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

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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

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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 . . . . .

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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

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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

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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 . . . . . . . . . . .

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ii

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .10 8. . . . . . . . .2 Autoregressions . . . . . . 10.4 Testing . . . . . . . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11. . . . . . . . . . . .2 GMM Estimator . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Overidentiﬁed Linear Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8. . . . . . . . . . . . . . . .3 Distribution of GMM Estimator . . . . . . . . . .7 Asymptotic Distribution . . . . . . . . . . 12. . . . . . . . . . . 12. . . . . . . . .3 Stationarity of AR(1) Process . . . . . . . . . 12. . . . . . . . . . . . . . . . . . . . . .2 Reduced Form . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Stationarity and Ergodicity . . . . .3 Overidentifying Restrictions .6 Bekker Asymptotics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Instrumental Variables . . . . . . . . . . . . . . . . iii . . . . . . . .6 Estimation . . . . . . . . . . . . .2 Asymptotic Distribution of EL Estimator 10. . . . . . . . . . . . . . . . . . . .10 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .11Model Selection . . . . . . . 12. . . . . . 12. . . . . . . .6 Over-Identiﬁcation Test . . . . . . . . . . . . . . . . .5 GMM: The General Case . . . . . . . . . . . . . . . 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. . 9. . . . . . . . . . . . . . . . . . . . Percentile Conﬁdence Intervals . . . . . . . . . . . . . 9. . . .8 Bootstrap for Autoregressions . . . . . . . . . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4 Lag Operator . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11. . . . . . . . . .5 Numerical Computation . . . . . . . . . . . . . . . 11. . . . . . .9 Trend Stationarity . . . . . . . . .9 Bootstrap GMM Inference . . . . . . . . . . . . . . . . . .1 Non-Parametric Likelihood . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .10Testing for Omitted Serial Correlation 12. . . . . . . . . . . . . . . . . . . . . .8 Conditional Moment Restrictions . . . . . . . . . . . . . . . . . .5 Stationarity of AR(k) . . . . . . . . . . . . . . . . . .3 Identiﬁcation . . . .8 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10. . . . . . . . . . . . . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9. . . . . . . . . . . . . . . . . .12Autoregressive Unit Roots . . . . . . . . . . . . . . . . . . . . . . . . Bootstrap Methods for Regression Models Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9. . . . . . . 10 Empirical Likelihood 10. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . .4 Estimation of the Eﬃcient Weight Matrix . . . . . . . . . . . . . 11. . . . . . . . . . . . . . .7 Identiﬁcation Failure . . . . . . . . . . . . . . . 11 Endogeneity 11. . . . . . . . . . . . . . 12 Univariate Time Series 12. . . . . . . . . . . . . 10. . . . 12. . . . . . . . . . . . . . . . . 12.12 8. . . . . . . . . . . . . . . . . . .11 8. . . . . . . . . . . . . . . .4 Estimation .13 One-Sided Tests . .7 Hypothesis Testing: The Distance Statistic 9. . . . . . . . . . . . . . . . . . . . . . . . . . . . 11. . . . . . . . . . . . . . . . . . . . . . . 11. . . . . . . . . . . . . . . . . . . .5 Special Cases: IV and 2SLS 11. . . . . . . . . . . . . . .9 8. . Symmetric Two-Sided Tests .

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

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

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

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

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

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

For example. A k × k identity matrix is denoted as ⎡ ⎤ 1 0 ··· 0 ⎢ 0 1 ··· 0 ⎥ ⎢ ⎥ Ik = ⎢ . . are said to be orthogonal if A0 A = Ir . then AIr = A and Ik A = A. . ⎦ ⎣ . . for k × r A and r × k B we have tr (AB) = tr (BA) tr (A + B) = tr (A) + tr (B) 6 .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.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. . ⎤ ⎥ ⎥ ⎥ ⎦ 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. . which has ones on the diagonal. r ≤ k. The columns of a k × r matrix A. ⎥ . We say that two vectors a and b are orthogonal if a0 b = 0. . ¸ B12 B22 ¸ A11 B12 + A12 B22 A21 B12 + A22 B22 ⎡ B1 B2 . 0 0 ··· 1 2. An important diagonal matrix is the identity matrix. Also. . . A square matrix A is called orthogonal if A0 A = Ik .

. a0 bk k ⎤ ⎥ ⎥ ⎥ ⎦ a0 bi i b0 ai i = = tr (BA) .1) . In this case there exists a unique matrix B such that AB = BA = Ik . (2. if there is no c 6= 0 such that Ac = 0. . some properties include AA−1 = A−1 A = Ik ¡ ¢−1 ¡ −1 ¢0 = A0 A Even if a matrix A does not possess an inverse. 0b 0b ak 1 ak 2 · · · a0 bk 1 a0 bk 2 .4 Inverse A k × k matrix A has full rank. The Moore-Penrose generalized inverse A− satisﬁes (2.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 . . (2. This matrix is called the inverse of A and is denoted by A−1 .3) plus the following three conditions A− AA− = A− AA− is symmetric A− A is symmetric For any matrix A. the Moore-Penrose generalized inverse A− exists and is unique. If A − BD−1 C and D − CA−1 B are non-singular. For non-singular A and C. if A is an orthogonal matrix. . . . we can still deﬁne a generalized inverse A− as a matrix which satisﬁes AA− A = A.3) The matrix A− is not necessarily unique. then A−1 = A. The following fact about inverting partitioned matrices is sometimes useful. 2.2) 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. 7 Also. then # ¡ ¢−1 ¡ ¢−1 ∙ ¸−1 " A − BD−1 C A B − A − BD−1 C BD−1 ¡ ¡ ¢−1 ¢−1 = . . or is nonsingular.

c0 Ac ≥ 0. • If A is symmetric.. • The characteristic roots of A−1 are λ−1 . k < n. there exists a nonsingular matrix P such that A = P −1 ΛP and P AP −1 = Λ. 2.) If A is positive deﬁnite. Let Λ be a diagonal matrix with the characteristic roots in the diagonal. 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 . then A > 0 if and only if all its characteristic roots are positive. X 0 X is symmetric and positive deﬁnite.. 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 = G0 G.. λ−1 .. If A > 0 we can ﬁnd a matrix B such that A = BB 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. If A is also symmetric (most idempotent matrices are) then all its characteristic roots equal either zero or one. then A is positive semi-deﬁnite. i = 1. then A is non-singular and A−1 exists. then A = HΛH 0 and H 0 AH = Λ. A square matrix A is idempotent if AA = A. 8 . Let λi and hi . which are not necessarily distinct and may be real or complex. Furthermore. • If A has distinct characteristic roots.2. λ−1 . We now state some useful properties. c0 Ac = α0 a ≥ 0 where α = Gc. We say that X is n × k. Then A = AA = HΛH 0 HΛH 0 = HΛ2 H 0 . has full rank k if there is no non-zero c such that Xc = 0. k denote the k eigenvalues and eigenvectors of a square matrix A. This is written as A > 0. This is written as A ≥ 0. 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.5 Eigenvalues det (A − λIk ) = 0. To see this. If A is symmetric. and let H = [h1 · · · hk ]. . note that we can write A = HΛH 0 where H is orthogonal and Λ contains the (real) characteristic roots.. The matrix B need not be unique. We say that a square matrix A is positive semi-deﬁnite if for all non-zero c. A−1 > 0. and the characteristic roots are all real. We say that A is positive deﬁnite if for all non-zero c. In this case. We call B a matrix square root of A. . c0 Ac > 0.6 Rank and Positive Deﬁniteness The rank of a square matrix is the number of its non-zero characteristic roots. (For any c 6= 0. and then set B = HΛ1/2 . 1 2 k The decomposition A = HΛH 0 is called the spectral decomposition of a matrix.. They are called the latent roots or characteristic roots or eigenvalues of A.

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

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

or the covariates.2) m(x) = E (yi | xi = x) = −∞ In general. holding the other variables constant. gender.1) xi = ⎜ . An important summary measure is the conditional mean Z ∞ yf (y | x) dy.1 by the arrows drawn to the x-axis. m(x) can take any form. we can focus on f (y | x) . which is a common feature of wage distributions.22. In this context we partition the observations into the pair (yi . We list the elements of xi in the vector ⎞ ⎛ x1i ⎜ x2i ⎟ ⎟ ⎜ (3. While it is easy to observe that the two densities are unequal.1. and exists so long as E |yi | < ∞.1 Conditional Mean To study how the distribution of yi varies with the variables xi in the population.Chapter 3 Regression and Projection The most commonly applied econometric tool is regression. Figure 3. the mean is not necessarily a good summary of the central tendency. In the example presented in Figure 3. The data are from the 2004 Current Population Survey 1 11 . When a distribution is skewed. Take a closer look at the density functions displayed in Figure 3. These are asymmetric (skewed) densities. This is used when the goal is to quantify the impact of one set of variables on another variable. The two density curves show the eﬀect of gender on the distribution of wages. We call xi alternatively the regressor. See Chapter 16. These are conditional density functions — the density of hourly wages conditional on race. education and experience. ⎟ . You can see that the right tail of then density is much thicker than the left tail. from the population of white non-military wage earners with a college degree and 10-15 years of potential work experience. ⎠ ⎝ . it is useful to have numerical measures of the diﬀerence. These are indicated in Figure 3. xi ) where yi is a scalar (real-valued) and xi is a vector. In this context it is often convenient These are nonparametric density estimates using a Gaussian kernel with the bandwidth selected by crossvalidation. the mean wage for men is $27.73. We call yi the dependent variable. and that for women is $20. xki 3. (3. the conditioning variable. . the conditional density of yi given xi .1. To illustrate.1 displays the density1 of hourly wages for men and women.

3 displays a scatter plot2 of log wages against education levels. For this reason. 3. the dashed line is a linear projection approximation which will be discussed in the Section 3.A. this yields the formula yi = m(xi ) + ei .36.1: Wage Densities for White College Grads with 10-15 Years Work Experience to transform the data by taking the (natural) logarithm.3 is how the conditional expectation describes an important feature of the conditional distribution. Figure 3.5. which implies a 30% average wage diﬀerence for this population. The main point to be learned from Figure 3.D.Figure 3. then comparisons become more complicated.2 shows the density of log hourly wages for the same population. degree in mean log hourly wages is 0.30. To illustrate. 2 (3. The conditional expectation function is close to linear. Assuming for simplicity that this is the true joint distribution. When the distribution of the control variable is continuous. the solid line displays the conditional expectation of log wages varying with education. The comparison in Figure 3. implying an average 36% diﬀerence in wage levels.2 Regression Equation The regression error ei is deﬁned to be the diﬀerence between yi and its conditional mean (3. By construction. 12 . This is a more robust measure of the typical wage gap between men and women than the diﬀerence in the untransformed wage means.3) White non-military male wage earners with 10-15 years of potential work experience.2) evaluated at the observed value of xi : ei = yi − m(xi ). and a Ph.1 is facilitated by the fact that the control variable (gender) is discrete. wage regressions typically use log wages as a dependent variable rather than the level of wages. with mean log hourly wages drawn in with the arrows. Of particular interest to graduate students may be the observation that diﬀerence between a B. The diﬀerence in the log mean wage between men and women is 0. Figure 3.

It is important to understand that this is a framework.2.2: Log Wage Densities Theorem 3. E (ei | xi ) = 0. most typically. E (ei | xi ) = E ((yi − m(xi )) | xi ) = m(xi ) − m(xi ) = E (yi | xi ) − E (m(xi ) | xi ) = 0.Figure 3. These equations hold true by deﬁnition. E(ei ) = 0. 2. A regression model imposes further restrictions on the joint distribution. because no restrictions have been placed on the joint distribution of the data. 4. The equations yi = m(xi ) + ei E (ei | xi ) = 0. restrictions on the permissible class of regression functions m(x). not a model. The remaining parts of the Theorem are left as an exercise. To show the ﬁrst statement. E (h(xi )ei ) = 0 for any function h (·) . E(xi ei ) = 0. 3. 13 . by the deﬁnition of ei and the linearity of conditional expectations. are often stated jointly as the regression framework.1 Properties of the regression error ei 1.

the conditional variance of yi is σ 2 = σ 2 (xi ). A common measure of the dispersion is the conditional variance ¡ ¢ σ 2 (x) = V ar (yi | xi = x) = E e2 | xi = x .1.Figure 3.3. and can take any form.3 Conditional Variance Generally. Given the random variable xi . σ 2 (x) is a non-trivial function of x.3: Conditional Mean of Wages Given Education The conditional mean also has the property of being the the best predictor of yi . In the general case i where σ 2 (x) depends on x we say that the error ei is heteroskedastic. To see this. let g(x) be an arbitrary predictor of yi given xi = x. subject to the restriction p that it is non-negative. i . it does not provide information about the spread of the distribution. in the sense of achieving the lowest mean squared error. 3. The conditional standard deviation is its square root σ(x) = σ 2 (x). Thus the mean squared error is minimized by the conditional mean.2. 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. when σ 2 (x) is a constant so that ¢ ¡ (3.4) E e2 | xi = σ 2 i 14 While the conditional mean is a good measure of the location of a conditional distribution. The right-hand-side is minimized by setting g(x) = m(x). In contrast.

Some textbooks inappropriately describe heteroskedasticity as the case where “the variance of ei varies across observation i”. βk ⎛ (3.5) xi = ⎜ . ⎠ . ⎟ . we assume that x1i = 1. i (3.6) (3.we say that the error ei is homoskedastic. ⎠ .3) can be writen as yi = x0 β + ei i E (ei | xi ) = 0. take the conditional wage densities displayed in Figure 3. it is more realistic to view the linear speciﬁcation (3. where x1i is the ﬁrst element of the vector xi deﬁned in (3.5 Best Linear Predictor While the conditional mean m(x) = E (yi | xi = x) is the best predictor of yi among all functions of xi . we can write it as m(x) = x0 β = β 1 + x2i β 2 + · · · + xki β k where ⎞ β1 ⎜ . 3.3) is when the conditional mean function m(x) is linear in x (or linear in functions of x). We call this the “constant” or “intercept”. Equivalently. ⎟ β=⎝ .6) as an approximation. xki When m(x) is linear in x. In this case (3. This concept is less helpful than deﬁning heteroskedasticity as the dependence of the conditional variance on the observables xi . An important special case is homoskedastic linear regression model yi = x0 β + ei i E (ei | xi ) = 0 ¢ ¡ E e2 | xi = σ 2 .1 and that for women is 10.4 Linear Regression An important special case of (3. 15 .1). ⎝ . which we derive in this section. and the linear assumption of the previous section is empirically unlikely to accurate.5.7) is a k × 1 parameter vector.1) has been redeﬁned as the k × 1 vector ⎛ ⎞ 1 ⎜ x2i ⎟ ⎜ ⎟ (3. they are also somewhat more dispersed. So while men have higher average wages. Equation (3. Notationally. Thus (3.9) 3. As an example.1. it is convenient to augment the regressor vector xi by listing the number “1” as an element. Instead.8) is called the linear regression model. The conditional standard deviation for men is 12. its functional form is typically unknown.8) (3.

We now summarize the assumptions necessary for its derivation and list the implications in Theorem 3.11) 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 . i (3. 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. α0 E (xi x0 ) α = E (α0 xi )2 > 0. otherwise they are distinct. Rewriting. i 16 . Given the deﬁnition of β in (3.1.10) It is worth taking the time to understand the notation involved in this expression. i (3. Therefore. The best linear predictor is obtained by selecting β to minimize S(β). E (xi x0 ) is a mai E(x y trix and E (xi yi ) is a vector. It is invertible if and only if it is positive deﬁnite. xi contains an intercept. The vector (3. i 4. Observe i that for any non-zero α ∈ Rk . alternative expressions such as E xixi ) or E (xi yi ) (E (xi x0 ))−1 i ( i 0i ) are incoherent and incorrect. i i (3. this situation must be excluded. Equivalently. In order for β to be uniquely deﬁned.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. The ﬁrst-order condition for minimization (from Section 2.7) is 0= Solving for β we ﬁnd ¡ ¢ ∂ S(β) = −2E (xi yi ) + 2E xi x0 β.10). The error is i ei = yi − x0 β. This occurs when redundant variables are included in xi . by “best” we mean the predictor function with lowest mean squared error. 2 2. i which requires that for all non-zero α.which is quadratic in β. Assumption 3. written E (xi x0 ) > 0. i ∂β ¢¢−1 ¡ ¡ E (xi yi ) . 3.5.1 1. there cannot i exist a non-zero vector α such that α0 xi = 0 identically. As before. E (x0 xi ) < ∞.5. x0 β is the best linear predictor for yi . we obtain a decomposition of yi into linear predictor and error yi = x0 β + ei . α0 E (xi x0 ) α = E (α0 xi )2 ≥ 0 so the matrix E (xi x0 ) is by construction i i positive semi-deﬁnite. Eyi < ∞. E (xi x0 ) is invertible.

5.13) The two equations (3. (3. The ﬁnite variance Assumptions 3.11) and (3. Then i i Exi e2 = Ex3 = 0 yet E (ei | xi ) = x2 6= 0.1.5. 17 .1. By deﬁnition.5.5. Assumption 3.14).1.1.13) and Assumption 3.1.10) and (3.1 is employed to guarantee that (3.1. Using the deﬁnitions (3. However. x0 β is the i projection of yi on xi since the error ei is orthogonal with xi .4 is required to ensure that β is uniquely deﬁned. Assumption 3.1.1. Assumption 3.5.12) can be alternatively interpreted as a projection decomposition. Let’s compare it with the linear regression model (3.13) implies that xi and ei are uncorrelated.11) are well deﬁned.4: Hourly Wage as a Function of Experience The conditions listed in Assumption 3.2 and 3. i i i Since E (xi ei ) = 0 we say that xi and ei are orthogonal. Furthermore. Since from Theorem 3. suppose that for xi ∈ R that Ex3 = 0 and ei = x2 . it follows that linear regression is a special case of the projection model.8)-(3.4 guarantees that the solution β exits.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 3.12) and (3. Equation (3.14) Proof. This means that the equation (3. the converse is not true as the projection error does not necessarily satisfy E (ei | xi ) = 0.4 we know that the regression error has the property E (xi ei ) = 0.1 Under Assumption 3. ¥ (3.5. Since ei is mean zero by (3.5.3 ensure that the moments in (3. For example.1 are weak.Theorem 3.1.10) are deﬁned.14) holds. E (xi ei ) = 0 and E (ei ) = 0. (3.2.9).1. Figure 3.5. the orthogonality restriction (3.1.5.5.5.14) follows from (3.3 are called regularity conditions. Assumption 3.13) summarize the linear projection model.

since the resulting function is quadratic in experience.5 for a 3 In the population of Caucasian non-military male wage earners with 12 years of education. In Figure 1. 18 . and are discussed in Chapter 11. and under-predicts for the rest. xi ) we can deﬁne a linear projection equation (3. In contrast. the dashed line is the linear projection of log wages on eduction. We illustrate the issue in Figure 3.4 we display as well this quadratic projection. there are no changes in our methods or analysis. In this case (3.We have shown that under mild regularity conditions. In this example it is a much better approximation to the conditional mean than the linear projection.4 displays the relationship3 between mean log hourly wages and labor market experience. Most importantly.1.12) with the properties listed in Theorem 3.10) may not hold and the implications of Theorem 3. Returning to the joint distribution displayed in Figure 3. Other than the redeﬁnition of the regressor vector.1 may be false.3.5. The solid line is the conditional mean. In the example just presented. for those over 53 in age). we can augment the regressor vector xi to include both experience and experience2 . It over-predicts wages for young and old workers. Figure 3. it misses the strong downturn in expected wages for those above 35 years work experience (equivalently.5.5: 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. in many economic models the parameter β may be deﬁned within the model. No additional assumptions are required.10).12) is deﬁned by projection and the associated coeﬃcient deﬁnition (3. These structural models require alternative estimation methods. Figure 3. The linear equation (3. However. for any pair (yi . A projection of log wages on these two variables can be called a quadratic projection. This defect in linear projection can be partially corrected through a careful selection of regressors. it is important to not misinterpret the generality of this statement. In this case the linear projection is a poor approximation to the conditional mean. In other cases the two may be quite diﬀerent. and the straight dashed line is the linear projection. In this example the linear projection is a close approximation to the conditional mean.

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

(x − µ)2 − σ 2 Show that Eg (X.6 Exercises 1. True or False. Compute the conditional mean m(x) = E (yi | xi = x) . and E(ei | xi ) = 0. xi ∈ R. Take the bivariate linear projection model yi = β 0 + β 1 xi + ei E (ei ) = 0 E (xi ei ) = 0 Deﬁne µy = Eyi . i 11. then E(x2 ei ) = 0. σ 2 = V ar(yi ) and σ xy = Cov(xi .1.1 . x 6. µx = Exi . i 10. 1. σ = . Are they diﬀerent? Hint: If P (Y = j) = 5. then ei is i i independent of xi . ¡ ¢ 4. If yi = xi β + ei . Compute E(yi | xi = x) and V ar(yi | xi = x). . True or False. Suppose that yi is discrete-valued. Let X be a random variable with µ = EX and σ 2 = V ar(X). then E(ei | xi ) = 0. Compute 2 the coeﬃcients of the linear projection yi = β 0 + β 1 xi + ei . then ei is independent of xi . E(Y 2 | X = x) and V ar(Y | X = x). µ. σ 2 = V ar(xi ). Does this justify a linear regression model of the form yi = x0 β + εi ? i then EY = λ and V ar(Y ) = λ. Show that x y β 1 = σ xy /σ 2 and β 0 = µy − β 1 µx . taking values only on the non-negative integers. j! 0 j = 0. Suppose that Y and X only take the values 0 and 1. i 7. 9. 0 ≤ y ≤ 1. True or False. 3. and E(xi ei ) = 0.3 Find E(Y | X = x). 3 and 4 of Theorem 3.4 . a constant.. If yi = xi β + ei . 20 . If yi = x0 β + ei . True or False. and have the following joint probability distribution X=0 X=1 Y =0 . If yi = x0 β + ei and E(xi ei ) = 0.2. Deﬁne µ ¶ ¢ ¡ x−µ 2 g x. 2. True or False. and the conditional distribution of yi given xi is Poisson: P (yi = k | xi = x) = e−x β (x0 β)j . e−λ λj j! . yi ). If yi = x0 β + ei and E(ei | xi ) = 0. i 8. y) = 3 x2 + y 2 on 0 ≤ x ≤ 1. E(ei | xi ) = 0.3.2 Y =1 . Prove parts 2. then E(x2 ei ) = 0. xi ∈ R. Let xi and yi have the joint density f (x. and E(e2 | xi ) = σ 2 . m. 2.. s) = 0 if and only if m = µ and s = σ 2 .

we narrow the focus to the linear regression model. i n i=1 n 21 .3) In Sections 4. 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 . The function g(β) can be estimated by form g(β) = E (xi (yi − xi g (β) = ˆ ¢ 1X ¡ xi yi − x0 β . but for most of the chapter we retain the broader focus on the projection model.1 Estimation Equation (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 .4) i i=1 i=1 ˆ Another way to derive β is as follows.8.1) (4.7 and 4.3) writes the projection coeﬃcient β as an explicit function of population moments E (xi yi ) and E (xi x0 ) . i It follows that the moment estimator of β replaces the population moments in (4. (4. Observe that (4.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. 4.2) can be written in the parametric 0 β)) = 0.2) (4.

