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

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

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Contents

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

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

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

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

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

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

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ii

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

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

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

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

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

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

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

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

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

. Furthermore. which are not necessarily distinct and may be real or complex.. and let H = [h1 · · · hk ]. In this case. If A = G0 G. then A = HΛH 0 and H 0 AH = Λ. • If A has distinct characteristic roots. 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. To see this. Let Λ be a diagonal matrix with the characteristic roots in the diagonal. . A−1 > 0. and the characteristic roots are all real. One way to construct B is to use the spectral decomposition A = HΛH 0 where Λ is diagonal.) If A is positive deﬁnite. c0 Ac = α0 a ≥ 0 where α = Gc. 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. 2. then A is non-singular and A−1 exists.. note that we can write A = HΛH 0 where H is orthogonal and Λ contains the (real) characteristic roots.. This is written as A ≥ 0. λ−1 . If A is symmetric. λ−1 . 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 . If A > 0 we can ﬁnd a matrix B such that A = BB 0 .6 Rank and Positive Deﬁniteness The rank of a square matrix is the number of its non-zero characteristic roots.. This is written as A > 0. We say that A is positive deﬁnite if for all non-zero c. . We now state some useful properties. We say that X is n × k. k denote the k eigenvalues and eigenvectors of a square matrix A.. 1 2 k The decomposition A = HΛH 0 is called the spectral decomposition of a matrix. • The characteristic roots of A−1 are λ−1 . The matrix B need not be unique. k < n. then A > 0 if and only if all its characteristic roots are positive. c0 Ac > 0. Let λi and hi . They are called the latent roots or characteristic roots or eigenvalues of A. If A is also symmetric (most idempotent matrices are) then all its characteristic roots equal either zero or one. Then A = AA = HΛH 0 HΛH 0 = HΛ2 H 0 . there exists a nonsingular matrix P such that A = P −1 ΛP and P AP −1 = Λ. (For any c 6= 0. c0 Ac ≥ 0.5 Eigenvalues det (A − λIk ) = 0. X 0 X is symmetric and positive deﬁnite. 8 . We call B a matrix square root of A. If λi is an eigenvalue of A. and then set B = HΛ1/2 . then A is positive semi-deﬁnite.2. i = 1. We say that a square matrix A is positive semi-deﬁnite if for all non-zero c. A square matrix A is idempotent if AA = A. • If A is symmetric. has full rank k if there is no non-zero c such that Xc = 0.

xk ) : Rk → R. . ∂ g(x) ∂xk ··· ∂ ∂xk g(x) ⎞ ³ ∂ g(x) = ∂x0 Some properties are now summarized. jk ) denote a permutation of (1.. xk ) be k × 1 and g(x) = g(x1 . tr(A) = rank(A). ⎠ . k)). then its determinant is det A = a11 a22 − a12 a21 .. .. The vector derivative is ∂ ⎜ g(x) = ⎝ ∂x ∂ ∂x1 g(x) and ⎟ . 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 .. . we deduce that Λ2 = Λ and λ2 = λi for i = 1.. and let επ = +1 if this count is even and επ = −1 if the count is odd.. It follows that the spectral decomposition of A takes the form ¸ ∙ In−k 0 (2. There are k! such permutations.... we can deﬁne the determinant as follows. k) . k.. 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 (1.7 Matrix Calculus ⎛ ∂ ∂x1 g(x) Let x = (x1 .4) H0 M =H 0 0 with H 0 H = In .8 Determinant The determinant is deﬁned for square matrices. . ...By the uniqueness of the characteristic roots.. Additionally... .. If A is 2 × 2. (a0 x) = ∂ ∂x (x0 a) = a (Ax) = A (x0 Ax) = (A + A0 ) x (x0 Ax) = A + A0 ∂2 ∂x∂x0 2. i Hence they must equal either 0 or 1. • • • • ∂ ∂x ∂ ∂x0 ∂ ∂x ´ .. Let π = (j1 . .. 2.

