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

# ECONOMETRICS

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

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

1

Contents

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

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

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

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

i

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

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

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

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

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

ii

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

.4 Common Distributions . . . . . . . . . . . . . . . . . . . .4 Single Equation from a VAR . . . . .1 Foundations . . . . . . . . . . . . . .4 Sample Selection . . .1 Individual-Eﬀects Model . . . . . . . . . . . . . . . . . . . .13 Multivariate Time Series 13. . . . . . . . .3 Derivative-Free Methods . 13. . . . .3 Censored Data . . . . . . . . . . . . . . . . . . . .7 Transformations . . . . . . . . . . . . . . . . . . . . . . . A. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13. . . . . . . . . . . . . . . . . . . . . . . A. . . . . . . . . . . . . . . . . . . . . . . . . . . .2 Fixed Eﬀects .3 Expectation . . . . . . . . . . . . . . . . . . . . . . .2 Asymptotic MSE for Kernel Estimates . . . . .5 Multivariate Random Variables . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Binary Choice . . . . . . . . . .3 Restricted VARs . . . . . . . . . .2 Estimation . . 157 15. . . . . . .6 Conditional Distributions and Expectation . 14.2 Gradient Methods .1 Vector Autoregressions (VARs) . . . . . . . . . 157 15. . . . . . . . . . . 160 16. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9 Maximum Likelihood . . . .6 Selection of Lag Length in an VAR . .8 Normal and Related Distributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165 165 167 168 169 171 173 175 175 178 183 183 184 185 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9 Cointegrated VARs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159 16 Nonparametrics 160 16. . . . . .1 Kernel Density Estimation . . . . . . . . . . . iv . . . . . . . . . . . . . . . . . . . . . . . . . A. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 Limited Dependent Variables 14. . . . . . . . . . . . . . 13. . . . . . . . . 14. A. . . . . . . B. . . . . . . . . . . . . . . . . . . 162 A Probability A. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13. . . . . . . . . . . . . . . . . . . . . . . . . . 13. . . .1 Grid Search . . . . . . . . . . . . . . B. . . . . . . . . . . . . . . . . . . .2 Random Variables . 13. . . . . . . . . . . . . . . . . . 15 Panel Data 157 15. . . . . . . . . . . . . . . . . .2 Count Data . . . . . . . . . . . . . . . . A. . . . . . . . B Numerical Optimization B. . . . . . . . . . . . . . 145 145 146 146 147 147 148 148 149 149 151 151 153 153 154 . . . . . . . . . . . .3 Dynamic Panel Regression . . . . . . . . . . . . .7 Granger Causality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A. .5 Testing for Omitted Serial Correlation 13. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8 Cointegration . . . 13. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14. . . . . .

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

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

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

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

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

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

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

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

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

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

While it is easy to observe that the two densities are unequal. An important summary measure is the conditional mean Z ∞ yf (y | x) dy. or the covariates. In the example presented in Figure 3. We call xi alternatively the regressor.22. ⎟ . from the population of white non-military wage earners with a college degree and 10-15 years of potential work experience. holding the other variables constant. When a distribution is skewed.1 displays the density1 of hourly wages for men and women. gender. xi ) where yi is a scalar (real-valued) and xi is a vector. The data are from the 2004 Current Population Survey 1 11 . (3. Figure 3.1.73. the mean is not necessarily a good summary of the central tendency.1 Conditional Mean To study how the distribution of yi varies with the variables xi in the population.2) m(x) = E (yi | xi = x) = −∞ In general. 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. These are asymmetric (skewed) densities. xki 3. We list the elements of xi in the vector ⎞ ⎛ x1i ⎜ x2i ⎟ ⎟ ⎜ (3. These are conditional density functions — the density of hourly wages conditional on race. it is useful to have numerical measures of the diﬀerence. We call yi the dependent variable. we can focus on f (y | x) . To illustrate. and that for women is $20. . education and experience. This is used when the goal is to quantify the impact of one set of variables on another variable. These are indicated in Figure 3. ⎠ ⎝ . See Chapter 16. the conditional density of yi given xi .1 by the arrows drawn to the x-axis.1. Take a closer look at the density functions displayed in Figure 3. In this context we partition the observations into the pair (yi .1) xi = ⎜ . the conditioning variable. You can see that the right tail of then density is much thicker than the left tail.Chapter 3 Regression and Projection The most commonly applied econometric tool is regression. and exists so long as E |yi | < ∞. The two density curves show the eﬀect of gender on the distribution of wages. which is a common feature of wage distributions. m(x) can take any form.

A. 2 (3. the solid line displays the conditional expectation of log wages varying with education.36.5. which implies a 30% average wage diﬀerence for this population. This is a more robust measure of the typical wage gap between men and women than the diﬀerence in the untransformed wage means.1: Wage Densities for White College Grads with 10-15 Years Work Experience to transform the data by taking the (natural) logarithm.3) White non-military male wage earners with 10-15 years of potential work experience. By construction.Figure 3. Of particular interest to graduate students may be the observation that diﬀerence between a B.30.D. The diﬀerence in the log mean wage between men and women is 0.2 shows the density of log hourly wages for the same population. Assuming for simplicity that this is the true joint distribution.3 is how the conditional expectation describes an important feature of the conditional distribution. degree in mean log hourly wages is 0. For this reason. then comparisons become more complicated. and a Ph. The comparison in Figure 3.3 displays a scatter plot2 of log wages against education levels. To illustrate. 3. wage regressions typically use log wages as a dependent variable rather than the level of wages.1 is facilitated by the fact that the control variable (gender) is discrete.2) evaluated at the observed value of xi : ei = yi − m(xi ). the dashed line is a linear projection approximation which will be discussed in the Section 3. Figure 3. When the distribution of the control variable is continuous. The main point to be learned from Figure 3. this yields the formula yi = m(xi ) + ei . with mean log hourly wages drawn in with the arrows. implying an average 36% diﬀerence in wage levels. The conditional expectation function is close to linear. Figure 3.2 Regression Equation The regression error ei is deﬁned to be the diﬀerence between yi and its conditional mean (3. 12 .

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

The right-hand-side is minimized by setting g(x) = m(x). let g(x) be an arbitrary predictor of yi given xi = x. A common measure of the dispersion is the conditional variance ¡ ¢ σ 2 (x) = V ar (yi | xi = x) = E e2 | xi = x . The expected squared error using this prediction function is E (yi − g(xi ))2 = E (ei + m(xi ) − g(xi ))2 = Ee2 + 2E (ei (m(xi ) − g(xi ))) + E (m(xi ) − g(xi ))2 i = Ee2 + E (m(xi ) − g(xi ))2 i ≥ Ee2 i where the second equality uses Theorem 3. 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 . it does not provide information about the spread of the distribution.3.Figure 3. To see this. The conditional standard deviation is its square root σ(x) = σ 2 (x).4) E e2 | xi = σ 2 i 14 While the conditional mean is a good measure of the location of a conditional distribution. In the general case i where σ 2 (x) depends on x we say that the error ei is heteroskedastic. In contrast. and can take any form. the conditional variance of yi is σ 2 = σ 2 (xi ).3 Conditional Variance Generally.1.2. subject to the restriction p that it is non-negative. Thus the mean squared error is minimized by the conditional mean. 3. Given the random variable xi . when σ 2 (x) is a constant so that ¢ ¡ (3. i . σ 2 (x) is a non-trivial function of x.

8) (3. where x1i is the ﬁrst element of the vector xi deﬁned in (3. So while men have higher average wages.6) (3. it is convenient to augment the regressor vector xi by listing the number “1” as an element.3) is when the conditional mean function m(x) is linear in x (or linear in functions of x).3) can be writen as yi = x0 β + ei i E (ei | xi ) = 0. take the conditional wage densities displayed in Figure 3.9) 3. we assume that x1i = 1. Equivalently.1) has been redeﬁned as the k × 1 vector ⎛ ⎞ 1 ⎜ x2i ⎟ ⎜ ⎟ (3. ⎟ β=⎝ . i (3.7) is a k × 1 parameter vector. they are also somewhat more dispersed. This concept is less helpful than deﬁning heteroskedasticity as the dependence of the conditional variance on the observables xi .we say that the error ei is homoskedastic. xki When m(x) is linear in x.5. Thus (3. Notationally. and the linear assumption of the previous section is empirically unlikely to accurate. ⎝ . We call this the “constant” or “intercept”. ⎟ .5) xi = ⎜ . 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 .1. ⎠ . Equation (3. Instead.8) is called the linear regression model.1 and that for women is 10. βk ⎛ (3. As an example. In this case (3. The conditional standard deviation for men is 12.6) as an approximation. we can write it as m(x) = x0 β = β 1 + x2i β 2 + · · · + xki β k where ⎞ β1 ⎜ . An important special case is homoskedastic linear regression model yi = x0 β + ei i E (ei | xi ) = 0 ¢ ¡ E e2 | xi = σ 2 . it is more realistic to view the linear speciﬁcation (3. ⎠ . which we derive in this section.4 Linear Regression An important special case of (3. 15 . its functional form is typically unknown. Some textbooks inappropriately describe heteroskedasticity as the case where “the variance of ei varies across observation i”.1).

i (3. alternative expressions such as E xixi ) or E (xi yi ) (E (xi x0 ))−1 i ( i 0i ) are incoherent and incorrect. The error is i ei = yi − x0 β. i (3. In order for β to be uniquely deﬁned. by “best” we mean the predictor function with lowest mean squared error. E (xi x0 ) is invertible. This occurs when redundant variables are included in xi .5. Eyi < ∞.10) exists and is unique as long as the k ×k matrix E (xi x0 ) is invertible.7) is 0= Solving for β we ﬁnd ¡ ¢ ∂ S(β) = −2E (xi yi ) + 2E xi x0 β. Therefore. i 4. E (xi x0 ) is a mai E(x y trix and E (xi yi ) is a vector. E (x0 xi ) < ∞. x0 β is the best linear predictor for yi . The ﬁrst-order condition for minimization (from Section 2. 3. i ∂β ¢¢−1 ¡ ¡ E (xi yi ) .10). Rewriting. Equivalently. The vector (3. Observe i that for any non-zero α ∈ Rk .10) It is worth taking the time to understand the notation involved in this expression. i i (3. β = E xi x0 i In the linear projection model the coeﬃcient β is deﬁned so that the function x0 β is the i best linear predictor of yi . xi contains an intercept. 2 2. α0 E (xi x0 ) α = E (α0 xi )2 ≥ 0 so the matrix E (xi x0 ) is by construction i i positive semi-deﬁnite.1 1. otherwise they are distinct.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 .1. this situation must be excluded. written E (xi x0 ) > 0.12) This completes the derivation of the linear projection model. we obtain a decomposition of yi into linear predictor and error yi = x0 β + ei .which is quadratic in β. there cannot i exist a non-zero vector α such that α0 xi = 0 identically. We now summarize the assumptions necessary for its derivation and list the implications in Theorem 3. α0 E (xi x0 ) α = E (α0 xi )2 > 0. i which requires that for all non-zero α. i 16 . 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. As before. It is invertible if and only if it is positive deﬁnite. Assumption 3. The best linear predictor is obtained by selecting β to minimize S(β). Given the deﬁnition of β in (3.5.

5.5.Theorem 3. suppose that for xi ∈ R that Ex3 = 0 and ei = x2 . Assumption 3. Since ei is mean zero by (3.13) The two equations (3. (3.12) and (3.8)-(3. Furthermore. it follows that linear regression is a special case of the projection model.1. x0 β is the i projection of yi on xi since the error ei is orthogonal with xi .1.1.14) follows from (3.4 is required to ensure that β is uniquely deﬁned.2 and 3. Assumption 3.1.4 we know that the regression error has the property E (xi ei ) = 0.14). Using the deﬁnitions (3. For example. Then i i Exi e2 = Ex3 = 0 yet E (ei | xi ) = x2 6= 0.5.1.12) can be alternatively interpreted as a projection decomposition.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. This means that the equation (3.9).5.4 guarantees that the solution β exits. the converse is not true as the projection error does not necessarily satisfy E (ei | xi ) = 0.5.4: Hourly Wage as a Function of Experience The conditions listed in Assumption 3. However.2.5.10) are deﬁned.11) are well deﬁned.5.1.14) holds.14) Proof.1 are weak. Since from Theorem 3. Let’s compare it with the linear regression model (3.3 are called regularity conditions. By deﬁnition. ¥ (3.13) and Assumption 3.1. i i i Since E (xi ei ) = 0 we say that xi and ei are orthogonal.5.1. 17 . Equation (3. Figure 3. Assumption 3.5.10) and (3.1. Assumption 3.2 and 3.13) implies that xi and ei are uncorrelated. The ﬁnite variance Assumptions 3. E (xi ei ) = 0 and E (ei ) = 0.5. the orthogonality restriction (3.1.1 is employed to guarantee that (3.5.1 Under Assumption 3. (3.11) and (3.3 ensure that the moments in (3.13) summarize the linear projection model.1.

there are no changes in our methods or analysis. and under-predicts for the rest. it misses the strong downturn in expected wages for those above 35 years work experience (equivalently. In contrast. In this example the linear projection is a close approximation to the conditional mean. The solid line is the conditional mean.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. xi ) we can deﬁne a linear projection equation (3. the dashed line is the linear projection of log wages on eduction. However.12) is deﬁned by projection and the associated coeﬃcient deﬁnition (3.1 may be false. 18 . It over-predicts wages for young and old workers. In other cases the two may be quite diﬀerent. In this example it is a much better approximation to the conditional mean than the linear projection. In Figure 1.4 displays the relationship3 between mean log hourly wages and labor market experience. and are discussed in Chapter 11. Figure 3. Most importantly. The linear equation (3. in many economic models the parameter β may be deﬁned within the model. for any pair (yi .We have shown that under mild regularity conditions.10) may not hold and the implications of Theorem 3. This defect in linear projection can be partially corrected through a careful selection of regressors.1. In this case (3. Figure 3. No additional assumptions are required. These structural models require alternative estimation methods.3. since the resulting function is quadratic in experience.5.5 for a 3 In the population of Caucasian non-military male wage earners with 12 years of education.4 we display as well this quadratic projection. it is important to not misinterpret the generality of this statement. and the straight dashed line is the linear projection. In this case the linear projection is a poor approximation to the conditional mean. Other than the redeﬁnition of the regressor vector.12) with the properties listed in Theorem 3. Returning to the joint distribution displayed in Figure 3.5. we can augment the regressor vector xi to include both experience and experience2 . In the example just presented. A projection of log wages on these two variables can be called a quadratic projection.10). for those over 53 in age). We illustrate the issue in Figure 3.

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

3. True or False. m. σ 2 = V ar(xi ). σ = . then ei is i i independent of xi . Prove parts 2. i 7. . σ 2 = V ar(yi ) and σ xy = Cov(xi . Compute 2 the coeﬃcients of the linear projection yi = β 0 + β 1 xi + ei . i 10. Compute the conditional mean m(x) = E (yi | xi = x) . xi ∈ R. Compute E(yi | xi = x) and V ar(yi | xi = x). Show that x y β 1 = σ xy /σ 2 and β 0 = µy − β 1 µx . then E(ei | xi ) = 0. and E(e2 | xi ) = σ 2 . E(Y 2 | X = x) and V ar(Y | X = x).3 Find E(Y | X = x). i 8. a constant. Deﬁne µ ¶ ¢ ¡ x−µ 2 g x. µx = Exi . taking values only on the non-negative integers. e−λ λj j! . 3 and 4 of Theorem 3. x 6. 2. True or False. i 11. If yi = x0 β + ei and E(ei | xi ) = 0. and E(xi ei ) = 0. and the conditional distribution of yi given xi is Poisson: P (yi = k | xi = x) = e−x β (x0 β)j . Does this justify a linear regression model of the form yi = x0 β + εi ? i then EY = λ and V ar(Y ) = λ. 2...2. xi ∈ R. s) = 0 if and only if m = µ and s = σ 2 . 0 ≤ y ≤ 1. True or False. (x − µ)2 − σ 2 Show that Eg (X.1. yi ).3. Suppose that Y and X only take the values 0 and 1. then ei is independent of xi . 9. ¡ ¢ 4. True or False. Suppose that yi is discrete-valued.6 Exercises 1. Take the bivariate linear projection model yi = β 0 + β 1 xi + ei E (ei ) = 0 E (xi ei ) = 0 Deﬁne µy = Eyi . 1. If yi = xi β + ei . E(ei | xi ) = 0. If yi = x0 β + ei . then E(x2 ei ) = 0. True or False. and E(ei | xi ) = 0. 20 . Let X be a random variable with µ = EX and σ 2 = V ar(X).1 . y) = 3 x2 + y 2 on 0 ≤ x ≤ 1. If yi = x0 β + ei and E(xi ei ) = 0. then E(x2 ei ) = 0. Let xi and yi have the joint density f (x. Are they diﬀerent? Hint: If P (Y = j) = 5. µ. If yi = xi β + ei . and have the following joint probability distribution X=0 X=1 Y =0 .2 Y =1 . j! 0 j = 0.4 .

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 . 4.8.3) writes the projection coeﬃcient β as an explicit function of population moments E (xi yi ) and E (xi x0 ) .7 and 4.2) (4.1) (4.3) In Sections 4.2) can be written in the parametric 0 β)) = 0. we narrow the focus to the linear regression model. i It follows that the moment estimator of β replaces the population moments in (4. (4.4) i i=1 i=1 ˆ Another way to derive β is as follows. 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 (4.1 Estimation Equation (4.3) with the sample moments: ³ ¡ ¢´−1 ˆ ˆ ˆ β = E xi x0 E (xi yi ) i Ã n !−1 n 1X 1X 0 xi xi xi yi = n n i=1 i=1 Ã n !−1 n X X = xi x0 xi yi .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.

95 xi yi = 42.117 Educationi .14 14. 0.14 14.30 + 0. 30 = .37 µ ¶ 1.3.14 205.117 1 14.71 = −2.4). Then µ ¶ n 1X 2.94 −2.ˆ This is a set of k equations which are linear in β. n X i=1 2 yi − 2β 0 n X i=1 xi yi + β 0 n X i=1 xi x0 β.83 µ We often write the estimated equation using the format \ log(W agei ) = 1.14 205.5) = n n 1X 1X ˆ xi yi − xi x0 β i n n i=1 i=1 whose solution is (4. excluding military. An interpretation of the estimated equation is that each year of education is associated with an 11. To illustrate.83 ¶−1 µ ¶ .4).7% increase in mean wages. consider the data used to generate Figure 3. The estimator β is the value which jointly sets these equations equal to zero: 0 = g (β) ˆ ˆ n ´ 1X ³ ˆ xi yi − x0 β = i n i=1 (4.2 Least Squares There is another classic motivation for the estimator (4. ¶ 2. These are white male wage earners from the March 2004 Current Population Survey. Let yi be log wages and xi be an intercept and years of education. i 22 . 4. This sample has 988 observations. 40 2. 40 0.40 µ ¶µ ¶ 34.40 n i=1 1 n Thus ˆ β = n X i=1 xi x0 i = µ 1 14.170 37. with 10-15 years of potential work experience. 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.95 42.

Figure 4.The Ordinary Least Squares (OLS) estimator is the value of β which minimizes Sn (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. The error is unobservable. the contour lines are ellipses.2 displays the contour lines of the same function — horizontal slices at equally spaced heights. which can cause confusion.1 displays an example sum—of-squared errors function Sn (β) for the case k = 2.7) 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. These two ˆ variables are frequently mislabeled. To visualize the sum-of-squared errors function. while the residual is a by-product of estimation. 23 . It is important to understand the distinction between the error ei and the residual ei . Matrix calculus (see Appendix 2.4). i ˆ ˆ Note that yi = yi + ei . Following convention we will call β the OLS estimator of β.1: Sum-of-Squared Errors Function As a by-product of OLS estimation. Figure 4. Since the function Sn (β) is a quadratic function of β.

and hold true for all linear regression estimates. These are algebraic results.5) implies that 1X xi ei = 0.6) An alternative estimator uses the formula n 1 X 2 s = ei . ˆ n−k 2 i=1 (4. Its method of moments estimator is the sample average 1X 2 ei .2: Sum-of-Squared Error Function Contours Equation (4. It measures the variation in the i “unexplained” part of the regression.7) A justiﬁcation for the latter choice will be provided in Section 4. 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. The error variance σ 2 = Ee2 is also a parameter of interest. one implication is that n 1X ei = 0.Figure 4.7. ˆ σ = ˆ n 2 i=1 n (4. ˆ n i=1 n Since xi contains a constant.

