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

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

1

Contents

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

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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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i

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

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

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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

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

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

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

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

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

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

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

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

or is nonsingular. (2. the Moore-Penrose generalized inverse A− exists and is unique. . The Moore-Penrose generalized inverse A− satisﬁes (2.3) The matrix A− is not necessarily unique.The can be seen since ⎢ ⎢ tr (AB) = tr ⎢ ⎣ = k X i=1 k X i=1 ⎡ a0 b1 a0 b2 · · · 1 1 a0 b1 a0 b2 · · · 2 2 . 2. 0b 0b ak 1 ak 2 · · · a0 bk 1 a0 bk 2 . If A − BD−1 C and D − CA−1 B are non-singular.1) .3) plus the following three conditions A− AA− = A− AA− is symmetric A− A is symmetric For any matrix A. some properties include AA−1 = A−1 A = Ik ¡ ¢−1 ¡ −1 ¢0 = A0 A Even if a matrix A does not possess an inverse. In this case there exists a unique matrix B such that AB = BA = Ik . a0 bk k ⎤ ⎥ ⎥ ⎥ ⎦ a0 bi i b0 ai i = = tr (BA) . . This matrix is called the inverse of A and is denoted by A−1 . (2. 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. . . then A−1 = A. .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 (2.4 Inverse A k × k matrix A has full rank. 7 Also. The following fact about inverting partitioned matrices is sometimes useful. then # ¡ ¢−1 ¡ ¢−1 ∙ ¸−1 " A − BD−1 C A B − A − BD−1 C BD−1 ¡ ¡ ¢−1 ¢−1 = . . if there is no c 6= 0 such that Ac = 0.

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

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

⎟ . . The vec of A. • If A is orthogonal. . The Kronecker product of A and B. am1 B am2 B · · · amn B Some important properties are now summarized. denoted by vec (A) . • (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. . ⎣ ⎦ . is the matrix ⎡ ⎤ a11 B a12 B a1n B ⎢ a21 B a22 B · · · a2n B ⎥ ⎢ ⎥ A⊗B =⎢ ⎥.• det ∙ A B C D ¸ • det A 6= 0 if and only if A is nonsingular. . . . an Let B be any matrix. denoted A ⊗ B. 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 . 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). is the mn × 1 vector ⎞ ⎛ a1 ⎜ a2 ⎟ ⎟ ⎜ vec (A) = ⎜ . ⎠ ⎝ . . . These results hold for matrices for which all matrix multiplications are conformable. then det A = 2.9 Kronecker Products and the Vec Operator Let A = [a1 a2 · · · an ] = [aij ] be m × n. .

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

Figure 3.30. which implies a 30% average wage diﬀerence for this population.D.2 Regression Equation The regression error ei is deﬁned to be the diﬀerence between yi and its conditional mean (3. with mean log hourly wages drawn in with the arrows. implying an average 36% diﬀerence in wage levels. this yields the formula yi = m(xi ) + ei . The main point to be learned from Figure 3. and a Ph.3 displays a scatter plot2 of log wages against education levels. This is a more robust measure of the typical wage gap between men and women than the diﬀerence in the untransformed wage means. The diﬀerence in the log mean wage between men and women is 0.1: Wage Densities for White College Grads with 10-15 Years Work Experience to transform the data by taking the (natural) logarithm. 2 (3. Figure 3.3 is how the conditional expectation describes an important feature of the conditional distribution.1 is facilitated by the fact that the control variable (gender) is discrete. the dashed line is a linear projection approximation which will be discussed in the Section 3. Of particular interest to graduate students may be the observation that diﬀerence between a B. For this reason. wage regressions typically use log wages as a dependent variable rather than the level of wages.2 shows the density of log hourly wages for the same population. The comparison in Figure 3. To illustrate.36. Assuming for simplicity that this is the true joint distribution. then comparisons become more complicated. 12 .A.Figure 3. degree in mean log hourly wages is 0.3) 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 ). By construction. When the distribution of the control variable is continuous. The conditional expectation function is close to linear. the solid line displays the conditional expectation of log wages varying with education.5. 3.

most typically. by the deﬁnition of ei and the linearity of conditional expectations. The remaining parts of the Theorem are left as an exercise. It is important to understand that this is a framework.2: Log Wage Densities Theorem 3. E (ei | xi ) = E ((yi − m(xi )) | xi ) = m(xi ) − m(xi ) = E (yi | xi ) − E (m(xi ) | xi ) = 0. E(xi ei ) = 0. 13 . A regression model imposes further restrictions on the joint distribution. not a model. 2. The equations yi = m(xi ) + ei E (ei | xi ) = 0. restrictions on the permissible class of regression functions m(x). These equations hold true by deﬁnition. E (h(xi )ei ) = 0 for any function h (·) . E (ei | xi ) = 0. To show the ﬁrst statement.Figure 3. 3.2.1 Properties of the regression error ei 1. 4. E(ei ) = 0. because no restrictions have been placed on the joint distribution of the data. are often stated jointly as the regression framework.

Given the random variable xi . when σ 2 (x) is a constant so that ¢ ¡ (3. the conditional variance of yi is σ 2 = σ 2 (xi ). and can take any form.2. To see this. σ 2 (x) is a non-trivial function of x.Figure 3. A common measure of the dispersion is the conditional variance ¡ ¢ σ 2 (x) = V ar (yi | xi = x) = E e2 | xi = x . it does not provide information about the spread of the distribution.3 Conditional Variance Generally. The conditional standard deviation is its square root σ(x) = σ 2 (x). In contrast. The right-hand-side is minimized by setting g(x) = m(x).3. subject to the restriction p that it is non-negative. 3. in the sense of achieving the lowest mean squared error.3: Conditional Mean of Wages Given Education The conditional mean also has the property of being the the best predictor of yi . 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. In the general case i where σ 2 (x) depends on x we say that the error ei is heteroskedastic. Thus the mean squared error is minimized by the conditional mean. let g(x) be an arbitrary predictor of yi given xi = x. i .4) E e2 | xi = σ 2 i 14 While the conditional mean is a good measure of the location of a conditional distribution.1.

its functional form is typically unknown.6) as an approximation. 3. where x1i is the ﬁrst element of the vector xi deﬁned in (3. ⎝ . This concept is less helpful than deﬁning heteroskedasticity as the dependence of the conditional variance on the observables xi . Instead. Equation (3. Equivalently.9) 3. Notationally. In this case (3. ⎟ .1) has been redeﬁned as the k × 1 vector ⎛ ⎞ 1 ⎜ x2i ⎟ ⎜ ⎟ (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 . ⎠ .5.7) is a k × 1 parameter vector. Some textbooks inappropriately describe heteroskedasticity as the case where “the variance of ei varies across observation i”. We call this the “constant” or “intercept”. i (3. 15 . and the linear assumption of the previous section is empirically unlikely to accurate. they are also somewhat more dispersed. we assume that x1i = 1.3) can be writen as yi = x0 β + ei i E (ei | xi ) = 0.8) is called the linear regression model.3) is when the conditional mean function m(x) is linear in x (or linear in functions of x). it is more realistic to view the linear speciﬁcation (3. An important special case is homoskedastic linear regression model yi = x0 β + ei i E (ei | xi ) = 0 ¢ ¡ E e2 | xi = σ 2 . we can write it as m(x) = x0 β = β 1 + x2i β 2 + · · · + xki β k where ⎞ β1 ⎜ . The conditional standard deviation for men is 12.1.we say that the error ei is homoskedastic. take the conditional wage densities displayed in Figure 3. So while men have higher average wages.8) (3. ⎠ .1). which we derive in this section.1 and that for women is 10. ⎟ β=⎝ .6) (3. Thus (3. As an example. βk ⎛ (3.5) xi = ⎜ . it is convenient to augment the regressor vector xi by listing the number “1” as an element. xki When m(x) is linear in x.4 Linear Regression An important special case of (3.

12) This completes the derivation of the linear projection model. 2 2. E (xi x0 ) is invertible. i ∂β ¢¢−1 ¡ ¡ E (xi yi ) . The error is i ei = yi − x0 β. Equivalently. 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 . This occurs when redundant variables are included in xi .1 1. The vector (3. there cannot i exist a non-zero vector α such that α0 xi = 0 identically. 3. Given the deﬁnition of β in (3. by “best” we mean the predictor function with lowest mean squared error. We now summarize the assumptions necessary for its derivation and list the implications in Theorem 3. i 4. alternative expressions such as E xixi ) or E (xi yi ) (E (xi x0 ))−1 i ( i 0i ) are incoherent and incorrect. we obtain a decomposition of yi into linear predictor and error yi = x0 β + ei . E (x0 xi ) < ∞.10) It is worth taking the time to understand the notation involved in this expression. In order for β to be uniquely deﬁned. 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 < ∞. written E (xi x0 ) > 0. Observe i that for any non-zero α ∈ Rk . Assumption 3. Rewriting.10) exists and is unique as long as the k ×k matrix E (xi x0 ) is invertible. this situation must be excluded.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 .7) is 0= Solving for β we ﬁnd ¡ ¢ ∂ S(β) = −2E (xi yi ) + 2E xi x0 β. 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.which is quadratic in β. x0 β is the best linear predictor for yi .5. i (3. i which requires that for all non-zero α. i 16 .5. It is invertible if and only if it is positive deﬁnite.1. Therefore. The ﬁrst-order condition for minimization (from Section 2. α0 E (xi x0 ) α = E (α0 xi )2 > 0.10). i (3. As before. E (xi x0 ) is a mai E(x y trix and E (xi yi ) is a vector. xi contains an intercept. i i (3. The best linear predictor is obtained by selecting β to minimize S(β). otherwise they are distinct.

2 and 3. x0 β is the i projection of yi on xi since the error ei is orthogonal with xi .3 are called regularity conditions.5.5.4 we know that the regression error has the property E (xi ei ) = 0.1. Figure 3. Assumption 3.5. the converse is not true as the projection error does not necessarily satisfy E (ei | xi ) = 0.5.1 is employed to guarantee that (3. 17 . Assumption 3. Furthermore. the orthogonality restriction (3.13) and Assumption 3.10) are deﬁned.4 is required to ensure that β is uniquely deﬁned. Assumption 3.5.1.1.5.8)-(3. This means that the equation (3.Theorem 3.1. suppose that for xi ∈ R that Ex3 = 0 and ei = x2 .1. (3.12) can be alternatively interpreted as a projection decomposition.1. i i i Since E (xi ei ) = 0 we say that xi and ei are orthogonal. Equation (3.5.11) and (3.12) and (3.14) follows from (3.13) implies that xi and ei are uncorrelated. By deﬁnition. The ﬁnite variance Assumptions 3. Since from Theorem 3.1.10) ¡ ¡ ¢¢ E (xi ei ) = E xi yi − x0 β i ¡ ¢¡ ¡ ¢¢−1 E (xi yi ) = E (xi yi ) − E xi x0 E xi x0 i i = 0.14).5. it follows that linear regression is a special case of the projection model. However. Using the deﬁnitions (3.1 are weak. Since ei is mean zero by (3.9).13) The two equations (3. ¥ (3.10) and (3. Let’s compare it with the linear regression model (3.5.14) holds. Then i i Exi e2 = Ex3 = 0 yet E (ei | xi ) = x2 6= 0.4 guarantees that the solution β exits.14) Proof.1.13) summarize the linear projection model.3 ensure that the moments in (3. For example.2 and 3.1. (3.5. Assumption 3.1 Under Assumption 3.1. E (xi ei ) = 0 and E (ei ) = 0.1.5.2.11) are well deﬁned.4: Hourly Wage as a Function of Experience The conditions listed in Assumption 3.

A projection of log wages on these two variables can be called a quadratic projection. In this case (3.5. Figure 3.10) may not hold and the implications of Theorem 3.1 may be false.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. Figure 3. Returning to the joint distribution displayed in Figure 3. No additional assumptions are required. it is important to not misinterpret the generality of this statement. there are no changes in our methods or analysis. and under-predicts for the rest. for any pair (yi .10). However. Other than the redeﬁnition of the regressor vector.We have shown that under mild regularity conditions.3. and the straight dashed line is the linear projection.1.12) with the properties listed in Theorem 3. since the resulting function is quadratic in experience. This defect in linear projection can be partially corrected through a careful selection of regressors. xi ) we can deﬁne a linear projection equation (3. we can augment the regressor vector xi to include both experience and experience2 . In contrast.5 for a 3 In the population of Caucasian non-military male wage earners with 12 years of education. In Figure 1. Most importantly. and are discussed in Chapter 11. In other cases the two may be quite diﬀerent.4 displays the relationship3 between mean log hourly wages and labor market experience. In this example it is a much better approximation to the conditional mean than the linear projection. In this example the linear projection is a close approximation to the conditional mean.5. for those over 53 in age). the dashed line is the linear projection of log wages on eduction.12) is deﬁned by projection and the associated coeﬃcient deﬁnition (3. The solid line is the conditional mean.4 we display as well this quadratic projection. It over-predicts wages for young and old workers. We illustrate the issue in Figure 3. The linear equation (3. in many economic models the parameter β may be deﬁned within the model. These structural models require alternative estimation methods. 18 . In the example just presented. it misses the strong downturn in expected wages for those above 35 years work experience (equivalently. In this case the linear projection is a poor approximation to the conditional mean.

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

then E(x2 ei ) = 0. y) = 3 x2 + y 2 on 0 ≤ x ≤ 1. and the conditional distribution of yi given xi is Poisson: P (yi = k | xi = x) = e−x β (x0 β)j . True or False. then E(x2 ei ) = 0. E(ei | xi ) = 0. and E(ei | xi ) = 0.3 Find E(Y | X = x). then E(ei | xi ) = 0. and E(xi ei ) = 0. s) = 0 if and only if m = µ and s = σ 2 . Compute E(yi | xi = x) and V ar(yi | xi = x). taking values only on the non-negative integers. Let xi and yi have the joint density f (x. Show that x y β 1 = σ xy /σ 2 and β 0 = µy − β 1 µx . Let X be a random variable with µ = EX and σ 2 = V ar(X). 20 . then ei is i i independent of xi . E(Y 2 | X = x) and V ar(Y | X = x). j! 0 j = 0. If yi = xi β + ei . If yi = x0 β + ei . a constant. σ 2 = V ar(xi ). σ 2 = V ar(yi ) and σ xy = Cov(xi . µ. m. 3 and 4 of Theorem 3. Prove parts 2. then ei is independent of xi ..2 Y =1 . σ = . Does this justify a linear regression model of the form yi = x0 β + εi ? i then EY = λ and V ar(Y ) = λ. µx = Exi . 2.6 Exercises 1. True or False. xi ∈ R.. True or False. i 7. Suppose that Y and X only take the values 0 and 1. i 8. x 6. yi ). 2. 0 ≤ y ≤ 1. 9. Deﬁne µ ¶ ¢ ¡ x−µ 2 g x. and have the following joint probability distribution X=0 X=1 Y =0 .3. Are they diﬀerent? Hint: If P (Y = j) = 5. (x − µ)2 − σ 2 Show that Eg (X. Compute the conditional mean m(x) = E (yi | xi = x) . If yi = x0 β + ei and E(xi ei ) = 0. True or False. 3.1. If yi = x0 β + ei and E(ei | xi ) = 0. . Suppose that yi is discrete-valued. ¡ ¢ 4. If yi = xi β + ei . xi ∈ R. True or False. and E(e2 | xi ) = σ 2 . 1. Compute 2 the coeﬃcients of the linear projection yi = β 0 + β 1 xi + ei . e−λ λj j! .4 . i 10. i 11. Take the bivariate linear projection model yi = β 0 + β 1 xi + ei E (ei ) = 0 E (xi ei ) = 0 Deﬁne µy = Eyi .2.1 .

1 Estimation Equation (4.1) (4.3) writes the projection coeﬃcient β as an explicit function of population moments E (xi yi ) and E (xi x0 ) . i n i=1 n 21 . The function g(β) can be estimated by form g(β) = E (xi (yi − xi g (β) = ˆ ¢ 1X ¡ xi yi − x0 β . Observe that (4.8. (4.4) i i=1 i=1 ˆ Another way to derive β is as follows. but for most of the chapter we retain the broader focus on the projection model. 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 . i It follows that the moment estimator of β replaces the population moments in (4. we narrow the focus to the linear regression model.3) In Sections 4. 4.2) (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 (4.7 and 4.2) can be written in the parametric 0 β)) = 0.3) 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 .

95 42.14 205. 30 = .3. 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.2 Least Squares There is another classic motivation for the estimator (4. consider the data used to generate Figure 3. An interpretation of the estimated equation is that each year of education is associated with an 11.117 Educationi . excluding military.40 µ ¶µ ¶ 34. This sample has 988 observations.ˆ This is a set of k equations which are linear in β.14 14. 0. 40 0.83 µ We often write the estimated equation using the format \ log(W agei ) = 1. Then µ ¶ n 1X 2.37 µ ¶ 1.71 = −2. 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 (4.95 xi yi = 42.14 205. These are white male wage earners from the March 2004 Current Population Survey. n X i=1 2 yi − 2β 0 n X i=1 xi yi + β 0 n X i=1 xi x0 β. 4. i 22 . 40 2.14 14. Let yi be log wages and xi be an intercept and years of education.94 −2.83 ¶−1 µ ¶ .40 n i=1 1 n Thus ˆ β = n X i=1 xi x0 i = µ 1 14.4).170 37. To illustrate.7% increase in mean wages.30 + 0.117 1 14.4).5) = n n 1X 1X ˆ xi yi − xi x0 β i n n i=1 i=1 whose solution is (4. ¶ 2. with 10-15 years of potential work experience.

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

7) A justiﬁcation for the latter choice will be provided in Section 4. ˆ n i=1 n Since xi contains a constant.6) An alternative estimator uses the formula n 1 X 2 s = ei . Its method of moments estimator is the sample average 1X 2 ei . The error variance σ 2 = Ee2 is also a parameter of interest.7.5) implies that 1X xi ei = 0.2: Sum-of-Squared Error Function Contours Equation (4.Figure 4. ˆ n−k 2 i=1 (4. ˆ σ = ˆ n 2 i=1 n (4. one implication is that n 1X ei = 0. 24 . 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. and hold true for all linear regression estimates. It measures the variation in the i “unexplained” part of the regression.

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

. ⎟. ˆi 2 ∂σ 2 2ˆ σ 2 σ ˆ i=1 ˆ ˆ Solving for σ 2 yields the method of moments estimator (4. n X i=1 Thus the estimator (4.8) . one for each observation. ⎠ . ⎝ ⎝ . 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. σ 2 ) for the normal ˆ regression model are identical to the method of moment estimators. the ˆ OLS estimator β is frequently referred to as the Gaussian MLE. en ⎞ Observe that Y and e are n × 1 vectors. . and X is an n × k matrix. σ 2 ) = − 2 + ¡ ¢2 e2 = 0. .4 Model in Matrix Notation convenient to write the model and statistics in x0 1 x0 2 . yn ⎟ ⎟ ⎟. . Due to this equivalence. ⎠ xi x0 = X 0 X i xi yi = X 0 Y. Sample sums can also be written in matrix notation. We deﬁne ⎛ ⎞ ⎛ y1 ⎜ ⎜ y2 ⎟ ⎜ ⎟ ⎜ X=⎜ Y = ⎜ . including computation. The linear equation (3. ⎠ ⎜ ⎜ e=⎜ ⎝ ⎟ ⎟ ⎟.Maximization with respect to σ 2 yields the ﬁrst-order condition n X ∂ n 1 ˆ ˆ Ln (β. .12) is a system of n equations. Thus the MLE (β. yn = x0 β + en . . For example n X i=1 For many purposes. = β+ XX 26 (4. 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. 4.6). it is matrix notation. n or equivalently Y = Xβ + e.4). x0 n ⎞ ⎛ e1 e2 . residual vector. We can stack these n equations together as y1 = x0 β + e1 1 y2 = x0 β + e2 2 .