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

⎠ ⎝ . These are asymmetric (skewed) densities. While it is easy to observe that the two densities are unequal. the conditional density of yi given xi . education and experience. the conditioning variable. To illustrate. which is a common feature of wage distributions. This is used when the goal is to quantify the impact of one set of variables on another variable. we can focus on f (y | x) . (3.2) m(x) = E (yi | xi = x) = −∞ In general. and exists so long as E |yi | < ∞. When a distribution is skewed. The data are from the 2004 Current Population Survey 1 11 . These are indicated in Figure 3.1 Conditional Mean To study how the distribution of yi varies with the variables xi in the population. In this context it is often convenient These are nonparametric density estimates using a Gaussian kernel with the bandwidth selected by crossvalidation.22.Chapter 3 Regression and Projection The most commonly applied econometric tool is regression. An important summary measure is the conditional mean Z ∞ yf (y | x) dy. We list the elements of xi in the vector ⎞ ⎛ x1i ⎜ x2i ⎟ ⎟ ⎜ (3.1) xi = ⎜ . or the covariates. You can see that the right tail of then density is much thicker than the left tail. xki 3.1 displays the density1 of hourly wages for men and women. These are conditional density functions — the density of hourly wages conditional on race. Figure 3. In this context we partition the observations into the pair (yi . from the population of white non-military wage earners with a college degree and 10-15 years of potential work experience. gender. . We call yi the dependent variable. The two density curves show the eﬀect of gender on the distribution of wages. holding the other variables constant. xi ) where yi is a scalar (real-valued) and xi is a vector. m(x) can take any form. Take a closer look at the density functions displayed in Figure 3.1. In the example presented in Figure 3.73. it is useful to have numerical measures of the diﬀerence.1. the mean is not necessarily a good summary of the central tendency. See Chapter 16. the mean wage for men is $27. ⎟ .1 by the arrows drawn to the x-axis. We call xi alternatively the regressor. and that for women is $20.

D.3) White non-military male wage earners with 10-15 years of potential work experience.A. The conditional expectation function is close to linear. 2 (3. Figure 3. For this reason.2) evaluated at the observed value of xi : ei = yi − m(xi ). To illustrate.2 Regression Equation The regression error ei is deﬁned to be the diﬀerence between yi and its conditional mean (3. degree in mean log hourly wages is 0. the dashed line is a linear projection approximation which will be discussed in the Section 3. then comparisons become more complicated. and a Ph.30.2 shows the density of log hourly wages for the same population.Figure 3.5. The diﬀerence in the log mean wage between men and women is 0. 3. By construction. the solid line displays the conditional expectation of log wages varying with education. wage regressions typically use log wages as a dependent variable rather than the level of wages. The main point to be learned from Figure 3. implying an average 36% diﬀerence in wage levels. Of particular interest to graduate students may be the observation that diﬀerence between a B. this yields the formula yi = m(xi ) + ei . Assuming for simplicity that this is the true joint distribution. which implies a 30% average wage diﬀerence for this population. with mean log hourly wages drawn in with the arrows.3 is how the conditional expectation describes an important feature of the conditional distribution. 12 .3 displays a scatter plot2 of log wages against education levels. The comparison in Figure 3. Figure 3.1 is facilitated by the fact that the control variable (gender) is discrete.1: Wage Densities for White College Grads with 10-15 Years Work Experience to transform the data by taking the (natural) logarithm. When the distribution of the control variable is continuous. This is a more robust measure of the typical wage gap between men and women than the diﬀerence in the untransformed wage means.36.