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. 40 0. with 10-15 years of potential work experience. 30 = .94 −2. These are white male wage earners from the March 2004 Current Population Survey. excluding military. n X i=1 2 yi − 2β 0 n X i=1 xi yi + β 0 n X i=1 xi x0 β. Let yi be log wages and xi be an intercept and years of education.4).4).170 37.95 xi yi = 42.7% increase in mean wages.117 1 14.95 42.71 = −2. 0.14 14. 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. ¶ 2.40 n i=1 1 n Thus ˆ β = n X i=1 xi x0 i = µ 1 14.14 205.2 Least Squares There is another classic motivation for the estimator (4.83 ¶−1 µ ¶ .14 14.ˆ This is a set of k equations which are linear in β. 4.14 205.30 + 0.117 Educationi .83 µ We often write the estimated equation using the format \ log(W agei ) = 1. 40 2. consider the data used to generate Figure 3.3. i 22 . Then µ ¶ n 1X 2. This sample has 988 observations.40 µ ¶µ ¶ 34.5) = n n 1X 1X ˆ xi yi − xi x0 β i n n i=1 i=1 whose solution is (4. To illustrate.37 µ ¶ 1. An interpretation of the estimated equation is that each year of education is associated with an 11.

The Ordinary Least Squares (OLS) estimator is the value of β which minimizes Sn (β). Figure 4. It is important to understand the distinction between the error ei and the residual ei . which can cause confusion.2 displays the contour lines of the same function — horizontal slices at equally spaced heights. while the residual is a by-product of estimation.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. 23 . i ˆ ˆ Note that yi = yi + ei .4). Since the function Sn (β) is a quadratic function of β. Matrix calculus (see Appendix 2. To visualize the sum-of-squared errors function. These two ˆ variables are frequently mislabeled. we deﬁne the predicted value ˆ yi = x0 β ˆ i and the residual ˆ ei = yi − yi ˆ ˆ = yi − x0 β. Figure 4.1 displays an example sum—of-squared errors function Sn (β) for the case k = 2.1: Sum-of-Squared Errors Function As a by-product of OLS estimation. Following convention we will call β the OLS estimator of β. Figure 4. The error is unobservable. the contour lines are ellipses.

ˆ n i=1 n Since xi contains a constant. and hold true for all linear regression estimates.6) An alternative estimator uses the formula n 1 X 2 s = ei .7) A justiﬁcation for the latter choice will be provided in Section 4. It measures the variation in the i “unexplained” part of the regression.5) implies that 1X xi ei = 0.2: Sum-of-Squared Error Function Contours Equation (4. 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. These are algebraic results.Figure 4. one implication is that n 1X ei = 0. ˆ σ = ˆ n 2 i=1 n (4. 24 . The error variance σ 2 = Ee2 is also a parameter of interest.7. ˆ n−k 2 i=1 (4. Its method of moments estimator is the sample average 1X 2 ei .

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

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

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

By the independence of the observations and (3. .18) E (e | X) = ⎜ E (ei | X) ⎟ = ⎜ E (ei | xi ) ⎟ = 0. The FWL theorem says that β 2 is the OLS estimate from a regression of ˜ ˜ Y on X2 . A common application of the FWL theorem. .9).9). ˆ ˜ ˜ ˆ 3. ˜ 2. 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) . ⎠ ⎝ ⎠ ⎝ . Regress Y on X2 . the OLS estimator of β 2 and the OLS residuals e may be equivalently computed by either the OLS regression (4. . In this case. 4. obtain residuals X2 . Rather.13). ! Thus the OLS estimator for the slope coeﬃcients is a regression with demeaned data. the primary use is theoretical. In some contexts. . . the FWL theorem can be used to speed computation.Theorem 4. observe that ⎞ ⎛ ⎞ ⎛ . which you may have seen in an introductory econometrics course.8)(3.14) or via the ˆ following algorithm: ˜ 1. obtain residuals Y . . is the demeaning formula for regression. 30 . In the model (4. ˆ which are “demeaned”. and X2 is the vector of observed regressors.7 Bias and Variance In this and the following section we consider the special case of the linear regression model (3.1 (Frisch-Waugh-Lovell). In this section we derive the small sample conditional mean and variance of the OLS estimator. 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. . obtain OLS estimates β 2 and residuals e. . ⎟ ⎜ ⎟ ⎜ (4. ¡ ¢−1 0 ι. . but in most cases there is little computational advantage to using the two-step algorithm. Regress Y on X1 .6. Regress X2 on X1 . Partition X = [X1 X2 ] where X1 = ι is a vector of ones. .

. σ 2 = σ 2 and we have the simplii ﬁcations D = In σ 2 . From (4. and the trace operator observe that. the properties of conditional expectations...Using (4. V ar β | X = X 0 X ⎟ ⎟ ⎟. . . 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 ³ ´ ¡ ¢−1 2 ˆ σ . Thus D is a diagonal matrix with i’th diagonal element σ 2 : i ⎛ 2 σ1 0 · · · ⎜ 0 σ2 · · · 2 ⎜ D = diag{σ 2 . 0 0 ··· 0 0 .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 . for any random vector Z deﬁne the covariance materix V ar(Z) = E (Z − EZ) (Z − EZ)0 = EZZ 0 − (EZ) (EZ)0 . 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. ⎠ (4. and (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 ) = 0.20) .8). . Then given (4.12). σ2 n ⎞ We now calculate the ﬁnite sample bias of the method ¡ moments estimator σ 2 for σ 2 .19) ˆ and thus the OLS estimator β is unbiased for β. σ 2 } = ⎜ . the properties additional assumption of conditional homoskedasticity E ei i of projection matrices. . . .18). X 0 DX = X 0 Xσ 2 . under the of ˆ ¢ 2 | x = σ 2 .. .. Next. We have shown that which implies ³ ´ ˆ E β|X =β ³ ´ ˆ E β =β (4. 1 n . ⎝ .

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

(We know the values yi and xi can take. and is a strong justiﬁcation for the least-squares estimator.Proof.. That is. π j is the percentage of the observations ˆ ˆ which fall in each category. the maximum likelihood estimator (MLE) is ¡ ¢ 1X 1 (yi = τ j ) 1 xi = ξ j πj = ˆ n i=1 n for j = 1.5) as required.. The MLE β mle for β is then the analog of (4. xi = ξ j = π j . the deﬁnition (4.3) can be rewritten as ⎞−1 ⎛ ⎞ ⎛ r r X X β=⎝ πj ξ j ξ 0 ⎠ ⎝ πj ξ j τ j ⎠ (4.. The variance of the least-squares estimator is (X 0 X)−1 σ 2 and that of A0 Y is A0 Aσ 2 . 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 2.9 Semiparametric Eﬃciency In the previous section we presented the Gauss-Markov theorem as a limited eﬃciency justiﬁcation for the least-squares estimator. Not only has the class of models has been restricted to homoskedastic linear regressions. π r ) . who established that in the projection model the OLS estimator has the smallest asymptotic meansquared error among feasible estimators. 4.. .. Let A be any n×k function of X such that A0 X = Ik . Assume that the τ j and ξ j are known. Set C = A − X (X 0 X)−1 . xi ) is discrete. Suppose that the joint distribution of (yi . ˆ β mle = ⎝ j j=1 j=1 33 . As the data are multinomial. This latter restriction is particularly unsatisfactory. This property is called semiparametric eﬃciency. and π j .) In this discrete setting. but we don’t know the probabilities.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 ⎠ . It is suﬃcient to show that the diﬀerence A0 A − (X 0 X)−1 is positive semi-deﬁnite. ξ j . where 1 (·) is the indicator function. A broader justiﬁcation is provided in Chamberlain (1987). 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. . but the π j are unknown. j = 1. We discuss the intuition behind his result in this section. the class of potential estimators has been restricted to linear unbiased estimators. That is... but it is quite limited in scope. ¡ ¢ P yi = τ j . r.21) j j=1 j=1 Thus β is a function of (π 1 . for ﬁnite r. r for some constant vectors τ j .. .. Note that X 0 C = 0. ¥ The Gauss-Markov theorem is an eﬃciency justiﬁcation for the least-squares estimator.

10 Omitted Variables xi = µ x1i x2i ¶ . the maximum likelihood estimator is identical to the OLS estimator. He observes that the above argument holds for all multinomial distributions.10) for the class of models satisfying Assumption 3.9). if the data have a discrete distribution.5.1. 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. 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 . 1X xi x0 i n i=1 1X xi yi n i=1 n ˆ = β ols 4. He proves that generically the OLS estimator (4. and thus so is the OLS estimator. and any continuous distribution can be arbitrarily well approximated by a multinomial distribution.22) 34 .4) is an asymptotically eﬃcient estimator for the parameter β deﬁned in (3. Since this is a regular parametric model the MLE is asymptotically eﬃcient (see Appendix A. 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 . Chamberlain (1987) extends this argument to the case of continuously-distributed data.Substituting in the expressions for π j . (4.

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

27) (4. and 1 0 XX= n µ 1 ρ ρ 1 ¶ In this case The correlation ρ indexes collinearity. 1] and sum to k. We can see this most simply in a homoskedastic linear regression model with two regressors yi = x1i β 1 + x2i β 2 + ei . As a consequence. A convenient alternative expression is ¡ ¢−1 ˆ ˆ xi ei ˆ (4.24) β (−i) = X(−i) X(−i) is the i’th diagonal element of the projection matrix X (X 0 X)−1 X 0 . 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. Thus the more “collinear” are the estimate σ 2 1 − ρ2 regressors. it is statistically diﬃcult to disentangle the impact of β 1 from that of β 2 . What is happening is that when the regressors are highly dependent. the precision of individual estimates are reduced. The hi take values in [0. ˆ ˆ (4. ˆ i A simple comparison yields that ˆ ei − ei.26) As we can see.12 Inﬂuential Observations where X(−i) and Y(−i) are the data matrices omitting the i’th row. In extreme cases it is possible that the reported calculations will be in error due to ﬂoating-point calculation diﬃculties.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. We can also deﬁne the leave-one-out residual ˆ ˆ ei.−i = (1 − hi )−1 hi ei . the worse the precision of the individual coeﬃcient estimates. If the i’th observation 36 . We derive expression (4. = V ar β ρ 1 n n (1 − ρ2 ) −ρ 1 4. since as ρ approaches 1 the matrix becomes singular. deﬁne the leave-one-out least-squares estimator of β. A more relevant implication of near multicollinearity is that individual coeﬃcient estimates will be imprecise. the change in the coeﬃcient estimate by deletion of the i’th observation depends critically on the magnitude of hi .25) below. the OLS estimator based on the sample excluding the i’th observation. To investigate the possibility of inﬂuential observations. µ ¶−1 µ ¶ ³ ´ 2 σ2 1 ρ 1 −ρ ˆ|X = σ .−i = yi − x0 β (−i) = (1 − hi )−1 ei .One implication of near singularity of matrices is that the numerical reliability of the calculations is reduced. This equals ´−1 ³ 0 ˆ X(−i) Y(−i) (4. that is.

ˆ We now derive equation (4. The key is equation (2. ˆ = β − (1 − hi )−1 X 0 X and thus ˆ β (−i) = 37 .4 which states that ¡ ¢ (A + BCD)−1 = A−1 − A−1 BC C + CDA−1 BC CDA−1 . then this observation is a leverage point and has the potential to be an inﬂuential observation. 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 2.25).This implies has a large value of hi .27). which is considerably more informative than plots of the uncorrected residuals ei .

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

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

2.2 Weak Law of Large Numbers Let Zn ∈ Rk be a random vector. The WLLN shows that sample averages converge in probability to the population average. Set Y = g(X) and let f denote the density function of Y. Let a + bx be the tangent line to g(x) at x = EX. g(x) ≥ a + bx yet g(EX) = a + bEX since the curve is tangent at EX. P (g(X) > α) ≤ α−1 Eg(X).3). This is a probabilistic way of generalizing the mathematical deﬁnition of a limit. Note EU = EV = 1. ¥ 5. For any strictly increasing function g(X) ≥ 0. tangent lines lie below it. Since g(x) is convex. (E |X|p )1/p (E |Y |q )1/q ¥ µ ¶ ´ ³ U V 1 1 1/p 1/q ≤E + = + = 1. =E U V p q p q Proof of Markov’s Inequality.1 Weak Law of Large Numbers (WLLN). n i=1 42 . ¥ Proof of Holder’s Inequality. Theorem 5. Eg(X) ≥ a + bEX = g(EX). 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 ) = + . p p p q which is (5.4) Proof of Jensen’s Inequality. Applying expectations. Let U = |X|p /E |X|p and V = |Y |q /E |Y |q . then as n → ∞ n 1X Xn = Xi →p E(X). n→∞ lim P (|Zn − Z| > δ) = 0. denoted Zn →p Z as n → ∞. as stated. If Xi ∈ Rk is iid and E |Xi | < ∞. (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}. if for all δ > 0.Markov’s Inequality. We say that Zn converges in probability to Z as n → ∞. So for all x.

V ) . denoted Zn →d Z.3. as needed. then as n→∞ n ¢ √ ¡ 1 X n Xn − µ = √ (Xi − µ) →d N (0. We have shown that for any δ > 0 and η > 0 then for all ¢ ¡¯ ¯ ¥ n ≥ 36C 2 /δ 2 η 2 .1 Central Limit Theorem (CLT). Finally.5) (where 1 (·) is the indicator function) which is possible since E |X| < ∞. If Xi ∈ Rk is iid and E |Xi |2 < ∞.6) and (5. Jensen’s inequality (5. Fn (x) → F (x) as n → ∞. ¯¢2 ¡ ¯ 2 ≤ EW n E ¯W n ¯ = EWi2 n 4C 2 ≤ n ≤ ε2 (5. if for all x at which F (x) is continuous. Theorem 5. the triangle inequality. We say that Zn converges in distribution to Z as n → ∞. 5. Pick C < ∞ large enough so that E (|X| 1 (|X| > C)) ≤ ε (5. 43 . Set ε = δη/3.4). We need to ¢show that for all δ > 0 and η > 0 there is some N < ∞ so that for all n ≥ N. ≤ 2E |Xi | 1 (|Xi | > C) Zi = Xi 1 (|Xi | > C) − E (Xi 1 (|Xi | > C)) . P ¯X n ¯ > δ ≤ η. where Z has distribution F (x) = P (Z ≤ x) .Proof: Without loss of generality. n i=1 0 where µ = EX and V = E (X − µ) (X − µ) . by Markov’s inequality (5. the fact that X n = W n + Z n .3 Convergence in Distribution Let Zn be a random variable with distribution Fn (x) = P (Zn ≤ x) . ¯ ¯ E ¯Z n ¯ ≤ E |Zi | ≤ 2ε. and the bound |Wi | ≤ 2C. we can set E(X) = 0 (by recentering Xi on its expectation).6) By Jensen’s inequality (5.1) and (5.5). ≤ E |Xi | 1 (|Xi | > C) + |E (Xi 1 (|Xi | > C))| (5. ¡¯ ¯ P ¯X n ¯ > δ ≤ η. P ¯X n ¯ > δ ≤ δ δ δ the equality by the deﬁnition of ε.7).7) the ﬁnal inequality holding for n ≥ 4C 2 /ε2 = 36C 2 /δ 2 η 2 . (5.1). Fix δ and η. ¯ ¯ ¯ ¯ ¯ ¯ ¢ E ¯X n ¯ ¡¯ ¯ E ¯W n ¯ + E ¯Z n ¯ 3ε ≤ ≤ = η. Deﬁne the random vectors Wi = Xi 1 (|Xi | ≤ C) − E (Xi 1 (|Xi | ≤ C)) By the triangle inequality. the fact that the Wi are iid and mean zero.

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 .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 . the deﬁnition of c(λ) and (5.Proof: Without loss of generality. For ¡ ¢ λ ∈ Rk . ∂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. 1 1 c(λ) = c(0) + cλ (0)0 λ + λ0 cλλ (λ∗ )λ = λ0 cλλ (λ∗ )λ 2 2 (5. 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 . By a second-order Taylor series expansion of c(λ) about λ = 0. By the properties of the exponential function. 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 .8) where λ∗ lies on the line segment joining 0 and λ. the independence of the Xi .

Σ) = N 0. for each element of g.1 Continuous Mapping Theorem 1 (CMT). Thus P (|g (Zn ) − g (c)| ≤ ε) ≥ P (|Zn − c| < δ) → 1 as n → ∞ by the assumption that Zn →p c.2 Continuous Mapping Theorem 2. If Zn →p c as n → ∞ and g (·) is continuous at c. then g(Zn ) →d g(Z) as n → ∞.√ where λn → 0 lies on the line segment joining 0 and λ/ n. Theorem 5. gθ Σgθ where gθ (θ) = ∂ g(θ) ∂θ0 and gθ = gθ (θ0 ). Proof : By a vector Taylor series expansion. Ik ) distribution. we see that as n → ∞.4. Recall that A ⊂ B implies P (A) ≤ P (B). Hence g(Zn ) →p g(c) as n → ∞. Stacking across elements of g. Σ) . gθ Σgθ . then g(Zn ) →p g(c) as n → ∞. k ≤ m. It follows that ajn = gjθ (θ∗ ) − gjθ →p 0.3 Delta Method: If n (θn − θ0 ) →d N (0. 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 . we ﬁnd jn ¢ ¡ √ √ 0 n (g (θn ) − g(θ0 )) = (gθ + an ) n (θn − θ0 ) →d gθ N (0. then ¡ ¢ √ 0 n (g (θn ) − g(θ0 )) →d N 0. Proof: Since g is continuous at c. where θ is m × 1 and Σ is m × m. 45 .4 Asymptotic Transformations Theorem 5. for all ε > 0 we can ﬁnd a δ > 0 such that if |Zn − c| < δ then |g (Zn ) − g (c)| ≤ ε.4. ¥ 5.4. This is suﬃcient to establish the theorem. and g(θ) : Rm → Rk . If Zn →d Z as n → ∞ and g (·) is continuous. Since cλλ (λn ) → cλλ (0) = −Ik . µ ¶ 1 Cn (λ) → exp − λ0 λ 2 the characteristic function of the N (0. √ Theorem 5.

its distribution is a complicated function of the joint distribution of (yi . In general. ˆ Figure 6. y) = 2πxy 2 2 ˆ and let β 2 be the slope coeﬃcient estimate computed on observations from this joint density.1: Sampling Density of β 2 To illustrate the possibilities in one example. Using ˆ simulation methods.Chapter 6 Inference 6. since it is a function of the random data. 46 .1 for sample sizes of n = 25.1 Sampling Distribution The least-squares estimator is a random vector. the density function of β 2 was computed and plotted in Figure 6. 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. The verticle line marks the true value of the projection coeﬃcient. n = 100 and n = 800. and therefore has a sampling distribution.

3) Ã where g(A. Equation (4.4 implies that Q−1 exists and thus g(·. b) = A−1 b is a continuous function of A and b at all values of the arguments such that A−1 exist. Assumption 3.1). Proof.1). xi ei = g i n n i=1 i=1 1X xi ei →p E (xi ei ) = 0. 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. Asymptotic (large sample) methods approximate sampling distributions based on the limiting experiment that the sample size n tends to inﬁnity. ˆ Theorem 6. (6.1). (6.2) i i n i=1 n From (6.2. This is illustrated in Figure 6.5. To characterize the sampling distribution more fully. (6. First. ˆ 47 .1. Hence by the continuous mapping theorem (Theorem 5. we will use the methods of asymptotic approximation. the OLS estimator β is has a statistical distribution which is unknown. For a complete argument. Assumption 3.1) and ˆ We now deduce the consistency of β.3).8) implies that ˆ β−β = Ã n X i=1 xi x0 i !−1 n X i=1 xi ei . ¥ We can similarly show that the estimators σ 2 and s2 are consistent for σ 2 .5.1. xi ei →p g (Q.1). Ã n ! n X 1X 0 1 ˆ xi xi .4. n i=1 (6. 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 . β →p β as n → ∞.1 and the WLLN (Theorem 5. As the sample size increases the density becomes more concentrated about the population coeﬃcient.From the ﬁgure we can see that the density functions are dispersed and highly non-normal.2 Consistency ˆ As discussed in Section 6. we can conclude ˆ that β →p β.5. 0). ·) is continuous at (Q. 6. using (6. 0) = Q−1 0 = 0 β−β =g n n i=1 i=1 ˆ which implies β →p β as stated.2).2.1.1 Under Assumption 3. and the continuous mapping theorem (Theorem 5.1 by the fact that the sampling densities become more concentrated as n gets larger.4.1) imply that n ¡ ¢ 1X xi x0 →p E xi x0 = Q (6.

