α% level iﬀ pn < α. We have established: ³ ´0 ³ ´ ˆ − θ0 V −1 ˆ − θ0 →d Z 0 V −1 Z = χ2 . The Wald test fails to reject if Wn is q 1 ¡ ¢ less than χ2 (α). Also h(β) = a selector matrix.15) showed that n ˆ − θ →d Z ∼ N (0. As before. An asymptotic Wald test rejects H0 in favor of H1 if Wn exceeds χ2 (α).5.When h is a linear function of β. then the Wald statistic can be written in the form ¶ µ 2 ˆ σ − σ2 ˜ Wn = n (6. For example. Furthermore.10. 6. We know that the Wald statistic takes the form 0 Wn = nˆ Vθ−1 ˆ θ ˆ θ ³ ´−1 ˆ ˆ0 ˆ β 2. Hence β β by Theorem A. q and pn is asymptotically U[0. so by the continuous mapping ˆ ˆ ˆ ˆ ˆ theorem. and there are q = k2 restrictions. and Theorem 6. Thus Vθ = H 0 V Hβ →p H 0 V Hβ = Vθ > 0 if Hβ has full rank q.05) = 3.2.1. ˜˜ n ˜ e = Y − X1 β 1 . ˜ 58 ¡ 0 ¢−1 0 ˜ β 1 = X1 X1 X1 Y .

This statistic is typically reported as an “F-statistic” which is deﬁned as ¡ 2 ¢ σ − σ 2 /k2 ˜ ˆ n − k Wn .19). Because of this connection we call (6.19) only holds if V 0 = σ 2 n−1 X 0 X ˆ . The elegant feature about (6.19) the F form of the Wald statistic. 2 2 2 or alternatively. ˆ ¡ ¢−1 0 ˆ β = X 0X XY are from OLS of Y on X = (X1 . since ˆ0 0 ˆ β 2 X2 M1 X2 β 2 = e0 e − e0 e. ˜ ˆ ˜ 2 β 2 + e and X 0 e = 0. X2 ).are from OLS of Y on X1 . µ e0 e − e0 e ˜˜ ˆˆ e0 e ˆˆ ¶ =n µ σ2 − σ2 ˜ ˆ 2 σ ˆ ¶ . First. ˜˜ ˆˆ ˆˆ σ 2 = n−1 e0 e ˆ we conclude that Wn = n as claimed. We now derive expression (6. ˆˆ n ˆ e = Y − X β. note that if we regress Y on X1 alone. 59 . the residual is ˜ ˜ e = M1 Y. note that partitioned matrix inversion (2. Now consider the residual regression of e on X2 = M1 X2 . as the sum of squared errors is a typical output from statistical packages. = F = n k2 σ 2 /(n − k) ˆ ¢−1 ¡ ˆ While it should be emphasized that equality (6. Also. By the FWL theorem.2) ¢−1 ¡ R = R0 R X 0X 0 µ 0 0 X1 X1 X1 X2 0X 0 X2 1 X2 X2 ¶−1 0 0 where M1 = I − X1 (X1 X1 )−1 X1 . 2 σ ˆ To simplify this expression further. still this formula often ﬁnds good use in reading applied papers. and σ2 = ˆ 1 0 e e. Thus ¡ 0 ¢−1 R = X2 M1 X2 and ³ ¡ ´−1 ³ ¢−1 ´−1 ¡ 0 ¢ ˆ = σ −2 n−1 R0 X 0 X ˆ R = σ −2 n−1 X2 M1 X2 ˆ R0 V 0 R ³ ´−1 ˆ0 ˆ ˆ Wn = nβ 2 R0 V 0 R β2 = 0 ˆ ˆ0 β 2 (X2 M1 X2 ) β 2 .19) is that it is directly computable from the standard output from two simple OLS regressions. Thus ˜ ˆ e=X ˜ ˆ 2 ³ ´0 ³ ´ ˜ ˆ ˜ ˆ e0 e = X2 β 2 + e ˜˜ ˆ ˆ X2 β 2 + e ˆ0 ˜ 0 ˜ ˆ = β 2 X2 X2 β 2 + e0 e ˆˆ 0 0 ˆ ˆ ˆˆ = β X M1 X2 β + e0 e.

as sample sizes are typically suﬃciently large that this F statistic is highly “signiﬁcant”. equivalently the residual variance from an intercept-only model. there is an exact distribution theory available for the normal linear regression model. n−k 60 . this implies that conditional on X µ ¶ µ ¶ µ µ 2 0 −1 ¶¶ ˆ β−β (X 0 X)−1 X 0 σ (X X) 0 = e ∼ N 0. introduced in Section 4. Then (n − k) s2 σ2 1 0 ee ˆˆ σ2 1 0 e Me = σ2 ∙ ¸ 1 0 In−k 0 eH = H 0e 0 0 σ2 ∙ ¸ In−k 0 0 = u u 0 0 = ∼ χ2 . an “F statistic” is reported. when an OLS regression is reported. This is ¢ ¡ 2 ˆ σ y − σ 2 / (k − 1) ˜ F = . The modelling assumption that the error ei is independent of xi and N (0. Let u = σ −1 H 0 e ∼ N (0. it follows ˆ that β is independent of any function of the OLS residuals. This is rarely an issue today. Since uncorrelated normal variables are independent. This was a popular statistic in the early days of econometric reporting. In ) . including the estimated error variance 2. 6.12 Normal Regression Model As an alternative to asymptotic distribution theory. While there are special cases where this F statistic is useful. H 0 H) ∼ N (0. In σ 2 . In particular. s The spectral decomposition of M yields ¸ ∙ In−k−1 0 H0 M =H 0 0 (see equation (2. these cases are atypical.4)) where H 0 H = In . under the normality assumption the error vector e is independent of X and ¢ ¡ has distribution N 0. σ 2 ) can be be used to calculate a set of exact distribution results. e ˆ M 0 σ2 M where M = I − X (X 0 X)−1 X 0 . σ 2 /(n − k) ˆ σ2 = ˜y 1 (y − y)0 (y − y) n is the sample variance of yi .where In many statistical packages.3. when sample sizes were very small and researchers wanted to know if there was “any explanatory power” to their regression. This special F statistic is testing the hypothesis that all slope coeﬃcients (other than the intercept) are zero. Since linear functions of normals are also normal.

σ 2 ) ¡ ¢¢ ¡ ¡ ¢ ˆ = n log σ 2 − log σ 2 ˜ µ 2¶ σ ˜ = n log . The estimator under the alternative is the unrestricted estimator ˆ ˆ ˆ (β 1 . (Unless the sample size is unreasonably small. 0. σ 2 ) = − log 2πˆ 2 − 2 e0 e ˆˆ 2 2ˆ σ ¡ ¢ n n n = − log σ 2 − log (2π) − . The log-likelihood of this model is ¡ 2¢ n n n ˜ ˜ ˜ Ln (β 1 . 2 2 2 The LR statistic for H0 is ´ ³ ˆ ˆ ˆ ˜ ˜ LR = 2 Ln (β 1 . which is twice the diﬀerence in the log-likelihood function evaluated under the null and alternative hypotheses. σ2 ˆ 61 . The Gaussian log-likelihood at these estimates is ¡ ¢ n 1 ˆ ˆ ˆ σ Ln (β 1 . σ 2 ) discussed above.a chi-square distribution with n − k degrees of freedom.1 shows that under the strong assumption of ˆ normality. σ 2 ). the notable distinction is between the N (0. As inference (conﬁdence intervals) are based on the t-ratio.10) µ h i ¶ 2 (X 0 X)−1 N 0. 0. with residual variance σ . σ 2 ) where β 1 is the OLS estimate from ˜ 2 ˜ a regression of yi on x1i only. The critical values are quite close if n − k ≥ 30. σ 2 ) = − log σ − log (2π) − .1 we showed that in large samples.8. 0. σ ˆ ˆ βj − βj βj − βj N (0. We summarize these ﬁndings Theorem 6. 1) jj rh ∼ tn−k = rh i ∼q i = q χ2 ˆ s(β j ) n−k σ2 2 0 X)−1 0 X)−1 (X s (X n−k n−k χn−k jj jj a t distribution with n − k degrees of freedom. n−k • ∼ tn−k ˆ In Theorem 6. In contrast.3. Theorem 6. β and t are approximately normally distributed. β 2 ) and consider tests of the linear restriction H0 : β 2 = 0 H1 : β 2 6= 0 In the context of parametric models. and standard errors are calculated using the homoskedastic formula (6.) Now let us partition β = (β 1 . if standard errors are calculated using the homoskedastic formula (6. Furthermore.1 and Theorem 6. β 2 . 1) and tn−k distributions. σ 2 ) − Ln (β 1 .1 If ei is independent of xi and distributed N(0.12. β has an exact normal distribution and t has an exact t distribution.10) then ´ ³ ˆ • β ∼ N 0.12. σ 2 (X 0 X)−1 • (n−k)s2 σ2 ˆ β j −β j ˆ s(β ) j ∼ χ2 . β 2 . so as a practical matter it does not matter which distribution is used. ˆ 2 2 2 ˜ ˜ The MLE of the model under the null hypothesis is (β 1 . β 2 . a good testing procedure is based on the likelihood ratio statistic.

the statistic Wn (s) varies with s. σ 2 ) and consider the hypothesis H0 : β = 1.7. LR = n log 1 + 2 − 1 ' n σ ˆ σ2 ˆ the F statistic. This is an unfortunate feature of the Wald statistic. This is a context where Monte Carlo simulation can be quite useful as a tool to study and compare the exact distributions statistical procedures in ﬁnite samples. as Wn (s) →d χ2 under H0 for 1 any s. 62 . It is easy to see that in each case there are values of s for which the line is for the case β test statistic is signiﬁcant relative to asymptotic critical values. Our ﬁrst-order asymptotic theory is not useful to help pick s. This produces random draws from the sampling distribution of interest. one feature of importance is the Type I error of the test using the asymptotic 5% critical value 3. σ2 ˆ Now notice that H0 is equivalent to the hypothesis H0 (s) : β s = 1 for any positive integer s. features of this distribution can be calculated. Letting h(β) = β s . setting n/σ 2 = 10. σ 2 s2 β ˆ ˆ While the hypothesis β s = 1 is unaﬀected by the choice of s. Through repetition.8.84 — the probability of a false rejection. Then the standard Wald test for H0 is ˆ ³ ´2 ˆ β−1 Wn = n . In the present context of the Wald statistic. The decreasing dashed ˆ = 1. To demonstrate this eﬀect. The method uses random simulation to create an artiﬁcial dataset to apply the statistical tools of interest. and noting Hβ = sβ s−1 .13 Problems with Tests of NonLinear Hypotheses While the t and Wald tests work well when the hypothesis is a linear restriction on β. while there are other values of s for which test test statistic is insigniﬁcant.By a ﬁrst-order Taylor series approximation ¶ µ 2 ¶ µ σ ˜ σ2 ˜ − 1 = Wn . we have plotted in Figure 6.4 the Wald statistic Wn (s) as a function ˆ of s. This can be seen by a simple example introduced by Lafontaine and White (1986). Take the model yi = β + ei ei ∼ N (0. This is distressing since the choice of s seems arbitrary and irrelevant to the actual hypothesis. The increasing solid line is for the case β = 0. we ﬁnd that the standard Wald test for H0 (s) is ´2 ³ s ˆ β −1 Wn (s) = n 2s−2 . ˆ Let β and σ 2 be the sample mean and variance of yi . 6. they can work quite poorly when the restrictions are nonlinear.

no magic choice of n for which all tests perform uniformly well. In Table 2. the Type I error probability improves towards 5% as the sample size n increases. and σ is varied among 1 and 3.Figure 6. These probabilities are calculated as the percentage of the 50. we compare the rates row by row. Each row of the table corresponds to a diﬀerent value of s — and thus corresponds to a particular choice of test statistic.05) with deviations indicating+ distortion. When comparing statistical procedures. however. Rates above 20% are unexceptable.000 random samples. The value of s is varied from 1 to 10. remember that the ideal Type I error probability is 5% (. The null hypothesis β s = 1 is true. the only test which meets this criterion is the conventional Wn = Wn (1) test. which is not surprising given the dependence of Wn (s) on s as shown in Figure 6. Table 4.1 Type I error Probability of Asymptotic 5% Wn (s) Test 63 .4: Wald Statistic as a function of s P (Wn (s) > 3.84.000 simulated Wald statistics Wn (s) which are larger than 3.1 reports the simulation estimate of the Type I error probability from 50. Table 4. Error rates avove 10% are considered excessive. and σ 2 . Type I error rates between 3% and 8% are considered reasonable. this probability depends only on s. In Table 4.4. n. 100 and 500.84 | β = 1) . The second through seventh columns contain the Type I error probabilities for diﬀerent combinations of n and σ.1 we report the results of a Monte Carlo simulation where we vary these three parameters. Typically. Any other choice of s leads to a test with unacceptable Type I error probabilities. n is varied among 20. and rarely fall outside of the 3%-8% range. For this particular example. In each case. To interpret the table. Test performance deteriorates as s increases. Given the simplicity of the model. looking for tests for which rate rejection rates are close to 5%. There is. so these probabilities are Type I error.1 you can also see the impact of variation in sample size.

25 .24 . Deﬁne θ ˆ ˆ ⎞ ⎛ 0 ⎟ ⎜ ⎟ ⎜ ⎜ 1 ⎟ ⎟ ⎜ ⎜ ˆ ⎟ ˆ H1 = ⎜ β 2 ⎟ ⎟ ⎜ ⎟ ⎜ ⎜ β ⎟ ˆ ⎠ ⎝ − 1 ˆ2 β2 ´ s(ˆ θ) −r . ˆ ˆ ˆ ˆ ˆ Let β = (β 0 .13 .05 .20 . let V be an estimate of the ˆ asymptotic variance matrix for β and set ˆ = β 1 /β 2 . While this is clear in this particular example. In this case a t-statistic for H0 is t1n = ³ˆ β1 ˆ β2 where r is a known constant.25 .12 .07 . β 1 .20) ³ ´1/2 ˆ0 ˆ ˆ so that the standard error for ˆ is s(ˆ = n−1 H1 V H1 θ θ) .08 .13 . An alternative statistic can be constructed through reformulating the null hypothesis as H0 : β 1 − rβ 2 = 0. Equivalently.15 . β 2 ) be the least-squares estimates of (6.s 1 2 3 4 5 6 7 8 9 10 Note: σ=1 σ=3 n = 20 n = 100 n = 500 n = 20 n = 100 n = 500 .16 Rejection frequencies from 50.22 .05 .06 .06 .14 . Take the model yi = β 0 + x1i β 1 + x2i β 2 + ei E (xi ei ) = 0 and the hypothesis H0 : β1 =r β2 (6.05 .15 .08 .06 .10 .000 simulated random samples In this example it is not surprising that the choice s = 1 yields the best test statistic.05 .07 .26 .14 .18 .31 .06 .08 .30 .11 .20 .33 . deﬁne θ = β 1 /β 2 .07 .10 .15 .12 .21 .28 . so the hypothesis can be stated as H0 : θ = r.05 .35 . Other choices are arbitrary and would not be used in practice.17 .05 .07 . in other examples natural choices are not always obvious and the best choices may in fact appear counter-intuitive at ﬁrst.09 .08 .06 .06 .22 .23 .19 . This point can be illustrated through another example.34 .06 .06 .08 .10 .07 .15 .20).13 . 64 .

25.645) P (tn < −1.06 .05 .645) greatly exceed 5%. .00 .10 .05 .10 . if the hypothesis can be expressed as a linear restriction on the model parameters. 1) variables.05 . The implication of Table 4.06 .2 is that the two t-ratios have dramatically diﬀerent sampling behavior.00 . and alternatives to asymptotic critical values should be considered.26 .05. In this section we describe the method in more detail.05 .06 .15 .06 .05 .645) and P (tn > 1.645) are calculated from 50.00 .00 .645) are close to zero in most cases. We vary β 2 among . the rejection rates for the linear t2n statistic are invariant to the value of β 2 . We let x1i and x2i be mutually independent N (0.75 1.05 . However.2 Type I error Probability of Asymptotic 5% t-tests n = 100 n = 500 P (tn < −1. such as the GMM distance statistic which will be presented in Section 9.02 . ei be an independent N (0. The results are presented in Table 4. then the “most linear” formulation should be selected. The common message from both examples is that Wald statistics are sensitive to the algebraic formulation of the null hypothesis.00 .05 .A t-statistic based on this formulation of the hypothesis is ´2 ³ ˆ 1 − rβ 2 ˆ β =³ ´1/2 .06 . In contrast.00 . −1 H V H ˆ 2 n 2 ⎞ 0 H2 = ⎝ 1 ⎠ . and are close to the ideal 5% rate for both sample sizes. Table 4.12 . 6.00 .09 .47 .7.0 and n among 100 and 500.05 β2 . In all cases.645) t1n t2n t1n t2n t1n t2n t1n t2n . .50 .1. along with sample size n. σ 2 ) draw with σ = 3.06 .07 . and 1. −r ⎛ t2n where To compare t1n and t2n we perform another simple Monte Carlo simulation.05 .000 simulated samples. especially for small values of β 2 . It is also prudent to consider alternative tests to the Wald statistic.25 .75.06 .05 .06 . while the right tail probabilities P (t1n > 1.10 .2. the entries in the table should be 0.645) P (tn > 1. the rejection rates for the t1n statistic diverge greatly from this value.28 .00 . If no linear formulation is feasible.06 . 65 . This leaves β 2 as a free parameter.06 . this formulation should be used. .50. and normalize β 0 = 0 and β 1 = 1. Ideally.14 Monte Carlo Simulation In the previous section we introduced the method of Monte Carlo simulation to illustrate the small sample problems with tests of nonlinear hypotheses.00 The one-sided Type I error probabilities P (tn < −1.645) P (tn > 1. The left tail probabilities P (t1n < −1.15 .00 .

F ) = P (Tn ≤ x | F ) .. x∗ ) .. xn . Notationally. xi ) which are random draws from a population distribution F. a chi-square can be generated by sums of squares of normals. The basic idea is that for any given F..... While the asymptotic distribution of Tn might be known.. (For example. The above experiment creates one random draw from the distribution Gn (x. i = 1. and calculate θ of θ \ ˆ Bias(θ) = B B 1 X 1 Xˆ Tnb = θb − θ B B b=1 b=1 B 1 X \θ) (Tnb )2 M SE(ˆ = B b=1 µ ¶2 \ = M SE(ˆ − Bias(ˆ \θ) \ ˆ V ar(θ) θ) 66 . These results are stored. run the above experiment. F ). The researcher chooses F (the distribution of the data) and the sample size n. the exact (ﬁnite sample) distribution Gn is generally unknown. for example an estimator ˆ or a t-statistic (ˆ − θ)/s(ˆ The exact distribution of Tn is θ θ θ). They constitute a random sample of size B from the distribution of Gn (x. we set B = 1000 or B = 5000. b = 1. are drawn from the distribution F using i the computer’s random number generator. B. Let θ be a parameter and let Tn = Tn (y1 . F ) = P (Tnb ≤ x) = P (Tn ≤ x | F ) . x1 . we can estimate any feature of interest using (typically) a method of moments estimator. where B is a large number. mean-squared error (MSE). . n. This is useful to investigate the performance of the statistic Tn in reasonable situations and sample sizes. or equivalently the value θ is selected directly by the researcher. Monte Carlo simulation uses numerical simulation to compute Gn (x. Typically. and from these most random variables can be constructed. let the b0 th experiment result in the draw Tnb . From a random sample. our data consist of observations (yi . 1) random numbers. yn . Gn (x. Then the following experiment is conducted ∗ • n independent random pairs (yi . We will discuss this choice later. Clearly. For example: Suppose we are interested in the bias... F ) for selected choices of F. which implies restrictions on F . where games of chance are played. F ) can be calculated numerically through simulation. from one observation very little can be said. . most computer packages have built-in procedures for generating U [0. it is important that the statistic be evaluated at the “true” value of θ corresponding to the choice of F. A “true” value of θ is implied by this choice. x∗ .. or variance of the distribution ˆ − θ. The name Monte Carlo derives from the famous Mediterranean gambling resort. n n For step 1. θ) be a statistic of interest.Recall. The method of Monte Carlo is quite simple to describe. θ) is calculated on this pseudo data. We then set Tn = ˆ − θ. x∗ . yn . This is one observation from an unknown distribution.. So the researcher repeats the experiment B times.) For step 2.. the distribution function Gn (x. ∗ ∗ • The statistic Tn = Tn (y1 . 1] and N (0.

and our regressors include years of education. potential work experience. if we set B = 999. . then we can set s P = (. As P is unknown.96) . Hence the ³ ´ ˆ standard errors for B = 100. so that coeﬃcients may be interpreted as semi-elasticities. and hispanic.05) (. As discussed above. it is simple to make inferences about rejection probabilities from statistical tests. and dummy variable indicators for the following: married. 6. such as the percentage estimate reported in (6. It is therefore convenient to pick B so that N is an integer. It is therefore useful to conduct a variety of experiments. Suppose we are interested in the 5% and 95% quantile of Tn = ˆ We then compute the 10% θ. if we are ³ ´ p √ ˆ assessing an asymptotic 5% test. The random variable 1 (Tnb ≥ 1. We would then set Tn = ¯ˆ − θ¯ /s(ˆ and calculate B X ˆ= 1 P 1 (Tnb ≥ 1. The typical purpose of a Monte Carlo simulation is to investigate the performance of a statistical procedure (estimator or test) in realistic settings. In practice. union member. therefore. an estimator or test may perform wonderfully for some values. potential work experience. this may ˆ be approximated by replacing P with P or with an hypothesized value. immigrant. B. where N = (B +1)α. and poorly for others. experience squared.22/ B. hispanic. In many cases. The α% sample quantile is a number qα such that α% of the sample are less than qα . we included a dummy 67 . then the 5% sample quantile is 50’th sorted value and the 95% sample quantile is the 950’th sorted value.96) . but requires more computational time. the researcher must select the number of experiments. Often this is called the number of replications. For regressors we include years of education. s P = . Quite simply.15 Estimating a Wage Equation We again return to our wage equation.21) the percentage of the simulated t-ratios which exceed the asymptotic 5% critical value. experience squared. a larger B results in more precise estimates of the features of interest of Gn . We now expand the sample all non-military wage earners. and .96) is iid Bernoulli. and therefore it is straightforward to calculate standard errors for any quantity of interest. Since the results of a Monte Carlo experiment are estimates computed from a random sample of size B. Again our dependent variable is the natural log of wages. and 5000. For example. female.Suppose we are interested in the ¯Type I error associated with an asymptotic 5% two-sided ¯ ¯ ¯ θ) θ t-test. We us the sample of wage earners from the March 2004 Current Population Survey. and non-white. female. In particular. Furthermore. and estimate a multivariate regression. For example. union member. are. respectively. immigrant. 1000.007. If the standard error is too large to make a reliable inference. excluding military. and 90% sample quantiles of the sample {Tnb }. equalling 1 with probability P = E1 (Tnb ≥ 1. the choice of B is often guided by the computational demands of the statistical procedure. for a selection of choices of n and F.21) is therefore an ³ ´ p ˆ unbiased estimator of P with standard error s P = P (1 − P ) /B.003. Then qα is the N ’th number in this ordered sequence. For the dependent variable we use the natural log of wages. the performance will depend on n and F. and dummy variable indicators for the following: married. then B will have to be increased. A simple way to compute sample quantiles is to sort the sample {Tnb } from low to high. Generally. We separately estimate equations for white and non-whites.95) /B ' . The average (6.21).022. B b=1 (6.

18) that the state coeﬃcients are jointly zero.027 .49452 σ ˜ Notice that the two statistics are close.008 .097 −.1. Alternatively. excluding the coeﬃcients on the state dummy variables.1 we ﬁnd the point estimate ˆ ˆ = − β 2 = 28.001 . the restricted standard deviation estimate is σ = . reestimating the model with the 50 state dummies excluded.00057 .010 .19) is ˜ µ ¶ µ ¶ σ2 ˆ . if β 2 > 0 and β 3 < 0 the solution is θ=− From Table 4.4945. The F form of the Wald statistic (6. 808 1 − .014 .102 −.variable for state of residence (including the District of Columbia. The available sample is 18. Wn = n 1 − 2 = 18. 50 Another interesting question which can be addressed from these estimates is the maximal impact of experience on mean wages.34 ˆ s(β) . but not equal.808 so the parameter estimates are quite precise and reported in Table 4. this adds 50 regressors).101 .070 .010 Intercept Education Experience Experience2 Married Female Union Member Immigrant Hispanic Non-White σ ˆ Sample Size R2 One question is whether or not the state dummy variables are relevant.00002 .4877 18. θ ˆ 2β 3 β2 .033 −.121 −.808 .013 .48772 = 515. we ﬁnd Wn = 550. Computing the Wald statistic (6. Using either statistic the hypothesis is easily rejected. as the 1% critical value for the χ2 distribution is 76. Table 4.232 . Ignoring the other coeﬃcients.007 .102 −.1 OLS Estimates of Linear Equation for Log(Wage) ˆ β 1.032 .002 . we can write this eﬀect as log(W age) = β 2 Experience + β 3 Experience2 + · · · Our question is: At which level of experience θ do workers achieve the highest wage? In this quadratic model.69. 2β 3 68 .

this is a poor choice. but it can be found numerically quite easily. These t-statistics take the form ˆ ˆ β + 2β 3 θ tn (θ) = ³ 2 ´1/2 ˆ h0 V hθ θ hθ = µ −1 2θ ¶ where ˆ ˆ ˆ and V is the covariance matrix for (β 2 β 3 ).40. so we have to go one step further. However. Notice that the upper end of the conﬁdence interval is the same as that from the delta method. we can calculate a standard error of s(ˆ = . Instead.5]. This set is [27.9. 69 .Using the Delta Method. In the previous section we discovered that such t-tests had very poor Type I error rates. Our desired conﬁdence interval will be the set of parameter values θ which are not rejected by the hypothesis test.5]. implying a 95% conﬁdence θ) interval of [27. but the lower end is substantially lower. not testing a hypothesis. Since tn (θ) is a non-linear function of θ. there is not a simple expression for this set.96. we found better Type I error rates by reformulating the hypothesis as a linear restriction. 29. This is the set of θ such that |tn (θ)| ≤ 1. In the present context we are interested in forming a conﬁdence interval. 29. as the coverage probability of this conﬁdence interval is one minus the Type I error of the hypothesis test based on the t-test.0.

β 2 ). then ¶ µ ¡ ¢−1 h 0 ¡ 0 ¢−1 i−1 0 ¡ 0 ¢−1 0 ˜ XX R R XX R R X e. ˜ That is. 3. 1. (c) Show that if R0 β = r is true. ˜ (b) Verify that R0 β = r. show that the least-squares estimate of β = (β 1 . ﬁnd the least-squares estimate of β = (β 1 . Take the model Y = Xβ + e with the restriction R0 β = r where R is a known k × s matrix.16 Exercises For exercises 1-4. β 2 ) subject to the constraint that β 2 = 0 is the OLS regression of Y on X1 . In the model Y = X1 β 1 + X2 β 2 + e. ˜ (e) Find an appropriate formula to calculate standard errors for the elements of β. In the model Y = Xβ + e. (a) Show that the solution is ´ ¢−1 h 0 ¡ 0 ¢−1 i−1 ³ 0 ¡ ˆ ˜ ˆ Rβ−r R R XX R β = β − X 0X ´ h ¡ ¢−1 i−1 ³ 0 ˆ ˆ Rβ−r R λ = R0 X 0 X ¢−1 0 ¡ ˆ XY β = X 0X where is the unconstrained OLS estimator. In the model Y = X1 β 1 + X2 β 2 + e. β minimizes the sum of squared errors Sn (β) over all β such that the restriction holds. 4.6. the following deﬁnition is used. subject to the constraint that β 1 = c (where c is some given vector) is simply the OLS regression of Y − X1 c on X2 . the least-squares estimate of β subject to the restriction h(β) = 0 is ˜ β = argmin Sn (β) h(β)=0 Sn (β) = (Y − Xβ)0 (Y − Xβ) . and rank(R) = s. subject to the constraint that β 1 = −β 2 . 2. (d) Under the ´ standard assumptions plus R0 β = r. 0 < s < k. λ) = Sn (β) + λ0 R0 β − r 2 where λ is s × 1. Explain why β solves the minimization of the Lagrangian ¢ ¡ 1 L(β. ﬁnd the asymptotic distribution of √ ³˜ n β − β as n → ∞. β − β = Ik − X 0 X 70 . show that the least-squares estimate of β = (β 1 . r ˜ is a known s × 1 vector. β 2 ). In the model Y = X1 β 1 + X2 β 2 + e.

5. You have two independent samples (Y1 , X1 ) and (Y2 , X2 ) which satisfy Y1 = X1 β 1 + e1 and Y2 = X2 β 2 + e2 , where E (x1i ei1 ) = 0 and E (x2i e2i ) = 0, and both X1 and X2 have k ˆ ˆ columns. Let β 1 and β 2 be the OLS estimates of β 1 and β 2 . For simplicity, you may assume that both samples have the same number of observations n. ´ ´ √ ³³ ˆ ˆ (a) Find the asymptotic distribution of n β 2 − β 1 − (β 2 − β 1 ) as n → ∞. (b) Find an appropriate test statistic for H0 : β 2 = β 1 . (c) Find the asymptotic distribution of this statistic under H0 . 6. The model is yi = x0 β + ei i E (xi ei ) = 0 ¡ ¢ Ω = E xi x0 e2 . i i

ˆ ˆ (a) Find the method of moments estimators (β, Ω) for (β, Ω). ˆ ˆ (b) In this model, are (β, Ω) eﬃcient estimators of (β, Ω)? (c) If so, in what sense are they eﬃcient? 7. Take the model yi = x0 β 1 + x0 β 2 + ei with Exi ei = 0. Suppose that β 1 is estimated by 1i 2i regressing yi on x1i only. Find the probability limit of this estimator. In general, is it consistent for β 1 ? If not, under what conditions is this estimator consistent for β 1 ? 8. Verify that equation (6.13) equals (6.14) as claimed in Section 6.6. 9. Prove that if an additional regressor Xk+1 is added to X, Theil’s adjusted R increases if ˆ ˆ ˆ and only if |tk+1 | > 1, where tk+1 = β k+1 /s(β k+1 ) is the t-ratio for β k+1 and ¡ ¢1/2 ˆ s(β k+1 ) = s2 [(X 0 X)−1 ]k+1,k+1

2

is the homoskedasticity-formula standard error.

**10. Let Y be n × 1, X be n × k (rank k). Y = Xβ + e with E(xi ei ) = 0. Deﬁne the ridge regression estimator Ã n !−1 Ã n ! X X 0 ˆ xi xi + λIk xi yi β=
**

i=1 i=1

ˆ ˆ where λ > 0 is a ﬁxed constant. Find the probability limit of β as n → ∞. Is β consistent for β?

∗ ∗ 11. Of the variables (yi , yi , xi ) only the pair (yi , xi ) are observed. In this case, we say that yi is a latent variable. Suppose ∗ yi = x0 β + ei i

E (xi ei ) = 0

∗ yi = yi + ui

71

**where ui is a measurement error satisfying E (xi ui ) = 0
**

∗ E (yi ui ) = 0

ˆ Let β denote the OLS coeﬃcient from the regression of yi on xi . (a) Is β the coeﬃcient from the linear projection of yi on xi ? ˆ (b) Is β consistent for β as n → ∞? ´ √ ³ˆ (c) Find the asymptotic distribution of n β − β as n → ∞.

12. The data set invest.dat contains data on 565 U.S. ﬁrms extracted from Compustat for the year 1987. The variables, in order, are • Ii Investment to Capital Ratio (multiplied by 100). Total Market Value to Asset Ratio (Tobin’s Q). Cash Flow to Asset Ratio. Long Term Debt to Asset Ratio.

• Qi • Di • Ci

The ﬂow variables are annual sums for 1987. The stock variables are beginning of year. (a) Estimate a linear regression of Ii on the other variables. Calculate appropriate standard errors. (b) Calculate asymptotic conﬁdence intervals for the coeﬃcients. (c) This regression is related to Tobin’s q theory of investment, which suggests that investment should be predicted solely by Qi . Thus the coeﬃcient on Qi should be positive and the others should be zero. Test the joint hypothesis that the coeﬃcients on Ci and Di are zero. Test the hypothesis that the coeﬃcient on Qi is zero. Are the results consistent with the predictions of the theory?

2 (d) Now try a non-linear (quadratic) speciﬁcation. Regress Ii on Qi , Ci , Di , Q2 , Ci2 , Di , i Qi Ci , Qi Di , Ci Di . Test the joint hypothesis that the six interaction and quadratic coeﬃcients are zero.

13. In a paper in 1963, Marc Nerlove analyzed a cost function for 145 American electric companies. (The problem is discussed in Example 8.3 of Greene, section 1.7 of Hayashi, and the empirical exercise in Chapter 1 of Hayashi). The data ﬁle nerlov.dat contains his data. The variables are described on page 77 of Hayashi. Nerlov was interested in estimating a cost function: T C = f (Q, P L, P F, P K). (a) First estimate an unrestricted Cobb-Douglass speciﬁcation ln T Ci = β 1 + β 2 ln Qi + β 3 ln P Li + β 4 ln P Ki + β 5 ln P Fi + ei . (6.22)

Report parameter estimates and standard errors. You should obtain the same OLS estimates as in Hayashi’s equation (1.7.7), but your standard errors may diﬀer. (b) Using a Wald statistic, test the hypothesis H0 : β 3 + β 4 + β 5 = 1. 72

(c) Estimate (6.22) by least-squares imposing this restriction by substitution. Report your parameter estimates and standard errors. (d) Estimate (6.22) subject to β 3 + β 4 + β 5 = 1 using the restricted least-squares estimator from problem 4. Do you obtain the same estimates as in part (c)? .

73

... σ 2 } and σ 2 = σ 2 (x ) = E e2 | x .1 Generalized Least Squares In the projection model. σ 2 }. However. the least-squares estimator is ineﬃcient.1) infeasible since the matrix D is unknown. Then i 0 E (η i | xi ) = α0 + z1i α1 0 η i = α0 + z1i α1 + ξ i and we have the regression equation (7. where z1i is some q × 1 function of xi . A ˆ ˆn feasible GLS (FGLS) estimator replaces the unknown D with an estimate D = diag{ˆ 2 . σ1 We now discuss this estimation problem. in the linear regression model yi = x0 β + ei i E (ei | xi ) = 0.Chapter 7 Additional Regression Topics 7. Let η i = e2 . 74 .1) XD Y β = X 0 D−1 X ¡ ¢ 2 . The GLS estimator (7.. Typically.2) E (ξ i | xi ) = 0. . we know that the least-squares estimator is semi-parametrically eﬃcient for the projection coeﬃcient.. The theory of Chamberlain (1987) can be used to show that in this model the semiparametric eﬃciency bound is obtained by the Generalized Least Squares (GLS) estimator ¢−1 ¡ 0 −1 ¢ ¡ ˜ (7. The error ξ i in this regression error ξ i is generally heteroskedastic and has the conditional variance ¡ ¢ V ar (ξ i | xi ) = V ar e2 | xi i ´ ³¡ ¢¢2 ¡ = E e2 − E e2 | xi | xi i i ¡ 4 ¢ ¡ ¡ 2 ¢¢2 = E ei | xi − E ei | xi .. Suppose that we model the conditional variance using the parametric form 0 σ 2 = α0 + z1i α1 i = α0 zi . z1i are squares (and perhaps levels) of some (or all) elements of xi . Often the functional form is kept simple for parsimony. The GLS estimator is sometimes called where D = diag{σ 1 i i n i i the Aitken estimator. .