E(xi ei ) = 0. restrictions on the permissible class of regression functions m(x). 3. most typically. are often stated jointly as the regression framework. The equations yi = m(xi ) + ei E (ei | xi ) = 0. It is important to understand that this is a framework. To show the ﬁrst statement. E (ei | xi ) = 0. because no restrictions have been placed on the joint distribution of the data. E (h(xi )ei ) = 0 for any function h (·) .1 Properties of the regression error ei 1.Figure 3. The remaining parts of the Theorem are left as an exercise. E(ei ) = 0. by the deﬁnition of ei and the linearity of conditional expectations. not a model. These equations hold true by deﬁnition.2. 4. A regression model imposes further restrictions on the joint distribution.2: Log Wage Densities Theorem 3. 2. 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). Given the random variable xi . i . The conditional standard deviation is its square root σ(x) = σ 2 (x).1.3 Conditional Variance Generally. 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. the conditional variance of yi is σ 2 = σ 2 (xi ). Thus the mean squared error is minimized by the conditional mean.2.4) E e2 | xi = σ 2 i 14 While the conditional mean is a good measure of the location of a conditional distribution. and can take any form. σ 2 (x) is a non-trivial function of x.3: Conditional Mean of Wages Given Education The conditional mean also has the property of being the the best predictor of yi . when σ 2 (x) is a constant so that ¢ ¡ (3.3. To see this. let g(x) be an arbitrary predictor of yi given xi = x.Figure 3. 3. In contrast. A common measure of the dispersion is the conditional variance ¡ ¢ σ 2 (x) = V ar (yi | xi = x) = E e2 | xi = x . it does not provide information about the spread of the distribution. In the general case i where σ 2 (x) depends on x we say that the error ei is heteroskedastic. in the sense of achieving the lowest mean squared error. subject to the restriction p that it is non-negative.

it is more realistic to view the linear speciﬁcation (3.5. we assume that x1i = 1. they are also somewhat more dispersed. ⎠ . As an example. Thus (3. Equivalently.7) is a k × 1 parameter vector. xki When m(x) is linear in x.8) (3.5) xi = ⎜ .8) is called the linear regression model. Notationally.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 . and the linear assumption of the previous section is empirically unlikely to accurate. take the conditional wage densities displayed in Figure 3.1). its functional form is typically unknown. ⎟ β=⎝ . i (3. it is convenient to augment the regressor vector xi by listing the number “1” as an element.6) (3.9) 3. ⎟ .we say that the error ei is homoskedastic. An important special case is homoskedastic linear regression model yi = x0 β + ei i E (ei | xi ) = 0 ¢ ¡ E e2 | xi = σ 2 . Instead.1) has been redeﬁned as the k × 1 vector ⎛ ⎞ 1 ⎜ x2i ⎟ ⎜ ⎟ (3. we can write it as m(x) = x0 β = β 1 + x2i β 2 + · · · + xki β k where ⎞ β1 ⎜ . where x1i is the ﬁrst element of the vector xi deﬁned in (3.3) can be writen as yi = x0 β + ei i E (ei | xi ) = 0. In this case (3. βk ⎛ (3. So while men have higher average wages. ⎠ . We call this the “constant” or “intercept”. which we derive in this section. The conditional standard deviation for men is 12. ⎝ . Equation (3. 3.1 and that for women is 10.1. Some textbooks inappropriately describe heteroskedasticity as the case where “the variance of ei varies across observation i”. This concept is less helpful than deﬁning heteroskedasticity as the dependence of the conditional variance on the observables xi .3) is when the conditional mean function m(x) is linear in x (or linear in functions of x). 15 .6) as an approximation.4 Linear Regression An important special case of (3.