1.2.1).2). 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 . (6.5.5.1 In addition to Assumption 3. ˆ Finally. by the Cauchy-Schwarz inequality (5. By the central limit theorem (Theorem 5.2.1).3 Asymptotic Normality ˆ We now establish the asymptotic distribution of β after normalization. Thus σ 2 is consistent for σ 2 . σ 2 →p σ 2 and s2 →p σ 2 as n → ∞.3) and Theorem (6.2). (6. n 1 X √ xi ei →d N (0. Assumption 6. (6. ˆ n−k 6.Theorem 6.3. To see this. i Now deﬁne ¡ ¢ Ω = E xi x0 e2 .1 guarantees that the elements of Ω are ﬁnite. ´1/2 ¡ ¯ ¯¢ ¯ ³ ¯ ¯2 ´1/2 ¡ ¯ 4 ¯¢1/2 ³ ¯ 1/2 E ¯xi x0 e2 ¯ ≤ E ¯xi x0 ¯ = E |xi |4 < ∞. it follows that s2 = ¥ n σ 2 →p σ 2 . Ee4 < ∞ and E |xi |4 < ∞. E ¯ei ¯ E ¯e4 ¯ i i i i (6. (6.1.3. We need a strengthening of the moment conditions.3.5) Thus xi ei is iid with mean zero and has covariance matrix Ω. Ω) .6) n i=1 48 . ˆ Proof. i i Assumption 6.2 Under Assumption 3. 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.

when xi and ei are independent.9) In (6. (6. 1).3.1. We illustrate this problem using a simulation.1. Under (6. For α 49 . The trouble is that no matter how large is the sample size. and εi is independent of xi with the Double Pareto density f (ε) = α |ε|−α−1 . after rescaling. i i Condition (6. for example. Let yi = β 0 + β 1 xi + εi where xi is N (0. V ) where V = Q−1 ΩQ−1 . We call V 0 the homoskedastic covariance matrix.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. In Figure 6. In this context the normalized least-squares slope estimator n α−2 β 2 − β 2 has α →d Q−1 N (0. there is no simple answer to this reasonable question. for any ˆ ﬁxed n the sampling distribution of β can be arbitrarily far from the normal distribution. There is a special case where Ω and V simplify. As α approaches 2. ´ √ ³ˆ As V is the variance of the asymptotic distribution of n β − β .2 we display the ﬁnite sample densities of the q ³ ˆ normalized estimator n α−2 β 2 − β 2 . The expression V = Q−1 ΩQ−1 is called a sandwich form. otherwise V 6= V 0 . V is often referred to as ˆ the asymptotic covariance matrix of β.7) holds. Theorem 6. When (6.7) is true then V = V 0 . is approximately normal when the sample size n is suﬃciently large.9) we deﬁne V 0 = Q−1 σ 2 whether (6.3. its variance diverges q ³ ´ ˆ to inﬁnity.8) Ω = E xi x0 E e2 = Qσ 2 i i V = Q−1 ΩQ−1 = Q−1 σ 2 ≡ V 0 (6. If α > 2 the 2 error εi has zero mean and variance α/(α − 2). The approximation may be poor when n is small. however.3.2). Q−1 ΩQ−1 .1). ´ √ ³ ˆ n β−β = Ã 1X xi x0 i n i=1 n !−1 Ã Theorem 6.7) Cov(xi x0 . e2 ) = 0.6).7) the asymptotic variance formulas simplify as ¡ ¢ ¡ ¢ (6. Ω) ¡ ¢ = N 0. In´Figure 6. xi ) which satisfy the conditions of Assumption 6.1 states that the sampling distribution of the least-squares estimator. The asymptotic distribution ´ Theorem 6.Then using (6.3.1 Under Assumption 6. as n → ∞ ´ √ ³ ˆ n β − β →d N (0. |ε| ≥ 1. 1 X √ xi ei n i=1 n ! the N (0.3. 1) asymptotic distibution.7) is true or false. This holds true for all joint distibutions of (yi . and (6. the normal approximation is arbitrarily poor for some data distribution satisfying the assumptions.1 is commonly used to approximate the ﬁnite of √ ³ˆ sample distribution of n β − β . However. We say that ei is a Homoskedastic Projection Error when (6. setting n = 100 and varying the parameter α. How large should n be in order for the approximation to be useful? Unfortunately. but this is not a necessary condition.

1) it is clear that V 0 →p V 0 . 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. The MME estimator is i i 1X ˆ xi x0 e2 Ω= i ˆi n i=1 n (6.4 Let Covariance Matrix Estimation 1X ˆ xi x0 Q= i n i=1 n be the method of moments estimator for Q. for k = 1. 6 and 8. σ may also be substituted for s ˆ ¡ ¢ To estimate V = Q−1 ΩQ−1 . 1). 1) asymptotic approximation is never guaranteed to be accurate.Figure 6. we need an estimate of Ω = E xi x0 e2 .3. As k increases.11) 50 .3 is that the N (0.2 and 6. 4.10) without changing this result. The estimator 2 2 in (6. As α diminishes the density changes signiﬁcantly. 6.0 the density is very close to the N (0. 1) density.2) and Theorem 6.2. Another example is shown in Figure 6.10) V 0 = Q−1 s2 . ˆ ˆ Since Q →p Q and s2 →p σ 2 (see (6. We show the sampling distribution of n β 1 − β 1 setting n = 100. The lesson from Figures 6. the sampling distribution becomes highly skewed and non-normal. The homoskedastic covariance matrix V 0 = Q−1 σ 2 is typically estimated by ˆ ˆ (6. concentrating most of the probability mass around zero.2: Density of Normalized OLS estimator α = 3.

. ´ p √ ³ˆ ˆ ˆ ˆ When β is scalar. j = 0. Thus q ˆ ˆ s(β j ) = n−1/2 Vjj . It is therefore important to understand what formula and method is 51 .3: Sampling distribution where ei are the OLS residuals. we focus on individual elements of β one-at-a-time.4. and was still the standard choice for much empirical work done in the early 1980s. or that they use a “heteroskedasticity-robust covariance matrix estimator”. ˆ The estimator V 0 was the dominate covariance estimator used before 1980. This motivates the deﬁnition of a standard error. 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). it is important to pay ˆ ˆ attention to the distinction between V 0 and V . many authors will state that their “standard errors have been corrected for heteroskedasticity”. we set s(β) = n−1/2 V . and V is an estimator of the variance of n β − β . these all mean the same thing. standard errors are not unique. so that by the late 1990s White estimate V emerged as the standard covariance matrix estimator.. the “Huber formula”.. the “Huber-White formula” or the “GMM covariance matrix”. 1.1 A standard error s(β) for an estimator β is an estimate of the standard ˆ deviation of the distribution of β. Generically. . The methods switched during ˆ the late 1980s and early 1990s. When β is a vector. ˆ ˆ When V is used rather than the traditional choice V 0 . When reading and reporting applied work. as there may be more than one estimator of the variance of the estimator. as it is not always clear which has been computed.. ˆ ˆ The variance estimator V is an estimate of the variance of the asymptotic distribution of β. β j . ˆ ˆ Deﬁnition 6.Figure 6. k. In most cases. A more easily interpretable measure of spread is its square root — the standard deviation. vis. or that they use the “White formula”. the “Eicker-White formula”.

085) (. and then the square roots.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 . It is also important to understand that a particular standard error may be relevant under one set of model assumptions. We calculate that s2 = 0. i i i i n i=1 Second.6 Therefore the two covariance matrix estimates are µ ¶−1 µ ¶ 1 14. Ω 2.020.199 2.80 40.14 205. but not under another set of assumptions. E ¯e4 ¯ i ³ ´ 1X |xi |3 |ei | →p E |xi |3 |ei | . We can write the estimated equation with standards errors using the format \ log(W agei ) = 1.20 = V 14. p ˆ In this case the two estimates are quite similar.493 −0.14 205.5) and the WLLN (Theorem 5.020) 6.1) show that n ¡ ¢ 1X xi x0 e2 →p E xi x0 e2 = Ω. just as any other estimator.039 and ˆ V = µ 1 14.035 ¶ .14 6. Using (6. the standard method to calculate the standard errors is to ˆ ﬁrst calculate n−1 V . (6.20 −0.6 ¶µ 1 14.085 p ˆ and that for β 1 is .3) so by the WLLN ³ ´ ³ ´3/4 ¡ ¯ ¯¢ 1/4 E |xi |3 |ei | ≤ E |xi |4 < ∞.98 −0.12) in turn.480 ˆ0 = 0.83 −0.5 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.83 ¶−1 µ .2.1.14 14. To illustrate.2/988 = . we return to the log wage regression of Section 4. (6.493 0. then take the diagonal elements.80 2.117 Educationi . (. From a computational standpoint.199 2.35/988 = .80 40.83 ¶−1 = µ 7. from which it follows that V →p V as n → ∞.14 14.used by an author when studying their work. First. by Holder’s inequality (5.12) i i n n n i=1 i=1 We now examine each sum on the right-hand-side of (6.14 205. n n i=1 52 .30 + 0. The standard errors for β 0 are 7.20 and µ ¶ ˆ = 0.480 .80 .

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. Recall from Section 4.13) Using formula (4.14) 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 .−i = (1 − hi )−1 ei ˆ presented in (4.12 the deﬁnition of β (−i) as the least-squares estimator with the i’th observation deleted.13) of Efron (1982).6 Alternative Covariance Matrix Estimators ˆ MacKinnon and White (1985) suggested a small-sample corrected version of V based on the jackˆ knife principle. Ω →p Ω and V →p V. Andrews (1991) suggested an similar estimator based on cross-validation. 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. Andrews’ proposed estimator is ˆ ˆ ˆ ˆ V ∗∗ = Q−1 Ω∗∗ Q−1 53 . is deﬁned ˆ ˆ by replacing the OLS residual ei in (6. 6. From equation (3. ¯ 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 0.26). you can show that 1 Xˆ ¯ β= β (−i) .1 As n → ∞. these establish consistency.5. MacKinnon and White (1985) present numerical (simulation) evidence i ˆ ˆ that V ∗ works better than V as an estimator of V . ¯ ¯ ¯ ¯ ¯n ¯ n i=1 i=1 1X |xi |4 →p E |xi |4 . n i=1 n ˆ ˆ Theorem 6. They also suggest that the scaling factor (n − 1)/n in (??) can be omitted. ¯ ¯n ¯ n i=1 so Together.11) with the leave-one-out estimator ei. i=1 Third.¯ ¯ ¯ ¯ˆ and thus since ¯β − β ¯ →p 0. which. Using this substitution. 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 (6.25).

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

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

Another helpful observation is that the p-value function has simply made a unit-free transformation of the test statistic. so the “unusualness” of the test statistic can be compared to the easy-to-understand uniform distribution. If the p-value pn is small (close to zero) then the evidence against H0 is strong. and is a function of the data and hence is / random. P (1 − p(tn ) ≤ u) establishing that 1 − pn →d U [0. z. This is because ¡ ¢ P (reject H0 | H0 true) = P |tn | > zα/2 | θ = θ0 ¢ ¡ → P |Z| > zα/2 = α. An alternative approach. The coverage probability is P (θ ∈ Cn ). regardless of the complication of the distribution of the original test statistic. That is. 1). Thus an equivalent statement of a Neyman-Pearson test is to reject at the α% level if and only if pn < α. from which it follows that pn →d U [0. under H0 . Otherwise the test does not reject. p-values and hypothesis tests are equivalent since pn < α if and only if |tn | > zα/2 . 6. That is. note that the asymptotic distribution of |tn | is F (x) = 1 − p(x). pn →d U [0. The asymptotic p-value for the above statistic is constructed as follows. It is designed to cover θ with high probability. 1). In a sense.The standard test for H0 against H1 is the t-statistic (or studentized statistic) tn = tn (θ0 ) = ˆ − θ0 θ . The rejection/acceptance dichotomy is associated with the Neyman-Pearson approach to hypothesis testing. A test of asymptotic signiﬁcance α rejects H0 if |tn | > zα/2 . Let zα/2 is the upper α/2 quantile of the standard normal distribution. associated with Fisher.025 = 1. Either θ ∈ Cn or θ ∈ Cn . Then the asymptotic p-value of the statistic tn is pn = p(tn ). then P (Z > zα/2 ) = α/2 and P (|Z| > zα/2 ) = α.645. For example. 1]. in contrast to Neyman-Pearson rejection/acceptance reporting where the researcher picks the level. is to report an asymptotic p-value. Deﬁne the tail probability. tn →d N (0. s(ˆ θ) Under H0 .05 = 1. 1]. To see this fact.9 Conﬁdence Intervals A conﬁdence interval Cn is an interval estimate of θ. if Z ∼ N (0. in that the reader is allowed to pick the level of signiﬁcance α. The p-value is more general. 56 .96 and z. Thus P (1 − pn ≤ u) = = P (F (tn ) ≤ u) ¡ ¢ = P |tn | ≤ F −1 (u) ¡ ¢ → F F −1 (u) = u. or “accepts” H0 . or asymptotic p-value function p(t) = P (|Z| > |t|) = 2 (1 − Φ(|t|)) . 1]. however.

We typically cannot calculate the exact coverage probability P (θ ∈ Cn ). We say that Cn has asymptotic (1 − α)% coverage for θ if P (θ ∈ Cn ) → 1 − α as n → ∞. However we often can calculate the asymptotic coverage probability limn→∞ P (θ ∈ Cn ). θ θ) (6. = n h(β) − θ0 Hβ V Hβ 57 (6. and values of θ outside two standard θ errors of the estimated ˆ are considered unlikely or unreasonable candidates for the true value. ˆ + zα/2 s(ˆ . While there is no hard-and-fast guideline for choosing the coverage probability 1 − α. and it is desired to test the joint restrictions simultaneously. In this case the t-statistic approach does not work. This corresponds to selecting the conﬁdence h i h ˆ ± 1. 6. θ The interval has been constructed so that as n → ∞. or α = . 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).05.10 Wald Tests Sometimes θ = h(β) is a q × 1 vector.16) and zα/2 is the upper α/2 quantile of the standard normal distribution. the most common professional choice isi95%. 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).18) .17) = ˆ − zα/2 s(ˆ θ and Cn is an asymptotic (1 − α)% conﬁdence interval. 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. The t-test of the previous setion rejects H0 : θ0 = θ if |tn (θ)| > zα/2 where tn (θ) is the t-statistic (6. ¢ ¡ ¢ ¡ P (θ ∈ Cn ) = P |tn (θ)| ≤ zα/2 → P |Z| ≤ zα/2 = 1 − α. We have the null and alternative H0 : θ = θ0 H1 : θ 6= θ0 . A good method for construction of a conﬁdence interval is the collection of parameter values which are not rejected by a statistical test. 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 .96s(ˆ ≈ ˆ ± 2s(ˆ .

6.When h is a linear function of β. the upper-α quantile q 2 of the χ2 distribution.2.1.84 = z. Wn = n R0 β − θ0 ´ √ ³ The delta method (6. Hence β β by Theorem A. then the Wald statistic can be written in the form ¶ µ 2 ˆ σ − σ2 ˜ Wn = n (6. Hβ (β) is a continuous function of β.025 . In this case.1 Under H0 and Assumption 6.19) σ2 ˆ where σ2 = ˜ 1 0 e e. ˜ 58 ¡ 0 ¢−1 0 ˜ β 1 = X1 X1 X1 Y . As before. Vθ ). θ = β 2 . so by the continuous mapping ˆ ˆ ˆ ˆ ˆ theorem. then the Wald statistic takes the form ´0 ³ ´ ³ ´−1 ³ ˆ ˆ ˆ R0 V R R0 β − θ 0 . 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. The Wald test fails to reject if Wn is q 1 ¡ ¢ less than χ2 (α). ˆ Wn = n θ θ q θ θ Theorem 6. = nβ 2 R0 V R R0 β is linear with R = µ 0 I ¶ ¢−1 ¡ ˆ ˆ ˆ . An asymptotic Wald test rejects H0 in favor of H1 if Wn exceeds χ2 (α). 1] under H0 . h(β) = R0 β.05) = 3.5. Thus Vθ = H 0 V Hβ →p H 0 V Hβ = Vθ > 0 if Hβ has full rank q. The null hypothesis is H0 : β 2 = 0. then Wn →d χ2 . The asymptotic p-value for Wn is pn = p(Wn ).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 . where p(x) = P χ2 ≥ x is the tail q q probability function of the χ2 distribution. We have established: ³ ´0 ³ ´ ˆ − θ0 V −1 ˆ − θ0 →d Z 0 V −1 Z = χ2 . if rank(Hβ ) = q. q and pn is asymptotically U[0. Furthermore. Also h(β) = a selector matrix.8. ˜˜ n ˜ e = Y − X1 β 1 . For example.15) showed that n ˆ − θ →d Z ∼ N (0.10. and there are q = k2 restrictions.3.1 showed θ ˆ that V →p V. Hβ (β) →p Hβ . 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. a chiq square random variable with q degrees of freedom. the test rejects at the α% level iﬀ pn < α. and Theorem 6. χ2 (.

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

4)) where H 0 H = In . it follows ˆ that β is independent of any function of the OLS residuals. This special F statistic is testing the hypothesis that all slope coeﬃcients (other than the intercept) are zero. 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 . there is an exact distribution theory available for the normal linear regression model. This is ¢ ¡ 2 ˆ σ y − σ 2 / (k − 1) ˜ F = . In ) . n−k 60 . e ˆ M 0 σ2 M where M = I − X (X 0 X)−1 X 0 . In σ 2 . introduced in Section 4. s The spectral decomposition of M yields ¸ ∙ In−k−1 0 H0 M =H 0 0 (see equation (2. as sample sizes are typically suﬃciently large that this F statistic is highly “signiﬁcant”.3. 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. under the normality assumption the error vector e is independent of X and ¢ ¡ has distribution N 0. While there are special cases where this F statistic is useful. these cases are atypical. Since linear functions of normals are also normal. The modelling assumption that the error ei is independent of xi and N (0. equivalently the residual variance from an intercept-only model. Since uncorrelated normal variables are independent. Let u = σ −1 H 0 e ∼ N (0. H 0 H) ∼ N (0. σ 2 /(n − k) ˆ σ2 = ˜y 1 (y − y)0 (y − y) n is the sample variance of yi . σ 2 ) can be be used to calculate a set of exact distribution results. This is rarely an issue today.where In many statistical packages. when sample sizes were very small and researchers wanted to know if there was “any explanatory power” to their regression. 6. when an OLS regression is reported. including the estimated error variance 2. an “F statistic” is reported. This was a popular statistic in the early days of econometric reporting.12 Normal Regression Model As an alternative to asymptotic distribution theory. In particular.

10) µ h i ¶ 2 (X 0 X)−1 N 0. β 2 . n−k • ∼ tn−k ˆ In Theorem 6.a chi-square distribution with n − k degrees of freedom.10) then ´ ³ ˆ • β ∼ N 0. Theorem 6. 0.3. The estimator under the alternative is the unrestricted estimator ˆ ˆ ˆ (β 1 . σ2 ˆ 61 . ˆ 2 2 2 ˜ ˜ The MLE of the model under the null hypothesis is (β 1 . β has an exact normal distribution and t has an exact t distribution.12. 0. β 2 ) and consider tests of the linear restriction H0 : β 2 = 0 H1 : β 2 6= 0 In the context of parametric models. 0. The Gaussian log-likelihood at these estimates is ¡ ¢ n 1 ˆ ˆ ˆ σ Ln (β 1 . Furthermore. σ 2 ) where β 1 is the OLS estimate from ˜ 2 ˜ a regression of yi on x1i only. σ 2 ) = − log σ − log (2π) − . (Unless the sample size is unreasonably small. The critical values are quite close if n − k ≥ 30. the notable distinction is between the N (0. 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.8.1 and Theorem 6. In contrast. 2 2 2 The LR statistic for H0 is ´ ³ ˆ ˆ ˆ ˜ ˜ LR = 2 Ln (β 1 . σ 2 ) = − log 2πˆ 2 − 2 e0 e ˆˆ 2 2ˆ σ ¡ ¢ n n n = − log σ 2 − log (2π) − . which is twice the diﬀerence in the log-likelihood function evaluated under the null and alternative hypotheses. β 2 . We summarize these ﬁndings Theorem 6. σ 2 ) discussed above. β 2 . σ 2 ). σ 2 (X 0 X)−1 • (n−k)s2 σ2 ˆ β j −β j ˆ s(β ) j ∼ χ2 . so as a practical matter it does not matter which distribution is used. σ ˆ ˆ βj − βj βj − βj N (0. a good testing procedure is based on the likelihood ratio statistic.1 shows that under the strong assumption of ˆ normality.1 we showed that in large samples. and standard errors are calculated using the homoskedastic formula (6. 1) and tn−k distributions. As inference (conﬁdence intervals) are based on the t-ratio.) Now let us partition β = (β 1 . β and t are approximately normally distributed. with residual variance σ . σ 2 ) ¡ ¢¢ ¡ ¡ ¢ ˆ = n log σ 2 − log σ 2 ˜ µ 2¶ σ ˜ = n log . The log-likelihood of this model is ¡ 2¢ n n n ˜ ˜ ˜ Ln (β 1 . if standard errors are calculated using the homoskedastic formula (6.12.1 If ei is independent of xi and distributed N(0. σ 2 ) − Ln (β 1 .

features of this distribution can be calculated. Then the standard Wald test for H0 is ˆ ³ ´2 ˆ β−1 Wn = n . This is distressing since the choice of s seems arbitrary and irrelevant to the actual hypothesis. In the present context of the Wald statistic. Our ﬁrst-order asymptotic theory is not useful to help pick s. 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. σ2 ˆ Now notice that H0 is equivalent to the hypothesis H0 (s) : β s = 1 for any positive integer s. the statistic Wn (s) varies with s. This produces random draws from the sampling distribution of interest. The decreasing dashed ˆ = 1. LR = n log 1 + 2 − 1 ' n σ ˆ σ2 ˆ the F statistic. σ 2 s2 β ˆ ˆ While the hypothesis β s = 1 is unaﬀected by the choice of s. ˆ Let β and σ 2 be the sample mean and variance of yi . and noting Hβ = sβ s−1 . This is an unfortunate feature of the Wald statistic.4 the Wald statistic Wn (s) as a function ˆ of s.7. 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. while there are other values of s for which test test statistic is insigniﬁcant. The increasing solid line is for the case β = 0. This can be seen by a simple example introduced by Lafontaine and White (1986). we ﬁnd that the standard Wald test for H0 (s) is ´2 ³ s ˆ β −1 Wn (s) = n 2s−2 . 6. To demonstrate this eﬀect. The method uses random simulation to create an artiﬁcial dataset to apply the statistical tools of interest. setting n/σ 2 = 10. we have plotted in Figure 6. they can work quite poorly when the restrictions are nonlinear. Through repetition. as Wn (s) →d χ2 under H0 for 1 any s. Take the model yi = β + ei ei ∼ N (0.84 — the probability of a false rejection.8. 62 . σ 2 ) and consider the hypothesis H0 : β = 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. Letting h(β) = β s . one feature of importance is the Type I error of the test using the asymptotic 5% critical value 3.By a ﬁrst-order Taylor series approximation ¶ µ 2 ¶ µ σ ˜ σ2 ˜ − 1 = Wn .