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

one for each observation. We can stack these n equations together as y1 = x0 β + e1 1 y2 = x0 β + e2 2 . n or equivalently Y = Xβ + e. residual vector. it is matrix notation. . n X i=1 Thus the estimator (4.6). = β+ XX 26 (4. For example n X i=1 For many purposes. yn = x0 β + en . .4 Model in Matrix Notation convenient to write the model and statistics in x0 1 x0 2 . ⎟. and X is an n × k matrix. ⎠ xi x0 = X 0 X i xi yi = X 0 Y. We deﬁne ⎛ ⎞ ⎛ y1 ⎜ ⎜ y2 ⎟ ⎜ ⎟ ⎜ X=⎜ Y = ⎜ . 4. σ 2 ) = − 2 + ¡ ¢2 e2 = 0. ⎝ ⎝ . . the ˆ OLS estimator β is frequently referred to as the Gaussian MLE. . en ⎞ Observe that Y and e are n × 1 vectors.12) is a system of n equations. 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.8) . Sample sums can also be written in matrix notation. ˆi 2 ∂σ 2 2ˆ σ 2 σ ˆ i=1 ˆ ˆ Solving for σ 2 yields the method of moments estimator (4. yn ⎟ ⎟ ⎟. ⎠ ⎜ ⎜ e=⎜ ⎝ ⎟ ⎟ ⎟. 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. including computation. Thus the MLE (β. ⎠ .Maximization with respect to σ 2 yields the ﬁrst-order condition n X ∂ n 1 ˆ ˆ Ln (β. The linear equation (3. . x0 n ⎞ ⎛ e1 e2 . .4). σ 2 ) for the normal ˆ regression model are identical to the method of moment estimators. Due to this equivalence.

4.5

Projection Matrices

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

Deﬁne the matrices and

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

and

PP

=

= M − MP = M

1

A matrix A is idempotent if AA = A.

27

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

r X j=1

(4.9) (4.10)

ajj

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

and

4.6

Residual Regression

X = [X1 X2 ] ¶ .

Partition and β= µ

β1 β2

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

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

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

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

It follows that

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

2

(4.15)

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

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

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

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

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

⎠ ⎝ ⎠ ⎝ . ! Thus the OLS estimator for the slope coeﬃcients is a regression with demeaned data. ˆ which are “demeaned”.14) or via the ˆ following algorithm: ˜ 1. . Regress Y on X2 . is the demeaning formula for regression. In this case. ˆ ˜ ˜ ˆ 3. observe that ⎞ ⎛ ⎞ ⎛ . which you may have seen in an introductory econometrics course. ˜ 2. . Regress X2 on X1 . 4. . A common application of the FWL theorem. ⎟ ⎜ ⎟ ⎜ (4. .9). and X2 is the vector of observed regressors. 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) . 30 . In the model (4.Theorem 4. M1 = I − ι ι0 ι Observe that ¡ ¢−1 0 ˜ ι X2 X2 = M1 X2 = X2 − ι ι0 ι = X2 − X 2 and ˜ Y ¡ ¢−1 0 = M1 Y = Y − ι ι0 ι ιY = Y −Y. obtain OLS estimates β 2 and residuals e.6. obtain residuals X2 . . Rather.8)(3. . In some contexts.9). . The FWL theorem says that β 2 is the OLS estimate from a regression of ˜ ˜ Y on X2 .13). the primary use is theoretical. By the independence of the observations and (3. Partition X = [X1 X2 ] where X1 = ι is a vector of ones. the FWL theorem can be used to speed computation.1 (Frisch-Waugh-Lovell). obtain residuals Y . In this section we derive the small sample conditional mean and variance of the OLS estimator. . Regress Y on X1 .7 Bias and Variance In this and the following section we consider the special case of the linear regression model (3. .18) E (e | X) = ⎜ E (ei | X) ⎟ = ⎜ E (ei | xi ) ⎟ = 0. . the OLS estimator of β 2 and the OLS residuals e may be equivalently computed by either the OLS regression (4. ¡ ¢−1 0 ι. but in most cases there is little computational advantage to using the two-step algorithm.

Thus D is a diagonal matrix with i’th diagonal element σ 2 : i ⎛ 2 σ1 0 · · · ⎜ 0 σ2 · · · 2 ⎜ D = diag{σ 2 .12).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 . σ2 n ⎞ We now calculate the ﬁnite sample bias of the method ¡ moments estimator σ 2 for σ 2 . . .18). and the trace operator observe that. ⎝ . 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. the properties additional assumption of conditional homoskedasticity E ei i of projection matrices.. . ⎠ (4.. 1 n . σ 2 } = ⎜ . . . V ar β | X = X 0 X ⎟ ⎟ ⎟. the properties of conditional expectations. 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. From (4. under the of ˆ ¢ 2 | x = σ 2 . X 0 DX = X 0 Xσ 2 .Using (4. We have shown that which implies ³ ´ ˆ E β|X =β ³ ´ ˆ E β =β (4. Then given (4. . ¡ X 0X ¢−1 ¡ ¢−1 X 0 DX X 0 X while the ij 0 th oﬀ-diagonal element of D is ¢ ¢ ¡ ¡ E e2 | X = E e2 | xi = σ 2 i i i E (ei ej | X) = E (ei | xi ) E (ej | xj ) = 0. Next. .19) ˆ and thus the OLS estimator β is unbiased for β. and ³ ´ ¡ ¢−1 2 ˆ σ . and (4. σ 2 = σ 2 and we have the simplii ﬁcations D = In σ 2 . for any random vector Z deﬁne the covariance materix V ar(Z) = E (Z − EZ) (Z − EZ)0 = EZZ 0 − (EZ) (EZ)0 ..20) . . 0 0 ··· 0 0 ..8).

˜ so β is unbiased if (and only if) A0 X = Ik . The following result. 32 . however. says that the least-squares estimator is the best choice. ³ ´ ˜ V ar β | X = A0 V ar (e | X) A = A0 Aσ 2 .8 Gauss-Markov Theorem In this section we restrict attention to the homoskedastic linear regression model. and thus can be written as ˜ β = A0 Y where A is an n × k function of X. Thus σ 2 is biased towards zero.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 . = σ2 n the ﬁnal equality by (4. which is (3. 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.7) is unbiased for σ 2 by this calculation. By a calculation similar to those of the previous section. is a famous statement of the solution. ³ ´ ˜ E β | X = A0 Xβ.1 Gauss-Markov. In the homoskedastic linear regression model. In this case. which we now present. What is the best choice of A? The Gauss-Markov theorem. 4. It is important to remember. Theorem 4. ˜ β L = A0 Y = A (Xβ + e) = β + Ae. It is not unbiased in the absence of homoskedasticity. Thus since V ar (e | X) = In σ 2 under homoskedasticity.8. Now consider the class of estimators of β which are linear functions of i the vector Y. we can write The “best” linear estimator is obtained by ﬁnding the matrix A for which this variance is the smallest in the positive deﬁnite sense. the best (minimumvariance) unbiased linear estimator is OLS.10). or in the projection model. as it yields the smallest variance among all unbiased linear estimators. As an alternative. known as the Gauss-Markov theorem.8)¢ ¡ (3. the estimator ˆ 2 deﬁned (4.9) plus E e2 | xi = σ 2 . The least-squares estimator is the special case obtained by setting A = X(X 0 X)−1 .

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

and any continuous distribution can be arbitrarily well approximated by a multinomial distribution.22) 34 .9). He proves that generically the OLS estimator (4.10 Omitted Variables xi = µ x1i x2i ¶ . He observes that the above argument holds for all multinomial distributions. 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 . Since this is a regular parametric model the MLE is asymptotically eﬃcient (see Appendix A. Chamberlain (1987) extends this argument to the case of continuously-distributed data. 1X xi x0 i n i=1 1X xi yi n i=1 n ˆ = β ols 4. (4.5. the maximum likelihood estimator is identical to the OLS estimator. and thus so is the OLS estimator.Substituting in the expressions for π j . 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 .1. ˆ r X j=1 πj ξ j ξ 0 ˆ j r n X1X ¡ ¢ = 1 (yi = τ j ) 1 xi = ξ j ξ j ξ 0 j n j=1 = 1 n 1 n i=1 n X X r i=1 j=1 n X i=1 ¡ ¢ 1 (yi = τ j ) 1 xi = ξ j xi x0 i = and r X j=1 xi x0 i πj ξ j τ j ˆ r n X1X ¡ ¢ = 1 (yi = τ j ) 1 xi = ξ j ξ j τ j n j=1 i=1 = r n ¡ ¢ 1 XX 1 (yi = τ j ) 1 xi = ξ j xi yi n = Thus ˆ β mle = Ã 1 n n i=1 j=1 n X i=1 xi yi !−1 Ã ! In other words.4) is an asymptotically eﬃcient estimator for the parameter β deﬁned in (3.10) for the class of models satisfying Assumption 3. if the data have a discrete distribution.

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

the worse the precision of the individual coeﬃcient estimates. Thus the more “collinear” are the estimate σ 2 1 − ρ2 regressors.25) below. We can also deﬁne the leave-one-out residual ˆ ˆ ei. We can see this most simply in a homoskedastic linear regression model with two regressors yi = x1i β 1 + x2i β 2 + ei . 1] and sum to k. ˆ i A simple comparison yields that ˆ ei − ei.12 Inﬂuential Observations where X(−i) and Y(−i) are the data matrices omitting the i’th row. To investigate the possibility of inﬂuential observations.One implication of near singularity of matrices is that the numerical reliability of the calculations is reduced. µ ¶−1 µ ¶ ³ ´ 2 σ2 1 ρ 1 −ρ ˆ|X = σ . We derive expression (4. that is. If the i’th observation 36 . In extreme cases it is possible that the reported calculations will be in error due to ﬂoating-point calculation diﬃculties. The hi take values in [0. A more relevant implication of near multicollinearity is that individual coeﬃcient estimates will be imprecise.26) As we can see.27) (4. This equals ´−1 ³ 0 ˆ X(−i) Y(−i) (4. the precision of individual estimates are reduced. deﬁne the leave-one-out least-squares estimator of β. A convenient alternative expression is ¡ ¢−1 ˆ ˆ xi ei ˆ (4. = V ar β ρ 1 n n (1 − ρ2 ) −ρ 1 4. the OLS estimator based on the sample excluding the i’th observation. it is statistically diﬃcult to disentangle the impact of β 1 from that of β 2 .−i = yi − x0 β (−i) = (1 − hi )−1 ei . and 1 0 XX= n µ 1 ρ ρ 1 ¶ In this case The correlation ρ indexes collinearity.24) β (−i) = X(−i) X(−i) is the i’th diagonal element of the projection matrix X (X 0 X)−1 X 0 . the change in the coeﬃcient estimate by deletion of the i’th observation depends critically on the magnitude of hi . What is happening is that when the regressors are highly dependent. since as ρ approaches 1 the matrix becomes singular.−i = (1 − hi )−1 hi ei . We can see the eﬀect of collinearity on precision by observing that the asymptotic variance of a coeﬃcient ¡ ¢−1 approaches inﬁnity as ρ approaches 1.25) 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. ˆ ˆ (4. As a consequence.

¢−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 . The key is equation (2. which is considerably more informative than plots of the uncorrected residuals ei . Investigations into the presence of inﬂuential observations can plot the values of (4. ˆ = β − (1 − hi )−1 X 0 X and thus ˆ β (−i) = 37 .27). 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 .25). ˆ We now derive equation (4.1) in Section 2.This implies has a large value of hi .

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

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

This is a probabilistic way of generalizing the mathematical deﬁnition of a limit. Let a + bx be the tangent line to g(x) at x = EX. ¥ Proof of Holder’s Inequality. Since g(x) is convex. 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}. denoted Zn →p Z as n → ∞. then as n → ∞ n 1X Xn = Xi →p E(X). So for all x. p p p q which is (5. Eg(X) ≥ a + bEX = g(EX). Let U = |X|p /E |X|p and V = |Y |q /E |Y |q . =E U V p q p q Proof of Markov’s Inequality. (5. Theorem 5. P (g(X) > α) ≤ α−1 Eg(X). n→∞ lim P (|Zn − Z| > δ) = 0.2 Weak Law of Large Numbers Let Zn ∈ Rk be a random vector. Note EU = EV = 1. Set Y = g(X) and let f denote the density function of Y. 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 ) = + . If Xi ∈ Rk is iid and E |Xi | < ∞. We say that Zn converges in probability to Z as n → ∞. (E |X|p )1/p (E |Y |q )1/q ¥ µ ¶ ´ ³ U V 1 1 1/p 1/q ≤E + = + = 1.2.3). as stated.1 Weak Law of Large Numbers (WLLN).Markov’s Inequality. n i=1 42 .4) Proof of Jensen’s Inequality. g(x) ≥ a + bx yet g(EX) = a + bEX since the curve is tangent at EX. Applying expectations. ¥ 5. if for all δ > 0. For any strictly increasing function g(X) ≥ 0. tangent lines lie below it. The WLLN shows that sample averages converge in probability to the population average.

¯ ¯ ¯ ¯ ¯ ¯ ¢ E ¯X n ¯ ¡¯ ¯ E ¯W n ¯ + E ¯Z n ¯ 3ε ≤ ≤ = η.6) and (5. by Markov’s inequality (5.1 Central Limit Theorem (CLT). and the bound |Wi | ≤ 2C.5) (where 1 (·) is the indicator function) which is possible since E |X| < ∞.5).3 Convergence in Distribution Let Zn be a random variable with distribution Fn (x) = P (Zn ≤ x) . denoted Zn →d Z.Proof: Without loss of generality.1) and (5.7). Theorem 5. Set ε = δη/3.1). (5. We say that Zn converges in distribution to Z as n → ∞. ≤ 2E |Xi | 1 (|Xi | > C) Zi = Xi 1 (|Xi | > C) − E (Xi 1 (|Xi | > C)) . 5. the fact that the Wi are iid and mean zero. If Xi ∈ Rk is iid and E |Xi |2 < ∞. the triangle inequality. where Z has distribution F (x) = P (Z ≤ x) . ≤ E |Xi | 1 (|Xi | > C) + |E (Xi 1 (|Xi | > C))| (5. Fix δ and η. We have shown that for any δ > 0 and η > 0 then for all ¢ ¡¯ ¯ ¥ n ≥ 36C 2 /δ 2 η 2 .7) the ﬁnal inequality holding for n ≥ 4C 2 /ε2 = 36C 2 /δ 2 η 2 . ¯¢2 ¡ ¯ 2 ≤ EW n E ¯W n ¯ = EWi2 n 4C 2 ≤ n ≤ ε2 (5. ¡¯ ¯ P ¯X n ¯ > δ ≤ η. P ¯X n ¯ > δ ≤ η. as needed. Finally. Pick C < ∞ large enough so that E (|X| 1 (|X| > C)) ≤ ε (5. ¯ ¯ E ¯Z n ¯ ≤ E |Zi | ≤ 2ε. Fn (x) → F (x) as n → ∞. if for all x at which F (x) is continuous. then as n→∞ n ¢ √ ¡ 1 X n Xn − µ = √ (Xi − µ) →d N (0.3. Jensen’s inequality (5.4). V ) . n i=1 0 where µ = EX and V = E (X − µ) (X − µ) . 43 . we can set E(X) = 0 (by recentering Xi on its expectation). P ¯X n ¯ > δ ≤ δ δ δ the equality by the deﬁnition of ε. Deﬁne the random vectors Wi = Xi 1 (|Xi | ≤ C) − E (Xi 1 (|Xi | ≤ C)) By the triangle inequality.6) By Jensen’s inequality (5. We need to ¢show that for all δ > 0 and η > 0 there is some N < ∞ so that for all n ≥ N. the fact that X n = W n + Z n .

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

45 . 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 .4. for each element of g. √ Theorem 5. gθ Σgθ . If Zn →p c as n → ∞ and g (·) is continuous at c. Σ) = N 0. then g(Zn ) →p g(c) as n → ∞. Proof: Since g is continuous at c.1 Continuous Mapping Theorem 1 (CMT). It follows that ajn = gjθ (θ∗ ) − gjθ →p 0. Since cλλ (λn ) → cλλ (0) = −Ik . µ ¶ 1 Cn (λ) → exp − λ0 λ 2 the characteristic function of the N (0. and g(θ) : Rm → Rk . k ≤ m. Ik ) distribution. Hence g(Zn ) →p g(c) as n → ∞. then g(Zn ) →d g(Z) as n → ∞.4. Stacking across elements of g. If Zn →d Z as n → ∞ and g (·) is continuous. for all ε > 0 we can ﬁnd a δ > 0 such that if |Zn − c| < δ then |g (Zn ) − g (c)| ≤ ε. ¥ 5. Recall that A ⊂ B implies P (A) ≤ P (B). gθ Σgθ where gθ (θ) = ∂ g(θ) ∂θ0 and gθ = gθ (θ0 ).4. we see that as n → ∞. Theorem 5. where θ is m × 1 and Σ is m × m.√ where λn → 0 lies on the line segment joining 0 and λ/ n. we ﬁnd jn ¢ ¡ √ √ 0 n (g (θn ) − g(θ0 )) = (gθ + an ) n (θn − θ0 ) →d gθ N (0.2 Continuous Mapping Theorem 2.4 Asymptotic Transformations Theorem 5. then ¡ ¢ √ 0 n (g (θn ) − g(θ0 )) →d N 0.3 Delta Method: If n (θn − θ0 ) →d N (0. Proof : By a vector Taylor series expansion. Σ) . Thus P (|g (Zn ) − g (c)| ≤ ε) ≥ P (|Zn − c| < δ) → 1 as n → ∞ by the assumption that Zn →p c. This is suﬃcient to establish the theorem.

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

Assumption 3.1 and the WLLN (Theorem 5. First. To characterize the sampling distribution more fully. (6. the OLS estimator β is has a statistical distribution which is unknown. 0) = Q−1 0 = 0 β−β =g n n i=1 i=1 ˆ which implies β →p β as stated. ·) is continuous at (Q. Ã n ! n X 1X 0 1 ˆ xi xi . and the continuous mapping theorem (Theorem 5.1).1 by the fact that the sampling densities become more concentrated as n gets larger.1) and ˆ We now deduce the consistency of β.1).4.From the ﬁgure we can see that the density functions are dispersed and highly non-normal.3). we will use the methods of asymptotic approximation. (6.2. we can conclude ˆ that β →p β.1). This is illustrated in Figure 6. Proof. Hence by the continuous mapping theorem (Theorem 5. 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 . As the sample size increases the density becomes more concentrated about the population coeﬃcient. Asymptotic (large sample) methods approximate sampling distributions based on the limiting experiment that the sample size n tends to inﬁnity.4.4 implies that Q−1 exists and thus g(·. xi ei →p g (Q.5.2) i i n i=1 n From (6.2.1). xi ei = g i n n i=1 i=1 1X xi ei →p E (xi ei ) = 0. ¥ We can similarly show that the estimators σ 2 and s2 are consistent for σ 2 .1. Assumption 3.2).2 Consistency ˆ As discussed in Section 6.3) Ã where g(A.8) implies that ˆ β−β = Ã n X i=1 xi x0 i !−1 n X i=1 xi ei . ˆ Theorem 6.5. using (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. Equation (4.1.1. (6. 0).1 Under Assumption 3. n i=1 (6. For a complete argument.5. ˆ 47 . 6. β →p β as n → ∞.1) imply that n ¡ ¢ 1X xi x0 →p E xi x0 = Q (6. b) = A−1 b is a continuous function of A and b at all values of the arguments such that A−1 exist.

(6.2).2.1).1.3 Asymptotic Normality ˆ We now establish the asymptotic distribution of β after normalization.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. We need a strengthening of the moment conditions. n 1 X √ xi ei →d N (0. ˆ Finally.3. Ee4 < ∞ and E |xi |4 < ∞. ˆ Proof. σ 2 →p σ 2 and s2 →p σ 2 as n → ∞.Theorem 6.1). E ¯ei ¯ E ¯e4 ¯ i i i i (6. i Now deﬁne ¡ ¢ Ω = E xi x0 e2 . (6.5) Thus xi ei is iid with mean zero and has covariance matrix Ω. ´1/2 ¡ ¯ ¯¢ ¯ ³ ¯ ¯2 ´1/2 ¡ ¯ 4 ¯¢1/2 ³ ¯ 1/2 E ¯xi x0 e2 ¯ ≤ E ¯xi x0 ¯ = E |xi |4 < ∞.6) n i=1 48 .3) and Theorem (6. Thus σ 2 is consistent for σ 2 . Assumption 6.2. Ω) .5.2 Under Assumption 3. by the Cauchy-Schwarz inequality (5. By the central limit theorem (Theorem 5. i i Assumption 6. since n/(n − k) → 1 as n → ∞.3.2).3.1 In addition to Assumption 3. it follows that s2 = ¥ n σ 2 →p σ 2 . (6. ˆ n−k 6.5. Note that ˆ ei = yi − x0 β ˆ i i Thus and n ˆ = ei + x0 β − x0 β i i ³ ´ ˆ = ei − x0 β − β . (6.1 guarantees that the elements of Ω are ﬁnite.1. To see this.