written E (xi x0 ) > 0. 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. this situation must be excluded. Observe i that for any non-zero α ∈ Rk . Assumption 3. i (3. Therefore. i (3. The best linear predictor is obtained by selecting β to minimize S(β). we obtain a decomposition of yi into linear predictor and error yi = x0 β + ei . In order for β to be uniquely deﬁned.10) It is worth taking the time to understand the notation involved in this expression. α0 E (xi x0 ) α = E (α0 xi )2 > 0. i 16 . The vector (3. Eyi < ∞. α0 E (xi x0 ) α = E (α0 xi )2 ≥ 0 so the matrix E (xi x0 ) is by construction i i positive semi-deﬁnite. by “best” we mean the predictor function with lowest mean squared error.10) exists and is unique as long as the k ×k matrix E (xi x0 ) is invertible.10).5. x0 β is the best linear predictor for yi . We now summarize the assumptions necessary for its derivation and list the implications in Theorem 3. 2 2. Given the deﬁnition of β in (3. i ∂β ¢¢−1 ¡ ¡ E (xi yi ) .1. The ﬁrst-order condition for minimization (from Section 2. E (x0 xi ) < ∞.5. there cannot i exist a non-zero vector α such that α0 xi = 0 identically.11) Notice that the error from the linear prediction equation ei is equal to the error from the regression equation when (and only when) the conditional mean is linear in xi . i i (3. E (xi x0 ) is invertible. Rewriting. It is invertible if and only if it is positive deﬁnite.which is quadratic in β. For any β ∈ Rk a linear predictor for yi is x0 β with expected squared prediction i error ¢2 ¡ S(β) = E yi − x0 β i ¢ ¢ ¡ ¡ 2 = Eyi − 2E yi x0 β + β 0 E xi x0 β. As before. i 4. Equivalently.1 1. alternative expressions such as E xixi ) or E (xi yi ) (E (xi x0 ))−1 i ( i 0i ) are incoherent and incorrect. i which requires that for all non-zero α. The error is i ei = yi − x0 β. otherwise they are distinct.7) is 0= Solving for β we ﬁnd ¡ ¢ ∂ S(β) = −2E (xi yi ) + 2E xi x0 β. 3.12) This completes the derivation of the linear projection model. E (xi x0 ) is a mai E(x y trix and E (xi yi ) is a vector. This occurs when redundant variables are included in xi .

13) and Assumption 3. E (xi ei ) = 0 and E (ei ) = 0.10) and (3.4 we know that the regression error has the property E (xi ei ) = 0. i i i Since E (xi ei ) = 0 we say that xi and ei are orthogonal. x0 β is the i projection of yi on xi since the error ei is orthogonal with xi .14) Proof.5.5.5.1. The ﬁnite variance Assumptions 3.1 Under Assumption 3.1. 17 .13) implies that xi and ei are uncorrelated.8)-(3.3 ensure that the moments in (3.1.1.5.14).14) follows from (3.5.12) can be alternatively interpreted as a projection decomposition.Theorem 3.10) are deﬁned.1. the converse is not true as the projection error does not necessarily satisfy E (ei | xi ) = 0. Using the deﬁnitions (3. the orthogonality restriction (3.2 and 3.10) ¡ ¡ ¢¢ E (xi ei ) = E xi yi − x0 β i ¡ ¢¡ ¡ ¢¢−1 E (xi yi ) = E (xi yi ) − E xi x0 E xi x0 i i = 0. Furthermore.1.1.4 is required to ensure that β is uniquely deﬁned. Assumption 3.5.1 are weak. This means that the equation (3. Assumption 3. Since ei is mean zero by (3.3 are called regularity conditions.5.11) and (3. Then i i Exi e2 = Ex3 = 0 yet E (ei | xi ) = x2 6= 0.2. Assumption 3. Figure 3.12) and (3.13) The two equations (3. (3.5. However.2 and 3.1. Equation (3.13) summarize the linear projection model. ¥ (3.1.4: Hourly Wage as a Function of Experience The conditions listed in Assumption 3.4 guarantees that the solution β exits.5. it follows that linear regression is a special case of the projection model. suppose that for xi ∈ R that Ex3 = 0 and ei = x2 . By deﬁnition.1 is employed to guarantee that (3. Let’s compare it with the linear regression model (3.11) are well deﬁned.1.9). Assumption 3. For example. (3.5. Since from Theorem 3.1.5.14) holds.