σ 2 } σ1 ˜n and ³ ´−1 ˜ ˜ ˜ β = X 0 D−1 X X 0 D−1 Y. We may call (7. . then the FGLS ˜i estimator is not well deﬁned. This suggests 75 . One typical problem with implementation of FGLS estimation is that in a linear regression ˜i speciﬁcation. and will depend on the model (and estimation method) for the skedastic regression. Vα ) α ¡ ¡ 0 ¢¢−1 ¡ 0 2 ¢ ¡ ¡ 0 ¢¢−1 E zi zi ξ i E zi zi . there is no guarantee that σ 2 > 0 for all i. we have the OLS residual ei = yi − x0 β = ei − x0 (β − β). xi ). which is typically undesirable. Then set ˜i ˜ D = diag{˜ 2 . Thus ˆ i i η − η i = e2 − e2 ˆ ˆi i = φi . ˜i Suppose that σ 2 > 0 for all i. Vα ) (7. We have shown that α is consistently estimated by a simple procedure.6) σ 2 = α0 zi . This is the feasible GLS..3) ˆ ˆ While ei is not observed. as it is estimating the conditional variance of the regression of yi on xi . and hence we can estimate 0 σ 2 = zi α by i ˜ (7. Vα = E zi zi (7.Suppose ei (and thus η i ) were observed..4) the skedastic regression. if σ 2 ≈ 0 for some i. or FGLS. then the FGLS estimator will force ˜i the regression equation through the point (yi . If σ 2 < 0 for some i.. ³ ´ ˆ ˆ ˆ = −2ei x0 β − β + (β − β)0 xi x0 (β − β) i i say. Then we could estimate α by OLS: ¢−1 0 ¡ Z η →p α α = Z 0Z ˆ and where √ n (ˆ − α) →d N (0. Then ˆ ¢−1 0 ¡ Zη ˆ α = Z 0Z ˜ (7.5) ˆ Thus the fact that η i is replaced with η i is asymptotically irrelevant. Note that n n n ´ 1X √ ³ √ −2 X 1 X ˆ ˆ ˆ √ zi φi = zi ei x0 n β − β + zi (β − β)0 xi x0 (β − β) n i i n n n i=1 i=1 i=1 →p 0 Let be from OLS regression of η i on zi .4) ¡ ¢−1 −1/2 0 √ √ n (˜ − α) = n (ˆ − α) + n−1 Z 0 Z α α n Zφ →d N (0. estimator of β. Furthermore. Since there is not a unique speciﬁcation for the conditional variance the FGLS estimator is not unique.

´ √ ³ ˜ ˜ n β GLS − β F GLS →p 0. 1992). ´´−1 ³ ³¡ ´´−1 ³ ³¡ ¢−1 ¢−2 2 0 ´´ ³ ³¡ 0 ¢−1 E α0 zi E α zi xi x0 σ i xi xi xi x0 .. similar to the covariance matrix of the OLS estimator. FGLS estimation depends on speciﬁcation and estimation of the skedastic regression.1 If the skedastic regression is correctly speciﬁed. In the linear regression model. Its asymptotic variance is not that given in Theorem 7. β should perhaps be i i called a quasi-FGLS estimator of β. σ 2 ] σi i for some σ 2 > 0. FGLS is asymptotically superior to OLS. Theorem 7. but the proof of this can be tricky. then FGLS is asymptotically equivalent to GLS. It is possible to show that if the skedastic regression is correctly speciﬁed. V = E σ −2 xi x0 i i ˆ where D = diag{ˆ2 . V n n i=1 .1. Unless σ 2 = α0 zi . Instead. the natural estimator of the asympˆ totic variance of β is Ã n !−1 µ ¶−1 1 X −2 0 1 0 ˜ −1 ˜0 = XD X σ i xi xi ˜ = . V = E α0 zi i i Examining the asymptotic distribution of Theorem 7. and it may be estimated with considerable 76 V takes a sandwich form√. First.. V ˜ An appropriate solution is to use a White-type estimator in place of V 0 .1.2) is correctly speciﬁed. This may be written as !−1 Ã n !Ã n !−1 Ã n 1 X −4 2 0 1 X −2 0 1 X −2 0 ˜ σ i xi xi ˜ σ i ei xi xi ˜ ˆ σ i xi xi ˜ V = n n n i=1 i=1 i=1 ³ ´−1 ³ ´³ ´−1 ˜ ˜ ˆ˜ ˜ X 0 D−1 DD−1 X X 0 D−1 X = n X 0 D−1 X ˜ which is consistent for V as n → ∞. This is an estimator which is robust to misspeciﬁcation of the condie1 ˆn tional variance.1. This estimator V 0 is appropriate when the skedastic regression (7.1. and was proposed by Cragg (Journal of Econometrics.that there is a need to bound the estimated variances away from zero. . e2 }. Since the form of the skedastic regression is unknown.. ¢¢−1 ¡ ¡ . There are three reasons. It may be the case that α0 zi is only an approximation to the true conditional variance σ 2 = i ˜ E(e2 | xi ). We just state the result without proof. i ˜ 0 is inconsistent for V . A trimming rule might make sense: σ 2 = max[˜ 2 . Why then do we not exclusively estimate regression models by FGLS? This is a good question. V ). In this case we interpret α0 zi as a linear projection of e2 on zi . and thus where ´ √ ³ ˜ n β F GLS − β →d N (0.1.

FGLS will do worse than OLS in practice. The point is that the eﬃciency gains from FGLS are built on the stronger assumption of a correct conditional mean. This introduces an element of arbitrariness which is unsettling to empirical researchers. its squares.4) and constructing a Wald statistic. And the FGLS probability limit will depend on the particular function selected for the skedastic regression. The asymptotic distribution (7. as they will be estimating two diﬀerent projections. In the linear regression model the conditional mean of yi given xi = x is 77 . Motivated by the form of the asymptotic variance ˆ of the OLS estimator β. Typically. The main diﬀerences between popular “tests” is which transformations of xi enter zi . but the only diﬀerence is that they a ¢ allowed for general choice of zi . and not a conditional mean.7) Hence the standard test of H0 is a classic F (or Wald) test for exclusion of all regressors from the skedastic regression (7. Vα = E zi zi (7. We may therefore test this hypothesis by the estimation (7. we impose the stronger hypothesis and test the hypothesis that ei is independent of xi . If the equation of interest is a linear projection. Theorem 7. and the cost is a reduction of robustness to misspeciﬁcatio 7. then the OLS and FGLS estimators will converge in probability to diﬀerent limits. Third. and replaced E ξ 2 with 2σ 4 which holds when ei is N(0. on the other hand. BreuschPagan (1979) proposed what might appear to be ¡ distinct test.4). the two tests coincide. individual estimated conditional variances may be negative. OLS is a more robust estimator of the parameter vector. White (1980) proposed that the test for heteroskedasticity be based on setting zi to equal all non-redundant elements of xi . or equivalently that i H0 : α1 = 0 in the regression (7. but also under the assumptions of linear projection. and all cross-products.1 Under H0 and ei independent of xi .error.2 Testing for Heteroskedasticity ¢ ¡ The hypothesis of homoskedasticity is that E e2 | xi = σ 2 . in which case ξ i is ˜ independent of xi and the asymptotic variance (7. and this requires trimming to solve. If i this simpliﬁcation is replaced by the standard formula (under independence of the error). the Wald test of H0 is asymptotically χ2 .5) and the asymptotic variance (7.7) under independence show that this test has an asymptotic chi-square distribution. The GLS and FGLS estimators. however.2). This hypothesis does not imply that ξ i is independent of xi . Second.2. 7. q Most tests for heteroskedasticity take this basic form.3 Forecast Intervals m(x) = E (yi | xi = x) = x0 β. the estimated conditional variances may contain more noise than information about the true conditional variances. It is consistent not only in the regression model. require the assumption of a correct conditional mean. σ 2 ). In this case.3) for α simpliﬁes to ¡ ¡ 0 ¢¢−1 ¡ 2 ¢ E ξi .

Letting h(β) = x0 β and θ = h(β). this would require the asymptotic normality of the ratio ³ ´ ˆ ei − x0 β − β .In some cases. θ) = E (yi | xi = x) which is a non-linear function of the parameters θ. For a given value of xi = x. The only special exception is the case where ei has the exact distribution N (0. the width of the conﬁdence set is dependent on x. To get an accurate forecast interval. Given the diﬃculty. As the out-of-sample error ei is ˆ ˆ independent of the in-sample estimate β. Notice that this is a (linear) ˆ ˆ θ function of β. the natural estimate of this variance is σ 2 + n−1 x0 V x. e. p h i ˆ ˆ x0 β ± 2 n−1 x0 V x .4 NonLinear Least Squares In some cases we might use a parametric regression function m(x. We would also like a measure of uncertainty for ˆ the forecast. but this turns out to be incorrect. this has variance ³ ´³ ´0 ¡ ¢ ˆ ˆ Eˆ2 = E e2 | xi = x + x0 E β − β β − β x ei i = σ 2 (x) + n−1 x0 V x.6). Notice that this is diﬀerent from the standard ˆ ˆ error for the conditional mean. many applied forecasters focus h i ˆ on the simple approximate interval x0 β ± 2ˆ(x) . s(x) ˆ But no such asymptotic approximation can be made. we want to estimate m(x) at a particular point x. ³ ´ ˆ ˆ The forecast error is ei = yi − m(x) = ei − x0 β − β . q 2 0 0 ˆ ˜ ˆ ˜ σ (x) = α z from (7. Thus an asymptotic 95% conﬁdence interval for m(x) is θ) It is interesting to observe that if this is viewed as a function of x. If we have an estimate of the conditional variance function. we may want to forecast (guess) yi out-of-sample. σ 2 ). so p ˆ s(ˆ = n−1 x0 V x. then the forecast standard error is s(x) = σ 2 (x) + n−1 x0 V x ˜ It would appear natural to conclude that an asymptotic 95% forecast interval for yi is i h ˆ s x0 β ± 2ˆ(x) .g. ¡ ¢ ˆ Assuming E e2 | xi = σ 2 . A point forecast ˆ is the estimated conditional mean m(x) = x0 β. 78 . so a standard ˆ i p ˆ error for the forecast is s(x) = σ 2 + n−1 x0 V x. the validity of an asymptotic conﬁdence interval is based on the asymptotic normality of the studentized ratio. we need to estimate the conditional distribution of ei given xi = x. which is generally invalid. s 7. A reasonable rule is the conditional mean m(x) as it is the mean-square-minimizing forecast. In general. In the present case. which is a much more diﬃcult task. we see that m(x) = ˆ = x0 β and Hβ = x. We describe this setting as non-linear regression.

θ)ˆ (7. V ) θ where mθi = mθ (xi . θ). θ) = θ1 + θ2 x1 + (θ3 + θ4 x1 ) Φ θ6 m(x. ˆ must be found by numerical θ methods. θ) is diﬀerentiable. it must be shown that ˆ →p θ0 . θi 79 . θ) = θ1 + θ2 x + θ4 (x − θ3 ) 1 (x > θ3 ) µ ¶ m(x. Since ˆ →p θ0 . See Appendix E. θ) = θ1 + θ2 m(x. θ) = G(x0 θ). ¢¢−1 ¡ ¡ ¢¢ ¡ ¡ ¢¢−1 ¡ ¡ E mθi m0 e2 E mθi m0 V = E mθi m0 θi θi i θi Sketch of Proof. we call this the nonlinear least squares (NLLS) θ).Examples of nonlinear regression functions include x 1 + θ3 x m(x. then the FOC for minimization are 0= n X i=1 mθ (xi . When it exists.8) Theorem 7. ´ √ ³ n ˆ − θ0 →d N (0. so the minimization of Sn (θ) only needs to be examined for θ close to θ0 . θ) is (generically) diﬀerentiable in the parameters θ.4. but we won’t cover that argument here. θ) is diﬀerentiable with respect to θ. θ) = θ1 + θ2 xθ3 m(x. First. ˆ ˆ One motivation for the choice of NLLS as the estimation method is that the parameter θ is the solution to the population problem minθ E (yi − m(xi . θ0 ). estimator. θ))2 . Let 0 yi = ei + m0 θ0 . G known x2 − θ5 m(x. it is adopted as a ﬂexible approximation to an unknown regression function. In the ﬁnal two examples. m(x. θ) = ∂θ Nonlinear regression is frequently adopted because the functional form m(x. let ∂ m(x. θ) = θ1 + θ2 exp(θ3 x) m(x. θ))2 Since sum-of-squared-errors function Sn (θ) is not quadratic. The NLLS residuals are ei = yi − m(xi .1 If the model is identiﬁed and m(x. θ) = (θ1 + θ2 x1 ) 1 (x2 < θ3 ) + (θ4 + θ5 x1 ) 1 (x2 > θ3 ) In the ﬁrst ﬁve examples. ˆ ei . θ) is suggested by an economic model. m is not diﬀerentiable with respect to θ3 . This can be done using arguments θ for optimization estimators. When the regression function is nonlinear. mθ (x. In other cases. ˆ is close to θ θ θ0 for n large. which alters some of the analysis. When m(x. The least squares estimator ˆ minimizes the sum-of-squared-errors θ Sn (θ) = n X i=1 (yi − m(xi .

4. tests of H0 do not have asymptotic normal or chi-square distributions. θ) = β 0 zi + β 0 xi (γ). 1 2 The model is linear when β 2 = 0. θi Thus ¡ ¢ yi − m(xi . θ0 ) + m0 (θ − θ0 ) . θ0 ) + m0 (θ − θ0 ) θi = ei − m0 (θ − θ0 ) θi 0 = yi − m0 θ.For θ close to the true value θ0 . the model is yi = β 0 zi + εi 1 and both β 2 and γ have dropped out. θ which is that stated in the theorem. γ is not identiﬁed. θi Hence the sum of squared errors function is Sn (θ) = n X i=1 (yi − m(xi . Thus we want to test H0 : β 2 = 0. θ) ' m(xi . under H0 . 80 . but these are not the only measures of central tendency. Thus when the truth is that β 2 = 0.5 Least Absolute Deviations We stated that a conventional goal in econometrics is estimation of impact of variation in xi on the central tendency of yi . ˆ and ei = yi − m(xi . θ))2 ' n X¡ ¢2 0 yi − m0 θ θi i=1 0 and the right-hand-side is the SSE function for a linear regression of yi on mθi . ¥ Based on Theorem 7. an estimate of the asymptotic variance V is ˆ V = Ã 1X mθi m0 ˆ ˆ θi n i=1 n !−1 Ã 1X mθi m0 e2 ˆ ˆ θi ˆi n i=1 n !Ã 1X mθi m0 ˆ ˆ θi n i=1 n !−1 where mθi = mθ (xi . and this is often a useful hypothesis (sub-model) to consider. by a ﬁrst-order Taylor series approximation. 7. ˆ ˆ θ) ˆ θ). Thus the NLLS 0 estimator ˆ has the same asymptotic distribution as the (infeasible) OLS regression of yi on mθi . the parameter estimates are not asymptotically normally distributed. θ0 )) − m(xi . Identiﬁcation is often tricky in nonlinear regression models. Furthermore. Hansen shows how to use simulation (similar to the bootstrap) to construct the asymptotic critical values (or p-values) in a given application. This means that under H0 . In particular. We have discussed projections and conditional means. This renders the distribution theory presented in the previous section invalid. θ) ' (ei + m(xi . Hansen (1996). An alternative good measure is the conditional median. The asymptotic theory of such tests have been worked out by Andrews and Ploberger (1994) and B. Suppose that m(xi . m(xi .1. However.

i n n i=1 (7. These distinctions are illusory. The linear median regression model takes the form yi = x0 β + ei i M ed (ei | xi ) = 0 In this model. The least absolute deviations (LAD) estimator of β minimizes this function ˆ β = argmin Ln (β) β Equivalently. These facts deﬁnitions motivate three estimators of θ. the linear function M ed (yi | xi = x) = x0 β is the conditional median function. Let m(x) = M ed (Y | X = x) denote the conditional median of Y given X = x. Two useful facts about the median are that (7.10) The LAD estimator has the asymptotic distribution 81 .5 • E (sgn (ei ) | xi ) = 0 • E (xi sgn (ei )) = 0 • β 0 = minβ E |yi − x0 β| i These facts motivate the following estimator.5. it is a solution to the moment condition ³ ´ 1X ˆ xi sgn yi − x0 β = 0. and let M ed (Y | X) = m(X) be this function evaluated at the random variable X. The median θ0 = M ed(Y ) is the value such that P (Y ≤ θ0 ) = P (Y ≥ θ0 ) = . The ﬁrst deﬁnition is the 50th empirical 1 P quantile. let Y be a continuous random variable.9) θ0 = argmin E |Y − θ| θ and E sgn (Y − θ0 ) = 0 where sgn (u) = ½ 1 −1 if u ≥ 0 if u < 0 is the sign function. and the third deﬁnition is the i=1 1 P solution to the moment equation n n sgn (yi − θ) . Conditional analogs of the facts about the median are • P (yi ≤ x0 β 0 | xi = x) = P (yi > x0 β | xi = x) = . and the substantive assumption is that the median function is linear in x. Let ¯ 1 X¯ ¯yi − x0 β ¯ Ln (β) = i n i=1 n be the average of absolute deviations. however. as i=1 these estimators are indeed identical.To recall the deﬁnition and properties of the median. Now let’s consider the conditional median of Y given a random variable X. The second is the value which minimizes n n |yi − θ| .

Theorem 7. ∂ g(β) = ∂β 0 ¡ ¡ ¢¢ ∂ 0 0 Exi 1 − 2 · 1 yi ≤ xi β ∂β £ ¡ ¡ ¢ ¢¤ ∂ = −2 0 E xi E 1 ei ≤ x0 β − x0 β 0 | xi i i ∂β " Z 0 # xi β−x0 β 0 i ∂ = −2 0 E xi f (e | xi ) de ∂β −∞ £ ¢¤ ¡ = −2E xi x0 f x0 β − x0 β 0 | xi i i i £ 0 ¤ ∂ 0 g(β 0 ) = −2E xi xi f (0 | xi ) . ˆ Proof of Theorem 7.5. ∂β 0 so Third. we provide a sketch here for completeness.10) is equivalent to g n (β) = 0. In the special case where the error is independent of xi . and this improves estimation of the median. where V = and f (e | x) is the conditional density of ei given xi = x.11) This simpliﬁcation is similar to the simpliﬁcation of the asymptotic covariance of the OLS estimator under homoskedasticity.11). First.1 is advanced. (7.1 ´ √ ³ˆ n β − β 0 →d N (0. Let g(β) = Eg (β). then f (0 | x) = f (0) and the asymptotic variance simpliﬁes V = (Exi x0 )−1 i 4f (0)2 (7. ¢¢−1 ¡ ¢¢−1 ¢¡ ¡ 1¡ ¡ 0 Exi x0 E xi x0 f (0 | xi ) E xi xi f (0 | xi ) i i 4 The variance of the asymptotic distribution inversely depends on f (0 | x) .5. by a Taylor series expansion and the fact g(β 0 ) = 0 82 . We need where g n (β) = n i i=1 gi (β) and gi (β) = xi (1 − 2 · 1 (yi ≤ xi three preliminary result. the height of the error density at its median. The main diﬃculty is the estimation of f (0).3. While a complete proof of Theorem 7. See Chapter 16.1) n X √ −1/2 n (g n (β 0 ) − g(β 0 )) = −n gi (β 0 ) →d N (0. Exi x0 ) i i=1 since Egi (β 0 )gi (β 0 )0 = Exi x0 .5. ∂β ˆ g(β) ' ´ ³ ∂ ˆ g(β 0 ) β − β 0 . the conditional density of the error at its median. then there are many innovations near to the median.1: Since sgn (a) = 1 − 2 · 1 (a ≤ 0) . This can be done with kernel estimation techniques. Pn −1 0 β)) . Computation of standard error for LAD estimates typically is based on equation (7. V ). When f (0 | x) is large. Second using the law of iterated expectations and the chain rule of i diﬀerentiation. by the central limit theorem (Theorm 5.

Again. 1] the τ ’th quantile Qτ of a random variable with distribution function F (u) is deﬁned as Qτ = inf {u : F (u) ≥ τ } When F (u) is continuous and strictly monotonic. Exi x0 ) →d i 2 = N (0.Together ´ √ ³ ˆ n β − β0 ' ' ¶−1 √ ∂ ˆ ng(β) 0 g(β 0 ) ∂β ´ ¡ £ ¤¢−1 √ ³ ˆ ˆ = −2E xi x0 f (0 | xi ) n g(β) − g n (β) i µ ¤¢−1 √ 1¡ £ 0 n (g n (β 0 ) − g(β 0 )) E xi xi f (0 | xi ) 2 ¤¢−1 1¡ £ 0 E xi xi f (0 | xi ) N (0. the quantile regression function qτ (x) describes how the τ ’th quantile of the conditional distribution varies with the regressors. The median is the special case τ = .13) This generalizes representation (7. The following alternative representation is useful. the quantile regression functions can take any shape. so you can think of the quantile as the inverse of the distribution function. when F (y | x) is continuous and strictly monotonic in y. ¥ 7. then F (Qτ (x) | x) = τ . If the random variable U has τ ’th quantile Qτ . For τ ∈ [0.5.9) for the median to all quantiles. However for computational convenience it is typical to assume that they are (approximately) linear in x (after suitable transformations). V ). The quantile Qτ is the value such that τ (percent) of the mass of the distribution is less than Qτ . (7.6 Quantile Regression The method of quantile regression has become quite popular in recent econometric practice. The third line follows from an asymptotic empirical process argument. We then have the linear quantile regression model yi = x0 β τ + ei i 83 . xi ) with conditional distribution function F (y | x) the conditional quantile function qτ (x) is Qτ (x) = inf {y : F (y | x) ≥ τ } .12) Qτ = argmin Eρτ (U − θ) . then (7. This linear speciﬁcation assumes that Qτ (x) = β 0 x where the coeﬃcients β τ τ vary across the quantiles τ . then F (Qτ ) = τ . As functions of x. For the random variables (yi . θ where ρτ (q) is the piecewise linear function ½ −q (1 − τ ) q<0 ρτ (q) = qτ q≥0 = q (τ − 1 (q < 0)) . For ﬁxed τ .

where and f (e | x) is the conditional density of ei given xi = x. fast linear programming methods have been developed for this problem. the unconditional density of ei at 0. A asymptotic distribution theory for the quantile regression estimator can be derived using similar arguments as those for the LAD estimator in Theorem 7. Thus.7 Testing for Omitted NonLinearity If the goal is to estimate the conditional expectation E (yi | xi ) . ˆ Given the representation (7.13). n numerical methods are necessary for its minimization. 7. the quantile regression estimator β τ for β τ solves the minimization problem ˆ β τ = argmin Lτ (β) n β∈Rk n where Lτ (β) = n and ρτ (q) is deﬁned in (7. and are widely available. Since the quanitle regression criterion function Lτ (β) does not have an algebraic solution. ´ √ ³ˆ Theorem 7. since it has discontinuous derivatives. i By construction.6.1 n β τ − β τ →d N (0. the τ ’th conditional quantile of ei is zero. Furthermore.5.12). it is useful to have a general test of the adequacy of the speciﬁcation. if the model yi = x0 β + ei has i been ﬁt by OLS. and test their signiﬁcance using a Wald test. conventional Newton-type optimization methods are inappropriate. Fortunately. When the error ei is independent of xi .where ei is the error deﬁned to be the diﬀerence between yi and its τ ’th conditional quantile x0 β τ . The null model is yi = x0 β + εi i 84 . One simple test for neglected nonlinearity is to add nonlinear functions of the regressors to ˆ ˆ the regression. let zi = h(xi ) denote functions of xi which are not linear functions of xi (perhaps 0˜ ˜ ˜ squares of non-binary regressors) and then ﬁt yi = x0 β +zi γ + ei by OLS. E xi xi f (0)2 A recent monograph on the details of quantile regression is Koenker (2005). otherwise its properties are unspeciﬁed without further restrictions. then f (0 | xi ) = f (0) . ¡ ¡ ¢¢−1 ¡ ¢¢−1 ¢¡ ¡ Exi x0 E xi x0 f (0 | xi ) Vτ = τ (1 − τ ) E xi x0 f (0 | xi ) i i i ¢ 1X ¡ ρτ yi − x0 β i n i=1 In general. and we have the simpliﬁcation Vτ = τ (1 − τ ) ¡ ¡ 0 ¢¢−1 . Another popular approach is the RESET test proposed by Ramsey (1969). Vτ ).1. the asymptotic variance depends on the conditional density of the quantile regression error. and form a Wald statistic i for γ = 0.

β 2 ). or 4 seem to work best. and n→∞ say. ⎠ . then 22 Q11 > Q11 − Q12 Q−1 Q21 . ⎟ zi = ⎝ . yielding ˆ ˜ ˆ ˆ (β 1 . To implement the test. and the two estimators have equal asymptotic eﬃciency. 1i 2i 2i 1i 22 . β 1 = (X1 X1 )−1 (X1 Y ) . 3. In this case i ¡ ¢−1 2 ˜ σ = Q−1 σ 2 . However. Otherwise. It is easy (although somewhat tedious) to show that under the null hypothesis.14) by OLS. Another is to regress yi on x1i and x2i jointly. m must be selected in advance.be an (m − 1)-vector of powers of yi . lim nV ar( β 1 ) = Ex1i x0 1i 11 n→∞ say. yielding predicted values yi = x0 β. Now let ˆ i ⎛ 2 ⎞ yi ˆ ⎜ .14) may be written as ³ ´3 ³ ´m ³ ´2 ˜ ˆ ˜ ˆ ˜ ˆ yi = x0 β + x0 β γ 1 + x0 β γ 2 + · · · x0 β γ m−1 + ei ˜ ˜ i i i i which has essentially approximated G(·) by a m’th order polynomial. note that (7. yi ˆm (7. 7. they will (typically) have diﬀerence asymptotic variances. In the model x2i is “irrelevant” if β 1 is the parameter of interest and β 2 = 0. Thus the null is rejected at the α% level if Wn m−1 exceeds the upper α% tail critical value of the χ2 m−1 distribution. and consequently 22 ¡ ¢−1 2 σ . If Q12 = 0 (so the variables are orthogonal) then these two variance matrices equal.8 Irrelevant Variables yi = x0 β 1 + x0 β 2 + ei 1i 2i E (xi ei ) = 0. Then run the auxiliary regression ˆ 0 ˜ yi = x0 β + zi γ + ei ˜ ˜ i ˆ which is estimated by OLS. The RESET test appears to work well as a test of functional form against a wide range of smooth alternatives. It is particularly powerful at detecting single-index models of the form yi = G(x0 β) + εi i where G(·) is a smooth “link” function. One estimator of β 1 is to regress 0 0 ˜ yi on x1i alone. To see why this is the case. since Q12 Q−1 Q21 > 0. The comparison between the two estimators is straightforward when the error is conditionally ¢ ¡ homoskedastic E e2 | xi = σ 2 . small values such as m = 2. and form the Wald statistic Wn for γ = 0. Under which conditions is β 1 or β 1 superior? It is easy to see that both estimators are consistent for β 1 . Typically. Wn →d χ2 . Q−1 σ 2 < Q11 − Q12 Q−1 Q21 11 22 85 ¡ ¡ ¢ ¢−1 2 ¡ ¢−1 2 ˆ lim nV ar(β 1 ) = Ex1i x0 − Ex1i x0 Ex2i x0 Ex2i x0 σ = Q11 − Q12 Q−1 Q21 σ .

7). It is important that the model selection question be well-posed. we see that β 1 has a lower asymptotic variance.9 Model Selection In earlier sections we discussed the costs and beneﬁts of inclusion/exclusion of variables. x2i = σ 2 . In contrast. . when economic theory does not provide complete guidance? This is the question of model selection. the question: “What is the right model for y?” is not well posed. A model selection procedure is consistent if ´ ³ c → 1 P M = M1 | M1 ³ ´ c P M = M2 | M2 → 1 86 . etc. How does a researcher go about selecting an econometric speciﬁcation.. n→∞ σx ˜ When µ 6= 0. we say that M2 is true if β 2 6= 0. as the larger problem can be written as a sequence of such comparisons. the question. However. E (ε | X1 . In many cases the problem of model selection can be reduced to the comparison of two nested models. we will on ˆ1 ¡ occasion use the homoskedasticity assumption E e2 | x1i . estimated ˆ ˆ ˆ2 the variances σ 2 and σ 2 .. 7. For example. . this result can be reversed when the error is conditionally heteroskedastic. σ2 ˜ lim nV ar( β 1 ) = 2 n→∞ σ x + µ2 while σ2 ˆ lim nV ar( β 1 )−1 = 2 . xKi = xK )?” is well posed. with residual vectors e1 and e2 . there is no clear ranking of the eﬃciency of the ˜ restricted estimator β 1 versus the unrestricted estimator.. To ﬁx notation. x Then under (6. take the model yi = β 0 + β 1 xi + ei and suppose that β 0 = 0. estimate of β 1 from the unconstrained model.. Y = X1 β 1 + X2 β 2 + ε.. One useful property is consistency. and E (xi − µ)2 = σ 2 . ˆ For example. “Which subset of (x1 . respectively.˜ ˆ This means that β 1 has a lower asymptotic variance matrix than β 1 . Let β 1 be the ˜ be the estimate under the constraint β = 0. i A model selection procedure is a data-dependent rule which selects one of the two models.. because it does not make clear the conditioning set. In the absence of the homoskedasticity assumption. E (ε | X1 . xK ) enters the regression function E(yi | x1i = x1 . where X1 is n × k1 and X2 is n × k2 . We c can write this as M. and β 1 0 (The least-squares estimate with the intercept omitted. To simplify some of ¢ statistical discussion. that it selects the true model with probability one if the sample is suﬃciently large. X2 ) = 0. We thus consider the question of the inclusion of X2 in the linear regression Y = X1 β 1 + X2 β 2 + ε. X2 ) = 0 Note that M1 ⊂ M2 . There are many possible desirable properties for a model selection procedure. We conclude that the inclusion of irrelevant variable reduces estimation eﬃciency if these variables are correlated with the relevant variables. To be concrete. This is equivalent to the comparison of the two models M1 : M2 : Y = X1 β 1 + ε. Let Exi = µ. models 1 and 2 are estimated by OLS..).

17) Since log(n) > 2 (if n > 8). k ´ ³ c P M = M1 | M1 P (AIC1 < AIC2 | M1 ) µ ¶ k1 k1 + k2 2 2 σ | M1 = P log(ˆ 1 ) + 2 < log(ˆ 2 ) + 2 σ n n = P (LRn < 2k2 | M1 ) ¡ ¢ → P χ22 < 2k2 < 1. based on Bayesian arguments. Indeed. else select M2 . M)) between the true density and the model density. since (7. k A major problem with this approach is that the critical level α is indeterminate. it is more appropriate to view model selection as determining the best ﬁnite sample approximation. let cα satisfy ¢ ¡ P χ22 > cα . Another common approach to model selection is to to a selection criterion. The AIC for model m is ¡ ¢ km ˆm AICm = log σ 2 + 2 . His criterion.16) holds under M1 . LRn →p 0. the BIC places a larger penalty than the AIC on the number of estimated parameters and is more parsimonious. The rule is to select M1 if AIC1 < AIC2 . then this model selection procedure is inconsistent. if α is set to be a small number. n (7. known as the BIC.16) LRn = n log σ 2 − log σ 2 ' Wn →d χ22 . k = While many modiﬁcations of the AIC have been proposed. BIC model selection is consistent. One popular choice is the Akaike Information Criterion (AIC). For some critical level α. Then select M1 if Wn ≤ cα . That is. since under M1 . the most popular to be one proposed by Schwarz. ˆm The AIC can be derived as an estimate of the KullbackLeibler information distance K(M) = E (log f (Y | X) − log f (Y | X. AIC selection is inconsistent. and km is the number of coeﬃcients in the model. Another problem is that if α is held ﬁxed. depending on the sample size. In contrast to the AIC. n (7.However. The model selection rule is as follows. then P M ´ ³ c 1 − α but P M = M2 | M2 could vary dramatically. A common approach to model selection is to base the decision on a statistical test such as the Wald Wn . else select M2 . log(n) 87 . as the rule tends to overﬁt. as ³ ´ c P M = M1 | M1 → 1 − α < 1. is ¡ ¢ km ˆm BICm = log σ 2 + log(n) . The reasoning which helps guide the choice of α in hypothesis testing (controlling Type I error) is ´ not ³ c = M1 | M1 ≈ relevant for model selection. ¢ ¡ ˆ1 ˆ2 (7. If the truth is inﬁnite dimensional. etc. Indeed.15) then where σ 2 is the variance estimate for model m. this rule only makes sense when the true model is ﬁnite dimensional.

MK : β 1 6= 0. 576. which can be a very large number. one can show that thus LRn →p ∞. which are nested. . In the unordered case. In the ordered case. β 2 6= 0. . The methods extend readily to the issue of selection among multiple regressors. and 220 = 1. The AIC selection criteria estimates the K models by OLS. 88 . E (εi | xi ) = 0 and the question is which subset of the coeﬃcients are non-zero (equivalently. which regressors enter the regression). there are 2K such models. stores the residual variance σ 2 for each model. In the latter case. β 2 = β 3 = · · · = β K = 0 M2 : β 1 6= 0. β 3 = · · · = β K = 0 .17). . . xKi }. and the AIC or BIC in principle can be implemented by estimating all possible subset models.. a model consists of any possible subset of the regressors {x1i . .. a full-blown implementation of the BIC selection criterion would seem computationally prohibitive. The general problem is the model yi = β 1 x1i + β 2 x1i + · · · + β K xKi + εi . However.15). We have discussed model selection between two models. the models are M1 : β 1 6= 0. β K 6= 0. . Also under M2 . and then selects the model with the lowest AIC (7. There are two leading cases: ordered regressors and unordered. 210 = 1024. selecting based on (7. log(n) µ LRn > k2 | M2 log(n) ¶ ´ ³ c P M = M2 | M2 = P → 1.. . Similarly for ˆ the BIC. For example. 048.so ´ ³ c P M = M1 | M1 = = P (BIC1 < BIC2 | M1 ) P (LRn < log(n)k2 | M1 ) µ ¶ LRn = P < k2 | M1 log(n) → P (0 < k2 ) = 1. β 2 6= 0.