Test performance deteriorates as s increases. Error rates avove 10% are considered excessive. and σ is varied among 1 and 3.05) with deviations indicating+ distortion.1 reports the simulation estimate of the Type I error probability from 50. so these probabilities are Type I error. n. These probabilities are calculated as the percentage of the 50. no magic choice of n for which all tests perform uniformly well. Rates above 20% are unexceptable.000 simulated Wald statistics Wn (s) which are larger than 3. however. remember that the ideal Type I error probability is 5% (. To interpret the table. When comparing statistical procedures.4: Wald Statistic as a function of s P (Wn (s) > 3. the only test which meets this criterion is the conventional Wn = Wn (1) test. 100 and 500.84. Each row of the table corresponds to a diﬀerent value of s — and thus corresponds to a particular choice of test statistic. and rarely fall outside of the 3%-8% range. looking for tests for which rate rejection rates are close to 5%.000 random samples. which is not surprising given the dependence of Wn (s) on s as shown in Figure 6. Table 4. In Table 4. Type I error rates between 3% and 8% are considered reasonable. Typically.84 | β = 1) . we compare the rates row by row. In each case. the Type I error probability improves towards 5% as the sample size n increases. There is. n is varied among 20.Figure 6.1 Type I error Probability of Asymptotic 5% Wn (s) Test 63 . this probability depends only on s.1 you can also see the impact of variation in sample size. Table 4. The second through seventh columns contain the Type I error probabilities for diﬀerent combinations of n and σ. Given the simplicity of the model.1 we report the results of a Monte Carlo simulation where we vary these three parameters. The null hypothesis β s = 1 is true. For this particular example. and σ 2 . Any other choice of s leads to a test with unacceptable Type I error probabilities.4. In Table 2. The value of s is varied from 1 to 10.

05 .06 .07 .25 .19 .26 .06 .05 .07 .07 .17 .05 . 64 .34 .05 .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 .16 Rejection frequencies from 50.05 .15 .15 .14 .20 .25 .13 .09 . This point can be illustrated through another example. 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. Other choices are arbitrary and would not be used in practice.13 .10 .22 . β 1 .21 .15 . In this case a t-statistic for H0 is t1n = ³ˆ β1 ˆ β2 where r is a known constant.08 .22 . Equivalently.18 .35 .33 .14 .10 .28 .08 .08 .15 .06 . An alternative statistic can be constructed through reformulating the null hypothesis as H0 : β 1 − rβ 2 = 0.30 . β 2 ) be the least-squares estimates of (6.000 simulated random samples In this example it is not surprising that the choice s = 1 yields the best test statistic.06 .08 .13 .31 .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 . While this is clear in this particular example.06 .07 .12 . in other examples natural choices are not always obvious and the best choices may in fact appear counter-intuitive at ﬁrst. let V be an estimate of the ˆ asymptotic variance matrix for β and set ˆ = β 1 /β 2 .06 .06 . deﬁne θ = β 1 /β 2 . so the hypothesis can be stated as H0 : θ = r.20).23 .12 .08 .07 .06 .11 .20 .20) ³ ´1/2 ˆ0 ˆ ˆ so that the standard error for ˆ is s(ˆ = n−1 H1 V H1 θ θ) .10 .05 .

while the right tail probabilities P (t1n > 1. We vary β 2 among .05 . 65 .00 .10 .2 Type I error Probability of Asymptotic 5% t-tests n = 100 n = 500 P (tn < −1.00 .06 . .645) t1n t2n t1n t2n t1n t2n t1n t2n .10 .06 .645) greatly exceed 5%. In all cases.05 . this formulation should be used.00 .7.05 .15 .05.50.47 .00 .2 is that the two t-ratios have dramatically diﬀerent sampling behavior.645) P (tn > 1. and alternatives to asymptotic critical values should be considered. especially for small values of β 2 . .02 . The implication of Table 4.645) P (tn > 1.50 . Table 4.05 .000 simulated samples. ei be an independent N (0.A t-statistic based on this formulation of the hypothesis is ´2 ³ ˆ 1 − rβ 2 ˆ β =³ ´1/2 .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. However.05 β2 . and normalize β 0 = 0 and β 1 = 1.05 . .00 . the rejection rates for the t1n statistic diverge greatly from this value. then the “most linear” formulation should be selected. In this section we describe the method in more detail. along with sample size n.05 .07 .05 .0 and n among 100 and 500.12 .00 . −r ⎛ t2n where To compare t1n and t2n we perform another simple Monte Carlo simulation.06 . If no linear formulation is feasible.645) are calculated from 50.26 .15 .06 .1.06 .25 . The results are presented in Table 4. the entries in the table should be 0.00 The one-sided Type I error probabilities P (tn < −1. Ideally. In contrast.05 . We let x1i and x2i be mutually independent N (0. if the hypothesis can be expressed as a linear restriction on the model parameters.25. σ 2 ) draw with σ = 3. −1 H V H ˆ 2 n 2 ⎞ 0 H2 = ⎝ 1 ⎠ . The common message from both examples is that Wald statistics are sensitive to the algebraic formulation of the null hypothesis.06 .645) and P (tn > 1. It is also prudent to consider alternative tests to the Wald statistic. 1) variables.10 .2.09 .06 .645) are close to zero in most cases. and are close to the ideal 5% rate for both sample sizes.75 1. the rejection rates for the linear t2n statistic are invariant to the value of β 2 .06 .05 .00 . such as the GMM distance statistic which will be presented in Section 9. The left tail probabilities P (t1n < −1.75.00 .06 . and 1. This leaves β 2 as a free parameter. 6.28 .06 .645) P (tn < −1.00 .

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

and poorly for others. We us the sample of wage earners from the March 2004 Current Population Survey. it is simple to make inferences about rejection probabilities from statistical tests. therefore. hispanic. immigrant. and hispanic. We would then set Tn = ¯ˆ − θ¯ /s(ˆ and calculate B X ˆ= 1 P 1 (Tnb ≥ 1. and non-white. A simple way to compute sample quantiles is to sort the sample {Tnb } from low to high. we included a dummy 67 . The α% sample quantile is a number qα such that α% of the sample are less than qα . and therefore it is straightforward to calculate standard errors for any quantity of interest.21) the percentage of the simulated t-ratios which exceed the asymptotic 5% critical value. Quite simply. As P is unknown. The random variable 1 (Tnb ≥ 1. For example. 6. 1000. and 5000. potential work experience. then B will have to be increased. In many cases. and estimate a multivariate regression. potential work experience.003. excluding military. for a selection of choices of n and F. if we set B = 999. the choice of B is often guided by the computational demands of the statistical procedure.022.007. In particular. immigrant. Suppose we are interested in the 5% and 95% quantile of Tn = ˆ We then compute the 10% θ. Generally. Often this is called the number of replications. and . B b=1 (6. the performance will depend on n and F. We now expand the sample all non-military wage earners. Furthermore. It is therefore convenient to pick B so that N is an integer. For the dependent variable we use the natural log of wages. For regressors we include years of education. female.21) is therefore an ³ ´ p ˆ unbiased estimator of P with standard error s P = P (1 − P ) /B. then the 5% sample quantile is 50’th sorted value and the 95% sample quantile is the 950’th sorted value. Again our dependent variable is the natural log of wages. and dummy variable indicators for the following: married. where N = (B +1)α. union member. so that coeﬃcients may be interpreted as semi-elasticities. Then qα is the N ’th number in this ordered sequence. and our regressors include years of education. respectively.Suppose we are interested in the ¯Type I error associated with an asymptotic 5% two-sided ¯ ¯ ¯ θ) θ t-test.95) /B ' . Hence the ³ ´ ˆ standard errors for B = 100. if we are ³ ´ p √ ˆ assessing an asymptotic 5% test. The typical purpose of a Monte Carlo simulation is to investigate the performance of a statistical procedure (estimator or test) in realistic settings. We separately estimate equations for white and non-whites. are. The average (6. but requires more computational time. As discussed above. For example. s P = . such as the percentage estimate reported in (6. a larger B results in more precise estimates of the features of interest of Gn .05) (. It is therefore useful to conduct a variety of experiments. an estimator or test may perform wonderfully for some values. equalling 1 with probability P = E1 (Tnb ≥ 1. and dummy variable indicators for the following: married. experience squared.96) is iid Bernoulli. B. Since the results of a Monte Carlo experiment are estimates computed from a random sample of size B. the researcher must select the number of experiments.15 Estimating a Wage Equation We again return to our wage equation. union member. If the standard error is too large to make a reliable inference. In practice.22/ B. and 90% sample quantiles of the sample {Tnb }.96) . . then we can set s P = (. female.96) .21). this may ˆ be approximated by replacing P with P or with an hypothesized value. experience squared.

102 −. the restricted standard deviation estimate is σ = .19) is ˜ µ ¶ µ ¶ σ2 ˆ .34 ˆ s(β) .014 . if β 2 > 0 and β 3 < 0 the solution is θ=− From Table 4. Ignoring the other coeﬃcients.00002 . 808 1 − .232 . Alternatively.808 so the parameter estimates are quite precise and reported in Table 4.097 −.013 . Table 4. θ ˆ 2β 3 β2 . The available sample is 18. but not equal.033 −. Wn = n 1 − 2 = 18.101 .007 .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.4877 18. this adds 50 regressors). 2β 3 68 .070 .001 . reestimating the model with the 50 state dummies excluded.1 OLS Estimates of Linear Equation for Log(Wage) ˆ β 1.69. as the 1% critical value for the χ2 distribution is 76.18) that the state coeﬃcients are jointly zero.102 −.49452 σ ˜ Notice that the two statistics are close. 50 Another interesting question which can be addressed from these estimates is the maximal impact of experience on mean wages.48772 = 515. The F form of the Wald statistic (6. Computing the Wald statistic (6. 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.variable for state of residence (including the District of Columbia. excluding the coeﬃcients on the state dummy variables.1 we ﬁnd the point estimate ˆ ˆ = − β 2 = 28.121 −.808 .027 . Using either statistic the hypothesis is easily rejected.4945.032 .00057 . we ﬁnd Wn = 550.002 .010 .1.008 .

implying a 95% conﬁdence θ) interval of [27. However. In the previous section we discovered that such t-tests had very poor Type I error rates. as the coverage probability of this conﬁdence interval is one minus the Type I error of the hypothesis test based on the t-test. Notice that the upper end of the conﬁdence interval is the same as that from the delta method. Instead.9.5].0. In the present context we are interested in forming a conﬁdence interval. This set is [27. 69 . but it can be found numerically quite easily. we can calculate a standard error of s(ˆ = . we found better Type I error rates by reformulating the hypothesis as a linear restriction. so we have to go one step further.Using the Delta Method. Since tn (θ) is a non-linear function of θ.96.5]. Our desired conﬁdence interval will be the set of parameter values θ which are not rejected by the hypothesis test. 29. there is not a simple expression for this set. This is the set of θ such that |tn (θ)| ≤ 1. but the lower end is substantially lower. this is a poor choice.40. 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 ). 29. not testing a hypothesis.

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) . β 2 ) subject to the constraint that β 2 = 0 is the OLS regression of Y on X1 . In the model Y = Xβ + e. ˜ That is. 1. (c) Show that if R0 β = r is true. β 2 ). ˜ (b) Verify that R0 β = r. and rank(R) = s. β − β = Ik − X 0 X 70 . λ) = Sn (β) + λ0 R0 β − r 2 where λ is s × 1. then ¶ µ ¡ ¢−1 h 0 ¡ 0 ¢−1 i−1 0 ¡ 0 ¢−1 0 ˜ XX R R XX R R X e. ﬁnd the least-squares estimate of β = (β 1 . In the model Y = X1 β 1 + X2 β 2 + e. subject to the constraint that β 1 = −β 2 . ˜ (e) Find an appropriate formula to calculate standard errors for the elements of β. the following deﬁnition is used. 0 < s < k. ﬁnd the asymptotic distribution of √ ³˜ n β − β as n → ∞. In the model Y = X1 β 1 + X2 β 2 + e. (d) Under the ´ standard assumptions plus R0 β = r. 4. Explain why β solves the minimization of the Lagrangian ¢ ¡ 1 L(β. show that the least-squares estimate of β = (β 1 . 3. show that the least-squares estimate of β = (β 1 .16 Exercises For exercises 1-4. r ˜ is a known s × 1 vector.6. 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 . In the model Y = X1 β 1 + X2 β 2 + e. 2. (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. β 2 ). β minimizes the sum of squared errors Sn (β) over all β such that the restriction holds. Take the model Y = Xβ + e with the restriction R0 β = r where R is a known k × s matrix.

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

The GLS estimator (7... . σ1 We now discuss this estimation problem. σ 2 }.2) E (ξ i | xi ) = 0. σ 2 } and σ 2 = σ 2 (x ) = E e2 | x . we know that the least-squares estimator is semi-parametrically eﬃcient for the projection coeﬃcient. 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. 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..1) XD Y β = X 0 D−1 X ¡ ¢ 2 .. Typically. A ˆ ˆn feasible GLS (FGLS) estimator replaces the unknown D with an estimate D = diag{ˆ 2 . 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 .. .1) infeasible since the matrix D is unknown. the least-squares estimator is ineﬃcient. 74 .. where z1i is some q × 1 function of xi . 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 ¢ ¡ ˜ (7.1 Generalized Least Squares In the projection model. However. Let η i = e2 .Chapter 7 Additional Regression Topics 7. in the linear regression model yi = x0 β + ei i E (ei | xi ) = 0. The GLS estimator is sometimes called where D = diag{σ 1 i i n i i the Aitken estimator.

4) ¡ ¢−1 −1/2 0 √ √ n (˜ − α) = n (ˆ − α) + n−1 Z 0 Z α α n Zφ →d N (0. then the FGLS estimator will force ˜i the regression equation through the point (yi . This is the feasible GLS.4) the skedastic regression.3) ˆ ˆ While ei is not observed.Suppose ei (and thus η i ) were observed. We may call (7. . This suggests 75 . estimator of β. ˜i Suppose that σ 2 > 0 for all i.. Vα ) α ¡ ¡ 0 ¢¢−1 ¡ 0 2 ¢ ¡ ¡ 0 ¢¢−1 E zi zi ξ i E zi zi . If σ 2 < 0 for some i. which is typically undesirable... σ 2 } σ1 ˜n and ³ ´−1 ˜ ˜ ˜ β = X 0 D−1 X X 0 D−1 Y. as it is estimating the conditional variance of the regression of yi on xi .6) σ 2 = α0 zi . We have shown that α is consistently estimated by a simple procedure. 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. Vα = E zi zi (7. 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 . ³ ´ ˆ ˆ ˆ = −2ei x0 β − β + (β − β)0 xi x0 (β − β) i i say. Vα ) (7. Thus ˆ i i η − η i = e2 − e2 ˆ ˆi i = φi . we have the OLS residual ei = yi − x0 β = ei − x0 (β − β). Furthermore. then the FGLS ˜i estimator is not well deﬁned. and hence we can estimate 0 σ 2 = zi α by i ˜ (7. there is no guarantee that σ 2 > 0 for all i.5) ˆ Thus the fact that η i is replaced with η i is asymptotically irrelevant. Then set ˜i ˜ D = diag{˜ 2 . 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. or FGLS. xi ). Since there is not a unique speciﬁcation for the conditional variance the FGLS estimator is not unique. if σ 2 ≈ 0 for some i. Then ˆ ¢−1 0 ¡ Zη ˆ α = Z 0Z ˜ (7.

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

In this case. and replaced E ξ 2 with 2σ 4 which holds when ei is N(0. White (1980) proposed that the test for heteroskedasticity be based on setting zi to equal all non-redundant elements of xi . This introduces an element of arbitrariness which is unsettling to empirical researchers. and the cost is a reduction of robustness to misspeciﬁcatio 7. we impose the stronger hypothesis and test the hypothesis that ei is independent of xi .2.7) under independence show that this test has an asymptotic chi-square distribution. and not a conditional mean. It is consistent not only in the regression model. And the FGLS probability limit will depend on the particular function selected for the skedastic regression.3) for α simpliﬁes to ¡ ¡ 0 ¢¢−1 ¡ 2 ¢ E ξi .error. Vα = E zi zi (7. individual estimated conditional variances may be negative. then the OLS and FGLS estimators will converge in probability to diﬀerent limits. its squares. 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 .4). and this requires trimming to solve. σ 2 ). as they will be estimating two diﬀerent projections.2 Testing for Heteroskedasticity ¢ ¡ The hypothesis of homoskedasticity is that E e2 | xi = σ 2 . BreuschPagan (1979) proposed what might appear to be ¡ distinct test. the Wald test of H0 is asymptotically χ2 .5) and the asymptotic variance (7.1 Under H0 and ei independent of xi . q Most tests for heteroskedasticity take this basic form. and all cross-products. Motivated by the form of the asymptotic variance ˆ of the OLS estimator β. OLS is a more robust estimator of the parameter vector. In the linear regression model the conditional mean of yi given xi = x is 77 . the two tests coincide. or equivalently that i H0 : α1 = 0 in the regression (7.7) Hence the standard test of H0 is a classic F (or Wald) test for exclusion of all regressors from the skedastic regression (7.3 Forecast Intervals m(x) = E (yi | xi = x) = x0 β. on the other hand. FGLS will do worse than OLS in practice. but also under the assumptions of linear projection.4) and constructing a Wald statistic. We may therefore test this hypothesis by the estimation (7. If i this simpliﬁcation is replaced by the standard formula (under independence of the error). The GLS and FGLS estimators. Typically. This hypothesis does not imply that ξ i is independent of xi . require the assumption of a correct conditional mean. Theorem 7. 7. Second. however. Third. The asymptotic distribution (7. in which case ξ i is ˜ independent of xi and the asymptotic variance (7. the estimated conditional variances may contain more noise than information about the true conditional variances. If the equation of interest is a linear projection.2). The point is that the eﬃciency gains from FGLS are built on the stronger assumption of a correct conditional mean.

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

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

but these are not the only measures of central tendency. Suppose that m(xi . Identiﬁcation is often tricky in nonlinear regression models. θ which is that stated in the theorem. In particular. 1 2 The model is linear when β 2 = 0. θ0 ) + m0 (θ − θ0 ) . Hansen shows how to use simulation (similar to the bootstrap) to construct the asymptotic critical values (or p-values) in a given application. Thus when the truth is that β 2 = 0.4. by a ﬁrst-order Taylor series approximation. Thus the NLLS 0 estimator ˆ has the same asymptotic distribution as the (infeasible) OLS regression of yi on mθi . ˆ ˆ θ) ˆ θ). m(xi . 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 . However. Hansen (1996).1. θi Hence the sum of squared errors function is Sn (θ) = n X i=1 (yi − m(xi . tests of H0 do not have asymptotic normal or chi-square distributions. 7.5 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 . γ is not identiﬁed. θ0 ) + m0 (θ − θ0 ) θi = ei − m0 (θ − θ0 ) θi 0 = yi − m0 θ. the model is yi = β 0 zi + εi 1 and both β 2 and γ have dropped out. θ) = β 0 zi + β 0 xi (γ). This renders the distribution theory presented in the previous section invalid. θ) ' m(xi . 80 . and this is often a useful hypothesis (sub-model) to consider. We have discussed projections and conditional means. θ0 )) − m(xi . This means that under H0 . θ) ' (ei + m(xi . ¥ Based on Theorem 7. ˆ and ei = yi − m(xi . The asymptotic theory of such tests have been worked out by Andrews and Ploberger (1994) and B. Thus we want to test H0 : β 2 = 0. 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 . the parameter estimates are not asymptotically normally distributed.For θ close to the true value θ0 . θi Thus ¡ ¢ yi − m(xi . under H0 . An alternative good measure is the conditional median. Furthermore.

as i=1 these estimators are indeed identical. the linear function M ed (yi | xi = x) = x0 β is the conditional median function. however. and let M ed (Y | X) = m(X) be this function evaluated at the random variable X.To recall the deﬁnition and properties of the median.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. The second is the value which minimizes n n |yi − θ| . The least absolute deviations (LAD) estimator of β minimizes this function ˆ β = argmin Ln (β) β Equivalently.10) The LAD estimator has the asymptotic distribution 81 . Conditional analogs of the facts about the median are • P (yi ≤ x0 β 0 | xi = x) = P (yi > x0 β | xi = x) = . let Y be a continuous random variable.5. and the substantive assumption is that the median function is linear in x. i n n i=1 (7. These distinctions are illusory. it is a solution to the moment condition ³ ´ 1X ˆ xi sgn yi − x0 β = 0. These facts deﬁnitions motivate three estimators of θ.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. 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. The ﬁrst deﬁnition is the 50th empirical 1 P quantile. and the third deﬁnition is the i=1 1 P solution to the moment equation n n sgn (yi − θ) . The median θ0 = M ed(Y ) is the value such that P (Y ≤ θ0 ) = P (Y ≥ θ0 ) = . The linear median regression model takes the form yi = x0 β + ei i M ed (ei | xi ) = 0 In this model. Let ¯ 1 X¯ ¯yi − x0 β ¯ Ln (β) = i n i=1 n be the average of absolute deviations. Now let’s consider the conditional median of Y given a random variable X.