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

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) . and X2 is the vector of observed regressors. Rather. but in most cases there is little computational advantage to using the two-step algorithm. A common application of the FWL theorem. ˆ which are “demeaned”. 30 . the primary use is theoretical. observe that ⎞ ⎛ ⎞ ⎛ . ˜ 2. ¡ ¢−1 0 ι. .9). In the model (4. In this section we derive the small sample conditional mean and variance of the OLS estimator. 4.7 Bias and Variance In this and the following section we consider the special case of the linear regression model (3. In this case.9). . Regress Y on X1 . . The FWL theorem says that β 2 is the OLS estimate from a regression of ˜ ˜ Y on X2 . . ! Thus the OLS estimator for the slope coeﬃcients is a regression with demeaned data. which you may have seen in an introductory econometrics course. . .1 (Frisch-Waugh-Lovell). 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. . the FWL theorem can be used to speed computation. ⎟ ⎜ ⎟ ⎜ (4.8)(3.Theorem 4. Regress X2 on X1 . Partition X = [X1 X2 ] where X1 = ι is a vector of ones. ˆ ˜ ˜ ˆ 3. . obtain residuals Y . By the independence of the observations and (3. obtain residuals X2 . .18) E (e | X) = ⎜ E (ei | X) ⎟ = ⎜ E (ei | xi ) ⎟ = 0. is the demeaning formula for regression. . obtain OLS estimates β 2 and residuals e.6.14) or via the ˆ following algorithm: ˜ 1. In some contexts. ⎠ ⎝ ⎠ ⎝ . Regress Y on X2 .13). the OLS estimator of β 2 and the OLS residuals e may be equivalently computed by either the OLS regression (4.

. V ar β | X = X 0 X ⎟ ⎟ ⎟. 0 0 ··· 0 0 . ¡ X 0X ¢−1 ¡ ¢−1 X 0 DX X 0 X while the ij 0 th oﬀ-diagonal element of D is ¢ ¢ ¡ ¡ E e2 | X = E e2 | xi = σ 2 i i i E (ei ej | X) = E (ei | xi ) E (ej | xj ) = 0. . . . Then given (4. σ2 n ⎞ We now calculate the ﬁnite sample bias of the method ¡ moments estimator σ 2 for σ 2 .20) . under the of ˆ ¢ 2 | x = σ 2 . σ 2 = σ 2 and we have the simplii ﬁcations D = In σ 2 . From (4. and (4. ⎝ .19) ˆ and thus the OLS estimator β is unbiased for β. X 0 DX = X 0 Xσ 2 . the properties of conditional expectations. 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. for any random vector Z deﬁne the covariance materix V ar(Z) = E (Z − EZ) (Z − EZ)0 = EZZ 0 − (EZ) (EZ)0 . ⎠ (4. 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 . .18). Next. 1 n .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 .. and the trace operator observe that.. We have shown that which implies ³ ´ ˆ E β|X =β ³ ´ ˆ E β =β (4. σ2 = ˆ ¢ 1 ¡ ¢ 1 0 1 1 1 ¡ e e = e0 M M e = e0 M e = tr e0 M e = tr M ee0 ˆˆ n n n n n 31 In the special case of the linear homoskedastic regression model.8). .12).. . .Using (4. the properties additional assumption of conditional homoskedasticity E ei i of projection matrices. σ 2 } = ⎜ .

and thus can be written as ˜ β = A0 Y where A is an n × k function of X. In the homoskedastic linear regression model.8)¢ ¡ (3. 4.7) is unbiased for σ 2 by this calculation. however. that this estimator is only unbiased in the special case of the homoskedastic linear regression model. This is the justiﬁcation for the common s ˆ preference of s2 over σ 2 in empirical practice. 32 . or in the projection model. ³ ´ ˜ E β | X = A0 Xβ. Thus since V ar (e | X) = In σ 2 under homoskedasticity. is a famous statement of the solution. the estimator ˆ 2 deﬁned (4. It is important to remember. ³ ´ ˜ V ar β | X = A0 V ar (e | X) A = A0 Aσ 2 . The following result. the best (minimumvariance) unbiased linear estimator is OLS. as it yields the smallest variance among all unbiased linear estimators. In this case. What is the best choice of A? The Gauss-Markov theorem. As an alternative.8. known as the Gauss-Markov theorem.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 . which we now present.9) plus E e2 | xi = σ 2 .1 Gauss-Markov. Theorem 4. By a calculation similar to those of the previous section. ˜ so β is unbiased if (and only if) A0 X = Ik .10). Thus σ 2 is biased towards zero. says that the least-squares estimator is the best choice. It is not unbiased in the absence of homoskedasticity. The least-squares estimator is the special case obtained by setting A = X(X 0 X)−1 . 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. which is (3. Now consider the class of estimators of β which are linear functions of i the vector Y. = σ2 n the ﬁnal equality by (4.8 Gauss-Markov Theorem In this section we restrict attention to the homoskedastic linear regression model. ˜ β L = A0 Y = A (Xβ + e) = β + Ae.

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

(4. He proves that generically the OLS estimator (4. and any continuous distribution can be arbitrarily well approximated by a multinomial distribution. We can write the model as yi = x0 β 1 + x0 β 2 + ei 1i 2i E (xi ei ) = 0 where the parameter of interest is β 1 .4) is an asymptotically eﬃcient estimator for the parameter β deﬁned in (3. Chamberlain (1987) extends this argument to the case of continuously-distributed data. 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 .9).Substituting in the expressions for π j . 1X xi x0 i n i=1 1X xi yi n i=1 n ˆ = β ols 4. Since this is a regular parametric model the MLE is asymptotically eﬃcient (see Appendix A.5. the maximum likelihood estimator is identical to the OLS estimator. if the data have a discrete distribution.1. and thus so is the OLS estimator. He observes that the above argument holds for all multinomial distributions. 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.10) for the class of models satisfying Assumption 3.10 Omitted Variables xi = µ x1i x2i ¶ .22) 34 .

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

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

The key is equation (2. Investigations into the presence of inﬂuential observations can plot the values of (4.27). ¢−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 . ˆ = β − (1 − hi )−1 X 0 X and thus ˆ β (−i) = 37 . then this observation is a leverage point and has the potential to be an inﬂuential observation.4 which states that ¡ ¢ (A + BCD)−1 = A−1 − A−1 BC C + CDA−1 BC CDA−1 .This implies has a large value of hi . which is considerably more informative than plots of the uncorrected residuals ei .25). ˆ We now derive equation (4.1) in Section 2.

4.13

Exercises

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

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

Pn

i=1 g

¡ ¢ Xi , µ, σ 2 .

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

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

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

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

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

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

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

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

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

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

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

39

(f) (g) (h)

Pn

Pn

ˆˆ i=1 yi ei ˆ2 i=1 ei R2

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

40

We list here some of the most critical deﬁnitions and inequalities. If g(·) : R → R is convex. then its Euclidean norm is The following are an important set of inequalities which are used in asymptotic distribution theory. ij i=1 j=1 (5.3) E |XY | ≤ (E |X|p )1/p (E |Y |q )1/q . Cauchy-Schwarz Inequality. ´1/2 ³ ´1/2 ³ E |Y |2 E |XY | ≤ E |X|2 Holder’s Inequality. The Euclidean norm of an m × 1 vector a is Ã m !1/2 X ¡ 0 ¢1/2 = a2 .Chapter 5 Asymptotic Theory This chapter reviews the essential components of asymptotic theory. 5. |a| = a a i i=1 If A is a m × n matrix.1 Inequalities Asymptotic theory is based on a set of approximations. 41 . then g(E(X)) ≤ E(g(X)).1) (5.2) + 1 q = 1. then (5. If p > 1 and q > 1 and 1 p ⎞1/2 ⎛ m n XX ¡ 0 ¢1/2 |A| = tr A A =⎝ a2 ⎠ . Triangle inequality |X + Y | ≤ |X| + |Y | . Jensen’s Inequality. These approximations are bounded through the use of mathematical inequalities.

2. (5. ¥ Proof of Holder’s Inequality.Markov’s Inequality. if for all δ > 0. 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 ) = + . ¥ 5. Eg(X) ≥ a + bEX = g(EX).4) Proof of Jensen’s Inequality. P (g(X) > α) ≤ α−1 Eg(X). So for all x. Set Y = g(X) and let f denote the density function of Y. Since g(x) is convex. denoted Zn →p Z as n → ∞. If Xi ∈ Rk is iid and E |Xi | < ∞. then as n → ∞ n 1X Xn = Xi →p E(X). n i=1 42 . Let U = |X|p /E |X|p and V = |Y |q /E |Y |q . n→∞ lim P (|Zn − Z| > δ) = 0. (E |X|p )1/p (E |Y |q )1/q ¥ µ ¶ ´ ³ U V 1 1 1/p 1/q ≤E + = + = 1. p p p q which is (5.1 Weak Law of Large Numbers (WLLN). tangent lines lie below it.3). We say that Zn converges in probability to Z as n → ∞. The WLLN shows that sample averages converge in probability to the population average. 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}. g(x) ≥ a + bx yet g(EX) = a + bEX since the curve is tangent at EX. For any strictly increasing function g(X) ≥ 0. =E U V p q p q Proof of Markov’s Inequality. This is a probabilistic way of generalizing the mathematical deﬁnition of a limit.2 Weak Law of Large Numbers Let Zn ∈ Rk be a random vector. as stated. Applying expectations. Note EU = EV = 1. Let a + bx be the tangent line to g(x) at x = EX. Theorem 5.

and the bound |Wi | ≤ 2C. as needed. P ¯X n ¯ > δ ≤ δ δ δ the equality by the deﬁnition of ε. the triangle inequality. n i=1 0 where µ = EX and V = E (X − µ) (X − µ) . ¯ ¯ ¯ ¯ ¯ ¯ ¢ E ¯X n ¯ ¡¯ ¯ E ¯W n ¯ + E ¯Z n ¯ 3ε ≤ ≤ = η. Jensen’s inequality (5. P ¯X n ¯ > δ ≤ η. ¯ ¯ E ¯Z n ¯ ≤ E |Zi | ≤ 2ε. ≤ E |Xi | 1 (|Xi | > C) + |E (Xi 1 (|Xi | > C))| (5.5) (where 1 (·) is the indicator function) which is possible since E |X| < ∞. We need to ¢show that for all δ > 0 and η > 0 there is some N < ∞ so that for all n ≥ N. we can set E(X) = 0 (by recentering Xi on its expectation). Fix δ and η. then as n→∞ n ¢ √ ¡ 1 X n Xn − µ = √ (Xi − µ) →d N (0. If Xi ∈ Rk is iid and E |Xi |2 < ∞. the fact that the Wi are iid and mean zero. (5.3.5). Fn (x) → F (x) as n → ∞. if for all x at which F (x) is continuous. 5. ¯¢2 ¡ ¯ 2 ≤ EW n E ¯W n ¯ = EWi2 n 4C 2 ≤ n ≤ ε2 (5.3 Convergence in Distribution Let Zn be a random variable with distribution Fn (x) = P (Zn ≤ x) .1 Central Limit Theorem (CLT). Deﬁne the random vectors Wi = Xi 1 (|Xi | ≤ C) − E (Xi 1 (|Xi | ≤ C)) By the triangle inequality. by Markov’s inequality (5. Finally.7) the ﬁnal inequality holding for n ≥ 4C 2 /ε2 = 36C 2 /δ 2 η 2 .7). where Z has distribution F (x) = P (Z ≤ x) . 43 . ≤ 2E |Xi | 1 (|Xi | > C) Zi = Xi 1 (|Xi | > C) − E (Xi 1 (|Xi | > C)) .1) and (5. Theorem 5. Pick C < ∞ large enough so that E (|X| 1 (|X| > C)) ≤ ε (5.Proof: Without loss of generality. ¡¯ ¯ P ¯X n ¯ > δ ≤ η. Set ε = δη/3. We say that Zn converges in distribution to Z as n → ∞.6) and (5. V ) . We have shown that for any δ > 0 and η > 0 then for all ¢ ¡¯ ¯ ¥ n ≥ 36C 2 /δ 2 η 2 .1). denoted Zn →d Z.6) By Jensen’s inequality (5. the fact that X n = W n + Z n .4).

By the properties of the exponential function. Then observe ¡ ¡ ¢¢ ∂ C(λ) = iE X exp iλ0 X ∂λ ¡ ¡ 0 ¢¢ ∂2 2 0 0 C(λ) = i E XX exp iλ X ∂λ∂λ C(0) = 1 ∂ C(0) = iE (X) = 0 ∂λ ¡ ¢ ∂2 0 0 C(0) = −E XX = −Ik . By a second-order Taylor series expansion of c(λ) about λ = 0. the independence of the Xi . ∂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. it is suﬃcient to consider the case µ = 0 and V = Ik . For ¡ ¢ λ ∈ Rk .8) where λ∗ lies on the line segment joining 0 and λ. so when evaluated at λ = 0 c(0) = 0 cλ (0) = 0 cλλ (0) = −Ik .Proof: Without loss of generality. 1 1 c(λ) = c(0) + cλ (0)0 λ + λ0 cλλ (λ∗ )λ = λ0 cλλ (λ∗ )λ 2 2 (5. ¢ ¡ √ √ We now compute Cn (λ) = E exp iλ0 nX n the characteristic function of nX n .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. let C(λ) = E exp iλ0 X denote the characteristic function of X and set c(λ) = ln C(λ).

we see that as n → ∞.4. Proof: Since g is continuous at c.3 Delta Method: If n (θn − θ0 ) →d N (0. and g(θ) : Rm → Rk . Stacking across elements of g. we ﬁnd jn ¢ ¡ √ √ 0 n (g (θn ) − g(θ0 )) = (gθ + an ) n (θn − θ0 ) →d gθ N (0. then g(Zn ) →d g(Z) as n → ∞.√ where λn → 0 lies on the line segment joining 0 and λ/ n. where θ is m × 1 and Σ is m × m.4 Asymptotic Transformations Theorem 5.4. Thus P (|g (Zn ) − g (c)| ≤ ε) ≥ P (|Zn − c| < δ) → 1 as n → ∞ by the assumption that Zn →p c. Theorem 5.2 Continuous Mapping Theorem 2. It follows that ajn = gjθ (θ∗ ) − gjθ →p 0.1 Continuous Mapping Theorem 1 (CMT). This is suﬃcient to establish the theorem. If Zn →d Z as n → ∞ and g (·) is continuous. Hence g(Zn ) →p g(c) as n → ∞. Since cλλ (λn ) → cλλ (0) = −Ik . for all ε > 0 we can ﬁnd a δ > 0 such that if |Zn − c| < δ then |g (Zn ) − g (c)| ≤ ε. 45 . Σ) = N 0. gθ Σgθ where gθ (θ) = ∂ g(θ) ∂θ0 and gθ = gθ (θ0 ).4. Proof : By a vector Taylor series expansion. Recall that A ⊂ B implies P (A) ≤ P (B). √ Theorem 5. for each element of g. then ¡ ¢ √ 0 n (g (θn ) − g(θ0 )) →d N 0. Ik ) distribution. then g(Zn ) →p g(c) as n → ∞. gθ Σgθ . Σ) . k ≤ m. µ ¶ 1 Cn (λ) → exp − λ0 λ 2 the characteristic function of the N (0. ¥ 5. If Zn →p c as n → ∞ and g (·) is continuous at c. 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 .

1 Sampling Distribution The least-squares estimator is a random vector. n = 100 and n = 800. 46 . The verticle line marks the true value of the projection coeﬃcient. y) = 2πxy 2 2 ˆ and let β 2 be the slope coeﬃcient estimate computed on observations from this joint density. ˆ Figure 6. In general.Chapter 6 Inference 6.1: Sampling Density of β 2 To illustrate the possibilities in one example. 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. since it is a function of the random data. Using ˆ simulation methods.1 for sample sizes of n = 25. its distribution is a complicated function of the joint distribution of (yi . and therefore has a sampling distribution. the density function of β 2 was computed and plotted in Figure 6. xi ) and the sample size n.

we will use the methods of asymptotic approximation.1). xi ei →p g (Q.2) i i n i=1 n From (6. 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.1. Assumption 3. Equation (4. the OLS estimator β is has a statistical distribution which is unknown. we can conclude ˆ that β →p β. To characterize the sampling distribution more fully.1 Under Assumption 3. 0).1.5.From the ﬁgure we can see that the density functions are dispersed and highly non-normal. using (6. As the sample size increases the density becomes more concentrated about the population coeﬃcient. (6. xi ei = g i n n i=1 i=1 1X xi ei →p E (xi ei ) = 0. For a complete argument.8) implies that ˆ β−β = Ã n X i=1 xi x0 i !−1 n X i=1 xi ei . and the continuous mapping theorem (Theorem 5. First.1) imply that n ¡ ¢ 1X xi x0 →p E xi x0 = Q (6. This is illustrated in Figure 6. Assumption 3.3) Ã where g(A. β →p β as n → ∞.2 Consistency ˆ As discussed in Section 6.5. b) = A−1 b is a continuous function of A and b at all values of the arguments such that A−1 exist. Ã n ! n X 1X 0 1 ˆ xi xi .1) and ˆ We now deduce the consistency of β. ·) is continuous at (Q.2). Asymptotic (large sample) methods approximate sampling distributions based on the limiting experiment that the sample size n tends to inﬁnity. 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 . ¥ We can similarly show that the estimators σ 2 and s2 are consistent for σ 2 .1).4 implies that Q−1 exists and thus g(·. 6.1 and the WLLN (Theorem 5. ˆ Theorem 6.4. Proof.3).5. n i=1 (6. ˆ 47 .1).1 by the fact that the sampling densities become more concentrated as n gets larger. (6.4.1. Hence by the continuous mapping theorem (Theorem 5.1).2.2. (6. 0) = Q−1 0 = 0 β−β =g n n i=1 i=1 ˆ which implies β →p β as stated.

1). i Now deﬁne ¡ ¢ Ω = E xi x0 e2 .3) and Theorem (6.5) Thus xi ei is iid with mean zero and has covariance matrix Ω. (6.3. 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 .2).2 Under Assumption 3.1 In addition to Assumption 3. by the Cauchy-Schwarz inequality (5. Ee4 < ∞ and E |xi |4 < ∞.2.Theorem 6. To see this.3. ´1/2 ¡ ¯ ¯¢ ¯ ³ ¯ ¯2 ´1/2 ¡ ¯ 4 ¯¢1/2 ³ ¯ 1/2 E ¯xi x0 e2 ¯ ≤ E ¯xi x0 ¯ = E |xi |4 < ∞. We need a strengthening of the moment conditions.5. E ¯ei ¯ E ¯e4 ¯ i i i i (6. σ 2 →p σ 2 and s2 →p σ 2 as n → ∞.5. since n/(n − k) → 1 as n → ∞.1). Assumption 6.1 guarantees that the elements of Ω are ﬁnite.2).1. ˆ Proof. Ω) . i i Assumption 6. n 1 X √ xi ei →d N (0. By the central limit theorem (Theorem 5. (6.3 Asymptotic Normality ˆ We now establish the asymptotic distribution of β after normalization. it follows that s2 = ¥ n σ 2 →p σ 2 . (6.4) 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.1. (6.2. Thus σ 2 is consistent for σ 2 . ˆ Finally.6) n i=1 48 .3. ˆ n−k 6.

|ε| ≥ 1. If α > 2 the 2 error εi has zero mean and variance α/(α − 2). xi ) which satisfy the conditions of Assumption 6.1). There is a special case where Ω and V simplify.7) the asymptotic variance formulas simplify as ¡ ¢ ¡ ¢ (6. 1).3. The approximation may be poor when n is small.7) holds. V is often referred to as ˆ the asymptotic covariance matrix of β.Then using (6.7) Cov(xi x0 . We call V 0 the homoskedastic covariance matrix. its variance diverges q ³ ´ ˆ to inﬁnity. and (6.3. As α approaches 2.3. is approximately normal when the sample size n is suﬃciently large. ´ √ ³ˆ As V is the variance of the asymptotic distribution of n β − β . In this context the normalized least-squares slope estimator n α−2 β 2 − β 2 has α →d Q−1 N (0.9) we deﬁne V 0 = Q−1 σ 2 whether (6. However. after rescaling. but this is not a necessary condition.6).2 we display the ﬁnite sample densities of the q ³ ˆ normalized estimator n α−2 β 2 − β 2 . We illustrate this problem using a simulation. When (6. setting n = 100 and varying the parameter α. for any ˆ ﬁxed n the sampling distribution of β can be arbitrarily far from the normal distribution. e2 ) = 0. Q−1 ΩQ−1 . as n → ∞ ´ √ ³ ˆ n β − β →d N (0.7) is true then V = V 0 . for example. We say that ei is a Homoskedastic Projection Error when (6. The trouble is that no matter how large is the sample size. V ) where V = Q−1 ΩQ−1 . How large should n be in order for the approximation to be useful? Unfortunately. however.1. and εi is independent of xi with the Double Pareto density f (ε) = α |ε|−α−1 . For α 49 .3. This holds true for all joint distibutions of (yi . Let yi = β 0 + β 1 xi + εi where xi is N (0. In Figure 6. 1 X √ xi ei n i=1 n ! the N (0. Ω) ¡ ¢ = N 0.2).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.8) Ω = E xi x0 E e2 = Qσ 2 i i V = Q−1 ΩQ−1 = Q−1 σ 2 ≡ V 0 (6. when xi and ei are independent.1 Under Assumption 6. otherwise V 6= V 0 . Under (6. The expression V = Q−1 ΩQ−1 is called a sandwich form.1 is commonly used to approximate the ﬁnite of √ ³ˆ sample distribution of n β − β . The asymptotic distribution ´ Theorem 6.1.3. (6. Theorem 6. In´Figure 6.1 states that the sampling distribution of the least-squares estimator.7) is true or false. 1) asymptotic distibution.9) In (6. i i Condition (6. ´ √ ³ ˆ n β−β = Ã 1X xi x0 i n i=1 n !−1 Ã Theorem 6. the normal approximation is arbitrarily poor for some data distribution satisfying the assumptions. there is no simple answer to this reasonable question.