The linear equation (3. The solid line is the conditional mean. In other cases the two may be quite diﬀerent. It over-predicts wages for young and old workers. there are no changes in our methods or analysis.1.10). xi ) we can deﬁne a linear projection equation (3. the dashed line is the linear projection of log wages on eduction. In this case (3. for any pair (yi . and under-predicts for the rest.5. A projection of log wages on these two variables can be called a quadratic projection.12) is deﬁned by projection and the associated coeﬃcient deﬁnition (3.12) with the properties listed in Theorem 3.5. in many economic models the parameter β may be deﬁned within the model.4 we display as well this quadratic projection.4 displays the relationship3 between mean log hourly wages and labor market experience. it misses the strong downturn in expected wages for those above 35 years work experience (equivalently.5 for a 3 In the population of Caucasian non-military male wage earners with 12 years of education. In this example the linear projection is a close approximation to the conditional mean. No additional assumptions are required.We have shown that under mild regularity conditions. Most importantly. In contrast. In Figure 1.10) may not hold and the implications of Theorem 3. These structural models require alternative estimation methods. In the example just presented. 18 . Figure 3. it is important to not misinterpret the generality of this statement.3. In this case the linear projection is a poor approximation to the conditional mean. since the resulting function is quadratic in experience. This defect in linear projection can be partially corrected through a careful selection of regressors. we can augment the regressor vector xi to include both experience and experience2 . and the straight dashed line is the linear projection. for those over 53 in age). Returning to the joint distribution displayed in Figure 3. In this example it is a much better approximation to the conditional mean than the linear projection. Figure 3. We illustrate the issue in Figure 3. and are discussed in Chapter 11.5: 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. Other than the redeﬁnition of the regressor vector.1 may be false. However.

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

E(ei | xi ) = 0. 9. σ 2 = V ar(yi ) and σ xy = Cov(xi . and the conditional distribution of yi given xi is Poisson: P (yi = k | xi = x) = e−x β (x0 β)j . j! 0 j = 0. 0 ≤ y ≤ 1. True or False. Show that x y β 1 = σ xy /σ 2 and β 0 = µy − β 1 µx . a constant. 3 and 4 of Theorem 3. then E(ei | xi ) = 0. then E(x2 ei ) = 0.6 Exercises 1. σ 2 = V ar(xi ). s) = 0 if and only if m = µ and s = σ 2 . If yi = x0 β + ei . i 10. µ. 1. and E(e2 | xi ) = σ 2 .1 . yi ). E(Y 2 | X = x) and V ar(Y | X = x). i 7. taking values only on the non-negative integers.3. 20 . Suppose that yi is discrete-valued. and E(ei | xi ) = 0. If yi = x0 β + ei and E(ei | xi ) = 0. then E(x2 ei ) = 0. ¡ ¢ 4. Compute 2 the coeﬃcients of the linear projection yi = β 0 + β 1 xi + ei . Let X be a random variable with µ = EX and σ 2 = V ar(X). (x − µ)2 − σ 2 Show that Eg (X. If yi = x0 β + ei and E(xi ei ) = 0. i 8. and have the following joint probability distribution X=0 X=1 Y =0 .3 Find E(Y | X = x). True or False. If yi = xi β + ei . Let xi and yi have the joint density f (x. If yi = xi β + ei .2.1. True or False. σ = .. Does this justify a linear regression model of the form yi = x0 β + εi ? i then EY = λ and V ar(Y ) = λ. and E(xi ei ) = 0. 2. m. Compute the conditional mean m(x) = E (yi | xi = x) . i 11. 3. 2. Are they diﬀerent? Hint: If P (Y = j) = 5. Compute E(yi | xi = x) and V ar(yi | xi = x). True or False. µx = Exi . Prove parts 2. y) = 3 x2 + y 2 on 0 ≤ x ≤ 1. .4 . Suppose that Y and X only take the values 0 and 1. then ei is independent of xi . Take the bivariate linear projection model yi = β 0 + β 1 xi + ei E (ei ) = 0 E (xi ei ) = 0 Deﬁne µy = Eyi . True or False. e−λ λj j! . xi ∈ R. Deﬁne µ ¶ ¢ ¡ x−µ 2 g x. xi ∈ R. then ei is i i independent of xi . x 6..2 Y =1 .

but for most of the chapter we retain the broader focus on the projection model.4) i i=1 i=1 ˆ Another way to derive β is as follows.3) writes the projection coeﬃcient β as an explicit function of population moments E (xi yi ) and E (xi x0 ) . (4. i n i=1 n 21 . 4. Observe that (4. i It follows that the moment estimator of β replaces the population moments in (4. we narrow the focus to the linear regression model.8.1 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 .2) can be written in the parametric 0 β)) = 0. The function g(β) can be estimated by form g(β) = E (xi (yi − xi g (β) = ˆ ¢ 1X ¡ xi yi − x0 β .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 (4.1) (4.3) In Sections 4.2) (4. Their moment estimators are the sample moments i ˆ E (xi yi ) = ¢ ¡ ˆ E xi x0 = i 1X xi yi n 1 n i=1 n X i=1 n xi x0 .7 and 4.