∂β ˆ g(β) ' ´ ³ ∂ ˆ g(β 0 ) β − β 0 .5.11).Theorem 7. When f (0 | x) is large. We need where g n (β) = n i i=1 gi (β) and gi (β) = xi (1 − 2 · 1 (yi ≤ xi three preliminary result. then there are many innovations near to the median. the conditional density of the error at its median. See Chapter 16. First.5. Let g(β) = Eg (β). Computation of standard error for LAD estimates typically is based on equation (7. (7.1: Since sgn (a) = 1 − 2 · 1 (a ≤ 0) . In the special case where the error is independent of xi . Exi x0 ) i i=1 since Egi (β 0 )gi (β 0 )0 = Exi x0 .3.11) This simpliﬁcation is similar to the simpliﬁcation of the asymptotic covariance of the OLS estimator under homoskedasticity. and this improves estimation of the median.10) is equivalent to g n (β) = 0. the height of the error density at its median. ∂ 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. Pn −1 0 β)) . Second using the law of iterated expectations and the chain rule of i diﬀerentiation. by a Taylor series expansion and the fact g(β 0 ) = 0 82 . then f (0 | x) = f (0) and the asymptotic variance simpliﬁes V = (Exi x0 )−1 i 4f (0)2 (7. where V = and f (e | x) is the conditional density of ei given xi = x. This can be done with kernel estimation techniques. by the central limit theorem (Theorm 5. ¢¢−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) .1) n X √ −1/2 n (g n (β 0 ) − g(β 0 )) = −n gi (β 0 ) →d N (0. V ).1 is advanced. While a complete proof of Theorem 7. ∂β 0 so Third.1 ´ √ ³ˆ n β − β 0 →d N (0.5. The main diﬃculty is the estimation of f (0). we provide a sketch here for completeness.

For τ ∈ [0. when F (y | x) is continuous and strictly monotonic in y.13) This generalizes representation (7. then (7. (7. ¥ 7. then F (Qτ ) = τ . The quantile Qτ is the value such that τ (percent) of the mass of the distribution is less than Qτ .6 Quantile Regression The method of quantile regression has become quite popular in recent econometric practice. Exi x0 ) →d i 2 = N (0.12) Qτ = argmin Eρτ (U − θ) .9) for the median to all quantiles. If the random variable U has τ ’th quantile Qτ . then F (Qτ (x) | x) = τ . V ). Again. The following alternative representation is useful. As functions of x. so you can think of the quantile as the inverse of the distribution function. We then have the linear quantile regression model yi = x0 β τ + ei i 83 . The third line follows from an asymptotic empirical process argument. 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)) . xi ) with conditional distribution function F (y | x) the conditional quantile function qτ (x) is Qτ (x) = inf {y : F (y | x) ≥ τ } . 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. For the random variables (yi . The median is the special case τ = .5. However for computational convenience it is typical to assume that they are (approximately) linear in x (after suitable transformations). the quantile regression functions can take any shape. the quantile regression function qτ (x) describes how the τ ’th quantile of the conditional distribution varies with the regressors. This linear speciﬁcation assumes that Qτ (x) = β 0 x where the coeﬃcients β τ τ vary across the quantiles τ . For ﬁxed τ .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.

Since the quanitle regression criterion function Lτ (β) does not have an algebraic solution. the asymptotic variance depends on the conditional density of the quantile regression error. then f (0 | xi ) = f (0) . E xi xi f (0)2 A recent monograph on the details of quantile regression is Koenker (2005). ´ √ ³ˆ Theorem 7. and test their signiﬁcance using a Wald test.5.1. 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 (7.12). and we have the simpliﬁcation Vτ = τ (1 − τ ) ¡ ¡ 0 ¢¢−1 . fast linear programming methods have been developed for this problem. The null model is yi = x0 β + εi i 84 .7 Testing for Omitted NonLinearity If the goal is to estimate the conditional expectation E (yi | xi ) . and are widely available. and form a Wald statistic i for γ = 0.1 n β τ − β τ →d N (0. Furthermore. ˆ Given the representation (7. Another popular approach is the RESET test proposed by Ramsey (1969). the τ ’th conditional quantile of ei is zero. conventional Newton-type optimization methods are inappropriate. Vτ ). A asymptotic distribution theory for the quantile regression estimator can be derived using similar arguments as those for the LAD estimator in Theorem 7. 7. ¡ ¡ ¢¢−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.where ei is the error deﬁned to be the diﬀerence between yi and its τ ’th conditional quantile x0 β τ . i By construction. where and f (e | x) is the conditional density of ei given xi = x. One simple test for neglected nonlinearity is to add nonlinear functions of the regressors to ˆ ˆ the regression. Thus. if the model yi = x0 β + ei has i been ﬁt by OLS. it is useful to have a general test of the adequacy of the speciﬁcation. the unconditional density of ei at 0.6.13). otherwise its properties are unspeciﬁed without further restrictions. Fortunately. n numerical methods are necessary for its minimization. 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. since it has discontinuous derivatives. When the error ei is independent of xi .

⎟ zi = ⎝ . yielding ˆ ˜ ˆ ˆ (β 1 . 7. ⎠ . and form the Wald statistic Wn for γ = 0. and n→∞ say. β 1 = (X1 X1 )−1 (X1 Y ) . note that (7.8 Irrelevant Variables yi = x0 β 1 + x0 β 2 + ei 1i 2i E (xi ei ) = 0. and the two estimators have equal asymptotic eﬃciency. To implement the test. To see why this is the case. β 2 ). Wn →d χ2 . yielding predicted values yi = x0 β. Otherwise. lim nV ar( β 1 ) = Ex1i x0 1i 11 n→∞ say. Then run the auxiliary regression ˆ 0 ˜ yi = x0 β + zi γ + ei ˜ ˜ i ˆ which is estimated by OLS. and consequently 22 ¡ ¢−1 2 σ .be an (m − 1)-vector of powers of yi .14) by OLS. Now let ˆ i ⎛ 2 ⎞ yi ˆ ⎜ . 3. However.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. 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 . yi ˆm (7. since Q12 Q−1 Q21 > 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. One estimator of β 1 is to regress 0 0 ˜ yi on x1i alone. If Q12 = 0 (so the variables are orthogonal) then these two variance matrices equal. In the model x2i is “irrelevant” if β 1 is the parameter of interest and β 2 = 0. small values such as m = 2. The RESET test appears to work well as a test of functional form against a wide range of smooth alternatives. Under which conditions is β 1 or β 1 superior? It is easy to see that both estimators are consistent for β 1 . In this case i ¡ ¢−1 2 ˜ σ = Q−1 σ 2 . 1i 2i 2i 1i 22 . they will (typically) have diﬀerence asymptotic variances. m must be selected in advance. or 4 seem to work best. then 22 Q11 > Q11 − Q12 Q−1 Q21 . The comparison between the two estimators is straightforward when the error is conditionally ¢ ¡ homoskedastic E e2 | xi = σ 2 . Typically. Another is to regress yi on x1i and x2i jointly. It is easy (although somewhat tedious) to show that under the null hypothesis. 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.

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

That is. known as the BIC. then this model selection procedure is inconsistent. In contrast to the AIC. Then select M1 if Wn ≤ cα . Indeed. k = While many modiﬁcations of the AIC have been proposed. M)) between the true density and the model density. LRn →p 0. depending on the sample size. k A major problem with this approach is that the critical level α is indeterminate. ¢ ¡ ˆ1 ˆ2 (7. If the truth is inﬁnite dimensional. since (7. if α is set to be a small number. n (7. Indeed. based on Bayesian arguments. log(n) 87 .16) holds under M1 . The model selection rule is as follows. For some critical level α.17) Since log(n) > 2 (if n > 8). AIC selection is inconsistent. as the rule tends to overﬁt. 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. the BIC places a larger penalty than the AIC on the number of estimated parameters and is more parsimonious. BIC model selection is consistent. Another common approach to model selection is to to a selection criterion. is ¡ ¢ km ˆm BICm = log σ 2 + log(n) .15) then where σ 2 is the variance estimate for model m. etc. as ³ ´ c P M = M1 | M1 → 1 − α < 1. 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.However. 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. His criterion. and km is the number of coeﬃcients in the model. else select M2 . else select M2 . n (7. this rule only makes sense when the true model is ﬁnite dimensional. Another problem is that if α is held ﬁxed. then P M ´ ³ c 1 − α but P M = M2 | M2 could vary dramatically. the most popular to be one proposed by Schwarz. The rule is to select M1 if AIC1 < AIC2 . A common approach to model selection is to base the decision on a statistical test such as the Wald Wn . The AIC for model m is ¡ ¢ km ˆm AICm = log σ 2 + 2 . it is more appropriate to view model selection as determining the best ﬁnite sample approximation. let cα satisfy ¢ ¡ P χ22 > cα . One popular choice is the Akaike Information Criterion (AIC).16) LRn = n log σ 2 − log σ 2 ' Wn →d χ22 . since under M1 .

selecting based on (7. The AIC selection criteria estimates the K models by OLS. MK : β 1 6= 0. a model consists of any possible subset of the regressors {x1i .. . which are nested. which regressors enter the regression).. E (εi | xi ) = 0 and the question is which subset of the coeﬃcients are non-zero (equivalently. 576. . β 3 = · · · = β K = 0 . 88 . xKi }. β 2 6= 0. which can be a very large number. In the unordered case. . In the ordered case.. there are 2K such models. and then selects the model with the lowest AIC (7. and 220 = 1.17). log(n) µ LRn > k2 | M2 log(n) ¶ ´ ³ c P M = M2 | M2 = P → 1. . 048.15). and the AIC or BIC in principle can be implemented by estimating all possible subset models. The general problem is the model yi = β 1 x1i + β 2 x1i + · · · + β K xKi + εi . Similarly for ˆ the BIC. We have discussed model selection between two models.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. a full-blown implementation of the BIC selection criterion would seem computationally prohibitive. stores the residual variance σ 2 for each model. . There are two leading cases: ordered regressors and unordered. 210 = 1024. the models are M1 : β 1 6= 0. In the latter case. . Also under M2 . β K 6= 0. one can show that thus LRn →p ∞. . β 2 = β 3 = · · · = β K = 0 M2 : β 1 6= 0. The methods extend readily to the issue of selection among multiple regressors. For example. However. β 2 6= 0.

X). V . Show that the function g(x) which minimizes the MAE is the conditional median M (x). Verify equation (7. the residuals e. i ˆ ˆ suppose β is the OLS estimate of β with covariance matrix V . ˜ the residual vector is e = Y − X β.7. and the out-of-sample value of the regressors. .. Deﬁne g(u) = τ − 1 (u < 0) where 1 (·) is the indicator function (takes the value 1 if the argument is true. the GLS estimator is ¡ ¢−1 ¡ 0 −1 ¢ ˜ β = X 0 Ω−1 X XΩ Y . Consider the Weighted Least Squares (WLS) estimator of β ¢−1 ¡ 0 ¢ ¡ ˜ X WY β = X 0W X where W = diag(w1 . Is θ a quantile of the distribution of Yi ? 3. 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 ar(e | X) = σ 2 Ω with Ω known. In a linear model Y = Xβ + e. 5. xi ) be a random sample with E(Y | X) = Xβ. the mean absolute error (MAE) is E |yi − g(xi )| . ji ˜ (a) In which contexts would β be a good estimator? ˜ (b) Using your intuition. You wish to forecast an out-of-sample value of y given that ˆ ˆ ˆ ˆ X = x...12). 4. based on a sample of size n. ˆ (a) Find a point forecast of y. x. . where xji is one of the xi . Let σ 2 be the estimate of σ 2 . σ 2 ). Let (yi . ˆ ˆ n−k 6. (b) Find an estimate of the variance of this forecast. the estimates (β. For any predictor g(xi ) for y. E(e | X) = 0. In the homoskedastic regression model Y = Xβ + e with E(ei | xi ) = 0 and E(e2 | xi ) = σ 2 . (b) Prove that e = M1 e. Thus the available information is the sample (Y. 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 . and an estimate of σ 2 is ˆ s2 = 1 e0 Ω−1 e. Let θ satisfy Eg(Yi − θ) = 0.10 Exercises 1. else equals zero). 2. wn ) and wi = x−2 .

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

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

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

. The random draws are from the N (0. xi ≤ x) = E (1 (yi ≤ y) 1 (xi ≤ x)) . Fn is by construction a step function. x) . The method of moments estimator is the corresponding sample moment: n 1X 1 (yi ≤ y) 1 (xi ≤ x) . xi ). . and 100. as the sample size gets larger. x)..1). ∗ P (yi ≤ y. x). the EDF is only a crude approximation to the CDF.1: Empirical Distribution Functions The EDF is a valid discrete probability distribution which puts probability mass 1/n at each ∗ pair (yi . 1) distribution. Note that while F may be either discrete or continuous. x) = P (yi ≤ y. Thus by the WLLN (Theorem 5. Notationally.1). x∗ ≤ x) = Fn (y. x) →p F (y.2) Fn (y. Recall that F (y.2 The Empirical Distribution Function Fn (y. √ n (Fn (y.3.2. 1 (yi ≤ y) 1 (xi ≤ x) is an iid random variable with expectation F (y. (8. by the CLT (Theorem 5. in the Figure below. the EDF step function gets uniformly close to the true CDF. I have plotted the EDF and true CDF for three random samples of size n = 25. Fn (y. F (y. To see this. To see the eﬀect of sample size on the EDF. In general. Fn is a nonparametric estimate of F. i = 1. This is a population moment. x) − F (y. x) (1 − F (y. but the approximation appears to improve for the large n. note that for any (y.. i 93 . x))) . n. x∗ ) with the i distribution Fn . 50.8. For n = 25. where 1(·) is the indicator function. it is helpful to think of a random pair (yi . x). x) is called the empirical distribution function (EDF). The EDF is a consistent estimator of the CDF. x)) →d N (0. Furthermore. x) = n i=1 Figure 8. That is.

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

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

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

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

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

∗ where qn (α) is the bootstrap critical value for a two-sided hypothesis test.4) v ¡ ¢ While (8. (8. The ideal test rejects if Wn ≥ qn (α).8 Asymptotic Expansions Tn →d N (0. where qn (α) is the (1 − α)% quantile of the distribution of ³ ∗ ³ ∗ ´0 ´ ∗ Wn = n ˆ − ˆ Vθ∗−1 ˆ − ˆ . writing Tn ∼ Gn (x. C4 is called the symmetric percentile-t interval. F ) then ³x´ . Deﬁnition 8. lim Gn (x. it says nothing. θ θ θ ˆ θ ∗ ∗ Computationally. not ˆ − θ0 . then to test H0 : θ = θ0 against H1 : θ 6= θ0 at size α. θ [This is a typical mistake made by practitioners. 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. If θ is a vector. where qn (α) is the (1 − α)% quantile of the distribution of Wn .8. and vice-versa. or the size of the divergence for any particular sample size n.3) ´ √ ³ˆ If Tn = n θ − θ0 then v = V while if Tn is a t-ratio then v = 1. 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. and a function h(x) is odd if h(−x) = −h(x). Equivalently. The following notation will be helpful. about the rate v of convergence. The bootstrap test ∗ ∗ rejects if Wn ≥ qn (α). Thus here Tn (θ) = Wn (θ). v 2 ).4) says that Gn converges to Φ x as n → ∞. We say that a function g(x) is even if g(−x) = g(x). however. n ´ ³ ∗ ³ ∗ θ θ Note in the simulation that the Wald statistic is a quadratic form in ˆ − ˆ .8. The derivative of an even function is odd. Basically.3 an = o(n−r ) if nr |an | → 0 as n → ∞. F ) = Φ n→∞ v or ³x´ Gn (x.8.] 8. 99 . Deﬁnition 8. Let Tn be a statistic such that (8.1 an = o(1) if an → 0 as n → ∞ Deﬁnition 8. A better asymptotic approximation may be obtained through an asymptotic expansion. Let an be a sequence. an = O(n−r ) if it declines to zero like n−r . F ) = Φ + o (1) . the critical value qn (α) is found as the quantile from simulated values of W´ .2 an = O(1) if |an | is uniformly bounded.

1/2 1 n Because Φ(x) appears in both expansions. F0 ) ≈ ∂ g1 (x. F ) v which adds a symmetric non-normal component to the approximate density (for example. Moreover. ³x´ Gn (x. which from Theorem 8. and g2 is an odd function of x.8. we can assess the accuracy of one-sided hypothesis tests and conﬁdence regions based on an asymptotically normal t-ratio Tn . F0 ) + O(n−1 ) 1/2 1 n 1 g (x. An asymptotic test is based on Φ(x). F ) + g2 (x. and g1 is continuous with respect to F. F0 ) + O(n−1 ) 1/2 1 n = O(n−1/2 ).8. F0 )) converges to 0 at rate n.3). F ) converges to the normal limit at rate n1/2 . F ) + n−1 g2 (x. First. Heuristically. F ) ≈ Φ + n−1/2 g1 (x. Fn ) − g1 (x. the diﬀerence √ (g1 (x. √ Since Fn converges to F at rate n.uniformly over x.8. To a second order of approximation.1 as follows. We can interpret Theorem 8. F0 )) + O(n−1 ). A bootstrap test is based on G∗ (x). To the second order.8. adding leptokurtosis). Fn ) = Φ(x) + n 1 g (x. so the order of the error is O(n−1/2 ). F0 ) = n 1 n1/2 (g1 (x. F0 ) = Φ(x) + since v = 1.9 One-Sided Tests Using the expansion of Theorem 8.1 has the expansion n G∗ (x) = Gn (x. the diﬀerence between the bootstrap distribution and the true distribution is G∗ (x) − Gn (x. v Since the derivative of g1 is odd. the density function is skewed. ³x´ Gn (x. The diﬀerence is Φ(x) − Gn (x. F0 ) (Fn − F0 ) ∂F = O(n−1/2 ). Theorem 8. F ). F ) ≈ Φ + n−1/2 g1 (x. Fn ) − g1 (x. To a third order of approximation. Fn ) + O(n−1 ). where g1 is an even function of x.1 Under regularity conditions and (8.1. Fn ) − g1 (x. g1 (x. 100 . ³x´ 1 1 + 1/2 g1 (x. F ) + O(n−3/2 ) Gn (x. F ) = Φ v n n 8. Gn (x. g1 and g2 are diﬀerentiable functions of x and continuous in F relative to the supremum norm on the space of distribution functions. F0 ) = 1 g (x. the exact distribution is P (Tn < x) = Gn (x.

F ) + g2 (x. F0 ) = The order of the error is O(n−1 ). F0 ) + O(n−3/2 ) = O(n−1 ). F ) − Gn (−x. We conclude that G∗ (x) − Gn (x. F ) = Gn (x. n . F ) + g2 (−x. then |Z| has distribution function Φ(x) = Φ(x) − Φ(−x) = 2Φ(x) − 1. n or ∗ P (Tn ≤ x) = P (Tn ≤ x) + O(n−1 ). as F is a function. 8. if Z ∼ N (0. A two-sided hypothesis test rejects H0 for large values of |Tn | .The “derivative” ∂ ∂F g1 (x. 101 2 g2 (x. Similarly. F ) ¶ µ 1 1 = Φ(x) + 1/2 g1 (x. = P (X ≤ x) − P (X ≤ −x) For example. Hence the diﬀerence between the asymptotic distribution and the exact distribution is Φ(x) − Gn (x. F ) − Gn (−x. which is an improved rate of convergence over the asymptotic test (which converged at rate O(n−1/2 )). n (8.5) where the simpliﬁcations are because g1 is even and g2 is odd. F ) = Gn (x. 1). F ). F ) + O(n−3/2 ) n n 2 = Φ(x) + g2 (x. F0 ) distribution. and exact critical values are taken from the Gn (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. if Tn has exact distribution Gn (x. F ) + O(n−3/2 ). then |Tn | →d |Z| ∼ Φ.1.10 Symmetric Two-Sided Tests If a random variable X has distribution function H(x) = P (X ≤ x). then |Tn | has the distribution function Gn (x. F ). we can calculate that Gn (x. F ) n n µ ¶ 1 1 − Φ(−x) + 1/2 g1 (−x. From Theorem 8. Thus asymptotic critical values are taken from the Φ distribution. Since Tn →d Z. F ) is only heuristic. F0 ) = O(n−1 ).8. 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).

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

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

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

Using the non-parametric bootstrap. ˆ − s(ˆ n (. you generate bootstrap samples.95). What is wrong with this procedure? Tn = θ/s(θ) n 6. θ θ)q ∗ θ θ)q ∗ θ/s(θ) 5. The test for H0 is to reject if Tn = ˆ ˆ > c where c is picked so that Type I error is α. lot size.75 and 1. The ˆ are sorted. θ θ) ∗ 1000 samples are generated from the bootstrap distribution. You replace c with qn (. and deﬁne the bootstrap conﬁdence interval h i C = ˆ − s(ˆ n (. The dataﬁle hprice1. and ˆ is calculated on each θ ∗ ∗ θ sample.5% and 97.95). ∗ ∗ ∗ Let qn (.2.05) . Let qn (. size of house. You want to test H0 : θ = 0 against H1 : θ > 0. and thus reject H0 if ˆ ˆ > q ∗ (.95) denote the 95% quantile of Tn .pdf. (c) With the given information. and the 2. calculate the estimates ˆ on these samples and θ then calculate ∗ ∗ ∗ θ θ Tn = ˆ /s(ˆ ). 105 . Using the non-parametric ∗ bootstrap. (b) Report the 95% Alternative Percentile interval for θ.95).dat contains data on house prices (sales).Show that C exactly equals the Alternative percentile interval (not the percentile-t interval).3. (a) Report the 95% Efron Percentile interval for θ. You do this as follows. ∗ ∗ where s(ˆ is the standard error in the original data. Suppose that in an application.95) denote the 5% θ) ∗ and 95% quantiles of Tn .5% quantiles of the ˆ are . with variables listed in the ﬁle hprice1. and the colonial dummy.2 and s(ˆ = . θ respectively. Estimate a linear regression of price on the number of bedrooms. Calculate 95% conﬁdence intervals for the regression coeﬃcients using both the asymptotic normal approximation and the percentile-t bootstrap.05) and qn (. can you report the 95% Percentile-t interval for θ? 7. ˆ = 1.