8) Ω = E xi x0 E e2 = Qσ 2 i i V = Q−1 ΩQ−1 = Q−1 σ 2 ≡ V 0 (6.1).1. How large should n be in order for the approximation to be useful? Unfortunately. We call V 0 the homoskedastic covariance matrix. and εi is independent of xi with the Double Pareto density f (ε) = α |ε|−α−1 .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.6). Let yi = β 0 + β 1 xi + εi where xi is N (0.2 we display the ﬁnite sample densities of the q ³ ˆ normalized estimator n α−2 β 2 − β 2 . for example.7) the asymptotic variance formulas simplify as ¡ ¢ ¡ ¢ (6. otherwise V 6= V 0 .2).Then using (6. i i Condition (6. (6. V is often referred to as ˆ the asymptotic covariance matrix of β.3.1. The trouble is that no matter how large is the sample size.3. 1) asymptotic distibution. The expression V = Q−1 ΩQ−1 is called a sandwich form.3. For α 49 . When (6. Under (6. the normal approximation is arbitrarily poor for some data distribution satisfying the assumptions. but this is not a necessary condition.1 is commonly used to approximate the ﬁnite of √ ³ˆ sample 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 (0.7) is true then V = V 0 . Theorem 6. xi ) which satisfy the conditions of Assumption 6. there is no simple answer to this reasonable question. as n → ∞ ´ √ ³ ˆ n β − β →d N (0. Ω) ¡ ¢ = N 0. ´ √ ³ˆ As V is the variance of the asymptotic distribution of n β − β . As α approaches 2. However. after rescaling. We illustrate this problem using a simulation.1 Under Assumption 6. 1). Q−1 ΩQ−1 .3. This holds true for all joint distibutions of (yi . |ε| ≥ 1. when xi and ei are independent. There is a special case where Ω and V simplify. The asymptotic distribution ´ Theorem 6. V ) where V = Q−1 ΩQ−1 . ´ √ ³ ˆ n β−β = Ã 1X xi x0 i n i=1 n !−1 Ã Theorem 6.7) Cov(xi x0 . In Figure 6. for any ˆ ﬁxed n the sampling distribution of β can be arbitrarily far from the normal distribution.7) holds.9) In (6. and (6. is approximately normal when the sample size n is suﬃciently large. e2 ) = 0.9) we deﬁne V 0 = Q−1 σ 2 whether (6. The approximation may be poor when n is small.1 states that the sampling distribution of the least-squares estimator. In´Figure 6. We say that ei is a Homoskedastic Projection Error when (6. however. 1 X √ xi ei n i=1 n ! the N (0. If α > 2 the 2 error εi has zero mean and variance α/(α − 2). its variance diverges q ³ ´ ˆ to inﬁnity. setting n = 100 and varying the parameter α.3.7) is true or false.

2.0 the density is very close to the N (0. for k = 1. As α diminishes the density changes signiﬁcantly. the sampling distribution becomes highly skewed and non-normal. We show the sampling distribution of n β 1 − β 1 setting n = 100. 6 and 8. The homoskedastic covariance matrix V 0 = Q−1 σ 2 is typically estimated by ˆ ˆ (6. concentrating most of the probability mass around zero. 1).3. 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 (0.4 Let Covariance Matrix Estimation 1X ˆ xi x0 Q= i n i=1 n be the method of moments estimator for Q. The MME estimator is i i 1X ˆ xi x0 e2 Ω= i ˆi n i=1 n (6. 1) density. we need an estimate of Ω = E xi x0 e2 . The estimator 2 2 in (6.2) and Theorem 6. Another example is shown in Figure 6.10) V 0 = Q−1 s2 .1) it is clear that V 0 →p V 0 . σ may also be substituted for s ˆ ¡ ¢ To estimate V = Q−1 ΩQ−1 .2: Density of Normalized OLS estimator α = 3.11) 50 . 1) asymptotic approximation is never guaranteed to be accurate.Figure 6.2 and 6. 4. As k increases. ˆ ˆ Since Q →p Q and s2 →p σ 2 (see (6.3 is that the N (0.10) without changing this result. 6. The lesson from Figures 6.

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

14 205.199 2. (.80 2. The standard errors for β 0 are 7. It is also important to understand that a particular standard error may be relevant under one set of model assumptions.14 6. by Holder’s inequality (5. From a computational standpoint. (6.14 14. Using (6.30 + 0.4) ˆ Ω = = n n n ³ ´0 ³ ´0 ³ ´ 1X 2X 1X 0 2 0 ˆ ˆ ˆ xi xi ei − xi xi β − β xi ei + xi x0 β − β xi x0 β − β .12) in turn.80 40. To illustrate.80 .14 14.used by an author when studying their work.5) and the WLLN (Theorem 5. p ˆ In this case the two estimates are quite similar. just as any other estimator.83 ¶−1 µ . from which it follows that V →p V as n → ∞. then take the diagonal elements.480 .14 205.20 −0.80 40. the standard method to calculate the standard errors is to ˆ ﬁrst calculate n−1 V . Ω 2.6 ¶µ 1 14.35/988 = .117 Educationi .12) i i n n n i=1 i=1 We now examine each sum on the right-hand-side of (6.83 −0. We can write the estimated equation with standards errors using the format \ log(W agei ) = 1.2.035 ¶ .085) (.085 p ˆ and that for β 1 is . we return to the log wage regression of Section 4.1) show that n ¡ ¢ 1X xi x0 e2 →p E xi x0 e2 = Ω.480 ˆ0 = 0.020.83 ¶−1 = µ 7.199 2.6 Therefore the two covariance matrix estimates are µ ¶−1 µ ¶ 1 14.3) so by the WLLN ³ ´ ³ ´3/4 ¡ ¯ ¯¢ 1/4 E |xi |3 |ei | ≤ E |xi |4 < ∞. (6. E ¯e4 ¯ i ³ ´ 1X |xi |3 |ei | →p E |xi |3 |ei | . n n i=1 52 .039 and ˆ V = µ 1 14.020) 6. We calculate that s2 = 0. and then the square roots.493 0.20 = V 14.98 −0. i i i i n i=1 Second. First.14 205.2/988 = .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. but not under another set of assumptions.493 −0.20 and µ ¶ ˆ = 0.1.

you can show that 1 Xˆ ¯ β= β (−i) . 6. MacKinnon and White (1985) present numerical (simulation) evidence i ˆ ˆ that V ∗ works better than V as an estimator of V . From equation (3.26).6 Alternative Covariance Matrix Estimators ˆ MacKinnon and White (1985) suggested a small-sample corrected version of V based on the jackˆ knife principle. Andrews’ proposed estimator is ˆ ˆ ˆ ˆ V ∗∗ = Q−1 Ω∗∗ Q−1 53 . which. ¯ ¯ ¯ ¯ ¯n ¯ n i=1 i=1 1X |xi |4 →p E |xi |4 . They also suggest that the scaling factor (n − 1)/n in (??) can be omitted. ¯ 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. Ω →p Ω and V →p V.11) with the leave-one-out estimator ei.1 As n → ∞. Using this substitution. is deﬁned ˆ ˆ by replacing the OLS residual ei in (6.12 the deﬁnition of β (−i) as the least-squares estimator with the i’th observation deleted.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. 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. i=1 Third.13) of Efron (1982). Recall from Section 4.13) Using formula (4. these establish consistency.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 . 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. ¯ ¯n ¯ n i=1 so Together.25). Andrews (1991) suggested an similar estimator based on cross-validation.−i = (1 − hi )−1 ei ˆ presented in (4.¯ ¯ ¯ ¯ˆ and thus since ¯β − β ¯ →p 0. n i=1 n ˆ ˆ Theorem 6.

then the natural estimate for the variance of ˆ is θ ˆ0 ˆ ˆ ˆ Vθ = Hβ V Hβ where ∂ ˆ ˆ h(β). The estimate of θ is ˆ = h(β).. so Vθ = R0 V 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. Hβ = ∂β In many cases. By a ﬁrst-order Taylor series approximation: ³ ´ 0 ˆ ˆ h(β) ' h(β) + Hβ β − β . = N (0. .where ˆ It is similar to the MacKinnon-White estimator V ∗ . V ) where ∂ h(β) ∂β (k + 1) × q. ˆ ˆ If V is the estimated covariance matrix for β. In this case. (6.7 Functions of Parameters Sometimes we are interested in some lower-dimensional function of the parameter vector β = (β 1 . Vθ ). Let h : Rk → Rq denote this function and let θ = h(β) denote the parameter of interest.. In these cases we can write the parameter of interest as a function of β. For example. Andrews ˆ ˆ (1991) argues that simulation evidence indicates that V ∗∗ is an improvement on V ∗ . β k+1 ). Hβ = R and Hβ = R.15) where 0 Vθ = Hβ V Hβ . but omits the mean correction. 1X ˆ (1 − hi )−2 xi x0 e2 .. 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. ˆ θ What is an appropriate standard error for ˆ Assume that h(β) is diﬀerentiable at the true θ? value of β. 54 . the function h(β) is linear: h(β) = R0 β ˆ ˆ ˆ for some k × q matrix R.

1) →d ˆ−θ θ . θ) β 6. Since the standard normal distribution does not depend on the parameters. pivotal statistics are unavailable and so we must rely on asymptotically pivotal statistics. we say that tn is an exactly pivotal statistic. Consider the studentized statistic tn (θ) = Theorem 6. (For example. In this case. A simple null and composite hypothesis takes the form H0 : θ = θ0 H1 : θ 6= θ0 where θ0 is some pre-speciﬁed value. ˆ its estimate and s(ˆ its asymptotic θ θ) standard error.8. s(ˆ θ) (6. ˆ When q = 1q h(β) is real-valued). β 2 ). the standard error for ˆ is the square root of n−1 Vθ . Vθ ) √ Vθ = N (0. then θ = R0 β = β 1 and ˆ Vθ = ¡ I 0 ¢ ˆ V µ I 0 ¶ ˆ = V11 . 1) Proof. we say that tn (θ) is asymptotically pivotal.15) tn (θ) = ˆ−θ θ s(ˆ θ) ´ √ ³ˆ n θ−θ q = ˆ Vθ N (0.8 t tests Let θ = h(β) : Rk → R be any parameter of interest. that (so θ ˆ ˆ ˆ is. In general. the statistic tn has an exact t distribution. if R is a “selector matrix” R= so that if β = (β 1 . By (6. s(ˆ = n−1/2 H 0 V Hβ .16) ¥ Thus the asymptotic distribution of the t-ratio tn (θ) is the standard normal. however. see Section X).1 tn (θ) →d N (0. and θ = h(β) is some function of the parameter vector.For example. In special cases (such as the normal regression model. θ could be a single element of β). and is therefore exactly free of unknowns. µ I 0 ¶ ˆ the upper-left block of V . 55 .

The p-value is more general. Another helpful observation is that the p-value function has simply made a unit-free transformation of the test statistic. 1). 1]. Thus an equivalent statement of a Neyman-Pearson test is to reject at the α% level if and only if pn < α. In a sense. A test of asymptotic signiﬁcance α rejects H0 if |tn | > zα/2 . associated with Fisher. if Z ∼ N (0. tn →d N (0.96 and z. If the p-value pn is small (close to zero) then the evidence against H0 is strong. or “accepts” H0 . Let zα/2 is the upper α/2 quantile of the standard normal distribution. The rejection/acceptance dichotomy is associated with the Neyman-Pearson approach to hypothesis testing.The standard test for H0 against H1 is the t-statistic (or studentized statistic) tn = tn (θ0 ) = ˆ − θ0 θ . 6. The asymptotic p-value for the above statistic is constructed as follows.025 = 1. The coverage probability is P (θ ∈ Cn ). in contrast to Neyman-Pearson rejection/acceptance reporting where the researcher picks the level. in that the reader is allowed to pick the level of signiﬁcance α. so the “unusualness” of the test statistic can be compared to the easy-to-understand uniform distribution. or asymptotic p-value function p(t) = P (|Z| > |t|) = 2 (1 − Φ(|t|)) . P (1 − p(tn ) ≤ u) establishing that 1 − pn →d U [0. 1]. Deﬁne the tail probability. note that the asymptotic distribution of |tn | is F (x) = 1 − p(x). Thus P (1 − pn ≤ u) = = P (F (tn ) ≤ u) ¡ ¢ = P |tn | ≤ F −1 (u) ¡ ¢ → F F −1 (u) = u.645. and is a function of the data and hence is / random.9 Conﬁdence Intervals A conﬁdence interval Cn is an interval estimate of θ. This is because ¡ ¢ P (reject H0 | H0 true) = P |tn | > zα/2 | θ = θ0 ¢ ¡ → P |Z| > zα/2 = α. p-values and hypothesis tests are equivalent since pn < α if and only if |tn | > zα/2 . That is. s(ˆ θ) Under H0 . For example. To see this fact. under H0 . 1). however. It is designed to cover θ with high probability. regardless of the complication of the distribution of the original test statistic.05 = 1. Then the asymptotic p-value of the statistic tn is pn = p(tn ). 56 . z. Otherwise the test does not reject. That is. pn →d U [0. 1]. is to report an asymptotic p-value. An alternative approach. Either θ ∈ Cn or θ ∈ Cn . then P (Z > zα/2 ) = α/2 and P (|Z| > zα/2 ) = α. from which it follows that pn →d U [0.

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

5. Hβ (β) →p Hβ . the covariance What we will show in this section is that if V is replaced with V 0 = σ 2 n−1 X 0 X matrix estimator valid under homoskedasticity.When h is a linear function of β. and there are q = k2 restrictions. the upper-α quantile q 2 of the χ2 distribution. h(β) = R0 β. if rank(Hβ ) = q. The asymptotic p-value for Wn is pn = p(Wn ). θ = β 2 . q and pn is asymptotically U[0. In this case.3. For example. Also h(β) = a selector matrix. ˜ 58 ¡ 0 ¢−1 0 ˜ β 1 = X1 X1 X1 Y . a chiq square random variable with q degrees of freedom.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 .1 Under H0 and Assumption 6.1 showed θ ˆ that V →p V. then the Wald statistic can be written in the form ¶ µ 2 ˆ σ − σ2 ˜ Wn = n (6.10. χ2 (. Hβ (β) is a continuous function of β. ˆ Wn = n θ θ q θ θ Theorem 6.84 = z. then Wn →d χ2 . ˜˜ 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 . the test rejects at the α% level iﬀ pn < α. Wn = n R0 β − θ0 ´ √ ³ The delta method (6.2. Hence β β by Theorem A. 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. so by the continuous mapping ˆ ˆ ˆ ˆ ˆ theorem. The Wald test fails to reject if Wn is q 1 ¡ ¢ less than χ2 (α). As before. Thus Vθ = H 0 V Hβ →p H 0 V Hβ = Vθ > 0 if Hβ has full rank q. We have established: ³ ´0 ³ ´ ˆ − θ0 V −1 ˆ − θ0 →d Z 0 V −1 Z = χ2 .8.1. Vθ ). 6.05) = 3.15) showed that n ˆ − θ →d Z ∼ N (0.025 . An asymptotic Wald test rejects H0 in favor of H1 if Wn exceeds χ2 (α).19) σ2 ˆ where σ2 = ˜ 1 0 e e. Furthermore. and Theorem 6. The null hypothesis is H0 : β 2 = 0. 1] under H0 . = nβ 2 R0 V R R0 β is linear with R = µ 0 I ¶ ¢−1 ¡ ˆ ˆ ˆ . where p(x) = P χ2 ≥ x is the tail q q probability function of the χ2 distribution.

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

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

σ 2 ) where β 1 is the OLS estimate from ˜ 2 ˜ a regression of yi on x1i only. n−k • ∼ tn−k ˆ In Theorem 6. σ2 ˆ 61 .) Now let us partition β = (β 1 .10) then ´ ³ ˆ • β ∼ N 0. 0. Theorem 6. As inference (conﬁdence intervals) are based on the t-ratio. σ ˆ ˆ βj − βj βj − βj N (0. σ 2 ) = − log σ − log (2π) − . 0.1 we showed that in large samples. σ 2 ) = − log 2πˆ 2 − 2 e0 e ˆˆ 2 2ˆ σ ¡ ¢ n n n = − log σ 2 − log (2π) − . β 2 . β 2 . σ 2 ). β has an exact normal distribution and t has an exact t distribution. σ 2 ) − Ln (β 1 . The Gaussian log-likelihood at these estimates is ¡ ¢ n 1 ˆ ˆ ˆ σ Ln (β 1 . The log-likelihood of this model is ¡ 2¢ n n n ˜ ˜ ˜ Ln (β 1 .8. and standard errors are calculated using the homoskedastic formula (6. The critical values are quite close if n − k ≥ 30.3. 0. the notable distinction is between the N (0. σ 2 ) ¡ ¢¢ ¡ ¡ ¢ ˆ = n log σ 2 − log σ 2 ˜ µ 2¶ σ ˜ = n log . σ 2 ) discussed above. which is twice the diﬀerence in the log-likelihood function evaluated under the null and alternative hypotheses. β 2 . Furthermore.12. σ 2 (X 0 X)−1 • (n−k)s2 σ2 ˆ β j −β j ˆ s(β ) j ∼ χ2 . ˆ 2 2 2 ˜ ˜ The MLE of the model under the null hypothesis is (β 1 . (Unless the sample size is unreasonably small. In contrast. if standard errors are calculated using the homoskedastic formula (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.12. 2 2 2 The LR statistic for H0 is ´ ³ ˆ ˆ ˆ ˜ ˜ LR = 2 Ln (β 1 .1 shows that under the strong assumption of ˆ normality. β and t are approximately normally distributed.1 If ei is independent of xi and distributed N(0. a good testing procedure is based on the likelihood ratio statistic.a chi-square distribution with n − k degrees of freedom. so as a practical matter it does not matter which distribution is used.10) µ h i ¶ 2 (X 0 X)−1 N 0. with residual variance σ . We summarize these ﬁndings Theorem 6. 1) jj rh ∼ tn−k = rh i ∼q i = q χ2 ˆ s(β j ) n−k σ2 2 0 X)−1 0 X)−1 (X s (X n−k n−k χn−k jj jj a t distribution with n − k degrees of freedom.1 and Theorem 6. 1) and tn−k distributions. The estimator under the alternative is the unrestricted estimator ˆ ˆ ˆ (β 1 .

This produces random draws from the sampling distribution of interest. they can work quite poorly when the restrictions are nonlinear. LR = n log 1 + 2 − 1 ' n σ ˆ σ2 ˆ the F statistic. 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.By a ﬁrst-order Taylor series approximation ¶ µ 2 ¶ µ σ ˜ σ2 ˜ − 1 = Wn . we ﬁnd that the standard Wald test for H0 (s) is ´2 ³ s ˆ β −1 Wn (s) = n 2s−2 . Through repetition. This is distressing since the choice of s seems arbitrary and irrelevant to the actual hypothesis. The increasing solid line is for the case β = 0.7. This can be seen by a simple example introduced by Lafontaine and White (1986). setting n/σ 2 = 10. The decreasing dashed ˆ = 1.84 — the probability of a false rejection.8. while there are other values of s for which test test statistic is insigniﬁcant. as Wn (s) →d χ2 under H0 for 1 any 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. σ 2 ) and consider the hypothesis H0 : β = 1. 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. 62 . Our ﬁrst-order asymptotic theory is not useful to help pick s. Take the model yi = β + ei ei ∼ N (0. The method uses random simulation to create an artiﬁcial dataset to apply the statistical tools of interest. 6. To demonstrate this eﬀect. Then the standard Wald test for H0 is ˆ ³ ´2 ˆ β−1 Wn = n . σ 2 s2 β ˆ ˆ While the hypothesis β s = 1 is unaﬀected by the choice of s. and noting Hβ = sβ s−1 . the statistic Wn (s) varies with s. This is an unfortunate feature of the Wald statistic. one feature of importance is the Type I error of the test using the asymptotic 5% critical value 3.4 the Wald statistic Wn (s) as a function ˆ of s. σ2 ˆ Now notice that H0 is equivalent to the hypothesis H0 (s) : β s = 1 for any positive integer s. ˆ Let β and σ 2 be the sample mean and variance of yi . Letting h(β) = β s . we have plotted in Figure 6. In the present context of the Wald statistic. features of this distribution can be calculated.