Let (yi . i ˆ ˆ suppose β is the OLS estimate of β with covariance matrix V . For any predictor g(xi ) for y. ˆ ˆ n−k 6. ˜ the residual vector is e = Y − X β. (b) Find an estimate of the variance of this forecast. Verify equation (7. where M1 = I − X X 0 Ω−1 X ˆ ¡ 0 −1 ¢−1 0 −1 0 (c) Prove that M1 Ω−1 M1 = Ω−1 − Ω−1 X X Ω X XΩ . V . wn ) and wi = x−2 . V ar(e | X) = σ 2 Ω with Ω known. in which situations would you expect that β would perform better than OLS? 89 (a) Why is this a reasonable estimator for σ 2 ? ¡ ¢−1 0 −1 XΩ . Let θ satisfy Eg(Yi − θ) = 0. 4. the GLS estimator is ¡ ¢−1 ¡ 0 −1 ¢ ˜ β = X 0 Ω−1 X XΩ Y . In a linear model Y = Xβ + e. else equals zero).. Show that the function g(x) which minimizes the MAE is the conditional median M (x).10 Exercises 1. xi ) be a random sample with E(Y | X) = Xβ. In the homoskedastic regression model Y = Xβ + e with E(ei | xi ) = 0 and E(e2 | xi ) = σ 2 .. and the out-of-sample value of the regressors. σ 2 ). E(e | X) = 0. based on a sample of size n. X). and an estimate of σ 2 is ˆ s2 = 1 e0 Ω−1 e. the residuals e. . the mean absolute error (MAE) is E |yi − g(xi )| . . 5. x. the estimates (β. Thus the available information is the sample (Y. ji ˜ (a) In which contexts would β be a good estimator? ˜ (b) Using your intuition. ˆ (a) Find a point forecast of y. Consider the Weighted Least Squares (WLS) estimator of β ¢−1 ¡ 0 ¢ ¡ ˜ X WY β = X 0W X where W = diag(w1 . (b) Prove that e = M1 e. You wish to forecast an out-of-sample value of y given that ˆ ˆ ˆ ˆ X = x. 2. Deﬁne g(u) = τ − 1 (u < 0) where 1 (·) is the indicator function (takes the value 1 if the argument is true. Let σ 2 be the estimate of σ 2 .7. Is θ a quantile of the distribution of Yi ? 3..12). where xji is one of the xi .

impose the restriction a3 + a4 + a5 = 1. where zi = ln Qi (1 + exp (− (ln Qi − a7 )))−1 .. In addition. . The model is yi = xi β + ei E (ei | xi ) = 0 where xi ∈ R. the regression slope is a2 + a6 . Consider model (7. (7. θ) + ei with E (ei | xi ) = 0. at least 10 to 15) of ln Qi are both below and above a7 . Do so. n xi i=1 (a) Under the stated assumptions. (d) Calculate standard errors for all the parameters (a1 . Find an asymptotic 95% conﬁdence interval for g(x). a7 ). (iii) BIC criterion. For values much above a7 . The model is non-linear because of the parameter a7 . In Chapter 6. and ﬁnd the value of a7 for which the sum of squared errors is minimized. For each value of a7 . θ is the NLLS estimator. the variable ln Qi has a regression slope of a2 . (c) Estimate the model by non-linear least squares. 8. add the variable (ln Qi )2 to the regression. Record the sum of squared errors.ˆ ˆ 7. Consider the two estimators ˆ β = ˜ β = Pn i=1 x y Pn i 2 i i=1 xi n 1 X yi . 90 . Examine the data and pick an appropriate range for a7 . Assess the merits of this new speciﬁcation using (i) a hypothesis test. Do you agree with this modiﬁcation? (b) Now try a non-linear speciﬁcation. (ii) AIC criterion. The equation you estimated was ln T Ci = β 1 + β 2 ln Qi + β 3 ln P Li + β 4 ln P Ki + β 5 ln P Fi + ei . you estimated a cost function on a cross-section of electric companies.18) plus the extra term a6 zi .. Exercise 13.. You are interested in the conditional mean function E (yi | xi = x) = θ g(x) at some x. Suppose that yi ³ ´ i . and the model imposes a smooth transition between these regimes. I recommend the concentration method: Pick 10 (or more or you like) values of a7 in this range. This model is called a smooth threshold model. calculate zi and estimate the model by OLS. and V is the = g(x estimate of V ar ˆ . The model works best when a7 is selected so that several values (in this example. For values of ln Qi much below a7 .18) (a) Following Nerlove. are both estimators consistent for β? (b) Are there conditions under which either estimator is eﬃcient? 9.

Interpret. (e) Test whether the error variance is diﬀerent for whites and nonwhites. Interpret. Note any interesting diﬀerences. (h) Do the OLS and FGLS estimates diﬀer greatly? Note any interesting diﬀerences. (g) Using this model for the conditional variance.10. 91 . Estimate such a model. Variables are listed in the ﬁle cps78. (i) Compare the estimated standard errors. if desired. (c) Are there any variables which seem to be unimportant as a determinant of wages? You may re-estimate the model without these variables. (d) Test whether the error variance is diﬀerent for men and women. (a) Start by an OLS regression of LNWAGE on the other variables. (f) Construct a model for the conditional variance.pdf.dat contains 550 observations on 20 variables taken from the May 1978 current population survey. test for general heteroskedasticity and report the results. (b) Consider augmenting the model by squares and/or cross-products of the conditioning variables. The goal of the exercise is to estimate a model for the log of earnings (variable LNWAGE) as a function of the conditioning variables. Report the results. Estimate your selected model and report the results. The data ﬁle cps78. Report coeﬃcient estimates and standard errors. re-estimate the model from part (c) using FGLS.

Fn ) constructed on n 1. x1..1) We call G∗ the bootstrap distribution. The statistic Tn = Tn (y1 . The distribution of Tn is identical to that of Tn when the true CDF of Fn rather than F. n (8. . ∗ .. we say that Tn is asymptotically pivotal and use the distribution function G(x) for inferential purposes. the t-statistic is a function of the parameter θ which itself is a function of F. x∗ .1 Deﬁnition of the Bootstrap Let F denote a distribution function for the population of observations (yi . P (T ∗ ≤ x) = G∗ (x). The unknown F is replaced by a consistent estimate Fn (one choice is discussed in the next section). F ) with G(x. as it depends on the sample through the estimator Fn . n n ∗ Let (yi . xn . Plugged into Gn (x. for example an estimator ˆ or a t-statistic ˆ − θ /s(ˆ Note that we θ θ θ). write Tn as possibly a function of F . x∗ . F ) ³ ´ be a statistic of interest. Bootstrap inference is based on G∗ (x). x∗ ) denote random variables with the distribution Fn . The bootstrap distribution is itself random. The exact CDF of Tn when the data are sampled from the distribution F is Gn (x. When G(x. F ) = G(x) does not depend on F. We call T ∗ this sample is a random variable with distribution Gn n n n ∗ the bootstrap statistic. Fn ).. Let Tn = Tn (y1 . F ) we obtain G∗ (x) = Gn (x.. inference would be based on Gn (x. F ). F ). Gn (x. This is generally impossible since F is unknown. F ) = P (Tn ≤ x | F ) In general. In the next sections we describe computation of the bootstrap distribution. That is.Chapter 8 The Bootstrap 8. In a seminal contribution... xi ) . yn . F ) depends on F. For example. which makes a diﬀerent approximation. Ideally. Asymptotic inference is based on approximating Gn (x. yn . Efron (1979) proposed the bootstrap. F ) = limn→∞ Gn (x. meaning that G changes as F changes. 92 . A random sample from this i ∗ ∗ ∗ distribution is call the bootstrap data.

and 100. by the CLT (Theorem 5. For n = 25. x).1).1: Empirical Distribution Functions The EDF is a valid discrete probability distribution which puts probability mass 1/n at each ∗ pair (yi .2 The Empirical Distribution Function Fn (y. Notationally. (8. 50. To see this. x).2) Fn (y. To see the eﬀect of sample size on the EDF. ∗ P (yi ≤ y. x∗ ≤ x) = Fn (y. x) = P (yi ≤ y. the EDF is only a crude approximation to the CDF. The method of moments estimator is the corresponding sample moment: n 1X 1 (yi ≤ y) 1 (xi ≤ x) . xi ≤ x) = E (1 (yi ≤ y) 1 (xi ≤ x)) . x) − F (y. Furthermore. as the sample size gets larger. x))) . 1) distribution. x∗ ) with the i distribution Fn . x) . F (y. i = 1. but the approximation appears to improve for the large n. Note that while F may be either discrete or continuous. i 93 . x)) →d N (0. Thus by the WLLN (Theorem 5. note that for any (y.2. x) = n i=1 Figure 8. the EDF step function gets uniformly close to the true CDF. The EDF is a consistent estimator of the CDF.3. x) (1 − F (y. .. Fn (y. Fn is by construction a step function. I have plotted the EDF and true CDF for three random samples of size n = 25. 1 (yi ≤ y) 1 (xi ≤ x) is an iid random variable with expectation F (y. x) →p F (y. n. xi ).8. it is helpful to think of a random pair (yi . Fn is a nonparametric estimate of F.. x). √ n (Fn (y.1). in the Figure below. That is.. Recall that F (y. In general. The random draws are from the N (0. x) is called the empirical distribution function (EDF). where 1(·) is the indicator function. This is a population moment.

∗ • The random vectors (yi . x∗ = xi ) i n 1X h (yi . a bootstrap ∗ ∗ sample {y1 . The algorithm is identical to our discussion of Monte Carlo simulation. x∗ } will necessarily have some ties and multiple values. 94 The bias of ˆ is θ . When the statistic Tn³is a function of F. As the bootstrap statistic replaces F with θ θ) ˆ Fn . B is known as the number of bootstrap replications. . This is i equivalent to sampling a pair (yi . as there are 2n possible samples {(y1 ..∗ We can easily calculate the moments of functions of (yi . the value of θ implied by Fn . ∗ ∗ ∗ The bootstrap statistic Tn = Tn (y1 . It is desireable for B to be large.. with the following points of clariﬁcation: • The sample size n used for the simulation is the same as the sample size. x∗ ) . xi ) . in principle the distribution G∗ n ∗ ∗ could be calculated by direct methods. ´ For example.. n i=1 8. x∗ . sampling from the EDF is equivalent to random sampling a pair (yi . However. the t-ratio ˆ − θ /s(ˆ depends on θ. x∗ . which is generally n 1 not a problem. x∗ )) = h(y. x∗ ) are drawn randomly from the empirical distribution.4 Bootstrap Estimation of Bias and Variance θ τ n = E(ˆ − θ0 ).. it similarly replaces θ with θn .. it is typically through dependence on a parameter.. x) i = = the empirical sample average.2) as the estimate Fn of F. Fn ) is calculated for each bootstrap sample. the parameter ˆ estimate. In consequence. so long as the computational costs are reasonable. x)dFn (y. 8. n X i=1 ∗ h (yi . B = 1000 typically suﬃces. Since the EDF Fn is a multinomial (with n support points). xi ) P (yi = yi .. Typically θn = θ. Sampling from the EDF is particularly easy..3 Nonparametric Bootstrap The nonparametric bootstrap is obtained when the bootstrap distribution (8. n 1 such a calculation is computationally infeasible. x∗ ) : i Z ∗ Eh (yi .) at the sample estimate ˆ θ. xi ) randomly from the sample. yn . (yn . (When in doubt use θ. x∗ )}. . Since Fn is a discrete probability distribution putting probability mass 1/n at each sample point. yn .. A theory for the determination of the number of bootstrap replications B has been developed by Andrews and Buchinsky (2000). . xi ) from the observed data with replacement. The popular alternative is to use simulation to approximate the distribution. n i This is repeated B times. x∗ .1) is deﬁned using the EDF (8.

and we turn to this next. θ = ˆ −ˆ B 1 X ˆ∗ ˆ θb − θ B b=1 ∗ ∗ Note. Ideally. the use of the bootstrap presumes that such asymptotic approximations might be poor. θ θ If ˆ is biased. estimator is downward-biased. θ θ θ. x∗ ) and Tn = ˆ − θn = ˆ − ˆ The bootstrap θ θ(y ∗ 1 θ θ θ. this would be ˜ = ˆ − τ n. that the biased-corrected estimator is not ˆ . θ. in which case the normal approximation is suspected. B ´2 X³ ∗ ∗ ˆ − ˆ∗ . It appears superior to calculate bootstrap conﬁdence intervals.. The (estimated) bootstrap biased-corrected estimator is ˜∗ = ˆ − τ ∗ θ ˆn θ ∗ = ˆ − (ˆ − ˆ θ θ) θ ∗ = 2ˆ − ˆ . the bootstrap makes θ the following experiment. ∗ ∗ the best guess is the diﬀerence between ˆ and ˆ . which are based on the asymptotic normal approximation to the t-ratio. While this standard error may be calculated and reported. However. n If this is calculated by the simulation described in the previous section. n estimate of τ n is ∗ τ ∗ = E(Tn ).. Suppose that ˆ is the truth.. If this is lower than ˆ this suggests that the calculated from such samples? The answer is θ θ. ∗ ∗ ∗ Vn = E(Tn − ETn )2 . it might be desirable to construct a biased-corrected estimator (one with reduced θ bias). it is not clear if it is useful. Similarly if ˆ is higher than ˆ then the estimator θ θ. θ Let Tn = ˆ The variance of ˆ is ∗ θ Let Tn = ˆ . θ θ is upward-biased and the biased-corrected estimator should be lower than ˆ θ. Then θ ∗ τ n = E(Tn (θ0 )). Then what is the average value of ˆ θ θ ˆ∗ . ˆn = 1 θb θ V B b=1 The simulation estimate is A bootstrap standard error for ˆ is the square root of the bootstrap estimate of variance. It has variance ∗ Vn = E(Tn − ETn )2 . θ q ˆ ˆ∗ s(β) = Vn . so a biased-corrected estimator of θ should be larger than ˆ and θ. The primary use of asymptotic standard errors is to construct asymptotic conﬁdence intervals. Intuitively.Let Tn (θ) = ˆ − θ. the estimate of τ ∗ is n τ∗ = ˆn = B 1 X ∗ Tnb B b=1 but τ n is unknown. 95 . x∗ . in particular. yn . ∗ ∗ ∗ ∗ The bootstrap counterparts are ˆ = ˆ 1 .

simple to motivate. F ) is discrete. θ. F0 )) − (1 − Gn (qn (1 − α/2). That is. F0 ) = 1 − Gn (x. and qn (α) = qn (α. then percentile method ∗ ∗ applied to this problem will produce the conﬁdence interval [f (qn (α/2)). with θ subtracted. This is because it is easy to compute. θ n ˆ + qn (1 − α/2)]. the quantile qn (x) is estimated by qn (x). Note that this function will change depending on the underlying statistic Tn whose distribution is Gn . ˆ + q ∗ (1 − α/2)]. ∗ qn (1 − α/2)]. F0 ) which generally is not 1−α! There is one important exception. qn (1 − α/2)]. qn (1 − α/2)]. F ) = α. F0 )) ³ ³ α ´´ α´ ³ − 1− 1− = 1− 2 2 = 1−α 96 . θ This is a bootstrap estimate of the “ideal” conﬁdence interval 0 θ C1 = [ˆ + qn (α/2). Fn ) denote the quantile function of the bootstrap distribution. ˆ lies in the region [qn (α/2). qn (α. This motivates a conﬁdence interval proposed by Efron: ∗ C1 = [qn (α/2). This is often called the percentile conﬁdence interval. Let Tn (θ) = ˆ − θ and let qn (α) be the quantile function of its distribution.8. [When Gn (x. f (qn (1 − α/2))]. as discussed in the section on Monte Carlo simulation. T ∗ }. F ) may be non-unique. let qn (α. the x’th sample quantile of the ∗ . and also has the feature that it is translation invariant. F0 ) denote the quantile function of the true sampling distribution. F ). F ). The latter has coverage probability ³ ´ ¢ ¡ 0 θ P θ0 ∈ C1 = P ˆ + qn (α/2) ≤ θ0 ≤ ˆ + qn (1 − α/2) θ ´ ³ θ = P −qn (1 − α/2) ≤ ˆ − θ0 ≤ −qn (α/2) = Gn (−qn (α/2). The simulated statistics {Tn1 nB ˆ∗ (1 − α)% Efron percentile interval is then [ˆn (α/2). which is a naturally good property. This is the function which solves Gn (qn (α.) Then C1 can alternatively be written as ∗ θ C1 = [ˆ + qn (α/2). If ˆ 0 has a symmetric distribution.. F0 ) − Gn (−qn (1 − α/2). θ Let Tn = ˆ an estimate of a parameter of interest. but we will ignore such complications. F0 ) = (1 − Gn (qn (α/2). q∗ The interval C1 is a popular bootstrap conﬁdence interval often used in empirical practice. C1 is in a deep sense very poorly motivated. ∗ ˆ∗ Computationally. F0 ). F0 ) − Gn (−qn (1 − α/2). . so ¡ ¢ 0 P θ0 ∈ C1 = Gn (−qn (α/2).5 Percentile Intervals For a distribution function Gn (x. In (1 − α)% of samples. However. θ It will be useful if we introduce an alternative deﬁnition C1 .. (These are the original quantiles. if we deﬁne φ = f (θ) as the parameter of interest for a monotonic function f.] ∗ Let qn (α) = qn (α. θ−θ then Gn (−x. as we show now. was popularized by Efron early in the history of the bootstrap. F ) denote its quantile function..

025)]. C1 may perform quite poorly. Note. θ ˆ − qn (α/2)]. C1 and C1 are designed for the case that ˆ has a symmetric distribution about θ0 . θ Let Tn (θ) = ˆ − θ. θ n Notice that generally this is very diﬀerent from the Efron interval C1 ! They coincide in the special case that G∗ (x) is symmetric about ˆ but otherwise they diﬀer. where c would be selected so that θ θ) P (Tn (θ0 ) < c) = α. We would set Tn (θ) = ´ ³ ˆ − θ /s(ˆ and reject H0 in favor of H1 if Tn (θ0 ) < c. θ When ˆ does not have a symmetric distribution. θ. by the translation invariance argument presented above. The problems with the percentile method can be circumvented by an alternative method. ˆ − q ∗ (α/2)]. Since this is unknown. θ sample. this³interval can be estimated from a bootstrap simulation by sorting the ´ ∗ ∗ bootstrap statistics Tn = ˆ − ˆ . 8. the bootstrap test rejects if Tn (θ0 ) > qn (1 − α). it also follows that if there exists some monotonic transformation f (·) such that f (ˆ is symmetrically distributed about f (θ0 ). which are centered at the sample estimate ˆ These are sorted θ θ θ. Then so an exact (1 − α)% conﬁdence interval for θ0 would be 0 C2 = [ˆ − qn (1 − α/2).0 and this idealized conﬁdence interval is accurate. ∗ Similarly. that the bootstrap test θ θ θ ∗ statistic is centered at the estimate ˆ and the standard error s(ˆ ) is calculated on the bootstrap θ. θ However. a bootstrap test replaces qn (α) with the bootstrap estimate ∗ ∗ qn (α). These t-statistics are sorted to ﬁnd the estimated quantiles qn (α) and/or qn (1 − α). ˆ − q ∗ (. and the test rejects if Tn (θ0 ) < qn (α).975).975). θ) then the idealized percentile bootstrap method will be accurate.6 Percentile-t Equal-Tailed Interval Suppose we want to test H0 : θ = θ0 against H1 : θ < θ0 at size α.025) and q ∗ (. and this is important. θ 1 − α = P (qn (α/2) ≤ Tn (θ0 ) ≤ qn (1 − α/2)) ´ ³ θ = P ˆ − qn (1 − α/2) ≤ θ0 ≤ ˆ − qn (α/2) . Based on these arguments. n Computationally. Therefore. ˆ∗ ˆ∗ 97 . Thus c = qn (α). these critical values can be estimated from a bootstrap simulation by sorting ³ ∗ ´ ∗ ∗ the bootstrap t-statistics Tn = ˆ − ˆ /s(ˆ ). θ This motivates a bootstrap analog ∗ θ C2 = [ˆ − qn (1 − α/2). Computationally. many argue that the percentile interval should not be used unless the sampling distribution is close to unbiased and symmetric. The 95% conﬁdence interval is then [θ − ˆ to yield the quantile estimates qn ˆ ˆn ∗ (. but is not widely used in practice. if the alternative is H1 : θ > θ0 . θ ˆn qn ˆ This conﬁdence interval is discussed in most theoretical treatments of the bootstrap. ∗ (.

Let Tn (θ) = ˆ − θ /s(ˆ Then so an exact (1 − α)% conﬁdence interval for θ0 would be 0 θ θ)q C3 = [ˆ − s(ˆ n (1 − α/2). The ideal critical value c = qn (α) solves the equation Gn (qn (α)) = 1 − α. Computationally.7 Symmetric Percentile-t Intervals Suppose we want to test H0 : θ = θ0 against H1 : θ 6= θ0 at size α. ∗ 98 . discussed above. 1 − α = P (qn (α/2) ≤ Tn (θ0 ) ≤ qn (1 − α/2)) ´ ³ ´ ³ θ) θ = P qn (α/2) ≤ ˆ − θ0 /s(ˆ ≤ qn (1 − α/2) ³ ´ = P ˆ − s(ˆ n (1 − α/2) ≤ θ0 ≤ ˆ − s(ˆ n (α/2) . Equivalently. each α/2.´ ³ θ θ). ˆ + s(ˆ n (α)]. ∗ ∗ The bootstrap estimate is qn (α). Let θ θ)q ∗ θ θ)q ∗ C4 = [ˆ − s(ˆ n (α). θ θ)q θ θ)q ˆ − s(ˆ n (α/2)]. This is often called a percentile-t conﬁdence interval. Note that P (|Tn (θ0 )| < c) = P (−c < Tn (θ0 ) < c) = Gn (c) − Gn (−c) ≡ Gn (c). The bootstrap test rejects if ∗ |Tn (θ0 )| > qn (α). θ θ)qn This motivates a bootstrap analog θ θ)q ∗ C3 = [ˆ − s(ˆ n (1 − α/2). qn (α) is the 1 − α quantile of the distribution of |Tn (θ0 )| . qn¯ ¯ ∗ ∗ ¯ ¯ ∗ θ θ θ statistics |Tn | = ¯ˆ − ˆ¯ /s(ˆ ). and taking the upper α% quantile. We would set Tn (θ) = ³ ´ ˆ − θ /s(ˆ and reject H0 in favor of H1 if |Tn (θ0 )| > c. n n ∗ (α) is estimated from a bootstrap simulation by sorting the bootstrap tComputationally. the 1 − α quantile of the distribution of |Tn | . which is a symmetric distribution function. It is equal-tailed or central since the probability that θ0 is below the left endpoint approximately equals the probability that θ0 is above the right endpoint. this is based on the critical values from the one-sided hypothesis tests. or the number which solves the equation ∗ ∗ ∗ Gn (qn (α)) = G∗ (qn (α)) − G∗ (−qn (α)) = 1 − α. θ θ)q ˆ − s(ˆ ∗ (α/2)]. 8. where c would be selected so that θ θ) P (|Tn (θ0 )| > c) = α.

the critical value qn (α) is found as the quantile from simulated values of W´ . not ˆ − θ0 . Deﬁnition 8.] 8. The ideal test rejects if Wn ≥ qn (α). n ´ ³ ∗ ³ ∗ θ θ Note in the simulation that the Wald statistic is a quadratic form in ˆ − ˆ .1 an = o(1) if an → 0 as n → ∞ Deﬁnition 8. We say that a function g(x) is even if g(−x) = g(x). The bootstrap test ∗ ∗ rejects if Wn ≥ qn (α). an = O(n−r ) if it declines to zero like n−r . θ θ θ ˆ θ ∗ ∗ Computationally. where qn (α) is the (1 − α)% quantile of the distribution of ³ ∗ ³ ∗ ´0 ´ ∗ Wn = n ˆ − ˆ Vθ∗−1 ˆ − ˆ . Deﬁnition 8. The derivative of an even function is odd. If θ is a vector. then to test H0 : θ = θ0 against H1 : θ 6= θ0 at size α. θ [This is a typical mistake made by practitioners.8. however.∗ where qn (α) is the bootstrap critical value for a two-sided hypothesis test. lim Gn (x. about the rate v of convergence.3) ´ √ ³ˆ If Tn = n θ − θ0 then v = V while if Tn is a t-ratio then v = 1. or the size of the divergence for any particular sample size n.3 an = o(n−r ) if nr |an | → 0 as n → ∞. It is designed to work well since ³ ´ P (θ0 ∈ C4 ) = P ˆ − s(ˆ n (α) ≤ θ0 ≤ ˆ + s(ˆ n (α) θ θ)q ∗ θ θ)q ∗ ∗ = P (|Tn (θ0 )| < qn (α)) ' P (|Tn (θ0 )| < qn (α)) = 1 − α.8 Asymptotic Expansions Tn →d N (0. Let an be a sequence. 99 . Let Tn be a statistic such that (8. F ) = Φ + o (1) .8.2 an = O(1) if |an | is uniformly bounded. F ) = Φ n→∞ v or ³x´ Gn (x. and vice-versa. it says nothing. F ) then ³x´ . Thus here Tn (θ) = Wn (θ). C4 is called the symmetric percentile-t interval.8. we would use a Wald statistic ³ ´ ³ ´0 ˆ θ Wn (θ) = n ˆ − θ Vθ−1 ˆ − θ θ or some other asymptotically chi-square statistic.4) says that Gn converges to Φ x as n → ∞. v 2 ). The following notation will be helpful. writing Tn ∼ Gn (x.4) v ¡ ¢ While (8. A better asymptotic approximation may be obtained through an asymptotic expansion. Equivalently. where qn (α) is the (1 − α)% quantile of the distribution of Wn . and a function h(x) is odd if h(−x) = −h(x). Basically. (8.

√ Since Fn converges to F at rate n. F ) + O(n−3/2 ) Gn (x. F ) v which adds a symmetric non-normal component to the approximate density (for example. we can assess the accuracy of one-sided hypothesis tests and conﬁdence regions based on an asymptotically normal t-ratio Tn . F ) + g2 (x.8. We can interpret Theorem 8.8.9 One-Sided Tests Using the expansion of Theorem 8. F ) ≈ Φ + n−1/2 g1 (x.3).1. F ) ≈ Φ + n−1/2 g1 (x. the diﬀerence √ (g1 (x. Fn ) = Φ(x) + n 1 g (x. To a second order of approximation. and g1 is continuous with respect to F.1 as follows. ³x´ Gn (x. 100 . the density function is skewed. F ). and g2 is an odd function of x. so the order of the error is O(n−1/2 ). the exact distribution is P (Tn < x) = Gn (x. F0 ) ≈ ∂ g1 (x. g1 and g2 are diﬀerentiable functions of x and continuous in F relative to the supremum norm on the space of distribution functions.8. An asymptotic test is based on Φ(x). F ) = Φ v n n 8. Fn ) − g1 (x. adding leptokurtosis). F0 ) = 1 g (x. F0 )) + O(n−1 ). Moreover. ³x´ Gn (x. F ) + n−1 g2 (x. To a third order of approximation. A bootstrap test is based on G∗ (x). F0 ) = n 1 n1/2 (g1 (x.1 Under regularity conditions and (8. v Since the derivative of g1 is odd. 1/2 1 n Because Φ(x) appears in both expansions. F0 ) + O(n−1 ) 1/2 1 n = O(n−1/2 ). F0 )) converges to 0 at rate n. Fn ) − g1 (x. F ) converges to the normal limit at rate n1/2 . The diﬀerence is Φ(x) − Gn (x.8. Theorem 8. Fn ) − g1 (x. which from Theorem 8. Fn ) + O(n−1 ).1 has the expansion n G∗ (x) = Gn (x. To the second order. where g1 is an even function of x. ³x´ 1 1 + 1/2 g1 (x. F0 ) (Fn − F0 ) ∂F = O(n−1/2 ). F0 ) = Φ(x) + since v = 1. First.uniformly over x. the diﬀerence between the bootstrap distribution and the true distribution is G∗ (x) − Gn (x. Heuristically. F0 ) + O(n−1 ) 1/2 1 n 1 g (x. Gn (x. g1 (x.

then |Tn | has the distribution function Gn (x. We conclude that G∗ (x) − Gn (x. then |Z| has distribution function Φ(x) = Φ(x) − Φ(−x) = 2Φ(x) − 1. F ). F ) − Gn (−x. F0 ) = The order of the error is O(n−1 ). Similarly. F ) + O(n−3/2 ). F ) = Gn (x. if Tn has exact distribution Gn (x.The “derivative” ∂ ∂F g1 (x. n (8. F ) is only heuristic. F ) ¶ µ 1 1 = Φ(x) + 1/2 g1 (x. F ) + g2 (−x. This rate can be used to show that one-tailed bootstrap inference based on the tratio achieves a so-called asymptotic reﬁnement — the Type I error of the test converges at a faster rate than an analogous asymptotic test. F0 ) + O(n−3/2 ) = O(n−1 ). F ) − Gn (−x. F0 ) = O(n−1 ). n or ∗ P (Tn ≤ x) = P (Tn ≤ x) + O(n−1 ). 8. F ). and exact critical values are taken from the Gn (x. F ) n n µ ¶ 1 1 − Φ(−x) + 1/2 g1 (−x. = P (X ≤ x) − P (X ≤ −x) For example. n . which is an improved rate of convergence over the asymptotic test (which converged at rate O(n−1/2 )). A two-sided hypothesis test rejects H0 for large values of |Tn | .5) where the simpliﬁcations are because g1 is even and g2 is odd. if Z ∼ N (0. Since Tn →d Z. Hence the diﬀerence between the asymptotic distribution and the exact distribution is Φ(x) − Gn (x.8. we can calculate that Gn (x. From Theorem 8.1. F ) + g2 (x. then |Tn | →d |Z| ∼ Φ. as F is a function. Thus asymptotic critical values are taken from the Φ distribution.10 Symmetric Two-Sided Tests If a random variable X has distribution function H(x) = P (X ≤ x). F ) + O(n−3/2 ) n n 2 = Φ(x) + g2 (x. F ) = Gn (x. 101 2 g2 (x. then the random variable |X| has distribution function H(x) = H(x) − H(−x) since P (|X| ≤ x) = P (−x ≤ X ≤ x) = H(x) − H(−x). F0 ) distribution. 1).

The diﬀerence is ³x´ ³x´ −Φ + O(n−1/2 ) G∗ (x) − Gn (x. Fn ) = Φ n v ˆ ˆ where V = V (Fn ) is the bootstrap estimate of V. V ).1 shows that a ﬁrst-order approximation ³x´ + O(n−1/2 ). We know that θ Tn →d N (0. Gn (x. F0 ) = ∗ 2 (g2 (x. This is because the ﬁrst term in the asymptotic expansion. set Tn = n ˆ − θ0 .5) to the bootstrap distribution. as it depends on the unknown V. Another way of writing this is ∗ P (|Tn | < x) = P (|Tn | < x) + O(n−3/2 ) so the error from using the bootstrap distribution (relative to the true unknown distribution) is O(n−3/2 ).11 Percentile Conﬁdence Intervals ´ √ ³ To evaluate the coverage rate of the percentile interval. Twosided tests will have more accurate size (Reported Type I error). Two-sided tests have better rates of convergence than the one-sided tests. but one-sided tests might have more power against alternatives of interest. Conﬁdence intervals based on the bootstrap can be asymmetric if based on one-sided tests (equal-tailed intervals) and can therefore be more informative and have smaller length than symmetric intervals. and bootstrap tests have better rates of convergence than asymptotic tests. g1 . whose error is O(n−1 ). which is not pivotal. Thus a two-sided bootstrap test also achieves an asymptotic reﬁnement. F0 )) + O(n−3/2 ) n = O(n−3/2 ). F ) = Φ v √ where v = V . Fn ) + O(n−3/2 ). we ﬁnd Gn (x) = Gn (x. and for the bootstrap ³x´ + O(n−1/2 ).Interestingly. G∗ (x) = Gn (x. meaning that the errors in the two directions exactly cancel out. Fn ) = Φ(x) + ∗ 2 g2 (x. This is in contrast to the use of the asymptotic distribution. 8. the choice between symmetric and equal-tailed conﬁdence intervals is unclear. n Thus the diﬀerence between the bootstrap and exact distributions is Gn (x) − Gn (x. Fn ) − g2 (x. and g2 is continuous in F. A reader might get confused between the two simultaneous eﬀects. The analysis shows that there may be a trade-oﬀ between one-sided and two-sided tests. the asymptotic two-sided test has a better coverage rate than the asymptotic one-sided test.8. similar to a one-sided test. Theorem 8. Applying (8. √ the last equality because Fn converges to F0 at rate n. is an even function. and needs to be determined on a case-by-case basis. Therefore. F0 ) = Φ n v ´ ˆ v ³x x (ˆ − v) + O(n−1/2 ) v = −φ v v ˆ ˆ = O(n−1/2 ) 102 .

12 Bootstrap Methods for Regression Models The bootstrap methods we have discussed have set G∗ (x) = Gn (x. . 8. A third approach sets x∗ = xi . A parametric method is to sample x∗ from an estimated parametric i distribution. where Fn is the EDF. The bad news is that the rate of convergence is disappointing.. This is equivalent to treating the regressors as ﬁxed i in repeated samples. Based on these arguments.. 1992. i i The the bootstrap distribution does not impose the regression assumption. it is unclear if there are any beneﬁts from using the percentile bootstrap over simple asymptotic methods. Hall. and is thus an ineﬃcient estimator of the true distribution (when in fact the regression assumption is true. and then create i i ∗ = x∗0 β + ε∗ . ∗ The non-parametric bootstrap distribution resamples the observations (yi .. To impose independence. It is no better than the rate obtained from an asymptotic one-sided conﬁdence region. If this is done. σ 2 ). But since it is fully nonparametric... x∗ ) from the EDF. √ The good news is that the percentile-type methods (if appropriately used) can yield nconvergent asymptotic inference.g.Hence the order of the error is O(n−1/2 ). a nonparametric method is to sample the x∗ randomly from the EDF i i or sample values {x1 . The disadvantage is that the bootstrap distribution may be a poor approximation when the error is not independent of the regressors. The advantage is that in this case it is straightforward to construct bootstrap distributions. en }. There are diﬀerent ways to impose independence. A non-parametric method is ˆ yi i i e ˆ to sample the bootstrap errors ε∗ randomly from the OLS residuals {ˆ1 . n Any other consistent estimate of F0 may be used to deﬁne a feasible bootstrap estimator. the theoretical literature (e. The advantage of the EDF is that it is fully nonparametric. Horowitz. 2002) tends to advocate the use of the percentile-t bootstrap methods rather than percentile methods.) One approach to this problem is to impose the very strong assumption that the error εi is independent of the regressor xi . A parametric i method is to generate the bootstrap errors ε∗ from a parametric distribution. Fn ). such as the normal i ˆ ε∗ ∼ N (0. then all inferential statements are made conditionally on the 103 . it imposes no conditions.. Therefore if standard errors are available. We discuss some bootstrap methods appropriate for the case of a regression model where yi = x0 β + εi i E (ei | xi ) = 0. the percentile bootstrap methods provide an attractive inference method. xn }. i which implies ∗ ˆ yi = x∗0 β + ε∗ i i E (x∗ ε∗ ) = 0 i i but generally E (ε∗ | x∗ ) 6= 0. it may be ineﬃcient in contexts where more is known about F. . Yet these methods do not require the calculation of standard errors! This means that in contexts where standard errors are not available or are diﬃcult to calculate. and works in nearly any context. i For the regressors x∗ . it is suﬃcient to sample the x∗ and ε∗ independently.