We show the sampling distribution of n β 1 − β 1 setting n = 100. ˆ ˆ Since Q →p Q and s2 →p σ 2 (see (6. 1) asymptotic approximation is never guaranteed to be accurate.3. 6. 1) density. 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 (0.2: Density of Normalized OLS estimator α = 3.10) V 0 = Q−1 s2 . 4.4 Let Covariance Matrix Estimation 1X ˆ xi x0 Q= i n i=1 n be the method of moments estimator for Q.1) it is clear that V 0 →p V 0 . concentrating most of the probability mass around zero. the sampling distribution becomes highly skewed and non-normal.3 is that the N (0.2.10) without changing this result. we need an estimate of Ω = E xi x0 e2 . The homoskedastic covariance matrix V 0 = Q−1 σ 2 is typically estimated by ˆ ˆ (6.Figure 6. Another example is shown in Figure 6. The MME estimator is i i 1X ˆ xi x0 e2 Ω= i ˆi n i=1 n (6. σ may also be substituted for s ˆ ¡ ¢ To estimate V = Q−1 ΩQ−1 . The lesson from Figures 6.11) 50 . 6 and 8.2) and Theorem 6.0 the density is very close to the N (0. As k increases. The estimator 2 2 in (6. 1). As α diminishes the density changes signiﬁcantly. for k = 1.2 and 6.

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

14 14. n n i=1 52 . We calculate that s2 = 0. we return to the log wage regression of Section 4. i i i i n i=1 Second. To illustrate.020) 6. and then the square roots.14 6.14 205. It is also important to understand that a particular standard error may be relevant under one set of model assumptions.12) i i n n n i=1 i=1 We now examine each sum on the right-hand-side of (6.117 Educationi . Using (6. then take the diagonal elements.3) so by the WLLN ³ ´ ³ ´3/4 ¡ ¯ ¯¢ 1/4 E |xi |3 |ei | ≤ E |xi |4 < ∞.1.6 ¶µ 1 14.80 40.14 205.4) 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 .20 −0.used by an author when studying their work.5) and the WLLN (Theorem 5.035 ¶ .83 ¶−1 µ . E ¯e4 ¯ i ³ ´ 1X |xi |3 |ei | →p E |xi |3 |ei | . from which it follows that V →p V as n → ∞. by Holder’s inequality (5. p ˆ In this case the two estimates are quite similar.480 . Ω 2. From a computational standpoint.14 205.80 .98 −0.085 p ˆ and that for β 1 is .2/988 = .493 0. The standard errors for β 0 are 7.493 −0.30 + 0.020.039 and ˆ V = µ 1 14. just as any other estimator.2. the standard method to calculate the standard errors is to ˆ ﬁrst calculate n−1 V .480 ˆ0 = 0.199 2. but not under another set of assumptions. (6.20 = V 14.1) show that n ¡ ¢ 1X xi x0 e2 →p E xi x0 e2 = Ω.80 2.20 and µ ¶ ˆ = 0. We can write the estimated equation with standards errors using the format \ log(W agei ) = 1.80 40.085) (.83 −0.14 14.199 2. (6.83 ¶−1 = µ 7.35/988 = . First.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. (.12) in turn.6 Therefore the two covariance matrix estimates are µ ¶−1 µ ¶ 1 14.

¯ 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.−i = (1 − hi )−1 ei ˆ presented in (4.11) with the leave-one-out estimator ei.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 . Andrews’ proposed estimator is ˆ ˆ ˆ ˆ V ∗∗ = Q−1 Ω∗∗ Q−1 53 .13) of Efron (1982). From equation (3. MacKinnon and White (1985) present numerical (simulation) evidence i ˆ ˆ that V ∗ works better than V as an estimator of V . n i=1 n ˆ ˆ Theorem 6. Ω →p Ω and V →p V. these establish consistency.5. n i=1 n − 1 ˆ −1 ˆ ∗ ˆ −1 ˆ V∗ = Q Ω Q n where 1X ˆ (1 − hi )−2 xi x0 e2 − Ω∗ = i ˆi n i=1 n (6. ¯ ¯n ¯ n i=1 so Together.26). They also suggest that the scaling factor (n − 1)/n in (??) can be omitted.6 Alternative Covariance Matrix Estimators ˆ MacKinnon and White (1985) suggested a small-sample corrected version of V based on the jackˆ knife principle.¯ ¯ ¯ ¯ˆ and thus since ¯β − β ¯ →p 0.25). Recall from Section 4. which. Andrews (1991) suggested an similar estimator based on cross-validation. i=1 Third.1 As n → ∞. 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 (6.13) Using formula (4. Using this substitution. you can show that 1 Xˆ ¯ β= β (−i) .12 the deﬁnition of β (−i) as the least-squares estimator with the i’th observation deleted. 6. ¯ ¯ ¯ ¯ ¯n ¯ n i=1 i=1 1X |xi |4 →p E |xi |4 . 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. is deﬁned ˆ ˆ by replacing the OLS residual ei in (6.

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

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

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

or α = .10 Wald Tests Sometimes θ = h(β) is a q × 1 vector. We say that Cn has asymptotic (1 − α)% coverage for θ if P (θ ∈ Cn ) → 1 − α as n → ∞.05. ˆ + zα/2 s(ˆ . and values of θ outside two standard θ errors of the estimated ˆ are considered unlikely or unreasonable candidates for the true value. 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).96s(ˆ ≈ ˆ ± 2s(ˆ .18) . However we often can calculate the asymptotic coverage probability limn→∞ P (θ ∈ Cn ). θ The interval has been constructed so that as n → ∞. = n h(β) − θ0 Hβ V Hβ 57 (6. 6. The t-test of the previous setion rejects H0 : θ0 = θ if |tn (θ)| > zα/2 where tn (θ) is the t-statistic (6. While there is no hard-and-fast guideline for choosing the coverage probability 1 − α. In this case the t-statistic approach does not work.17) = ˆ − zα/2 s(ˆ θ and Cn is an asymptotic (1 − α)% conﬁdence interval. θ θ) (6. 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 . 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 most common professional choice isi95%. We have the null and alternative H0 : θ = θ0 H1 : θ 6= θ0 .16) and zα/2 is the upper α/2 quantile of the standard normal distribution. and it is desired to test the joint restrictions simultaneously. This corresponds to selecting the conﬁdence h i h ˆ ± 1. 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).We typically cannot calculate the exact coverage probability P (θ ∈ Cn ). A good method for construction of a conﬁdence interval is the collection of parameter values which are not rejected by a statistical test. ¢ ¡ ¢ ¡ P (θ ∈ Cn ) = P |tn (θ)| ≤ zα/2 → P |Z| ≤ zα/2 = 1 − α.

h(β) = R0 β.1. Hence β β by Theorem A. Hβ (β) →p Hβ .19) σ2 ˆ where σ2 = ˜ 1 0 e e.2.025 . q and pn is asymptotically U[0. if rank(Hβ ) = q. The null hypothesis is H0 : β 2 = 0.8.15) showed that n ˆ − θ →d Z ∼ N (0. the upper-α quantile q 2 of the χ2 distribution.10. ˜ 58 ¡ 0 ¢−1 0 ˜ β 1 = X1 X1 X1 Y .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 . then Wn →d χ2 .When h is a linear function of β. Thus Vθ = H 0 V Hβ →p H 0 V Hβ = Vθ > 0 if Hβ has full rank q.05) = 3.1 Under H0 and Assumption 6. so by the continuous mapping ˆ ˆ ˆ ˆ ˆ theorem. 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. Hβ (β) is a continuous function of β. 1] under H0 . 6. the test rejects at the α% level iﬀ pn < α.3. We have established: ³ ´0 ³ ´ ˆ − θ0 V −1 ˆ − θ0 →d Z 0 V −1 Z = χ2 . 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. Vθ ).1 showed θ ˆ that V →p V. The Wald test fails to reject if Wn is q 1 ¡ ¢ less than χ2 (α). ˜˜ n ˜ e = Y − X1 β 1 . then the Wald statistic takes the form ´0 ³ ´ ³ ´−1 ³ ˆ ˆ ˆ R0 V R R0 β − θ 0 . = nβ 2 R0 V R R0 β is linear with R = µ 0 I ¶ ¢−1 ¡ ˆ ˆ ˆ . Also h(β) = a selector matrix. As before. then the Wald statistic can be written in the form ¶ µ 2 ˆ σ − σ2 ˜ Wn = n (6. For example. The asymptotic p-value for Wn is pn = p(Wn ). ˆ Wn = n θ θ q θ θ Theorem 6. and there are q = k2 restrictions. a chiq square random variable with q degrees of freedom. where p(x) = P χ2 ≥ x is the tail q q probability function of the χ2 distribution.5. χ2 (. An asymptotic Wald test rejects H0 in favor of H1 if Wn exceeds χ2 (α). θ = β 2 . Wn = n R0 β − θ0 ´ √ ³ The delta method (6. and Theorem 6. Furthermore. In this case.84 = z.

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

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

σ 2 (X 0 X)−1 • (n−k)s2 σ2 ˆ β j −β j ˆ s(β ) j ∼ χ2 . which is twice the diﬀerence in the log-likelihood function evaluated under the null and alternative hypotheses. (Unless the sample size is unreasonably small. 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. ˆ 2 2 2 ˜ ˜ The MLE of the model under the null hypothesis is (β 1 .3. σ 2 ) ¡ ¢¢ ¡ ¡ ¢ ˆ = n log σ 2 − log σ 2 ˜ µ 2¶ σ ˜ = n log . β has an exact normal distribution and t has an exact t distribution. a good testing procedure is based on the likelihood ratio statistic. The critical values are quite close if n − k ≥ 30. and standard errors are calculated using the homoskedastic formula (6. n−k • ∼ tn−k ˆ In Theorem 6. The log-likelihood of this model is ¡ 2¢ n n n ˜ ˜ ˜ Ln (β 1 . β 2 .1 we showed that in large samples. The Gaussian log-likelihood at these estimates is ¡ ¢ n 1 ˆ ˆ ˆ σ Ln (β 1 . 2 2 2 The LR statistic for H0 is ´ ³ ˆ ˆ ˆ ˜ ˜ LR = 2 Ln (β 1 . the notable distinction is between the N (0. In contrast. σ 2 ) = − log σ − log (2π) − .10) µ h i ¶ 2 (X 0 X)−1 N 0. σ 2 ).) Now let us partition β = (β 1 . 0.12. β 2 .a chi-square distribution with n − k degrees of freedom. β 2 .12. σ 2 ) discussed above. so as a practical matter it does not matter which distribution is used.10) then ´ ³ ˆ • β ∼ N 0.1 shows that under the strong assumption of ˆ normality. Theorem 6.1 If ei is independent of xi and distributed N(0. 1) and tn−k distributions. The estimator under the alternative is the unrestricted estimator ˆ ˆ ˆ (β 1 . if standard errors are calculated using the homoskedastic formula (6. σ2 ˆ 61 . We summarize these ﬁndings Theorem 6.8. Furthermore. σ ˆ ˆ βj − βj βj − βj N (0. β and t are approximately normally distributed. with residual variance σ . σ 2 ) where β 1 is the OLS estimate from ˜ 2 ˜ a regression of yi on x1i only. As inference (conﬁdence intervals) are based on the t-ratio. σ 2 ) − Ln (β 1 . 0.1 and Theorem 6. β 2 ) and consider tests of the linear restriction H0 : β 2 = 0 H1 : β 2 6= 0 In the context of parametric models. σ 2 ) = − log 2πˆ 2 − 2 e0 e ˆˆ 2 2ˆ σ ¡ ¢ n n n = − log σ 2 − log (2π) − .

we have plotted in Figure 6. we ﬁnd that the standard Wald test for H0 (s) is ´2 ³ s ˆ β −1 Wn (s) = n 2s−2 . 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. Through repetition. It is easy to see that in each case there are values of s for which the line is for the case β test statistic is signiﬁcant relative to asymptotic critical values. Our ﬁrst-order asymptotic theory is not useful to help pick s. In the present context of the Wald statistic. σ 2 ) and consider the hypothesis H0 : β = 1. LR = n log 1 + 2 − 1 ' n σ ˆ σ2 ˆ the F statistic. 62 . This is distressing since the choice of s seems arbitrary and irrelevant to the actual hypothesis. Then the standard Wald test for H0 is ˆ ³ ´2 ˆ β−1 Wn = n .7.8. This produces random draws from the sampling distribution of interest. The increasing solid line is for the case β = 0. This is an unfortunate feature of the Wald statistic. To demonstrate this eﬀect. σ 2 s2 β ˆ ˆ While the hypothesis β s = 1 is unaﬀected by the choice of s.13 Problems with Tests of NonLinear Hypotheses While the t and Wald tests work well when the hypothesis is a linear restriction on β. setting n/σ 2 = 10. they can work quite poorly when the restrictions are nonlinear. and noting Hβ = sβ s−1 . while there are other values of s for which test test statistic is insigniﬁcant. 6.84 — the probability of a false rejection.4 the Wald statistic Wn (s) as a function ˆ of s. features of this distribution can be calculated. The method uses random simulation to create an artiﬁcial dataset to apply the statistical tools of interest. the statistic Wn (s) varies with s. as Wn (s) →d χ2 under H0 for 1 any s. ˆ Let β and σ 2 be the sample mean and variance of yi . Take the model yi = β + ei ei ∼ N (0. The decreasing dashed ˆ = 1. Letting h(β) = β s . σ2 ˆ Now notice that H0 is equivalent to the hypothesis H0 (s) : β s = 1 for any positive integer 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 . This can be seen by a simple example introduced by Lafontaine and White (1986).

Each row of the table corresponds to a diﬀerent value of s — and thus corresponds to a particular choice of test statistic. Given the simplicity of the model.4: Wald Statistic as a function of s P (Wn (s) > 3. n is varied among 20. and σ 2 .05) with deviations indicating+ distortion. Typically.4. When comparing statistical procedures. In each case. 100 and 500. To interpret the table. In Table 4. These probabilities are calculated as the percentage of the 50. so these probabilities are Type I error.000 simulated Wald statistics Wn (s) which are larger than 3. this probability depends only on s.1 you can also see the impact of variation in sample size.84 | β = 1) .1 reports the simulation estimate of the Type I error probability from 50. In Table 2. Table 4.000 random samples. For this particular example. and rarely fall outside of the 3%-8% range.84.1 Type I error Probability of Asymptotic 5% Wn (s) Test 63 . The value of s is varied from 1 to 10. however. the Type I error probability improves towards 5% as the sample size n increases. Type I error rates between 3% and 8% are considered reasonable. There is. The null hypothesis β s = 1 is true. Table 4. Error rates avove 10% are considered excessive. remember that the ideal Type I error probability is 5% (.1 we report the results of a Monte Carlo simulation where we vary these three parameters. Any other choice of s leads to a test with unacceptable Type I error probabilities. The second through seventh columns contain the Type I error probabilities for diﬀerent combinations of n and σ. the only test which meets this criterion is the conventional Wn = Wn (1) test. looking for tests for which rate rejection rates are close to 5%. and σ is varied among 1 and 3.Figure 6. n. Test performance deteriorates as s increases. Rates above 20% are unexceptable. no magic choice of n for which all tests perform uniformly well. which is not surprising given the dependence of Wn (s) on s as shown in Figure 6. we compare the rates row by row.

000 simulated random samples In this example it is not surprising that the choice s = 1 yields the best test statistic. Take the model yi = β 0 + x1i β 1 + x2i β 2 + ei E (xi ei ) = 0 and the hypothesis H0 : β1 =r β2 (6.06 .07 .33 .05 .12 .07 . so the hypothesis can be stated as H0 : θ = r.08 .07 .18 .31 . An alternative statistic can be constructed through reformulating the null hypothesis as H0 : β 1 − rβ 2 = 0.05 .22 .13 . β 2 ) be the least-squares estimates of (6.07 .09 .25 .06 .10 .35 .30 .06 .22 .06 .13 .16 Rejection frequencies from 50.20) ³ ´1/2 ˆ0 ˆ ˆ so that the standard error for ˆ is s(ˆ = n−1 H1 V H1 θ θ) .05 .21 .07 .05 .14 .08 . 64 . in other examples natural choices are not always obvious and the best choices may in fact appear counter-intuitive at ﬁrst.26 .15 .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 .10 .05 .20). While this is clear in this particular example.20 .14 . This point can be illustrated through another example. Equivalently. Deﬁne θ ˆ ˆ ⎞ ⎛ 0 ⎟ ⎜ ⎟ ⎜ ⎜ 1 ⎟ ⎟ ⎜ ⎜ ˆ ⎟ ˆ H1 = ⎜ β 2 ⎟ ⎟ ⎜ ⎟ ⎜ ⎜ β ⎟ ˆ ⎠ ⎝ − 1 ˆ2 β2 ´ s(ˆ θ) −r . deﬁne θ = β 1 /β 2 .10 .11 .08 .19 .05 .08 . In this case a t-statistic for H0 is t1n = ³ˆ β1 ˆ β2 where r is a known constant.17 .25 .12 . Other choices are arbitrary and would not be used in practice.15 .13 .28 .08 .23 . let V be an estimate of the ˆ asymptotic variance matrix for β and set ˆ = β 1 /β 2 . ˆ ˆ ˆ ˆ ˆ Let β = (β 0 .06 .06 .06 .15 . β 1 .06 .20 .15 .24 .34 .