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

1 ˆ 2Z 0 XWn X 0 Z β = 2Z 0 XWn X 0 Y While the estimator depends on Wn . For example.2.9. β GMM = Z 0 XWn X 0 Z 9. let Jn (β) = n · g n (β)0 Wn g n (β). This is a non-negative measure of the “length” of the vector g n (β). For some × weight matrix Wn > 0.2 GMM Estimator n n ¢ 1¡ 0 ¢ 1X 1X ¡ 0 X Y − X 0 Zβ . but this is generally not possible when > k. gi (β) = xi yi − zi β = n n n i=1 i=1 Deﬁne the sample analog of (9. Let and where gi = xi ei . the square of the Euclidean length. then.2) g n (β) = (9. The GMM estimator minimizes Jn (β). then g n (β) = 0. i i . ˆ Deﬁnition 9. β ˆ Note that if k = . and the GMM estimator is the MME. if Wn = I. the dependence is only up to scale. ¡ ¢−1 0 ˆ Z XWn X 0 Y. for if Wn is replaced ˆ by cWn for some c > 0.3) The method of moments estimator for β is deﬁned as the parameter value which sets g n (β) = 0. 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. 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 . The idea of the generalized method of moments (GMM) is to deﬁne an estimator which sets g n (β) “close” to zero. β GMM does not change.2.3 Distribution of GMM Estimator ¡ 0¢ Q = E xi zi Assume that Wn →p W > 0. Proposition 9. Jn (β) = n · g n (β)0 g n (β) = n · |g n (β)|2 .1 β GMM = argmin Jn (β).

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. For example. but it can be estimated consistently. In the linear model. Given any such ﬁrst0ˆ ˆ ˆ ˆ step estimator. without imposing additional assumptions. where In general. Q W ΩW Q Q0 W Q V = Q0 W Q Thus we have Theorem 9. we can set Wn = I . ˆ∗ ˆ 108 . as shown by Gary Chamberlain (1987). Q0 Ω−1 Q ¢−1 ¡ 0 ¢¡ ¢−1 ¡ . ˆ Construct n 1X ˆ g n = g n (β) = gi . The proof is left as an exercise. However. If it is known that E (gi (β)) = 0.1 ´ √ ³ˆ n β − β →d N (0. This yields the eﬃcient GMM estimator: ¢−1 0 ¡ ˆ Z XΩ−1 X 0 Y. ˆ We have described the estimator β as “eﬃcient GMM” if the optimal (variance minimizing) weight matrix is selected.and µ µ ¶ ¶ 1 0 1 0 Z X Wn X e →d Q0 W N (0. this is a semi-parametric problem. No estimator can do better (in this ﬁrst-order asymptotic sense). as it has the same asymptotic distribution. β = Z 0 XΩ−1 X 0 Z ´ ³ ¡ ¢−1 ´ √ ³ˆ . it is semiparametrically eﬃcient. n β − β →d N 0. no semiparametric estimator (one which is consistent globally for the class of models considered) ¢−1 ¡ . W0 = Ω−1 is not known in practice. For any Wn →p W0 . n n We conclude: Theorem 9. we can deﬁne the residuals ei = yi −zi β and moment equations gi = xi ei = g(wi .2 For the eﬃcient GMM estimator.3. ˆ we still call β the eﬃcient GMM estimator. and this is all that is known.3. V ) . β).4 Estimation of the Eﬃcient Weight Matrix ˆ Given any weight matrix Wn > 0. Since the GMM estimator has this can have a smaller asymptotic variance than G0 Ω−1 G asymptotic variance. it turns out that the GMM estimator is semiparametrically eﬃcient. Ω) . This turns out to be W0 = Ω−1 . 9. as the distribution of the data is unknown. the GMM estimator β is consistent yet ineﬃcient. ˆ n i=1 gi = gi − g n . This results shows that in the linear model. Chamberlain showed that in this context. This is a weak concept of optimality. no estimator has greater asymptotic eﬃciency than the eﬃcient linear GMM estimator. GMM estimators are asymptotically normal with “sandwich form” asymptotic variances. as we are only considering alternative weight matrices Wn . The optimal weight matrix W0 is one which minimizes V. a better choice is Wn = (X 0 X)−1 .

these two estimators are asymptotically equivalent under the hypothesis of correct speciﬁcation. There is an important alternative to the two-step GMM estimator just described. Hansen. 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 . Here is a simple way to compute the eﬃcient GMM estimator. as in (9. The criterion function is then Ã n !−1 1X ∗ 0 ∗ 0 gi (β)gi (β) g n (β). Instead. 109 . but can be numerically tricky to obtain in some cases. ∗ gi (β) = gi (β) − g n (β) 9. under the alternative hypothesis the moment conditions are violated. 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. and was introduced by L. When constructing hypothesis tests. ˆ and let g be the associated n × matrix.5 GMM: The General Case In its most general form. This is a current area of research in econometrics. Heaton and Yaron (1996). First. Alastair Hall (2000) has shown that the uncentered estimator is a poor choice. we can let the weight matrix be considered as a function of β. Set ³ ¡ ¢−1 0 ´−1 ˆ ˆˆ XZ . ˆ An estimator of the asymptotic variance of β can be seen from the above formula. There is little point in using an ineﬃcient GMM estimator as it is easy to compute. when we say “GMM”. and GMM using Wn as the weight matrix is asymptotically eﬃcient. 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. A simple solution is to use the centered moment conditions to construct the weight matrix. Since Egi = 0. i. The estimator appears to have some better properties than traditional GMM. Egi 6= 0. GMM applies whenever an economic or statistical model implies the × 1 moment condition E (gi (β)) = 0. (9.4) which uses the uncentered moment conditions. 0ˆ ˆ ˆ ˆ estimate β using this weight matrix.and deﬁne Wn = Ã Then Wn →p Ω−1 = W0 . J(β) = n · g n (β) n i=1 In most cases. we actually mean “eﬃcient GMM”. set Wn = (X 0 X)−1 .4) above. However. 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 . Then set gi = xi ei . so the uncentered estimator will contain an undesirable bias term and the power of the test will be adversely aﬀected. and construct the residual ei = yi − zi β.e.

Hansen (1982). 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 . ˆˆ n is a quadratic form in g n . For example. and then β recomputed. Thus the model — the overidentifying restrictions — are testable. 110 . The general theory of GMM estimation and testing was exposited by L.1 (Sargan-Hansen). often the weight ˆ matrix Wn is updated.1 Under general regularity conditions. Theorem 9. this is all that is known. Note that g n →p Egi . take the linear model yi = β 0 x1i + β 0 x2i + ei with E (x1i ei ) = 0 and E (x2i ei ) = 0. β) = 0 holds. 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. n β − β →d N 0. However. 1 2 It is possible that β 2 = 0. ´ ³ ¡ ¢−1 ´ √ ³ˆ Theorem 9. This estimator can be iterated if needed. and is thus a natural test statistic for H0 : Egi = 0. 1 it is possible that β 2 6= 0.Often. where ³ ´−1 ∂ 0 ˆ ˆ ˆ ˆ Ω = (E (gi gi ))−1 and G = E ∂β 0 gi (β). so that the linear equation may be written as yi = β 0 x1i + ei .5. and thus g n can be used to assess whether or not the hypothesis that Egi = 0 is true or not.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 . Identiﬁcation requires l ≥ k = dim(β). and if the weight matrix is asymptotically eﬃcient.6. ˆ J = J(β) →d χ2−k . i i i i ∂β 1X 0 gi gi − g n g 0 ˆˆ n n i=1 n !−1 . Since the GMM estimator depends upon the ﬁrst-stage estimator. perhaps obtained by ﬁrst ˆ setting Wn = I. Under the hypothesis of correct speciﬁcation. In this sense an 1i 1i exclusion restriction can be seen as an overidentifying restriction. 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. G0 Ω−1 G . 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).

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

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

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

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

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

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. Let ˆ ˆ ˆ Jn = ng n (β)0 Ω−1 g n (β) denote the test of overidentifying restrictions. Take the linear model 0 yi = zi β + ei E (xi ei ) = 0.. 116 . l−k Hint: Il − R (R0 R)−1 R0 is a projection matrix. ˆ and consider the GMM estimator β of β. 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.

. these probabilities must satisfy the requirements that pi ≥ 0 and n X pi = 1. 2001) and has been extended to moment condition models by Qin and Lawless (1994). In this case the moment condition places no additional restrictions on the multinomial distribution.. the log-likelihood function for this multinomial distribution is n X ln(pi ).. The idea is to construct a multinomial distribution F (p1 .3) i=1 117 . .1) we ﬁnd that the MLE is pi = n−1 yielding the log-likelihood −n log(n).. .1) i=1 First let us consider a just-identiﬁed model.. The multinomial distribution which places probability pi at each observation (yi . It is a non-parametric analog of likelihood estimation. β). Combined with i the constraint (10.. pn ) = i=1 An alternative to GMM is empirical likelihood. To be a valid multinomial distribution. xi . zi . xi . pn ) are those which maximize the log-likelihood subject to the constraint (10. The idea is due to Art Owen (1988. (10.1). The maximum likelihood estimator of the probabilities (p1 .. 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. The n ﬁrst order conditions are 0 = p−1 − µ.Chapter 10 Empirical Likelihood 10.1 Non-Parametric Likelihood Since each observation is observed once in the sample.. pn ) which places probability pi at each observation.2) Ln (p1 .. (10. 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 .. zi ) will satisfy this condition if and only if n X pi gi (β) = 0 (10.

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

G = −E (xi zi ).12) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ 0 ' G0 λ − λ0 . λ) = − (10.9) (10.14) 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 . ˆ The asymptotic variance V for β is the same as for eﬃcient GMM.1 Under regularity conditions.13) yields n n Expanding (10.9) and (10.13) Premultiplying by G0 Ω−1 and using (10. 0 = Rn (β. Vλ ) ´ √ ˆ √ ³ˆ where V and Vλ are deﬁned in (10. ´ √ ³ ˆ n β − β 0 →d √ ˆ nλ →d N (0. β) = −xi zi .11) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ ˆ 0 ' −g n − Gn β − β 0 + Ωn λ (10. Thus the EL estimator is asymptotically eﬃcient.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 i Theorem 10. λ) jointly solve ³ ´ ˆ n gi β X ∂ ³ ³ ´´ Rn (β. and n β − β 0 and nλ are asymptotically independent.2.2 Deﬁne Asymptotic Distribution of EL Estimator Gi (β) = ∂ gi (β) ∂β 0 (10.8) and ¢ 0 0 For example. ˆ ˆ Proof.10. in the linear model.10) ¡ Ω−1 N (0. g n = n n gi (β 0 ) and Ωn = n n g (β 0 ) gi (β 0 )0 . n (10. i=1 i=1 i=1i Expanding (10.11) 0 = ∂λ ˆ0 ˆ i=1 1 + λ gi β ³ ´0 ˆ n X Gi . λ) = − (10. β λ ∂ ³ ´. Gi (. and Ω = E xi x0 e2 . 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.

1 If Eg(wi . First. ¥ Chamberlain (1987) showed that V is the semiparametric eﬃciency bound for β in the overidentiﬁed moment condition model. and (10. 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. Twice the diﬀerence between the unrestricted empirical likelihood −n log (n) and the maximized empirical likelihood for the model (10. Ω) GΩ G →d = N (0. and it is advisable to report the statistic LRn whenever EL is the estimation method. The EL overidentiﬁcation test is similar to the GMM overidentiﬁcation test. β 0 ) = 0 then LRn →d χ2−k .17) 2 ln 1 + λ gi β . and have the same interpretation. 120 . This means that no consistent estimator for this class of models can have a lower asymptotic variance than V .16). (10. 10. Proof.3 Overidentifying Restrictions In a parametric likelihood context.15). The same statistic can be constructed for empirical likelihood. n ³ ´´ ´ √ ³ 1 X ³ ˆ ˆ √ g wi . The overidentiﬁcation test is a very useful by-product of EL estimation.14) for λ and using (10. it is an asymptotically eﬃcient estimator for β.7) is n ³ ´´ ³ X ˆ ˆ0 (10. Since the EL estimator achieves this bound.16) ´ √ ˆ √ ³ˆ n β − β 0 and nλ are asymptotically uncorrelated and hence independent.15) (10. They are asymptotically ﬁrst-order equivalent. Vλ ) Furthermore. V ) ˆ Solving (10. Ω) →d Ω−1 I − G G Ω G GΩ = Ω−1 N (0.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. by a Taylor expansion. LRn = i=1 Theorem 10. since ³ ¡ ¢−1 0 ´ G0 I − Ω−1 G G0 Ω−1 G G =0 (10.15) 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 (0.3. tests are based on the diﬀerence in the log likelihood functions.

Theorem 10.18) and H0 : h(β) = 0.18) Let the maintained model be where g is × 1 and β is k × 1. By “maintained” we mean that the overidentfying restrictions contained in (10.18) are assumed to hold and are not being challenged (at least for the test discussed in this section). Vλ ) ¥ where the proof of the ﬁnal equality is left as an exercise. the restricted EL estimator β is simply an EL estimator with − k + a overidenti˜ ˆ fying restrictions. This test statistic is a natural analog of the GMM distance statistic. The restricted EL estimator and likelihood are the values which solve ˜ β = argmax Ln (β) h(β)=0 ˜ ˜ Ln = Ln (β) = max Ln (β). the simple overidentifying restrictions test (10. since ln(1 + x) ' x − x2 /2 for x small. a The proof of this result is more challenging and is omitted. so there is no fundamental change in the distribution theory for β relative to β.17) is not appropriate. 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. Instead we use the diﬀerence in log-likelihoods: ³ ´ ˆ ˜ LRn = 2 Ln − Ln . LRn →d χ2 . To test the hypothesis h(β) while maintaining (10.1 Under (10.Second. The hypothesis of interest is h(β) = 0.edu/~bhansen/progs/elike.4. h(β)=0 ˜ Fundamentally.5 Numerical Computation Gauss code which implements the methods discussed below can be found at http://www. 10.18). 10.ssc.wisc.prc 121 . Vλ )0 Ω−1 N (0. where h : Rk → Ra .4 Testing Egi (β) = 0 (10.

λj ) is smaller than some prespeciﬁed tolerance.19) is continued until the gradient Rλ (β. 1.4). λ) = i The ﬁrst derivatives of (10..19) X ∂2 ∗ ∗ gi (β. A complication is that λ must be constrained so that 0 ≤ pi ≤ 1 which holds if ¢ ¡ n 1 + λ0 gi (β) ≥ 1 122 (10. The modiﬁed Newton method takes a quadratic approximation to Rn (β. λ)0 − Rn (β. One method uses the following quadratic approximation. Eﬃcient convergence requires a good choice of steplength δ. λ) = G∗ (β. λ) G∗ (β. λ)0 0 Rn (β. The iteration (10. (10. The value of δ which minimizes this quadratic is ˆ = R2 + 3R0 − 4R1 . λ) gi (β. λj ))−1 Rλ (β. λj ))−1 Rλ (β. λ)0 − ∂β∂β Rn (β. Set δ 0 = 0. Deﬁne ∗ gi (β.19). λ) = − ∂β n X i=1 G∗ (β. λ) = ∂λ∂λ i=1 ¶ n 2 Xµ ∂ Gi (β) ∗ gi (β. λ) = − gi (β. λ) yielding the iteration rule λj+1 = λj − δ (Rλλ (β.5) for given β. λj ) .Derivatives The numerical calculations depend on derivatives of the dual likelihood function (10. λp ) A quadratic function can be ﬁt exactly through these three points. λ) G∗ (β. 2. δ 4R2 + 4R0 − 8R1 yielding the steplength to be plugged into (10. λ) ∂λ i=1 n ∂ Rn (β. δ 1 = 1 and δ 2 = 1. The starting value λ1 can be set to the zero vector.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. λj )) Rp = Rn (β. λ) . i Rββ = Inner Loop The so-called “inner loop” solves (10. λ) = i i ∂β∂β 0 1 + λ0 gi (β) i=1 n where δ > 0 is a scalar steplength (to be discussed next). set 2 λp = λj − δ p (Rλλ (β. For p = 0.20) . λ) = i ∂λ∂β 0 1 + λ0 gi (β) i=1 ⎞ ⎛ ¡ 0 ¢ ∂2 n 2 X 0 gi (β) λ ∂ ⎠ ⎝G∗ (β.

If not.6) is Lβ = ∂ ∂ Ln (β) = Rn (β. It is not guaranteed that Lββ > 0.6). the eigenvalues of Lββ should be adjusted so that all are positive. the stepsize δ needs to be decreased. The Newton iteration rule is β j+1 = β j − δL−1 Lβ ββ where δ is a scalar stepsize. The gradient for (10. λ) = 0 at λ = λ(β).for all i.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 . This can be done by the modiﬁed Newton method described in the previous section. ∂β 0 the second equality following from the implicit function theorem applied to Rλ (β. where λβ = ∂ −1 λ(β) = −Rλλ Rλβ . The Hessian for (10. 123 . λ(β)) β ∂β ¡ ¢ 0 = − Rββ (β. If (10. λ(β)) + λ0 Rλ (β. and the rule is iterated until convergence.20) fails. λ(β)) = 0. λ) = Rβ + λ0 Rλ = Rβ β ∂β ∂β since Rλ (β. Outer Loop The outer loop is the minimization (10.

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

In matrix notation. In a typical set-up.1 Instrumental Variables 0 yi = zi β + ei Let the equation of interest be (11.1) if E (xi ei ) = 0.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 ¶ . 11. which does not equal either β 1 or β 2 . β →p β ∗ . some regressors in zi will be uncorrelated with ei (for example. (11. We call (11. so should be included in xi .1 The × 1 random vector xi is an instrumental variable for (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.1). z1i is an instrumental variable for (11. By the above deﬁnition. and x2i are the excluded exogenous variables.1) where zi is k × 1.4) xi = x2i 2 where z1i = x1i are the included exogenous variables.1) the structural equation. Thus we make the partition ¶ µ k1 z1i (11.2) Any solution to the problem of endogeneity requires additional information which we call instruments. This is called simultaneous equations bias. So we have the partition µ ¶ z1i k1 (11. That is x2i are variables which could be included in the equation for yi (in the sense 125 . Deﬁnition 11. at least the intercept). this can be written as Y = Zβ + e. and assume that E(zi ei ) 6= 0 so there is endogeneity.3) zi = z2i k2 where E(z1i ei ) = 0 yet E(z2i ei ) 6= 0.1. We call z1i exogenous and z2i endogenous.

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

¶ 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 ) . ¡ ¢−1 ¡ 0 ¢ ˆ β 2SLS = Z 0 PX Z Z PX Y .12). X is n × l so there are l instruments. 129 . In our notation. let’s analyze the approximate bias of OLS applied to (11. 11.12) Z = XΓ + u ξ = (e. u) E (ξ | X) = 0 ¢ ¡ E ξξ 0 | X = S As before. Using (11.ˆ It is useful to scrutinize the projection Z. Thus in the second stage. Recall.11) (11. X2 ].11). Z2 ] and X = [Z1 . Z = [Z1 . ˆ since Z1 lies in the span of X. Then i h ˆ ˆ ˆ Z = Z1 . We now derive a similar result for the 2SLS estimator. Z2 . 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 (11.6 Bekker Asymptotics Bekker (1994) used an alternative asymptotic framework to analyze the ﬁnite-sample bias in the 2SLS estimator.13) which is zero only when S21 = 0 (when Z is exogenous). So only the endogenous variables Z2 are replaced by their ﬁtted values: ˆ ˆ ˆ Z2 = X1 Γ12 + X2 Γ22 . PX Z2 ] = [Z1 . PX Z2 ] h i ˆ = Z1 . the model is Y = Zβ + e (11. we regress Y on Z1 and Z2 . Z2 = [PX Z1 . Here we present a simpliﬁed version of one of his results. First.