ˆi A conditional distribution with these features will preserve the main important features of the data. you sample ε∗ using this two-point distribution. . Find the bootstrap moments ETn and V ar(Tn ). The methods discussed above are unattractive for most applications in econometrics because they impose the stringent assumption that xi and εi are independent. yn } with µ = Eyi and σ 2 = V ar(yi ). and set x∗ = xi0 and e∗ = ei0 .. Take a random sample {y1 ... Consider the following bootstrap procedure for a regression of yi on xi . It does not really matter. Typically what is desirable is to impose only the regression condition E (εi | xi ) = 0. whether or not the xi are really “ﬁxed” or random. ˆ∗ (b) Regress Y ∗ on X ∗ . Let the statistic of interest be the sample mean Tn = y n . 4. 2. Show that this bootstrap procedure is (numerically) identical to the non-parametric bootstrap. ˆ Draw (with replacement) n such vectors. . i 8.. Show that √ n (Fn (x) − F0 (x)) →d N (0. however.. and e = Y − X β ˆ (a) Draw a random vector (x∗ . calculate the estimate ˆ on these samples and then calculate θ ∗ ∗ θ θ)/s(ˆ θ). X ∗ ).13 Exercises 1.. Let β denote the ˆ the OLS residuals. generate ∗ bootstrap samples. Find the population moments ETn and V ar(Tn ). n]. . Consider the following bootstrap procedure. Tn = (ˆ − ˆ 104 ... One proposal which imposes the regression condition without independence is the Wild Bootstrap. ei ) : i = 1. e∗ ) from the pair {(xi .. creating a random bootstrap data set (Y ∗ . which is a valid statistical approach.observed values of the regressors. This can be achieved using a two-point distribution of the form Ã Ã √ ! ! √ 1+ 5 5−1 ∗ √ ei ˆ = P εi = 2 2 5 Ã Ã √ ! ! √ 1− 5 5+1 ∗ √ P εi = = ei ˆ 2 2 5 For each xi . The idea is to construct a conditional distribution for ε∗ so that i E (ε∗ | xi ) = 0 i ¡ ∗2 ¢ E εi | xi = e2 ˆi ¡ ∗3 ¢ E εi | xi = e3 . n} . 2. Let ∗ ∗ ∗ {y1 . Unfortunately this is a harder problem. draw a ˆ ˆ random integer i0 from [1.. OLS estimator from the regression of Y on X. F0 (x) (1 − F0 (x))) .. Set y∗ = x∗0 β + e∗ . ˆ 3. yn } be a random sample from the empirical distribution function and let Tn = y ∗ be n ∗ ∗ its sample mean. . That is. yielding OLS estimates β and any other statistic of interest.. Let Fn (x) denote the EDF of a random sample. Using the non-parametric bootstrap.

The dataﬁle hprice1. What is wrong with this procedure? Tn = θ/s(θ) n 6. You want to test H0 : θ = 0 against H1 : θ > 0. calculate the estimates ˆ on these samples and θ then calculate ∗ ∗ ∗ θ θ Tn = ˆ /s(ˆ ).05) and qn (. Let qn (. size of house. The ˆ are sorted. and the 2. and ˆ is calculated on each θ ∗ ∗ θ sample.95) denote the 5% θ) ∗ and 95% quantiles of Tn . (c) With the given information. can you report the 95% Percentile-t interval for θ? 7.95) denote the 95% quantile of Tn . Using the non-parametric bootstrap.5% quantiles of the ˆ are . You replace c with qn (. ˆ = 1. θ respectively. Using the non-parametric ∗ bootstrap. and thus reject H0 if ˆ ˆ > q ∗ (.3.75 and 1. You do this as follows.dat contains data on house prices (sales). you generate bootstrap samples. θ θ) ∗ 1000 samples are generated from the bootstrap distribution. ∗ ∗ ∗ Let qn (.2 and s(ˆ = . ˆ − s(ˆ n (. lot size. 105 .95).pdf. Estimate a linear regression of price on the number of bedrooms. Suppose that in an application. with variables listed in the ﬁle hprice1. ∗ ∗ where s(ˆ is the standard error in the original data. (a) Report the 95% Efron Percentile interval for θ.95). (b) Report the 95% Alternative Percentile interval for θ. The test for H0 is to reject if Tn = ˆ ˆ > c where c is picked so that Type I error is α. and deﬁne the bootstrap conﬁdence interval h i C = ˆ − s(ˆ n (. θ θ)q ∗ θ θ)q ∗ θ/s(θ) 5.2.Show that C exactly equals the Alternative percentile interval (not the percentile-t interval). Calculate 95% conﬁdence intervals for the regression coeﬃcients using both the asymptotic normal approximation and the percentile-t bootstrap. and the colonial dummy.95).05) .5% and 97.

This method. We know that without further restrictions.1 Overidentiﬁed Linear Model yi = x0 β + ei i = x0 β 1 + x0 β 2 + ei 1i 2i E (xi ei ) = 0 where x1i is k × 1 and x2 is r × 1 with = k + r. There are − k = r more moment restrictions than free parameters. We call r the number of overidentifying restrictions. Now we can write the model as yi = x0 β 1 + ei 1i E (xi ei ) = 0. This situation is called overidentiﬁed. these are known as estimating equations.1) where β 0 is the true value of β. In our previous example. while β 1 is of dimension k < . how should β 1 be estimated? One method is OLS regression of yi on x1i alone. however. x. If k = the model is just identiﬁed. Let g(y. β) be an × 1 function of a k × 1 parameter β with ≥ k such that Eg(yi . This model falls in the class (9. g(y. Now suppose that we are given the information that β 2 = 0. In econometrics. z. with ≥ k. The variables zi may be components and functions of xi . x. In this case. x. As an important special case we will devote special attention to linear moment condition models. zi . z. In the statistics literature. This is a special case of a more general class of moment condition models. β 0 ) = x(y − z 0 β) 106 (9. where the dimensions of zi and xi are k × 1 and × 1 . an asymptotically eﬃcient estimator of β is the OLS estimator. but this is not required. β) = x(y − x0 β). as their are restrictions in E (xi ei ) = 0.1) by setting g(y. xi . 1 this class of models are called moment condition models. which can be written as 0 yi = zi β + ei Consider the linear model E (xi ei ) = 0. is not necessarily eﬃcient.Chapter 9 Generalized Method of Moments 9. β 0 ) = 0 (9.2) . otherwise it is overidentiﬁed.

the dependence is only up to scale. then. The GMM estimator minimizes Jn (β). The idea of the generalized method of moments (GMM) is to deﬁne an estimator which sets g n (β) “close” to zero.1 ˆ 2Z 0 XWn X 0 Z β = 2Z 0 XWn X 0 Y While the estimator depends on Wn . let Jn (β) = n · g n (β)0 Wn g n (β). Let and where gi = xi ei . gi (β) = xi yi − zi β = n n n i=1 i=1 Deﬁne the sample analog of (9. ˆ Deﬁnition 9.3) The method of moments estimator for β is deﬁned as the parameter value which sets g n (β) = 0.2) g n (β) = (9. ¡ ¢−1 0 ˆ Z XWn X 0 Y. Proposition 9. the square of the Euclidean length. β ˆ Note that if k = .1 β GMM = argmin Jn (β). Then µ ¶ ¶ µ 1 0 1 0 Z X Wn X Z →p Q0 W Q n n 107 ¡ ¢ ¡ 0¢ Ω = E xi x0 e2 = E gi gi . for if Wn is replaced ˆ by cWn for some c > 0. This is a non-negative measure of the “length” of the vector g n (β).2. For example. but this is generally not possible when > k.9. β GMM does not change.2 GMM Estimator n n ¢ 1¡ 0 ¢ 1X 1X ¡ 0 X Y − X 0 Zβ . Jn (β) = n · g n (β)0 g n (β) = n · |g n (β)|2 . if Wn = I. then g n (β) = 0. β GMM = Z 0 XWn X 0 Z 9. and the GMM estimator is the MME.2. For some × weight matrix Wn > 0. i i . The ﬁrst order conditions for the GMM estimator are 0 = ∂ ˆ Jn (β) ∂β ∂ ˆ ˆ = 2 g n (β)0 Wn g n (β) ∂β ´ 1 1 ³ ˆ = −2 Z 0 XWn X 0 Y − Z β n n so which establishes the following.3 Distribution of GMM Estimator ¡ 0¢ Q = E xi zi Assume that Wn →p W > 0.

as it has the same asymptotic distribution. Chamberlain showed that in this context. as the distribution of the data is unknown. The optimal weight matrix W0 is one which minimizes V. W0 = Ω−1 is not known in practice. 9. as we are only considering alternative weight matrices Wn . This is a weak concept of optimality. β). this is a semi-parametric problem. If it is known that E (gi (β)) = 0. the GMM estimator β is consistent yet ineﬃcient. β = Z 0 XΩ−1 X 0 Z ´ ³ ¡ ¢−1 ´ √ ³ˆ . we can set Wn = I . without imposing additional assumptions. where In general. In the linear model. Ω) . The proof is left as an exercise. but it can be estimated consistently.and µ µ ¶ ¶ 1 0 1 0 Z X Wn X e →d Q0 W N (0. it turns out that the GMM estimator is semiparametrically eﬃcient. Since the GMM estimator has this can have a smaller asymptotic variance than G0 Ω−1 G asymptotic variance. ˆ Construct n 1X ˆ g n = g n (β) = gi .4 Estimation of the Eﬃcient Weight Matrix ˆ Given any weight matrix Wn > 0. n β − β →d N 0. For example. no estimator has greater asymptotic eﬃciency than the eﬃcient linear GMM estimator. as shown by Gary Chamberlain (1987). This results shows that in the linear model. This estimator is eﬃcient only in the sense that it is the best (asymptotically) in the class of GMM estimators with this set of moment conditions. This yields the eﬃcient GMM estimator: ¢−1 0 ¡ ˆ Z XΩ−1 X 0 Y. it is semiparametrically eﬃcient.1 ´ √ ³ˆ n β − β →d N (0. However. ˆ we still call β the eﬃcient GMM estimator.2 For the eﬃcient GMM estimator. Q0 Ω−1 Q ¢−1 ¡ 0 ¢¡ ¢−1 ¡ . n n We conclude: Theorem 9. This turns out to be W0 = Ω−1 . we can deﬁne the residuals ei = yi −zi β and moment equations gi = xi ei = g(wi . no semiparametric estimator (one which is consistent globally for the class of models considered) ¢−1 ¡ . Q W ΩW Q Q0 W Q V = Q0 W Q Thus we have Theorem 9. No estimator can do better (in this ﬁrst-order asymptotic sense). ˆ∗ ˆ 108 .3. ˆ n i=1 gi = gi − g n . and this is all that is known. V ) . ˆ We have described the estimator β as “eﬃcient GMM” if the optimal (variance minimizing) weight matrix is selected. Given any such ﬁrst0ˆ ˆ ˆ ˆ step estimator. For any Wn →p W0 .3. GMM estimators are asymptotically normal with “sandwich form” asymptotic variances. a better choice is Wn = (X 0 X)−1 .

The estimator appears to have some better properties than traditional GMM. and was introduced by L. we actually mean “eﬃcient GMM”. Then the eﬃcient GMM estimator is ˆ ³ ¡ ¢−1 0 ´−1 0 ¡ 0 ¢−1 0 ˆ ˆˆ XZ Z X g g − ng n g 0 ˆˆ X Y. There is an important alternative to the two-step GMM estimator just described. Heaton and Yaron (1996). i. Alastair Hall (2000) has shown that the uncentered estimator is a poor choice. ∗ gi (β) = gi (β) − g n (β) 9. (9. ˆ An estimator of the asymptotic variance of β can be seen from the above formula. and GMM using Wn as the weight matrix is asymptotically eﬃcient. First. 0ˆ ˆ ˆ ˆ estimate β using this weight matrix.4) which uses the uncentered moment conditions. and construct the residual ei = yi − zi β. β = Z 0 X g 0 g − ng n g 0 n n ˆ Asymptotic standard errors are given by the square roots of the diagonal elements of V . GMM applies whenever an economic or statistical model implies the × 1 moment condition E (gi (β)) = 0. A common alternative choice is to set Ã n !−1 1X 0 gi gi ˆˆ Wn = n i=1 1 X ∗ ∗0 gi gi ˆ ˆ n i=1 n !−1 = Ã 1X 0 gi gi − g n g 0 ˆˆ n n i=1 n !−1 . Instead. ˆ and let g be the associated n × matrix. Then set gi = xi ei . There is little point in using an ineﬃcient GMM estimator as it is easy to compute. However. J(β) = n · g n (β) n i=1 In most cases.5 GMM: The General Case In its most general form. these two estimators are asymptotically equivalent under the hypothesis of correct speciﬁcation.4) above. under the alternative hypothesis the moment conditions are violated.and deﬁne Wn = Ã Then Wn →p Ω−1 = W0 . 109 . but can be numerically tricky to obtain in some cases. we can let the weight matrix be considered as a function of β. This is a current area of research in econometrics. V = n Z 0 X g 0 g − ng n g 0 n where ˆ The β which minimizes this function is called the continuously-updated GMM estimator. The criterion function is then Ã n !−1 1X ∗ 0 ∗ 0 gi (β)gi (β) g n (β). Set ³ ¡ ¢−1 0 ´−1 ˆ ˆˆ XZ . so the uncentered estimator will contain an undesirable bias term and the power of the test will be adversely aﬀected. Here is a simple way to compute the eﬃcient GMM estimator. When constructing hypothesis tests. when we say “GMM”. Since Egi = 0. set Wn = (X 0 X)−1 . A simple solution is to use the centered moment conditions to construct the weight matrix. Egi 6= 0. Hansen.e. as in (9.

ˆˆ n is a quadratic form in g n .Often. and thus g n can be used to assess whether or not the hypothesis that Egi = 0 is true or not. 110 . ˆ J = J(β) →d χ2−k . Under the hypothesis of correct speciﬁcation. Thus the model — the overidentifying restrictions — are testable. G0 Ω−1 G . i i i i ∂β 1X 0 gi gi − g n g 0 ˆˆ n n i=1 n !−1 . perhaps obtained by ﬁrst ˆ setting Wn = I. However. Since the GMM estimator depends upon the ﬁrst-stage estimator. often the weight ˆ matrix Wn is updated. The general theory of GMM estimation and testing was exposited by L. Theorem 9.1 Under general regularity conditions. In this sense an 1i 1i exclusion restriction can be seen as an overidentifying restriction.1 (Sargan-Hansen). 9. The variance of β may be estimated by G0 Ω−1 G where P ∗ ∗0 P ∂ ˆ ˆ ˆ g g and G = n−1 ˆ ˆ Ω = n−1 0 gi (β). ´ ³ ¡ ¢−1 ´ √ ³ˆ Theorem 9. and in this case it would be impossible to ﬁnd a value of β 1 so that both E (x1i (yi − x0 β 1 )) = 0 and E (x2i (yi − x0 β 1 )) = 0 hold simultaneously. This estimator can be iterated if needed. 1 it is possible that β 2 6= 0. The criterion function at the parameter estimates is J = n g 0 Wn g n n ¡ ¢−1 2 0 = n g n g 0 g − ng n g 0 gn . where ³ ´−1 ∂ 0 ˆ ˆ ˆ ˆ Ω = (E (gi gi ))−1 and G = E ∂β 0 gi (β).6 Over-Identiﬁcation Test Overidentiﬁed models ( > k) are special in the sense that there may not be a parameter value β such that the moment condition Eg(wi . β) = 0 holds. so that the linear equation may be written as yi = β 0 x1i + ei . n β − β →d N 0.6. The GMM estimator minimizes J(β) = n · g n (β)0 Wn g n (β) where g n (β) = and Wn = Ã 1X gi (β) n i=1 n ˜ ˜ with gi = gi (β) constructed using a preliminary consistent estimator β. take the linear model yi = β 0 x1i + β 0 x2i + ei with E (x1i ei ) = 0 and E (x2i ei ) = 0. Note that g n →p Egi .5. and if the weight matrix is asymptotically eﬃcient. this is all that is known. Hansen (1982). Identiﬁcation requires l ≥ k = dim(β). and is thus a natural test statistic for H0 : Egi = 0. 1 2 It is possible that β 2 = 0. For example. and then β recomputed.

and by L. h(β)=0 ˆ ˜ The two minimizing criterion functions are J(β) and J(β). the Wald statistic can work quite poorly. The GMM overidentiﬁcation test is a very useful by-product of the GMM methodology.7. The estimates under H1 are ˆ β = argmin J(β) β and those under H0 are ˜ β = argmin J(β). as this ensures that D ≥ 0. This is sometimes called the GMM Distance statistic. and it is advisable to report the statistic J whenever GMM is the estimation method. it is customary to report the J statistic as a general test of model adequacy. For a given weight matrix Wn . and sometimes called a LR-like statistic (the LR is for likelihood-ratio). These may be used to construct Wald tests of statistical hypotheses. Proposition 9. but it is typically cause for concern. If h is non-linear. the hypothesis is H0 : h(β) = 0. and is the preferred test statistic. If h is linear in β. we can reject the model. it is unclear what is wrong. The degrees of freedom of the asymptotic distribution are the number of overidentifying restrictions. If the hypothesis is non-linear. If the statistic J exceeds the chi-square critical value. 9. This test shares the useful feature of LR tests in that it is a natural by-product of the computation of alternative models. then D equals the Wald statistic. current evidence suggests that the D statistic appears to have quite good sampling properties. In contrast. Based on this information alone. Newey and West (1987) suggested to use the same weight matrix Wn for both null and alternative. a better approach is to directly use the GMM criterion function.1 If the same weight matrix Wn is used for both null and alternative. The GMM distance statistic is the diﬀerence ˜ ˆ D = J(β) − J(β).The proof of the theorem is left as an exercise. D →d χ2 r 3. The idea was ﬁrst put forward by Newey and West (1987). Hansen (1982) for the general case. 1. the GMM criterion function is J(β) = n · g n (β)0 Wn g n (β) For h : Rk → Rr . This reasoning is not compelling.7 Hypothesis Testing: The Distance Statistic We described before how to construct estimates of the asymptotic covariance matrix of the GMM estimates. D ≥ 0 2. When over-identiﬁed models are estimated by GMM. however. This result was established by Sargan (1958) for a specialized case. and some current research suggests that this restriction is not necessary for good performance of the test. 111 .

than the unconditional moment restriction discussed above. ei (β. β). It implies a conditional moment restriction of the form E (ei (β) | xi ) = 0 where ei (β) is some s × 1 function of the observation and the parameters. A recent study of this problem is Donald and Newey (2001). γ) = ⎩ 0 β)2 − f (x )0 γ (yi − xi i Here s = 2. 0 In the linear model ei (β) = yi − zi β.. except that in this case zi = xi . Another approach is to construct the optimal instrument. 0 Our linear model yi = zi β + ei with instruments xi falls into this class under the stronger 0 assumption E (ei | xi ) = 0. are all valid instruments. we can set gi (β) = φ(xi . The obvious problem is that the class of functions φ is inﬁnite. For example.9. Let ¶ µ ∂ ei (β) | xi Ri = E ∂β and Then the “optimal instrument” is so the optimal moment is gi (β) = Ai ei (β).. Take the case s = 1. x2 . β). while in a nonlinear i regression model ei (β) = yi − g(xi . In many cases. s = 1. Which should be selected? This is equivalent to the problem of selection of the best instruments. and then use the ﬁrst k instruments. The form was uncovered by Chamberlain (1987). Ai is unknown. Given a conditional moment restriction. ei (β) = yi − x0 β. etc. the model implies more than an unconditional moment restriction of the form Egi (β) = 0. Setting gi (β) to be this choice (which is k × 1. Then ei (β) = yi − zi β. If xi is a valid instrument satisfying E (ei | xi ) = 0. an unconditional moment restriction can always be constructed.. How is k to be determined? This is an area of theory still under development. x3 . then xi . note that Ri = −E (zi | xi ) 112 ¡ ¢ σ 2 = E ei (β)2 | xi . In a joint model of the conditional mean and variance ⎧ yi − x0 β ⎨ i . and restrictive. so is just-identiﬁed) yields the best GMM estimator possible.8 Conditional Moment Restrictions In many contexts. . i Ai = −σ −2 Ri i . It is also helpful to realize that conventional regression models also fall into this class.. That is for any × 1 function φ(xi . but its form does help us think about construction of optimal instruments. It turns out that this conditional moment restriction is much more powerful. in linear regression. β)ei (β) which satisﬁes Egi (β) = 0 and hence deﬁnes a GMM estimator. Which should be used? i i One solution is to construct an inﬁnite list of potent instruments. In practice.

113 . caution should be applied when interpreting such results. and construct conﬁdence intervals for β. ˆ β = Z ∗0 X ∗ W ∗ X ∗0 Z ∗ n n ∗ This means that wi do not satisfy the same moment conditions as the population distribution..and so In the case of linear regression. deﬁne the bootstrap GMM criterion ³ ³ ´0 ´ ∗ ˆ ˆ J ∗ (β) = n · g ∗ (β) − g n (β) Wn g ∗ (β) − g n (β) n n ˆ ˆ∗ where e = Y − Z β are the in-sample residuals. In the case of endogenous variables. However. not just an arbitrary linear projection. we need the best conditional mean model for zi given xi . However. the bootstrap applied J test will yield the wrong answer. Hence eﬃcient GMM is GLS. To date. ˆ Brown and Newey (2002) have an alternative solution. random variables (yi i i n ³ ³ ´´ ˆ ˆ E gi β = g n (β) 6= 0. there are very few empirical applications of bootstrap GMM. so ˆ Since i=1 pi gi β no recentering or adjustments are needed. Using the EDF of (yi . we can apply the ˆ bootstrap methods discussed in Chapter 8 to compute estimates of the bias and variance of β. Given the bootstrap sample (Y ∗ . so Ai = σ −2 xi . to get the best instrument for zi . wn } with the empirical likelihood probabilities {ˆi } described in Chapter X.. Furthermore. as we i discussed earlier in the course.. . i ¡ ¢ σ 2 = E e2 | xi . it fails to achieve an asymptotic reﬁnement when the model is over-identiﬁed. identically as in the regression model. This is the same as the GLS estimator. 1 ´ Pn ˆ = 0. Z ∗ ). X ∗ . In the linear model.9 Bootstrap GMM Inference ˆ Let β be the 2SLS or GMM estimator of β. note that the eﬃcient instrument Ai involves the estimation of the conditional mean of zi given xi . zi ). ˆ where g n (β) is from the in-sample data. jeopardizing the theoretical justiﬁcation for percentile-t methods. Ai = σ −2 E (zi | xi ) . xi . this implies that the bootstrap estimator is ¢−1 ¡ ∗0 ∗ ∗ ¡ ∗0 ∗ ¡ ¢¢ ˆ∗ Z X W X Y − X 0e . Brown and Newey argue that this bootstrap procedure will be more eﬃcient than the Hall-Horowitz GMM bootstrap. x∗ . β is the “true” value and yet g n (β) 6= 0. not from the bootstrap data. zi = xi . this sampling scheme preserves the moment conditions of the model. A correction suggested by Hall and Horowitz (1996) can solve the problem. This has been shown by Hahn (1996). The eﬃcient instrument is also inversely proportional to the conditional variance of ei . as this is a very new area of research. namely that improved eﬃciency can be obtained if the observations are weighted inversely to the conditional variance of the errors. ˆ ˆ The problem is that in the sample. ∗ ˆ Let β minimize J ∗ (β). They note that we can sample from the p observations {w³. The bootstrap J statistic is J ∗ (β ). In other words. i i 9. and deﬁne all statistics and tests accordingly. z ∗ ) drawn from the EDF F . Thus according to ∗ . A straightforward application of the nonparametric bootstrap works in the sense of consistently achieving the ﬁrst-order asymptotic distribution.

there exists a nonsingular matrix C such that C 0 C = Ω−1 . verify that A can be written as ³ ¡ ¢−1 0 ´ G H. σ 2 Q0 M −1 Q ) 0 where Q = E(xi zi ) and M = E(xi x0 ). 2. In the linear model estimated by GMM with general weight matrix W. From matrix algebra. and therefore positive semideﬁnite. Letting H = CQ and G = C 0−1 W Q. the asymptotic variˆ ance of β GMM is ¡ ¢−1 0 ¡ ¢−1 V = Q0 W Q Q W ΩW Q Q0 W Q ¡ ¢−1 (a) Let V0 be this matrix when W = Ω−1 . Let ei = yi − zi β where β is consistent for ˆ β (e. γ). Show that if β is estimated by GMM with weight matrix Wn = i 0 X)−1 .9. Take the single equation Y E(e = Zβ + e | X) = 0 ˆ Assume E(e2 | xi ) = σ 2 . V − V0 is positive semi-deﬁnite (for then V0 is the smaller possible covariance matrix and W = Ω−1 is the eﬃcient weight matrix). Write out the matrix A. γ ) for (β.g. Show that Wn →p Ω i i i 4. Show that V0 = Q0 Ω−1 Q . Take the model yi = zi β + ei with E (xi ei ) = 0. we know that V − V0 is positive semi-deﬁnite if and only if V0−1 − V −1 = A is positive semi-deﬁnite. ˆ ˆ Find the method of moments estimators (β. then (X ´ ¢−1 ¡ √ ³ ˆ n β − β →d N (0. a GMM estimator with arbitrary weight matrix). 114 . Hint: The matrix I −G (G0 G)−1 G0 is symmetric and idempotent. i 0 0ˆ ˆ 3. A = H 0 I − G G0 G (d) Show that A is positive semideﬁnite. Deﬁne the estimate of the optimal GMM weight matrix Ã n !−1 1X 0 2 xi xi ei ˆ . Wn = n i=1 ¡ ¢ −1 where Ω = E x x0 e2 .10 Exercises yi = x0 β + ei i E (xi ei ) = 0 0 e2 = zi γ + η i i 1. (c) Since Ω is positive deﬁnite. (b) We want to show that for any W. Take the model E (zi ηi ) = 0.

β) + ei E (zi ei ) = 0.5. the Generalized Method of Moments (GMM) criterion function for β is deﬁned as 1 ˆn (Y − Xβ)0 X Ω−1 X (Y − Xβ) (9. is deﬁned as Jn (β) = ˜ β = argmin Jn (β).5) n 1 P ˆ where ei are the OLS residuals and Ωn = n n xi x0 e2 . VR ) where ¡ ¢−1 0 R V.6) (a) Show that you can rewrite Jn (β) in (9. VR = V − V R R0 V R (d) Show that in this setting. λ) = 1 Jn (β) + λ0 (R0 β − r) where λ is 2 s × 1. xi . In the linear model Y = Xβ + e with E(xi ei ) = 0. zi ).5) as ³ ´ ³ ´0 ˆ ˆ ˆ −1 β − β Jn (β) = β − β Vn where (b) Now focus on linear restrictions: h(β) = R0 β − r. 6.6) equals the Wald statistic. Show that the minimizer is ³ ´−1 ³ ´ ˆ ˜ ˆ ˆ ˆ R0 β − r β = β − Vn R R0 Vn R ´ ´−1 ³ ³ ˆ ˆ ˆ R0 β − r . The GMM estimator of β. h(β)=0 (9. zi is l × 1 and β is k × 1. subject ˆ i ˆi i=1 to the restriction h(β) = 0. h(β)=0 The GMM test statistic (the distance statistic) of the hypothesis h(β) = 0 is ˜ D = Jn (β) = min Jn (β). Vn = X X i=1 ˜ and hence R0 β = r. Show how to construct an eﬃcient GMM estimator for β. 115 . the distance statistic D in (9. Thus ˜ β = argmin Jn (β) R0 β−r Ã n ! ¡ 0 ¢−1 ¡ 0 ¢−1 X 0 2 ˆ XX xi xi ei ˆ . The equation of interest is yi = g(xi . l ≥ k. The observed data is (yi . Deﬁne the Lagrangian L(β. λ = R0 Vn R (c) Show that if R0 β = r then ´ √ ³˜ n β − β →d N (0.

ˆ and consider the GMM estimator β of β. 116 . we can write Ω−1 = CC 0 and Ω = C 0−1 C −1 ³ ´0 ³ ´−1 ˆ ˆ ˆ C 0 ΩC (b) Jn = n C 0 g n (β) C 0 g n (β) ˆ (c) C 0 g n (β) = Dn C 0 g n (β 0 ) (d) Dn →p Il − R (R0 R)−1 R0 (e) n1/2 C 0 g n (β 0 ) →d N ∼ N (0. Il ) ³ ´ (f) Jn →d N 0 Il − R (R0 R)−1 R0 N ³ ´ (g) N 0 Il − R (R0 R)−1 R0 N ∼ χ2 .7. l−k Hint: Il − R (R0 R)−1 R0 is a projection matrix. Deﬁne ¶µ ¶−1 µ 1 0 ˆ −1 1 0 1 0 ˆ −1 0−1 0 1 0 XZ Z XΩ XZ Z XΩ C Dn = Il − C n n n n 1 0 Xe g n (β 0 ) = n ¡ ¢ 0 R = C 0 E xi zi Show that Jn →d χ2 as n → ∞ by demonstrating each of the following: l−k (a) Since Ω > 0.. Take the linear model 0 yi = zi β + ei E (xi ei ) = 0. Let ˆ ˆ ˆ Jn = ng n (β)0 Ω−1 g n (β) denote the test of overidentifying restrictions.

1) i=1 First let us consider a just-identiﬁed model. the log-likelihood function for this multinomial distribution is n X ln(pi ). these probabilities must satisfy the requirements that pi ≥ 0 and n X pi = 1. It is a non-parametric analog of likelihood estimation.3) i=1 117 . The idea is due to Art Owen (1988.1 Non-Parametric Likelihood Since each observation is observed once in the sample. . The idea is to construct a multinomial distribution F (p1 . In this case the moment condition places no additional restrictions on the multinomial distribution. pn ) are those which maximize the log-likelihood subject to the constraint (10..Chapter 10 Empirical Likelihood 10.. (10. xi . The multinomial distribution which places probability pi at each observation (yi .2) Ln (p1 . . (10. This is equivalent to maximizing Ã n ! n X X log(pi ) − µ pi − 1 i=1 i=1 where µ is a Lagrange multiplier. .. pn ) = i=1 An alternative to GMM is empirical likelihood. The n ﬁrst order conditions are 0 = p−1 − µ.. zi . pn ) which places probability pi at each observation.. zi ) will satisfy this condition if and only if n X pi gi (β) = 0 (10.. The maximum likelihood estimator of the probabilities (p1 . β)... To be a valid multinomial distribution. Now consider the case of an overidentiﬁed model with moment condition Egi (β 0 ) = 0 where g is × 1 and β is k × 1 and for simplicity we write gi (β) = g(yi . xi . Combined with i the constraint (10. 2001) and has been extended to moment condition models by Qin and Lawless (1994)..1) we ﬁnd that the MLE is pi = n−1 yielding the log-likelihood −n log(n).1).

1) and (10. probabilities 1 ³ ´´ . pn ..2) subject to the restrictions (10.5) ˆ ˆ As a by-product of estimation. pi gi (β) = 0. or equivalently minimizes its negative ˆ (10. Multiplying the ﬁrst equation by pi . The solution cannot be obtained explicitly. µ) = n i=1 i=1 i=1 L∗ n with respect to pi . λ). the Lagrange multiplier λ(β) minimizes Rn (β.7) 118 .. The solution (when it exists) is well deﬁned since Rn (β. The ﬁrst-order-conditions of and λ are 1 = µ + nλ0 gi (β) pi n X pi = 1 i=1 n X i=1 The empirical likelihood estimator is the value of β which maximizes the multinomial loglikelihood (10.3). Ln (β) = Rn (β. p (10. and using the second and third equations. λ) = −n ln (n) − n X i=1 For given β. but must be obtained numerically (see section 6. λ ¡ ¢ ln 1 + λ0 gi (β) . λ) is a convex function of λ. This yields the (proﬁle) empirical log-likelihood function for β. λ(β)) = −n ln (n) − n X i=1 ˆ The EL estimate β is the value which maximizes Ln (β).4) (10. summing over i.5).. we also obtain the Lagrange multiplier λ = λ(β). . pi = ³ ˆ ˆ ˆ0 n 1 + λ gi β ˆ Ln = n X i=1 ln (ˆi ) .where λ and µ are Lagrange multipliers. p1 . µ. (10. we ﬁnd µ = n and 1 ¢.6) β = argmin [−Ln (β)] β ¡ ¢ ln 1 + λ(β)0 gi (β) and maximized empirical likelihood ˆ Numerical methods are required for calculation of β.5) This minimization problem is the dual of the constrained maximization problem. λ. (see section 6. pi = ¡ n 1 + λ0 gi (β) Substituting into L∗ we ﬁnd n Rn (β. λ) : λ(β) = argmin Rn (β. The Lagrangian for this maximization problem is Ã n ! n n X X X ln(pi ) − µ pi − 1 − nλ0 pi gi (β) L∗ (β.

ˆ The asymptotic variance V for β is the same as for eﬃcient GMM.13) yields n n Expanding (10.2. λ) = − (10.10) ¡ Ω−1 N (0.9) and (10. and Ω = E xi x0 e2 . n (10.12) ∂β ˆ ˆ0 i=1 1 + λ gi β 1 P 1 P 1 P Let Gn = n n Gi (β 0 ) . i=1 i=1 i=1i Expanding (10. i i Theorem 10.2 Deﬁne Asymptotic Distribution of EL Estimator Gi (β) = ∂ gi (β) ∂β 0 (10.13) Premultiplying by G0 Ω−1 and using (10. g n = n n gi (β 0 ) and Ωn = n n g (β 0 ) gi (β 0 )0 . ´ √ ³ ˆ n β − β 0 →d √ ˆ nλ →d N (0.9) (10. 0 = Rn (β. and n β − β 0 and nλ are asymptotically independent. Thus the EL estimator is asymptotically eﬃcient. G = −E (xi zi ).14) ³ ´ ˆ ˆ 0 ' −G0 Ω−1 g n − G0 Ω−1 Gn β − β 0 + G0 Ω−1 Ωn λ n n n n n n ³ ´ ˆ = −G0 Ω−1 g n − G0 Ω−1 Gn β − β 0 n n n n 119 . in the linear model. V ) ¢−1 ¡ V = G0 Ω−1 G ¡ ¢−1 0 Vλ = Ω − G G0 Ω−1 G G G = EGi (β 0 ) ¡ ¢ Ω = E gi (β 0 ) gi (β 0 )0 (10. β λ ∂ ³ ´. ˆ ˆ Proof.8) and ¢ 0 0 For example.12) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ 0 ' G0 λ − λ0 . Gi (. Vλ ) ´ √ ˆ √ ³ˆ where V and Vλ are deﬁned in (10. λ) = − (10. β) = −xi zi . (β.10.10).11) 0 = ∂λ ˆ0 ˆ i=1 1 + λ gi β ³ ´0 ˆ n X Gi .11) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ ˆ 0 ' −g n − Gn β − β 0 + Ωn λ (10.1 Under regularity conditions. λ) jointly solve ³ ´ ˆ n gi β X ∂ ³ ³ ´´ Rn (β.