25.645) P (tn < −1. ei be an independent N (0.00 . the rejection rates for the t1n statistic diverge greatly from this value.09 . 65 .0 and n among 100 and 500. In this section we describe the method in more detail.06 . −r ⎛ t2n where To compare t1n and t2n we perform another simple Monte Carlo simulation.10 . .00 .2 is that the two t-ratios have dramatically diﬀerent sampling behavior. and normalize β 0 = 0 and β 1 = 1.05 .05 .05 . . σ 2 ) draw with σ = 3.06 . if the hypothesis can be expressed as a linear restriction on the model parameters.06 .00 The one-sided Type I error probabilities P (tn < −1. especially for small values of β 2 . The common message from both examples is that Wald statistics are sensitive to the algebraic formulation of the null hypothesis.02 .28 .A t-statistic based on this formulation of the hypothesis is ´2 ³ ˆ 1 − rβ 2 ˆ β =³ ´1/2 . However. −1 H V H ˆ 2 n 2 ⎞ 0 H2 = ⎝ 1 ⎠ .15 .00 . and are close to the ideal 5% rate for both sample sizes. and alternatives to asymptotic critical values should be considered.75 1. This leaves β 2 as a free parameter.1.05 .50 . In contrast. then the “most linear” formulation should be selected.645) P (tn > 1.10 .06 . the rejection rates for the linear t2n statistic are invariant to the value of β 2 .26 .00 . and 1. If no linear formulation is feasible.00 .645) are close to zero in most cases.05 .05. The results are presented in Table 4.645) greatly exceed 5%. We vary β 2 among .15 .06 .00 . while the right tail probabilities P (t1n > 1. this formulation should be used.05 .06 . .645) and P (tn > 1.05 β2 .2.645) P (tn > 1. It is also prudent to consider alternative tests to the Wald statistic. The implication of Table 4.06 .05 .06 . In all cases.645) t1n t2n t1n t2n t1n t2n t1n t2n .50.10 .05 .47 . such as the GMM distance statistic which will be presented in Section 9. The left tail probabilities P (t1n < −1.06 . 6. along with sample size n.07 . Table 4.12 .75. Ideally.05 . 1) variables.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. We let x1i and x2i be mutually independent N (0.645) are calculated from 50.00 .06 . the entries in the table should be 0.00 .2 Type I error Probability of Asymptotic 5% t-tests n = 100 n = 500 P (tn < −1.00 .000 simulated samples.25 .7.

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

s P = . The random variable 1 (Tnb ≥ 1. potential work experience. Since the results of a Monte Carlo experiment are estimates computed from a random sample of size B. If the standard error is too large to make a reliable inference. then we can set s P = (. for a selection of choices of n and F.15 Estimating a Wage Equation We again return to our wage equation. equalling 1 with probability P = E1 (Tnb ≥ 1. 6. if we are ³ ´ p √ ˆ assessing an asymptotic 5% test.003. Hence the ³ ´ ˆ standard errors for B = 100. are.22/ B. and hispanic. The α% sample quantile is a number qα such that α% of the sample are less than qα . The typical purpose of a Monte Carlo simulation is to investigate the performance of a statistical procedure (estimator or test) in realistic settings. respectively. the choice of B is often guided by the computational demands of the statistical procedure. B. union member. Generally. female. For the dependent variable we use the natural log of wages. Furthermore.Suppose we are interested in the ¯Type I error associated with an asymptotic 5% two-sided ¯ ¯ ¯ θ) θ t-test. We us the sample of wage earners from the March 2004 Current Population Survey. immigrant. hispanic. experience squared. the performance will depend on n and F. In particular. For regressors we include years of education. It is therefore useful to conduct a variety of experiments. We separately estimate equations for white and non-whites. it is simple to make inferences about rejection probabilities from statistical tests.95) /B ' . where N = (B +1)α. potential work experience. B b=1 (6. female.96) . if we set B = 999. and dummy variable indicators for the following: married. but requires more computational time.007. and 5000. this may ˆ be approximated by replacing P with P or with an hypothesized value. Suppose we are interested in the 5% and 95% quantile of Tn = ˆ We then compute the 10% θ.21). then B will have to be increased. . and . 1000. and poorly for others. experience squared.21) the percentage of the simulated t-ratios which exceed the asymptotic 5% critical value. we included a dummy 67 . The average (6. the researcher must select the number of experiments. such as the percentage estimate reported in (6.96) is iid Bernoulli. excluding military. Then qα is the N ’th number in this ordered sequence. For example. Quite simply. and non-white. For example. then the 5% sample quantile is 50’th sorted value and the 95% sample quantile is the 950’th sorted value. It is therefore convenient to pick B so that N is an integer. and estimate a multivariate regression. As P is unknown. union member. and 90% sample quantiles of the sample {Tnb }. so that coeﬃcients may be interpreted as semi-elasticities. We would then set Tn = ¯ˆ − θ¯ /s(ˆ and calculate B X ˆ= 1 P 1 (Tnb ≥ 1. immigrant. Again our dependent variable is the natural log of wages. Often this is called the number of replications. and therefore it is straightforward to calculate standard errors for any quantity of interest.022. and our regressors include years of education. and dummy variable indicators for the following: married.05) (. We now expand the sample all non-military wage earners. As discussed above. In practice. In many cases. a larger B results in more precise estimates of the features of interest of Gn . an estimator or test may perform wonderfully for some values. therefore.21) is therefore an ³ ´ p ˆ unbiased estimator of P with standard error s P = P (1 − P ) /B.96) . A simple way to compute sample quantiles is to sort the sample {Tnb } from low to high.

Table 4.033 −. we ﬁnd Wn = 550.18) that the state coeﬃcients are jointly zero. The available sample is 18.070 . 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.001 .121 −. excluding the coeﬃcients on the state dummy variables. if β 2 > 0 and β 3 < 0 the solution is θ=− From Table 4.013 .002 . Alternatively.808 so the parameter estimates are quite precise and reported in Table 4.010 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. reestimating the model with the 50 state dummies excluded. 2β 3 68 .00057 .34 ˆ s(β) .1 we ﬁnd the point estimate ˆ ˆ = − β 2 = 28. the restricted standard deviation estimate is σ = .032 .102 −. but not equal.008 .00002 .1.48772 = 515.097 −. θ ˆ 2β 3 β2 . Wn = n 1 − 2 = 18.101 . 808 1 − . 50 Another interesting question which can be addressed from these estimates is the maximal impact of experience on mean wages. Using either statistic the hypothesis is easily rejected.007 .1 OLS Estimates of Linear Equation for Log(Wage) ˆ β 1. this adds 50 regressors).49452 σ ˜ Notice that the two statistics are close.014 . The F form of the Wald statistic (6.232 .19) is ˜ µ ¶ µ ¶ σ2 ˆ .027 .variable for state of residence (including the District of Columbia. Computing the Wald statistic (6. as the 1% critical value for the χ2 distribution is 76.808 .4877 18.010 . Ignoring the other coeﬃcients.102 −.69.4945.

69 . In the present context we are interested in forming a conﬁdence interval. In the previous section we discovered that such t-tests had very poor Type I error rates. but it can be found numerically quite easily. we can calculate a standard error of s(ˆ = . This is the set of θ such that |tn (θ)| ≤ 1. but the lower end is substantially lower. Notice that the upper end of the conﬁdence interval is the same as that from the delta method. Instead. This set is [27.96. as the coverage probability of this conﬁdence interval is one minus the Type I error of the hypothesis test based on the t-test. 29. Since tn (θ) is a non-linear function of θ.5]. not testing a hypothesis.9.40. implying a 95% conﬁdence θ) interval of [27. we found better Type I error rates by reformulating the hypothesis as a linear restriction. so we have to go one step further. 29. there is not a simple expression for this set.Using the Delta Method.0.5]. However. this is a poor choice. 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 ). Our desired conﬁdence interval will be the set of parameter values θ which are not rejected by the hypothesis test.

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

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

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

2

is the homoskedasticity-formula standard error.

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

i=1 i=1

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

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

E (xi ei ) = 0

∗ yi = yi + ui

71

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

∗ E (yi ui ) = 0

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

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

• Qi • Di • Ci

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

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

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

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

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

73

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

Thus ˆ i i η − η i = e2 − e2 ˆ ˆi i = φi . 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.. We have shown that α is consistently estimated by a simple procedure. or FGLS. then the FGLS ˜i estimator is not well deﬁned.6) σ 2 = α0 zi . This is the feasible GLS. ˜i Suppose that σ 2 > 0 for all i. xi ). .. σ 2 } σ1 ˜n and ³ ´−1 ˜ ˜ ˜ β = X 0 D−1 X X 0 D−1 Y.5) ˆ Thus the fact that η i is replaced with η i is asymptotically irrelevant. Then set ˜i ˜ D = diag{˜ 2 . then the FGLS estimator will force ˜i the regression equation through the point (yi . Then ˆ ¢−1 0 ¡ Zη ˆ α = Z 0Z ˜ (7. and will depend on the model (and estimation method) for the skedastic regression. which is typically undesirable. This suggests 75 .3) ˆ ˆ While ei is not observed..4) the skedastic regression. ³ ´ ˆ ˆ ˆ = −2ei x0 β − β + (β − β)0 xi x0 (β − β) i i say. 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 . Since there is not a unique speciﬁcation for the conditional variance the FGLS estimator is not unique. there is no guarantee that σ 2 > 0 for all i. we have the OLS residual ei = yi − x0 β = ei − x0 (β − β). One typical problem with implementation of FGLS estimation is that in a linear regression ˜i speciﬁcation. as it is estimating the conditional variance of the regression of yi on xi . if σ 2 ≈ 0 for some i. Vα ) α ¡ ¡ 0 ¢¢−1 ¡ 0 2 ¢ ¡ ¡ 0 ¢¢−1 E zi zi ξ i E zi zi . and hence we can estimate 0 σ 2 = zi α by i ˜ (7. Vα = E zi zi (7. Vα ) (7.4) ¡ ¢−1 −1/2 0 √ √ n (˜ − α) = n (ˆ − α) + n−1 Z 0 Z α α n Zφ →d N (0. Furthermore.Suppose ei (and thus η i ) were observed. If σ 2 < 0 for some i. We may call (7. estimator of β.

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

Theorem 7. This introduces an element of arbitrariness which is unsettling to empirical researchers. its squares. and replaced E ξ 2 with 2σ 4 which holds when ei is N(0.2 Testing for Heteroskedasticity ¢ ¡ The hypothesis of homoskedasticity is that E e2 | xi = σ 2 .4) and constructing a Wald statistic. And the FGLS probability limit will depend on the particular function selected for the skedastic regression. or equivalently that i H0 : α1 = 0 in the regression (7. but the only diﬀerence is that they a ¢ allowed for general choice of zi . require the assumption of a correct conditional mean. and this requires trimming to solve.2).3) for α simpliﬁes to ¡ ¡ 0 ¢¢−1 ¡ 2 ¢ E ξi . the two tests coincide. and not a conditional mean. Motivated by the form of the asymptotic variance ˆ of the OLS estimator β. OLS is a more robust estimator of the parameter vector. The asymptotic distribution (7. The point is that the eﬃciency gains from FGLS are built on the stronger assumption of a correct conditional mean. If the equation of interest is a linear projection. The GLS and FGLS estimators. The main diﬀerences between popular “tests” is which transformations of xi enter zi . q Most tests for heteroskedasticity take this basic form.error.1 Under H0 and ei independent of xi . It is consistent not only in the regression model. 7. In this case. on the other hand. in which case ξ i is ˜ independent of xi and the asymptotic variance (7. Vα = E zi zi (7. White (1980) proposed that the test for heteroskedasticity be based on setting zi to equal all non-redundant elements of xi . BreuschPagan (1979) proposed what might appear to be ¡ distinct test. and all cross-products. however. In the linear regression model the conditional mean of yi given xi = x is 77 . FGLS will do worse than OLS in practice. and the cost is a reduction of robustness to misspeciﬁcatio 7. If i this simpliﬁcation is replaced by the standard formula (under independence of the error). Second. σ 2 ).7) under independence show that this test has an asymptotic chi-square distribution.5) and the asymptotic variance (7. the estimated conditional variances may contain more noise than information about the true conditional variances. This hypothesis does not imply that ξ i is independent of xi . Typically.2. we impose the stronger hypothesis and test the hypothesis that ei is independent of xi . individual estimated conditional variances may be negative.4). then the OLS and FGLS estimators will converge in probability to diﬀerent limits. but also under the assumptions of linear projection.3 Forecast Intervals m(x) = E (yi | xi = x) = x0 β. Third. the Wald test of H0 is asymptotically χ2 .7) Hence the standard test of H0 is a classic F (or Wald) test for exclusion of all regressors from the skedastic regression (7. as they will be estimating two diﬀerent projections. We may therefore test this hypothesis by the estimation (7.

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

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

However. θi Thus ¡ ¢ yi − m(xi . ˆ and ei = yi − m(xi . Thus when the truth is that β 2 = 0. tests of H0 do not have asymptotic normal or chi-square distributions. γ is not identiﬁed. Thus we want to test H0 : β 2 = 0. θi Hence the sum of squared errors function is Sn (θ) = n X i=1 (yi − m(xi . but these are not the only measures of central tendency. Suppose that m(xi . Hansen (1996). m(xi . This means that under H0 . by a ﬁrst-order Taylor series approximation. the parameter estimates are not asymptotically normally distributed. 1 2 The model is linear when β 2 = 0.1. We have discussed projections and conditional means. 7. an estimate of the asymptotic variance V is ˆ V = Ã 1X mθi m0 ˆ ˆ θi n i=1 n !−1 Ã 1X mθi m0 e2 ˆ ˆ θi ˆi n i=1 n !Ã 1X mθi m0 ˆ ˆ θi n i=1 n !−1 where mθi = mθ (xi . and this is often a useful hypothesis (sub-model) to consider. ¥ Based on Theorem 7. An alternative good measure is the conditional median. θ0 ) + m0 (θ − θ0 ) . θ) = β 0 zi + β 0 xi (γ). the model is yi = β 0 zi + εi 1 and both β 2 and γ have dropped out. θ which is that stated in the theorem. θ0 )) − m(xi . Thus the NLLS 0 estimator ˆ has the same asymptotic distribution as the (infeasible) OLS regression of yi on mθi . 80 .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 . The asymptotic theory of such tests have been worked out by Andrews and Ploberger (1994) and B. θ0 ) + m0 (θ − θ0 ) θi = ei − m0 (θ − θ0 ) θi 0 = yi − m0 θ. Furthermore. In particular.4. ˆ ˆ θ) ˆ θ).For θ close to the true value θ0 . θ) ' (ei + m(xi . Identiﬁcation is often tricky in nonlinear regression models. under H0 . 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 . Hansen shows how to use simulation (similar to the bootstrap) to construct the asymptotic critical values (or p-values) in a given application. This renders the distribution theory presented in the previous section invalid. θ) ' m(xi .

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

and this improves estimation of the median.10) is equivalent to g n (β) = 0. then there are many innovations near to the median. we provide a sketch here for completeness.11) This simpliﬁcation is similar to the simpliﬁcation of the asymptotic covariance of the OLS estimator under homoskedasticity. V ). ∂β ˆ g(β) ' ´ ³ ∂ ˆ g(β 0 ) β − β 0 . where V = and f (e | x) is the conditional density of ei given xi = x. First. the height of the error density at its median.1: Since sgn (a) = 1 − 2 · 1 (a ≤ 0) . Let g(β) = Eg (β). Computation of standard error for LAD estimates typically is based on equation (7.5. then f (0 | x) = f (0) and the asymptotic variance simpliﬁes V = (Exi x0 )−1 i 4f (0)2 (7.1 is advanced.1 ´ √ ³ˆ n β − β 0 →d N (0. Pn −1 0 β)) . Exi x0 ) i i=1 since Egi (β 0 )gi (β 0 )0 = Exi x0 .5. by the central limit theorem (Theorm 5. (7. ∂ g(β) = ∂β 0 ¡ ¡ ¢¢ ∂ 0 0 Exi 1 − 2 · 1 yi ≤ xi β ∂β £ ¡ ¡ ¢ ¢¤ ∂ = −2 0 E xi E 1 ei ≤ x0 β − x0 β 0 | xi i i ∂β " Z 0 # xi β−x0 β 0 i ∂ = −2 0 E xi f (e | xi ) de ∂β −∞ £ ¢¤ ¡ = −2E xi x0 f x0 β − x0 β 0 | xi i i i £ 0 ¤ ∂ 0 g(β 0 ) = −2E xi xi f (0 | xi ) .11).5. When f (0 | x) is large. ¢¢−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) . ∂β 0 so Third. In the special case where the error is independent of xi . The main diﬃculty is the estimation of f (0). the conditional density of the error at its median. This can be done with kernel estimation techniques.1) n X √ −1/2 n (g n (β 0 ) − g(β 0 )) = −n gi (β 0 ) →d N (0. by a Taylor series expansion and the fact g(β 0 ) = 0 82 . ˆ Proof of Theorem 7. We need where g n (β) = n i i=1 gi (β) and gi (β) = xi (1 − 2 · 1 (yi ≤ xi three preliminary result.Theorem 7. Second using the law of iterated expectations and the chain rule of i diﬀerentiation.3. See Chapter 16. While a complete proof of Theorem 7.

However for computational convenience it is typical to assume that they are (approximately) linear in x (after suitable transformations).6 Quantile Regression The method of quantile regression has become quite popular in recent econometric practice. This linear speciﬁcation assumes that Qτ (x) = β 0 x where the coeﬃcients β τ τ vary across the quantiles τ . As functions of x. The quantile Qτ is the value such that τ (percent) of the mass of the distribution is less than Qτ . The median is the special case τ = . then F (Qτ ) = τ . the quantile regression functions can take any shape. Again. so you can think of the quantile as the inverse of the distribution function. then F (Qτ (x) | x) = τ .9) for the median to all quantiles.12) Qτ = argmin Eρτ (U − θ) . the quantile regression function qτ (x) describes how the τ ’th quantile of the conditional distribution varies with the regressors. then (7.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. For ﬁxed τ . For τ ∈ [0. ¥ 7. xi ) with conditional distribution function F (y | x) the conditional quantile function qτ (x) is Qτ (x) = inf {y : F (y | x) ≥ τ } . For the random variables (yi . when F (y | x) is continuous and strictly monotonic in y.13) This generalizes representation (7. 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)) . (7. 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. If the random variable U has τ ’th quantile Qτ .5. Exi x0 ) →d i 2 = N (0. The following alternative representation is useful. V ). 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.

and test their signiﬁcance using a Wald test. if the model yi = x0 β + ei has i been ﬁt by OLS. A asymptotic distribution theory for the quantile regression estimator can be derived using similar arguments as those for the LAD estimator in Theorem 7.where ei is the error deﬁned to be the diﬀerence between yi and its τ ’th conditional quantile x0 β τ . since it has discontinuous derivatives. and form a Wald statistic i for γ = 0. it is useful to have a general test of the adequacy of the speciﬁcation. ¡ ¡ ¢¢−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. The null model is yi = x0 β + εi i 84 . and we have the simpliﬁcation Vτ = τ (1 − τ ) ¡ ¡ 0 ¢¢−1 . ˆ Given the representation (7. Vτ ). Thus. 7. the τ ’th conditional quantile of ei is zero. ´ √ ³ˆ Theorem 7. the quantile regression estimator β τ for β τ solves the minimization problem ˆ β τ = argmin Lτ (β) n β∈Rk n where Lτ (β) = n and ρτ (q) is deﬁned in (7. then f (0 | xi ) = f (0) . Fortunately. Another popular approach is the RESET test proposed by Ramsey (1969). where and f (e | x) is the conditional density of ei given xi = x. the unconditional density of ei at 0.13). n numerical methods are necessary for its minimization. When the error ei is independent of xi . Since the quanitle regression criterion function Lτ (β) does not have an algebraic solution.12). the asymptotic variance depends on the conditional density of the quantile regression error.1.1 n β τ − β τ →d N (0.7 Testing for Omitted NonLinearity If the goal is to estimate the conditional expectation E (yi | xi ) . fast linear programming methods have been developed for this problem. Furthermore. otherwise its properties are unspeciﬁed without further restrictions. i By construction.6. One simple test for neglected nonlinearity is to add nonlinear functions of the regressors to ˆ ˆ the regression. E xi xi f (0)2 A recent monograph on the details of quantile regression is Koenker (2005). and are widely available.5. 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. conventional Newton-type optimization methods are inappropriate.