14) In general this is non-zero. Bekker (1994) pointed out that it also has the reverse implication — that when α = l/n is large. Indeed as α → 1. It is also close to zero when α = 0. n and (11.12) and this result. 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. P = HΛH 0 0 0 where Λ = diag(Il . ¢ 1 ¡ ¢ 1 ¡ ¢ 1 ¡ 0 E Z PX e = E Γ0 X 0 e + E u0 PX e = αS21 . By the spectral decomposition of an idempotent matrix. 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 . the expression in (11.7 Identiﬁcation Failure Recall the reduced form equation Z2 = X1 Γ12 + X2 Γ22 + u2 . The parameter β fails to be identiﬁed if Γ22 has deﬁcient rank.Let PX = X (X 0 X)−1 X 0 .13). 0).14) approaches that in (11. the bias in the 2SLS estimator will be large. l . 130 . 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. indicating that the bias in 2SLS approaches that of OLS as the number of instruments increases. The consequences of identiﬁcation failure for inference are quite severe. 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 .14) is the probability limit of β 2SLS − β 11. 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.

but (11. but is weak. as the Cauchy distribution does not have a ﬁnite mean. This is particularly nasty. N2 since the ratio of two normals is Cauchy.Take the simplest case where k = l = 1 (so there is no X1 ). Suppose this condition fails. Here. which occurs i when E (zi xi ) 6= 0. once again take the simple case k = l = 1. viz Γ22 = n−1/2 C. but small. where C is a full rank matrix. E x2 e2 i i n i=1 n (11. the instrument xi is weak for zi if γ = n−1/2 c. Then by the CLT ¡ ¡ ¢¢ 1 X √ xi ei →d N1 ∼ N 0. This can be handled in an asymptotic analysis by modeling it as local-to-zero.15) therefore ¢¢ ¡ ¡ 1 X 1 X √ xi zi = √ xi ui →d N2 ∼ N 0. meaning that inferences about parameters of interest can be misleading. so E (zi xi ) = 0. E x2 u2 i i n n i=1 i=1 n n (11. Thus identiﬁcation hinges on the existence of correlation between the excluded exogenous variable and the included endogenous variable.16) ˆ β−β = 1 √ n 1 √ n Pn Pn i=1 xi ei i=1 xi zi →d N1 ∼ Cauchy. Then the model may be written as yi = zi β + ei zi = xi γ + ui and Γ22 = γ = E (xi zi ) /Ex2 . we ﬁnd that β is inconsistent for β and the ˆ is non-normal. We see that β is identiﬁed if and only if Γ22 = γ 6= 0. Suppose that identiﬁcation does not complete fail. This occurs when Γ22 is full rank. standard test statistics have non-standard asymptotic distribution of β distributions. In addition. Then (11.16) 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 . This result carries over to more general settings. and was examined by Phillips (1989) and Choi and Phillips (1992). The n−1/2 is picked because it provides just the right balancing to allow a rich distribution theory. Qc + N2 ˆ As in the case of complete identiﬁcation failure. 131 .15) is unaﬀected. To see the consequences.

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

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

Report estimates and standard errors. (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). of the mother). and South and Black are regional and racial dummy variables. 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.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). I suggest that you use the 2SLS estimates as the ﬁrst-step to get the weight matrix. (b) Now treat Education as endogenous. (a) Estimate the model by OLS. Report estimates and standard errors. Does this diﬀer from 2SLS and/or OLS? 7..pdf. f atheduc (the education. 134 .(b) Deﬁne the 2SLS estimator of β. in years. 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. using the instrument near4. 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. 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). (e) Calculate and report the J statistic for overidentiﬁcation. and then calculate the GMM estimator from this weight matrix without further iteration. are the parameters identiﬁed? 8. and the remaining variables as exogenous. (d) Re-estimate the model by eﬃcient GMM. in years. a dummy indicating that the observation lives near a 4-year college. Estimate the model by 2SLS. In this model. using zi as an instrument for xi . of the father) and motheduc (the education. The data ﬁle card. (f) Discuss your ﬁndings. listed in card. Report the estimates and standard errors.

A stationary time series is ergodic if γ(k) → 0 as k → ∞.2 {Yt } is strictly stationary if the joint distribution of (Yt . Theorem 12.3 ρ(k) = γ(k)/γ(0) = Corr(Yt . we expect that Yt and Yt−1 are not independent. . and Cov (Yt . . We can separate time series into two categories: univariate (yt ∈ R is scalar). Deﬁnition 12. γ(k) is called the autocovariance function. Yt−k ) is independent of t for all k. Deﬁnition 12..1.. Yt−1 .1 Stationarity and Ergodicity Deﬁnition 12.) is a random variable.. The following two theorems are essential to the analysis of stationary time series. The primary model for multivariate time series is vector autoregressions (VARs)..1. Yt−k ) is the autocorrelation function. and multivariate (yt ∈ Rm is vector-valued).1. so classical assumptions are not valid.. The primary model for univariate time series is autoregressions (ARs). . Deﬁnition 12. To indicate the dependence on time. T . and use the subscript t to denote the individual observation. and T to denote the number of observations...4 (loose). There proofs are rather diﬃcult. we adopt new notation. Because of the sequential nature of time series. however. t = 1.1..Chapter 12 Univariate Time Series A time series yt is a process observed in sequence over time.1. Yt−k ) = γ(k) is independent of t for all k.1 If Yt is strictly stationary and ergodic and Xt = f (Yt . then Xt is strictly stationary and ergodic. 135 . 12.1 {Yt } is covariance (weakly) stationary if E(Yt ) = µ is independent of t.

1. Thus an application of the Ergodic Theorem yields T 1X Yt Yt−k →p E(Yt Yt−k ).3 If Yt is strictly stationary and ergodic and EYt2 < ∞. If Xt is strictly stationary and ergodic and E |Xt | < ∞. then as T → ∞. ˆ ˆ T t=1 T t=1 T t=1 By Theorem 12.2 (Ergodic Theorem). T t=1 Thus γ (k) →p E(Yt Yt−k ) − µ2 − µ2 + µ2 = E(Yt Yt−k ) − µ2 = γ(k). 1. and it has a ﬁnite mean by the assumption that EYt2 < ∞. 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) . ˆ 2. γ (k) →p γ(k). Part (1) is a direct consequence of the Ergodic theorem. 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 .1. ˆ ˆ T t=1 γ (k) = ˆ The sample autocorrelation ρ(k) = ˆ γ (k) ˆ . T 1X Xt →p E(Xt ).Theorem 12. then as T → ∞. ˆ Part (3) follows by the continuous mapping theorem: ρ(k) = γ (k)/ˆ (0) →p γ(k)/γ(0) = ρ(k). ρ(k) →p ρ(k).1.1 above. ˆ Proof. ˆ 3. For Part (2). µ →p E(Yt ). the sequence Yt Yt−k is strictly stationary and ergodic. ˆ ˆ γ ¥ 136 . γ (0) ˆ Theorem 12.

. .12.. 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 . the series {.. it is even more important in the time-series context.. An autoregressive (AR) model speciﬁes that only a ﬁnite number of past lags matter: E (Yt | It−1 ) = E (Yt | Yt−1 ..3 Stationarity of AR(1) Process Yt = ρYt−1 + et . Regression errors are naturally a MDS. The last property deﬁnes a special time-series process. E(Yt−k et ) = 0. 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. We consider the conditional expectation E (Yt | It−1 ) where It−1 = {Yt−1 . 137 . t By back-substitution. this series converges if the sequence ρk et−k gets small as k → ∞. Yt−k ) .. ∞ X = ρk et−k . A mean-zero AR(1) is Assume that et is iid.2.} is the past history of the series. E(et ) = 0 and Ee2 = σ 2 < ∞.. we ﬁnd Yt = et + ρet−1 + ρ2 et−2 + . Deﬁnition 12.2 Autoregressions In time-series. . should be a MDS. A useful property of a MDS is that et is uncorrelated with any function of the lagged information It−1 . then we have the autoregressive model Yt = α + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et E (et | It−1 ) = 0. Y2 . 12. For example. or consumption growth rates. This occurs when |ρ| < 1... Most asset pricing models imply that asset returns should be the sum of a constant plus a MDS. some versions of the life-cycle hypothesis imply that either changes in consumption. Yt−2 . Some time-series processes may be a MDS as a consequence of optimizing behavior. k=0 Loosely speaking. as it is diﬃcult to derive distribution theories without this property. Y1 .... .1 et is a martingale diﬀerence sequence (MDS) if E (et | It−1 ) = 0.. Thus for k > 0.} are jointly random. In fact. Letting et = Yt − E (Yt | It−1 ) ... YT ..

Deﬁnition 12. The AR(1) model can be written in the format Yt − ρYt−1 + et or (1 − ρL) Yt−1 = et . We say that the root of the polynomial is 1/ρ.Theorem 12. we see that L2 Yt = LYt−1 = Yt−2 . The AR(k) model is Using the lag operator. an AR(1) is stationary iﬀ |ρ| < 1. 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).5 Stationarity of AR(k) Yt = ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et .1. 1 − ρ2 V ar(Yt ) = If the equation for Yt has an intercept. In general. We call ρ(L) the autoregressive polynomial of Yt . Deﬁning L2 = LL. The operator ρ(L) = (1 − ρL) is a polynomial in the operator L. or ρ(L)Yt = et where ρ(L) = 1 − ρ1 L − ρ2 L2 − · · · − ρk Lk . Lk Yt = Yt−k . since ρ(z) = 0 when z = 1/ρ. and solving for EYt = EYt−1 we ﬁnd EYt = α/(1 − ρ). Yt − ρ1 LYt − ρ2 L2 Yt − · · · − ρk Lk Yt = et . the above results are unchanged.1 If |ρ| < 1 then Yt is strictly stationary and ergodic. 12.3.3. ∞ X k=0 ρ2k V ar (et−k ) = 12.4. We can compute the moments of Yt using the inﬁnite sum: EYt = ∞ X k=0 ρk E (et−k ) = 0 σ2 . We call ρ(L) the autoregressive polynomial of Yt .1 The lag operator L satisﬁes LYt = Yt−1 . except that the mean of Yt can be computed from the relationship EYt = α + ρEYt−1 .4 Lag Operator An algebraic construct which is useful for the analysis of autoregressive models is the lag operator. From Theorem 12. 138 .

1 The AR(k) is strictly stationary and ergodic if and only if |λj | > 1 for all j. T ¢ ¡ 1X xt x0 →p E xt x0 = Q. Thus t by the Ergodic Theorem..1. the requirement is that all roots are larger than one. so is xt x0 . since E (ut | It−1 ) = E (xt et | It−1 ) = xt E (et | It−1 ) = 0. Note that ut is a MDS.1 If the AR(k) process Yt is strictly stationary and ergodic and EYt2 < ∞.6.1) and the continuous mapping theorem.1) Theorem 12.6 Let Estimation xt = β = ¡ 1 Yt−1 Yt−2 · · · α ρ1 ρ2 · · · yt = x0 β + et . For an AR(k).1. By Theorem 12.. and is of great interest in applied time series. ¢0 Then the model can be written as The OLS estimator is ¡ ˆ To study β. β = X 0X (12.. t T t=1 T t=1 139 . This is a special case of non-stationarity. then ˆ β →p β as T → ∞. λk are the complex roots of ρ(z). 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. t t T t=1 ¥ Combined with (12. it is also strictly stationary and ergodic. it is helpful to deﬁne the process ut = xt et . . The vector xt is strictly stationary and ergodic. which satisfy ρ(λj ) = 0. Let |λ| denote the modulus of a complex number λ. Theorem 12. T t=1 T t=1 ¢−1 0 ¡ ˆ X Y. One way of stating this is that “All roots lie outside the unit circle.1. Thus T T 1X 1X xt et = ut →p E (ut ) = 0. 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 .” If one of the roots equals 1. “has a unit root”.where the λ1 .1. and by Theorem 12. we say that ρ(L).5. Proof. we see that Ã !−1 Ã ! T T 1X 1X ˆ β=β+ xt x0 xt et →p Q−1 0 = 0. and hence Yt .

It also presumes that the AR(k) structure is the truth. Y−k+2 . .. 12.. Q−1 ΩQ−1 . Y0 ). Ω) . ˆ 2.7. This is identical in form to the asymptotic distribution of OLS in cross-section regression. Divide the sample into T /m blocks of length m. T t=1 Since xt et is a MDS. the asymptotic covariance matrix is estimated just as in the cross-section case. 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∗ . Estimate β and residuals et .7 Asymptotic Distribution Theorem 12.1 to see that T 1 X √ xt et →d N (0. 140 . Ω) . If ut is a strictly stationary and ergodic MDS and E(ut u0 ) = Ω < ∞. we constructed the bootstrap sample by randomly resampling from the data values {yt . there are two popular methods to implement bootstrap resampling for time-series data. t then as T → ∞. Simulate iid draws e∗ from the empirical distribution of the residuals {ˆ1 . t This construction imposes homoskedasticity on the errors e∗ . as this imposes inappropriate independence.7.2 If the AR(k) process Yt is strictly stationary and ergodic and EYt4 < ∞. ˆ 1. Fix an initial condition (Y−k+1 . i 4. This creates an iid bootstrap sample. e ˆ 3. T 1 X √ ut →d N (0. eT }. The implication is that asymptotic inference is the same. this cannot work in a time-series application. we can apply Theorem 12. t t Theorem 12.. Method 2: Block Resampling 1... In particular. which may be diﬀerent than the i properties of the actual ei . xt }.. . Brieﬂy.12. ´ √ ³ ¡ ¢ ˆ T β − β →d N 0.8 Bootstrap for Autoregressions In the non-parametric bootstrap. then as T → ∞. Clearly. Method 1: Model-Based (Parametric) Bootstrap.1 MDS CLT. T t=1 where Ω = E(xt x0 e2 ).7.

(12. The reason why these two procedures are (essentially) the same is the Frisch-Waugh-Lovell theorem. Resample complete blocks. • First apply a seasonal diﬀerencing operator. • You can estimate (12. This allows for arbitrary stationary serial correlation. The results may be sensitive to the block length.3) replacing St with St .2. and the way that the data are partitioned into blocks. 6. For each simulated sample. . 141 . and perhaps this was of relevance. 4. 12. also alters the time-series correlations of the data. 3. May not work well in small samples. This presumes that “seasonality” does not change over the sample. ∆s Yt = Yt − Yt−s . The series ∆s Yt is clearly free of seasonality.4) by OLS. Seasonal Eﬀects There are three popular methods to deal with seasonal data.2). If s is the number of seasons (typically s = 4 or s = 12). This procedure is sometimes called Detrending. • Use “seasonally adjusted” data.3) sequentially by OLS. and then perform regression (12. This is a ﬂexible approach which can extract a wide range of seasonal factors.2)-(12. Thus the seasonally adjusted data is a “ﬁltered” series. • You can estimate (12.2) (12. Paste the blocks together to create the bootstrap time-series Yt∗ . The seasonal adjustment. however. ρk ). and for modelmisspeciﬁcation. That is. But the long-run trend is also eliminated.. • Include dummy variables for each season. 5. get the ˆ ˆ residual St . heteroskedasticity. draw T /m blocks.9 Trend Stationarity Yt = µ0 + µ1 t + St St = ρ1 St−1 + ρ2 St−2 + · · · + ρk St−l + et . or the season-to-season change. (12. The seasonal factor is typically estimated by a two-sided weighted average of the data for that season in neighboring years. ﬁrst estimate (12.4) There are two essentially equivalent ways to estimate the autoregressive parameters (ρ1 ...3) or Yt = α0 + α1 t + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et .

To combine (12.5) and (12.11 Model Selection What is the appropriate choice of k in practice? This is a problem of model selection. you need more initial conditions...g. H0 may be expressed as the restriction that the coeﬃcient on Yt−2 is zero. We model this as an AR(1): ut = θut−1 + et with et a MDS. 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.5) and lag the equation once: Yt−1 = α + ρYt−2 + ut−1 . AR(k) on this (uniﬁed) sample. e. we take (12. Yt−k−m are jointly zero.) This can induce strange behavior in the AIC. (If you increase k.5) We are interested in the question if the error ut is serially correlated. AIC(k) = log σ 2 (k) + ˆ 2k . .5).6) 12. let the null hypothesis be an AR(1): Yt = α + ρYt−1 + ut .6).12. (12. In general. An appropriate test is the Wald test of this restriction. and then estimate the models AR(1). We then multiply this by θ and subtract from (12. or Yt = α(1 − θ) + (ρ + θ) Yt−1 − θρYt−2 + et = AR(2). Yt is an AR(1).. The hypothesis of no omitted serial correlation is H0 : θ = 0 H1 : θ 6= 0. if the null hypothesis is that Yt is an AR(k). . this is the same as saying that under the alternative Yt is an AR(k+m). (A simple exclusion test). and under H1 it is an AR(2). One approach to model selection is to choose k based on a Wald tests. An appropriate test of H0 against H1 is therefore a Wald test that the coeﬃcient on Yt−2 is zero. (12. and this is equivalent to the restriction that the coeﬃcients on Yt−k−1 . The best remedy is to ﬁx a upper value k. Another is to minimize the AIC or BIC information criterion.. 142 .. Thus under H0 . to ﬁnd Yt − θYt−1 = α − θα + ρYt−1 − θρYt−1 + ut − θut−1 . AR(2).. We want to test H0 against H1 . and then reserve the ﬁrst k as initial conditions.10 Testing for Omitted Serial Correlation For simplicity. and the alternative is that the error is an AR(m).

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

All we can say is that there is insuﬃcient evidence to conclude whether the data are stationary or not. and have negative means. but does not depend on the parameters α. and may be used for testing the hypothesis H0 . where c is the critical value from the ADF table.g. the ADF test rejects H0 in favor of H1 when ADF < c. Another popular setting includes as well a linear time trend. The ADF test has a diﬀerent distribution when the time trend has been included. 144 . this means that it is computed as the t-ratio for α0 from OLS estimation of (12. (12. T α0 →d (1 − α1 − α2 − · · · − αk−1 ) DFα ˆ ADF = α0 ˆ → DFt . the test procedure is the same. it is a silly waste of time to ﬁt an AR model to the level of the series without a time trend. They are skewed to the left. If the series has a linear trend (e. If a time trend is included. If the test does not reject H0 . as the AR model cannot conceivably describe this data. but diﬀerent critical values are required. s(ˆ 0 ) α The limit distributions DFα and DFt are non-normal. this means that the evidence points to Yt being stationary. This is called a “super-consistent” rate of convergence. Note: The standard error s(ˆ 0 ) is the conventional (“homoskedastic”) standard error. but it may be stationary around the linear time trend. The ﬁrst result states that α0 converges to its true value (of zero) at rate T. and a diﬀerent table should be consulted. a common conclusion is that the data suggests that Yt is non-stationary. This model is ∆Yt = µ1 + µ2 t + α0 Yt−1 + α1 ∆Yt−1 + · · · + αk−1 ∆Yt−(k−1) + et . These are included for completeness (from a pedagogical perspective) but have no relevance for empirical practice where intercepts are always included.12.8). The natural solution is to include a time trend in the ﬁtted OLS equation. This distribution has been extensively α tabulated. GDP. Most texts include as well the critical values for the extreme polar case where the intercept has been omitted from the model.1 (Dickey-Fuller Theorem). As T → ∞. But the theorem does not require an assumption of homoskedasticity. In this context. rather than the ˆ 1/2 . Since the alternative hypothesis is one-sided.8) This is natural when the alternative hypothesis is that the series is stationary about a linear time trend. Assume α0 = 0. If the test rejects H0 . then the series itself is nonstationary. Thus the Dickey-Fuller test is robust to heteroskedasticity. Stock Prices).Theorem 12. however. This is not really a correct conclusion. conventional rate of T The second result states that the t-statistic for α0 converges to a limit distribution which is ˆ non-normal. When conducting the ADF test. We have described the test for the setting of with an intercept.

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

or as a linear projection. These are implied by the VAR model. The GMM estimator corresponding to these moment conditions is equation-by-equation OLS aj = (X 0 X)−1 X 0 Yj . One way to write this is to let a0 be the jth row j of A. either as a regression.3 Restricted VARs The unrestricted VAR is a system of m equations. ˆ An alternative way to compute this is as follows. each with the same set of regressors..then Yt = Axt + et . . some regressors may be excluded from some of the equations. ¡ Y1 Y2 · · · where Y = Ym 0 the T × m matrix of the stacked yt . and was originally derived by Zellner (1962) ¢ 13.. we ﬁnd ⎞ ⎛ Y10 ⎜ Y0 ⎟ ˆ = ⎜ . Note that a0 = Yj0 X(X 0 X)−1 . A restricted VAR imposes restrictions on the system. 146 . This (system) estimator is known as the SUR (Seemingly Unrelated Regressions) estimator. j Unrestricted VARs were introduced to econometrics by Sims (1980). For example. ⎟ ⎝ . ⎠ 0 Ym+1 = Y 0 X(X 0 X)−1 . Consider the moment conditions j = 1.2 Estimation E (xt ejt ) = 0. ˆj ˆ And if we stack these to create the estimate A.2 ⎟ X(X 0 X)−1 A ⎜ . or across equations. Then the VAR system can be written as the equations Yjt = a0 xt + ejt . The GMM framework gives a convenient method to impose such restrictions on estimation. 13.. The VAR model is a system of m equations. m. Restrictions may be imposed on individual equations.

which is called a common factor restriction. it is convenient to re-deﬁne the variables. t or yt = θyt−1 + x0 β + x0 γ + ut .) Since the common factor restriction appears arbitrary. 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 . and is typically rejected empirically. and simple way to test for omitted serial correlation is to test the signiﬁcance of extra lagged values of the dependent variable and regressors. with time series data.2) may be estimated by iterated GLS. direct estimation of (13.2) is a special case of (13. In this case. (A simple version of this estimator is called Cochrane-Orcutt. 13.3). 1). Let et = ejt and β = aj . Otherwise it is invalid. Let yt = Yjt . This restriction. t t−1 (13.1) yt = x0 β + et . which once was very popular.2) Take the equation yt = x0 β + et . If valid. Then yt = x0 β + et t et = θet−1 + ut E (ut | It−1 ) = 0. xt−1 ) to the regression. under the restriction γ = −βθ. The DW test is appropriate only when regression yt = x0 β + et is not dynamic (has no lagged values on the RHS). we are only interested in a single equation out of a VAR system. You may have heard of the Durbin-Watson test for omitted serial correlation. may be tested if desired. and Zt be the other variables. the model (13. This takes the form 0 and xt consists of lagged values of Yjt and the other Ylt s. Suppose that et is an AR(1).4 Single Equation from a VAR Yjt = a0 xt + et . We see that an appropriate. This can be done by a Wald test.13.3) which is a valid regression model. t and xt = This is just a conventional regression. Another interesting fact is that (13.2) is uncommon in recent applications. and subtract oﬀ the equation once lagged multiplied by θ. h¡ 1 Yt−1 · · · 0 Yt−k Zt−1 · · · 0 Zt−k ¢0 i . So testing H0 versus H1 is equivalent to testing for the signiﬁcance of adding (yt−1 . and is still routinely reported by conventional regression packages.5 Testing for Omitted Serial Correlation Consider the problem of testing for omitted serial correlation in equation (13. (13. Then the null and alternative are H0 : θ = 0 H1 : θ 6= 0. general. 147 . j Often. Then the single equation takes the form (13. t and et is iid N (0.1).