15) yields ³ ¡ ¢−1 0 −1 ´ √ √ ˆ nλ ' Ω−1 I − Gn G0 Ω−1 Gn Gn Ωn ng n n n n ³ ¡ 0 −1 ¢−1 0 −1 ´ N (0. Ω) →d Ω−1 I − G G Ω G GΩ = Ω−1 N (0.17) 2 ln 1 + λ gi β . n ³ ´´ ´ √ ³ 1 X ³ ˆ ˆ √ g wi .16) ´ √ ˆ √ ³ˆ n β − β 0 and nλ are asymptotically uncorrelated and hence independent. The EL overidentiﬁcation test is similar to the GMM overidentiﬁcation test.14) for λ and using (10. V ) ˆ Solving (10. by a Taylor expansion. LRn = i=1 Theorem 10. Ω) GΩ G →d = N (0. it is an asymptotically eﬃcient estimator for β. First. β ' n g n + Gn β − β 0 n i=1 ³ ¡ ¢−1 0 −1 ´ √ Gn Ωn ng n ' I − Gn G0 Ω−1 Gn n n √ ˆ ' Ωn nλ. Proof.7) is n ³ ´´ ³ X ˆ ˆ0 (10. Vλ ) Furthermore. The same statistic can be constructed for empirical likelihood. Since the EL estimator achieves this bound. 120 . β 0 ) = 0 then LRn →d χ2−k . They are asymptotically ﬁrst-order equivalent.16). The overidentiﬁcation test is a very useful by-product of EL estimation. Twice the diﬀerence between the unrestricted empirical likelihood −n log (n) and the maximized empirical likelihood for the model (10. This means that no consistent estimator for this class of models can have a lower asymptotic variance than V . 10.3 Overidentifying Restrictions In a parametric likelihood context. and (10. since ³ ¡ ¢−1 0 ´ G0 I − Ω−1 G G0 Ω−1 G G =0 (10. (10.ˆ Solving for β and using the WLLN and CLT yields ´ ¢−1 0 −1 √ ¡ √ ³ ˆ ' − G0 Ω−1 Gn n β − β0 Gn Ωn ng n n n ¡ 0 −1 ¢−1 0 −1 G Ω N (0.1 If Eg(wi . and have the same interpretation.15) (10.15). ¥ Chamberlain (1987) showed that V is the semiparametric eﬃciency bound for β in the overidentiﬁed moment condition model.3. and it is advisable to report the statistic LRn whenever EL is the estimation method. tests are based on the diﬀerence in the log likelihood functions.

the simple overidentifying restrictions test (10.18) are assumed to hold and are not being challenged (at least for the test discussed in this section).Second. LRn →d χ2 . This test statistic is a natural analog of the GMM distance statistic. Vλ )0 Ω−1 N (0. The restricted EL estimator and likelihood are the values which solve ˜ β = argmax Ln (β) h(β)=0 ˜ ˜ Ln = Ln (β) = max Ln (β). where h : Rk → Ra . the restricted EL estimator β is simply an EL estimator with − k + a overidenti˜ ˆ fying restrictions. so there is no fundamental change in the distribution theory for β relative to β.4 Testing Egi (β) = 0 (10.wisc. 10.4. since ln(1 + x) ' x − x2 /2 for x small. a The proof of this result is more challenging and is omitted. Theorem 10. Vλ ) ¥ where the proof of the ﬁnal equality is left as an exercise.ssc. h(β)=0 ˜ Fundamentally.prc 121 .1 Under (10. The hypothesis of interest is h(β) = 0.18) and H0 : h(β) = 0. Instead we use the diﬀerence in log-likelihoods: ³ ´ ˆ ˜ LRn = 2 Ln − Ln . To test the hypothesis h(β) while maintaining (10. By “maintained” we mean that the overidentfying restrictions contained in (10.5 Numerical Computation Gauss code which implements the methods discussed below can be found at http://www.edu/~bhansen/progs/elike.18). LRn = n X i=1 ˆ0 ' 2λ →d ˆ0 ˆ ' nλ Ωn λ = χ2−k n X i=1 ³ ´´ ³ ˆ ˆ0 2 ln 1 + λ gi β i=1 n ³ ´ X ³ ´ ³ ´0 ˆ − λ0 ˆ ˆ ˆ ˆ gi β gi β gi β λ N (0.17) is not appropriate. 10.18) Let the maintained model be where g is × 1 and β is k × 1.

Deﬁne ∗ gi (β. i Rββ = Inner Loop The so-called “inner loop” solves (10. λ) = i The ﬁrst derivatives of (10. λ) = − ∂β n X i=1 G∗ (β. λ)0 0 Rn (β. λj ) is smaller than some prespeciﬁed tolerance. λ) G∗ (β. The modiﬁed Newton method takes a quadratic approximation to Rn (β. λj ))−1 Rλ (β. 1. λj ))−1 Rλ (β. λ) G∗ (β. λ) yielding the iteration rule λj+1 = λj − δ (Rλλ (β.4). A complication is that λ must be constrained so that 0 ≤ pi ≤ 1 which holds if ¢ ¡ n 1 + λ0 gi (β) ≥ 1 122 (10. δ 4R2 + 4R0 − 8R1 yielding the steplength to be plugged into (10. λ) = ∂λ∂λ i=1 ¶ n 2 Xµ ∂ Gi (β) ∗ gi (β. λ) = i i ∂β∂β 0 1 + λ0 gi (β) i=1 n where δ > 0 is a scalar steplength (to be discussed next).Derivatives The numerical calculations depend on derivatives of the dual likelihood function (10.19) is continued until the gradient Rλ (β. λ) = − gi (β. λj ) . The value of δ which minimizes this quadratic is ˆ = R2 + 3R0 − 4R1 . λj )) Rp = Rn (β. 2. The starting value λ1 can be set to the zero vector. The iteration (10.5) for given β. (10.20) .19).19) X ∂2 ∗ ∗ gi (β. Set δ 0 = 0.. set 2 λp = λj − δ p (Rλλ (β. For p = 0. Eﬃcient convergence requires a good choice of steplength δ. λ) gi (β. λ) = G∗ (β.4) are Rλ = Rβ = The second derivatives are Rλλ = Rλβ = ¡ Gi (β)0 λ 1 + λ0 gi (β) gi (β) ¢ 1 + λ0 gi (β) X ∂ ∗ Rn (β. λ) = i ∂λ∂β 0 1 + λ0 gi (β) i=1 ⎞ ⎛ ¡ 0 ¢ ∂2 n 2 X 0 gi (β) λ ∂ ⎠ ⎝G∗ (β. λ)0 − ∂β∂β Rn (β. λ) . λp ) A quadratic function can be ﬁt exactly through these three points. λ) ∂λ i=1 n ∂ Rn (β. δ 1 = 1 and δ 2 = 1. One method uses the following quadratic approximation. λ)0 − Rn (β.

123 .for all i. λ) = 0 at λ = λ(β).20) fails. ∂β 0 the second equality following from the implicit function theorem applied to Rλ (β. λ(β)) = 0. where λβ = ∂ −1 λ(β) = −Rλλ Rλβ . the stepsize δ needs to be decreased. Outer Loop The outer loop is the minimization (10. and the rule is iterated until convergence. If (10. It is not guaranteed that Lββ > 0. The Newton iteration rule is β j+1 = β j − δL−1 Lβ ββ where δ is a scalar stepsize.6) is Lβ = ∂ ∂ Ln (β) = Rn (β. λ(β)) β ∂β ¡ ¢ 0 = − Rββ (β. The gradient for (10. If not. the eigenvalues of Lββ should be adjusted so that all are positive. λ) = Rβ + λ0 Rλ = Rβ β ∂β ∂β since Rλ (β. This can be done by the modiﬁed Newton method described in the previous section. The Hessian for (10.6).6) is Lββ = − ∂ Ln (β) ∂β∂β 0 ¤ ∂ £ = − 0 Rβ (β. λ(β)) + Rλβ λβ + λ0 Rλβ + λ0 Rλλ λβ β β −1 0 = Rλβ Rλλ Rλβ − Rββ . λ(β)) + λ0 Rλ (β.

The variables qi and pi (quantity and price) are determined jointly by the demand equation qi = −β 1 pi + e1i µ ¶ qi = β 2 pi + e2i . independent of yi and x∗ . The coeﬃcient β must have meaning separately from the deﬁnition of a conditional mean or linear projection. Example: Measurement error in the regressor. β →p β ∗ = β − E xi x0 i This is called measurement error bias. It follows that if β is the OLS estimator. so requires a structural interpretation. i The problem is that £ ¡ ¢¤ ¡ ¢ E (xi vi ) = E (x∗ + ui ) ei − u0 β = −E ui u0 β 6= 0 i i i ˆ if β 6= 0 and E (ui u0 ) 6= 0. what happens? It is helpful to solve for qi and pi in terms of the errors. then i ¡ ¡ ¢¢−1 ¡ 0 ¢ ˆ E ui ui β 6= β. x∗ ) are joint random i variables. This cannot happen if β is deﬁned by linear projection. β is the parameter of interest. β 1 + β 2 = 1 and Eei e0 = I2 (the latter for simplicity). i e2i The question is. ¸µ ¶ µ ¶ ∙ qi e1i 1 β1 = 1 −β 2 pi e2i 124 Assume that ei = . Suppose that (yi . and x∗ is not observed. Instead i i i we observe xi = x∗ + ui where ui is an k × 1 measurement error. if we regress qi on pi . and the supply equation e1i is iid. Example: Supply and Demand. In matrix notation. E(yi | x∗ ) = x∗0 β is linear. Then i i yi = x∗0 β + ei i = (xi − ui )0 β + ei = x0 β + vi i where vi = ei − u0 β.Chapter 11 Endogeneity 0 We say that there is endogeneity in the linear model y = zi β + ei if β is the parameter of interest and E(zi ei ) 6= 0. Eei = 0.

So we have the partition µ ¶ z1i k1 (11. 11. ¶ µ ∙ β2 β1 1 −1 β 2 e1i + β 1 e2i (e1i − e2i ) ¸µ e1i e2i ¶ ˆ Hence if it is estimated by OLS. some regressors in zi will be uncorrelated with ei (for example.so µ qi pi ¶ = = = The projection of qi on pi yields qi = β ∗ pi + εi E (pi εi ) = 0 where β∗ = β − β1 E (pi qi ) ¡ 2¢ = 2 2 E pi ∙ 1 β1 1 −β 2 ¸−1 µ e1i e2i ¶ .1 The × 1 random vector xi is an instrumental variable for (11. which does not equal either β 1 or β 2 . We call (11. That is x2i are variables which could be included in the equation for yi (in the sense 125 .1) the structural equation.1.2) Any solution to the problem of endogeneity requires additional information which we call instruments. and assume that E(zi ei ) 6= 0 so there is endogeneity. β →p β ∗ . In a typical set-up.4) xi = x2i 2 where z1i = x1i are the included exogenous variables. z1i is an instrumental variable for (11.1) if E (xi ei ) = 0. Deﬁnition 11.1) where zi is k × 1. at least the intercept). (11. and x2i are the excluded exogenous variables. In matrix notation. By the above deﬁnition.3) zi = z2i k2 where E(z1i ei ) = 0 yet E(z2i ei ) 6= 0. this can be written as Y = Zβ + e. Thus we make the partition ¶ µ k1 z1i (11. This is called simultaneous equations bias. so should be included in xi . We call z1i exogenous and z2i endogenous.1).1 Instrumental Variables 0 yi = zi β + ei Let the equation of interest be (11.

that they are uncorrelated with ei ) yet can be excluded, as they would have true zero coeﬃcients in the equation. The model is just-identiﬁed if = k (i.e., if 2 = k2 ) and over-identiﬁed if > k (i.e., if 2 > k2 ). We have noted that any solution to the problem of endogeneity requires instruments. This does not mean that valid instruments actually exist.

11.2

Reduced Form

The reduced form relationship between the variables or “regressors” zi and the instruments xi is found by linear projection. Let ¡ ¢−1 ¡ 0 ¢ E xi zi Γ = E xi x0 i be the × k matrix of coeﬃcients from a projection of zi on xi , and deﬁne ui = zi − x0 Γ i as the projection error. Then the reduced form linear relationship between zi and xi is zi = Γ0 xi + ui . In matrix notation, we can write (11.5) as Z = XΓ + u where u is n × k. By construction, E(xi u0 ) = 0, i so (11.5) is a projection and can be estimated by OLS: ˆ ˆ Z = XΓ + u ¡ 0 ¢−1 ¡ 0 ¢ ˆ XZ . Γ = XX Y = (XΓ + u) β + e = Xλ + v, where λ = Γβ and v = uβ + e. Observe that ¡ ¢ E (xi vi ) = E xi u0 β + E (xi ei ) = 0. i ˆ ˆ Y = X λ + v, ¡ 0 ¢−1 ¡ 0 ¢ ˆ λ = XX XY 126 (11.8) (11.7) (11.6) (11.5)

Substituting (11.6) into (11.2), we ﬁnd

Thus (11.7) is a projection equation and may be estimated by OLS. This is

The equation (11.7) is the reduced form for Y. (11.6) and (11.7) together are the reduced form equations for the system Y = Xλ + v Z = XΓ + u. ˆ ˆ As we showed above, OLS yields the reduced-form estimates (λ, Γ)

11.3

Identiﬁcation

The structural parameter β relates to (λ, Γ) through (11.8). The parameter β is identiﬁed, meaning that it can be recovered from the reduced form, if rank(Γ) = k. (11.9) Assume that (11.9) holds. If = k, then β = Γ−1 λ. If > k, then for any W > 0, β = (Γ0 W Γ)−1 Γ0 W λ. If (11.9) is not satisﬁed, then β cannot be recovered from (λ, Γ). Note that a necessary (although not suﬃcient) condition for (11.9) is ≥ k. Since X and Z have the common variables X1 , we can rewrite some of the expressions. Using (11.3) and (11.4) to make the matrix partitions X = [X1 , X2 ] and Z = [X1 , Z2 ], we can partition Γ as ∙ ¸ Γ11 Γ12 Γ = Γ21 Γ22 ∙ ¸ I Γ12 = 0 Γ22 (11.6) can be rewritten as Z1 = X1 Z2 = X1 Γ12 + X2 Γ22 + u2 . (11.10) β is identiﬁed if rank(Γ) = k, which is true if and only if rank(Γ22 ) = k2 (by the upperdiagonal structure of Γ). Thus the key to identiﬁcation of the model rests on the 2 × k2 matrix Γ22 in (11.10).

11.4

Estimation

0 yi = zi β + ei

The model can be written as E (xi ei ) = 0 or Eg (wi , β) = 0 ¢ ¡ 0 g (wi , β) = xi yi − zi β .

This a moment condition model. Appropriate estimators include GMM and EL. The estimators and distribution theory developed in those Chapter 8 and 9 directly apply. Recall that the GMM estimator, for given weight matrix Wn , is ¡ ¢−1 0 ˆ β = Z 0 XWn X 0 Z Z XWn X 0 Y. 127

11.5

Special Cases: IV and 2SLS

This estimator is often called the instrumental variables estimator (IV) of β, where X is used as an instrument for Z. Observe that the weight matrix Wn has disappeared. In the just-identiﬁed case, the weight matrix places no role. This is also the MME estimator of β, and the EL estimator. Another interpretation stems from the fact that since β = Γ−1 λ, we can construct the Indirect Least Squares (ILS) estimator: ˆ ˆ ˆ β = Γ−1 λ ³¡ ¢−1 ¡ 0 ¢´−1 ³¡ 0 ¢−1 ¡ 0 ¢´ XX XZ XY = X 0X ¡ 0 ¢−1 ¡ 0 ¢ ¡ 0 ¢−1 ¡ 0 ¢ = XZ XX XX XY ¡ 0 ¢−1 ¡ 0 ¢ = XZ XY .

If the model is just-identiﬁed, so that k = , then the formula for GMM simpliﬁes. We ﬁnd that ¡ ¢−1 0 ˆ β = Z 0 XWn X 0 Z Z XWn X 0 Y ¡ ¢−1 −1 ¡ 0 ¢−1 0 = X 0Z Wn Z X Z XWn X 0 Y ¡ ¢−1 0 = X 0Z XY

which again is the IV estimator.

¡ ¢ Recall that the optimal weight matrix is an estimate of the inverse of Ω = E xi x0 e2 . In the i i ¢ ¡ 2 special case that E ei | xi = σ 2 (homoskedasticity), then Ω = E (xi x0 ) σ 2 ∝ E (xi x0 ) suggesting i i the weight matrix Wn = (X 0 X)−1 . Using this choice, the GMM estimator equals ³ ¡ ¢−1 0 ´−1 0 ¡ 0 ¢−1 0 ˆ β 2SLS = Z 0 X X 0 X XZ ZX XX XY

then

This is called the two-stage-least squares (2SLS) estimator. It was originally proposed by Theil (1953) and Basmann (1957), and is the classic estimator for linear equations with instruments. Under the homoskedasticity assumption, the 2SLS estimator is eﬃcient GMM, but otherwise it is ineﬃcient. It is useful to observe that writing ¡ ¢−1 0 X, PX = X X 0 X ¡ 0 ¢−1 0 ˆ X Z, Z = PX Z = X X X ˆ β = ¢−1 0 Z PX Y Z 0 PX Z ´ ³ ˆ ˆ ˆ = Z 0 Z Z 0 Y. ¡

The source of the “two-stage” name is since it can be computed as follows ˆ ˆ ˆ • First regress Z on X, vis., Γ = (X 0 X)−1 (X 0 Z) and Z = X Γ = PX Z. ³ ´−1 ˆ ˆ ˆ ˆ ˆ • Second, regress Y on Z, vis., β = Z 0 Z Z 0 Y. 128

let’s analyze the approximate bias of OLS applied to (11. We now derive a similar result for the 2SLS estimator. Hence by a ﬁrst-order approximation i µ µ ¶¶−1 µ ¶ ³ ´ 1 0 1 0 ˆ OLS − β E β ZZ Ze ≈ E E n n ¡ ¢−1 = Γ0 QΓ + S22 S21 (11.11) (11. PX Z2 ] h i ˆ = Z1 .13) which is zero only when S21 = 0 (when Z is exogenous). 129 . the model is Y = Zβ + e (11.12) Z = XΓ + u ξ = (e.11). In our notation. Z2 = [PX Z1 . ˆ since Z1 lies in the span of X.6 Bekker Asymptotics Bekker (1994) used an alternative asymptotic framework to analyze the ﬁnite-sample bias in the 2SLS estimator. ¶ µ 1 0 Z e = E (zi ei ) = Γ0 E (xi ei ) + E (ui ei ) = S21 E n and E µ 1 0 ZZ n ¶ ¡ 0¢ = E zi zi ¢ ¡ ¢ ¢ ¡ ¢ ¡ ¡ = Γ0 E xi x0 Γ + E ui x0 Γ + Γ0 E xi u0 + E ui u0 i i i i = Γ0 QΓ + S22 where Q = E (xi x0 ) .12). So only the endogenous variables Z2 are replaced by their ﬁtted values: ˆ ˆ ˆ Z2 = X1 Γ12 + X2 Γ22 . First. X2 ].ˆ It is useful to scrutinize the projection Z. Here we present a simpliﬁed version of one of his results. Thus in the second stage. u) E (ξ | X) = 0 ¢ ¡ E ξξ 0 | X = S As before. Z2 . ¡ ¢−1 ¡ 0 ¢ ˆ β 2SLS = Z 0 PX Z Z PX Y . 11. X is n × l so there are l instruments. Recall. Then i h ˆ ˆ ˆ Z = Z1 . PX Z2 ] = [Z1 . Z = [Z1 . we regress Y on Z1 and Z2 . Using (11. Z2 ] and X = [Z1 .

except when S21 = 0 (when Z is exogenous). Let q = H 0 ξS −1/2 which satisﬁes Eqq 0 = In and partition q = (q1 q2 ) where q1 is l × 1.14) In general this is non-zero. the bias in the 2SLS estimator will be large.12) and this result. Bekker (1994) showed further that under the alternative asymptotic approximation that α is ﬁxed as n → ∞ (so that the number of instruments goes to inﬁnity proportionately with sample ˆ size) then the expression in (11.14) is the probability limit of β 2SLS − β 11. l . Indeed as α → 1.13). The consequences of identiﬁcation failure for inference are quite severe.14) approaches that in (11. ¢ 1 ¡ ¢ 1 ¡ ¢ 1 ¡ 0 E Z PX e = E Γ0 X 0 e + E u0 PX e = αS21 . 130 . n and (11. Together µ µ ¶¶−1 µ ¶ ³ ´ 1 0 1 0 ˆ 2SLS − β E β Z PX Z Z PX e ≈ E E n n ¡ ¢−1 = α Γ0 QΓ + αS22 S21 . The parameter β fails to be identiﬁed if Γ22 has deﬁcient rank. It is also close to zero when α = 0. Bekker (1994) pointed out that it also has the reverse implication — that when α = l/n is large.7 Identiﬁcation Failure Recall the reduced form equation Z2 = X1 Γ12 + X2 Γ22 + u2 .Let PX = X (X 0 X)−1 X 0 . By the spectral decomposition of an idempotent matrix. Hence µ ¶ 1 0 1 1/20 ¡ 0 ¢ 1/2 ξ PX ξ S E q Λq S E = n n µ ¶ 1 0 1 1/20 S E q q1 S 1/2 = n n 1 l 1/20 1/2 S S = n = αS where α= Using (11. 0). n n n ¢ ¡ ¡ ¢ ¢ ¢ 1 ¡ 0 1 ¡ E Z PX Z = Γ0 E xi x0 Γ + Γ0 E (xi ui ) + E ui x0 Γ + E u0 PX u i i n n = Γ0 QΓ + αS22 . P = HΛH 0 0 0 where Λ = diag(Il . indicating that the bias in 2SLS approaches that of OLS as the number of instruments increases. the expression in (11.

The n−1/2 is picked because it provides just the right balancing to allow a rich distribution theory. but (11. which occurs i when E (zi xi ) 6= 0. N2 since the ratio of two normals is Cauchy. Then by the CLT ¡ ¡ ¢¢ 1 X √ xi ei →d N1 ∼ N 0. Qc + N2 ˆ As in the case of complete identiﬁcation failure.16) ˆ β−β = 1 √ n 1 √ n Pn Pn i=1 xi ei i=1 xi zi →d N1 ∼ Cauchy. We see that β is identiﬁed if and only if Γ22 = γ 6= 0. This can be handled in an asymptotic analysis by modeling it as local-to-zero. Then (11. This occurs when Γ22 is full rank. Here. 131 . viz Γ22 = n−1/2 C.Take the simplest case where k = l = 1 (so there is no X1 ). once again take the simple case k = l = 1.15) is unaﬀected. Suppose that identiﬁcation does not complete fail. This result carries over to more general settings. meaning that inferences about parameters of interest can be misleading. the instrument xi is weak for zi if γ = n−1/2 c. This is particularly nasty. In addition. where C is a full rank matrix.15) therefore ¢¢ ¡ ¡ 1 X 1 X √ xi zi = √ xi ui →d N2 ∼ N 0. Thus identiﬁcation hinges on the existence of correlation between the excluded exogenous variable and the included endogenous variable. standard test statistics have non-standard asymptotic distribution of β distributions. Suppose this condition fails. E x2 e2 i i n i=1 n (11. E x2 u2 i i n n i=1 i=1 n n (11. so E (zi xi ) = 0. but is weak. we ﬁnd that β is inconsistent for β and the ˆ is non-normal. Then the model may be written as yi = zi β + ei zi = xi γ + ui and Γ22 = γ = E (xi zi ) /Ex2 . To see the consequences. and was examined by Phillips (1989) and Choi and Phillips (1992). but small.16) instead takes the form 1 X √ xi zi n i=1 n = = 1 X 2 1 X √ xi γ + √ xi ui n n 1 n i=1 n X x2 c + i i=1 n n 1 √ n →d Qc + N2 therefore ˆ β − β →d i=1 n X i=1 xi ui N1 . as the Cauchy distribution does not have a ﬁnite mean.

this cannot be interpreted as deﬁnitive proof that Γ22 has full rank. So while a minimal check is to test that each columns of Γ22 is non-zero. it appears reasonable to explicitly estimate and report the reduced form equations for X2 . Further results on testing were obtained by Wang and Zivot (1998). 132 . Γ22 6= 0 is not suﬃcient for identiﬁcation. and at a minimum check that the test rejects H0 : Γ22 = 0. In any event. and attempt to assess the likelihood that Γ22 has deﬁcient rank. Unfortunately. construct the test of Γ22 = 0.The distribution theory for this model was developed by Staiger and Stock (1997) and extended to nonlinear GMM estimation by Stock and Wright (2000). which is straightforward to assess using a hypothesis test on the reduced form. the equation to focus on is the reduced form Z2 = X1 Γ12 + X2 Γ22 + u2 and identiﬁcation requires rank(Γ22 ) = k2 . Once again. If k2 = 1. Therefore in the case of k2 = 1 (one RHS endogenous variable). The bottom line is that it is highly desirable to avoid identiﬁcation failure. It is not even suﬃcient that each column of Γ22 is non-zero (each column corresponds to a distinct endogenous variable in X2 ). this requires Γ22 6= 0. one constructive recommendation is to explicitly estimate the reduced form equation for Z2 . When k2 > 1. tests of deﬁcient rank are diﬃcult to implement.

we claim that β is identiﬁed (can be recovered from the reduced form) if rank(Γ) = k. Z is n × k.8 Exercises yi = zi β + ei . ˆ ˆ Let the OLS estimator for β be β and the OLS residual be e = Y − Z β. Take the linear model Y = Zβ + e. l ≥ k.) 3. at ˆˆ If X is indeed endogeneous. 2. and Γ is l × k. In the structural model Y = Zβ + e Z = XΓ + u with Γ l × k. 5. show that if rank(Γ) < k then β cannot be identiﬁed. in the sense that e ˜ ˜ least in large samples? 4. The parameter Γ is deﬁned by the population moment condition ¡ ¢ E xi u0 = 0 i ˆ Show that the method of moments estimator for Γ is Γ = (X 0 X)−1 (X 0 Z) . That is. Consider the single equation model ˆ where yi and zi are both real-valued (1 × 1). Explain why this is true. ˜ 0 e < e0 e. Show that the GLS estimator of β can be written as an i IV estimator using some instrument xi . Let β denote the IV estimator of β using as an instrument a dummy variable di (takes only the values 0 and 1). Find a simple expression for the IV estimator in this context. 6. 1. xi is l × 1. (Find an expression for xi . will IV “ﬁt” better than OLS. Take the linear model yi = xi β + ei E (ei | xi ) = 0. where xi and β are 1 × 1. u is n × k.11. 133 . ˆ ˜ ˜ Let the IV estimator for β using some instrument X be β and the IV residual be e = Y − Z β. X is n × l. In the linear model 0 yi = zi β + ei E (ei | zi ) = 0 ¡ 2 ¢ suppose σ 2 = E ei | zi is known. The reduced form between the regressors zi and instruments xi takes the form zi = x0 Γ + ui i or Z = XΓ + u where zi is k × 1.

(b) Deﬁne the 2SLS estimator of β.. of the mother). (d) Re-estimate the model by eﬃcient GMM. Report the estimates and standard errors. We want to estimate a wage equation log(W age) = β 0 + β 1 Educ + β 2 Exper + β 3 Exper2 + β 4 South + β 5 Black + e where Educ = Eduation (Years) Exper = Experience (Years). a dummy indicating that the observation lives near a 4-year college. (e) Calculate and report the J statistic for overidentiﬁcation. and then calculate the GMM estimator from this weight matrix without further iteration. In this model. Is zi = (xi i for estimation of β? x2 ) a valid instrumental variable i where income (Y ) and wage (W ) are determined outside the market. are the parameters identiﬁed? 8. f atheduc (the education. The data ﬁle card. I suggest that you use the 2SLS estimates as the ﬁrst-step to get the weight matrix. (f) Discuss your ﬁndings. and South and Black are regional and racial dummy variables. Report estimates and standard errors. listed in card. of the father) and motheduc (the education. and the remaining variables as exogenous. using the instrument near4. in years. 134 . (a) Estimate the model by OLS. (c) Re-estimate by 2SLS (report estimates and standard errors) adding three additional instruments: near2 (a dummy indicating that the observation lives near a 2-year college). Report estimates and standard errors.dat is taken from David Card “Using Geographic Variation in College Proximity to Estimate the Return to Schooling” in Aspects of Labour Market Behavior (1995). using zi as an instrument for xi . Suppose that price and quantity are determined by the intersection of the linear demand and supply curves Demand : Supply : Q = a0 + a1 P + a2 Y + e1 Q = b0 + b1 P + b2 W + e2 ¡ ¢ (a) Show that E (xi ei ) = 0 and E x2 ei = 0. There are 2215 observations with 19 variables. (b) Now treat Education as endogenous. How does this diﬀer from OLS? (c) Find the eﬃcient GMM estimator of β based on the moment condition E (zi (yi − xi β)) = 0. in years.pdf. Estimate the model by 2SLS. Does this diﬀer from 2SLS and/or OLS? 7.

1. 135 . and multivariate (yt ∈ Rm is vector-valued). Deﬁnition 12. The following two theorems are essential to the analysis of stationary time series. Yt−k ) is independent of t for all k.. Yt−k ) = γ(k) is independent of t for all k.. Because of the sequential nature of time series..4 (loose).) is a random variable. so classical assumptions are not valid. We can separate time series into two categories: univariate (yt ∈ R is scalar). There proofs are rather diﬃcult.1. and Cov (Yt . γ(k) is called the autocovariance function. . The primary model for univariate time series is autoregressions (ARs).1 Stationarity and Ergodicity Deﬁnition 12. 12. The primary model for multivariate time series is vector autoregressions (VARs).1 {Yt } is covariance (weakly) stationary if E(Yt ) = µ is independent of t.. Yt−k ) is the autocorrelation function.3 ρ(k) = γ(k)/γ(0) = Corr(Yt .. then Xt is strictly stationary and ergodic.1. and T to denote the number of observations..1. however. Yt−1 .1. and use the subscript t to denote the individual observation. A stationary time series is ergodic if γ(k) → 0 as k → ∞. we expect that Yt and Yt−1 are not independent. .. we adopt new notation. . t = 1. Theorem 12. T .1 If Yt is strictly stationary and ergodic and Xt = f (Yt .Chapter 12 Univariate Time Series A time series yt is a process observed in sequence over time.2 {Yt } is strictly stationary if the joint distribution of (Yt . Deﬁnition 12.. To indicate the dependence on time. Deﬁnition 12.

T t=1 This allows us to consistently estimate parameters using time-series moments: The sample mean: T 1X µ= ˆ Yt T t=1 The sample autocovariance T 1X (Yt − µ) (Yt−k − µ) . ρ(k) →p ρ(k).Theorem 12.1. ˆ Proof.1. For Part (2). Thus an application of the Ergodic Theorem yields T 1X Yt Yt−k →p E(Yt Yt−k ). µ →p E(Yt ). the sequence Yt Yt−k is strictly stationary and ergodic. γ (k) →p γ(k). T 1X Xt →p E(Xt ). ˆ ˆ T t=1 γ (k) = ˆ The sample autocorrelation ρ(k) = ˆ γ (k) ˆ . ˆ 2. γ (0) ˆ Theorem 12.2 (Ergodic Theorem). and it has a ﬁnite mean by the assumption that EYt2 < ∞. then as T → ∞.1 above. then as T → ∞. ˆ 3.3 If Yt is strictly stationary and ergodic and EYt2 < ∞. ˆ Part (3) follows by the continuous mapping theorem: ρ(k) = γ (k)/ˆ (0) →p γ(k)/γ(0) = ρ(k). 1. If Xt is strictly stationary and ergodic and E |Xt | < ∞. T t=1 Thus γ (k) →p E(Yt Yt−k ) − µ2 − µ2 + µ2 = E(Yt Yt−k ) − µ2 = γ(k). note that γ (k) = ˆ T 1X (Yt − µ) (Yt−k − µ) ˆ ˆ T t=1 = T T T 1X 1X 1X Yt Yt−k − Yt µ − ˆ Yt−k µ + µ2 . ˆ ˆ T t=1 T t=1 T t=1 By Theorem 12. Part (1) is a direct consequence of the Ergodic theorem. ˆ ˆ γ ¥ 136 .1.

the series {. this series converges if the sequence ρk et−k gets small as k → ∞. it is even more important in the time-series context. A linear AR model (the most common type used in practice) speciﬁes linearity: E (Yt | It−1 ) = α + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k .. we ﬁnd Yt = et + ρet−1 + ρ2 et−2 + . In fact.2.} is the past history of the series. Most asset pricing models imply that asset returns should be the sum of a constant plus a MDS. . .1 et is a martingale diﬀerence sequence (MDS) if E (et | It−1 ) = 0... A mean-zero AR(1) is Assume that et is iid. k=0 Loosely speaking. E(et ) = 0 and Ee2 = σ 2 < ∞. Regression errors are naturally a MDS.} are jointly random..12. as it is diﬃcult to derive distribution theories without this property. then we have the autoregressive model Yt = α + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et E (et | It−1 ) = 0. Yt−2 . 137 ... YT . The MDS property for the regression error plays the same role in a time-series regression as does the conditional mean-zero property for the regression error in a cross-section regression. This occurs when |ρ| < 1.2 Autoregressions In time-series. We consider the conditional expectation E (Yt | It−1 ) where It−1 = {Yt−1 . Thus for k > 0. Y1 ... some versions of the life-cycle hypothesis imply that either changes in consumption.. A useful property of a MDS is that et is uncorrelated with any function of the lagged information It−1 . Letting et = Yt − E (Yt | It−1 ) ..3 Stationarity of AR(1) Process Yt = ρYt−1 + et .. For example. ∞ X = ρk et−k . . Yt−k ) . should be a MDS. The last property deﬁnes a special time-series process. Deﬁnition 12... . An autoregressive (AR) model speciﬁes that only a ﬁnite number of past lags matter: E (Yt | It−1 ) = E (Yt | Yt−1 . 12. t By back-substitution... Some time-series processes may be a MDS as a consequence of optimizing behavior. Y2 . E(Yt−k et ) = 0. or consumption growth rates.

Yt − ρ1 LYt − ρ2 L2 Yt − · · · − ρk Lk Yt = et .3. We can compute the moments of Yt using the inﬁnite sum: EYt = ∞ X k=0 ρk E (et−k ) = 0 σ2 .1.3. Note that an equivalent way to say this is that an AR(1) is stationary iﬀ the root of the autoregressive polynomial is larger than one (in absolute value). we see that L2 Yt = LYt−1 = Yt−2 .1 The lag operator L satisﬁes LYt = Yt−1 . Deﬁnition 12. We say that the root of the polynomial is 1/ρ. We call ρ(L) the autoregressive polynomial of Yt . The AR(1) model can be written in the format Yt − ρYt−1 + et or (1 − ρL) Yt−1 = et .4 Lag Operator An algebraic construct which is useful for the analysis of autoregressive models is the lag operator. 138 . From Theorem 12. and solving for EYt = EYt−1 we ﬁnd EYt = α/(1 − ρ). Lk Yt = Yt−k . Deﬁning L2 = LL. In general. We call ρ(L) the autoregressive polynomial of Yt .4. The operator ρ(L) = (1 − ρL) is a polynomial in the operator L. except that the mean of Yt can be computed from the relationship EYt = α + ρEYt−1 . or ρ(L)Yt = et where ρ(L) = 1 − ρ1 L − ρ2 L2 − · · · − ρk Lk . The AR(k) model is Using the lag operator. the above results are unchanged. since ρ(z) = 0 when z = 1/ρ. an AR(1) is stationary iﬀ |ρ| < 1. ∞ X k=0 ρ2k V ar (et−k ) = 12. 1 − ρ2 V ar(Yt ) = If the equation for Yt has an intercept.5 Stationarity of AR(k) Yt = ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et . 12.1 If |ρ| < 1 then Yt is strictly stationary and ergodic.Theorem 12.