Error rates avove 10% are considered excessive. remember that the ideal Type I error probability is 5% (.1 reports the simulation estimate of the Type I error probability from 50. Rates above 20% are unexceptable. In Table 2.1 Type I error Probability of Asymptotic 5% Wn (s) Test 63 . Each row of the table corresponds to a diﬀerent value of s — and thus corresponds to a particular choice of test statistic. Type I error rates between 3% and 8% are considered reasonable. Typically.000 random samples.4: Wald Statistic as a function of s P (Wn (s) > 3. Table 4. For this particular example. Given the simplicity of the model. 100 and 500. In each case. To interpret the table. In Table 4.1 you can also see the impact of variation in sample size.1 we report the results of a Monte Carlo simulation where we vary these three parameters. this probability depends only on s. Table 4. and σ is varied among 1 and 3. we compare the rates row by row. There is. Any other choice of s leads to a test with unacceptable Type I error probabilities. which is not surprising given the dependence of Wn (s) on s as shown in Figure 6. The null hypothesis β s = 1 is true.000 simulated Wald statistics Wn (s) which are larger than 3. and σ 2 . When comparing statistical procedures. no magic choice of n for which all tests perform uniformly well.Figure 6. The second through seventh columns contain the Type I error probabilities for diﬀerent combinations of n and σ. looking for tests for which rate rejection rates are close to 5%. and rarely fall outside of the 3%-8% range.84 | β = 1) .84. These probabilities are calculated as the percentage of the 50. Test performance deteriorates as s increases.4. the Type I error probability improves towards 5% as the sample size n increases. n is varied among 20. so these probabilities are Type I error. n. The value of s is varied from 1 to 10. however.05) with deviations indicating+ distortion. the only test which meets this criterion is the conventional Wn = Wn (1) test.

06 .06 .06 .11 . While this is clear in this particular example.10 .35 .20) ³ ´1/2 ˆ0 ˆ ˆ so that the standard error for ˆ is s(ˆ = n−1 H1 V H1 θ θ) .21 . β 2 ) be the least-squares estimates of (6.31 .07 .22 .08 . Equivalently.17 .08 .15 .12 .07 .23 .18 .08 . In this case a t-statistic for H0 is t1n = ³ˆ β1 ˆ β2 where r is a known constant.07 .33 .05 .12 .13 .16 Rejection frequencies from 50.06 .24 . Deﬁne θ ˆ ˆ ⎞ ⎛ 0 ⎟ ⎜ ⎟ ⎜ ⎜ 1 ⎟ ⎟ ⎜ ⎜ ˆ ⎟ ˆ H1 = ⎜ β 2 ⎟ ⎟ ⎜ ⎟ ⎜ ⎜ β ⎟ ˆ ⎠ ⎝ − 1 ˆ2 β2 ´ s(ˆ θ) −r . in other examples natural choices are not always obvious and the best choices may in fact appear counter-intuitive at ﬁrst.25 .13 .09 .08 .25 .19 .14 .06 . deﬁne θ = β 1 /β 2 .15 .34 .20 .05 .10 .08 .05 .05 .05 .20).14 .000 simulated random samples In this example it is not surprising that the choice s = 1 yields the best test statistic.30 .28 . let V be an estimate of the ˆ asymptotic variance matrix for β and set ˆ = β 1 /β 2 .10 .06 .06 . so the hypothesis can be stated as H0 : θ = r.05 .06 .15 .07 . ˆ ˆ ˆ ˆ ˆ Let β = (β 0 . Take the model yi = β 0 + x1i β 1 + x2i β 2 + ei E (xi ei ) = 0 and the hypothesis H0 : β1 =r β2 (6.15 .13 .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 .07 . β 1 .20 . An alternative statistic can be constructed through reformulating the null hypothesis as H0 : β 1 − rβ 2 = 0.22 .26 . Other choices are arbitrary and would not be used in practice. 64 . This point can be illustrated through another example.

645) and P (tn > 1.06 . . In this section we describe the method in more detail.00 .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.05 β2 . Table 4.05 .645) P (tn > 1. We vary β 2 among .2 is that the two t-ratios have dramatically diﬀerent sampling behavior.75 1. ei be an independent N (0.25. 1) variables.15 . . The common message from both examples is that Wald statistics are sensitive to the algebraic formulation of the null hypothesis. such as the GMM distance statistic which will be presented in Section 9.47 .A t-statistic based on this formulation of the hypothesis is ´2 ³ ˆ 1 − rβ 2 ˆ β =³ ´1/2 . This leaves β 2 as a free parameter.1. We let x1i and x2i be mutually independent N (0. −r ⎛ t2n where To compare t1n and t2n we perform another simple Monte Carlo simulation.06 .00 The one-sided Type I error probabilities P (tn < −1.05 . The left tail probabilities P (t1n < −1. Ideally.15 .645) greatly exceed 5%. the rejection rates for the linear t2n statistic are invariant to the value of β 2 . However. .06 .645) are close to zero in most cases. and 1.645) P (tn > 1. if the hypothesis can be expressed as a linear restriction on the model parameters. then the “most linear” formulation should be selected.05.02 .00 . while the right tail probabilities P (t1n > 1. If no linear formulation is feasible.00 . The results are presented in Table 4.10 . The implication of Table 4. In contrast.28 .06 .50 .05 . and are close to the ideal 5% rate for both sample sizes.00 .000 simulated samples.10 . In all cases.10 .05 . the entries in the table should be 0. 6.05 . and normalize β 0 = 0 and β 1 = 1.2.09 .12 .7.00 .05 .00 .06 . 65 . especially for small values of β 2 .05 .75.06 . It is also prudent to consider alternative tests to the Wald statistic.26 .00 .645) t1n t2n t1n t2n t1n t2n t1n t2n .05 .645) are calculated from 50.06 .645) P (tn < −1.50. this formulation should be used.06 . σ 2 ) draw with σ = 3.00 . along with sample size n.2 Type I error Probability of Asymptotic 5% t-tests n = 100 n = 500 P (tn < −1. and alternatives to asymptotic critical values should be considered.00 .0 and n among 100 and 500.25 .06 . the rejection rates for the t1n statistic diverge greatly from this value. −1 H V H ˆ 2 n 2 ⎞ 0 H2 = ⎝ 1 ⎠ .06 .07 .05 .

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

experience squared. For example. It is therefore convenient to pick B so that N is an integer. As discussed above. such as the percentage estimate reported in (6. but requires more computational time. then we can set s P = (. female. For the dependent variable we use the natural log of wages.22/ B. then B will have to be increased. the choice of B is often guided by the computational demands of the statistical procedure. For regressors we include years of education. and 90% sample quantiles of the sample {Tnb }. If the standard error is too large to make a reliable inference. this may ˆ be approximated by replacing P with P or with an hypothesized value. are.003. Since the results of a Monte Carlo experiment are estimates computed from a random sample of size B.95) /B ' . We now expand the sample all non-military wage earners. experience squared. so that coeﬃcients may be interpreted as semi-elasticities. The typical purpose of a Monte Carlo simulation is to investigate the performance of a statistical procedure (estimator or test) in realistic settings. We would then set Tn = ¯ˆ − θ¯ /s(ˆ and calculate B X ˆ= 1 P 1 (Tnb ≥ 1. and dummy variable indicators for the following: married. immigrant. Quite simply. The α% sample quantile is a number qα such that α% of the sample are less than qα . and non-white. In many cases. where N = (B +1)α. equalling 1 with probability P = E1 (Tnb ≥ 1. a larger B results in more precise estimates of the features of interest of Gn . and therefore it is straightforward to calculate standard errors for any quantity of interest. the researcher must select the number of experiments. and estimate a multivariate regression. potential work experience. we included a dummy 67 . It is therefore useful to conduct a variety of experiments. In particular. and hispanic. union member. potential work experience. if we set B = 999. it is simple to make inferences about rejection probabilities from statistical tests.Suppose we are interested in the ¯Type I error associated with an asymptotic 5% two-sided ¯ ¯ ¯ θ) θ t-test.21) the percentage of the simulated t-ratios which exceed the asymptotic 5% critical value. As P is unknown. and dummy variable indicators for the following: married. respectively.96) is iid Bernoulli. hispanic.96) . B b=1 (6.05) (. immigrant. s P = . Hence the ³ ´ ˆ standard errors for B = 100.21) is therefore an ³ ´ p ˆ unbiased estimator of P with standard error s P = P (1 − P ) /B. an estimator or test may perform wonderfully for some values.022. B. We us the sample of wage earners from the March 2004 Current Population Survey. if we are ³ ´ p √ ˆ assessing an asymptotic 5% test. and .007. excluding military. female. therefore. The random variable 1 (Tnb ≥ 1.96) .15 Estimating a Wage Equation We again return to our wage equation. union member. and 5000. and our regressors include years of education. for a selection of choices of n and F. In practice. Again our dependent variable is the natural log of wages. Suppose we are interested in the 5% and 95% quantile of Tn = ˆ We then compute the 10% θ. . Generally. We separately estimate equations for white and non-whites. For example. A simple way to compute sample quantiles is to sort the sample {Tnb } from low to high. Often this is called the number of replications. and poorly for others. Then qα is the N ’th number in this ordered sequence.21). The average (6. Furthermore. the performance will depend on n and F. then the 5% sample quantile is 50’th sorted value and the 95% sample quantile is the 950’th sorted value. 6. 1000.

032 . θ ˆ 2β 3 β2 . the restricted standard deviation estimate is σ = . reestimating the model with the 50 state dummies excluded. we ﬁnd Wn = 550. 50 Another interesting question which can be addressed from these estimates is the maximal impact of experience on mean wages.002 . Wn = n 1 − 2 = 18.010 .007 .48772 = 515.variable for state of residence (including the District of Columbia. Table 4.00057 . excluding the coeﬃcients on the state dummy variables. as the 1% critical value for the χ2 distribution is 76. this adds 50 regressors).102 −.1 OLS Estimates of Linear Equation for Log(Wage) ˆ β 1.101 .1 we ﬁnd the point estimate ˆ ˆ = − β 2 = 28.19) is ˜ µ ¶ µ ¶ σ2 ˆ . if β 2 > 0 and β 3 < 0 the solution is θ=− From Table 4.00002 . Computing the Wald statistic (6. Using either statistic the hypothesis is easily rejected. but not equal.013 .69.097 −.232 .4945.027 .102 −. 808 1 − .808 so the parameter estimates are quite precise and reported in Table 4. 2β 3 68 .033 −.001 .014 . 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.010 Intercept Education Experience Experience2 Married Female Union Member Immigrant Hispanic Non-White σ ˆ Sample Size R2 One question is whether or not the state dummy variables are relevant.4877 18.070 .49452 σ ˜ Notice that the two statistics are close. The available sample is 18.808 . Alternatively.1. The F form of the Wald statistic (6.121 −.18) that the state coeﬃcients are jointly zero. Ignoring the other coeﬃcients.34 ˆ s(β) .008 .

so we have to go one step further. as the coverage probability of this conﬁdence interval is one minus the Type I error of the hypothesis test based on the t-test. but the lower end is substantially lower. Our desired conﬁdence interval will be the set of parameter values θ which are not rejected by the hypothesis test. we can calculate a standard error of s(ˆ = .5]. Instead.Using the Delta Method.40. This set is [27. Since tn (θ) is a non-linear function of θ. Notice that the upper end of the conﬁdence interval is the same as that from the delta method. However. In the previous section we discovered that such t-tests had very poor Type I error rates. not testing a hypothesis.96.0. 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 ).9. 29. this is a poor choice. In the present context we are interested in forming a conﬁdence interval. we found better Type I error rates by reformulating the hypothesis as a linear restriction. but it can be found numerically quite easily. 69 .5]. 29. This is the set of θ such that |tn (θ)| ≤ 1. there is not a simple expression for this set. implying a 95% conﬁdence θ) interval of [27.

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

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

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

2

is the homoskedasticity-formula standard error.

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

i=1 i=1

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

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

E (xi ei ) = 0

∗ yi = yi + ui

71

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

∗ E (yi ui ) = 0

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

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

• Qi • Di • Ci

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

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

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

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

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

73

. .1 Generalized Least Squares In the projection model. Suppose that we model the conditional variance using the parametric form 0 σ 2 = α0 + z1i α1 i = α0 zi . The GLS estimator (7. σ1 We now discuss this estimation problem. in the linear regression model yi = x0 β + ei i E (ei | xi ) = 0.1) XD Y β = X 0 D−1 X ¡ ¢ 2 . σ 2 } and σ 2 = σ 2 (x ) = E e2 | x .Chapter 7 Additional Regression Topics 7.2) E (ξ i | xi ) = 0. However. 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.. we know that the least-squares estimator is semi-parametrically eﬃcient for the projection coeﬃcient. The GLS estimator is sometimes called where D = diag{σ 1 i i n i i the Aitken estimator. 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... 74 . Often the functional form is kept simple for parsimony. z1i are squares (and perhaps levels) of some (or all) elements of xi . Let η i = e2 ..1) infeasible since the matrix D is unknown. A ˆ ˆn feasible GLS (FGLS) estimator replaces the unknown D with an estimate D = diag{ˆ 2 .. the least-squares estimator is ineﬃcient. 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 .. Typically. where z1i is some q × 1 function of xi . σ 2 }.

If σ 2 < 0 for some i. We may call (7..4) ¡ ¢−1 −1/2 0 √ √ n (˜ − α) = n (ˆ − α) + n−1 Z 0 Z α α n Zφ →d N (0. which is typically undesirable. One typical problem with implementation of FGLS estimation is that in a linear regression ˜i speciﬁcation.Suppose ei (and thus η i ) were observed. Vα ) (7.3) ˆ ˆ While ei is not observed. σ 2 } σ1 ˜n and ³ ´−1 ˜ ˜ ˜ β = X 0 D−1 X X 0 D−1 Y.. 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.6) σ 2 = α0 zi .4) the skedastic regression. and will depend on the model (and estimation method) for the skedastic regression. Thus ˆ i i η − η i = e2 − e2 ˆ ˆi i = φi . xi ). This is the feasible GLS. ˜i Suppose that σ 2 > 0 for all i. 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 .5) ˆ Thus the fact that η i is replaced with η i is asymptotically irrelevant. Furthermore. Vα ) α ¡ ¡ 0 ¢¢−1 ¡ 0 2 ¢ ¡ ¡ 0 ¢¢−1 E zi zi ξ i E zi zi . there is no guarantee that σ 2 > 0 for all i. if σ 2 ≈ 0 for some i. estimator of β. This suggests 75 . . then the FGLS estimator will force ˜i the regression equation through the point (yi . as it is estimating the conditional variance of the regression of yi on xi . we have the OLS residual ei = yi − x0 β = ei − x0 (β − β).. Then ˆ ¢−1 0 ¡ Zη ˆ α = Z 0Z ˜ (7. Vα = E zi zi (7. or FGLS. and hence we can estimate 0 σ 2 = zi α by i ˜ (7. then the FGLS ˜i estimator is not well deﬁned. Since there is not a unique speciﬁcation for the conditional variance the FGLS estimator is not unique. Then set ˜i ˜ D = diag{˜ 2 .

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

in which case ξ i is ˜ independent of xi and the asymptotic variance (7.1 Under H0 and ei independent of xi . as they will be estimating two diﬀerent projections. FGLS will do worse than OLS in practice. The asymptotic distribution (7.2 Testing for Heteroskedasticity ¢ ¡ The hypothesis of homoskedasticity is that E e2 | xi = σ 2 . And the FGLS probability limit will depend on the particular function selected for the skedastic regression. BreuschPagan (1979) proposed what might appear to be ¡ distinct test. If i this simpliﬁcation is replaced by the standard formula (under independence of the error). and this requires trimming to solve. on the other hand. the two tests coincide. Motivated by the form of the asymptotic variance ˆ of the OLS estimator β. and replaced E ξ 2 with 2σ 4 which holds when ei is N(0. and all cross-products. This introduces an element of arbitrariness which is unsettling to empirical researchers. and not a conditional mean.5) and the asymptotic variance (7. This hypothesis does not imply that ξ i is independent of xi . the estimated conditional variances may contain more noise than information about the true conditional variances. In this case. Typically. 7.error. however.4). White (1980) proposed that the test for heteroskedasticity be based on setting zi to equal all non-redundant elements of xi . The GLS and FGLS estimators. The point is that the eﬃciency gains from FGLS are built on the stronger assumption of a correct conditional mean. but also under the assumptions of linear projection. or equivalently that i H0 : α1 = 0 in the regression (7. q Most tests for heteroskedasticity take this basic form. the Wald test of H0 is asymptotically χ2 .3 Forecast Intervals m(x) = E (yi | xi = x) = x0 β. The main diﬀerences between popular “tests” is which transformations of xi enter zi .2.7) Hence the standard test of H0 is a classic F (or Wald) test for exclusion of all regressors from the skedastic regression (7.2).3) for α simpliﬁes to ¡ ¡ 0 ¢¢−1 ¡ 2 ¢ E ξi . Theorem 7.4) and constructing a Wald statistic. require the assumption of a correct conditional mean. but the only diﬀerence is that they a ¢ allowed for general choice of zi . If the equation of interest is a linear projection. individual estimated conditional variances may be negative. Second. OLS is a more robust estimator of the parameter vector. then the OLS and FGLS estimators will converge in probability to diﬀerent limits.7) under independence show that this test has an asymptotic chi-square distribution. Third. In the linear regression model the conditional mean of yi given xi = x is 77 . σ 2 ). its squares. We may therefore test this hypothesis by the estimation (7. and the cost is a reduction of robustness to misspeciﬁcatio 7. It is consistent not only in the regression model. we impose the stronger hypothesis and test the hypothesis that ei is independent of xi . Vα = E zi zi (7.

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

θ)ˆ (7. θi 79 . θ) = G(x0 θ). which alters some of the analysis. let ∂ m(x.8) Theorem 7. then the FOC for minimization are 0= n X i=1 mθ (xi . θ))2 . The least squares estimator ˆ minimizes the sum-of-squared-errors θ Sn (θ) = n X i=1 (yi − m(xi . When the regression function is nonlinear. θ) = (θ1 + θ2 x1 ) 1 (x2 < θ3 ) + (θ4 + θ5 x1 ) 1 (x2 > θ3 ) In the ﬁrst ﬁve examples. θ). θ) = θ1 + θ2 m(x. estimator. θ) is (generically) diﬀerentiable in the parameters θ. First.Examples of nonlinear regression functions include x 1 + θ3 x m(x. V ) θ where mθi = mθ (xi . θ) = θ1 + θ2 exp(θ3 x) m(x. θ) is suggested by an economic model. Since ˆ →p θ0 . In other cases. ´ √ ³ n ˆ − θ0 →d N (0.4.1 If the model is identiﬁed and m(x. ˆ ei . This can be done using arguments θ for optimization estimators. it is adopted as a ﬂexible approximation to an unknown regression function. so the minimization of Sn (θ) only needs to be examined for θ close to θ0 . ¢¢−1 ¡ ¡ ¢¢ ¡ ¡ ¢¢−1 ¡ ¡ E mθi m0 e2 E mθi m0 V = E mθi m0 θi θi i θi Sketch of Proof. θ) = θ1 + θ2 x + θ4 (x − θ3 ) 1 (x > θ3 ) µ ¶ m(x. we call this the nonlinear least squares (NLLS) θ). ˆ is close to θ θ θ0 for n large. When it exists. θ0 ). When m(x. The NLLS residuals are ei = yi − m(xi . but we won’t cover that argument here. θ) is diﬀerentiable with respect to θ. θ) = θ1 + θ2 x1 + (θ3 + θ4 x1 ) Φ θ6 m(x. θ))2 Since sum-of-squared-errors function Sn (θ) is not quadratic. 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 . θ) = ∂θ Nonlinear regression is frequently adopted because the functional form m(x. m(x. it must be shown that ˆ →p θ0 . mθ (x. m is not diﬀerentiable with respect to θ3 . θ) = θ1 + θ2 xθ3 m(x. G known x2 − θ5 m(x. In the ﬁnal two examples. See Appendix E. Let 0 yi = ei + m0 θ0 . θ) is diﬀerentiable. ˆ must be found by numerical θ methods.