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 . ⎠ . Under which conditions is β 1 or β 1 superior? It is easy to see that both estimators are consistent for β 1 . m must be selected in advance. In the model x2i is “irrelevant” if β 1 is the parameter of interest and β 2 = 0. and consequently 22 ¡ ¢−1 2 σ . In this case i ¡ ¢−1 2 ˜ σ = Q−1 σ 2 . they will (typically) have diﬀerence asymptotic variances. yielding ˆ ˜ ˆ ˆ (β 1 . 7. β 1 = (X1 X1 )−1 (X1 Y ) . To see why this is the case. 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. Then run the auxiliary regression ˆ 0 ˜ yi = x0 β + zi γ + ei ˜ ˜ i ˆ which is estimated by OLS. 1i 2i 2i 1i 22 . then 22 Q11 > Q11 − Q12 Q−1 Q21 . Typically. However. To implement the test. yielding predicted values yi = x0 β. note that (7. The RESET test appears to work well as a test of functional form against a wide range of smooth alternatives. The comparison between the two estimators is straightforward when the error is conditionally ¢ ¡ homoskedastic E e2 | xi = σ 2 .8 Irrelevant Variables yi = x0 β 1 + x0 β 2 + ei 1i 2i E (xi ei ) = 0.be an (m − 1)-vector of powers of yi . β 2 ). Now let ˆ i ⎛ 2 ⎞ yi ˆ ⎜ . small values such as m = 2. 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. Wn →d χ2 . ⎟ zi = ⎝ . or 4 seem to work best. It is easy (although somewhat tedious) to show that under the null hypothesis.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. lim nV ar( β 1 ) = Ex1i x0 1i 11 n→∞ say. and form the Wald statistic Wn for γ = 0. 3. and n→∞ say. yi ˆm (7.14) by OLS. and the two estimators have equal asymptotic eﬃciency. 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. Otherwise. Another is to regress yi on x1i and x2i jointly.

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

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

β 2 6= 0. and then selects the model with the lowest AIC (7.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. the models are M1 : β 1 6= 0. a full-blown implementation of the BIC selection criterion would seem computationally prohibitive. β 3 = · · · = β K = 0 . We have discussed model selection between two models. . There are two leading cases: ordered regressors and unordered. For example.. . . β 2 = β 3 = · · · = β K = 0 M2 : β 1 6= 0. 576. In the latter case. . Similarly for ˆ the BIC. log(n) µ LRn > k2 | M2 log(n) ¶ ´ ³ c P M = M2 | M2 = P → 1. MK : β 1 6= 0. The general problem is the model yi = β 1 x1i + β 2 x1i + · · · + β K xKi + εi . The methods extend readily to the issue of selection among multiple regressors. one can show that thus LRn →p ∞. β K 6= 0. The AIC selection criteria estimates the K models by OLS. . and 220 = 1. which are nested. selecting based on (7.. However. there are 2K such models. a model consists of any possible subset of the regressors {x1i . which regressors enter the regression). and the AIC or BIC in principle can be implemented by estimating all possible subset models. . . 048. 210 = 1024.17). stores the residual variance σ 2 for each model. E (εi | xi ) = 0 and the question is which subset of the coeﬃcients are non-zero (equivalently.15). β 2 6= 0.. 88 . In the unordered case. In the ordered case. xKi }. which can be a very large number. Also under M2 .

2. 4.7. where M1 = I − X X 0 Ω−1 X ˆ ¡ 0 −1 ¢−1 0 −1 0 (c) Prove that M1 Ω−1 M1 = Ω−1 − Ω−1 X X Ω X XΩ . based on a sample of size n. and the out-of-sample value of the regressors. else equals zero). the residuals e. For any predictor g(xi ) for y. . Consider the Weighted Least Squares (WLS) estimator of β ¢−1 ¡ 0 ¢ ¡ ˜ X WY β = X 0W X where W = diag(w1 . Verify equation (7. x. (b) Find an estimate of the variance of this forecast. X). Show that the function g(x) which minimizes the MAE is the conditional median M (x). xi ) be a random sample with E(Y | X) = Xβ. V ar(e | X) = σ 2 Ω with Ω known. i ˆ ˆ suppose β is the OLS estimate of β with covariance matrix V . Deﬁne g(u) = τ − 1 (u < 0) where 1 (·) is the indicator function (takes the value 1 if the argument is true. ˆ (a) Find a point forecast of y.12). Let θ satisfy Eg(Yi − θ) = 0. Let σ 2 be the estimate of σ 2 .. and an estimate of σ 2 is ˆ s2 = 1 e0 Ω−1 e. where xji is one of the xi . 5. V . Let (yi .. E(e | X) = 0.. Thus the available information is the sample (Y. Is θ a quantile of the distribution of Yi ? 3. You wish to forecast an out-of-sample value of y given that ˆ ˆ ˆ ˆ X = x. the GLS estimator is ¡ ¢−1 ¡ 0 −1 ¢ ˜ β = X 0 Ω−1 X XΩ Y . wn ) and wi = x−2 . σ 2 ). the estimates (β.10 Exercises 1. ji ˜ (a) In which contexts would β be a good estimator? ˜ (b) Using your intuition. . (b) Prove that e = M1 e. 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 . ˜ the residual vector is e = Y − X β. the mean absolute error (MAE) is E |yi − g(xi )| . ˆ ˆ n−k 6. In a linear model Y = Xβ + e. In the homoskedastic regression model Y = Xβ + e with E(ei | xi ) = 0 and E(e2 | xi ) = σ 2 .

Record the sum of squared errors.ˆ ˆ 7. I recommend the concentration method: Pick 10 (or more or you like) values of a7 in this range. (ii) AIC criterion. The model is yi = xi β + ei E (ei | xi ) = 0 where xi ∈ R. Assess the merits of this new speciﬁcation using (i) a hypothesis test. In addition. (c) Estimate the model by non-linear least squares. The model is non-linear because of the parameter a7 . Do so. Consider the two estimators ˆ β = ˜ β = Pn i=1 x y Pn i 2 i i=1 xi n 1 X yi . the variable ln Qi has a regression slope of a2 . add the variable (ln Qi )2 to the regression. θ is the NLLS estimator. a7 ).18) (a) Following Nerlove.. and ﬁnd the value of a7 for which the sum of squared errors is minimized. impose the restriction a3 + a4 + a5 = 1. Examine the data and pick an appropriate range for a7 . where zi = ln Qi (1 + exp (− (ln Qi − a7 )))−1 . For values of ln Qi much below a7 . at least 10 to 15) of ln Qi are both below and above a7 . You are interested in the conditional mean function E (yi | xi = x) = θ g(x) at some x. the regression slope is a2 + a6 .. 90 . (d) Calculate standard errors for all the parameters (a1 . Do you agree with this modiﬁcation? (b) Now try a non-linear speciﬁcation. you estimated a cost function on a cross-section of electric companies. For each value of a7 . 8.18) plus the extra term a6 zi . (7. n xi i=1 (a) Under the stated assumptions. θ) + ei with E (ei | xi ) = 0. are both estimators consistent for β? (b) Are there conditions under which either estimator is eﬃcient? 9. In Chapter 6. Suppose that yi ³ ´ i . (iii) BIC criterion.. and V is the = g(x estimate of V ar ˆ . The model works best when a7 is selected so that several values (in this example. Consider model (7. . calculate zi and estimate the model by OLS. This model is called a smooth threshold model. and the model imposes a smooth transition between these regimes. Find an asymptotic 95% conﬁdence interval for g(x). Exercise 13. For values much above a7 . 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 .

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

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

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

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

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

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

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

qn¯ ¯ ∗ ∗ ¯ ¯ ∗ θ θ θ statistics |Tn | = ¯ˆ − ˆ¯ /s(ˆ ). θ θ)q θ θ)q ˆ − s(ˆ n (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). where c would be selected so that θ θ) P (|Tn (θ0 )| > c) = α. Equivalently. discussed above. 8.7 Symmetric Percentile-t Intervals Suppose we want to test H0 : θ = θ0 against H1 : θ 6= θ0 at size α. qn (α) is the 1 − α quantile of the distribution of |Tn (θ0 )| . the 1 − α quantile of the distribution of |Tn | . ∗ ∗ The bootstrap estimate is qn (α). Note that P (|Tn (θ0 )| < c) = P (−c < Tn (θ0 ) < c) = Gn (c) − Gn (−c) ≡ Gn (c). n n ∗ (α) is estimated from a bootstrap simulation by sorting the bootstrap tComputationally. Let θ θ)q ∗ θ θ)q ∗ C4 = [ˆ − s(ˆ n (α). or the number which solves the equation ∗ ∗ ∗ Gn (qn (α)) = G∗ (qn (α)) − G∗ (−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. Computationally. This is often called a percentile-t conﬁdence interval. θ θ)qn This motivates a bootstrap analog θ θ)q ∗ C3 = [ˆ − s(ˆ n (1 − α/2). and taking the upper α% quantile. We would set Tn (θ) = ³ ´ ˆ − θ /s(ˆ and reject H0 in favor of H1 if |Tn (θ0 )| > c. ∗ 98 . each α/2. which is a symmetric distribution function. The bootstrap test rejects if ∗ |Tn (θ0 )| > qn (α).´ ³ θ θ). ˆ + s(ˆ n (α)]. The ideal critical value c = qn (α) solves the equation Gn (qn (α)) = 1 − α. θ θ)q ˆ − s(ˆ ∗ (α/2)]. this is based on the critical values from the one-sided hypothesis tests. 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) .

θ θ θ ˆ θ ∗ ∗ Computationally. Let an be a sequence.4) v ¡ ¢ While (8. The following notation will be helpful.] 8. Let Tn be a statistic such that (8. an = O(n−r ) if it declines to zero like n−r . v 2 ). n ´ ³ ∗ ³ ∗ θ θ Note in the simulation that the Wald statistic is a quadratic form in ˆ − ˆ . writing Tn ∼ Gn (x. The bootstrap test ∗ ∗ rejects if Wn ≥ qn (α). and vice-versa. the critical value qn (α) is found as the quantile from simulated values of W´ . F ) = Φ n→∞ v or ³x´ Gn (x. Deﬁnition 8. Thus here Tn (θ) = Wn (θ). and a function h(x) is odd if h(−x) = −h(x). Deﬁnition 8. It is designed to work well since ³ ´ P (θ0 ∈ C4 ) = P ˆ − s(ˆ n (α) ≤ θ0 ≤ ˆ + s(ˆ n (α) θ θ)q ∗ θ θ)q ∗ ∗ = P (|Tn (θ0 )| < qn (α)) ' P (|Tn (θ0 )| < qn (α)) = 1 − α.8. not ˆ − θ0 . F ) then ³x´ .2 an = O(1) if |an | is uniformly bounded. lim Gn (x.∗ where qn (α) is the bootstrap critical value for a two-sided hypothesis test. however. where qn (α) is the (1 − α)% quantile of the distribution of Wn . The ideal test rejects if Wn ≥ qn (α). 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. The derivative of an even function is odd. A better asymptotic approximation may be obtained through an asymptotic expansion. F ) = Φ + o (1) . C4 is called the symmetric percentile-t interval.3) ´ √ ³ˆ If Tn = n θ − θ0 then v = V while if Tn is a t-ratio then v = 1. θ [This is a typical mistake made by practitioners. it says nothing. If θ is a vector. Equivalently.8. about the rate v of convergence.8 Asymptotic Expansions Tn →d N (0. or the size of the divergence for any particular sample size n.1 an = o(1) if an → 0 as n → ∞ Deﬁnition 8. where qn (α) is the (1 − α)% quantile of the distribution of ³ ∗ ³ ∗ ´0 ´ ∗ Wn = n ˆ − ˆ Vθ∗−1 ˆ − ˆ . Basically. (8.3 an = o(n−r ) if nr |an | → 0 as n → ∞.4) says that Gn converges to Φ x as n → ∞. We say that a function g(x) is even if g(−x) = g(x).8. 99 . then to test H0 : θ = θ0 against H1 : θ 6= θ0 at size α.

F ) + g2 (x. adding leptokurtosis). F ) ≈ Φ + n−1/2 g1 (x.8.8.1 as follows. Gn (x. The diﬀerence is Φ(x) − Gn (x. An asymptotic test is based on Φ(x). To a second order of approximation. F ) + n−1 g2 (x.3). √ Since Fn converges to F at rate n. F0 ) ≈ ∂ g1 (x. To the second order. F ) converges to the normal limit at rate n1/2 . Fn ) = Φ(x) + n 1 g (x. the diﬀerence between the bootstrap distribution and the true distribution is G∗ (x) − Gn (x. F ) ≈ Φ + n−1/2 g1 (x. we can assess the accuracy of one-sided hypothesis tests and conﬁdence regions based on an asymptotically normal t-ratio Tn . Fn ) − g1 (x. F0 ) + O(n−1 ) 1/2 1 n 1 g (x. and g1 is continuous with respect to F. We can interpret Theorem 8. Fn ) − g1 (x.1 has the expansion n G∗ (x) = Gn (x.8. F0 ) = Φ(x) + since v = 1. ³x´ 1 1 + 1/2 g1 (x. the diﬀerence √ (g1 (x. g1 and g2 are diﬀerentiable functions of x and continuous in F relative to the supremum norm on the space of distribution functions. Heuristically. the exact distribution is P (Tn < x) = Gn (x. g1 (x. F0 ) = n 1 n1/2 (g1 (x. A bootstrap test is based on G∗ (x). F0 ) = 1 g (x. ³x´ Gn (x. F0 )) converges to 0 at rate n. F ) = Φ v n n 8.1. the density function is skewed. 100 . and g2 is an odd function of x.1 Under regularity conditions and (8. To a third order of approximation. where g1 is an even function of x. F0 ) + O(n−1 ) 1/2 1 n = O(n−1/2 ). F ) v which adds a symmetric non-normal component to the approximate density (for example. Fn ) − g1 (x. Fn ) + O(n−1 ). v Since the derivative of g1 is odd. Theorem 8. so the order of the error is O(n−1/2 ).uniformly over x. F ) + O(n−3/2 ) Gn (x. which from Theorem 8. 1/2 1 n Because Φ(x) appears in both expansions.9 One-Sided Tests Using the expansion of Theorem 8. Moreover. First. F0 )) + O(n−1 ).8. F0 ) (Fn − F0 ) ∂F = O(n−1/2 ). F ). ³x´ Gn (x.

F0 ) distribution. 101 2 g2 (x. From Theorem 8. as F is a function. F0 ) + O(n−3/2 ) = O(n−1 ). Since Tn →d Z. Similarly. F0 ) = O(n−1 ). F ) − Gn (−x. F ) = Gn (x. 8. if Z ∼ N (0. n or ∗ P (Tn ≤ x) = P (Tn ≤ x) + O(n−1 ). 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). then |Tn | →d |Z| ∼ Φ. F0 ) = The order of the error is O(n−1 ). = P (X ≤ x) − P (X ≤ −x) For example. if Tn has exact distribution Gn (x. F ). 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. We conclude that G∗ (x) − Gn (x. F ) n n µ ¶ 1 1 − Φ(−x) + 1/2 g1 (−x. we can calculate that Gn (x. Hence the diﬀerence between the asymptotic distribution and the exact distribution is Φ(x) − Gn (x. 1). which is an improved rate of convergence over the asymptotic test (which converged at rate O(n−1/2 )). Thus asymptotic critical values are taken from the Φ distribution. F ) − Gn (−x.1. F ) ¶ µ 1 1 = Φ(x) + 1/2 g1 (x. F ) = Gn (x. F ) + g2 (−x.5) where the simpliﬁcations are because g1 is even and g2 is odd. F ) + O(n−3/2 ). F ) is only heuristic. then |Tn | has the distribution function Gn (x. F ). n (8. A two-sided hypothesis test rejects H0 for large values of |Tn | . and exact critical values are taken from the Gn (x. n . then |Z| has distribution function Φ(x) = Φ(x) − Φ(−x) = 2Φ(x) − 1.8.The “derivative” ∂ ∂F g1 (x. F ) + O(n−3/2 ) n n 2 = Φ(x) + g2 (x. F ) + g2 (x.10 Symmetric Two-Sided Tests If a random variable X has distribution function H(x) = P (X ≤ x).

F0 ) = ∗ 2 (g2 (x. but one-sided tests might have more power against alternatives of interest. whose error is O(n−1 ). is an even function. Therefore. meaning that the errors in the two directions exactly cancel out.8.1 shows that a ﬁrst-order approximation ³x´ + O(n−1/2 ). F0 )) + O(n−3/2 ) n = O(n−3/2 ). n Thus the diﬀerence between the bootstrap and exact distributions is Gn (x) − Gn (x. which is not pivotal. Two-sided tests have better rates of convergence than the one-sided tests. as it depends on the unknown V. The analysis shows that there may be a trade-oﬀ between one-sided and two-sided tests. F ) = Φ v √ where v = V . Applying (8. We know that θ Tn →d N (0. 8. Fn ) = Φ(x) + ∗ 2 g2 (x. Gn (x. Thus a two-sided bootstrap test also achieves an asymptotic reﬁnement. 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. Theorem 8. Fn ) − g2 (x. and bootstrap tests have better rates of convergence than asymptotic tests. similar to a one-sided test. and for the bootstrap ³x´ + O(n−1/2 ). Fn ) = Φ n v ˆ ˆ where V = V (Fn ) is the bootstrap estimate of V. g1 . Twosided tests will have more accurate size (Reported Type I error). Fn ) + O(n−3/2 ). we ﬁnd Gn (x) = Gn (x. This is because the ﬁrst term in the asymptotic expansion. and g2 is continuous in F. 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 . A reader might get confused between the two simultaneous eﬀects. the choice between symmetric and equal-tailed conﬁdence intervals is unclear. The diﬀerence is ³x´ ³x´ −Φ + O(n−1/2 ) G∗ (x) − Gn (x. the asymptotic two-sided test has a better coverage rate than the asymptotic one-sided test. √ the last equality because Fn converges to F0 at rate n. 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 ). V ).5) to the bootstrap distribution. set Tn = n ˆ − θ0 .11 Percentile Conﬁdence Intervals ´ √ ³ To evaluate the coverage rate of the percentile interval.Interestingly. G∗ (x) = Gn (x. This is in contrast to the use of the asymptotic distribution. and needs to be determined on a case-by-case basis.

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

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

75 and 1.dat contains data on house prices (sales). Let qn (. ˆ − s(ˆ n (.95) denote the 95% quantile of Tn . θ θ) ∗ 1000 samples are generated from the bootstrap distribution. calculate the estimates ˆ on these samples and θ then calculate ∗ ∗ ∗ θ θ Tn = ˆ /s(ˆ ). θ θ)q ∗ θ θ)q ∗ θ/s(θ) 5.2 and s(ˆ = .Show that C exactly equals the Alternative percentile interval (not the percentile-t interval). 105 . You replace c with qn (. and thus reject H0 if ˆ ˆ > q ∗ (. you generate bootstrap samples. You do this as follows.05) . (c) With the given information.95) denote the 5% θ) ∗ and 95% quantiles of Tn . can you report the 95% Percentile-t interval for θ? 7.95). with variables listed in the ﬁle hprice1.2.3. (b) Report the 95% Alternative Percentile interval for θ. lot size.5% and 97. The ˆ are sorted. and the colonial dummy. and ˆ is calculated on each θ ∗ ∗ θ sample. ˆ = 1. size of house. The dataﬁle hprice1. Using the non-parametric ∗ bootstrap. Calculate 95% conﬁdence intervals for the regression coeﬃcients using both the asymptotic normal approximation and the percentile-t bootstrap. You want to test H0 : θ = 0 against H1 : θ > 0. θ respectively. Using the non-parametric bootstrap.05) and qn (. and deﬁne the bootstrap conﬁdence interval h i C = ˆ − s(ˆ n (. The test for H0 is to reject if Tn = ˆ ˆ > c where c is picked so that Type I error is α.95). ∗ ∗ ∗ Let qn (. Estimate a linear regression of price on the number of bedrooms. What is wrong with this procedure? Tn = θ/s(θ) n 6. ∗ ∗ where s(ˆ is the standard error in the original data. (a) Report the 95% Efron Percentile interval for θ.95).pdf. and the 2.5% quantiles of the ˆ are . Suppose that in an application.