1. and is of great interest in applied time series. The vector xt is strictly stationary and ergodic.6 Let Estimation xt = β = ¡ 1 Yt−1 Yt−2 · · · α ρ1 ρ2 · · · yt = x0 β + et .5. The Fundamental Theorem of Algebra says that any polynomial can be factored as ¢¡ ¢ ¡ ¢ ¡ ρ(z) = 1 − λ−1 z 1 − λ−1 z · · · 1 − λ−1 z 1 2 k 12. One way of stating this is that “All roots lie outside the unit circle. We know that an AR(1) is stationary iﬀ the absolute value of the root of its autoregressive polynomial is larger than one. t Yt−k ¢0 ρk .1 If the AR(k) process Yt is strictly stationary and ergodic and EYt2 < ∞. it is also strictly stationary and ergodic. Thus t by the Ergodic Theorem.1. Let |λ| denote the modulus of a complex number λ. Thus T T 1X 1X xt et = ut →p E (ut ) = 0. . the requirement is that all roots are larger than one.1. so is xt x0 . By Theorem 12. Theorem 12. and by Theorem 12. then ˆ β →p β as T → ∞.6. t t T t=1 ¥ Combined with (12. it is helpful to deﬁne the process ut = xt et .1 The AR(k) is strictly stationary and ergodic if and only if |λj | > 1 for all j. and hence Yt . which satisfy ρ(λj ) = 0. ¢0 Then the model can be written as The OLS estimator is ¡ ˆ To study β.” If one of the roots equals 1. “has a unit root”.. λk are the complex roots of ρ(z). β = X 0X (12.. T ¢ ¡ 1X xt x0 →p E xt x0 = Q.. Note that ut is a MDS. T t=1 T t=1 ¢−1 0 ¡ ˆ X Y. For an AR(k).where the λ1 . Proof. t T t=1 T t=1 139 .1) and the continuous mapping theorem.1.1) Theorem 12. we say that ρ(L). This is a special case of non-stationarity. we see that Ã !−1 Ã ! T T 1X 1X ˆ β=β+ xt x0 xt et →p Q−1 0 = 0. since E (ut | It−1 ) = E (xt et | It−1 ) = xt E (et | It−1 ) = 0.

Divide the sample into T /m blocks of length m. 140 . Simulate iid draws e∗ from the empirical distribution of the residuals {ˆ1 .7.8 Bootstrap for Autoregressions In the non-parametric bootstrap. 12. Ω) . ˆ 2. we constructed the bootstrap sample by randomly resampling from the data values {yt . Clearly. xt }. Method 2: Block Resampling 1. there are two popular methods to implement bootstrap resampling for time-series data. the asymptotic covariance matrix is estimated just as in the cross-section case.12. This creates an iid bootstrap sample. This is identical in form to the asymptotic distribution of OLS in cross-section regression. If ut is a strictly stationary and ergodic MDS and E(ut u0 ) = Ω < ∞.. T 1 X √ ut →d N (0. which may be diﬀerent than the i properties of the actual ei . eT }. ´ √ ³ ¡ ¢ ˆ T β − β →d N 0. T t=1 Since xt et is a MDS. Y−k+2 . as this imposes inappropriate independence. then as T → ∞. Y0 ).1 MDS CLT. Estimate β and residuals et . t t Theorem 12.. T t=1 where Ω = E(xt x0 e2 ).. t This construction imposes homoskedasticity on the errors e∗ . In particular. Create the bootstrap series Yt∗ by the recursive formula ˆ ˆ ∗ ˆ ∗ ˆ ∗ Yt∗ = α + ρ1 Yt−1 + ρ2 Yt−2 + · · · + ρk Yt−k + e∗ .2 If the AR(k) process Yt is strictly stationary and ergodic and EYt4 < ∞.7. this cannot work in a time-series application. Q−1 ΩQ−1 . i 4. Brieﬂy.. t then as T → ∞. Fix an initial condition (Y−k+1 .7. we can apply Theorem 12. e ˆ 3. . The implication is that asymptotic inference is the same. ˆ 1. Method 1: Model-Based (Parametric) Bootstrap.7 Asymptotic Distribution Theorem 12. It also presumes that the AR(k) structure is the truth... . Ω) .1 to see that T 1 X √ xt et →d N (0.

Seasonal Eﬀects There are three popular methods to deal with seasonal data. . ρk ). The results may be sensitive to the block length. • You can estimate (12. ﬁrst estimate (12. 6. • Use “seasonally adjusted” data.3) replacing St with St . heteroskedasticity.9 Trend Stationarity Yt = µ0 + µ1 t + St St = ρ1 St−1 + ρ2 St−2 + · · · + ρk St−l + et . • Include dummy variables for each season. and for modelmisspeciﬁcation. 3. This procedure is sometimes called Detrending. If s is the number of seasons (typically s = 4 or s = 12). This presumes that “seasonality” does not change over the sample.4) There are two essentially equivalent ways to estimate the autoregressive parameters (ρ1 .2)-(12. The reason why these two procedures are (essentially) the same is the Frisch-Waugh-Lovell theorem. ∆s Yt = Yt − Yt−s . Paste the blocks together to create the bootstrap time-series Yt∗ . The series ∆s Yt is clearly free of seasonality. May not work well in small samples.. Resample complete blocks. however.2) (12. and the way that the data are partitioned into blocks. 5. and then perform regression (12. That is. also alters the time-series correlations of the data. 12. The seasonal adjustment. Thus the seasonally adjusted data is a “ﬁltered” series. draw T /m blocks.3) or Yt = α0 + α1 t + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et . This is a ﬂexible approach which can extract a wide range of seasonal factors.. But the long-run trend is also eliminated.2).2.4) by OLS. 141 .3) sequentially by OLS.. The seasonal factor is typically estimated by a two-sided weighted average of the data for that season in neighboring years. • You can estimate (12. or the season-to-season change. (12. This allows for arbitrary stationary serial correlation. For each simulated sample. 4. get the ˆ ˆ residual St . and perhaps this was of relevance. • First apply a seasonal diﬀerencing operator. (12.

you need more initial conditions. if the null hypothesis is that Yt is an AR(k).. We then multiply this by θ and subtract from (12. and under H1 it is an AR(2). In general. AR(k) on this (uniﬁed) sample. this is the same as saying that under the alternative Yt is an AR(k+m). 142 . (12. AR(2). One approach to model selection is to choose k based on a Wald tests.6) 12...g.5) and (12. Thus under H0 . An appropriate test is the Wald test of this restriction. Yt is an AR(1).5) and lag the equation once: Yt−1 = α + ρYt−2 + ut−1 . Another is to minimize the AIC or BIC information criterion. To combine (12.5) We are interested in the question if the error ut is serially correlated. T where σ 2 (k) is the estimated residual variance from an AR(k) ˆ One ambiguity in deﬁning the AIC criterion is that the sample available for estimation changes as k changes. to ﬁnd Yt − θYt−1 = α − θα + ρYt−1 − θρYt−1 + ut − θut−1 . let the null hypothesis be an AR(1): Yt = α + ρYt−1 + ut . . or Yt = α(1 − θ) + (ρ + θ) Yt−1 − θρYt−2 + et = AR(2). (If you increase k. We model this as an AR(1): ut = θut−1 + et with et a MDS. Yt−k−m are jointly zero.) This can induce strange behavior in the AIC. An appropriate test of H0 against H1 is therefore a Wald test that the coeﬃcient on Yt−2 is zero.11 Model Selection What is the appropriate choice of k in practice? This is a problem of model selection.5). (A simple exclusion test). and then reserve the ﬁrst k as initial conditions.6). we take (12. AIC(k) = log σ 2 (k) + ˆ 2k . and this is equivalent to the restriction that the coeﬃcients on Yt−k−1 ..10 Testing for Omitted Serial Correlation For simplicity. . (12. and then estimate the models AR(1). and the alternative is that the error is an AR(m). We want to test H0 against H1 .12... The best remedy is to ﬁx a upper value k. The hypothesis of no omitted serial correlation is H0 : θ = 0 H1 : θ 6= 0. e. H0 may be expressed as the restriction that the coeﬃcient on Yt−2 is zero.

under H0 . the model for Yt is ∆Yt = µ + α1 ∆Yt−1 + · · · + αk−1 ∆Yt−(k−1) + et . the hypothesis of a unit root in Yt can be stated as H0 : α0 = 0. A helpful way to write the equation is the so-called Dickey-Fuller reparameterization: ∆Yt = µ + α0 Yt−1 + α1 ∆Yt−1 + · · · + αk−1 ∆Yt−(k−1) + et . observe that the lag polynomial for the Yt computed from (12. As we discussed before. then Yt is “integrated of order d”. Thus a time series with unit root is I(1). Thus if Yt has a (single) unit root. which is an AR(k-1) in the ﬁrst-diﬀerence ∆Yt . since ρ(1) = −α0 . or ρ1 + ρ2 + · · · + ρk = 1. (12. Since α0 is the parameter of a linear regression. Because of this property. We do not have the time to develop this theory in detail. It would seem natural to assess the signiﬁcance of the ADF statistic using the normal table. The ergodic theorem and MDS CLT do not apply. or I(d). Under H0 . then ∆Yt is a stationary AR process. To see this. and test statistics are asymptotically non-normal. The DF parameterization is convenient because the parameter α0 summarizes the information about the unit root. this is the most popular unit root test. In this case. However. as the models are equivalent. and is called the Augmented Dickey-Fuller (ADF) test for a unit root. Yt is non-stationary. 143 .12. An alternative asymptotic framework has been developed to deal with non-stationary data.7). So the natural alternative is H1 : α0 < 0.12 Autoregressive Unit Roots The AR(k) model is ρ(L)Yt = µ + et ρ(L) = 1 − ρ1 L − · · · − ρk Lk . the natural test statistic is the t-statistic for H0 from OLS estimation of (12. Hence. we say that if Yt is non-stationary but ∆d Yt is stationary. but simply assert the main results. so conventional normal asymptotics are invalid.7) These models are equivalent linear transformations of one another. Yt is non-stationary. Indeed. Yt has a unit root when ρ(1) = 0. Note that the model is stationary if α0 < 0.7) is (1 − L) − α0 L − α1 (L − L2 ) − · · · − αk−1 (Lk−1 − Lk ) But this must equal ρ(L). Thus ρ(1) = (1 − 1) − α0 − (1 − 1) − · · · − (1 − 1) = −α0 .

If the test rejects H0 . Stock Prices). In this context. then the series itself is nonstationary. Since the alternative hypothesis is one-sided. If the test does not reject H0 . (12.Theorem 12. this means that it is computed as the t-ratio for α0 from OLS estimation of (12. The ﬁrst result states that α0 converges to its true value (of zero) at rate T. but does not depend on the parameters α. this means that the evidence points to Yt being stationary. and have negative means. however. but diﬀerent critical values are required. s(ˆ 0 ) α The limit distributions DFα and DFt are non-normal.8). where c is the critical value from the ADF table. a common conclusion is that the data suggests that Yt is non-stationary. This distribution has been extensively α tabulated. They are skewed to the left. and may be used for testing the hypothesis H0 . As T → ∞. and a diﬀerent table should be consulted. 144 . Note: The standard error s(ˆ 0 ) is the conventional (“homoskedastic”) standard error.12. All we can say is that there is insuﬃcient evidence to conclude whether the data are stationary or not. Most texts include as well the critical values for the extreme polar case where the intercept has been omitted from the model. Another popular setting includes as well a linear time trend.g. If the series has a linear trend (e. the ADF test rejects H0 in favor of H1 when ADF < c. This is called a “super-consistent” rate of convergence.8) This is natural when the alternative hypothesis is that the series is stationary about a linear time trend. but it may be stationary around the linear time trend. These are included for completeness (from a pedagogical perspective) but have no relevance for empirical practice where intercepts are always included. as the AR model cannot conceivably describe this data.1 (Dickey-Fuller Theorem). This model is ∆Yt = µ1 + µ2 t + α0 Yt−1 + α1 ∆Yt−1 + · · · + αk−1 ∆Yt−(k−1) + et . But the theorem does not require an assumption of homoskedasticity. The natural solution is to include a time trend in the ﬁtted OLS equation. it is a silly waste of time to ﬁt an AR model to the level of the series without a time trend. We have described the test for the setting of with an intercept. T α0 →d (1 − α1 − α2 − · · · − αk−1 ) DFα ˆ ADF = α0 ˆ → DFt . Assume α0 = 0. GDP. rather than the ˆ 1/2 . This is not really a correct conclusion. The ADF test has a diﬀerent distribution when the time trend has been included. When conducting the ADF test. If a time trend is included. conventional rate of T The second result states that the t-statistic for α0 converges to a limit distribution which is ˆ non-normal. Thus the Dickey-Fuller test is robust to heteroskedasticity. the test procedure is the same.

deﬁning the mk + 1 vector ⎜ Yt−1 ⎜ ⎜ xt = ⎜ Yt−2 ⎜ . Yt−k ) .. A linear VAR speciﬁes that this conditional mean is linear in the arguments: E (Yt | Yt−1 .1 Vector Autoregressions (VARs) A VAR model speciﬁes that the conditional mean is a function of only a ﬁnite number of lags: E (Yt | It−1 ) = E (Yt | Yt−1 .. Let It−1 = (Yt−1 . .. 13. Yt−2 .) be all lagged information at time t. ⎝ ... Observe that A0 is m × 1. and the m × (mk + 1) matrix A0 A1 A2 · · · 145 . this conditional expectation is also a vector. Note that since Yt is a vector.. Yt−k A= ¡ ⎛ 1 ⎞ ⎟ ⎟ ⎟ ⎟ ⎟ ⎠ Ak ¢ .and each of A1 through Ak are m × m matrices.Chapter 13 Multivariate Time Series A multivariate time series Yt is a vector process m × 1. .. Yt−k ) = A0 + A1 Yt−1 + A2 Yt−2 + · · · Ak Yt−k . . The typical goal is to ﬁnd the conditional expectation E (Yt | It−1 ) . we have the VAR model Yt = A0 + A1 Yt−1 + A2 Yt−2 + · · · Ak Yt−k + et E (et | It−1 ) = 0.. Alternatively. . Deﬁning the m × 1 regression error et = Yt − E (Yt | It−1 ) .

3 Restricted VARs The unrestricted VAR is a system of m equations. some regressors may be excluded from some of the equations. ¡ Y1 Y2 · · · where Y = Ym 0 the T × m matrix of the stacked yt .then Yt = Axt + et . The VAR model is a system of m equations. Note that a0 = Yj0 X(X 0 X)−1 .. The GMM framework gives a convenient method to impose such restrictions on estimation. or across equations. This (system) estimator is known as the SUR (Seemingly Unrelated Regressions) estimator. ⎟ ⎝ . ˆj ˆ And if we stack these to create the estimate A.2 ⎟ X(X 0 X)−1 A ⎜ . each with the same set of regressors. either as a regression. 13. The GMM estimator corresponding to these moment conditions is equation-by-equation OLS aj = (X 0 X)−1 X 0 Yj .. 146 . ⎠ 0 Ym+1 = Y 0 X(X 0 X)−1 . . A restricted VAR imposes restrictions on the system. Consider the moment conditions j = 1. Then the VAR system can be written as the equations Yjt = a0 xt + ejt ..2 Estimation E (xt ejt ) = 0. ˆ An alternative way to compute this is as follows. j Unrestricted VARs were introduced to econometrics by Sims (1980). For example. Restrictions may be imposed on individual equations. or as a linear projection. we ﬁnd ⎞ ⎛ Y10 ⎜ Y0 ⎟ ˆ = ⎜ . m. One way to write this is to let a0 be the jth row j of A. These are implied by the VAR model. and was originally derived by Zellner (1962) ¢ 13.

t or yt = θyt−1 + x0 β + x0 γ + ut . This can be done by a Wald test. xt−1 ) to the regression. h¡ 1 Yt−1 · · · 0 Yt−k Zt−1 · · · 0 Zt−k ¢0 i . and Zt be the other variables. Let yt = Yjt . t t−1 (13. we are only interested in a single equation out of a VAR system. and is typically rejected empirically.5 Testing for Omitted Serial Correlation Consider the problem of testing for omitted serial correlation in equation (13. If valid. We see that an appropriate. the model (13.2) is uncommon in recent applications. under the restriction γ = −βθ. 1).1). The DW test is appropriate only when regression yt = x0 β + et is not dynamic (has no lagged values on the RHS). 147 . Then yt = x0 β + et t et = θet−1 + ut E (ut | It−1 ) = 0. and simple way to test for omitted serial correlation is to test the signiﬁcance of extra lagged values of the dependent variable and regressors.2) is a special case of (13. may be tested if desired. (A simple version of this estimator is called Cochrane-Orcutt. This takes the form 0 and xt consists of lagged values of Yjt and the other Ylt s. which is called a common factor restriction.13. and is still routinely reported by conventional regression packages. Otherwise it is invalid.3) which is a valid regression model. it is convenient to re-deﬁne the variables. This restriction. t and et is iid N (0.4 Single Equation from a VAR Yjt = a0 xt + et . to get t ¡ ¢ ¡ ¢ yt − θyt−1 = x0 β + et − θ x0 β + et−1 t t−1 = x0 β − θxt−1 β + et − θet−1 . Another interesting fact is that (13. (13. Then the single equation takes the form (13. 13. So testing H0 versus H1 is equivalent to testing for the signiﬁcance of adding (yt−1 . Then the null and alternative are H0 : θ = 0 H1 : θ 6= 0. and subtract oﬀ the equation once lagged multiplied by θ. which once was very popular.) Since the common factor restriction appears arbitrary. t and xt = This is just a conventional regression. direct estimation of (13. with time series data. In this case.1) yt = x0 β + et . general. Suppose that et is an AR(1). Let et = ejt and β = aj .2) may be estimated by iterated GLS. j Often. You may have heard of the Durbin-Watson test for omitted serial correlation.3).2) Take the equation yt = x0 β + et .

t−1 ) . The hypothesis can be tested by using the appropriate multivariate Wald test. such as a futures price.. however. . or an information criterion approach. then we say that Zt Granger-causes Yt . This deﬁnition of causality was developed by Granger (1969) and Sims (1972). then Zt may help to forecast Yt even though it does not “cause” Yt . then we deduce that our time-series model of E (Yt | It−1 ) does not require the use of Zt . Note. that Zt may still be useful to explain other features of Yt . The reason why we call this “Granger Causality” rather than “causality” is because this is not a physical or structure deﬁnition of causality.7 Granger Causality Partition the data vector into (Yt . If it is found that Zt does not Granger-cause Yt .. for example. We say that Zt does not Granger-cause Yt if E (Yt | I1. and the information set I2t is generated by both Yt and Zt .13. That is. This may be tested using an exclusion (Wald) test. the Wald statistic). you may either use a testingbased approach (using. . 148 . such as the conditional variance.. The formula for the AIC and BIC are ³ ´ p ˆ AIC(k) = log det Ω(k) + 2 T ³ ´ p log(T ) ˆ BIC(k) = log det Ω(k) + T T X 1 ˆ et (k)ˆt (k)0 ˆ e Ω(k) = T t=1 p = m(km + 1) where p is the number of parameters in the model. Zt ). Yt−1 .) The information set I1t is generated only by the history of Yt . conditional on information in lagged Yt .6 Selection of Lag Length in an VAR If you want a data-dependent rule to pick the lag length k in a VAR. . 13. Zt does not Granger-cause Yt if and only if H0 : γ 1 = γ 2 = · · · = γ k = 0. If this condition does not hold. lagged Zt does not help to forecast Yt . Yt and/or Zt can be vectors. Yt−2 ..) I2t = (Yt . Zt−2 . The latter has more information. Yt−1 . If Zt is some sort of forecast of the future. Zt−1 . the equation for Yt is 0 0 Yt = α + ρ1 Yt−1 + · · · + ρk Yt−k + Zt−1 γ 1 + · · · + Zt−k γ k + et . and et (k) is the OLS residual vector from the ˆ model with k lags. That is. In a linear VAR. The log determinant is the criterion from the multivariate normal likelihood.t−1 ) = E (Yt | I2. Zt . This idea can be applied to blocks of variables. Deﬁne the two information sets I1t = (Yt . In this equation. Yt−2 .

149 . The r vectors in β are called the cointegrating vectors. We are often interested in testing the hypothesis of no cointegration: H0 : r = 0 H1 : r > 0. This is not. it may be necessary to include a time trend in the estimated cointegrating regression. Often. The asymptotic distribution was worked out by Phillips and Ouliaris (1990). Their justiﬁcation was Stock’s result that β is superˆ ˆ consistent under H1 . β = (1 − 1)0 .8 Cointegration The idea of cointegration is due to Granger (1981). Yt is I(1) and cointegrated. in general. Under H0 . If Y = (log(Consumption) log(Income))0 . so the ADF critical values are not appropriate. β may not be known. of rank r. so zt = β 0 Yt is known. Furthermore ˆ this estimation is super-consistent: T (β 2 − β 2 ) →d Limit. then it turns out that β can be consistently estimated by an OLS regression of one component of Yt on the others. however. Engle and Granger (1987) suggested using an ADF test on the estimated ˆ0 ˆ residual zt = β Yt . such that zt = β 0 Yt is I(0). the asymptotic distribution of the test is aﬀected by the presence of the time trend. Suppose that β is known. if Yt is a pair of interest rates. When the data have time trends. and was articulated in detail by Engle and Granger (1987). For example. Thus H0 can be tested using a univariate ADF test on zt . In some cases.9 Cointegrated VARs A(L)Yt = et A(L) = I − A1 L − A2 L2 − · · · − Ak Lk We can write a VAR as or alternatively as ∆Yt = ΠYt−1 + D(L)∆Yt−1 + et where Π = −A(1) = −I + A1 + A2 + · · · + Ak . In other cases.1 The m × 1 series Yt is cointegrated if Yt is I(1) yet there exists β. Thus Yt = ˆ (Y1t . then β = (1 − 1)0 speciﬁes that log(Consumption/Income) is stationary. from OLS of Y1t on Y2t . but it is useful in the construction of alternative estimators and tests. If the series Yt is not cointegrated.13. then Yt is I(0). When β is unknown. Y2t ) and β = (β 1 β 2 ) and normalize β 1 = 1. Hansen (1992). The asymptotic distribution was worked out in B. If Yt is cointegrated with a single cointegrating vector (r = 1). If r = m. m × r.8. Then β 2 = (Y20 Y2 )−1 Y2 Y1 →p β 2 . Then under H0 zt is I(1). as ﬁrst shown by Stock (1987). then r = 0. β is not consistent. Whether or not the time trend is included. For 0 < r < m. yet under H1 zt is I(0). 13. Deﬁnition 13. then β = (1 − 1)0 speciﬁes that the spread (the diﬀerence in returns) is stationary. it may be believed that β is known a priori. a good method to estimate β.

Yt is cointegrated with m × r β if and only if rank(Π) = r and Π = αβ 0 where α is m × r. Equivalently. they are typically called the “Johansen Max and Trace” tests. this is the MLE of the restricted parameters under the assumption that et is iid N (0. These tests are constructed as likelihood ratio (LR) tests.Theorem 13. this can be estimated by OLS of ∆Yt on zt−1 and the lags of ∆Yt . Thus cointegration imposes a restriction upon the parameters of a VAR. The restricted model can be written as ∆Yt = αβ 0 Yt−1 + D(L)∆Yt−1 + et ∆Yt = αzt−1 + D(L)∆Yt−1 + et .1 (Granger Representation Theorem). and are similar to the Dickey-Fuller distributions. and diﬀerent authors have adopted diﬀerent identiﬁcation schemes. As they were discovered by Johansen (1988. In the context of a cointegrated VAR estimated by reduced rank regression. 150 . 1991. this does not work. If β is unknown. When r > 1. One diﬃculty is that β is not identiﬁed without normalization. Ω). then estimation is done by “reduced rank regression”. 1995). When r = 1. Their asymptotic distributions are non-standard. If β is known. it is simple to test for cointegration by testing the rank of Π. which is least-squares subject to the stated restriction. we typically just normalize one element to equal unity. rank(α) = r.9.

as this is the full conditional distribution. allowing the construction of the likelihood function. 1. . 2. They still constitute the majority of LDV applications. The linear probability model speciﬁes that P (Yi = 1 | xi ) = x0 β.. the linear probability model does not impose the restriction that 0 ≤ P (Yi | xi ) ≤ 1. A parametric model is constructed. However.Chapter 14 Limited Dependent Variables A “limited dependent variable” Y is one which takes a “limited” set of values.} • Censored: Y = {x : x ≥ 0} The traditional approach to the estimation of limited dependent variable (LDV) models is parametric maximum likelihood. typically assumed to be symmetric about zero.1 Binary Choice The dependent variable Yi = {0. due to time constraints. A major practical issue is construction of the likelihood function. the goal is to describe P (Yi = 1 | xi ) . A more modern approach is semi-parametric. i As P (Yi = 1 | xi ) = E (Yi | xi ) .. If... so that F (z) = 1 − F (−z). The two standard choices for F are 151 . you were to write a thesis involving LDV estimation. The most common cases are • Binary: Y = {0. you would be advised to consider employing a semi-parametric estimation approach. We will discuss only the ﬁrst (parametric) approach. eliminating the dependence on a parametric distributional assumption. however. 1} • Multinomial: Y = {0. k} • Integer: Y = {0. This represents a Yes/No outcome. For the parametric approach. . estimation is by MLE. The standard alternative is to use a function of the form ¡ ¢ P (Yi = 1 | xi ) = F x0 β i where F (·) is a known CDF. this yields the regression: Yi = x0 β + ei which can be estimated by i OLS. 1. Even so estimation of a linear probability model is a useful starting point for subsequent analysis. 14. Given some regressors xi .. 1}. 2.

152 . To construct the likelihood. y = 0. Recall that if Y is Bernoulli. then we can write the density of Y as f (y) = py (1 − p)1−y . −1 . i | Hence the log-likelihood function is ln (β) = = = = n X i=1 n X i=1 n X i=1 log f (yi | xi ) ¡ ¡ ¢y ¡ ¢ ¢ log F x0 β i (1 − F x0 β )1−yi i i yi =1 X £ ¡ ¢ ¡ ¢¤ yi log F x0 β + (1 − yi ) log(1 − F x0 β ) i i ¡ ¢ X ¡ ¢ log F x0 β + log(1 − F x0 β ). i if Yi∗ > 0 . we call this the logit model. Yi is conditionally Bernoulli with P (Yi = 1 | xi ) = pi = F (x0 β) . and if F is normal. i i yi =0 ˆ The MLE β is the value of β which maximizes ln (β). This model is identical to the latent variable model Yi∗ = x0 β + ei i ei ∼ F (·) ½ 1 Yi = 0 For then P (Yi = 1 | xi ) = P (Yi∗ > 0 | xi ) ¡ ¢ = P x0 β + ei > 0 | xi i ¢ ¡ = P ei > −x0 β | xi i ¢ ¡ = 1 − F −x0 β i ¡ ¢ = F x0 β . If F is logistic. Details of such calculations are left to more advanced courses. such that P (Y = 1) = p and P (Y = 0) = 1 − p. we need the conditional distribution of an individual observation. Thus i the conditional density is f (yi xi ) = pyi (1 − pi )1−yi i ¡ 0 ¢yi ¡ ¢ = F xi β (1 − F x0 β )1−yi .• Logistic: F (u) = (1 + e−u ) • Normal: F (u) = Φ(u). Standard errors and test statistics are computed by asymptotic approximations. we call this the probit model. In the Binary choice model. 1. otherwise Estimation is by maximum likelihood.

σ 2 ) with the observed variable yi generated by the censoring equation (14. This model (now called the Tobit) speciﬁes that the latent (or ideal) value of consumption may be negative (the household 153 . or it may be a by-product of economic constraints.” Also observe that the model implies that V ar (Yi | xi ) = λi = exp(x0 β). In surveys..2 Count Data exp (−λi ) λk i . . The conditional density is the Poisson with parameter λi . incomes above a threshold are typically reported at the threshold. Tobin observed that for many households. k! = exp(x0 β). a typical approach is to employ Poisson regression. An example of a data collection censoring is top-coding of income.. The ﬁrst censored regression model was developed by Tobin (1958) to explain consumption of durable goods. i i i=1 ˆ The MLE is the value β which maximizes ln (β).1) yi = ∗ <0 . The functional form for λi has been picked to ensure that λi > 0.. but we observe only ½ ∗ ∗ yi if yi ≥ 0 (14. 1. i If Y = {0. 2. 14. this motivates the label Poisson “regression. He proposed the latent variable model ∗ yi = x0 β + ei i ei ∼ iid N (0. The log-likelihood function is ln (β) = n X i=1 log f (yi | xi ) = n X¡ ¢ − exp(x0 β) + yi x0 β − log(yi !) . . 2. This model speciﬁes that P (Yi = k | xi ) = λi k = 0.14. Censored models are typically applied when the data set has a meaningful proportion (say 5% or higher) of data at the boundary of the sample support. Thus the model is that there is some latent process yi with unbounded support. The censoring process may be explicit in data collection. 1. A generalization is the negative binomial. any known value can substitute. i so the model imposes the restriction that the conditional mean and variance of Yi are the same..}.3 Censored Data The idea of “censoring” is that some data above or below a threshold are mis-reported at the ∗ threshold.) The observed data yi therefore come from a mixed continuous/discrete distribution. 0 if yi (This is written for the case of the threshold being zero.1). Since E (Yi | xi ) = λi = exp(x0 β) i is the conditional mean. This may be considered restrictive. the consumption level (purchases) in a particular period was zero.

log Φ − log σ φ = σ σ y =0 y >0 X i i log f (yi | xi ) ˆ The MLE is the value β which maximizes ln (β). not just on the volunteers. For example. and the latter is of interest. and they wish to extrapolate the eﬀects of the experiment on a general population. To construct the likelihood. that the parameter of β is deﬁned by an alternative statistical structure. This occurs when the observed data is systematically diﬀerent from the population of interest. σ The conditional distribution function above zero is Gaussian: ¶ µ Z y z − x0 β −1 i dz. you should worry that the people who volunteer may be systematically diﬀerent from the general population. P (yi = y | xi ) = σ φ σ 0 Therefore.] Consistent estimation will be achieved by the MLE. The naive approach to estimate β is to regress yi on xi . if you ask for volunteers for an experiment. 14.would prefer to sell than buy). where the goal is to assess the eﬀect of “training” on the general population. The Tobit framework postulates that this is not inherently interesting.4 Sample Selection The problem of sample selection arises when the sample is a non-random selection of potential observations. Hence the log-likelihood is a mixture of the probit and the normal: ln (β) = n X i=1 ¶¸ µ 0 ¶ X ∙ µ xi β yi − x0 β −1 i + . All that is reported is that the household purchased zero units of the good. not E (Yi∗ | xi ) = x0 β. 154 . σ φ σ σ where 1 (·) is the indicator function. the density function can be written as y > 0. This has great relevance for the evaluation of anti-poverty and job-training programs. ¶¸ µ 0 ¶1(y=0) ∙ µ z − x0 β 1(y>0) xi β −1 i f (y | xi ) = Φ − . Thus OLS will be biased i for the parameter of interest β. This does not work because regression estimates E (Yi | xi ) . observe that the probability of being censored is ∗ P (yi = 0 | xi ) = P (yi < 0 | xi ) ¢ ¡ 0 = P xi β + ei < 0 | xi ¶ µ x0 β ei i <− | xi = P σ σ µ 0 ¶ xβ = Φ − i . [Note: it is still possible to estimate E (Yi | xi ) by LS techniques.

E (e0i | e0i > −x) = λ(x) = Φ(x) and the function λ(x) is called the inverse Mills ratio. i • The OLS standard errors will be incorrect. It is unknown. The “Heckit” estimator is thus calculated as follows • Estimate γ from a Probit. zi . alternatively. which can be observed only if a person is employed. but also can be consistently estimated by a Probit model for selection. Heckman (1979) observed that we could consistently estimate β and ρ from this equation. Thus E (ui | Ti = 1. 1). The equation for Ti is an equation specifying the probability that the person is employed. Or. Zi ¡ 0 ¢ = ρλ zi γ . The model is often completed by specifying that the errors are jointly normal ¶ µ µ ¶¶ µ 1 ρ e0i ∼ N 0. They can be corrected using a more complicated formula. However. as this is a two-step estimator. ˆ ³ ´ ˆ ˆ ˆ • Estimate β. which is non-zero. Zi ) = 0. The dependent variable yi is observed if (and only if) Ti = 1. Under the normality assumption.2) is a valid regression equation for the observations for which Ti = 1. ρ from OLS of yi on xi and λ(z 0 γ ). The naive estimator of β is OLS regression of yi on xi for those observations for which yi is available. Ti } for all observations. For example. where vi is independent of e0i ∼ N (0. . where Hence ¡ 0 ¢ e1i = ρλ zi γ + ui . e1i = ρe0i + vi . Zi ) = E e1i | {e0i > −zi γ}. by viewing the Probit/OLS estimation equations as a large joint GMM problem. Zi ¢ ¡ ¢ ¡ 0 0 = ρE e0i | {e0i > −zi γ}. yi could be a wage. 155 . if γ were known. ¡ 0 ¢ yi = x0 β + ρλ zi γ + ui i (14. The problem is that this is equivalent to conditioning on the event {Ti = 1}. Zi + E vi | {e0i > −zi γ}. A useful fact about the standard normal distribution is that φ(x) . e1i ρ σ2 It is presumed that we observe {xi . The binary dependent variable is Ti . ¡ ¢ 0 E (e1i | Ti = 1. Else it is unobserved.A simple sample selection model can be written as the latent model yi = x0 β + e1i i ¡ 0 ¢ Ti = 1 zi γ + e0i > 0 where 1 (·) is the indicator function. using regressors zi .

If 0ˆ this is valid. This can happen if the Probit equation does not “explain” much about the selection choice. so the second step OLS estimator will not be able to precisely estimate β. Some modern econometric research is exploring how to relax the normality assumption. then λ (zi γ ) can be highly collinear with xi . Based this observation. 0ˆ The estimator can also work quite poorly if λ (zi γ ) does not have much in-sample variation. and hence improve the second stage estimator’s precision. and the estimator can be quite sensitive to this assumption. Another 0ˆ potential problem is that if zi = xi . the estimator is built on the assumption of normality. it will ensure that λ (zi γ ) is not collinear with xi . it is typically recommended to ﬁnd a valid exclusion restriction: a variable should be in zi which is not in xi .The Heckit estimator is frequently used to deal with problems of sample selection. 156 . However.

It is consistent if E (xit ui ) = 0 (15.1) is true. OLS of yit on xit is called pooled estimation. xit }.1) If this condition fails. . xit } : t = 1. (15. If (15.. where the i subscript denotes the individual. . In either event.. that ui and eit are independent.2 Fixed Eﬀects This is the most common technique for estimation of non-dynamic linear panel regressions.1) is called the random eﬀects hypothesis.1 Individual-Eﬀects Model The standard panel data speciﬁcation is that there is an individual-speciﬁc eﬀect which enters linearly in the regression yit = x0 β + ui + eit . that eit is iid across individuals and time. it The typical maintained assumptions are that the individuals i are mutually independent.. It is a strong assumption. OLS appears a poor estimation choice. and that eit is uncorrelated with xit .Chapter 15 Panel Data A panel is a set of observations on individuals.... and most applied researchers try to avoid its use... 15. or unbalanced : {yit . then OLS is inconsistent. however.. There are several derivations of the estimator.. ti . t = ti . T . n. The goal is to eliminate ui from the estimator. This is often believed to be plausible if ui is an omitted variable. 157 . 15. OLS can be improved upon via a GLS technique. and the t subscript denotes time. The motivation is to allow ui to be arbitrary. collected over time.1) fails if the individual-speciﬁc unobserved eﬀect ui is correlated with the observed explanatory variables xit ... and thus achieve invariance. n. A panel may be balanced : {yit . . xit } : For i = 1. . i = 1. An observation is the pair {yit . Condition (15. and have arbitrary correlated with xi .