In particular. ˆ ˆ θ) ˆ θ). θ0 ) + m0 (θ − θ0 ) . Thus when the truth is that β 2 = 0. by a ﬁrst-order Taylor series approximation. Hansen (1996). ¥ Based on Theorem 7. θ0 ) + m0 (θ − θ0 ) θi = ei − m0 (θ − θ0 ) θi 0 = yi − m0 θ. the model is yi = β 0 zi + εi 1 and both β 2 and γ have dropped out. Furthermore. θ0 )) − m(xi . θi Hence the sum of squared errors function is Sn (θ) = n X i=1 (yi − m(xi . θ) ' m(xi . 1 2 The model is linear when β 2 = 0.5 Least Absolute Deviations We stated that a conventional goal in econometrics is estimation of impact of variation in xi on the central tendency of yi . θ) = β 0 zi + β 0 xi (γ).For θ close to the true value θ0 . 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 . An alternative good measure is the conditional median. Thus the NLLS 0 estimator ˆ has the same asymptotic distribution as the (infeasible) OLS regression of yi on mθi . 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 . θi Thus ¡ ¢ yi − m(xi . Suppose that m(xi . Thus we want to test H0 : β 2 = 0. θ) ' (ei + m(xi . This renders the distribution theory presented in the previous section invalid. under H0 . the parameter estimates are not asymptotically normally distributed.1. Identiﬁcation is often tricky in nonlinear regression models. θ which is that stated in the theorem. tests of H0 do not have asymptotic normal or chi-square distributions. γ is not identiﬁed. We have discussed projections and conditional means. m(xi . and this is often a useful hypothesis (sub-model) to consider. but these are not the only measures of central tendency. ˆ and ei = yi − m(xi . The asymptotic theory of such tests have been worked out by Andrews and Ploberger (1994) and B. 7.4. Hansen shows how to use simulation (similar to the bootstrap) to construct the asymptotic critical values (or p-values) in a given application. 80 . However. This means that under H0 .

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

The main diﬃculty is the estimation of f (0). then there are many innovations near to the median.11). Pn −1 0 β)) . where V = and f (e | x) is the conditional density of ei given xi = x. ∂β 0 so Third.5. ¢¢−1 ¡ ¢¢−1 ¢¡ ¡ 1¡ ¡ 0 Exi x0 E xi x0 f (0 | xi ) E xi xi f (0 | xi ) i i 4 The variance of the asymptotic distribution inversely depends on f (0 | x) . Exi x0 ) i i=1 since Egi (β 0 )gi (β 0 )0 = Exi x0 .1 ´ √ ³ˆ n β − β 0 →d N (0. Second using the law of iterated expectations and the chain rule of i diﬀerentiation.10) is equivalent to g n (β) = 0. ∂β ˆ g(β) ' ´ ³ ∂ ˆ g(β 0 ) β − β 0 . See Chapter 16.Theorem 7. Computation of standard error for LAD estimates typically is based on equation (7. the conditional density of the error at its median. by a Taylor series expansion and the fact g(β 0 ) = 0 82 .1 is advanced. and this improves estimation of the median. ∂ g(β) = ∂β 0 ¡ ¡ ¢¢ ∂ 0 0 Exi 1 − 2 · 1 yi ≤ xi β ∂β £ ¡ ¡ ¢ ¢¤ ∂ = −2 0 E xi E 1 ei ≤ x0 β − x0 β 0 | xi i i ∂β " Z 0 # xi β−x0 β 0 i ∂ = −2 0 E xi f (e | xi ) de ∂β −∞ £ ¢¤ ¡ = −2E xi x0 f x0 β − x0 β 0 | xi i i i £ 0 ¤ ∂ 0 g(β 0 ) = −2E xi xi f (0 | xi ) . Let g(β) = Eg (β). the height of the error density at its median.5. ˆ Proof of Theorem 7.3. This can be done with kernel estimation techniques. V ).11) This simpliﬁcation is similar to the simpliﬁcation of the asymptotic covariance of the OLS estimator under homoskedasticity. then f (0 | x) = f (0) and the asymptotic variance simpliﬁes V = (Exi x0 )−1 i 4f (0)2 (7.1) n X √ −1/2 n (g n (β 0 ) − g(β 0 )) = −n gi (β 0 ) →d N (0.5. When f (0 | x) is large. by the central limit theorem (Theorm 5. we provide a sketch here for completeness. First. We need where g n (β) = n i i=1 gi (β) and gi (β) = xi (1 − 2 · 1 (yi ≤ xi three preliminary result.1: Since sgn (a) = 1 − 2 · 1 (a ≤ 0) . While a complete proof of Theorem 7. (7. In the special case where the error is independent of xi .

12) Qτ = argmin Eρτ (U − θ) .9) for the median to all quantiles. The median is the special case τ = . when F (y | x) is continuous and strictly monotonic in y. This linear speciﬁcation assumes that Qτ (x) = β 0 x where the coeﬃcients β τ τ vary across the quantiles τ . the quantile regression functions can take any shape. We then have the linear quantile regression model yi = x0 β τ + ei i 83 . θ where ρτ (q) is the piecewise linear function ½ −q (1 − τ ) q<0 ρτ (q) = qτ q≥0 = q (τ − 1 (q < 0)) . xi ) with conditional distribution function F (y | x) the conditional quantile function qτ (x) is Qτ (x) = inf {y : F (y | x) ≥ τ } . For the random variables (yi . As functions of x. The third line follows from an asymptotic empirical process argument. The following alternative representation is useful. Again.13) This generalizes representation (7.6 Quantile Regression The method of quantile regression has become quite popular in recent econometric practice. 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. However for computational convenience it is typical to assume that they are (approximately) linear in x (after suitable transformations). For ﬁxed τ . the quantile regression function qτ (x) describes how the τ ’th quantile of the conditional distribution varies with the regressors. The quantile Qτ is the value such that τ (percent) of the mass of the distribution is less than Qτ . If the random variable U has τ ’th quantile Qτ .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. Exi x0 ) →d i 2 = N (0. then F (Qτ (x) | x) = τ . For τ ∈ [0. (7. then (7.5. ¥ 7. so you can think of the quantile as the inverse of the distribution function. V ). then F (Qτ ) = τ .

E xi xi f (0)2 A recent monograph on the details of quantile regression is Koenker (2005). and we have the simpliﬁcation Vτ = τ (1 − τ ) ¡ ¡ 0 ¢¢−1 . if the model yi = x0 β + ei has i been ﬁt by OLS. fast linear programming methods have been developed for this problem.5. One simple test for neglected nonlinearity is to add nonlinear functions of the regressors to ˆ ˆ the regression.where ei is the error deﬁned to be the diﬀerence between yi and its τ ’th conditional quantile x0 β τ .13). 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. since it has discontinuous derivatives.12). ˆ Given the representation (7. Furthermore. and test their signiﬁcance using a Wald test. otherwise its properties are unspeciﬁed without further restrictions. Another popular approach is the RESET test proposed by Ramsey (1969).6. where and f (e | x) is the conditional density of ei given xi = x. ¡ ¡ ¢¢−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. it is useful to have a general test of the adequacy of the speciﬁcation. the τ ’th conditional quantile of ei is zero.1. When the error ei is independent of xi . The null model is yi = x0 β + εi i 84 . and form a Wald statistic i for γ = 0.7 Testing for Omitted NonLinearity If the goal is to estimate the conditional expectation E (yi | xi ) . 7.1 n β τ − β τ →d N (0. then f (0 | xi ) = f (0) . and are widely available. conventional Newton-type optimization methods are inappropriate. 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. the unconditional density of ei at 0. Since the quanitle regression criterion function Lτ (β) does not have an algebraic solution. Fortunately. Thus. ´ √ ³ˆ Theorem 7. Vτ ). i By construction. A asymptotic distribution theory for the quantile regression estimator can be derived using similar arguments as those for the LAD estimator in Theorem 7. n numerical methods are necessary for its minimization. the asymptotic variance depends on the conditional density of the quantile regression error.

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

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

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

In the unordered case. which can be a very large number. 88 . β 2 6= 0. β 3 = · · · = β K = 0 . . However. one can show that thus LRn →p ∞. β 2 = β 3 = · · · = β K = 0 M2 : β 1 6= 0.15). The general problem is the model yi = β 1 x1i + β 2 x1i + · · · + β K xKi + εi . E (εi | xi ) = 0 and the question is which subset of the coeﬃcients are non-zero (equivalently. We have discussed model selection between two models. 576. For example. 210 = 1024. . a full-blown implementation of the BIC selection criterion would seem computationally prohibitive. . β 2 6= 0. There are two leading cases: ordered regressors and unordered. and the AIC or BIC in principle can be implemented by estimating all possible subset models. The methods extend readily to the issue of selection among multiple regressors. β K 6= 0. The AIC selection criteria estimates the K models by OLS. log(n) µ LRn > k2 | M2 log(n) ¶ ´ ³ c P M = M2 | M2 = P → 1. xKi }. and 220 = 1. selecting based on (7. and then selects the model with the lowest AIC (7. MK : β 1 6= 0. . Similarly for ˆ the BIC.. In the latter case. stores the residual variance σ 2 for each model.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. . Also under M2 . In the ordered case.. the models are M1 : β 1 6= 0. which regressors enter the regression). .17). . which are nested. a model consists of any possible subset of the regressors {x1i . 048. there are 2K such models..

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

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

(g) Using this model for the conditional variance. (f) Construct a model for the conditional variance. (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 data ﬁle cps78.pdf. (b) Consider augmenting the model by squares and/or cross-products of the conditioning variables. (d) Test whether the error variance is diﬀerent for men and women.dat contains 550 observations on 20 variables taken from the May 1978 current population survey. Note any interesting diﬀerences. (e) Test whether the error variance is diﬀerent for whites and nonwhites. Interpret. Interpret.10. Report coeﬃcient estimates and standard errors. The goal of the exercise is to estimate a model for the log of earnings (variable LNWAGE) as a function of the conditioning variables. (i) Compare the estimated standard errors. Estimate your selected model and report the results. (h) Do the OLS and FGLS estimates diﬀer greatly? Note any interesting diﬀerences. 91 . Estimate such a model. Variables are listed in the ﬁle cps78. (a) Start by an OLS regression of LNWAGE on the other variables. Report the results. test for general heteroskedasticity and report the results. if desired.

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

x) (1 − F (y.2. (8.. x))) . Thus by the WLLN (Theorem 5. x) →p F (y. where 1(·) is the indicator function. For n = 25. n. x) is called the empirical distribution function (EDF). Fn is by construction a step function. but the approximation appears to improve for the large n. by the CLT (Theorem 5. it is helpful to think of a random pair (yi . The method of moments estimator is the corresponding sample moment: n 1X 1 (yi ≤ y) 1 (xi ≤ x) . xi ). x) = P (yi ≤ y. x). Furthermore. 50.. in the Figure below. x) − F (y. x∗ ) with the i distribution Fn . Notationally.3. This is a population moment. the EDF is only a crude approximation to the CDF. . Fn (y. the EDF step function gets uniformly close to the true CDF. The EDF is a consistent estimator of the CDF. and 100.8. note that for any (y. x). i = 1. xi ≤ x) = E (1 (yi ≤ y) 1 (xi ≤ x)) . The random draws are from the N (0. x) . Fn is a nonparametric estimate of F. 1 (yi ≤ y) 1 (xi ≤ x) is an iid random variable with expectation F (y. i 93 . That is.1).. Recall that F (y. F (y.2) Fn (y. x∗ ≤ x) = Fn (y. x) = n i=1 Figure 8. To see the eﬀect of sample size on the EDF. I have plotted the EDF and true CDF for three random samples of size n = 25. In general.1: Empirical Distribution Functions The EDF is a valid discrete probability distribution which puts probability mass 1/n at each ∗ pair (yi . x). Note that while F may be either discrete or continuous.1). 1) distribution. x)) →d N (0. To see this. as the sample size gets larger. ∗ P (yi ≤ y. √ n (Fn (y.2 The Empirical Distribution Function Fn (y.

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

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

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

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

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

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

1. A bootstrap test is based on G∗ (x). g1 and g2 are diﬀerentiable functions of x and continuous in F relative to the supremum norm on the space of distribution functions. the diﬀerence √ (g1 (x. F0 )) converges to 0 at rate n. the exact distribution is P (Tn < x) = Gn (x.1 Under regularity conditions and (8. where g1 is an even function of x. F ) converges to the normal limit at rate n1/2 . adding leptokurtosis). F0 ) + O(n−1 ) 1/2 1 n 1 g (x. F0 ) ≈ ∂ g1 (x.1 has the expansion n G∗ (x) = Gn (x. Moreover. Heuristically. F0 ) = 1 g (x. Fn ) = Φ(x) + n 1 g (x. the diﬀerence between the bootstrap distribution and the true distribution is G∗ (x) − Gn (x. v Since the derivative of g1 is odd. Gn (x. ³x´ Gn (x. F ).3).8. ³x´ 1 1 + 1/2 g1 (x. which from Theorem 8. F0 ) = Φ(x) + since v = 1. F0 )) + O(n−1 ). Fn ) − g1 (x. F ) + g2 (x. F ) ≈ Φ + n−1/2 g1 (x.8. Fn ) − g1 (x. Fn ) − g1 (x. Theorem 8. F ) v which adds a symmetric non-normal component to the approximate density (for example. and g1 is continuous with respect to F. F ) + O(n−3/2 ) Gn (x. To a third order of approximation.1 as follows. An asymptotic test is based on Φ(x). the density function is skewed. so the order of the error is O(n−1/2 ). √ Since Fn converges to F at rate n. g1 (x. F ) + n−1 g2 (x. The diﬀerence is Φ(x) − Gn (x. 1/2 1 n Because Φ(x) appears in both expansions. F0 ) (Fn − F0 ) ∂F = O(n−1/2 ).8. F0 ) = n 1 n1/2 (g1 (x. F ) ≈ Φ + n−1/2 g1 (x. We can interpret Theorem 8.9 One-Sided Tests Using the expansion of Theorem 8.8. First. we can assess the accuracy of one-sided hypothesis tests and conﬁdence regions based on an asymptotically normal t-ratio Tn . ³x´ Gn (x. F ) = Φ v n n 8. To the second order. F0 ) + O(n−1 ) 1/2 1 n = O(n−1/2 ). 100 .uniformly over x. To a second order of approximation. and g2 is an odd function of x. Fn ) + O(n−1 ).

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

Twosided tests will have more accurate size (Reported Type I error). Therefore. and bootstrap tests have better rates of convergence than asymptotic tests. and g2 is continuous in F. 8. Thus a two-sided bootstrap test also achieves an asymptotic reﬁnement.11 Percentile Conﬁdence Intervals ´ √ ³ To evaluate the coverage rate of the percentile interval. Fn ) = Φ n v ˆ ˆ where V = V (Fn ) is the bootstrap estimate of V. V ). The analysis shows that there may be a trade-oﬀ between one-sided and two-sided tests. whose error is O(n−1 ). the asymptotic two-sided test has a better coverage rate than the asymptotic one-sided test. g1 . √ the last equality because Fn converges to F0 at rate n. as it depends on the unknown V. which is not pivotal.8.Interestingly. This is in contrast to the use of the asymptotic distribution. we ﬁnd Gn (x) = Gn (x. similar to a one-sided test. F0 )) + O(n−3/2 ) n = O(n−3/2 ). meaning that the errors in the two directions exactly cancel out. The diﬀerence is ³x´ ³x´ −Φ + O(n−1/2 ) G∗ (x) − Gn (x. G∗ (x) = Gn (x. F ) = Φ v √ where v = V . set Tn = n ˆ − θ0 .1 shows that a ﬁrst-order approximation ³x´ + O(n−1/2 ). This is because the ﬁrst term in the asymptotic expansion. the choice between symmetric and equal-tailed conﬁdence intervals is unclear. is an even function. Two-sided tests have better rates of convergence than the one-sided tests. Fn ) − g2 (x. Applying (8. but one-sided tests might have more power against alternatives of interest. Fn ) + O(n−3/2 ). Gn (x. 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. n Thus the diﬀerence between the bootstrap and exact distributions is Gn (x) − Gn (x. 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 ). F0 ) = ∗ 2 (g2 (x. and for the bootstrap ³x´ + O(n−1/2 ). We know that θ Tn →d N (0. 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 . Theorem 8.5) to the bootstrap distribution. and needs to be determined on a case-by-case basis. Fn ) = Φ(x) + ∗ 2 g2 (x. A reader might get confused between the two simultaneous eﬀects.

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

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

∗ ∗ where s(ˆ is the standard error in the original data. Using the non-parametric bootstrap. lot size. can you report the 95% Percentile-t interval for θ? 7. Using the non-parametric ∗ bootstrap. ˆ − s(ˆ n (. Suppose that in an application. You want to test H0 : θ = 0 against H1 : θ > 0. What is wrong with this procedure? Tn = θ/s(θ) n 6. (a) Report the 95% Efron Percentile interval for θ. The dataﬁle hprice1. θ θ)q ∗ θ θ)q ∗ θ/s(θ) 5. Estimate a linear regression of price on the number of bedrooms. and thus reject H0 if ˆ ˆ > q ∗ (. and ˆ is calculated on each θ ∗ ∗ θ sample. 105 . ∗ ∗ ∗ Let qn (. The ˆ are sorted.3.95).2.Show that C exactly equals the Alternative percentile interval (not the percentile-t interval). and the 2. θ θ) ∗ 1000 samples are generated from the bootstrap distribution.05) . You do this as follows. (b) Report the 95% Alternative Percentile interval for θ. You replace c with qn (. and the colonial dummy.5% and 97. ˆ = 1.95).95).dat contains data on house prices (sales). calculate the estimates ˆ on these samples and θ then calculate ∗ ∗ ∗ θ θ Tn = ˆ /s(ˆ ).2 and s(ˆ = .95) denote the 95% quantile of Tn . The test for H0 is to reject if Tn = ˆ ˆ > c where c is picked so that Type I error is α. θ respectively. with variables listed in the ﬁle hprice1. and deﬁne the bootstrap conﬁdence interval h i C = ˆ − s(ˆ n (. you generate bootstrap samples. Let qn (.75 and 1.95) denote the 5% θ) ∗ and 95% quantiles of Tn . size of house.pdf. (c) With the given information.5% quantiles of the ˆ are . Calculate 95% conﬁdence intervals for the regression coeﬃcients using both the asymptotic normal approximation and the percentile-t bootstrap.05) and qn (.

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

but this is generally not possible when > k. ˆ Deﬁnition 9. 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. This is a non-negative measure of the “length” of the vector g n (β). if Wn = I.9. β ˆ Note that if k = .2 GMM Estimator n n ¢ 1¡ 0 ¢ 1X 1X ¡ 0 X Y − X 0 Zβ . β GMM does not change. the dependence is only up to scale. β GMM = Z 0 XWn X 0 Z 9. for if Wn is replaced ˆ by cWn for some c > 0. The idea of the generalized method of moments (GMM) is to deﬁne an estimator which sets g n (β) “close” to zero. and the GMM estimator is the MME. The GMM estimator minimizes Jn (β). let Jn (β) = n · g n (β)0 Wn g n (β).2) g n (β) = (9.2. For some × weight matrix Wn > 0. 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. then g n (β) = 0. For example. then. i i . Proposition 9.1 β GMM = argmin Jn (β). Jn (β) = n · g n (β)0 g n (β) = n · |g n (β)|2 .1 ˆ 2Z 0 XWn X 0 Z β = 2Z 0 XWn X 0 Y While the estimator depends on Wn . ¡ ¢−1 0 ˆ Z XWn X 0 Y. Let and where gi = xi ei .2. gi (β) = xi yi − zi β = n n n i=1 i=1 Deﬁne the sample analog of (9.3 Distribution of GMM Estimator ¡ 0¢ Q = E xi zi Assume that Wn →p W > 0. 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 .

it is semiparametrically eﬃcient. we can set Wn = I . it turns out that the GMM estimator is semiparametrically eﬃcient. No estimator can do better (in this ﬁrst-order asymptotic sense). ˆ∗ ˆ 108 . V ) . n β − β →d N 0. This yields the eﬃcient GMM estimator: ¢−1 0 ¡ ˆ Z XΩ−1 X 0 Y. GMM estimators are asymptotically normal with “sandwich form” asymptotic variances.4 Estimation of the Eﬃcient Weight Matrix ˆ Given any weight matrix Wn > 0. but it can be estimated consistently. If it is known that E (gi (β)) = 0. where In general. as shown by Gary Chamberlain (1987). The optimal weight matrix W0 is one which minimizes V. without imposing additional assumptions. W0 = Ω−1 is not known in practice. the GMM estimator β is consistent yet ineﬃcient. ˆ We have described the estimator β as “eﬃcient GMM” if the optimal (variance minimizing) weight matrix is selected. no semiparametric estimator (one which is consistent globally for the class of models considered) ¢−1 ¡ . This turns out to be W0 = Ω−1 . This results shows that in the linear model. as the distribution of the data is unknown. Ω) .and µ µ ¶ ¶ 1 0 1 0 Z X Wn X e →d Q0 W N (0. 9. In the linear model. Q0 Ω−1 Q ¢−1 ¡ 0 ¢¡ ¢−1 ¡ . ˆ Construct n 1X ˆ g n = g n (β) = gi . a better choice is Wn = (X 0 X)−1 . The proof is left as an exercise.1 ´ √ ³ˆ n β − β →d N (0. and this is all that is known. ˆ we still call β the eﬃcient GMM estimator. this is a semi-parametric problem. we can deﬁne the residuals ei = yi −zi β and moment equations gi = xi ei = g(wi .2 For the eﬃcient GMM estimator. This is a weak concept of optimality. 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. n n We conclude: Theorem 9.3. no estimator has greater asymptotic eﬃciency than the eﬃcient linear GMM estimator. Chamberlain showed that in this context. β = Z 0 XΩ−1 X 0 Z ´ ³ ¡ ¢−1 ´ √ ³ˆ . β). Since the GMM estimator has this can have a smaller asymptotic variance than G0 Ω−1 G asymptotic variance. However. Given any such ﬁrst0ˆ ˆ ˆ ˆ step estimator. as it has the same asymptotic distribution. ˆ n i=1 gi = gi − g n . For example. For any Wn →p W0 .3. Q W ΩW Q Q0 W Q V = Q0 W Q Thus we have Theorem 9. as we are only considering alternative weight matrices Wn .