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

β GMM does not change. but this is generally not possible when > k. ˆ Deﬁnition 9. β GMM = Z 0 XWn X 0 Z 9.2.1 ˆ 2Z 0 XWn X 0 Z β = 2Z 0 XWn X 0 Y While the estimator depends on Wn .3 Distribution of GMM Estimator ¡ 0¢ Q = E xi zi Assume that Wn →p W > 0.2 GMM Estimator n n ¢ 1¡ 0 ¢ 1X 1X ¡ 0 X Y − X 0 Zβ . β ˆ Note that if k = . and the GMM estimator is the MME. then g n (β) = 0. gi (β) = xi yi − zi β = n n n i=1 i=1 Deﬁne the sample analog of (9. the square of the Euclidean length.3) The method of moments estimator for β is deﬁned as the parameter value which sets g n (β) = 0. For example.9. Let and where gi = xi ei . then. let Jn (β) = n · g n (β)0 Wn g n (β). for if Wn is replaced ˆ by cWn for some c > 0. the dependence is only up to scale. The idea of the generalized method of moments (GMM) is to deﬁne an estimator which sets g n (β) “close” to zero. i i . Jn (β) = n · g n (β)0 g n (β) = n · |g n (β)|2 . Proposition 9.2) g n (β) = (9. Then µ ¶ ¶ µ 1 0 1 0 Z X Wn X Z →p Q0 W Q n n 107 ¡ ¢ ¡ 0¢ Ω = E xi x0 e2 = E gi gi . For some × weight matrix Wn > 0. if Wn = I. This is a non-negative measure of the “length” of the vector g n (β). The GMM estimator minimizes Jn (β).2.1 β GMM = argmin Jn (β). 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. ¡ ¢−1 0 ˆ Z XWn X 0 Y.

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.1 ´ √ ³ˆ n β − β →d N (0. where In general. ˆ we still call β the eﬃcient GMM estimator. but it can be estimated consistently. β). this is a semi-parametric problem. GMM estimators are asymptotically normal with “sandwich form” asymptotic variances. ˆ n i=1 gi = gi − g n .3. 9. W0 = Ω−1 is not known in practice. This turns out to be W0 = Ω−1 . This is a weak concept of optimality. as the distribution of the data is unknown. no semiparametric estimator (one which is consistent globally for the class of models considered) ¢−1 ¡ . For any Wn →p W0 . ˆ We have described the estimator β as “eﬃcient GMM” if the optimal (variance minimizing) weight matrix is selected. Q W ΩW Q Q0 W Q V = Q0 W Q Thus we have Theorem 9. we can set Wn = I . as we are only considering alternative weight matrices Wn . no estimator has greater asymptotic eﬃciency than the eﬃcient linear GMM estimator. 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. Ω) . ˆ∗ ˆ 108 . without imposing additional assumptions.and µ µ ¶ ¶ 1 0 1 0 Z X Wn X e →d Q0 W N (0.3. n β − β →d N 0. and this is all that is known. This results shows that in the linear model. as shown by Gary Chamberlain (1987). No estimator can do better (in this ﬁrst-order asymptotic sense). the GMM estimator β is consistent yet ineﬃcient. For example. The proof is left as an exercise. In the linear model. V ) . Chamberlain showed that in this context. If it is known that E (gi (β)) = 0.4 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. ˆ Construct n 1X ˆ g n = g n (β) = gi . β = Z 0 XΩ−1 X 0 Z ´ ³ ¡ ¢−1 ´ √ ³ˆ . However. it is semiparametrically eﬃcient. it turns out that the GMM estimator is semiparametrically eﬃcient. Given any such ﬁrst0ˆ ˆ ˆ ˆ step estimator. as it has the same asymptotic distribution. a better choice is Wn = (X 0 X)−1 . The optimal weight matrix W0 is one which minimizes V. Q0 Ω−1 Q ¢−1 ¡ 0 ¢¡ ¢−1 ¡ . This yields the eﬃcient GMM estimator: ¢−1 0 ¡ ˆ Z XΩ−1 X 0 Y.

but can be numerically tricky to obtain in some cases. The criterion function is then Ã n !−1 1X ∗ 0 ∗ 0 gi (β)gi (β) g n (β). Since Egi = 0. i. so the uncentered estimator will contain an undesirable bias term and the power of the test will be adversely aﬀected. Alastair Hall (2000) has shown that the uncentered estimator is a poor choice. ˆ and let g be the associated n × matrix. Hansen. GMM applies whenever an economic or statistical model implies the × 1 moment condition E (gi (β)) = 0. The estimator appears to have some better properties than traditional GMM. Instead. as in (9.5 GMM: The General Case In its most general form.and deﬁne Wn = Ã Then Wn →p Ω−1 = W0 . 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 . 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. Then set gi = xi ei . 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 . This is a current area of research in econometrics. Set ³ ¡ ¢−1 0 ´−1 ˆ ˆˆ XZ . set Wn = (X 0 X)−1 . ∗ gi (β) = gi (β) − g n (β) 9.4) above. First. 109 . and construct the residual ei = yi − zi β.4) which uses the uncentered moment conditions.e. There is little point in using an ineﬃcient GMM estimator as it is easy to compute. and GMM using Wn as the weight matrix is asymptotically eﬃcient. ˆ An estimator of the asymptotic variance of β can be seen from the above formula. 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. 0ˆ ˆ ˆ ˆ estimate β using this weight matrix. (9. Egi 6= 0. we actually mean “eﬃcient GMM”. A simple solution is to use the centered moment conditions to construct the weight matrix. Heaton and Yaron (1996). and was introduced by L. these two estimators are asymptotically equivalent under the hypothesis of correct speciﬁcation. we can let the weight matrix be considered as a function of β. There is an important alternative to the two-step GMM estimator just described. J(β) = n · g n (β) n i=1 In most cases. under the alternative hypothesis the moment conditions are violated. when we say “GMM”. However. Here is a simple way to compute the eﬃcient GMM estimator. When constructing hypothesis tests.

Note that g n →p Egi . However. i i i i ∂β 1X 0 gi gi − g n g 0 ˆˆ n n i=1 n !−1 . ˆˆ n is a quadratic form in g n . Theorem 9. This estimator can be iterated if needed. For example. where ³ ´−1 ∂ 0 ˆ ˆ ˆ ˆ Ω = (E (gi gi ))−1 and G = E ∂β 0 gi (β). this is all that is known. and then β recomputed. and if the weight matrix is asymptotically eﬃcient. The general theory of GMM estimation and testing was exposited by L. perhaps obtained by ﬁrst ˆ setting Wn = I.1 (Sargan-Hansen). 1 it is possible that β 2 6= 0.6 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 .6. G0 Ω−1 G .Often. ˆ J = J(β) →d χ2−k . In this sense an 1i 1i exclusion restriction can be seen as an overidentifying restriction. often the weight ˆ matrix Wn is updated. and thus g n can be used to assess whether or not the hypothesis that Egi = 0 is true or not. Under the hypothesis of correct speciﬁcation.1 Under general regularity conditions. ´ ³ ¡ ¢−1 ´ √ ³ˆ Theorem 9. 9. Hansen (1982). Since the GMM estimator depends upon the ﬁrst-stage estimator. 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. Identiﬁcation requires l ≥ k = dim(β). 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. 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 .5. take the linear model yi = β 0 x1i + β 0 x2i + ei with E (x1i ei ) = 0 and E (x2i ei ) = 0. 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). β) = 0 holds. 1 2 It is possible that β 2 = 0. n β − β →d N 0. so that the linear equation may be written as yi = β 0 x1i + ei . 110 . Thus the model — the overidentifying restrictions — are testable. and is thus a natural test statistic for H0 : Egi = 0.

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

For example. in linear regression.. Setting gi (β) to be this choice (which is k × 1. How is k to be determined? This is an area of theory still under development. It turns out that this conditional moment restriction is much more powerful. except that in this case zi = xi . 0 In the linear model ei (β) = yi − zi β.. β)ei (β) which satisﬁes Egi (β) = 0 and hence deﬁnes a GMM estimator. The form was uncovered by Chamberlain (1987). Which should be used? i i One solution is to construct an inﬁnite list of potent instruments. Ai is unknown. and restrictive. γ) = ⎩ 0 β)2 − f (x )0 γ (yi − xi i Here s = 2. β). then xi . If xi is a valid instrument satisfying E (ei | xi ) = 0. That is for any × 1 function φ(xi . In practice. Take the case s = 1. Which should be selected? This is equivalent to the problem of selection of the best instruments.. we can set gi (β) = φ(xi . the model implies more than an unconditional moment restriction of the form Egi (β) = 0. i Ai = −σ −2 Ri i . Another approach is to construct the optimal instrument. etc. ei (β. The obvious problem is that the class of functions φ is inﬁnite. an unconditional moment restriction can always be constructed. β). x3 . A recent study of this problem is Donald and Newey (2001). . It is also helpful to realize that conventional regression models also fall into this class.9. while in a nonlinear i regression model ei (β) = yi − g(xi . so is just-identiﬁed) yields the best GMM estimator possible. than the unconditional moment restriction discussed above. 0 Our linear model yi = zi β + ei with instruments xi falls into this class under the stronger 0 assumption E (ei | xi ) = 0.8 Conditional Moment Restrictions In many contexts. Given a conditional moment restriction. Then ei (β) = yi − zi β. x2 . In a joint model of the conditional mean and variance ⎧ yi − x0 β ⎨ i .. ei (β) = yi − x0 β. It implies a conditional moment restriction of the form E (ei (β) | xi ) = 0 where ei (β) is some s × 1 function of the observation and the parameters. s = 1. note that Ri = −E (zi | xi ) 112 ¡ ¢ σ 2 = E ei (β)2 | xi . and then use the ﬁrst k instruments. In many cases. but its form does help us think about construction of optimal instruments. are all valid instruments. Let ¶ µ ∂ ei (β) | xi Ri = E ∂β and Then the “optimal instrument” is so the optimal moment is gi (β) = Ai ei (β).

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

From matrix algebra. Take the model yi = zi β + ei with E (xi ei ) = 0. σ 2 Q0 M −1 Q ) 0 where Q = E(xi zi ) and M = E(xi x0 ). γ). Letting H = CQ and G = C 0−1 W Q. and therefore positive semideﬁnite. 2. Write out the matrix A. 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 . then (X ´ ¢−1 ¡ √ ³ ˆ n β − β →d N (0.9. Hint: The matrix I −G (G0 G)−1 G0 is symmetric and idempotent. Wn = n i=1 ¡ ¢ −1 where Ω = E x x0 e2 . i 0 0ˆ ˆ 3.g. we know that V − V0 is positive semi-deﬁnite if and only if V0−1 − V −1 = A is positive semi-deﬁnite. Take the single equation Y E(e = Zβ + e | X) = 0 ˆ Assume E(e2 | xi ) = σ 2 . Take the model E (zi ηi ) = 0. A = H 0 I − G G0 G (d) Show that A is positive semideﬁnite. Show that V0 = Q0 Ω−1 Q . a GMM estimator with arbitrary weight matrix). (c) Since Ω is positive deﬁnite. Show that if β is estimated by GMM with weight matrix Wn = i 0 X)−1 .10 Exercises yi = x0 β + ei i E (xi ei ) = 0 0 e2 = zi γ + η i i 1. γ ) for (β. ˆ ˆ Find the method of moments estimators (β. there exists a nonsingular matrix C such that C 0 C = Ω−1 . Let ei = yi − zi β where β is consistent for ˆ β (e. Deﬁne the estimate of the optimal GMM weight matrix Ã n !−1 1X 0 2 xi xi ei ˆ . (b) We want to show that for any W. Show that Wn →p Ω i i i 4. verify that A can be written as ³ ¡ ¢−1 0 ´ G H. In the linear model estimated by GMM with general weight matrix 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). 114 .

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. β) + ei E (zi ei ) = 0. Deﬁne the Lagrangian L(β. 115 . zi ). The equation of interest is yi = g(xi .5. Vn = X X i=1 ˜ and hence R0 β = r. In the linear model Y = Xβ + e with E(xi ei ) = 0. Thus ˜ β = argmin Jn (β) R0 β−r Ã n ! ¡ 0 ¢−1 ¡ 0 ¢−1 X 0 2 ˆ XX xi xi ei ˆ . The GMM estimator of β. h(β)=0 The GMM test statistic (the distance statistic) of the hypothesis h(β) = 0 is ˜ D = Jn (β) = min Jn (β). 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 . xi . λ = R0 Vn R (c) Show that if R0 β = r then ´ √ ³˜ n β − β →d N (0.6) (a) Show that you can rewrite Jn (β) in (9. subject ˆ i ˆi i=1 to the restriction h(β) = 0. l ≥ k. VR ) where ¡ ¢−1 0 R V. 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. The observed data is (yi . λ) = 1 Jn (β) + λ0 (R0 β − r) where λ is 2 s × 1. 6. Show how to construct an eﬃcient GMM estimator for β. is deﬁned as Jn (β) = ˜ β = argmin Jn (β). VR = V − V R R0 V R (d) Show that in this setting. h(β)=0 (9. the distance statistic D in (9. zi is l × 1 and β is k × 1.5) n 1 P ˆ where ei are the OLS residuals and Ωn = n n xi x0 e2 .6) equals the Wald statistic.

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. 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. 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. Let ˆ ˆ ˆ Jn = ng n (β)0 Ω−1 g n (β) denote the test of overidentifying restrictions. 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.

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

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

i i Theorem 10. λ) = − (10. λ) = − (10. (β.13) Premultiplying by G0 Ω−1 and using (10. Gi (.8) and ¢ 0 0 For example. 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 (10.10. g n = n n gi (β 0 ) and Ωn = n n g (β 0 ) gi (β 0 )0 . 0 = Rn (β.10). ´ √ ³ ˆ n β − β 0 →d √ ˆ nλ →d N (0. β) = −xi zi . and Ω = E xi x0 e2 . Vλ ) ´ √ ˆ √ ³ˆ where V and Vλ are deﬁned in (10.12) ∂β ˆ ˆ0 i=1 1 + λ gi β 1 P 1 P 1 P Let Gn = n n Gi (β 0 ) . n (10.1 Under regularity conditions.2. ˆ ˆ Proof.9) (10. in the linear model. i=1 i=1 i=1i Expanding (10. β λ ∂ ³ ´. and n β − β 0 and nλ are asymptotically independent.13) yields n n Expanding (10.11) 0 = ∂λ ˆ0 ˆ i=1 1 + λ gi β ³ ´0 ˆ n X Gi .10) ¡ Ω−1 N (0. λ) jointly solve ³ ´ ˆ n gi β X ∂ ³ ³ ´´ Rn (β.2 Deﬁne Asymptotic Distribution of EL Estimator Gi (β) = ∂ gi (β) ∂β 0 (10. Thus the EL estimator is asymptotically eﬃcient.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 .12) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ 0 ' G0 λ − λ0 .11) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ ˆ 0 ' −g n − Gn β − β 0 + Ωn λ (10. ˆ The asymptotic variance V for β is the same as for eﬃcient GMM. G = −E (xi zi ).9) and (10.

n ³ ´´ ´ √ ³ 1 X ³ ˆ ˆ √ g wi . Since the EL estimator achieves this bound. and have the same interpretation.15) (10. ¥ Chamberlain (1987) showed that V is the semiparametric eﬃciency bound for β in the overidentiﬁed moment condition model. Vλ ) Furthermore. it is an asymptotically eﬃcient estimator for β. Twice the diﬀerence between the unrestricted empirical likelihood −n log (n) and the maximized empirical likelihood for the model (10. First.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 (0.3 Overidentifying Restrictions In a parametric likelihood context.17) 2 ln 1 + λ gi β .3.16). 120 .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. 10. This means that no consistent estimator for this class of models can have a lower asymptotic variance than V . The same statistic can be constructed for empirical likelihood. LRn = i=1 Theorem 10. and it is advisable to report the statistic LRn whenever EL is the estimation method. by a Taylor expansion.15). tests are based on the diﬀerence in the log likelihood functions.7) is n ³ ´´ ³ X ˆ ˆ0 (10.14) for λ and using (10. Ω) →d Ω−1 I − G G Ω G GΩ = Ω−1 N (0. 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.1 If Eg(wi . V ) ˆ Solving (10. β 0 ) = 0 then LRn →d χ2−k . Proof. and (10. (10. Ω) GΩ G →d = N (0. since ³ ¡ ¢−1 0 ´ G0 I − Ω−1 G G0 Ω−1 G G =0 (10. The EL overidentiﬁcation test is similar to the GMM overidentiﬁcation test.16) ´ √ ˆ √ ³ˆ n β − β 0 and nλ are asymptotically uncorrelated and hence independent. They are asymptotically ﬁrst-order equivalent. The overidentiﬁcation test is a very useful by-product of EL estimation.

prc 121 . since ln(1 + x) ' x − x2 /2 for x small.18) Let the maintained model be where g is × 1 and β is k × 1.wisc. Theorem 10.18) and H0 : h(β) = 0. 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. so there is no fundamental change in the distribution theory for β relative to β. a The proof of this result is more challenging and is omitted. 10. The restricted EL estimator and likelihood are the values which solve ˜ β = argmax Ln (β) h(β)=0 ˜ ˜ Ln = Ln (β) = max Ln (β).ssc.18).17) is not appropriate. The hypothesis of interest is h(β) = 0.Second. Vλ ) ¥ where the proof of the ﬁnal equality is left as an exercise. LRn →d χ2 . h(β)=0 ˜ Fundamentally.4.edu/~bhansen/progs/elike.5 Numerical Computation Gauss code which implements the methods discussed below can be found at http://www. Vλ )0 Ω−1 N (0. 10. where h : Rk → Ra . To test the hypothesis h(β) while maintaining (10.1 Under (10. the restricted EL estimator β is simply an EL estimator with − k + a overidenti˜ ˆ fying restrictions. Instead we use the diﬀerence in log-likelihoods: ³ ´ ˆ ˜ LRn = 2 Ln − Ln . By “maintained” we mean that the overidentfying restrictions contained in (10. This test statistic is a natural analog of the GMM distance statistic.18) are assumed to hold and are not being challenged (at least for the test discussed in this section). the simple overidentifying restrictions test (10.4 Testing Egi (β) = 0 (10.

λ) ∂λ i=1 n ∂ Rn (β. Eﬃcient convergence requires a good choice of steplength δ. Deﬁne ∗ gi (β. i Rββ = Inner Loop The so-called “inner loop” solves (10. λj ))−1 Rλ (β. λ) = G∗ (β. λp ) A quadratic function can be ﬁt exactly through these three points. λ) = i i ∂β∂β 0 1 + λ0 gi (β) i=1 n where δ > 0 is a scalar steplength (to be discussed next). λj ))−1 Rλ (β. λ) . δ 4R2 + 4R0 − 8R1 yielding the steplength to be plugged into (10.4) 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.19) is continued until the gradient Rλ (β. λ) = i The ﬁrst derivatives of (10. A complication is that λ must be constrained so that 0 ≤ pi ≤ 1 which holds if ¢ ¡ n 1 + λ0 gi (β) ≥ 1 122 (10. One method uses the following quadratic approximation.5) for given β. δ 1 = 1 and δ 2 = 1. For p = 0.. λ) G∗ (β.Derivatives The numerical calculations depend on derivatives of the dual likelihood function (10.19) X ∂2 ∗ ∗ gi (β.19).20) . λ)0 − ∂β∂β Rn (β. The value of δ which minimizes this quadratic is ˆ = R2 + 3R0 − 4R1 . λ) = − gi (β. λ) yielding the iteration rule λj+1 = λj − δ (Rλλ (β. The starting value λ1 can be set to the zero vector. λ)0 − Rn (β. λj )) Rp = Rn (β. λj ) is smaller than some prespeciﬁed tolerance. λj ) .4). (10. set 2 λp = λj − δ p (Rλλ (β. The modiﬁed Newton method takes a quadratic approximation to Rn (β. The iteration (10. λ) = ∂λ∂λ i=1 ¶ n 2 Xµ ∂ Gi (β) ∗ gi (β. λ) = − ∂β n X i=1 G∗ (β. λ)0 0 Rn (β. Set δ 0 = 0. λ) = i ∂λ∂β 0 1 + λ0 gi (β) i=1 ⎞ ⎛ ¡ 0 ¢ ∂2 n 2 X 0 gi (β) λ ∂ ⎠ ⎝G∗ (β. λ) G∗ (β. 1. λ) gi (β. 2.