Computationally. their gender) will be collinear with di . so will have to be omitted.2) is a valid regression. you do not want to actually implement conventional OLS estimation.First. OLS estimation of β proceeds by the FWL theorem. then by the FWL theorem. di ) = 0. . ⎟ di = ⎝ . so the intercept is typically omitted from xit . Stacking the observations together: Y = Xβ + Du + e..g. ˆ ˆ OLS on (15. ⎟ u = ⎝ . • There are n + k regression parameters. else Then note that and an n × 1 dummy vector with a “1” in the i0 th place. ⎠ . ⎠. which is quite large as typically n is very large. Let ⎛ ⎞ u1 ⎜ . un ui = d0 u. let dij = and ⎧ ⎨ 1 ⎩ 0 ⎛ if i = j . • Any regressor in xit which is constant over time for all individuals (e. Observe that • This is generally consistent.2) yields estimator (β. i yit = x0 β + d0 u + eit . Y ∗ = Y − D(D0 D)−1 D0 Y where X ∗ = X − D(D0 D)−1 D0 X. ˆ β = ¢−1 ¡ 0 ¢ ¡ 0 X (1 − PD ) Y X (1 − PD ) X ¡ ¢−1 ¡ ∗0 ∗ ¢ = X ∗0 X ∗ X Y . din Observe that E (eit | xit . as the parameter space is too large. it i (15. with di as a regressor along with xi . it will be collinear with di . . u). • If xit contains an intercept.2) ⎞ di1 ⎜ . 158 . so (15. Conventional inference applies.

This is because the sample mean of yit−1 is correlated with that of eit . we ﬁnd y i = x0 β + ui + ei . then it will be correlated with ∆yit−1 : E (∆yit−1 ∆eit ) = E ((yit−1 − yit−2 ) (eit − eit−1 )) = −E (yit−1 eit−1 ) = −σ 2 . 15. GMM using yt−2 and yt−3 as instruments (which is overidentiﬁed. we use lags of the dependent variable. Unfortunately. as this enables the moments from the diﬀerent timeperiods to be stacked together to create a list of all the moment conditions. so the instrument list should be diﬀerent for each equation. Alternatively. but loses a time-series observation). the dependent variable and regressors in deviationit from-mean form. e So OLS on (15. and the residual is the demean value ∗ yit = yit − yi . then IV or GMM can be used to estimate the equation. at least if T is held ﬁnite as n → ∞. But if there are valid instruments.3 Dynamic Panel Regression yit = αyit−1 + x0 β + ui + eit . k ≥ 2.3) eliminates the individual-speciﬁc eﬀect: ∆yit = α∆yit−1 + ∆x0 β + ∆eit . 159 (15. the ﬁxed eﬀects estimator is inconsistent. A more sophisticated GMM estimator recognizes that for time-periods later in the sample. A simple application of GMM yields the parameter estimates and standard errors.3) A dynamic panel regression has a lagged dependent variable This is a model suitable for studying dynamic behavior of individual agents.4) .4) by IV using yt−2 as an instrument for ∆yt−1 (which is just identiﬁed). it (15. Hence a valid estimator of α and β is to estimate (15. This is conveniently organized by the GMM principle. ∗ ˆ The ﬁxed eﬀects estimator β is OLS of yit on x∗ . the predicted value from these regressions is the individual speciﬁc mean y i . there are more instruments available. Typically. if eit is iid. The standard approach to estimate a dynamic panel is to combine ﬁrst-diﬀerencing with IV or GMM. two periods back. Taking ﬁrst-diﬀerences of (15. it However. are valid instruments. as yt−2 is uncorrelated with ∆eit .4) will be inconsistent. i ∗ yit = x∗0 β + e∗ .Since the regression of yit on di is a regression onto individual-speciﬁc dummies. it and then take individual-speciﬁc means by taking the average for the i0 th individual: ti ti ti 1 X 1 X 0 1 X yit = x β + ui + eit Ti t=t Ti t=t it Ti t=t i i i or Subtracting. it it which is free of the individual-eﬀect ui . Another derivation of the estimator is to take the equation yit = x0 β + ui + eit . Thus values of yit−k .

Deﬁnition 1 K(u) is a second-order kernel function if it is a symmetric zero-mean density function. |x| ≤ 1 0 |x| > 1 In practice. The kernel functions are used to smooth the data. |x| ≤ 1 0 |x| > 1 ¡ ¢2 1 − x2 . we cannot deﬁne d F (x) since F (x) is a step function. The kernel density estimator of f (x) is 1X ˆ f (x) = Kh (Xi − x) . The amount of smoothing is controlled by the bandwidth h > 0. While we are typically interested in estimating the entire function f (x). The ˆ ˆ EDF F i=1 dx standard nonparametric method to estimate f (x) is based on smoothing using a kernel.1 Kernel Density Estimation d Let X be a random variable with continuous distribution F (x) and density f (x) = dx F (x). n i=1 n 160 . Let 1 ³u´ .Chapter 16 Nonparametrics 16.. . The goal is to estimateP(x) from a random sample (X1 . Kh (u) = K h h be the kernel K rescaled by the bandwidth h.. Xn } While F (x) can be estimated by the f ˆ (x) = n−1 n 1 (Xi ≤ x) . and then see how the method generalizes to estimating the entire function. we can simply focus on the problem where x is a speciﬁc ﬁxed number. the choice between these three rarely makes a meaningful diﬀerence in the estimates. Three common choices for kernels include the Gaussian µ 2¶ x 1 K(x) = √ exp − 2 2π the Epanechnikov K(x) = and the Biweight or Quartic K(x) = 15 16 3 4 ¡ ¢ 1 − x2 ..

The bandwidth h controls the meaning of “near”. if only a few Xi are near x. f (x) ≥ 0 for all x. then the weights are small and f ˆ ˆ Interestingly. The mean is Z ∞ ˆ xf (x)dx = = = = −∞ 1X n 1 n 1 n 1 n n i=1 −∞ n XZ ∞ Z ∞ xKh (Xi − x) dx (Xi + uh) K (u) du n i=1 −∞ n X Z ∞ Xi Xi i=1 n X i=1 1X K (u) du + h n −∞ i=1 Z ∞ uK (u) du −∞ the sample mean of the Xi . It follows that the variance of the density f (x) is Ã n !2 ¶2 µZ ∞ Z ∞ n 1X 1X 2 ˆ ˆ x2 f (x)dx − xf (x)dx = Xi + h2 σ 2 − Xi K n n −∞ −∞ i=1 i=1 −∞ = σ ˆ 2 + h2 σ 2 K Thus the variance of the estimated density is inﬂated by the factor h2 σ 2 relative to the sample K moment.This estimator is the average of a set of weights. ˆ(x) is small. That is. 161 . ˆ We can also calculate the moments of the density f (x). where the second-to-last equality used the change-of-variables u = (Xi − x)/h which has Jacobian h. If a large number of the observations Xi are near ˆ x. f (x) is a valid density. The second moment of the estimated density is Z ∞ n Z 1X ∞ 2 2ˆ x f (x)dx = x Kh (Xi − x) dx n −∞ i=1 −∞ n Z 1X ∞ = (Xi + uh)2 K (u) du n −∞ i=1 Z ∞ Z n n n X 2X 1X 2 ∞ 2 1 2 Xi + Xi h K(u)du + h u K (u) du = n n n −∞ −∞ = where σ2 = K 1 n i=1 n X i=1 i=1 i=1 Xi2 + h2 σ 2 K Z ∞ x2 K (x) dx ˆ is the variance of the kernel. and Z ∞ ˆ f (x)dx = −∞ Z ∞ −∞ 1X 1X Kh (Xi − x) dx = n n i=1 i=1 n n Z ∞ −∞ Kh (Xi − x) dx = 1X n i=1 n Z ∞ K (u) du = 1 −∞ where the second-to-last equality makes the change-of-variables u = (Xi − x)/h. then the weights are relatively large and f (x) is larger. Conversely.

162 . Since it is an average of iid random variables. 2 Z ∞ ˆ The bias of f (x) is then 1 1X ˆ EKh (Xi − x) − f (x) = f 00 (x)h2 σ 2 . This integral (typically) is not analytically solvable. and is larger the greater the curvature in f (x). so is estimating a smoothed version of f (x). so we approximate it using a second order Taylor expansion of f (x + hu) in the argument hu about hu = 0. The last expression shows that the expected value is an average of f (z) locally about x. using ﬁrst-order Taylor approximations and the fact that n−1 is of smaller order than (nh)−1 V ar (x) = = ' = ' = where R(K) = R∞ −∞ K 1 V ar (Kh (Xi − x)) n 1 1 EKh (Xi − x)2 − (EKh (Xi − x))2 n n ¶ Z ∞ µ z−x 2 1 1 K f (z)dz − f (x)2 2 nh −∞ h n Z ∞ 1 K (u)2 f (x + hu) du nh −∞ Z f (x) ∞ K (u)2 du nh −∞ f (x) R(K) . Bias(x) = E f (x) − f (x) = K n 2 i=1 n ˆ We see that the bias of f (x) at x depends on the second derivative f 00 (x). ˆ the greater the bias. The bias results from this smoothing. ˆ We now examine the variance of f (x). which is valid as h → 0. the estimator f (x) smooths data local to Xi = x.16. nh (x)2 dx is called the roughness of K. Thus 1 f (x + hu) ' f (x) + f 0 (x)hu + f 00 (x)h2 u2 2 and therefore µ ¶ 1 00 0 2 2 K (u) f (x) + f (x)hu + f (x)h u du EKh (X − x) ' 2 −∞ Z ∞ Z ∞ Z ∞ 1 = f (x) K (u) du + f 0 (x)h K (u) udu + f 00 (x)h2 K (u) u2 du 2 −∞ −∞ −∞ 1 00 2 2 = f (x) + f (x)h σ K . The sharper the derivative.2 Asymptotic MSE for Kernel Estimates ∞ For ﬁxed x and bandwidth h observe that Z ∞ Z Kh (z − x) f (z)dz = EKh (X − x) = −∞ Kh (uh) f (x + hu)hdu = −∞ Z ∞ K (u) f (x + hu)du −∞ The second equality uses the change-of variables u = (z − x)/h. Intuitively.

h must tend to zero. the asymptotic mean-squared error (AMSE) for ﬁxed x is the sum of the approximate squared bias and approximate variance 1 f (x) R(K) . σ 2 . A classic simple solution proposed by Silverman (1986)has come to be known as the reference bandwidth or Silverman’s Rule-of-Thumb.2) depends on R(K). Note that this h declines to zero. This choice for h gives an optimal rule when f (x) is ˆ normal. Their K values for the three functions introduced in the previous section are given here. h0 = argmin AM ISEh h It can be found by solving the ﬁrst order condition d R(K) AM ISEh = h3 σ 4 R(f 00 ) − =0 K dh nh2 yielding h0 = µ R(K) 4 R(f 00 ) σK ¶1/5 n−1/2 .2) This solution takes the form h0 = cn−1/5 where c is a function of K and f. Equation (16.Together. That is. We thus say that the optimal bandwidth is of order O(n−1/5 ). we ﬁnd the reference rules for the three kernel functions introduced earlier. R∞ R∞ K σ 2 = −∞ x2 K (x) dx R(K) = −∞ K (x)2 dx K √ Gaussian 1 1/(2 π) Epanechnikov 1/5 1/5 Biweight 1/7 5/7 An obvious diﬃculty is that R(f 00 ) is unknown.1) AM ISEh = AM SEh (x)dx = 4 nh R where R(f 00 ) = (f 00 (x))2 dx is the roughness of f 00 . (16. In practice. but at a very slow rate. but at a slower rate than n−1 . but not of n. and gives a nearly optimal rule when f (x) is close to normal. and there is a large and continuing literature on the subject.06n−1/5 163 . Together with the above table. (16. The ﬁrst two are determined by the kernel function.2) but replaces R(f 00 ) with σ −5 R(φ00 ). We can calculate that √ R(φ00 ) = 3/ (8 π) . how should the bandwidth be selected? This is a diﬃcult problem. 1) distribution and σ 2 is an estimate of σ 2 = V ar(X). Thus for the AMISE to decline with n. The downside is that if the density is very far from normal. ˆ It uses formula (16. we need h → 0 but nh → ∞. Notice that the ﬁrst term (the squared bias) is increasing in h and the second term (the variance) is decreasing in nh. and R(f 00 ). Gaussian Kernel: hrule = 1.1) is an asymptotic approximation to the MSE. That is. The asymptotically optimal choice given in (16. the rule-of-thumb h can be quite ineﬃcient. where φ is the N (0. We deﬁne the asymptotically optimal bandwidth h0 as the value which minimizes this approximate MSE. AM SEh (x) = f 00 (x)2 h4 σ 4 + K 4 nh A global measure of precision is the asymptotic mean integrated squared error (AMISE) Z h4 σ 4 R(f 00 ) R(K) K + .

in particular the iterative method of Sheather and Jones (1991).34n−1/5 Biweight (Quartic) Kernel: hrule = 2. There are other approaches. which are known as smoothed cross-validation which is a close cousin of the bootstrap. Fortunately there are remedies. They are also quite ill-behaved when the data has some discretization (as is common in economics).2). in which case the cross-validation rule can sometimes select very small bandwidths leading to dramatically undersmoothed estimates.Epanechnikov Kernel: hrule = 2. 164 . This is more treacherous than may ﬁrst appear. and then plug this estimate into the formula (16. but they are also known to converge very slowly to the optimal values. perhaps adjusted by visual inspection of the resulting estimate ˆ f (x). This works by constructing an estimate of the MISE using leave-one-out estimators. but implementation can be delicate. There are some desirable properties of cross-validation bandwidths. However. as the optimal h for estimation of the roughness R(f 00 ) is quite diﬀerent than the optimal h for estimation of f (x).78n−1/5 Unless you delve more deeply into kernel estimation methods the rule-of-thumb bandwidth is a good practical bandwidth choice. Another popular choice for selection of h is cross-validation. I now discuss some of these choices. The plug-in approach is to estimate R(f 00 ) in a ﬁrst step. there are modern versions of this estimator work well.

A probability function assigns probabilities (numbers between 0 and 1) to events A in S. the sets {HH. A ∩ B = B ∩ A. are pairwise disjoint and ∪∞ Ai = S. Intersection: A ∩ B = {x : x ∈ A and x ∈ B}. Distributive Laws: A∩(B ∪ C) = (A ∩ B)∪(A ∩ C) . We only deﬁne probabilities for events contained in B. A simple example is {∅. Continuing the two coin example.. S} which is known as the trivial sigma i=1 algebra. A2 . A2 . An event A is any collection of possible outcomes of an experiment. This is straightforward when S is countable.. Associativity: A ∪ (B ∪ C) = (A ∪ B) ∪ C. is called a partition i=1 of S. A ∩ (B ∩ C) = (A ∩ B) ∩ C. so we can write S = {H.. and A1 . . then the collection A1 . Given S and B. B is simply the collection of all subsets of S.. . when S is uncountable we must be somewhat more careful. When S is the real line. Communtatitivity: A ∪ B = B ∪ A. then B is the collection of all open and closed intervals. A2 .Appendix A Probability A. one event is A = {HH.1 Foundations The set S of all possible outcomes of an experiment is called the sample space for the experiment. T T }. For any sample space S.A set B is called a sigma algebra (or Borel ﬁeld) if ∅ ∈ B . If two coins are tossed in sequence. the event that the ﬁrst coin is heads. A2 . a probability function P satisﬁes P (S) = 1. There are two outcomes. including ∅ and S. (A ∩ B)c = Ac ∪ B c . HT }. ∈ B implies ∪∞ Ai ∈ B. ∈ B are pairwise disjoint. T }. We say that A and B are disjoint or mutually exclusive if A ∩ B = ∅. The following are useful properties of set operations. Furthermore. Take the simple example of tossing a coin. and if A1 . A∪(B ∩ C) = (A ∪ B)∩(A ∪ C) . HT.. T H.. P (A) ≥ 0 for all A ∈ B. When S is countable. including S itself and the null set ∅.. The following are elementary set operations: Union: A ∪ B = {x : x ∈ A or x ∈ B}. . heads and tails. DeMorgan’s Laws: (A ∪ B)c = Ac ∩ B c . we can write the four outcomes as S = {HH. i=1 i=1 Some important properties of the probability function include the following • P (∅) = 0 165 . if the sets A1 . For example. let B be the smallest sigma algebra which contains all of the open sets in S. We now can give the axiomatic deﬁnition of probability. / Complement: Ac = {x : x ∈ A}. An event is a subset of S.. A ∈ B implies Ac ∈ B. We call B the sigma algebra associated with S. then P P (∪∞ Ai ) = ∞ P (Ai ). HT } and {T H} are disjoint. .

Depending on these two distinctions. Ã ! \ Y P Ai = P (Ai ) .1) We say that the events A and B are statistically independent when (A.. we can write P (A ∩ B) = P (A | B) P (B) which is often quite useful. n ≥ r.• P (A) ≤ 1 • P (Ac ) = 1 − P (A) • P (B ∩ Ac ) = P (B) − P (A ∩ B) • P (A ∪ B) = P (A) + P (B) − P (A ∩ B) • If A ⊂ B then P (A) ≤ P (B) • Bonferroni’s Inequality: P (A ∩ B) ≥ P (A) + P (B) − 1 • Boole’s Inequality: P (A ∪ B) ≤ P (A) + P (B) For some elementary probability models. we have four expressions for the number of objects (possible arrangements) of size r from n objects. 49.1) holds.. 816. These counting rules are facilitated by using the binomial coeﬃcients which are deﬁned for nonnegative integers n and r. ¢ counting is unordered and without replacement. Rearranging the deﬁnition. and is with replacement if this is allowed... For example. . the conditional probability function is a valid probability function where S has been replaced by B. Counting is ordered or not depending on whether the sequential order of the numbers is relevant to winning the lottery. . If P (B) > 0 the conditional probability of the event A given the event B is P (A | B) = P (A ∩ B) . in which case we ﬁnd P (A ∩ B) = P (A) P (B) (A.. consider a lottery where you pick six numbers from the set 1. This selection is without replacement if you are not allowed to select the same number twice. r r! (n − r)! When counting the number of objects in a set. 983. Counting may be ordered or unordered. We can say that the occurrence of B has no information about the likelihood of event A when P (A | B) = P (A). the number of ¡49 if potential combinations is 6 = 13. we say that the collection of events A1 . it is useful to have simple rules to count the number of objects in a set. Ak are mutually independent when for any subset {Ai : i ∈ I}. there are two important distinctions. Furthermore. P (B) With Replacement nr ¡n+r−1¢ r For any B. as µ ¶ n n! = . i∈I i∈I 166 .. 2. Without Replacement Ordered Unordered n! (n−r)! ¡n¢ r In the lottery example. Counting may be with replacement or without replacement.

F (x) is nondecreasing in x 3. ∞ A function f (x) is a PDF if and only if f (x) ≥ 0 for all x ∈ R and −∞ f (x)dx. Typically. (A. r (A. In this case P (X = τ ) = 0 for all τ ∈ R so the representation (A. we represent the relative probabilities by the probability density function (PDF) f (x) = so that F (x) = and P (a ≤ X ≤ b) = Z d F (x) dx x f (u)du Z b −∞ f (x)dx. a These expressions only make sense if F (x) is diﬀerentiable. these cases are unusualRand are typically ignored. the range of X consists of a countable set of real numbers τ 1 ... The probability function for X takes the form j = 1. Instead. This induces a new sample space — the real line — and a new probability function on the real line.. of the sample space. In the latter case. A2 . then for each i = 1. F (x) is right-continuous We say that the random variable X is discrete if F (x) is a step function. . and use lower case letters such as x for potential values and realized values. Pr where 0 ≤ π j ≤ 1 and j=1 π j = 1.3) is unavailable. P (B | Ai ) P (Ai ) P (Ai | B) = P∞ j=1 P (B | Aj ) P (Aj ) A. .. .2) Sometimes we write this as FX (x) to denote that it is the CDF of X.3) P (X = τ j ) = π j . τ r .2 Random Variables A random variable X is a function from a sample space S into the real line. For a random variable X we deﬁne its cumulative distribution function (CDF) as F (x) = P (X ≤ x) .. 167 . we denote random variables by uppercase letters such as X. While there are examples of continuous random variables which do not possess a PDF. For any set B and any partition A1 .. limx→−∞ F (x) = 0 and limx→∞ F (x) = 1 2.Theorem 2 (Bayes’ Rule)..... . 2. A function F (x) is a CDF if and only if the following three properties hold: 1. We say that the random variable X is continuous if F (x) is continuous in x.

A. If both I1 = ∞ and I2 = ∞ then Eg(X) is undeﬁned. evaluate I1 = Z Z ∞ g(x)f (x)dx. r X g(τ j )π j . −∞ ∞ −∞ |g(x)| f (x)dx < ∞. 168 . the characteristic function (CF) of X is C(λ) = E exp (iλX) . we say that expectation is a linear operator. Eg(X) = j=1 and if X is continuous Eg(X) = The latter is well deﬁned and ﬁnite if Z If (A. The MGF does not necessarily exist. we deﬁne the m0 th moment of X as EX m and the m0 th central moment as E (X − EX)m . For example. when it does and E |X|m < ∞ then ¯ ¯ dm ¯ = E (X m ) m M (λ)¯ dλ λ=0 which is why it is called the moment generating function. The moment generating function (MGF) of X is M (λ) = E exp (λX) . this allows the convenient expression V ar(a + bX) = b2 V ar(X). However. and when E |X|m < ∞ ¯ ¯ dm ¯ = im E (X m ) . √ where i = −1 is the imaginary unit. More generally. If X is discrete. Two special moments are the mean µ = EX and variance σ 2 = E (X − µ)2 = EX 2 − µ2 .4) does not hold. m C(λ)¯ dλ λ=0 The Lp norm. If I1 < ∞ and I2 = ∞ then we deﬁne Eg(X) = −∞. (A.3 Expectation For any measurable real function g. We √ call σ = σ 2 the standard deviation of X. The CF always exists. p ≥ 1. we deﬁne the mean or expectation Eg(X) as follows. Since E (a + bX) = a + bEX. We can also write σ 2 = V ar(X). For m > 0.4) g(x)f (x)dx Z g(x)f (x)dx g(x)>0 I2 = − g(x)<0 If I1 = ∞ and I2 < ∞ then we deﬁne Eg(X) = ∞. of the random variable X is kXkp = (E |X|p )1/p .

EX = p V ar(X) = p(1 − p) Binomial µ ¶ n x P (X = x) = p (1 − p)n−x . . .. 1.. x EX = V ar(X) = Poisson P (X = x) = exp (−λ) λx . . 169 .. 2... 1 EX = p 1−p V ar(X) = p2 Multinomial P (X1 = x1 . λ>0 x = 1. .... 0≤p≤1 x = 0. m x1 !x2 ! · · · xm ! 1 2 = n. 2... . Xm = xm ) = x1 + · · · + xm n! px1 px2 · · · pxm . x = 1. 0≤p≤1 V ar(X) = λ We now list some important continuous distributions.. 1. 0≤p≤1 p1 + · · · + pm = 1 EX = V ar(X) = Negative Binomial µ ¶ r+x−1 P (X = x) = p(1 − p)x−1 . Bernoulli P (X = x) = px (1 − p)1−x . x! EX = λ x = 0.. n.A.. X2 = x2 . we now list some important discrete distribution function. x EX = np V ar(X) = np(1 − p) Geometric P (X = x) = p(1 − p)x−1 . 0≤p≤1 x = 0. 2. 1.4 Common Distributions For reference...

V ar(X) = R1 0 x−2 dx Z ∞ 0 exp (−x) dx (1 + exp (−x))2 Lognormal Ã ! (ln x − µ)2 1 exp − f (x) = √ . 2σ 2 2πσx ¢ ¡ EX = exp µ + σ 2 /2 ¡ ¢ ¡ ¢ V ar(X) = exp 2µ + 2σ 2 − exp 2µ + σ 2 f (x) = EX = V ar(X) = 0 ≤ x < ∞. β > 0 V ar(X) = ∞ ExponentiaI f (x) = ³x´ 1 . Γ(α)Γ(β) α α+β αβ (α + β + 1) (α + β)2 0 ≤ x ≤ 1. σ>0 Pareto βαβ .Beta f (x) = µ = V ar(X) = Cauchy f (x) = 1 . β>1 β−1 βα2 . β>2 (β − 1)2 (β − 2) 170 β>0 . xβ+1 βα . π (1 + x2 ) EX = ∞ −∞ < x < ∞ Γ(α + β) α−1 x (1 − x)β−1 . α ≤ x < ∞. θ>0 V ar(X) = θ2 Logistic f (x) = exp (−x) . α > 0. (1 + exp (−x))2 EX = 0 −∞ < x < ∞. α > 0. exp θ θ EX = θ 0 ≤ x < ∞.

Y ) is F (x. y). y). y) = P (X ≤ x.5 Multivariate Random Variables A pair of bivariate random variables (X. y)dydx −∞ f (x. y) f (x. y)dy. y)f (x. y)dxdy. β > 0 1 . Y ≤ y) . y) = For a Borel measurable set A ∈ R2 . 0 ≤ x < ∞. −∞ lim F (x. Y ) is a function from the sample space into R2 . b−a a+b 2 (b − a)2 12 a≤x≤b A. The joint CDF of (X. −∞ 171 . Eg(X. P ((X < Y ) ∈ A) = For any measurable function g(x. exp − f (x) = β β µ ¶ 1 EX = β 1/γ Γ 1 + γ ¶ ¶¶ µ µ µ 2 1 2/γ 2 V ar(X) = β −Γ 1+ Γ 1+ γ γ γ > 0. y)dxdy A Z ∞ −∞ Z ∞ g(x. If F is continuous.Uniform f (x) = EX = V ar(X) = Weibull µ γ¶ x γ γ−1 x . Y ) = The marginal distribution of X is FX (x) = P (X ≤ x) = = so the marginal density of X is fX (x) = d FX (x) = dx Z ∞ y→∞ Z x Z ∞ −∞ ∂2 F (x. ∂x∂y Z Z f (x. the joint probability density function is f (x.

The correlation between X and Y is Corr(X. if EX = 0 and EX 3 = 0. then V ar (X + Y ) = V ar(X) + V ar(Y ). The covariance between X and Y is Cov(X. the variance of the sum is the sum of the variances. if X and Y are independent then E(XY ) = EXEY. the marginal density of Y is fY (y) = Z ∞ f (x. An implication is that if X and Y are independent. (A. A useful fact is that V ar (X + Y ) = V ar(X) + V ar(Y ) + 2Cov(X. −∞ The random variables X and Y are deﬁned to be independent if f (x. Furthermore. however. If X and Y are independent. For example. 172 .Similarly.The correlation is a measure of linear dependence.5) is that if X and Y are independent and Z = X + Y. The reverse. x)dydx Z Z = g(x)h(y)fY (y)fX (x)dydx Z Z = g(x)fX (x)dx h(y)fY (y)dy = Eg (X) Eh (Y ) .6) The Cauchy-Schwarz Inequality implies that |ρXY | ≤ 1. y) = fX (x)fY (y). then Z Z E (g(X)h(Y )) = g(x)h(y)f (y. Y ) = σ XY = E ((X − EX) (Y − EY )) = EXY − EXEY. Another implication of (A. σxσY (A. X and Y are independent if and only if there exist functions g(x) and h(y) such that f (x. then Cov(X.5) if the expectations exist. Y ) = ρXY = σ XY . then MZ (λ) = E exp (λ (X + Y )) = E (exp (λX) exp (λY )) ¡ ¢ ¡ ¢ = E exp λ0 X E exp λ0 Y = MX (λ)MY (λ). free of units of measurement. y)dx. X 2 ) = 0. For example. y) = g(x)h(y). Y ). then σ XY = 0 and ρXY = 0. If X and Y are independent. is not true.

y) . One way to derive this expression from the deﬁnition of conditional probability is fY |X (y | x) = = = = = = ∂ lim P (Y ≤ y | x ≤ X ≤ x + ε) ∂y ε→0 ∂ P ({Y ≤ y} ∩ {x ≤ X ≤ x + ε}) lim ∂y ε→0 P (x ≤ X ≤ x + ε) F (x + ε. In particular. y) − F (x. we have the k × 1 multivariate mean µ = EX and k × k covariance matrix ¡ ¢ Σ = E (X − µ) (X − µ)0 = EXX 0 − µµ0 If the elements of X are mutually independent.. Letting x = (x1 . .. y) fX (x) The conditional density of Y given X = x is deﬁned as fY |X (y | x) = if fX (x) > 0.A k × 1 random vector X = (X1 .. y) fX (x) f (x.. y) ∂ lim ∂y ε→0 FX (x + ε) − FX (x) ∂ lim ∂y ε→0 ∂ ∂x F (x + ε. fX (x) 173 . xk )0 . it has the distribution and density functions F (x) = P (X ≤ x) ∂k f (x) = F (x). then Σ is a diagonal matrix and Ã k ! k X X V ar Xi = V ar (Xi ) i=1 i=1 A. Xk )0 is a function from S to Rk .. . we deﬁne the expectation Z g(x)f (x)dx Eg(X) = Rk where the symbol dx denotes dx1 · · · dxk . ∂x1 · · · ∂xk For a measurable function g : Rk → Rs . y) fX (x + ε) ∂2 ∂x∂y F (x.6 Conditional Distributions and Expectation f (x..

Similarly. For example.8) (A. m(x) = E (Y | X = x) = −∞ The conditional mean m(x) is a function.7) Law of Iterated Expectations: E (E (Y | X. E (g(X)Y | X) = g (X) E (Y | X) Proof : Let h(x) = E (g(X)Y | X = x) Z ∞ g(x)yfY |X (y | x) dy = −∞ Z ∞ = g(x) yfY |X (y | x) dy = g(x)m(x) −∞ (A. −∞ −∞ (A. functions of X. For any function g(x). the conditional mean m(X) and conditional variance σ 2 (x) are random variables. Z) | X) = E (Y | X) Conditioning Theorem. Evaluated at x = X. which is the same as E (g(X)Y | X) = g (X) E (Y | X) . a transformation of X.9) where m(x) = E (Y | X = x) . The following are important facts about conditional expectations. 174 . then the expected value of Y is m(x).The conditional mean or conditional expectation is the function Z ∞ yfY |X (y | x) dy. Thus h(X) = g(X)m(X). x) dydx = E(Y ). meaning that when X equals x. We write this as E(Y | X) = m(X) and V ar (Y | X) = σ 2 (X). if E (Y | X = x) = α + βx. Simple Law of Iterated Expectations: E (E (Y | X)) = E (Y ) Proof : E (E (Y | X)) = E (m(X)) Z ∞ m(x)fX (x)dx = Z−∞ Z ∞ ∞ = yfY |X (y | x) fX (x)dydx −∞ −∞ Z ∞Z ∞ = yf (y. then E (Y | X) = α + βX. we deﬁne the conditional variance of Y given X = x as σ 2 (x) = V ar (Y | X = x) ´ ³ = E (Y − m(x))2 | X = x ¢ ¡ = E Y 2 | X = x − m(x)2 .

so the distribution function of Y is FY (y) = P (g(X) ≤ y) = FX (h(Y )) = P (X ≤ h(Y )) so the density of Y is fY (y) = d d FY (y) = fX (h(Y )) h(y). Let h(y) denote the inverse of g(x). take the case X ∼ U [0. dy dy If g(x) is a decreasing function. 1] and Y = − ln(X). then g(X) ≤ Y if and only if X ≥ h(Y ). that for Y is [0. but its justiﬁcation requires deeper results from analysis. φ(x) = √ exp − 2 2π 175 The standard normal density is −∞ < x < ∞.∞). The Jacobian is ¶ µ ∂ h(y) . g(x) = − ln(x) and h(y) = exp(−y) so the Jacobian is J(y) = − exp(y). then g(X) ≤ Y if and only if X ≤ h(Y ). Since fX (x) = 1 for 0 ≤ x ≤ 1 (A. (A. As one example. dy This is known as the change-of-variables formula.7 Transformations Suppose that X ∈ Rk with continuous distribution function FX (x) and density fX (x). A. . an exponential density. This same formula (A. J(y) = det ∂y 0 Consider the univariate case k = 1. so FY (y) = P (g(X) ≤ y) = 1 − P (X ≥ h(Y )) = 1 − FX (h(Y )) and the density of Y is fY (y) = −fX (h(Y )) We can write these two cases jointly as fY (y) = fX (h(Y )) |J(y)| .A.8 Normal and Related Distributions µ 2¶ 1 x . 0 ≤ y ≤ ∞. and invertible. Let Y = g(X) where g(x) : Rk → Rk is one-to-one. 1]. As the range of X is [0.10) shows that fY (y) = exp(−y). Here. If g(x) is an increasing function.10) holds for k > 1. diﬀerentiable.10) d h(y).

the density of Y is Ã ! (y − µY )0 Σ−1 (y − µY ) 1 Y exp − f (y) = . then Z 0 A−1 Z ∼ χ2 . Theorem A. exp − f (x) = k/2 1/2 2 (2π) det (Σ) The mean and covariance matrix of the distribution are µ and Σ. Since it is symmetric about zero all odd moments are zero. X has density Ã ! (x − µ)2 1 exp − . and it is conventional to write X ∼ N(µ. then using the change-of-variables formula. q × q. If X ∈ Rk is multivariate normal and the elements of X are mutually uncorrelated. σ 2 ).1 Let X ∼ N (0. ¢ ¡ It useful to observe ¢ that the MGF and CF of the multivariate normal are exp λ0 µ + λ0 Σλ/2 ¡ 0 and exp iλ µ − λ0 Σλ/2 .8. then Σ = diag{σ 2 } is a diagonal matrix. f (x) = √ 2σ 2 2πσ which is the univariate normal density. For x ∈ Rk . Its mean and r variance are µ = r and σ 2 = 2r. (A. The mean and variance of the distribution are µ and σ 2 . It is conventional to write X ∼ N (0. the multivariate normal density is ¶ µ (x − µ)0 Σ−1 (x − µ) 1 . Σ) and Y = a + BX with B an invertible matrix. Theorem A. where we used the fact that det (BΣB 0 )1/2 = det (Σ)1/2 det (B) .2 If Z ∼ N(0. x ∈ Rk . denoted χ2 . In this case the density function can be written as j Ã Ã !! (x1 − µ1 )2 /σ 2 + · · · + (xk − µk )2 /σ 2 1 1 k f (x) = exp − 2 (2π)k/2 σ 1 · · · σ k Ã ¡ ¢2 ! k Y xj − µj 1 = exp − 2σ 2 (2π)1/2 σ j j j=1 which is the product of marginal univariate normal densities. The latter has no closed-form solution. then by the change-of-variables formula. and it is conventional to write X ∼ N (µ. If Z is standard normal and X = µ + σZ. q 176 . y ≥ 0. and to denote the standard normal density function by φ(x) and its distribution function by Φ(x). x ∈ Rk . By iterated integration by parts. Q has the density f (y) = Γ 1 ¡r¢ 2 2r/2 yr/2−1 exp (−y/2) . This shows that linear transformations of normals are also normal.This density has all moments ﬁnite.8.11) and is known as the chi-square density with r degrees of freedom. we can also show that EX 2 = 1 and EX 4 = 3. Ir ) and set Q = X 0 X. 1). k/2 1/2 2 (2π) det (ΣY ) where µY = a+Bµ and ΣY = BΣB 0 . This shows that if X is multivariate normal with uncorrelated elements. −∞ < x < ∞. then they are mutually independent. respectively. Σ). A) with A > 0. Another useful fact is that if X ∼ N (µ.