This is a current area of research in econometrics. ˆ and let g be the associated n × matrix. A simple solution is to use the centered moment conditions to construct the weight matrix. 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. Hansen. set Wn = (X 0 X)−1 . under the alternative hypothesis the moment conditions are violated. so the uncentered estimator will contain an undesirable bias term and the power of the test will be adversely aﬀected.4) which uses the uncentered moment conditions. and GMM using Wn as the weight matrix is asymptotically eﬃcient. these two estimators are asymptotically equivalent under the hypothesis of correct speciﬁcation. as in (9. 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 . First.e. 0ˆ ˆ ˆ ˆ estimate β using this weight matrix. we actually mean “eﬃcient GMM”. The criterion function is then Ã n !−1 1X ∗ 0 ∗ 0 gi (β)gi (β) g n (β). Heaton and Yaron (1996). 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. Then set gi = xi ei . There is little point in using an ineﬃcient GMM estimator as it is easy to compute. When constructing hypothesis tests. and was introduced by L. (9. Since Egi = 0.5 GMM: The General Case In its most general form. The estimator appears to have some better properties than traditional GMM. However. but can be numerically tricky to obtain in some cases.4) above. when we say “GMM”.and deﬁne Wn = Ã Then Wn →p Ω−1 = W0 . 109 . i. GMM applies whenever an economic or statistical model implies the × 1 moment condition E (gi (β)) = 0. Instead. Alastair Hall (2000) has shown that the uncentered estimator is a poor choice. Set ³ ¡ ¢−1 0 ´−1 ˆ ˆˆ XZ . and construct the residual ei = yi − zi β. β = Z 0 X g 0 g − ng n g 0 n n ˆ Asymptotic standard errors are given by the square roots of the diagonal elements of V . There is an important alternative to the two-step GMM estimator just described. ˆ An estimator of the asymptotic variance of β can be seen from the above formula. we can let the weight matrix be considered as a function of β. Here is a simple way to compute the eﬃcient GMM estimator. J(β) = n · g n (β) n i=1 In most cases. Egi 6= 0. ∗ gi (β) = gi (β) − g n (β) 9.

Often. Under the hypothesis of correct speciﬁcation. 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). G0 Ω−1 G . where ³ ´−1 ∂ 0 ˆ ˆ ˆ ˆ Ω = (E (gi gi ))−1 and G = E ∂β 0 gi (β). For example. often the weight ˆ matrix Wn is updated. β) = 0 holds. 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 . n β − β →d N 0. Since the GMM estimator depends upon the ﬁrst-stage estimator.6. take the linear model yi = β 0 x1i + β 0 x2i + ei with E (x1i ei ) = 0 and E (x2i ei ) = 0. i i i i ∂β 1X 0 gi gi − g n g 0 ˆˆ n n i=1 n !−1 . so that the linear equation may be written as yi = β 0 x1i + ei . 1 it is possible that β 2 6= 0.1 (Sargan-Hansen). 110 . ˆ J = J(β) →d χ2−k .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 . 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. Theorem 9.5. Identiﬁcation requires l ≥ k = dim(β). However. and is thus a natural test statistic for H0 : Egi = 0. This estimator can be iterated if needed.1 Under general regularity conditions. 9. Note that g n →p Egi . The general theory of GMM estimation and testing was exposited by L. ´ ³ ¡ ¢−1 ´ √ ³ˆ Theorem 9. In this sense an 1i 1i exclusion restriction can be seen as an overidentifying restriction. Thus the model — the overidentifying restrictions — are testable. this is all that is known. and thus g n can be used to assess whether or not the hypothesis that Egi = 0 is true or not. and if the weight matrix is asymptotically eﬃcient. Hansen (1982). 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. ˆˆ n is a quadratic form in g n . 1 2 It is possible that β 2 = 0. and then β recomputed. perhaps obtained by ﬁrst ˆ setting Wn = I.

If the statistic J exceeds the chi-square critical value. and is the preferred test statistic. as this ensures that D ≥ 0. This test shares the useful feature of LR tests in that it is a natural by-product of the computation of alternative models. D ≥ 0 2.7 Hypothesis Testing: The Distance Statistic We described before how to construct estimates of the asymptotic covariance matrix of the GMM estimates. the Wald statistic can work quite poorly. The estimates under H1 are ˆ β = argmin J(β) β and those under H0 are ˜ β = argmin J(β). The GMM distance statistic is the diﬀerence ˜ ˆ D = J(β) − J(β). we can reject the model. The idea was ﬁrst put forward by Newey and West (1987). current evidence suggests that the D statistic appears to have quite good sampling properties. Based on this information alone. but it is typically cause for concern. This result was established by Sargan (1958) for a specialized case. 111 . the GMM criterion function is J(β) = n · g n (β)0 Wn g n (β) For h : Rk → Rr . The degrees of freedom of the asymptotic distribution are the number of overidentifying restrictions. These may be used to construct Wald tests of statistical hypotheses. a better approach is to directly use the GMM criterion function. If h is linear in β. and by L. Hansen (1982) for the general case. For a given weight matrix Wn . In contrast. This is sometimes called the GMM Distance statistic. h(β)=0 ˆ ˜ The two minimizing criterion functions are J(β) and J(β). it is customary to report the J statistic as a general test of model adequacy. it is unclear what is wrong. If h is non-linear.1 If the same weight matrix Wn is used for both null and alternative. If the hypothesis is non-linear. 1.7. The GMM overidentiﬁcation test is a very useful by-product of the GMM methodology. and some current research suggests that this restriction is not necessary for good performance of the test. 9. and it is advisable to report the statistic J whenever GMM is the estimation method. the hypothesis is H0 : h(β) = 0.The proof of the theorem is left as an exercise. D →d χ2 r 3. and sometimes called a LR-like statistic (the LR is for likelihood-ratio). however. This reasoning is not compelling. Newey and West (1987) suggested to use the same weight matrix Wn for both null and alternative. Proposition 9. When over-identiﬁed models are estimated by GMM. then D equals the Wald statistic.

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

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

V − V0 is positive semi-deﬁnite (for then V0 is the smaller possible covariance matrix and W = Ω−1 is the eﬃcient weight matrix). Let ei = yi − zi β where β is consistent for ˆ β (e. Take the single equation Y E(e = Zβ + e | X) = 0 ˆ Assume E(e2 | xi ) = σ 2 . (c) Since Ω is positive deﬁnite. ˆ ˆ Find the method of moments estimators (β. we know that V − V0 is positive semi-deﬁnite if and only if V0−1 − V −1 = A is positive semi-deﬁnite. and therefore positive semideﬁnite. γ).g. σ 2 Q0 M −1 Q ) 0 where Q = E(xi zi ) and M = E(xi x0 ). verify that A can be written as ³ ¡ ¢−1 0 ´ G H. 2. Show that V0 = Q0 Ω−1 Q . Hint: The matrix I −G (G0 G)−1 G0 is symmetric and idempotent. a GMM estimator with arbitrary weight matrix). (b) We want to show that for any W. then (X ´ ¢−1 ¡ √ ³ ˆ n β − β →d N (0. Deﬁne the estimate of the optimal GMM weight matrix Ã n !−1 1X 0 2 xi xi ei ˆ . Take the model E (zi ηi ) = 0. Letting H = CQ and G = C 0−1 W Q. A = H 0 I − G G0 G (d) Show that A is positive semideﬁnite. Show that if β is estimated by GMM with weight matrix Wn = i 0 X)−1 . Take the model yi = zi β + ei with E (xi ei ) = 0. there exists a nonsingular matrix C such that C 0 C = Ω−1 .9. Write out the matrix A. From matrix algebra. γ ) for (β. In the linear model estimated by GMM with general weight matrix W. Wn = n i=1 ¡ ¢ −1 where Ω = E x x0 e2 . 114 . 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 . Show that Wn →p Ω i i i 4.10 Exercises yi = x0 β + ei i E (xi ei ) = 0 0 e2 = zi γ + η i i 1. i 0 0ˆ ˆ 3.

β) + ei E (zi ei ) = 0.6) (a) Show that you can rewrite Jn (β) in (9. zi is l × 1 and β is k × 1. The observed data is (yi . λ) = 1 Jn (β) + λ0 (R0 β − r) where λ is 2 s × 1. Deﬁne the Lagrangian L(β. zi ). xi . h(β)=0 The GMM test statistic (the distance statistic) of the hypothesis h(β) = 0 is ˜ D = Jn (β) = min Jn (β). VR ) where ¡ ¢−1 0 R V. 115 . Vn = X X i=1 ˜ and hence R0 β = r. The GMM estimator of 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 .6) equals the Wald statistic. VR = V − V R R0 V R (d) Show that in this setting. Thus ˜ β = argmin Jn (β) R0 β−r Ã n ! ¡ 0 ¢−1 ¡ 0 ¢−1 X 0 2 ˆ XX xi xi ei ˆ . subject ˆ i ˆi i=1 to the restriction h(β) = 0. 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. Show how to construct an eﬃcient GMM estimator for β. 6.5. is deﬁned as Jn (β) = ˜ β = argmin Jn (β). l ≥ k. The equation of interest is yi = g(xi . h(β)=0 (9. In the linear model Y = Xβ + e with E(xi ei ) = 0. the distance statistic D in (9.5) n 1 P ˆ where ei are the OLS residuals and Ωn = n n xi x0 e2 . λ = R0 Vn R (c) Show that if R0 β = r then ´ √ ³˜ n β − β →d N (0.5) 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.

116 .7. Take the linear model 0 yi = zi β + ei E (xi ei ) = 0. Il ) ³ ´ (f) Jn →d N 0 Il − R (R0 R)−1 R0 N ³ ´ (g) N 0 Il − R (R0 R)−1 R0 N ∼ χ2 . Let ˆ ˆ ˆ Jn = ng n (β)0 Ω−1 g n (β) denote the test of overidentifying restrictions. ˆ and consider the GMM estimator β of β. l−k Hint: Il − R (R0 R)−1 R0 is a projection matrix. 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. 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..

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

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

ˆ ˆ Proof.2 Deﬁne Asymptotic Distribution of EL Estimator Gi (β) = ∂ gi (β) ∂β 0 (10. λ) jointly solve ³ ´ ˆ n gi β X ∂ ³ ³ ´´ Rn (β. n (10. G = −E (xi zi ).12) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ 0 ' G0 λ − λ0 . i=1 i=1 i=1i Expanding (10.1 Under regularity conditions. (β.8) and ¢ 0 0 For example.9) (10. in the linear model. and n β − β 0 and nλ are asymptotically independent. λ) = − (10. λ) = − (10. β) = −xi zi .13) yields n n Expanding (10. Thus the EL estimator is asymptotically eﬃcient.2.10). ´ √ ³ ˆ n β − β 0 →d √ ˆ nλ →d N (0. Gi (.13) Premultiplying by G0 Ω−1 and using (10. 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. β λ ∂ ³ ´. i i Theorem 10. ˆ The asymptotic variance V for β is the same as for eﬃcient GMM.12) ∂β ˆ ˆ0 i=1 1 + λ gi β 1 P 1 P 1 P Let Gn = n n Gi (β 0 ) . Vλ ) ´ √ ˆ √ ³ˆ where V and Vλ are deﬁned in (10.11) 0 = ∂λ ˆ0 ˆ i=1 1 + λ gi β ³ ´0 ˆ n X Gi .9) and (10. 0 = Rn (β.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 . g n = n n gi (β 0 ) and Ωn = n n g (β 0 ) gi (β 0 )0 .11) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ ˆ 0 ' −g n − Gn β − β 0 + Ωn λ (10. and Ω = E xi x0 e2 .10) ¡ Ω−1 N (0.

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

4 Testing Egi (β) = 0 (10. a The proof of this result is more challenging and is omitted. The hypothesis of interest is h(β) = 0. Instead we use the diﬀerence in log-likelihoods: ³ ´ ˆ ˜ LRn = 2 Ln − Ln . Vλ )0 Ω−1 N (0.18). LRn = n X i=1 ˆ0 ' 2λ →d ˆ0 ˆ ' nλ Ωn λ = χ2−k n X i=1 ³ ´´ ³ ˆ ˆ0 2 ln 1 + λ gi β i=1 n ³ ´ X ³ ´ ³ ´0 ˆ − λ0 ˆ ˆ ˆ ˆ gi β gi β gi β λ N (0. since ln(1 + x) ' x − x2 /2 for x small. 10. This test statistic is a natural analog of the GMM distance statistic.5 Numerical Computation Gauss code which implements the methods discussed below can be found at http://www. By “maintained” we mean that the overidentfying restrictions contained in (10. the simple overidentifying restrictions test (10.18) and H0 : h(β) = 0.1 Under (10. the restricted EL estimator β is simply an EL estimator with − k + a overidenti˜ ˆ fying restrictions.prc 121 . To test the hypothesis h(β) while maintaining (10. so there is no fundamental change in the distribution theory for β relative to β. Theorem 10. where h : Rk → Ra . LRn →d χ2 . The restricted EL estimator and likelihood are the values which solve ˜ β = argmax Ln (β) h(β)=0 ˜ ˜ Ln = Ln (β) = max Ln (β). h(β)=0 ˜ Fundamentally.ssc.Second. 10.18) are assumed to hold and are not being challenged (at least for the test discussed in this section). Vλ ) ¥ where the proof of the ﬁnal equality is left as an exercise.edu/~bhansen/progs/elike.wisc.17) is not appropriate.18) Let the maintained model be where g is × 1 and β is k × 1.4.

A complication is that λ must be constrained so that 0 ≤ pi ≤ 1 which holds if ¢ ¡ n 1 + λ0 gi (β) ≥ 1 122 (10. λ) gi (β. λ) = i ∂λ∂β 0 1 + λ0 gi (β) i=1 ⎞ ⎛ ¡ 0 ¢ ∂2 n 2 X 0 gi (β) λ ∂ ⎠ ⎝G∗ (β. The starting value λ1 can be set to the zero vector. λj ))−1 Rλ (β. λ) .19) is continued until the gradient Rλ (β. 1.4)..19). λ) = − ∂β n X i=1 G∗ (β. λ)0 0 Rn (β. λ) G∗ (β. Set δ 0 = 0. set 2 λp = λj − δ p (Rλλ (β. λ)0 − Rn (β. λ) yielding the iteration rule λj+1 = λj − δ (Rλλ (β.4) are Rλ = Rβ = The second derivatives are Rλλ = Rλβ = ¡ Gi (β)0 λ 1 + λ0 gi (β) gi (β) ¢ 1 + λ0 gi (β) X ∂ ∗ Rn (β. λj ))−1 Rλ (β. δ 1 = 1 and δ 2 = 1. λ) = − gi (β. 2. The value of δ which minimizes this quadratic is ˆ = R2 + 3R0 − 4R1 . λp ) A quadratic function can be ﬁt exactly through these three points. λ) ∂λ i=1 n ∂ Rn (β. Eﬃcient convergence requires a good choice of steplength δ.19) X ∂2 ∗ ∗ gi (β. The modiﬁed Newton method takes a quadratic approximation to Rn (β. One method uses the following quadratic approximation. Deﬁne ∗ gi (β. λ) = ∂λ∂λ i=1 ¶ n 2 Xµ ∂ Gi (β) ∗ gi (β.Derivatives The numerical calculations depend on derivatives of the dual likelihood function (10. λ) = G∗ (β. i Rββ = Inner Loop The so-called “inner loop” solves (10. λ) = i i ∂β∂β 0 1 + λ0 gi (β) i=1 n where δ > 0 is a scalar steplength (to be discussed next).20) . The iteration (10. λj )) Rp = Rn (β. (10. λj ) is smaller than some prespeciﬁed tolerance. λ)0 − ∂β∂β Rn (β. δ 4R2 + 4R0 − 8R1 yielding the steplength to be plugged into (10. λj ) .5) for given β. λ) G∗ (β. For p = 0. λ) = i The ﬁrst derivatives of (10.

λ(β)) = 0. the eigenvalues of Lββ should be adjusted so that all are positive. It is not guaranteed that Lββ > 0. ∂β 0 the second equality following from the implicit function theorem applied to Rλ (β. The Newton iteration rule is β j+1 = β j − δL−1 Lβ ββ where δ is a scalar stepsize. and the rule is iterated until convergence. λ(β)) β ∂β ¡ ¢ 0 = − Rββ (β. If (10.20) fails. Outer Loop The outer loop is the minimization (10. λ(β)) + λ0 Rλ (β.6) is Lββ = − ∂ Ln (β) ∂β∂β 0 ¤ ∂ £ = − 0 Rβ (β. λ) = Rβ + λ0 Rλ = Rβ β ∂β ∂β since Rλ (β.for all i. the stepsize δ needs to be decreased. λ) = 0 at λ = λ(β).6). If not. 123 . The gradient for (10.6) is Lβ = ∂ ∂ Ln (β) = Rn (β. This can be done by the modiﬁed Newton method described in the previous section. The Hessian for (10. where λβ = ∂ −1 λ(β) = −Rλλ Rλβ . λ(β)) + Rλβ λβ + λ0 Rλβ + λ0 Rλλ λβ β β −1 0 = Rλβ Rλλ Rλβ − Rββ .

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

and x2i are the excluded exogenous variables.4) xi = x2i 2 where z1i = x1i are the included exogenous variables.1) where zi is k × 1. So we have the partition µ ¶ z1i k1 (11. this can be written as Y = Zβ + e. β →p β ∗ . In a typical set-up. Thus we make the partition ¶ µ k1 z1i (11. By the above deﬁnition.1 The × 1 random vector xi is an instrumental variable for (11. which does not equal either β 1 or β 2 .1 Instrumental Variables 0 yi = zi β + ei Let the equation of interest be (11. at least the intercept). and assume that E(zi ei ) 6= 0 so there is endogeneity. (11.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 ¶ . so should be included in xi . In matrix notation. z1i is an instrumental variable for (11.1). Deﬁnition 11. ¶ µ ∙ β2 β1 1 −1 β 2 e1i + β 1 e2i (e1i − e2i ) ¸µ e1i e2i ¶ ˆ Hence if it is estimated by OLS. some regressors in zi will be uncorrelated with ei (for example.1) the structural equation. We call z1i exogenous and z2i endogenous.2) Any solution to the problem of endogeneity requires additional information which we call instruments. 11.1) if E (xi ei ) = 0. That is x2i are variables which could be included in the equation for yi (in the sense 125 . We call (11.3) zi = z2i k2 where E(z1i ei ) = 0 yet E(z2i ei ) 6= 0.1. This is called simultaneous equations bias.

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

¡ ¢−1 ¡ 0 ¢ ˆ β 2SLS = Z 0 PX Z Z PX Y .12). 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. PX Z2 ] = [Z1 . Z = [Z1 . We now derive a similar result for the 2SLS estimator.12) Z = XΓ + u ξ = (e. Z2 . Then i h ˆ ˆ ˆ Z = Z1 . X2 ]. Z2 ] and X = [Z1 . u) E (ξ | X) = 0 ¢ ¡ E ξξ 0 | X = S As before. Recall. let’s analyze the approximate bias of OLS applied to (11.13) which is zero only when S21 = 0 (when Z is exogenous). Here we present a simpliﬁed version of one of his results. ˆ since Z1 lies in the span of X.6 Bekker Asymptotics Bekker (1994) used an alternative asymptotic framework to analyze the ﬁnite-sample bias in the 2SLS estimator.11) (11. In our notation. the model is Y = Zβ + e (11. Using (11.ˆ It is useful to scrutinize the projection Z. X is n × l so there are l instruments. we regress Y on Z1 and Z2 . PX Z2 ] h i ˆ = Z1 .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 ) . Thus in the second stage. 11. So only the endogenous variables Z2 are replaced by their ﬁtted values: ˆ ˆ ˆ Z2 = X1 Γ12 + X2 Γ22 . First. 129 . Z2 = [PX Z1 .

except when S21 = 0 (when Z is exogenous). indicating that the bias in 2SLS approaches that of OLS as the number of instruments increases. Bekker (1994) pointed out that it also has the reverse implication — that when α = l/n is large. The parameter β fails to be identiﬁed if Γ22 has deﬁcient rank.Let PX = X (X 0 X)−1 X 0 . By the spectral decomposition of an idempotent matrix. The consequences of identiﬁcation failure for inference are quite severe.12) and this result. l . Indeed as α → 1. 130 . P = HΛH 0 0 0 where Λ = diag(Il .14) In general this is non-zero. 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 . Let q = H 0 ξS −1/2 which satisﬁes Eqq 0 = In and partition q = (q1 q2 ) where q1 is l × 1. ¢ 1 ¡ ¢ 1 ¡ ¢ 1 ¡ 0 E Z PX e = E Γ0 X 0 e + E u0 PX e = αS21 . the bias in the 2SLS estimator will be large. 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. 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 (11.13). n and (11.7 Identiﬁcation Failure Recall the reduced form equation Z2 = X1 Γ12 + X2 Γ22 + u2 . Together µ µ ¶¶−1 µ ¶ ³ ´ 1 0 1 0 ˆ 2SLS − β E β Z PX Z Z PX e ≈ E E n n ¡ ¢−1 = α Γ0 QΓ + αS22 S21 .14) is the probability limit of β 2SLS − β 11. the expression in (11. It is also close to zero when α = 0.