The gradient for (10. the stepsize δ needs to be decreased. If not. the eigenvalues of Lββ should be adjusted so that all are positive.6) is Lβ = ∂ ∂ Ln (β) = Rn (β. 123 .for all i.6). λ(β)) + Rλβ λβ + λ0 Rλβ + λ0 Rλλ λβ β β −1 0 = Rλβ Rλλ Rλβ − Rββ . λ(β)) β ∂β ¡ ¢ 0 = − Rββ (β. Outer Loop The outer loop is the minimization (10.20) fails. This can be done by the modiﬁed Newton method described in the previous section. λ(β)) = 0. λ(β)) + λ0 Rλ (β. λ) = 0 at λ = λ(β). The Newton iteration rule is β j+1 = β j − δL−1 Lβ ββ where δ is a scalar stepsize. It is not guaranteed that Lββ > 0. ∂β 0 the second equality following from the implicit function theorem applied to Rλ (β.6) is Lββ = − ∂ Ln (β) ∂β∂β 0 ¤ ∂ £ = − 0 Rβ (β. λ) = Rβ + λ0 Rλ = Rβ β ∂β ∂β since Rλ (β. The Hessian for (10. If (10. where λβ = ∂ −1 λ(β) = −Rλλ Rλβ . and the rule is iterated until convergence.

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

some regressors in zi will be uncorrelated with ei (for example. and x2i are the excluded exogenous variables. ¶ µ ∙ β2 β1 1 −1 β 2 e1i + β 1 e2i (e1i − e2i ) ¸µ e1i e2i ¶ ˆ Hence if it is estimated by OLS. this can be written as Y = Zβ + e. so should be included in xi . Deﬁnition 11. at least the intercept).1) the structural equation. Thus we make the partition ¶ µ k1 z1i (11. So we have the partition µ ¶ z1i k1 (11.1 The × 1 random vector xi is an instrumental variable for (11. and assume that E(zi ei ) 6= 0 so there is endogeneity. In matrix notation. which does not equal either β 1 or β 2 . By the above deﬁnition.1) if E (xi ei ) = 0.1.1). That is x2i are variables which could be included in the equation for yi (in the sense 125 .2) Any solution to the problem of endogeneity requires additional information which we call instruments. (11.1) where zi is k × 1.4) xi = x2i 2 where z1i = x1i are the included exogenous variables.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 ¶ . This is called simultaneous equations bias. β →p β ∗ . z1i is an instrumental variable for (11. We call (11.3) zi = z2i k2 where E(z1i ei ) = 0 yet E(z2i ei ) 6= 0.1 Instrumental Variables 0 yi = zi β + ei Let the equation of interest be (11. In a typical set-up. We call z1i exogenous and z2i endogenous. 11.

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

11.2

Reduced Form

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

Substituting (11.6) into (11.2), we ﬁnd

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

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

11.3

Identiﬁcation

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

11.4

Estimation

0 yi = zi β + ei

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

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

11.5

Special Cases: IV and 2SLS

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

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

which again is the IV estimator.

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

then

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

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

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

Let q = H 0 ξS −1/2 which satisﬁes Eqq 0 = In and partition q = (q1 q2 ) where q1 is l × 1. Indeed as α → 1. the expression in (11. By the spectral decomposition of an idempotent matrix.12) and this result. n and (11. 130 .14) In general this is non-zero.Let PX = X (X 0 X)−1 X 0 . 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 (11.14) approaches that in (11. ¢ 1 ¡ ¢ 1 ¡ ¢ 1 ¡ 0 E Z PX e = E Γ0 X 0 e + E u0 PX e = αS21 . P = HΛH 0 0 0 where Λ = diag(Il . 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. The parameter β fails to be identiﬁed if Γ22 has deﬁcient rank. l . 0). n n n ¢ ¡ ¡ ¢ ¢ ¢ 1 ¡ 0 1 ¡ E Z PX Z = Γ0 E xi x0 Γ + Γ0 E (xi ui ) + E ui x0 Γ + E u0 PX u i i n n = Γ0 QΓ + αS22 . 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.13). except when S21 = 0 (when Z is exogenous). 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 . It is also close to zero when α = 0.7 Identiﬁcation Failure Recall the reduced form equation Z2 = X1 Γ12 + X2 Γ22 + u2 . the bias in the 2SLS estimator will be large.14) is the probability limit of β 2SLS − β 11. Bekker (1994) pointed out that it also has the reverse implication — that when α = l/n is large.

Suppose this condition fails. viz Γ22 = n−1/2 C. Suppose that identiﬁcation does not complete fail. This is particularly nasty. but (11. E x2 u2 i i n n i=1 i=1 n n (11. Then the model may be written as yi = zi β + ei zi = xi γ + ui and Γ22 = γ = E (xi zi ) /Ex2 . The n−1/2 is picked because it provides just the right balancing to allow a rich distribution theory. In addition. To see the consequences. 131 . Then by the CLT ¡ ¡ ¢¢ 1 X √ xi ei →d N1 ∼ N 0.15) is unaﬀected. This can be handled in an asymptotic analysis by modeling it as local-to-zero. standard test statistics have non-standard asymptotic distribution of β distributions. where C is a full rank matrix. This result carries over to more general settings. Qc + N2 ˆ As in the case of complete identiﬁcation failure. This occurs when Γ22 is full rank. we ﬁnd that β is inconsistent for β and the ˆ is non-normal. and was examined by Phillips (1989) and Choi and Phillips (1992). Here. N2 since the ratio of two normals is Cauchy. the instrument xi is weak for zi if γ = n−1/2 c.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 . but is weak.16) ˆ β−β = 1 √ n 1 √ n Pn Pn i=1 xi ei i=1 xi zi →d N1 ∼ Cauchy.15) therefore ¢¢ ¡ ¡ 1 X 1 X √ xi zi = √ xi ui →d N2 ∼ N 0. but small. so E (zi xi ) = 0. Then (11. which occurs i when E (zi xi ) 6= 0. We see that β is identiﬁed if and only if Γ22 = γ 6= 0. Thus identiﬁcation hinges on the existence of correlation between the excluded exogenous variable and the included endogenous variable. E x2 e2 i i n i=1 n (11. meaning that inferences about parameters of interest can be misleading. as the Cauchy distribution does not have a ﬁnite mean. once again take the simple case k = l = 1.Take the simplest case where k = l = 1 (so there is no X1 ).

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

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

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. Does this diﬀer from 2SLS and/or OLS? 7. of the father) and motheduc (the education. and then calculate the GMM estimator from this weight matrix without further iteration. (d) Re-estimate the model by eﬃcient GMM. There are 2215 observations with 19 variables. (f) Discuss your ﬁndings. I suggest that you use the 2SLS estimates as the ﬁrst-step to get the weight matrix. and South and Black are regional and racial dummy variables.(b) Deﬁne the 2SLS estimator of β.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). listed in card. Report estimates and standard errors. Report the estimates and standard errors. In this model.. in years. 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. are the parameters identiﬁed? 8. 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. 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. (b) Now treat Education as endogenous. The data ﬁle card. a dummy indicating that the observation lives near a 4-year college. f atheduc (the education. Report estimates and standard errors.pdf. using zi as an instrument for xi . of the mother). 134 . (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). in years. and the remaining variables as exogenous. Estimate the model by 2SLS. (a) Estimate the model by OLS. using the instrument near4.

1.1 {Yt } is covariance (weakly) stationary if E(Yt ) = µ is independent of t. We can separate time series into two categories: univariate (yt ∈ R is scalar). Yt−1 .. Because of the sequential nature of time series. To indicate the dependence on time.. The primary model for univariate time series is autoregressions (ARs). There proofs are rather diﬃcult. 12. Deﬁnition 12. Yt−k ) is independent of t for all k. and multivariate (yt ∈ Rm is vector-valued). so classical assumptions are not valid..1 If Yt is strictly stationary and ergodic and Xt = f (Yt .1 Stationarity and Ergodicity Deﬁnition 12. Deﬁnition 12. t = 1. then Xt is strictly stationary and ergodic. and T to denote the number of observations.) is a random variable... we expect that Yt and Yt−1 are not independent. The following two theorems are essential to the analysis of stationary time series..4 (loose). and Cov (Yt .3 ρ(k) = γ(k)/γ(0) = Corr(Yt . 135 . γ(k) is called the autocovariance function. we adopt new notation. Yt−k ) = γ(k) is independent of t for all k. however. and use the subscript t to denote the individual observation.1. The primary model for multivariate time series is vector autoregressions (VARs).1. Deﬁnition 12.2 {Yt } is strictly stationary if the joint distribution of (Yt .. . .1. . T .. Yt−k ) is the autocorrelation function. Theorem 12.1.Chapter 12 Univariate Time Series A time series yt is a process observed in sequence over time. A stationary time series is ergodic if γ(k) → 0 as k → ∞.

T 1X Xt →p E(Xt ). ˆ 3. ˆ ˆ T t=1 T t=1 T t=1 By Theorem 12. then as T → ∞. Thus an application of the Ergodic Theorem yields T 1X Yt Yt−k →p E(Yt Yt−k ). ˆ Part (3) follows by the continuous mapping theorem: ρ(k) = γ (k)/ˆ (0) →p γ(k)/γ(0) = ρ(k). γ (k) →p γ(k). Part (1) is a direct consequence of the Ergodic theorem. and it has a ﬁnite mean by the assumption that EYt2 < ∞. the sequence Yt Yt−k is strictly stationary and ergodic. ˆ 2. then as T → ∞. γ (0) ˆ Theorem 12. µ →p E(Yt ).2 (Ergodic Theorem).1 above.1. If Xt is strictly stationary and ergodic and E |Xt | < ∞.1. 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 ˆ γ ¥ 136 . 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 .1.3 If Yt is strictly stationary and ergodic and EYt2 < ∞. ˆ Proof. For Part (2). ˆ ˆ T t=1 γ (k) = ˆ The sample autocorrelation ρ(k) = ˆ γ (k) ˆ .Theorem 12. ρ(k) →p ρ(k). 1. T t=1 Thus γ (k) →p E(Yt Yt−k ) − µ2 − µ2 + µ2 = E(Yt Yt−k ) − µ2 = γ(k).

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

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

t t T t=1 ¥ Combined with (12. . it is also strictly stationary and ergodic.1) and the continuous mapping theorem. and by Theorem 12.. β = X 0X (12. Thus t by the Ergodic Theorem. By Theorem 12. “has a unit root”. the requirement is that all roots are larger than one.. then ˆ β →p β as T → ∞. t Yt−k ¢0 ρk .6 Let Estimation xt = β = ¡ 1 Yt−1 Yt−2 · · · α ρ1 ρ2 · · · yt = x0 β + et . we say that ρ(L). T ¢ ¡ 1X xt x0 →p E xt x0 = Q. and hence Yt . λk are the complex roots of ρ(z).1) Theorem 12. Let |λ| denote the modulus of a complex number λ.1.1.1 If the AR(k) process Yt is strictly stationary and ergodic and EYt2 < ∞. it is helpful to deﬁne the process ut = xt et .1 The AR(k) is strictly stationary and ergodic if and only if |λj | > 1 for all j.1. For an AR(k). 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. We know that an AR(1) is stationary iﬀ the absolute value of the root of its autoregressive polynomial is larger than one.6. which satisfy ρ(λj ) = 0. t T t=1 T t=1 139 . since E (ut | It−1 ) = E (xt et | It−1 ) = xt E (et | It−1 ) = 0.where the λ1 . This is a special case of non-stationarity. and is of great interest in applied time series. Theorem 12. Proof..5.” If one of the roots equals 1. Thus T T 1X 1X xt et = ut →p E (ut ) = 0. The vector xt is strictly stationary and ergodic. 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. ¢0 Then the model can be written as The OLS estimator is ¡ ˆ To study β. Note that ut is a MDS. we see that Ã !−1 Ã ! T T 1X 1X ˆ β=β+ xt x0 xt et →p Q−1 0 = 0. so is xt x0 .

. It also presumes that the AR(k) structure is the truth.. Divide the sample into T /m blocks of length m. this cannot work in a time-series application.1 to see that T 1 X √ xt et →d N (0. T t=1 where Ω = E(xt x0 e2 ). Ω) .1 MDS CLT. Clearly. Brieﬂy.. as this imposes inappropriate independence. T t=1 Since xt et is a MDS. ´ √ ³ ¡ ¢ ˆ T β − β →d N 0. Y0 ). . t This construction imposes homoskedasticity on the errors e∗ . In particular. ˆ 2.7 Asymptotic Distribution Theorem 12. xt }. there are two popular methods to implement bootstrap resampling for time-series data. then as T → ∞.. Fix an initial condition (Y−k+1 .. This creates an iid bootstrap sample. which may be diﬀerent than the i properties of the actual ei . This is identical in form to the asymptotic distribution of OLS in cross-section regression.7. 140 . 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∗ . The implication is that asymptotic inference is the same. Y−k+2 . we can apply Theorem 12. Q−1 ΩQ−1 .7.. e ˆ 3. t then as T → ∞. eT }.2 If the AR(k) process Yt is strictly stationary and ergodic and EYt4 < ∞. Method 1: Model-Based (Parametric) Bootstrap. i 4. Estimate β and residuals et . If ut is a strictly stationary and ergodic MDS and E(ut u0 ) = Ω < ∞. . Method 2: Block Resampling 1.7. we constructed the bootstrap sample by randomly resampling from the data values {yt .12.8 Bootstrap for Autoregressions In the non-parametric bootstrap. ˆ 1. 12. t t Theorem 12. the asymptotic covariance matrix is estimated just as in the cross-section case. Ω) . Simulate iid draws e∗ from the empirical distribution of the residuals {ˆ1 . T 1 X √ ut →d N (0.

The results may be sensitive to the block length.2) (12. This allows for arbitrary stationary serial correlation. • Use “seasonally adjusted” data. May not work well in small samples. Resample complete blocks. • You can estimate (12. and perhaps this was of relevance. 12. 6. also alters the time-series correlations of the data. • Include dummy variables for each season. 3. or the season-to-season change. The series ∆s Yt is clearly free of seasonality. 4.4) by OLS. . heteroskedasticity. The reason why these two procedures are (essentially) the same is the Frisch-Waugh-Lovell theorem.2)-(12. But the long-run trend is also eliminated. and then perform regression (12.. Paste the blocks together to create the bootstrap time-series Yt∗ .2). • You can estimate (12. For each simulated sample.. (12. (12. The seasonal adjustment. This presumes that “seasonality” does not change over the sample. get the ˆ ˆ residual St . The seasonal factor is typically estimated by a two-sided weighted average of the data for that season in neighboring years. Thus the seasonally adjusted data is a “ﬁltered” series. and the way that the data are partitioned into blocks. This is a ﬂexible approach which can extract a wide range of seasonal factors. however. That is. • First apply a seasonal diﬀerencing operator.3) or Yt = α0 + α1 t + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et .3) sequentially by OLS. Seasonal Eﬀects There are three popular methods to deal with seasonal data.3) replacing St with St . and for modelmisspeciﬁcation.9 Trend Stationarity Yt = µ0 + µ1 t + St St = ρ1 St−1 + ρ2 St−2 + · · · + ρk St−l + et . ﬁrst estimate (12.4) There are two essentially equivalent ways to estimate the autoregressive parameters (ρ1 . This procedure is sometimes called Detrending. draw T /m blocks. If s is the number of seasons (typically s = 4 or s = 12)..2. 141 . 5. ∆s Yt = Yt − Yt−s . ρk ).

To combine (12.. (12. In general. and this is equivalent to the restriction that the coeﬃcients on Yt−k−1 . . (A simple exclusion test). and then estimate the models AR(1). (If you increase k. and the alternative is that the error is an AR(m). One approach to model selection is to choose k based on a Wald tests. you need more initial conditions. We then multiply this by θ and subtract from (12. The hypothesis of no omitted serial correlation is H0 : θ = 0 H1 : θ 6= 0.6) 12. 142 . 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. Thus under H0 .g. to ﬁnd Yt − θYt−1 = α − θα + ρYt−1 − θρYt−1 + ut − θut−1 .5). this is the same as saying that under the alternative Yt is an AR(k+m).. Another is to minimize the AIC or BIC information criterion.10 Testing for Omitted Serial Correlation For simplicity. An appropriate test of H0 against H1 is therefore a Wald test that the coeﬃcient on Yt−2 is zero. or Yt = α(1 − θ) + (ρ + θ) Yt−1 − θρYt−2 + et = AR(2)..5) and (12..5) and lag the equation once: Yt−1 = α + ρYt−2 + ut−1 .6).. An appropriate test is the Wald test of this restriction. AR(2). e. Yt−k−m are jointly zero.. . The best remedy is to ﬁx a upper value k. AR(k) on this (uniﬁed) sample. We want to test H0 against H1 . let the null hypothesis be an AR(1): Yt = α + ρYt−1 + ut . and under H1 it is an AR(2).11 Model Selection What is the appropriate choice of k in practice? This is a problem of model selection.) This can induce strange behavior in the AIC. and then reserve the ﬁrst k as initial conditions. We model this as an AR(1): ut = θut−1 + et with et a MDS. H0 may be expressed as the restriction that the coeﬃcient on Yt−2 is zero.12. AIC(k) = log σ 2 (k) + ˆ 2k . we take (12. if the null hypothesis is that Yt is an AR(k). Yt is an AR(1). (12.5) We are interested in the question if the error ut is serially correlated.

Indeed. Thus if Yt has a (single) unit root. this is the most popular unit root test.7). and test statistics are asymptotically non-normal. the hypothesis of a unit root in Yt can be stated as H0 : α0 = 0.7) These models are equivalent linear transformations of one another. Yt is non-stationary.12 Autoregressive Unit Roots The AR(k) model is ρ(L)Yt = µ + et ρ(L) = 1 − ρ1 L − · · · − ρk Lk . 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 has a unit root when ρ(1) = 0. but simply assert the main results. We do not have the time to develop this theory in detail. Since α0 is the parameter of a linear regression. The DF parameterization is convenient because the parameter α0 summarizes the information about the unit root. then Yt is “integrated of order d”. Yt is non-stationary. so conventional normal asymptotics are invalid. as the models are equivalent. observe that the lag polynomial for the Yt computed from (12.7) is (1 − L) − α0 L − α1 (L − L2 ) − · · · − αk−1 (Lk−1 − Lk ) But this must equal ρ(L). 143 . To see this. However. we say that if Yt is non-stationary but ∆d Yt is stationary. Because of this property. Thus ρ(1) = (1 − 1) − α0 − (1 − 1) − · · · − (1 − 1) = −α0 . or I(d). Hence. It would seem natural to assess the signiﬁcance of the ADF statistic using the normal table. or ρ1 + ρ2 + · · · + ρk = 1. As we discussed before.12. the natural test statistic is the t-statistic for H0 from OLS estimation of (12. Thus a time series with unit root is I(1). under H0 . then ∆Yt is a stationary AR process. the model for Yt is ∆Yt = µ + α1 ∆Yt−1 + · · · + αk−1 ∆Yt−(k−1) + et . In this case. An alternative asymptotic framework has been developed to deal with non-stationary data. The ergodic theorem and MDS CLT do not apply. Under H0 . since ρ(1) = −α0 . (12. which is an AR(k-1) in the ﬁrst-diﬀerence ∆Yt . and is called the Augmented Dickey-Fuller (ADF) test for a unit root. Note that the model is stationary if α0 < 0. So the natural alternative is H1 : α0 < 0.