C −1 CC 0 C −10 ) = N (0. From (A. Using the simple law of iterated expectations. ¡ ¢ √ using the change—of-variables s = x2 and the fact Γ 1 = π.13). tr has distribution 177 . we see that the MGF of Z 2 is (1 − 2t)−1/2 .2.3. Since we can write Q = P 2 X 0 X = r Zj where the Zj are independent N(0. tr = p Q/r The density of tr is and is known as the student’s t distribution with r degrees of freedom.11).13) = (1 − 2t)−r/2 R∞ where the second equality uses the fact that 0 y a−1 exp (−by) dy = b−a Γ(a).8. The fact that A > 0 means that we can write A = CC 0 where C is non-singular. The MGF for the density (A. 1) and Q ∼ χ2 be independent.11) 2 with r = 1.8.13) is the MGF of the density (A.6) can be used to show that the MGF j=1 ¥ Proof of Theorem A. which we showed in (A. q Proof of Theorem A. Thus the density of Z 2 is (A. Thus ¥ ¡ ¢0 ¡ ¢ Z 0 A−1 Z = Z 0 C −10 C −1 Z = C −1 Z C −1 Z ∼ χ2 . (A.Theorem A. Iq ). For Z ∼ N(0. 1).8.3 Let Z ∼ N (0. C −1 AC −10 ) = N (0. which can be found by applying change-of-variables to the gamma function. 1) the distribution of Z 2 is ¡ ¢ √ P Z 2 ≤ y = 2P (0 ≤ Z ≤ y) µ 2¶ Z √y 1 x √ exp − dx = 2 2 2π 0 Z y ³ s´ 1 ¡1¢ = s−1/2 exp − ds 1/2 2 0 Γ 2 2 1 ¡r¢ 2 2r/2 y r/2−1 exp (ty) exp (−y/2) dy of Q is (1 − 2t)−r/2 .12) E exp (tQ) = 0 Γ (A.11) is Z ∞ ¢ ¡ Γ r+1 2 f (x) = ´ r+1 ¡r¢ ³ √ 2 2 πrΓ 2 1 + x r (A. Set r Z . Proof of Theorem A.1.8. Then A−1 = C −10 C −1 and C −1 Z ∼ N (0.

θ) = P (Y = y.9 Maximum Likelihood If the distribution of Yi is F (y. viewed as a function of θ. If the distribution F is continuous then the density of Yi can be written as f (y..θ = fn Y f (Yi .. 178 . θ) where F is a known distribution function and θ ∈ Θ is an unknown m × 1 vector. θ) . . i=1 The likelihood of the sample is this joint density evaluated at the observed sample values. In this setting the method of maximum likelihood is the appropriate technique for estimation and inference on θ. θ) and the joint ˜ density of a random sample Y = (Y1 . Yn ) is n ³ ´ Y ˜. θ) . θ) . The log-likelihood function is its natural log Ln (θ) = n X i=1 ln f (Yi . the likelihood and log-likelihood are constructed by setting f (y.function F (x) = = = = Thus its density is f (x) = = = Ã r ! Q d E Φ x dx r Ã Ã r !r ! Q Q E φ x r r ! µ ¶¶ r Ã Z ∞µ qx2 1 q 1 r/2−1 ¡r¢ √ exp − q exp (−q/2) dq 2r r Γ 2 2r/2 2π 0 ¢ µ ¡ ¶− r+1 Γ r+1 x2 ( 2 ) 2¡ ¢ . The space Θ is the set of permissible value for θ.. If the distribution F is discrete. 1+ √ r r rπΓ 2 ! Z P p ≤x Q/r ( r ) Q E Z≤x r !# " Ã r Q |Q E P Z≤x r Ã r ! Q EΦ x r Ã = ¥ A. we say that the distribution is parametric and that θ is the parameter of the distribution F.

θ) ∂θ ∂θ which holds at θ = θ0 by (A. θ0 ) ∂θ∂θ 0 (A. the log-likelihood is a sample average 1X 1 Ln (θ) = ln f (Yi . θ) →p E ln f (Yi . θ) The Cramer-Rao Theorem gives a lower bound for estimation.9. then θ V ar(˜ ≥ (nI0 )−1 . but these ˆ must be found by numerical methods. The ﬁrst-order condition for the latter problem is 0= ∂ ∂ L(θ) = E ln f (Yi .17) The matrix I0 is called the information.15) Two important features of the likelihood are Theorem A.Deﬁne the Hessian H = −E and the outer product matrix Ω=E µ ∂2 ln f (Yi .1 ¯ ¯ ∂ E ln f (Yi . under conventional regularity conditions. θ) ≡ L(θ).2 Cramer-Rao Lower Bound. However. which maximizes the log-likelihood). In fact. n n i=1 n As the MLE ˆ maximizes the left-hand-side. We can write this as ˆ = argmax Ln (θ).14) ¶ ∂ ∂ 0 ln f (Yi .9. and the equality (A.17) is often called the information matrix equality. we can ﬁnd an explicit expression for θ as a function of the data. If ˜ is an unbiased estimator of θ ∈ R. ˆ →p θ0 as n → ∞. The maximum likelihood estimator or MLE ˆ is the parameter value which maximizes θ the likelihood (equivalently. the restriction to unbiased estimators means that the theorem has little direct relevance for ﬁnite sample eﬃciency. 179 . cases are rare. ∂θ ∂θ (A. I0 .16) (A. θ0 ) . θ θ∈Θ ˆ In some simple cases. θ0 ) ln f (Yi . More typically.3 Under regularity conditions.16). ˆ is consistent θ for this value. Theorem A.9. we can see that it is an estimator of the maximizer θ of the right-hand-side. θ)¯ =0 ¯ ∂θ θ=θ0 H = Ω ≡ I0 (A. θ Theorem A. ´ ¡ −1 ¢ √ ³ˆ n θ − θ0 →d N 0. the MLE θ Why do we believe that the MLE ˆ is estimating the parameter θ? Observe that when stanθ dardized.

θ (A. A minor adjustment to Theorem (A. Instead we deﬁne the pseudo-true value θ0 as the maximizer of Z E ln f (Yi .ˆ ˆ−1 θ We then set I0 = H −1 . to estimate the asymptotic variance of the MLE we use an estimate based on the Hessian formula (A. θ V = H −1 ΩH −1 The moment estimator for V is ˆ where H is given in (A.17) does not hold. but has a diﬀerent covariance matrix than in the pure MLE case. but it is not literally believed that the model f (y. Thus the QMLE θ0 is the value which makes the parametric density “closest” to the true value according to this measure of distance. θ) dy which is the same as the minimizer of KLIC = Z f (y) ln µ f (y) f (y.3) yields the asymptotic distribution of the QMLE: ´ √ ³ n ˆ − θ0 →d N (0. In this case there is not a “true” value of the parameter θ.18) and ³ ³ ´ ∂ ´0 1X ∂ ˆ ln f Yi . 180 . θ θ Ω= n ∂θ ∂θ n i=1 ˆ ˆ ˆˆ V = H −1 ΩH −1 Asymptotic standard errors (sometimes called qmle standard errors) are then the square roots of ˆ the diagonal elements of n−1 V . ˆ . Typically. θ) is necessarily the true density.14) n ³ ´ 1 X ∂2 ˆ ˆ ln f Yi .9. Thus in large samples the MLE has approximately the best possible variance. V ) . Asymptotic standard errors for ˆ are then the square roots of the diagonal −1 I −1 . θ). since the information matrix equality (A. θ) is used to approximate the true unknown density f (y). θ) ¶ dy Thus in large samples. the approximate variance of the MLE is (nI0 )−1 which is the CramerRao lower bound. Therefore the MLE is called asymptotically eﬃcient. θ) θ In this case.18) H =− n ∂θ∂θ0 i=1 the Kullback-Leibler information distance between the true density f (y) and the parametric density f (y. θ) = f (y) ln f (y. we refer to Ln (ˆ as a quasi-likelihood and the its maximizer ˆ as a quasi-mle or QMLE. ˆ ln f Yi . ˆ elements of n 0 Sometimes a parametric density function f (y. The QMLE is consistent for the pseudo-true value.

θ0 ) = ∂θ∂θ0 = Taking expectations yields (A. θ) ¯θ=θ0 ¯ Z ¯ ∂ f (y. θ0 ) f (Yi . θ0 = ln f (Yi . θ0 ) ∂θ ∂θ n i=1 which by Theorem (A. θ)¯ = ¯ ∂θ θ=θ0 = = = Similarly. θ0 ) ∂ ∂ − ln f (Yi .16). . ¯ ¯ ∂ E ln f (Yi . θ0 ) ¯ ∂ f (y. ∂2 ln f (Yi . function of the data. θ0 ) − f (Yi .Proof of Theorem A.9. θ) d˜ = ˜ y ) ∂ ln f (˜. θ0 )2 (Yi . θ0 ) ∂ ∂θ f ∂ (Yi . S= ∂2 f ∂θ∂θ0 ∂2 f ∂θ∂θ0 ∂ ∂θ Z Ã ∂2 f ∂θ∂θ0 ¯ ¯ ln f (y.1. ∂θ ¯θ=θ0 Z ! = 0. θ0 ) ln f (Yi .1) has mean zero and variance nH. θ) dy ¯ ¯ ∂θ θ=θ0 ¯ ∂ ¯ 1¯ = 0. θ) f (y. f (Yi . Diﬀerentiating with respect to θ and evaluating at θ0 yields ˜ Z Z ³ ´ ˜ y ) ∂ f (˜.17).9. θ0 ) (Yi . θ) f (˜. (Yi . Write the estimator ˜ = ˜ Y ) as a θ θ( ˜ ˜ is unbiased for any θ. θ0 )0 f (Yi . To see (A.. θ0 ) ∂θ f (Yi .. θ0 ) ∂θ ∂θ ¥ ³ ´ X ∂ ∂ ˜ ln fn Y . Since θ Z ˜ = ˜ y)f (˜. we can show that E By direction computation. θ0 ) d˜ = E ˜ . yn ). θ) dy ¯ ∂θ f (y. V ar (S) nH so ¥ 181 . Proof of Theorem A.. y y θ(˜ y y y θS 1 = θ(˜ ∂θ ∂θ By the Cauchy-Schwarz inequality ¯ ³ ´¯2 ³ ´ ¯ ¯ θS θ 1 = ¯E ˜ ¯ ≤ V ar (S) V ar ˜ ³ ´ V ar ˜ ≥ θ 1 1 = .9.2. θ) d˜ θ = Eθ θ(˜ y y where y = (y1 . θ0 )0 . θ0 ) dy ¯ ¯ ¯ θ=θ0 f (y.

− ln f (Yi . Ω) = N 0. Together. ∂θ ∂θ∂θ i=1 i=1 θ where θn lies on a line segment joining ˆ and θ0 . then since θn →p θ0 we ﬁnd H(θn ) →p H and so ¶ n n µ ∂2 1X 1 X ∂2 − ln f (Yi .Proof of Theorem A. ´ ¡ ¢ ¡ ¢ √ ³ˆ n θ − θ0 →d H −1 N (0. θ n ) θ − θ 0 . θ0 ) is mean-zero with covariance matrix Ω. If it is continuous in θ.) Rewriting this equation.1 .3 Taking the ﬁrst-order condition for maximization of Ln (θ). Let ∂2 H(θ) = − ∂θ∂θ0 ln f (Yi . the speciﬁc value of θn varies by row in this expansion. H −1 ΩH −1 = N 0. (Technically. θ0 ) + ' 0 ln f (Yi . θn ) = ln f (Yi . the ﬁnal equality using Theorem A.9. θ0 ) .9. θ) . ∂θ n i=1 n The analysis of the sample Hessian is somewhat more complicated due to the presence of θn . we ﬁnd ´ ³ ˆ − θ0 = θ Since ∂ ∂θ Ã !−1 Ã n ! n X ∂2 X ∂ ln f (Yi . ˆ = θ ∂θ i=1 n n ´ ³ X ∂ X ∂2 ˆ ln f (Yi . and making a ﬁrst-order Taylor series expansion. an application of the CLT yields 1 X ∂ √ ln f (Yi . ¥ 182 . H −1 . θn ) ∂θ ∂θ∂θ0 i=1 i=1 ln f (Yi . θn ) − H(θn ) + H(θn ) − n n ∂θ∂θ0 ∂θ∂θ0 i=1 i=1 →p H by an application of a uniform WLLN. Ω) . θ0 ) →d N (0. ¯ ¯ ∂ Ln (θ)¯ 0 = ¯ ˆ ∂θ θ=θ n ³ ´ X ∂ ln f Yi .

183 . . numerical methods are required to θ obtain ˆ θ.Appendix B Numerical Optimization Many econometric estimators are deﬁned by an optimization problem of the form ˆ = argmin Q(θ) θ θ∈Θ (B. which is θ(ˆ) j j θ. ¯θ(ˆ) − θ¯ method is quite robust but potentially costly.. This j that is.1 Grid Search Many optimization problems are either one dimensional (m = 1) or involve one-dimensional optimization as a sub-problem (for example.. Plots of Q(θ(j)) against θ(j) can help diagnose errors in grid selection.. which is {θ(j) = a + j(b − a)/G : j = 0. a line search). Q(θ) can be computed for given θ. b] with G gridpoints. Construct an equally spaced grid on the region [a. This value θ(ˆ) is the gridpoint estimate of ˆ If the grid is ˆ suﬃciently ﬁne ¯ capture small oscillations in Q(θ). For example NLLS. θ(ˆ + 1)] with G gridpoints. In this context grid search may be employed. which is {θ0 (k) = j j ˆ θ θ(ˆ − 1) + 2k(b − a)/G2 : k = 0. Let k = argmin0≤k≤G Q(θ0 (k)). The advantage of the two-step method over a one-step grid search is that the number of p function evaluations has been reduced from (b − a)/ε to 2 (b − a)/ε which can be substantial. Pick some ε > 0 and set G = (b − a)/ε to be the number of gridpoints. . Let Θ = [a.1) where the parameter is θ ∈ Θ ⊂ Rm and the criterion function is Q(θ) : Θ → R.. In most cases. Two-Step Grid Search. G}. the approximation error is bounded by ε. The disadvantage is that if the function Q(θ) is irregular. The gridsearch method can be reﬁned by a two-step execution.. Grid Search. . G}. For an error bound of ε pick G so that G2 = (b − a)/ε For the ﬁrst step deﬁne an equally spaced grid on the region [a. the ﬁrst-step grid may not bracket ˆ θ which thus would be missed. b] with G gridpoints. G}. b] be an interval. where j = argmin0≤j≤G Q(θ(j)). MLE and GMM estimators take this form. For the second ˆ step deﬁne an equally spaced grid on [θ(ˆ − 1). to ¯ ¯ ˆ¯ ≤ ε.. but ˆ is not available in closed form. GLS.. At each point evaluate the criterion function and let j = argmin0≤j≤G Q(θ(j)). The estimate of ˆ is j 0 ˆ θ (k).. At each point evaluate the criterion function and ﬁnd the gridpoint which yields the smallest value of the criterion.. which is {θ(j) = a + j(b − a)/G : j = 0. In this case. B.

Most gradient methods are a variant of Newton’s method which is based on a quadratic approximation. however. a one-dimensional optimization.. In this case the iteration rule takes the form (B. of the gradient of Q(θ) ∂ Q(θ) g(θ) = ∂θ and some require the Hessian ∂2 H(θ) = Q(θ). θ where One problem with Newton’s method is that it will send the iterations in the wrong direction if H(θi ) is not positive deﬁnite. and all require the computation θ. θ This suggests the iteration rule ˆi+1 = θi − H(θi )−1 g(θi ). By a Taylor’s expansion for θ close to ˆ θ ³ ´ 0 = g(ˆ ' g(θ) + H(θ) ˆ − θ θ) θ gjk (θ) ' which implies ˆ = θ − H(θ)−1 g(θ). θ where αi is set just above the smallest eigenvalue of H(θi ) if H(θ) is not positive deﬁnite. One modiﬁcation to prevent this possibility is quadratic hill-climbing which sets ˆi+1 = θi − (H(θi ) + αi Im )−1 g(θi ).B. Then for ε small gj (θ) ' Similarly. In some cases. . numerical derivatives can be quite unstable.. Another productive modiﬁcation is to add a scalar steplength λi . 2. Q(θ + δ j ε + δ k ε) − Q(θ + δ k ε) − Q(θ + δ j ε) + Q(θ) ε2 In many cases.2) θi+1 = θi − Di gi λi Q(θ + δ j ε) − Q(θ) . Take the j 0 th element of g(θ). ε where gi = g(θi ) and Di = H(θi )−1 for Newton’s method and Di = (H(θi ) + αi Im )−1 for quadratic hill-climbing. ∂θ∂θ 0 If the functions g(θ) and H(θ) are not analytically available. Allowing the steplength to be a free parameter allows for a line search.2 Gradient Methods Gradient Methods are iterative methods which produce a sequence θi : i = 1. Let δ j be the j 0 th unit vector (zeros everywhere except for a one in the j 0 th row). they can be calculated numerically. which are designed to converge to ˆ All require the choice of a starting value θ1 . numerical derivatives can work well but can be computationally costly relative to analytic derivatives. To pick λi write the criterion function as a function of λ Q(λ) = Q(θi + Di gi λ) 184 .

The SA algorithm stops when a large number of iterations is unable to improve the criterion. 185 . These problems have motivated alternative choices for the weight matrix Di . Two popular methods are do to Davidson-Fletcher-Powell (DFP) and Broyden-Fletcher-Goldfarb-Shanno (BFGS). 1/4. In these cases.. As the iterations continue. alternative optimization methods are required. Like the gradient methods. If the criterion is increased. B.3 Derivative-Free Methods All gradient methods can be quite poor in locating the global minimum when Q(θ) has several local minima. At each iteration. The SA method is a sophisticated random search. |Q (θi ) − Q (θi−1 )| or |g(θi )| has become small. For a review see Goﬀe. One example is the simplex method of Nelder-Mead (1965). If the resulting criterion is decreased. this new value is accepted. The downside is that it can take considerable computer time to execute. A quadratic approximation evaluates the ﬁrst and second derivatives of Q(λ) with respect to λ. The SA method has been found to be successful at locating global minima. The DFP method sets Di = Di−1 + The BFGS methods sets Di = Di−1 + 0 ∆θi ∆θ0 ∆θi ∆θ0 ∆θi ∆gi Di−1 Di−1 ∆gi ∆θ0 i i i 0 −¡ ∆gi Di−1 ∆gi + + . The latter property is needed to keep the algorithm from selecting a local minimum. a random variable is drawn and added to the current value of the parameter. the methods are not well deﬁned when Q(θ) is non-diﬀerentiable. use this value. Ferrier. These methods are called Quasi-Newton methods. 1/2. the iterations continue until the sequence has converged in some sense. This can be deﬁned by examining whether |θi − θi−1 | . . Newton’s method does not perform well if Q(θ) is irregular. A more recent innovation is the method of simulated annealing (SA). If the criterion has improved over Q(θi ). and it can be quite computationally costly if H(θ) is not analytically available. ¢2 0 ∆θ0 ∆gi ∆θ0 ∆gi ∆θ0 ∆gi ∆θi ∆gi i i i 0 ∆θi ∆θ0 Di−1 ∆gi ∆gi Di−1 i + . Let ∆gi = gi − gi−1 ∆θi = θi − θi−1 and . and picks λi as the value minimizing this approximation. it relies on an iterative sequence. There are two common methods to perform a line search. and Rodgers (1994). Furthermore. otherwise move to the next element in the sequence. the variance of the random innovations is shrunk.. it may still be accepted depending on the extent of the increase and another randomization. The half-step method considers the sequence λ = 1.a one-dimensional optimization problem. . 1/8. Each value in the sequence is considered and the criterion Q(θi + Di gi λ) evaluated. 0 0 ∆gi Di−1 ∆gi ∆θi ∆gi For any of the gradient methods.

25. “Tests for parameter instability and structural change with unknown change point.W. 307-345. 62. Econometrica. 47. eﬃcient bootstrapping.W.W. (1991). 77-83. [9] Basmann.K. [5] Andrews. 61. P. [13] Bose. R.K. (1935): “On least squares and linear combinations of observations. 23-51. (1979): Probability and Measure. and improved inference . (1988): “Laws of large numbers for dependent non-identically distributed random variables.” Econometrica. and W. [12] Billingsley. and A. [8] Andrews. A. T. 62. 1383-1414. [15] Brown. and M. [14] Breusch. [3] Anderson.K. D.S.” Proceedings of the Royal Statistical Society.’ Econometric Theory. (1957): “A generalized classical method of linear estimation of coeﬃcients in a structural equation.” In B.W. H.” The Annals of Mathematical Statistics. Ploberger (1994): “Optimal tests when a nuisance parameter is present only under the alternative. 42-48. D.R. 16. (1973): “Information theory and an extension of the maximum likelihood principle. (1993).” Annals of Statistics. [10] Bekker.” Econometrica.W. A. T. (1994): “Alternative approximations to the distributions of instrumental variable estimators.W.Bibliography [1] Aitken. 68. “Asymptotic normality of series estimators for nonparameric and semiparametric regression models.” Review of Economic Studies. Buchinsky: (2000): “A three-step method for choosing the number of bootstrap replications. and W.C. [7] Andrews. 59. [11] Billingsley. Rubin (1949): “Estimation of the parameters of a single equation in a complete system of stochastic equations. Newey (2002): “GMM. 20. 4. 46-63. eds. Csake. 55. New York: Wiley. [4] Andrews. B.” Econometrica.” Econometrica. P. Second International Symposium on Information Theory. D. L.” Journal of Business and Economic Statistics. Pagan (1979): “The Lagrange multiplier test and its application to model speciﬁcation in econometrics.” Econometrica. D. [6] Andrews.W. and H. [2] Akaike. 821-8516. (1988): “Edgeworth correction by bootstrap in autoregressions.K. 239-253.K. 186 .A. 657-681. Petroc and F. (1968): Convergence of Probability Measures.K. P. 458-467.. 1709-1722. D. New York: Wiley.

427-431.” Annals of Statistics.” Econometrica. R. Fuller (1979): “Distribution of the estimators for autoregressive time series with a unit root. Tibshirani (1993): An Introduction to the Bootstrap. Cambridge: Harvard University Press. (1997): “Some impossibility theorems in econometrics with applications to structural and dynamic models. [27] Efron.” Journal of the American Statistical Association. Bradley (1982): The Jackknife. [30] Frisch. 65.W. Waugh (1933): “Partial time regressions as compared with individual trends.” Econometrica. (1994): Stochastic Limit Theory: An Introduction for Econometricians. Bradley (1979): “Bootstrap methods: Another look at the jackknife. New York: Chapman-Hall. and P. 387-401. I. Society for Industrial and Applied Mathematics. [22] Dickey.G.B. 1161-1191. and D. Oxford: Oxford University Press.V.J. E.F. 1. Bradley and R. Cambridge University Press. 51. 1171-1179. 69. estimation and testing. 591-603. D.C. [20] Davidson.” Econometrica.A. Phillips (1992): “Asymptotic and ﬁnite sample distribution theory for IV estimators and tests in partially identiﬁed structural equations. [23] Donald S. [26] Efron. 1-26.R.A. [18] Choi. (1963): “Asymptotic normality and consistency of the least squares estimators for families of linear regressions. 187 . (1987): “Asymptotic eﬃciency in estimation with conditional moment restrictions. G.K. A. and F. (1991): A Course in Econometrics. 305-334. Hinkley (1997): Bootstrap Methods and their Application. Granger (1987): “Co-integration and error correction: Representation. and W. New York: Basil Blackwell.C. 34. Nychka (1987): “Seminonparametric maximum likelihood estimation.” Econometrica. (1986): “The use of subseries methods for estimating the variance of a general statistic from a stationary time series. J.” Journal of Econometrics. [19] Chow. G. 7. and W. J.” Annals of Statistics.J. 55. 55. and D. [32] Gallant. [31] Gallant. A. 28. [25] Efron. 34. [33] Goldberger.W.[16] Carlstein. 74.C. [21] Davison.” Annals of Mathematical Statistics.” Journal of Econometrics. Newey (2001): “Choosing the number of instruments. 113-150. and Other Resampling Plans.F. (1960): “Tests of equality between sets of coeﬃcients in two linear regressions. F. [17] Chamberlain.” Econometrica. R. [29] Engle. 363-390. A. 251-276. the Bootstrap. White (1988): A Uniﬁed Theory of Estimation and Inference for Nonlinear Dynamic Models. 1365-1387. 14.M. and H. [28] Eicker. [24] Dufour.” Econometrica. and C. 447-456. Arthur S.

” Journal of Econometrics.” Econometrica. [39] Hall.K. 359-383.P.E. J. J. 12.” Econometrica. [40] Hall. (1992): The Bootstrap and Edgeworth Expansion. A.F. B. 14. homoskedasticity and serial independence of regression residuals.E. [48] Hausman. Spady and P.W. 262-280. 6. 16. [37] Granger.J. 65-99. 64.W. Engle and D.” Econometrica.M. 413-430. R.W. P. and J. (1982): “Large sample properties of generalized method of moments estimators. 50. Johnson (1998): “Information theoretic approaches to inference in moment condition models. C. 240-254. (1997): “One step estimators for over-identiﬁed generalized method of moments models. [42] Hall. R. (1981): “Some properties of time series data and their use in econometric speciﬁcation. 47. [38] Granger. Vol. VII. [46] Hansen. [36] Granger.” Econometrica. (2000): “Covariance matrix estimation and the power of the overidentifying restrictions test.D. 153161. Economic Letters.” Journal of Econometrics.J..” Journal of Econometrics. [45] Hansen. Rogers (1994): “Global optimization of statistical functions with simulated annealing. (1978): “Speciﬁcation tests in econometrics.L.” Review of Economic Studies. [50] Imbens. McFadden. 66. New York: Elsevier Science. Bera (1980): “Eﬃcient tests for normality.” Econometrica. Horowitz (1996): “Bootstrap critical values for tests based on GeneralizedMethod-of-Moments estimation. 64. Teräsvirta (1993): Modelling Nonlinear Economic Relationships. New York: Springer-Verlag.” Econometrica. [41] Hall.H. 1251-1271. G. 424-438. 187-197.” in Werke. and A. Ferrier and J. and T. 121-130. L. (1979): “Sample selection bias as a speciﬁcation error. [43] Hahn. G. 87-121. Vol. 1029-1054.” Econometric Theory. C. K. [44] Hansen. (1809): “Theoria motus corporum coelestium. (1996): “Inference when a nuisance parameter is not identiﬁed under the null hypothesis.W.” Handbook of Econometrics. 255-259. B. C. 68. IV. [52] Jarque.J. 53. [47] Hansen. 333-357. (1996): “A note on bootstrapping generalized method of moments estimators.. 46.F. (1992): “Eﬃcient estimation and testing of cointegrating vectors in the presence of deterministic trends. Oxford. [49] Heckman. (1969): “Investigating causal relations by econometric models and crossspectral methods. 60.P. R. P. [35] Gauss. Yaron (1996): “Finite sample properties of some alternative GMM estimators.A. (1994): “Methodology and theory for the bootstrap. Oxford University Press.[34] Goﬀe.L. Econometrica. J.” Econometrica. and A. J. 64.” Journal of Business and Economic Statistics. Heaton. L. 188 . 891-916.L. 1517-1527. G. eds. 37.. [51] Imbens. P. W. C.W.

777-787.J.W. [66] Magnus. [69] Newey. [64] MacKinnon. 861-874. 993-1010. W. and Y. J.J. 75. [65] MacKinnon. Y.. J. (1991): “Estimation and hypothesis testing of cointegration vectors in the presence of linear trend. 65.” Journal of the American Statistical Association. [67] Muirhead. 308-313.” Journal of Econometrics. R. Juselius (1992): “Testing structural hypotheses in a multivariate cointegration analysis of the PPP and the UIP for the UK. [70] Owen.F.B. New York: Wiley. and H. 7. (1989): “The jackknife and the bootstrap for general stationary observations. Shin (1992): “Testing the null hypothesis of stationarity against the alternative of a unit root: How sure are we that economic time series have a unit root?” Journal of Econometrics. 159-178. [61] Kwiatkowski. R. (1990): “Critical values for cointegration. S.R. Oxford.” Econometrica. (1988): “Empirical likelihood ratio conﬁdence intervals for a single functional. and K. Schmidt. Y.” Journal of Econometrics.K. [58] Kitamura. White (1985): “Some heteroskedasticity-consistent covariance matrix estimators with improved ﬁnite sample properties. Cambridge University Press. [54] Johansen. 189 .” Journal of Economic Dynamics and Control. Mead (1965): “A simplex method for function minimization. 211-244. and H. 1217-1241. (1963): “Seasonal adjustment of economic time series.G. S.” Computer Journal. [63] Lovell. 237-249. Stutzer (1997): “An information-theoretic alternative to generalized method of moments. 1661-1672. 29. 17. and R. (1988): “Statistical analysis of cointegrating vectors. [60] Kunsch. 35-40.G. Roger (2005): Quantile Regression. Neudecker (1988): Matrix Diﬀerential Calculus with Applications in Statistics and Econometrics.) Long-Run Economic Relationships: Readings in Cointegration. 1551-1580. New York: John Wiley and Sons. S. (2001): “Asymptotic optimality and empirical likelihood for testing moment restrictions. D.” Economics Letters. (1995): Likelihood-Based Inference in Cointegrated Vector Auto-Regressive Models. White (1986): “Obtaining any Wald statistic you want. Phillips. S.” in Engle. West (1987): “Hypothesis testing with eﬃcient method of moments estimation.D.” Econometrica. and C.” International Economic Review.[53] Johansen. Oxford University Press. 12.. 69. 59. 54.. J. 53. M. F. [59] Koenker. and M. P. 21.C. Art B. 28. P.C. 58.” Econometrica. [57] Kitamura. Granger (eds. R. 305-325. Oxford University Press. (1982): Aspects of Multivariate Statistical Theory. and K. 231-254. J. and K. [56] Johansen.” Annals of Statistics. H. [68] Nelder.” Biometrika. [62] Lafontaine. [55] Johansen.

London: Chapman and Hall. C. Jones (1991): “A reliable data-based bandwidth selection method for kernel density estimation.” Biometrika. and J. 22. (1972): “Money. [76] Qin. 10.[71] Owen. Wright (2000): “GMM with weak identiﬁcation.D. 3rd edition. Stock (1997): “Instrumental variables regression with weak instruments. 683-690.B.H.” Econometrica.” American Economic Review. 1035-1056. Lawless (1994): “Empirical likelihood and general estimating equations.” Econometric Theory. 28. 557-586. Y. and J. Journal of the Royal Statistical Society.P. 1303-1313. 48. J.A. W. 599-608. Series B. 31. [88] Stock.” Econometrica.” Journal of the American Statistical Association. [82] Sheather. [73] Phillips. J. 163-185. Tu (1995): The Jackknife and Bootstrap. (1991): “Eﬀects of model selection on inference. [72] Phillips. 7.” Econometrica.” Journal of the Royal Statistical Society.H. 5. (1991): “Conﬁdence intervals for the largest autoregressive root in U. B. and J.M.W. (1980): “Macroeconomics and reality. D. (1958): “The estimation of economic relationships using instrumental variables. 165-193.J. 58.” Econometric Theory. [84] Silverman. 91-115. (1987): Real and Complex Analysis. 68. 53. 300-325. 62. 71.B. [90] Stock. [80] Shao.H. 1055-1096. 89. J. 350-371. (1987): “Asymptotic properties of least squares estimators of cointegrating vectors. macroeconomic time series.” The Annals of Statistics.” Econometrica. J. Dickey (1984): “Testing for unit roots in autoregressive-moving average models of unknown order.S. J. [78] Rudin. J. and D. New York: McGraw-Hill.H. [86] Sims. (1986): Density Estimation for Statistics and Data Analysis. 1-48.N. [83] Shin.H. 435-460.C. [79] Said. [75] Potscher. 2 6. C. [77] Ramsey. and D. Ouliaris (1990): “Asymptotic properties of residual based tests for cointegration.A. 393-415. P. (1994): “A residual-based test of the null of cointegration against the alternative of no cointegration. income and causality.” Journal of Monetary Economics. and S. [74] Politis. and M. 181-240. P. NY: Springer. Series B. 55.A. [81] Sargan.C. J. Art B. D. (1969): “Tests for speciﬁcation errors in classical linear least-squares regression analysis. [89] Stock.” Econometrica. [87] Staiger. 540-552. 65. (2001): Empirical Likelihood. (1989): “Partially identiﬁed econometric models.” Econometrica. Romano (1996): “The stationary bootstrap. S. S. [85] Sims. and J.E. B. New York: Chapman & Hall. 190 .C. B.” Econometric Theory.

Academic Press.” Journal of the American Statistical Association.” Transactions of the American Mathematical Society. and E. [92] Tobin. (1980): “A heteroskedasticity-consistent covariance matrix estimator and a direct test for heteroskedasticity. 66. 1389-1404. J. A. 24-36. and tests for aggregation bias. H.[91] Theil. H. 54.” Econometrica. A. (1984): Asymptotic Theory for Econometricians. [93] Wald. 2 6. 426-482. J.” The Hague. Central Planning Bureau. 191 . (1953): “Repeated least squares applied to complete equation systems. [96] White. (1962): “An eﬃcient method of estimating seemingly unrelated regressions.” Econometrica. 48. 817-838. 57. [97] Zellner. H. mimeo. (1958): “Estimation of relationships for limited dependent variables. (1943): “Tests of statistical hypotheses concerning several parameters when the number of observations is large.” Econometrica. [94] Wang. Zivot (1998): “Inference on structural parameters in instrumental variables regression with weak instruments. 348-368. [95] White.

- SOLUTION CHARACTERISTICS OF QUADRATIC POWER FLOW PROBLEMS
- 2012.fall.prelim1.pdf
- A-Generalized-Optimal-Sensor-Placement-Technique-for-Structural-Health-Monitoring-and-System-Identification_2014_Procedia-Engineering.pdf
- A comprehensive analytical approach for policy analysis of system dynamics models.pdf
- 919-898-1-PB
- Large VARs Bandura Giannone Reichlin
- 40107h15sol
- artinvocab
- Bennett 1977
- Long Long Thesis on Nmf
- MATH 15 SYLLABUS (EE,ECE,CPE).pdf
- Chapter 13 II Matrices ENRICH
- MIMO Algebra
- Qr Method Proof
- UT Dallas Syllabus for meco6320.001.10f taught by Yexiao Xu (yexiaoxu)
- Design and Analysis of Thin-Rimmed Gears Using Finite Element Modelling
- Cryptography Using Matrices in Real Life
- final_10
- A Generalized Optimal Sensor Placement Technique for Structural Health Monitoring and System Identification 2014 Procedia Engineering
- Linear algebra
- Thesis Main
- MATLAB Materials
- 09math-e
- final.pdf
- Linn 7079
- Hamse Y. Mussa and Jonathan Tennyson- Bound and quasi-bound rotation-vibrational states using massively parallel computers
- GQB_IN.pdf
- A Tutorial on Principal Component Analysis
- Mining massive data sets
- dynamics.pdf

Sign up to vote on this title

UsefulNot usefulRead Free for 30 Days

Cancel anytime.

Close Dialog## Are you sure?

This action might not be possible to undo. Are you sure you want to continue?

Loading