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

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

X is n × l.11. Take the linear model Y = Zβ + e. 5. Find a simple expression for the IV estimator in this context. Explain why this is true. xi is l × 1. (Find an expression for xi .) 3. ˜ 0 e < e0 e. Take the linear model yi = xi β + ei E (ei | xi ) = 0. Consider the single equation model ˆ where yi and zi are both real-valued (1 × 1). ˆ ˆ Let the OLS estimator for β be β and the OLS residual be e = Y − Z β. 133 . 1. 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) .8 Exercises yi = zi β + ei . in the sense that e ˜ ˜ least in large samples? 4. In the linear model 0 yi = zi β + ei E (ei | zi ) = 0 ¡ 2 ¢ suppose σ 2 = E ei | zi is known. we claim that β is identiﬁed (can be recovered from the reduced form) if rank(Γ) = k. 2. u is n × k. and Γ is l × k. 6. 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. ˆ ˜ ˜ Let the IV estimator for β using some instrument X be β and the IV residual be e = Y − Z β. will IV “ﬁt” better than OLS. at ˆˆ If X is indeed endogeneous. Let β denote the IV estimator of β using as an instrument a dummy variable di (takes only the values 0 and 1). Show that the GLS estimator of β can be written as an i IV estimator using some instrument xi . Z is n × k. where xi and β are 1 × 1. 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. l ≥ k. That is.

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

A stationary time series is ergodic if γ(k) → 0 as k → ∞. Theorem 12. The primary model for univariate time series is autoregressions (ARs).1.. and use the subscript t to denote the individual observation..1. To indicate the dependence on time.1.1. we expect that Yt and Yt−1 are not independent. Yt−k ) = γ(k) is independent of t for all k. t = 1. we adopt new notation.. The primary model for multivariate time series is vector autoregressions (VARs). 135 . There proofs are rather diﬃcult. and T to denote the number of observations. T ..1 If Yt is strictly stationary and ergodic and Xt = f (Yt . Deﬁnition 12. so classical assumptions are not valid. γ(k) is called the autocovariance function. Because of the sequential nature of time series. Yt−1 .1 {Yt } is covariance (weakly) stationary if E(Yt ) = µ is independent of t. ...3 ρ(k) = γ(k)/γ(0) = Corr(Yt . The following two theorems are essential to the analysis of stationary time series.) is a random variable. and Cov (Yt . and multivariate (yt ∈ Rm is vector-valued).. We can separate time series into two categories: univariate (yt ∈ R is scalar). Deﬁnition 12. Yt−k ) is the autocorrelation function. .1..4 (loose). then Xt is strictly stationary and ergodic.1 Stationarity and Ergodicity Deﬁnition 12. Yt−k ) is independent of t for all k. Deﬁnition 12.Chapter 12 Univariate Time Series A time series yt is a process observed in sequence over time. . 12. however.2 {Yt } is strictly stationary if the joint distribution of (Yt .

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

..12. The last property deﬁnes a special time-series process. This occurs when |ρ| < 1. it is even more important in the time-series context. . or consumption growth rates.. . as it is diﬃcult to derive distribution theories without this property.. . E(Yt−k et ) = 0.2 Autoregressions In time-series.. Y1 . Deﬁnition 12... ∞ X = ρk et−k ... 137 .. A useful property of a MDS is that et is uncorrelated with any function of the lagged information It−1 . then we have the autoregressive model Yt = α + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et E (et | It−1 ) = 0.. . the series {. E(et ) = 0 and Ee2 = σ 2 < ∞. Regression errors are naturally a MDS. Yt−2 .3 Stationarity of AR(1) Process Yt = ρYt−1 + et . some versions of the life-cycle hypothesis imply that either changes in consumption.. YT .} are jointly random..} is the past history of the series.2. Y2 . A mean-zero AR(1) is Assume that et is iid. The MDS property for the regression error plays the same role in a time-series regression as does the conditional mean-zero property for the regression error in a cross-section regression. We consider the conditional expectation E (Yt | It−1 ) where It−1 = {Yt−1 . Thus for k > 0.. Yt−k ) .1 et is a martingale diﬀerence sequence (MDS) if E (et | It−1 ) = 0. should be a MDS.. 12. Letting et = Yt − E (Yt | It−1 ) . Some time-series processes may be a MDS as a consequence of optimizing behavior. this series converges if the sequence ρk et−k gets small as k → ∞. An autoregressive (AR) model speciﬁes that only a ﬁnite number of past lags matter: E (Yt | It−1 ) = E (Yt | Yt−1 . 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 . In fact. Most asset pricing models imply that asset returns should be the sum of a constant plus a MDS. we ﬁnd Yt = et + ρet−1 + ρ2 et−2 + . For example. t By back-substitution. k=0 Loosely speaking.

and solving for EYt = EYt−1 we ﬁnd EYt = α/(1 − ρ). Yt − ρ1 LYt − ρ2 L2 Yt − · · · − ρk Lk Yt = et . The AR(1) model can be written in the format Yt − ρYt−1 + et or (1 − ρL) Yt−1 = et . From Theorem 12. except that the mean of Yt can be computed from the relationship EYt = α + ρEYt−1 . We say that the root of the polynomial is 1/ρ. ∞ X k=0 ρ2k V ar (et−k ) = 12. We call ρ(L) the autoregressive polynomial of Yt .4 Lag Operator An algebraic construct which is useful for the analysis of autoregressive models is the lag operator. 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).Theorem 12. We call ρ(L) the autoregressive polynomial of Yt . In general. or ρ(L)Yt = et where ρ(L) = 1 − ρ1 L − ρ2 L2 − · · · − ρk Lk .3. The AR(k) model is Using the lag operator.3. Deﬁning L2 = LL. 1 − ρ2 V ar(Yt ) = If the equation for Yt has an intercept. 138 . The operator ρ(L) = (1 − ρL) is a polynomial in the operator L. the above results are unchanged.1 The lag operator L satisﬁes LYt = Yt−1 . an AR(1) is stationary iﬀ |ρ| < 1.1 If |ρ| < 1 then Yt is strictly stationary and ergodic.1. We can compute the moments of Yt using the inﬁnite sum: EYt = ∞ X k=0 ρk E (et−k ) = 0 σ2 . we see that L2 Yt = LYt−1 = Yt−2 . Deﬁnition 12.5 Stationarity of AR(k) Yt = ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et . Lk Yt = Yt−k . 12. since ρ(z) = 0 when z = 1/ρ.4.

t t T t=1 ¥ Combined with (12. β = X 0X (12. The vector xt is strictly stationary and ergodic. By Theorem 12. so is xt x0 .1) and the continuous mapping theorem.1 If the AR(k) process Yt is strictly stationary and ergodic and EYt2 < ∞.1.” If one of the roots equals 1. t T t=1 T t=1 139 . T t=1 T t=1 ¢−1 0 ¡ ˆ X Y. Theorem 12. ¢0 Then the model can be written as The OLS estimator is ¡ ˆ To study β. and is of great interest in applied time series. .. which satisfy ρ(λj ) = 0.where the λ1 . the requirement is that all roots are larger than one. we say that ρ(L). T ¢ ¡ 1X xt x0 →p E xt x0 = Q. “has a unit root”.. we see that Ã !−1 Ã ! T T 1X 1X ˆ β=β+ xt x0 xt et →p Q−1 0 = 0. since E (ut | It−1 ) = E (xt et | It−1 ) = xt E (et | It−1 ) = 0. Thus t by the Ergodic Theorem. This is a special case of non-stationarity.1. Thus T T 1X 1X xt et = ut →p E (ut ) = 0.1) Theorem 12.1. it is helpful to deﬁne the process ut = xt et . and hence Yt . and by Theorem 12. then ˆ β →p β as T → ∞. it is also strictly stationary and ergodic. We know that an AR(1) is stationary iﬀ the absolute value of the root of its autoregressive polynomial is larger than one.5.6..6 Let Estimation xt = β = ¡ 1 Yt−1 Yt−2 · · · α ρ1 ρ2 · · · yt = x0 β + et . For an AR(k). t Yt−k ¢0 ρk . Note that ut is a MDS.1 The AR(k) is strictly stationary and ergodic if and only if |λj | > 1 for all j. λk are the complex roots of ρ(z).1. 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. Let |λ| denote the modulus of a complex number λ. Proof. One way of stating this is that “All roots lie outside the unit circle.

Brieﬂy. Y0 ). Ω) . ˆ 2.. T 1 X √ ut →d N (0. This is identical in form to the asymptotic distribution of OLS in cross-section regression.7. Clearly.12.1 to see that T 1 X √ xt et →d N (0. T t=1 where Ω = E(xt x0 e2 ). Method 1: Model-Based (Parametric) Bootstrap. Ω) . as this imposes inappropriate independence. It also presumes that the AR(k) structure is the truth. 12. ˆ 1. If ut is a strictly stationary and ergodic MDS and E(ut u0 ) = Ω < ∞. .. In particular. ´ √ ³ ¡ ¢ ˆ T β − β →d N 0. e ˆ 3. which may be diﬀerent than the i properties of the actual ei . Fix an initial condition (Y−k+1 . .8 Bootstrap for Autoregressions In the non-parametric bootstrap. 140 . t This construction imposes homoskedasticity on the errors e∗ . Y−k+2 . t t Theorem 12. This creates an iid bootstrap sample. xt }. T t=1 Since xt et is a MDS.1 MDS CLT. Divide the sample into T /m blocks of length m. the asymptotic covariance matrix is estimated just as in the cross-section case. we constructed the bootstrap sample by randomly resampling from the data values {yt . Estimate β and residuals et . Method 2: Block Resampling 1... there are two popular methods to implement bootstrap resampling for time-series data.. i 4..7. The implication is that asymptotic inference is the same.7. then as T → ∞. we can apply Theorem 12. Q−1 ΩQ−1 . this cannot work in a time-series application.2 If the AR(k) process Yt is strictly stationary and ergodic and EYt4 < ∞. t then as T → ∞. 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∗ . Simulate iid draws e∗ from the empirical distribution of the residuals {ˆ1 . eT }.7 Asymptotic Distribution Theorem 12.

This presumes that “seasonality” does not change over the sample.2)-(12. • Include dummy variables for each season. 3. (12. This procedure is sometimes called Detrending. 6. and perhaps this was of relevance. and then perform regression (12. 12.2). and the way that the data are partitioned into blocks. ρk ). The seasonal factor is typically estimated by a two-sided weighted average of the data for that season in neighboring years. or the season-to-season change. and for modelmisspeciﬁcation.2. (12. heteroskedasticity. .4) by OLS.3) sequentially by OLS.2) (12.4) There are two essentially equivalent ways to estimate the autoregressive parameters (ρ1 . Resample complete blocks.. The results may be sensitive to the block length. May not work well in small samples. 141 .3) replacing St with St . draw T /m blocks. • First apply a seasonal diﬀerencing operator. get the ˆ ˆ residual St . • Use “seasonally adjusted” data. however. Paste the blocks together to create the bootstrap time-series Yt∗ . That is. The seasonal adjustment. ∆s Yt = Yt − Yt−s . The reason why these two procedures are (essentially) the same is the Frisch-Waugh-Lovell theorem. also alters the time-series correlations of the data. 4. If s is the number of seasons (typically s = 4 or s = 12). • You can estimate (12. For each simulated sample. 5.3) or Yt = α0 + α1 t + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et . ﬁrst estimate (12.9 Trend Stationarity Yt = µ0 + µ1 t + St St = ρ1 St−1 + ρ2 St−2 + · · · + ρk St−l + et . The series ∆s Yt is clearly free of seasonality. But the long-run trend is also eliminated. This is a ﬂexible approach which can extract a wide range of seasonal factors. • You can estimate (12. This allows for arbitrary stationary serial correlation. Thus the seasonally adjusted data is a “ﬁltered” series. Seasonal Eﬀects There are three popular methods to deal with seasonal data...

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

since ρ(1) = −α0 . the hypothesis of a unit root in Yt can be stated as H0 : α0 = 0. An alternative asymptotic framework has been developed to deal with non-stationary data. The DF parameterization is convenient because the parameter α0 summarizes the information about the unit root. We do not have the time to develop this theory in detail. and test statistics are asymptotically non-normal. Under H0 . Because of this property. we say that if Yt is non-stationary but ∆d Yt is stationary. under H0 . the natural test statistic is the t-statistic for H0 from OLS estimation of (12. As we discussed before. Yt is non-stationary. as the models are equivalent. so conventional normal asymptotics are invalid. or I(d). Since α0 is the parameter of a linear regression. 143 . However. To see this. the model for Yt is ∆Yt = µ + α1 ∆Yt−1 + · · · + αk−1 ∆Yt−(k−1) + et . Thus a time series with unit root is I(1). Hence. which is an AR(k-1) in the ﬁrst-diﬀerence ∆Yt . this is the most popular unit root test. Note that the model is stationary if α0 < 0. Yt is non-stationary. and is called the Augmented Dickey-Fuller (ADF) test for a unit root. (12. 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 . Thus ρ(1) = (1 − 1) − α0 − (1 − 1) − · · · − (1 − 1) = −α0 .7) These models are equivalent linear transformations of one another.7). then ∆Yt is a stationary AR process. The ergodic theorem and MDS CLT do not apply.12. observe that the lag polynomial for the Yt computed from (12.12 Autoregressive Unit Roots The AR(k) model is ρ(L)Yt = µ + et ρ(L) = 1 − ρ1 L − · · · − ρk Lk . Indeed. Thus if Yt has a (single) unit root. It would seem natural to assess the signiﬁcance of the ADF statistic using the normal table. then Yt is “integrated of order d”.7) is (1 − L) − α0 L − α1 (L − L2 ) − · · · − αk−1 (Lk−1 − Lk ) But this must equal ρ(L). or ρ1 + ρ2 + · · · + ρk = 1. but simply assert the main results. So the natural alternative is H1 : α0 < 0. In this case. Yt has a unit root when ρ(1) = 0.

Another popular setting includes as well a linear time trend. rather than the ˆ 1/2 . These are included for completeness (from a pedagogical perspective) but have no relevance for empirical practice where intercepts are always included. This is called a “super-consistent” rate of convergence. If the series has a linear trend (e. Most texts include as well the critical values for the extreme polar case where the intercept has been omitted from the model. the test procedure is the same. But the theorem does not require an assumption of homoskedasticity. If a time trend is included. and may be used for testing the hypothesis H0 . Assume α0 = 0. (12. Thus the Dickey-Fuller test is robust to heteroskedasticity.1 (Dickey-Fuller Theorem). then the series itself is nonstationary. where c is the critical value from the ADF table. however. If the test does not reject H0 . and a diﬀerent table should be consulted. T α0 →d (1 − α1 − α2 − · · · − αk−1 ) DFα ˆ ADF = α0 ˆ → DFt . as the AR model cannot conceivably describe this data. The ADF test has a diﬀerent distribution when the time trend has been included. 144 . This is not really a correct conclusion. The ﬁrst result states that α0 converges to its true value (of zero) at rate T. Stock Prices). All we can say is that there is insuﬃcient evidence to conclude whether the data are stationary or not. We have described the test for the setting of with an intercept. a common conclusion is that the data suggests that Yt is non-stationary.g. GDP. conventional rate of T The second result states that the t-statistic for α0 converges to a limit distribution which is ˆ non-normal. They are skewed to the left. the ADF test rejects H0 in favor of H1 when ADF < c. it is a silly waste of time to ﬁt an AR model to the level of the series without a time trend. The natural solution is to include a time trend in the ﬁtted OLS equation. but does not depend on the parameters α. but diﬀerent critical values are required. This model is ∆Yt = µ1 + µ2 t + α0 Yt−1 + α1 ∆Yt−1 + · · · + αk−1 ∆Yt−(k−1) + et . If the test rejects H0 . s(ˆ 0 ) α The limit distributions DFα and DFt are non-normal.8) This is natural when the alternative hypothesis is that the series is stationary about a linear time trend. this means that it is computed as the t-ratio for α0 from OLS estimation of (12.Theorem 12.12. this means that the evidence points to Yt being stationary. and have negative means. but it may be stationary around the linear time trend. When conducting the ADF test. Since the alternative hypothesis is one-sided. This distribution has been extensively α tabulated. In this context. As T → ∞. Note: The standard error s(ˆ 0 ) is the conventional (“homoskedastic”) standard error.8).

13. . Observe that A0 is m × 1.1 Vector Autoregressions (VARs) A VAR model speciﬁes that the conditional mean is a function of only a ﬁnite number of lags: E (Yt | It−1 ) = E (Yt | Yt−1 . Yt−2 . . ⎝ . Alternatively.... Deﬁning the m × 1 regression error et = Yt − E (Yt | It−1 ) . The typical goal is to ﬁnd the conditional expectation E (Yt | It−1 ) .. Yt−k ) = A0 + A1 Yt−1 + A2 Yt−2 + · · · Ak Yt−k .Chapter 13 Multivariate Time Series A multivariate time series Yt is a vector process m × 1. Yt−k ) .) be all lagged information at time t.. Let It−1 = (Yt−1 . .and each of A1 through Ak are m × m matrices. deﬁning the mk + 1 vector ⎜ Yt−1 ⎜ ⎜ xt = ⎜ Yt−2 ⎜ . Yt−k A= ¡ ⎛ 1 ⎞ ⎟ ⎟ ⎟ ⎟ ⎟ ⎠ Ak ¢ .. . we have the VAR model Yt = A0 + A1 Yt−1 + A2 Yt−2 + · · · Ak Yt−k + et E (et | It−1 ) = 0.. Note that since Yt is a vector. this conditional expectation is also a vector. and the m × (mk + 1) matrix A0 A1 A2 · · · 145 . A linear VAR speciﬁes that this conditional mean is linear in the arguments: E (Yt | Yt−1 ..

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

h¡ 1 Yt−1 · · · 0 Yt−k Zt−1 · · · 0 Zt−k ¢0 i .4 Single Equation from a VAR Yjt = a0 xt + et . 147 . Then the null and alternative are H0 : θ = 0 H1 : θ 6= 0. Let et = ejt and β = aj . which is called a common factor restriction. it is convenient to re-deﬁne the variables. You may have heard of the Durbin-Watson test for omitted serial correlation.2) may be estimated by iterated GLS. and subtract oﬀ the equation once lagged multiplied by θ. xt−1 ) to the regression.3). If valid. This takes the form 0 and xt consists of lagged values of Yjt and the other Ylt s. which once was very popular. Then yt = x0 β + et t et = θet−1 + ut E (ut | It−1 ) = 0. (13.13. the model (13. We see that an appropriate. Suppose that et is an AR(1). Otherwise it is invalid. t and xt = This is just a conventional regression.) Since the common factor restriction appears arbitrary. t and et is iid N (0.3) which is a valid regression model. This can be done by a Wald test. may be tested if desired.5 Testing for Omitted Serial Correlation Consider the problem of testing for omitted serial correlation in equation (13. and is still routinely reported by conventional regression packages.2) Take the equation yt = x0 β + et . and is typically rejected empirically.1). j Often. direct estimation of (13. Let yt = Yjt . we are only interested in a single equation out of a VAR system. 13. Another interesting fact is that (13. This restriction. to get t ¡ ¢ ¡ ¢ yt − θyt−1 = x0 β + et − θ x0 β + et−1 t t−1 = x0 β − θxt−1 β + et − θet−1 . and Zt be the other variables. So testing H0 versus H1 is equivalent to testing for the signiﬁcance of adding (yt−1 . In this case. general.2) is a special case of (13. (A simple version of this estimator is called Cochrane-Orcutt. with time series data.1) yt = x0 β + et . under the restriction γ = −βθ.2) is uncommon in recent applications. and simple way to test for omitted serial correlation is to test the signiﬁcance of extra lagged values of the dependent variable and regressors. 1). t t−1 (13. Then the single equation takes the form (13. t or yt = θyt−1 + x0 β + x0 γ + ut . The DW test is appropriate only when regression yt = x0 β + et is not dynamic (has no lagged values on the RHS).