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

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

j Unrestricted VARs were introduced to econometrics by Sims (1980). This (system) estimator is known as the SUR (Seemingly Unrelated Regressions) estimator.. For example. 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 . .. ˆ An alternative way to compute this is as follows. One way to write this is to let a0 be the jth row j of A. some regressors may be excluded from some of the equations.3 Restricted VARs The unrestricted VAR is a system of m equations. A restricted VAR imposes restrictions on the system. The GMM framework gives a convenient method to impose such restrictions on estimation. Restrictions may be imposed on individual equations. we ﬁnd ⎞ ⎛ Y10 ⎜ Y0 ⎟ ˆ = ⎜ . Then the VAR system can be written as the equations Yjt = a0 xt + ejt . Consider the moment conditions j = 1. 13.2 ⎟ X(X 0 X)−1 A ⎜ . or as a linear projection.then Yt = Axt + et .2 Estimation E (xt ejt ) = 0. either as a regression. 146 . ⎠ 0 Ym+1 = Y 0 X(X 0 X)−1 . The VAR model is a system of m equations. ˆj ˆ And if we stack these to create the estimate A. m. or across equations.. each with the same set of regressors. ⎟ ⎝ . and was originally derived by Zellner (1962) ¢ 13. Note that a0 = Yj0 X(X 0 X)−1 . ¡ Y1 Y2 · · · where Y = Ym 0 the T × m matrix of the stacked yt .

direct estimation of (13. xt−1 ) to the regression. If valid. Suppose that et is an AR(1).2) Take the equation yt = x0 β + et .1). and is typically rejected empirically.3). We see that an appropriate. we are only interested in a single equation out of a VAR system. Then yt = x0 β + et t et = θet−1 + ut E (ut | It−1 ) = 0. (A simple version of this estimator is called Cochrane-Orcutt. t and xt = This is just a conventional regression. 147 . (13. Otherwise it is invalid. t or yt = θyt−1 + x0 β + x0 γ + ut . Let yt = Yjt .2) may be estimated by iterated GLS. This restriction. with time series data. and Zt be the other variables. and is still routinely reported by conventional regression packages. The DW test is appropriate only when regression yt = x0 β + et is not dynamic (has no lagged values on the RHS).1) yt = x0 β + et . Another interesting fact is that (13.4 Single Equation from a VAR Yjt = a0 xt + et . h¡ 1 Yt−1 · · · 0 Yt−k Zt−1 · · · 0 Zt−k ¢0 i . j Often. So testing H0 versus H1 is equivalent to testing for the signiﬁcance of adding (yt−1 . the model (13.2) is uncommon in recent applications. it is convenient to re-deﬁne the variables. may be tested if desired. which is called a common factor restriction. and subtract oﬀ the equation once lagged multiplied by θ. and simple way to test for omitted serial correlation is to test the signiﬁcance of extra lagged values of the dependent variable and regressors. under the restriction γ = −βθ.3) which is a valid regression model. t and et is iid N (0. 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 . This can be done by a Wald test. In this case. which once was very popular.13. 13. This takes the form 0 and xt consists of lagged values of Yjt and the other Ylt s.5 Testing for Omitted Serial Correlation Consider the problem of testing for omitted serial correlation in equation (13. Let et = ejt and β = aj .) Since the common factor restriction appears arbitrary. You may have heard of the Durbin-Watson test for omitted serial correlation.2) is a special case of (13. t t−1 (13. Then the single equation takes the form (13. Then the null and alternative are H0 : θ = 0 H1 : θ 6= 0. 1). general.

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

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

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

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

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

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 !) . The ﬁrst censored regression model was developed by Tobin (1958) to explain consumption of durable goods. The censoring process may be explicit in data collection.) The observed data yi therefore come from a mixed continuous/discrete distribution. i i i=1 ˆ The MLE is the value β which maximizes ln (β). this motivates the label Poisson “regression.2 Count Data exp (−λi ) λk i . An example of a data collection censoring is top-coding of income. The functional form for λi has been picked to ensure that λi > 0. but we observe only ½ ∗ ∗ yi if yi ≥ 0 (14. Thus the model is that there is some latent process yi with unbounded support. 14.1)..}. He proposed the latent variable model ∗ yi = x0 β + ei i ei ∼ iid N (0.3 Censored Data The idea of “censoring” is that some data above or below a threshold are mis-reported at the ∗ threshold. . Tobin observed that for many households. σ 2 ) with the observed variable yi generated by the censoring equation (14. In surveys. This model speciﬁes that P (Yi = k | xi ) = λi k = 0.. Since E (Yi | xi ) = λi = exp(x0 β) i is the conditional mean.. i If Y = {0. k! = exp(x0 β). 1. The conditional density is the Poisson with parameter λi .” Also observe that the model implies that V ar (Yi | xi ) = λi = exp(x0 β). This model (now called the Tobit) speciﬁes that the latent (or ideal) value of consumption may be negative (the household 153 . 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. any known value can substitute. the consumption level (purchases) in a particular period was zero. or it may be a by-product of economic constraints. incomes above a threshold are typically reported at the threshold. 2. i so the model imposes the restriction that the conditional mean and variance of Yi are the same. a typical approach is to employ Poisson regression. 1. . 0 if yi (This is written for the case of the threshold being zero. This may be considered restrictive.14.. A generalization is the negative binomial. 2.1) yi = ∗ <0 .

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

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

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

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

un ui = d0 u. ⎠ . Conventional inference applies.2) ⎞ di1 ⎜ . let dij = and ⎧ ⎨ 1 ⎩ 0 ⎛ if i = j .. ⎟ u = ⎝ . else Then note that and an n × 1 dummy vector with a “1” in the i0 th place. • If xit contains an intercept. Computationally. OLS estimation of β proceeds by the FWL theorem. • There are n + k regression parameters. ⎟ di = ⎝ . u). so will have to be omitted. you do not want to actually implement conventional OLS estimation. so (15. di ) = 0.g. • Any regressor in xit which is constant over time for all individuals (e. it i (15. i yit = x0 β + d0 u + eit . 158 . so the intercept is typically omitted from xit . their gender) will be collinear with di . then by the FWL theorem. Y ∗ = Y − D(D0 D)−1 D0 Y where X ∗ = X − D(D0 D)−1 D0 X. which is quite large as typically n is very large. din Observe that E (eit | xit . ⎠. .2) yields estimator (β. Let ⎛ ⎞ u1 ⎜ . as the parameter space is too large. with di as a regressor along with xi . it will be collinear with di . Observe that • This is generally consistent.First. ˆ ˆ OLS on (15.2) is a valid regression. Stacking the observations together: Y = Xβ + Du + e. ˆ β = ¢−1 ¡ 0 ¢ ¡ 0 X (1 − PD ) Y X (1 − PD ) X ¡ ¢−1 ¡ ∗0 ∗ ¢ = X ∗0 X ∗ X Y . .

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

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

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

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

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

as the optimal h for estimation of the roughness R(f 00 ) is quite diﬀerent than the optimal h for estimation of f (x). This is more treacherous than may ﬁrst appear.Epanechnikov Kernel: hrule = 2. there are modern versions of this estimator work well. which are known as smoothed cross-validation which is a close cousin of the bootstrap. The plug-in approach is to estimate R(f 00 ) in a ﬁrst step. but they are also known to converge very slowly to the optimal values. 164 . Fortunately there are remedies. They are also quite ill-behaved when the data has some discretization (as is common in economics). in particular the iterative method of Sheather and Jones (1991).2). and then plug this estimate into the formula (16.78n−1/5 Unless you delve more deeply into kernel estimation methods the rule-of-thumb bandwidth is a good practical bandwidth choice. I now discuss some of these choices. There are some desirable properties of cross-validation bandwidths. However.34n−1/5 Biweight (Quartic) Kernel: hrule = 2. Another popular choice for selection of h is cross-validation. There are other approaches. but implementation can be delicate. in which case the cross-validation rule can sometimes select very small bandwidths leading to dramatically undersmoothed estimates. perhaps adjusted by visual inspection of the resulting estimate ˆ f (x). This works by constructing an estimate of the MISE using leave-one-out estimators.

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

These counting rules are facilitated by using the binomial coeﬃcients which are deﬁned for nonnegative integers n and r. the number of ¡49 if potential combinations is 6 = 13. Without Replacement Ordered Unordered n! (n−r)! ¡n¢ r In the lottery example. we can write P (A ∩ B) = P (A | B) P (B) which is often quite useful. If P (B) > 0 the conditional probability of the event A given the event B is P (A | B) = P (A ∩ B) . 816. n ≥ r... This selection is without replacement if you are not allowed to select the same number twice. and is with replacement if this is allowed. i∈I i∈I 166 .. we have four expressions for the number of objects (possible arrangements) of size r from n objects. r r! (n − r)! When counting the number of objects in a set. Ak are mutually independent when for any subset {Ai : i ∈ I}. Rearranging the deﬁnition. P (B) With Replacement nr ¡n+r−1¢ r For any B. Furthermore. For example. 49. consider a lottery where you pick six numbers from the set 1. there are two important distinctions.. Counting may be with replacement or without replacement.. Depending on these two distinctions. ¢ counting is unordered and without replacement. Counting is ordered or not depending on whether the sequential order of the numbers is relevant to winning the lottery. we say that the collection of events A1 . it is useful to have simple rules to count the number of objects in a set. in which case we ﬁnd P (A ∩ B) = P (A) P (B) (A. 983.1) We say that the events A and B are statistically independent when (A. the conditional probability function is a valid probability function where S has been replaced by B. Counting may be ordered or unordered. as µ ¶ n n! = . We can say that the occurrence of B has no information about the likelihood of event A when P (A | B) = P (A)..• 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. Ã ! \ Y P Ai = P (Ai ) .1) holds. . . 2.

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

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

. . 1 EX = p 1−p V ar(X) = p2 Multinomial P (X1 = x1 . x EX = np V ar(X) = np(1 − p) Geometric P (X = x) = p(1 − p)x−1 . 169 . X2 = x2 . λ>0 x = 1. EX = p V ar(X) = p(1 − p) Binomial µ ¶ n x P (X = x) = p (1 − p)n−x . 0≤p≤1 x = 0.. x! EX = λ x = 0.. 1. 1. Xm = xm ) = x1 + · · · + xm n! px1 px2 · · · pxm . 2... 0≤p≤1 x = 0. 2. m x1 !x2 ! · · · xm ! 1 2 = n.. 1.. we now list some important discrete distribution function. . . 0≤p≤1 V ar(X) = λ We now list some important continuous distributions. .... x EX = V ar(X) = Poisson P (X = x) = exp (−λ) λx .A. x = 1... 2. . Bernoulli P (X = x) = px (1 − p)1−x ..4 Common Distributions For reference. 0≤p≤1 p1 + · · · + pm = 1 EX = V ar(X) = Negative Binomial µ ¶ r+x−1 P (X = x) = p(1 − p)x−1 .. n..

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

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

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

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

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

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

and to denote the standard normal density function by φ(x) and its distribution function by Φ(x). exp − f (x) = k/2 1/2 2 (2π) det (Σ) The mean and covariance matrix of the distribution are µ and Σ. X has density Ã ! (x − µ)2 1 exp − . Ir ) and set Q = X 0 X. and it is conventional to write X ∼ N (µ. Theorem A. f (x) = √ 2σ 2 2πσ which is the univariate normal density. then Σ = diag{σ 2 } is a diagonal matrix. A) with A > 0. Since it is symmetric about zero all odd moments are zero. then they are mutually independent. k/2 1/2 2 (2π) det (ΣY ) where µY = a+Bµ and ΣY = BΣB 0 . By iterated integration by parts. respectively. Another useful fact is that if X ∼ N (µ.2 If Z ∼ N(0.1 Let X ∼ N (0. Σ) and Y = a + BX with B an invertible matrix. If Z is standard normal and X = µ + σZ. σ 2 ).8. (A. then by the change-of-variables formula.This density has all moments ﬁnite. q 176 . the density of Y is Ã ! (y − µY )0 Σ−1 (y − µY ) 1 Y exp − f (y) = . −∞ < x < ∞. and it is conventional to write X ∼ N(µ. then using the change-of-variables formula. x ∈ Rk . 1). y ≥ 0. denoted χ2 . For x ∈ Rk . Σ). we can also show that EX 2 = 1 and EX 4 = 3.11) and is known as the chi-square density with r degrees of freedom. Theorem A. In this case the density function can be written as j Ã Ã !! (x1 − µ1 )2 /σ 2 + · · · + (xk − µk )2 /σ 2 1 1 k f (x) = exp − 2 (2π)k/2 σ 1 · · · σ k Ã ¡ ¢2 ! k Y xj − µj 1 = exp − 2σ 2 (2π)1/2 σ j j j=1 which is the product of marginal univariate normal densities. The mean and variance of the distribution are µ and σ 2 . where we used the fact that det (BΣB 0 )1/2 = det (Σ)1/2 det (B) . ¢ ¡ 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 . If X ∈ Rk is multivariate normal and the elements of X are mutually uncorrelated. q × q. then Z 0 A−1 Z ∼ χ2 . x ∈ Rk . the multivariate normal density is ¶ µ (x − µ)0 Σ−1 (x − µ) 1 . The latter has no closed-form solution. It is conventional to write X ∼ N (0. This shows that if X is multivariate normal with uncorrelated elements. Q has the density f (y) = Γ 1 ¡r¢ 2 2r/2 yr/2−1 exp (−y/2) . This shows that linear transformations of normals are also normal. Its mean and r variance are µ = r and σ 2 = 2r.8.

Theorem A.3.11) is Z ∞ ¢ ¡ Γ r+1 2 f (x) = ´ r+1 ¡r¢ ³ √ 2 2 πrΓ 2 1 + x r (A.8.6) can be used to show that the MGF j=1 ¥ Proof of Theorem A.2. Iq ). q Proof of Theorem A. From (A. 1). Using the simple law of iterated expectations. The MGF for the density (A. Since we can write Q = P 2 X 0 X = r Zj where the Zj are independent N(0. Proof of Theorem A.11) 2 with r = 1. tr = p Q/r The density of tr is and is known as the student’s t distribution with r degrees of freedom. 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 . Thus ¥ ¡ ¢0 ¡ ¢ Z 0 A−1 Z = Z 0 C −10 C −1 Z = C −1 Z C −1 Z ∼ χ2 . Thus the density of Z 2 is (A. (A. which can be found by applying change-of-variables to the gamma function. Set r Z .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). For Z ∼ N(0. ¡ ¢ √ using the change—of-variables s = x2 and the fact Γ 1 = π.8.13) is the MGF of the density (A.1.3 Let Z ∼ N (0. we see that the MGF of Z 2 is (1 − 2t)−1/2 . 1) and Q ∼ χ2 be independent.8.8.12) E exp (tQ) = 0 Γ (A. C −1 AC −10 ) = N (0. The fact that A > 0 means that we can write A = CC 0 where C is non-singular.13). tr has distribution 177 . which we showed in (A. Then A−1 = C −10 C −1 and C −1 Z ∼ N (0. C −1 CC 0 C −10 ) = N (0.11).

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

the restriction to unbiased estimators means that the theorem has little direct relevance for ﬁnite sample eﬃciency. θ) ∂θ ∂θ which holds at θ = θ0 by (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. then θ V ar(˜ ≥ (nI0 )−1 .17) The matrix I0 is called the information. n n i=1 n As the MLE ˆ maximizes the left-hand-side. 179 .3 Under regularity conditions. we can see that it is an estimator of the maximizer θ of the right-hand-side. If ˜ is an unbiased estimator of θ ∈ R. cases are rare. θ Theorem A. θ θ∈Θ ˆ In some simple cases. which maximizes the log-likelihood).9.15) Two important features of the likelihood are Theorem A. but these ˆ must be found by numerical methods. In fact.17) is often called the information matrix equality.9. and the equality (A. More typically.2 Cramer-Rao Lower Bound.9. θ0 ) . ˆ is consistent θ for this value. θ)¯ =0 ¯ ∂θ θ=θ0 H = Ω ≡ I0 (A. θ) →p E ln f (Yi . The maximum likelihood estimator or MLE ˆ is the parameter value which maximizes θ the likelihood (equivalently.16). ˆ →p θ0 as n → ∞. However. Theorem A. θ) ≡ L(θ).1 ¯ ¯ ∂ E ln f (Yi . I0 . We can write this as ˆ = argmax Ln (θ).14) ¶ ∂ ∂ 0 ln f (Yi . The ﬁrst-order condition for the latter problem is 0= ∂ ∂ L(θ) = E ln f (Yi .16) (A. we can ﬁnd an explicit expression for θ as a function of the data. θ0 ) ∂θ∂θ 0 (A. the log-likelihood is a sample average 1X 1 Ln (θ) = ln f (Yi . ∂θ ∂θ (A.Deﬁne the Hessian H = −E and the outer product matrix Ω=E µ ∂2 ln f (Yi . θ) The Cramer-Rao Theorem gives a lower bound for estimation. θ0 ) ln f (Yi . under conventional regularity conditions.

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

Proof of Theorem A. θ) ¯θ=θ0 ¯ Z ¯ ∂ f (y.Proof of Theorem A. we can show that E By direction computation.. function of the data. θ0 ) ln f (Yi . θ0 ) ¯ ∂ f (y. θ0 ) dy ¯ ¯ ¯ θ=θ0 f (y. ∂θ ¯θ=θ0 Z ! = 0.16). θ0 ) ∂θ ∂θ ¥ ³ ´ X ∂ ∂ ˜ ln fn Y . θ) dy ¯ ¯ ∂θ θ=θ0 ¯ ∂ ¯ 1¯ = 0.1. θ0 ) ∂ ∂ − ln f (Yi .2.1) has mean zero and variance nH. θ) f (˜.9. f (Yi .. θ0 )0 f (Yi . θ) d˜ θ = Eθ θ(˜ y y where y = (y1 . θ0 ) ∂θ ∂θ n i=1 which by Theorem (A. (Yi . θ0 = ln f (Yi . θ0 ) (Yi . ∂2 ln f (Yi . . θ0 ) f (Yi . θ0 ) d˜ = E ˜ .9. θ0 ) − f (Yi . θ0 ) = ∂θ∂θ0 = Taking expectations yields (A. θ)¯ = ¯ ∂θ θ=θ0 = = = Similarly.. θ) f (y. Write the estimator ˜ = ˜ Y ) as a θ θ( ˜ ˜ is unbiased for any θ. To see (A. θ) d˜ = ˜ y ) ∂ ln f (˜. θ0 )0 . V ar (S) nH so ¥ 181 . 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 = . S= ∂2 f ∂θ∂θ0 ∂2 f ∂θ∂θ0 ∂ ∂θ Z Ã ∂2 f ∂θ∂θ0 ¯ ¯ ln f (y. Diﬀerentiating with respect to θ and evaluating at θ0 yields ˜ Z Z ³ ´ ˜ y ) ∂ f (˜. θ0 ) ∂θ f (Yi .9. θ) dy ¯ ∂θ f (y. yn ). θ0 ) ∂ ∂θ f ∂ (Yi .17). θ0 )2 (Yi . ¯ ¯ ∂ E ln f (Yi . Since θ Z ˜ = ˜ y)f (˜.

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

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

they can be calculated numerically. . One modiﬁcation to prevent this possibility is quadratic hill-climbing which sets ˆi+1 = θi − (H(θi ) + αi Im )−1 g(θi ). θ where αi is set just above the smallest eigenvalue of H(θi ) if H(θ) is not positive deﬁnite. Let δ j be the j 0 th unit vector (zeros everywhere except for a one in the j 0 th row). Q(θ + δ j ε + δ k ε) − Q(θ + δ k ε) − Q(θ + δ j ε) + Q(θ) ε2 In many cases. Then for ε small gj (θ) ' Similarly. Another productive modiﬁcation is to add a scalar steplength λi .2) θi+1 = θi − Di gi λi Q(θ + δ j ε) − Q(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 One problem with Newton’s method is that it will send the iterations in the wrong direction if H(θi ) is not positive deﬁnite. 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). In some cases. Most gradient methods are a variant of Newton’s method which is based on a quadratic approximation. θ This suggests the iteration rule ˆi+1 = θi − H(θi )−1 g(θi ). ∂θ∂θ 0 If the functions g(θ) and H(θ) are not analytically available.. 2.2 Gradient Methods Gradient Methods are iterative methods which produce a sequence θi : i = 1. a one-dimensional optimization.B. of the gradient of Q(θ) ∂ Q(θ) g(θ) = ∂θ and some require the Hessian ∂2 H(θ) = Q(θ). To pick λi write the criterion function as a function of λ Q(λ) = Q(θi + Di gi λ) 184 . numerical derivatives can work well but can be computationally costly relative to analytic derivatives. Take the j 0 th element of g(θ). and all require the computation θ. Allowing the steplength to be a free parameter allows for a line search.. which are designed to converge to ˆ All require the choice of a starting value θ1 . numerical derivatives can be quite unstable. In this case the iteration rule takes the form (B. however.

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

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