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

In other cases. The asymptotic distribution was worked out in B. 13. then r = 0. Then β 2 = (Y20 Y2 )−1 Y2 Y1 →p β 2 . This is not. if Yt is a pair of interest rates. and was articulated in detail by Engle and Granger (1987). The r vectors in β are called the cointegrating vectors. If Yt is cointegrated with a single cointegrating vector (r = 1). Deﬁnition 13. For 0 < r < m. If the series Yt is not cointegrated. 149 . then Yt is I(0). Hansen (1992). yet under H1 zt is I(0).8.8 Cointegration The idea of cointegration is due to Granger (1981). such that zt = β 0 Yt is I(0). then β = (1 − 1)0 speciﬁes that log(Consumption/Income) is stationary. it may be necessary to include a time trend in the estimated cointegrating regression. Under H0 . then it turns out that β can be consistently estimated by an OLS regression of one component of Yt on the others. so zt = β 0 Yt is known. Suppose that β is known. In some cases. but it is useful in the construction of alternative estimators and tests. however. Their justiﬁcation was Stock’s result that β is superˆ ˆ consistent under H1 . Yt is I(1) and cointegrated. so the ADF critical values are not appropriate. from OLS of Y1t on Y2t . Y2t ) and β = (β 1 β 2 ) and normalize β 1 = 1. m × r. If Y = (log(Consumption) log(Income))0 . If r = m. of rank r. Thus H0 can be tested using a univariate ADF test on zt . When β is unknown. β is not consistent. as ﬁrst shown by Stock (1987). Furthermore ˆ this estimation is super-consistent: T (β 2 − β 2 ) →d Limit. Often. the asymptotic distribution of the test is aﬀected by the presence of the time trend. it may be believed that β is known a priori.13. Then under H0 zt is I(1).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 . then β = (1 − 1)0 speciﬁes that the spread (the diﬀerence in returns) is stationary. a good method to estimate β. When the data have time trends. β may not be known. Engle and Granger (1987) suggested using an ADF test on the estimated ˆ0 ˆ residual zt = β Yt .1 The m × 1 series Yt is cointegrated if Yt is I(1) yet there exists β. For example. Whether or not the time trend is included. Thus Yt = ˆ (Y1t . The asymptotic distribution was worked out by Phillips and Ouliaris (1990). We are often interested in testing the hypothesis of no cointegration: H0 : r = 0 H1 : r > 0. in general. β = (1 − 1)0 .

and are similar to the Dickey-Fuller distributions. One diﬃculty is that β is not identiﬁed without normalization. and diﬀerent authors have adopted diﬀerent identiﬁcation schemes. 150 . If β is known. it is simple to test for cointegration by testing the rank of Π. rank(α) = r. Ω). this is the MLE of the restricted parameters under the assumption that et is iid N (0. then estimation is done by “reduced rank regression”. As they were discovered by Johansen (1988. Yt is cointegrated with m × r β if and only if rank(Π) = r and Π = αβ 0 where α is m × r. If β is unknown. they are typically called the “Johansen Max and Trace” tests. this can be estimated by OLS of ∆Yt on zt−1 and the lags of ∆Yt . In the context of a cointegrated VAR estimated by reduced rank regression.1 (Granger Representation Theorem). which is least-squares subject to the stated restriction. These tests are constructed as likelihood ratio (LR) tests.Theorem 13. Their asymptotic distributions are non-standard. 1991. 1995). When r = 1. 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 . we typically just normalize one element to equal unity. When r > 1.9. Equivalently. this does not work. Thus cointegration imposes a restriction upon the parameters of a VAR.

However.. allowing the construction of the likelihood function. you would be advised to consider employing a semi-parametric estimation approach. 1. due to time constraints. 2.. 1}. the linear probability model does not impose the restriction that 0 ≤ P (Yi | xi ) ≤ 1. 2. For the parametric approach. If. k} • Integer: Y = {0.Chapter 14 Limited Dependent Variables A “limited dependent variable” Y is one which takes a “limited” set of values. however. We will discuss only the ﬁrst (parametric) approach. the goal is to describe P (Yi = 1 | xi ) . A more modern approach is semi-parametric. The most common cases are • Binary: Y = {0. They still constitute the majority of LDV applications. 1. The linear probability model speciﬁes that P (Yi = 1 | xi ) = x0 β. 14.1 Binary Choice The dependent variable Yi = {0. estimation is by MLE.. 1} • Multinomial: Y = {0. 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 represents a Yes/No outcome. Even so estimation of a linear probability model is a useful starting point for subsequent analysis. A major practical issue is construction of the likelihood function. this yields the regression: Yi = x0 β + ei which can be estimated by i OLS.. you were to write a thesis involving LDV estimation. so that F (z) = 1 − F (−z). The two standard choices for F are 151 . . as this is the full conditional distribution. i As P (Yi = 1 | xi ) = E (Yi | xi ) . eliminating the dependence on a parametric distributional assumption. typically assumed to be symmetric about zero.. Given some regressors xi . A parametric model is constructed.} • Censored: Y = {x : x ≥ 0} The traditional approach to the estimation of limited dependent variable (LDV) models is parametric maximum likelihood. .

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

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

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

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

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

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

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

it However. so the instrument list should be diﬀerent for each equation. i ∗ yit = x∗0 β + e∗ . it it which is free of the individual-eﬀect ui . A more sophisticated GMM estimator recognizes that for time-periods later in the sample.3) eliminates the individual-speciﬁc eﬀect: ∆yit = α∆yit−1 + ∆x0 β + ∆eit . there are more instruments available.4) by IV using yt−2 as an instrument for ∆yt−1 (which is just identiﬁed). 15. at least if T is held ﬁnite as n → ∞.3) A dynamic panel regression has a lagged dependent variable This is a model suitable for studying dynamic behavior of individual agents. A simple application of GMM yields the parameter estimates and standard errors. we use lags of the dependent variable. This is conveniently organized by the GMM principle. the ﬁxed eﬀects estimator is inconsistent. k ≥ 2.Since the regression of yit on di is a regression onto individual-speciﬁc dummies. as this enables the moments from the diﬀerent timeperiods to be stacked together to create a list of all the moment conditions.4) . two periods back. as yt−2 is uncorrelated with ∆eit . Thus values of yit−k . we ﬁnd y i = x0 β + ui + ei . then IV or GMM can be used to estimate the equation. This is because the sample mean of yit−1 is correlated with that of eit . The standard approach to estimate a dynamic panel is to combine ﬁrst-diﬀerencing with IV or GMM. Hence a valid estimator of α and β is to estimate (15. 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 . but loses a time-series observation).4) will be inconsistent. e So OLS on (15. if eit is iid. it (15. ∗ ˆ The ﬁxed eﬀects estimator β is OLS of yit on x∗ . Typically. the predicted value from these regressions is the individual speciﬁc mean y i . 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. and the residual is the demean value ∗ yit = yit − yi . But if there are valid instruments. 159 (15. the dependent variable and regressors in deviationit from-mean form. GMM using yt−2 and yt−3 as instruments (which is overidentiﬁed. are valid instruments. Unfortunately. Another derivation of the estimator is to take the equation yit = x0 β + ui + eit . Alternatively. Taking ﬁrst-diﬀerences of (15.3 Dynamic Panel Regression yit = αyit−1 + x0 β + ui + eit .

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

if only a few Xi are near x. then the weights are relatively large and f (x) is larger. The bandwidth h controls the meaning of “near”. f (x) is a valid density. 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 . If a large number of the observations Xi are near ˆ x. 161 . where the second-to-last equality used the change-of-variables u = (Xi − x)/h which has Jacobian h. 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. That is. then the weights are small and f ˆ ˆ Interestingly.This estimator is the average of a set of weights. ˆ We can also calculate the moments of the density f (x). ˆ(x) is small. 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. Conversely. f (x) ≥ 0 for all x.

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). which is valid as h → 0. so we approximate it using a second order Taylor expansion of f (x + hu) in the argument hu about hu = 0. ˆ the greater the bias. The last expression shows that the expected value is an average of f (z) locally about x. ˆ We now examine the variance of f (x). nh (x)2 dx is called the roughness of K. 162 . Intuitively. the estimator f (x) smooths data local to Xi = x. and is larger the greater the curvature in f (x). The sharper the derivative. 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) . 2 Z ∞ ˆ The bias of f (x) is then 1 1X ˆ EKh (Xi − x) − f (x) = f 00 (x)h2 σ 2 . Since it is an average of iid random variables. 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 .16. so is estimating a smoothed version of f (x). The bias results from this smoothing.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. This integral (typically) is not analytically solvable.

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

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

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

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

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

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

2. x EX = np V ar(X) = np(1 − p) Geometric P (X = x) = p(1 − p)x−1 .. x EX = V ar(X) = Poisson P (X = x) = exp (−λ) λx .... x! EX = λ x = 0.4 Common Distributions For reference. . .A. . 1. 2. . Xm = xm ) = x1 + · · · + xm n! px1 px2 · · · pxm .. .. x = 1. 0≤p≤1 x = 0. 169 . X2 = x2 .... 1. we now list some important discrete distribution function.. m x1 !x2 ! · · · xm ! 1 2 = n. 0≤p≤1 x = 0. 1.. Bernoulli P (X = x) = px (1 − p)1−x . n. EX = p V ar(X) = p(1 − p) Binomial µ ¶ n x P (X = x) = p (1 − p)n−x . 2... 0≤p≤1 V ar(X) = λ We now list some important continuous distributions... 1 EX = p 1−p V ar(X) = p2 Multinomial P (X1 = x1 . λ>0 x = 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 .

α > 0. β>1 β−1 βα2 . α > 0. exp θ θ EX = θ 0 ≤ x < ∞. π (1 + x2 ) EX = ∞ −∞ < x < ∞ Γ(α + β) α−1 x (1 − x)β−1 . β > 0 V ar(X) = ∞ ExponentiaI f (x) = ³x´ 1 . θ>0 V ar(X) = θ2 Logistic f (x) = exp (−x) . α ≤ x < ∞. Γ(α)Γ(β) α α+β αβ (α + β + 1) (α + β)2 0 ≤ x ≤ 1.Beta f (x) = µ = V ar(X) = Cauchy f (x) = 1 . 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>2 (β − 1)2 (β − 2) 170 β>0 . (1 + exp (−x))2 EX = 0 −∞ < x < ∞. xβ+1 βα . σ>0 Pareto βαβ . 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) = √ .

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

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

Letting x = (x1 . y) ∂ lim ∂y ε→0 FX (x + ε) − FX (x) ∂ lim ∂y ε→0 ∂ ∂x F (x + ε.6 Conditional Distributions and Expectation f (x. . .A k × 1 random vector X = (X1 . then Σ is a diagonal matrix and Ã k ! k X X V ar Xi = V ar (Xi ) i=1 i=1 A. 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... Xk )0 is a function from S to Rk . y) fX (x) The conditional density of Y given X = x is deﬁned as fY |X (y | x) = if fX (x) > 0. y) fX (x + ε) ∂2 ∂x∂y F (x.. fX (x) 173 .. In particular. y) .. ∂x1 · · · ∂xk For a measurable function g : Rk → Rs .. xk )0 . it has the distribution and density functions F (x) = P (X ≤ x) ∂k f (x) = F (x). 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. y) fX (x) f (x. y) − F (x. we deﬁne the expectation Z g(x)f (x)dx Eg(X) = Rk where the symbol dx denotes dx1 · · · dxk .

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

that for Y is [0.8 Normal and Related Distributions µ 2¶ 1 x . then g(X) ≤ Y if and only if X ≥ h(Y ). then g(X) ≤ Y if and only if X ≤ h(Y ).7 Transformations Suppose that X ∈ Rk with continuous distribution function FX (x) and density fX (x). 1]. As the range of X is [0. 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)| .10) shows that fY (y) = exp(−y). This same formula (A. The Jacobian is ¶ µ ∂ h(y) . Since fX (x) = 1 for 0 ≤ x ≤ 1 (A. dy dy If g(x) is a decreasing function. 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). take the case X ∼ U [0.A. Here.10) holds for k > 1. J(y) = det ∂y 0 Consider the univariate case k = 1. 1] and Y = − ln(X). As one example. A. If g(x) is an increasing function. 0 ≤ y ≤ ∞. φ(x) = √ exp − 2 2π 175 The standard normal density is −∞ < x < ∞. g(x) = − ln(x) and h(y) = exp(−y) so the Jacobian is J(y) = − exp(y). an exponential density. Let Y = g(X) where g(x) : Rk → Rk is one-to-one. (A. . Let h(y) denote the inverse of g(x). diﬀerentiable.10) d h(y). but its justiﬁcation requires deeper results from analysis. and invertible. dy This is known as the change-of-variables formula.∞).

−∞ < x < ∞. It is conventional to write X ∼ N (0. q 176 . f (x) = √ 2σ 2 2πσ which is the univariate normal density. q × q. and it is conventional to write X ∼ N(µ. then Σ = diag{σ 2 } is a diagonal matrix. then Z 0 A−1 Z ∼ χ2 . Σ). respectively. denoted χ2 . then they are mutually independent. where we used the fact that det (BΣB 0 )1/2 = det (Σ)1/2 det (B) . A) with A > 0. Ir ) and set Q = X 0 X. σ 2 ). 1). Theorem A. we can also show that EX 2 = 1 and EX 4 = 3. The mean and variance of the distribution are µ and σ 2 . Since it is symmetric about zero all odd moments are zero. X has density Ã ! (x − µ)2 1 exp − . By iterated integration by parts. Σ) and Y = a + BX with B an invertible matrix. then by the change-of-variables formula. If Z is standard normal and X = µ + σZ. (A. and to denote the standard normal density function by φ(x) and its distribution function by Φ(x).2 If Z ∼ N(0.8. the density of Y is Ã ! (y − µY )0 Σ−1 (y − µY ) 1 Y exp − f (y) = .1 Let X ∼ N (0. x ∈ Rk . ¢ ¡ 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. Another useful fact is that if X ∼ N (µ. 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. This shows that if X is multivariate normal with uncorrelated elements. x ∈ Rk . then using the change-of-variables formula. For x ∈ Rk .11) and is known as the chi-square density with r degrees of freedom.This density has all moments ﬁnite. This shows that linear transformations of normals are also normal. k/2 1/2 2 (2π) det (ΣY ) where µY = a+Bµ and ΣY = BΣB 0 . The latter has no closed-form solution. and it is conventional to write X ∼ N (µ. y ≥ 0. Q has the density f (y) = Γ 1 ¡r¢ 2 2r/2 yr/2−1 exp (−y/2) . If X ∈ Rk is multivariate normal and the elements of X are mutually uncorrelated. the multivariate normal density is ¶ µ (x − µ)0 Σ−1 (x − µ) 1 . Theorem A. Its mean and r variance are µ = r and σ 2 = 2r. exp − f (x) = k/2 1/2 2 (2π) det (Σ) The mean and covariance matrix of the distribution are µ and Σ.

q Proof of Theorem A. Since we can write Q = P 2 X 0 X = r Zj where the Zj are independent N(0.3 Let Z ∼ N (0. The MGF for the density (A.12) E exp (tQ) = 0 Γ (A. Thus ¥ ¡ ¢0 ¡ ¢ Z 0 A−1 Z = Z 0 C −10 C −1 Z = C −1 Z C −1 Z ∼ χ2 .3.Theorem A.11) is Z ∞ ¢ ¡ Γ r+1 2 f (x) = ´ r+1 ¡r¢ ³ √ 2 2 πrΓ 2 1 + x r (A. we see that the MGF of Z 2 is (1 − 2t)−1/2 .1. tr has distribution 177 . Thus the density of Z 2 is (A.6) can be used to show that the MGF j=1 ¥ Proof of Theorem A. C −1 AC −10 ) = N (0. C −1 CC 0 C −10 ) = N (0.8.13) = (1 − 2t)−r/2 R∞ where the second equality uses the fact that 0 y a−1 exp (−by) dy = b−a Γ(a). The fact that A > 0 means that we can write A = CC 0 where C is non-singular. Proof of Theorem A. tr = p Q/r The density of tr is and is known as the student’s t distribution with r degrees of freedom. which we showed in (A.8. ¡ ¢ √ using the change—of-variables s = x2 and the fact Γ 1 = π. Set r Z . which can be found by applying change-of-variables to the gamma function.13). From (A.8.11). 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 .8. 1) and Q ∼ χ2 be independent.13) is the MGF of the density (A. Then A−1 = C −10 C −1 and C −1 Z ∼ N (0. For Z ∼ N(0.11) 2 with r = 1. Iq ). 1). (A. Using the simple law of iterated expectations.2.

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 log-likelihood function is its natural log Ln (θ) = n X i=1 ln f (Yi . In this setting the method of maximum likelihood is the appropriate technique for estimation and inference on θ. θ) = P (Y = y.9 Maximum Likelihood If the distribution of Yi is F (y. the likelihood and log-likelihood are constructed by setting f (y. If the distribution F is discrete. θ) . θ) and the joint ˜ density of a random sample Y = (Y1 .. θ) where F is a known distribution function and θ ∈ Θ is an unknown m × 1 vector. viewed as a function of θ. i=1 The likelihood of the sample is this joint density evaluated at the observed sample values. 178 . The space Θ is the set of permissible value for θ. 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.θ = fn Y f (Yi . θ) . If the distribution F is continuous then the density of Yi can be written as f (y. we say that the distribution is parametric and that θ is the parameter of the distribution F. . Yn ) is n ³ ´ Y ˜.. θ) .

but these ˆ must be found by numerical methods.17) The matrix I0 is called the information. I0 . ∂θ ∂θ (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. 179 . under conventional regularity conditions. the log-likelihood is a sample average 1X 1 Ln (θ) = ln f (Yi . θ) ≡ L(θ).Deﬁne the Hessian H = −E and the outer product matrix Ω=E µ ∂2 ln f (Yi . More typically.16).3 Under regularity conditions. θ) ∂θ ∂θ which holds at θ = θ0 by (A. We can write this as ˆ = argmax Ln (θ). However. then θ V ar(˜ ≥ (nI0 )−1 .9.9. θ0 ) . cases are rare. The ﬁrst-order condition for the latter problem is 0= ∂ ∂ L(θ) = E ln f (Yi . we can ﬁnd an explicit expression for θ as a function of the data. Theorem A. 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.17) is often called the information matrix equality.9.2 Cramer-Rao Lower Bound. the restriction to unbiased estimators means that the theorem has little direct relevance for ﬁnite sample eﬃciency.16) (A. θ) →p E ln f (Yi . θ) The Cramer-Rao Theorem gives a lower bound for estimation. which maximizes the log-likelihood). θ0 ) ∂θ∂θ 0 (A. The maximum likelihood estimator or MLE ˆ is the parameter value which maximizes θ the likelihood (equivalently. In fact. If ˜ is an unbiased estimator of θ ∈ R. n n i=1 n As the MLE ˆ maximizes the left-hand-side. ˆ is consistent θ for this value.14) ¶ ∂ ∂ 0 ln f (Yi . and the equality (A.15) Two important features of the likelihood are Theorem A. ˆ →p θ0 as n → ∞. θ0 ) ln f (Yi . θ θ∈Θ ˆ In some simple cases.1 ¯ ¯ ∂ E ln f (Yi .

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

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

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

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

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

Like the gradient methods. At each iteration. Furthermore. Each value in the sequence is considered and the criterion Q(θi + Di gi λ) evaluated. the iterations continue until the sequence has converged in some sense. ¢2 0 ∆θ0 ∆gi ∆θ0 ∆gi ∆θ0 ∆gi ∆θi ∆gi i i i 0 ∆θi ∆θ0 Di−1 ∆gi ∆gi Di−1 i + . As the iterations continue. and Rodgers (1994). this new value is accepted. . There are two common methods to perform a line search.. it may still be accepted depending on the extent of the increase and another randomization. If the resulting criterion is decreased. Newton’s method does not perform well if Q(θ) is irregular. 1/2. . alternative optimization methods are required. A more recent innovation is the method of simulated annealing (SA). and picks λi as the value minimizing this approximation. If the criterion has improved over Q(θi ). One example is the simplex method of Nelder-Mead (1965). 185 . B.a one-dimensional optimization problem. A quadratic approximation evaluates the ﬁrst and second derivatives of Q(λ) with respect to λ. These methods are called Quasi-Newton methods. 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 + + . it relies on an iterative sequence. 0 0 ∆gi Di−1 ∆gi ∆θi ∆gi For any of the gradient methods. Ferrier. These problems have motivated alternative choices for the weight matrix Di . The SA algorithm stops when a large number of iterations is unable to improve the criterion. In these cases. Let ∆gi = gi − gi−1 ∆θi = θi − θi−1 and . If the criterion is increased. use this value. 1/8. For a review see Goﬀe. otherwise move to the next element in the sequence. the methods are not well deﬁned when Q(θ) is non-diﬀerentiable.. The downside is that it can take considerable computer time to execute. The half-step method considers the sequence λ = 1.3 Derivative-Free Methods All gradient methods can be quite poor in locating the global minimum when Q(θ) has several local minima. Two popular methods are do to Davidson-Fletcher-Powell (DFP) and Broyden-Fletcher-Goldfarb-Shanno (BFGS). 1/4. The SA method has been found to be successful at locating global minima. the variance of the random innovations is shrunk. and it can be quite computationally costly if H(θ) is not analytically available. This can be deﬁned by examining whether |θi − θi−1 | . |Q (θi ) − Q (θi−1 )| or |g(θi )| has become small. The SA method is a sophisticated random search. a random variable is drawn and added to the current value of the parameter. The latter property is needed to keep the algorithm from selecting a local minimum.

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