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

When the data have time trends. as ﬁrst shown by Stock (1987). Yt is I(1) and cointegrated. We are often interested in testing the hypothesis of no cointegration: H0 : r = 0 H1 : r > 0. β = (1 − 1)0 . In some cases. however. yet under H1 zt is I(0). Thus Yt = ˆ (Y1t . The asymptotic distribution was worked out by Phillips and Ouliaris (1990). Y2t ) and β = (β 1 β 2 ) and normalize β 1 = 1. then r = 0. 13. For 0 < r < m. In other cases. Furthermore ˆ this estimation is super-consistent: T (β 2 − β 2 ) →d Limit. then β = (1 − 1)0 speciﬁes that the spread (the diﬀerence in returns) is stationary. but it is useful in the construction of alternative estimators and tests. When β is unknown. This is not.1 The m × 1 series Yt is cointegrated if Yt is I(1) yet there exists β. The asymptotic distribution was worked out in B. then it turns out that β can be consistently estimated by an OLS regression of one component of Yt on the others. If Y = (log(Consumption) log(Income))0 . Whether or not the time trend is included.13.9 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 . Thus H0 can be tested using a univariate ADF test on zt . 149 . Under H0 . if Yt is a pair of interest rates. a good method to estimate β.8. then Yt is I(0). it may be necessary to include a time trend in the estimated cointegrating regression. If Yt is cointegrated with a single cointegrating vector (r = 1). For example. the asymptotic distribution of the test is aﬀected by the presence of the time trend. β is not consistent. in general. so zt = β 0 Yt is known. such that zt = β 0 Yt is I(0). If r = m. m × r. of rank r. Suppose that β is known. β may not be known. The r vectors in β are called the cointegrating vectors. Their justiﬁcation was Stock’s result that β is superˆ ˆ consistent under H1 . If the series Yt is not cointegrated. from OLS of Y1t on Y2t . so the ADF critical values are not appropriate. Engle and Granger (1987) suggested using an ADF test on the estimated ˆ0 ˆ residual zt = β Yt . Deﬁnition 13. Often. Hansen (1992).8 Cointegration The idea of cointegration is due to Granger (1981). it may be believed that β is known a priori. and was articulated in detail by Engle and Granger (1987). then β = (1 − 1)0 speciﬁes that log(Consumption/Income) is stationary. Then under H0 zt is I(1). Then β 2 = (Y20 Y2 )−1 Y2 Y1 →p β 2 .

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

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

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

An example of a data collection censoring is top-coding of income. Since E (Yi | xi ) = λi = exp(x0 β) i is the conditional mean.. or it may be a by-product of economic constraints. i i i=1 ˆ The MLE is the value β which maximizes ln (β). . any known value can substitute.3 Censored Data The idea of “censoring” is that some data above or below a threshold are mis-reported at the ∗ threshold. 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.. 0 if yi (This is written for the case of the threshold being zero. 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 !) . k! = exp(x0 β).. 1. i If Y = {0.. incomes above a threshold are typically reported at the threshold.” Also observe that the model implies that V ar (Yi | xi ) = λi = exp(x0 β). this motivates the label Poisson “regression.1) yi = ∗ <0 .}. but we observe only ½ ∗ ∗ yi if yi ≥ 0 (14. A generalization is the negative binomial. the consumption level (purchases) in a particular period was zero.1). This model speciﬁes that P (Yi = k | xi ) = λi k = 0. Thus the model is that there is some latent process yi with unbounded support.14. The ﬁrst censored regression model was developed by Tobin (1958) to explain consumption of durable goods. In surveys. a typical approach is to employ Poisson regression. i so the model imposes the restriction that the conditional mean and variance of Yi are the same. 1. The functional form for λi has been picked to ensure that λi > 0. This model (now called the Tobit) speciﬁes that the latent (or ideal) value of consumption may be negative (the household 153 . The conditional density is the Poisson with parameter λi . 2. σ 2 ) with the observed variable yi generated by the censoring equation (14. Tobin observed that for many households. He proposed the latent variable model ∗ yi = x0 β + ei i ei ∼ iid N (0. This may be considered restrictive. . 14.) The observed data yi therefore come from a mixed continuous/discrete distribution. 2.2 Count Data exp (−λi ) λk i . The censoring process may be explicit in data collection.

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

The binary dependent variable is Ti . ˆ ³ ´ ˆ ˆ ˆ • Estimate β. It is unknown. Under the normality assumption. ρ from OLS of yi on xi and λ(z 0 γ ). if γ were known. Zi ) = 0. by viewing the Probit/OLS estimation equations as a large joint GMM problem. The problem is that this is equivalent to conditioning on the event {Ti = 1}. Or. using regressors zi . ¡ 0 ¢ yi = x0 β + ρλ zi γ + ui i (14. Zi ) = E e1i | {e0i > −zi γ}. 1). Ti } for all observations. ¡ ¢ 0 E (e1i | Ti = 1. i • The OLS standard errors will be incorrect.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. The naive estimator of β is OLS regression of yi on xi for those observations for which yi is available. Zi ¢ ¡ ¢ ¡ 0 0 = ρE e0i | {e0i > −zi γ}. e1i ρ σ2 It is presumed that we observe {xi . which can be observed only if a person is employed. alternatively. The equation for Ti is an equation specifying the probability that the person is employed. Heckman (1979) observed that we could consistently estimate β and ρ from this equation. where Hence ¡ 0 ¢ e1i = ρλ zi γ + ui . The “Heckit” estimator is thus calculated as follows • Estimate γ from a Probit. . which is non-zero. as this is a two-step estimator. However. The model is often completed by specifying that the errors are jointly normal ¶ µ µ ¶¶ µ 1 ρ e0i ∼ N 0. The dependent variable yi is observed if (and only if) Ti = 1. but also can be consistently estimated by a Probit model for selection. E (e0i | e0i > −x) = λ(x) = Φ(x) and the function λ(x) is called the inverse Mills ratio. Else it is unobserved. For example. Thus E (ui | Ti = 1.2) is a valid regression equation for the observations for which Ti = 1. A useful fact about the standard normal distribution is that φ(x) . Zi + E vi | {e0i > −zi γ}. where vi is independent of e0i ∼ N (0. Zi ¡ 0 ¢ = ρλ zi γ . They can be corrected using a more complicated formula. 155 . yi could be a wage. e1i = ρe0i + vi . zi .

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

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

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

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

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

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

This integral (typically) is not analytically solvable. the estimator f (x) smooths data local to Xi = x. The last expression shows that the expected value is an average of f (z) locally about x. 162 . so is estimating a smoothed version of f (x).16. Since it is an average of iid random variables. Intuitively. ˆ the greater the bias. 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). so we approximate it using a second order Taylor expansion of f (x + hu) in the argument hu about hu = 0.2 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. 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) . and is larger the greater the curvature in f (x). The bias results from this smoothing. 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 . nh (x)2 dx is called the roughness of K. ˆ We now examine the variance of f (x). 2 Z ∞ ˆ The bias of f (x) is then 1 1X ˆ EKh (Xi − x) − f (x) = f 00 (x)h2 σ 2 . which is valid as h → 0. The sharper the derivative.

We can calculate that √ R(φ00 ) = 3/ (8 π) . but at a very slow rate. Their K values for the three functions introduced in the previous section are given here. (16. Gaussian Kernel: hrule = 1. This choice for h gives an optimal rule when f (x) is ˆ normal. That is. We deﬁne the asymptotically optimal bandwidth h0 as the value which minimizes this approximate MSE. 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. h must tend to zero. Notice that the ﬁrst term (the squared bias) is increasing in h and the second term (the variance) is decreasing in nh. but not of n.2) depends on R(K). (16. 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 + . how should the bandwidth be selected? This is a diﬃcult problem. A classic simple solution proposed by Silverman (1986)has come to be known as the reference bandwidth or Silverman’s Rule-of-Thumb.2) but replaces R(f 00 ) with σ −5 R(φ00 ). 1) distribution and σ 2 is an estimate of σ 2 = V ar(X). Equation (16.1) AM ISEh = AM SEh (x)dx = 4 nh R where R(f 00 ) = (f 00 (x))2 dx is the roughness of f 00 . ˆ It uses formula (16. and R(f 00 ).Together. Note that this h declines to zero. The downside is that if the density is very far from normal. The ﬁrst two are determined by the kernel function. and there is a large and continuing literature on the subject.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) . and gives a nearly optimal rule when f (x) is close to normal. we ﬁnd the reference rules for the three kernel functions introduced earlier. where φ is the N (0. Together with the above table. but at a slower rate than n−1 . the rule-of-thumb h can be quite ineﬃcient. σ 2 . 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 . we need h → 0 but nh → ∞. That is. We thus say that the optimal bandwidth is of order O(n−1/5 ).06n−1/5 163 . Thus for the AMISE to decline with n. The asymptotically optimal choice given in (16. In practice.1) is an asymptotic approximation to the MSE.

in which case the cross-validation rule can sometimes select very small bandwidths leading to dramatically undersmoothed estimates. However. but they are also known to converge very slowly to the optimal values. Another popular choice for selection of h is cross-validation. The plug-in approach is to estimate R(f 00 ) in a ﬁrst step. I now discuss some of these choices. perhaps adjusted by visual inspection of the resulting estimate ˆ f (x). There are other approaches. and then plug this estimate into the formula (16.34n−1/5 Biweight (Quartic) Kernel: hrule = 2. There are some desirable properties of cross-validation bandwidths.2). but implementation can be delicate. in particular the iterative method of Sheather and Jones (1991). 164 . This is more treacherous than may ﬁrst appear. Fortunately there are remedies. This works by constructing an estimate of the MISE using leave-one-out estimators. as the optimal h for estimation of the roughness R(f 00 ) is quite diﬀerent than the optimal h for estimation of f (x).Epanechnikov Kernel: hrule = 2. which are known as smoothed cross-validation which is a close cousin of the bootstrap.78n−1/5 Unless you delve more deeply into kernel estimation methods the rule-of-thumb bandwidth is a good practical bandwidth choice. there are modern versions of this estimator work well. They are also quite ill-behaved when the data has some discretization (as is common in economics).

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

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

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

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

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

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

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

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

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

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

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

exp − f (x) = k/2 1/2 2 (2π) det (Σ) The mean and covariance matrix of the distribution are µ and Σ.11) and is known as the chi-square density with r degrees of freedom. q 176 . X has density Ã ! (x − µ)2 1 exp − . σ 2 ). we can also show that EX 2 = 1 and EX 4 = 3. 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) .8. x ∈ Rk .8. 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. ¢ ¡ 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 . 1). then they are mutually independent. −∞ < x < ∞.1 Let X ∼ N (0. q × q. and it is conventional to write X ∼ N (µ. Its mean and r variance are µ = r and σ 2 = 2r. Theorem A. then Z 0 A−1 Z ∼ χ2 . respectively. The mean and variance of the distribution are µ and σ 2 . It is conventional to write X ∼ N (0. the multivariate normal density is ¶ µ (x − µ)0 Σ−1 (x − µ) 1 . If X ∈ Rk is multivariate normal and the elements of X are mutually uncorrelated. x ∈ Rk . Theorem A. By iterated integration by parts. then using the change-of-variables formula. Another useful fact is that if X ∼ N (µ. For x ∈ Rk . A) with A > 0. Ir ) and set Q = X 0 X. f (x) = √ 2σ 2 2πσ which is the univariate normal density. Σ) and Y = a + BX with B an invertible matrix. (A. Since it is symmetric about zero all odd moments are zero.This density has all moments ﬁnite. then Σ = diag{σ 2 } is a diagonal matrix. The latter has no closed-form solution. and to denote the standard normal density function by φ(x) and its distribution function by Φ(x). the density of Y is Ã ! (y − µY )0 Σ−1 (y − µY ) 1 Y exp − f (y) = . If Z is standard normal and X = µ + σZ. k/2 1/2 2 (2π) det (ΣY ) where µY = a+Bµ and ΣY = BΣB 0 . and it is conventional to write X ∼ N(µ. then by the change-of-variables formula. Σ).2 If Z ∼ N(0. y ≥ 0. where we used the fact that det (BΣB 0 )1/2 = det (Σ)1/2 det (B) . denoted χ2 . This shows that linear transformations of normals are also normal.

C −1 AC −10 ) = N (0.8.8.1.2. 1). Thus the density of Z 2 is (A. From (A.12) E exp (tQ) = 0 Γ (A.6) can be used to show that the MGF j=1 ¥ Proof of Theorem A.Theorem A.11). which we showed in (A. we see that the MGF of Z 2 is (1 − 2t)−1/2 . For Z ∼ N(0.11) 2 with r = 1.11) is Z ∞ ¢ ¡ Γ r+1 2 f (x) = ´ r+1 ¡r¢ ³ √ 2 2 πrΓ 2 1 + x r (A. Iq ). (A. Set r Z . tr has distribution 177 . Then A−1 = C −10 C −1 and C −1 Z ∼ N (0. Proof of Theorem A. 1) and Q ∼ χ2 be independent.13) is the MGF of the density (A. ¡ ¢ √ using the change—of-variables s = x2 and the fact Γ 1 = π. The fact that A > 0 means that we can write A = CC 0 where C is non-singular. The MGF for the density (A.13). Since we can write Q = P 2 X 0 X = r Zj where the Zj are independent N(0.3 Let Z ∼ N (0. tr = p Q/r The density of tr is and is known as the student’s t distribution with r degrees of freedom.8. Thus ¥ ¡ ¢0 ¡ ¢ Z 0 A−1 Z = Z 0 C −10 C −1 Z = C −1 Z C −1 Z ∼ χ2 . which can be found by applying change-of-variables to the gamma function. C −1 CC 0 C −10 ) = N (0. Using the simple law of iterated expectations.3.13) = (1 − 2t)−r/2 R∞ where the second equality uses the fact that 0 y a−1 exp (−by) dy = b−a Γ(a). q Proof of Theorem A. 1) the distribution of Z 2 is ¡ ¢ √ P Z 2 ≤ y = 2P (0 ≤ Z ≤ y) µ 2¶ Z √y 1 x √ exp − dx = 2 2 2π 0 Z y ³ s´ 1 ¡1¢ = s−1/2 exp − ds 1/2 2 0 Γ 2 2 1 ¡r¢ 2 2r/2 y r/2−1 exp (ty) exp (−y/2) dy of Q is (1 − 2t)−r/2 .8.

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

the log-likelihood is a sample average 1X 1 Ln (θ) = ln f (Yi .16) (A. Theorem A. ˆ is consistent θ for this value.2 Cramer-Rao Lower Bound. the MLE θ Why do we believe that the MLE ˆ is estimating the parameter θ? Observe that when stanθ dardized.9. θ0 ) ∂θ∂θ 0 (A.3 Under regularity conditions.Deﬁne the Hessian H = −E and the outer product matrix Ω=E µ ∂2 ln f (Yi . We can write this as ˆ = argmax Ln (θ). θ Theorem A. n n i=1 n As the MLE ˆ maximizes the left-hand-side. The ﬁrst-order condition for the latter problem is 0= ∂ ∂ L(θ) = E ln f (Yi . and the equality (A.1 ¯ ¯ ∂ E ln f (Yi . θ0 ) ln f (Yi . θ) ≡ L(θ). the restriction to unbiased estimators means that the theorem has little direct relevance for ﬁnite sample eﬃciency. θ) The Cramer-Rao Theorem gives a lower bound for estimation. which maximizes the log-likelihood). In fact. under conventional regularity conditions. θ0 ) . The maximum likelihood estimator or MLE ˆ is the parameter value which maximizes θ the likelihood (equivalently. 179 .9. then θ V ar(˜ ≥ (nI0 )−1 . If ˜ is an unbiased estimator of θ ∈ R. θ) →p E ln f (Yi . ˆ →p θ0 as n → ∞.9.17) is often called the information matrix equality. θ) ∂θ ∂θ which holds at θ = θ0 by (A.15) Two important features of the likelihood are Theorem A. I0 . ∂θ ∂θ (A. θ θ∈Θ ˆ In some simple cases. θ)¯ =0 ¯ ∂θ θ=θ0 H = Ω ≡ I0 (A.17) The matrix I0 is called the information. we can ﬁnd an explicit expression for θ as a function of the data. However.16). but these ˆ must be found by numerical methods. More typically. ´ ¡ −1 ¢ √ ³ˆ n θ − θ0 →d N 0.14) ¶ ∂ ∂ 0 ln f (Yi . cases are rare. we can see that it is an estimator of the maximizer θ of the right-hand-side.

Thus in large samples the MLE has approximately the best possible variance. θ) θ In this case. ˆ ln f Yi .18) H =− n ∂θ∂θ0 i=1 the Kullback-Leibler information distance between the true density f (y) and the parametric density f (y. V ) . Typically. θ) is used to approximate the true unknown density f (y). θ (A.ˆ ˆ−1 θ We then set I0 = H −1 . ˆ .17) does not hold.14) n ³ ´ 1 X ∂2 ˆ ˆ ln f Yi . Therefore the MLE is called asymptotically eﬃcient. Instead we deﬁne the pseudo-true value θ0 as the maximizer of Z E ln f (Yi . but has a diﬀerent covariance matrix than in the pure MLE case. since the information matrix equality (A. θ) = f (y) ln f (y. A minor adjustment to Theorem (A. θ). 180 . the approximate variance of the MLE is (nI0 )−1 which is the CramerRao lower bound. θ) ¶ dy Thus in large samples. θ V = H −1 ΩH −1 The moment estimator for V is ˆ where H is given in (A. we refer to Ln (ˆ as a quasi-likelihood and the its maximizer ˆ as a quasi-mle or QMLE. Thus the QMLE θ0 is the value which makes the parametric density “closest” to the true value according to this measure of distance. 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 . θ) is necessarily the true density. but it is not literally believed that the model f (y. Asymptotic standard errors for ˆ are then the square roots of the diagonal −1 I −1 . ˆ elements of n 0 Sometimes a parametric density function f (y. The QMLE is consistent for the pseudo-true value.3) yields the asymptotic distribution of the QMLE: ´ √ ³ n ˆ − θ0 →d N (0.18) and ³ ³ ´ ∂ ´0 1X ∂ ˆ ln f Yi . θ) dy which is the same as the minimizer of KLIC = Z f (y) ln µ f (y) f (y. to estimate the asymptotic variance of the MLE we use an estimate based on the Hessian formula (A.9. In this case there is not a “true” value of the parameter θ.

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

∂θ ∂θ∂θ i=1 i=1 θ where θn lies on a line segment joining ˆ and θ0 . θ) . θ n ) θ − θ 0 . an application of the CLT yields 1 X ∂ √ ln f (Yi . we ﬁnd ´ ³ ˆ − θ0 = θ Since ∂ ∂θ Ã !−1 Ã n ! n X ∂2 X ∂ ln f (Yi . then since θn →p θ0 we ﬁnd H(θn ) →p H and so ¶ n n µ ∂2 1X 1 X ∂2 − ln f (Yi . Together. Ω) = N 0. θn ) ∂θ ∂θ∂θ0 i=1 i=1 ln f (Yi . − ln f (Yi . the speciﬁc value of θn varies by row in this expansion. ´ ¡ ¢ ¡ ¢ √ ³ˆ n θ − θ0 →d H −1 N (0. θ0 ) + ' 0 ln f (Yi . ˆ = θ ∂θ i=1 n n ´ ³ X ∂ X ∂2 ˆ ln f (Yi . ∂θ n i=1 n The analysis of the sample Hessian is somewhat more complicated due to the presence of θn . θn ) = ln f (Yi . H −1 ΩH −1 = N 0. (Technically.Proof of Theorem A. θ0 ) is mean-zero with covariance matrix Ω. ¯ ¯ ∂ Ln (θ)¯ 0 = ¯ ˆ ∂θ θ=θ n ³ ´ X ∂ ln f Yi . ¥ 182 . θ0 ) . and making a ﬁrst-order Taylor series expansion. the ﬁnal equality using Theorem A.9. If it is continuous in θ. Let ∂2 H(θ) = − ∂θ∂θ0 ln f (Yi . Ω) . θn ) − H(θn ) + H(θn ) − n n ∂θ∂θ0 ∂θ∂θ0 i=1 i=1 →p H by an application of a uniform WLLN.1 . θ0 ) →d N (0.9. H −1 .3 Taking the ﬁrst-order condition for maximization of Ln (θ).) Rewriting this equation.

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

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

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

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

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

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

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

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

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