37 µ ¶ 1.7% increase in mean wages. Deﬁne the sum-of-squared errors (SSE) function n X¡ ¢2 yi − x0 β Sn (β) = i i=1 = This is a quadratic function of β.40 n i=1 1 n Thus ˆ β = n X i=1 xi x0 i = µ 1 14.14 14.40 µ ¶µ ¶ 34. 30 = .ˆ This is a set of k equations which are linear in β. with 10-15 years of potential work experience.95 xi yi = 42. 40 0.117 1 14. 40 2. Then µ ¶ n 1X 2. 0. 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. An interpretation of the estimated equation is that each year of education is associated with an 11. 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 ) = 1.4). To illustrate.30 + 0. This sample has 988 observations. These are white male wage earners from the March 2004 Current Population Survey. ¶ 2.4). excluding military.71 = −2.170 37.14 205.94 −2.83 ¶−1 µ ¶ .117 Educationi . consider the data used to generate Figure 3. Let yi be log wages and xi be an intercept and years of education.5) = n n 1X 1X ˆ xi yi − xi x0 β i n n i=1 i=1 whose solution is (4.14 14.14 205. i 22 .3. 4.95 42.2 Least Squares There is another classic motivation for the estimator (4.

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

It measures the variation in the i “unexplained” part of the regression.Figure 4. Its method of moments estimator is the sample average 1X 2 ei .2: Sum-of-Squared Error Function Contours Equation (4. The error variance σ 2 = Ee2 is also a parameter of interest.7) A justiﬁcation for the latter choice will be provided in Section 4. ˆ n i=1 n Since xi contains a constant. one implication is that n 1X ei = 0. ˆ n i=1 Thus the residuals have a sample mean of zero and the sample correlation between the regressors and the residual is zero. These are algebraic results.6) An alternative estimator uses the formula n 1 X 2 s = ei . ˆ n−k 2 i=1 (4. and hold true for all linear regression estimates. 24 .7. ˆ σ = ˆ n 2 i=1 n (4.5) implies that 1X xi ei = 0.

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

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

4.5

Projection Matrices

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

Deﬁne the matrices and

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

and

PP

=

= M − MP = M

1

A matrix A is idempotent if AA = A.

27

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

r X j=1

(4.9) (4.10)

ajj

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

and

4.6

Residual Regression

X = [X1 X2 ] ¶ .

Partition and β= µ

β1 β2

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

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

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

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

It follows that

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

2

(4.15)

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

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

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

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

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

9). Regress Y on X1 . the OLS estimator of β 2 and the OLS residuals e may be equivalently computed by either the OLS regression (4. ! Thus the OLS estimator for the slope coeﬃcients is a regression with demeaned data. observe that ⎞ ⎛ ⎞ ⎛ . In the model (4. the FWL theorem can be used to speed computation. ¡ ¢−1 0 ι. In this section we derive the small sample conditional mean and variance of the OLS estimator. which you may have seen in an introductory econometrics course.8)(3. A common application of the FWL theorem. 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. .7 Bias and Variance In this and the following section we consider the special case of the linear regression model (3. . obtain OLS estimates β 2 and residuals e. ⎠ ⎝ ⎠ ⎝ . The FWL theorem says that β 2 is the OLS estimate from a regression of ˜ ˜ Y on X2 . and X2 is the vector of observed regressors. but in most cases there is little computational advantage to using the two-step algorithm.Theorem 4.14) or via the ˆ following algorithm: ˜ 1. Partition X = [X1 X2 ] where X1 = ι is a vector of ones. ⎟ ⎜ ⎟ ⎜ (4.6. . 4.1 (Frisch-Waugh-Lovell). 30 . is the demeaning formula for regression. By the independence of the observations and (3. .9). . ˆ which are “demeaned”. . the primary use is theoretical. 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) . Rather.18) E (e | X) = ⎜ E (ei | X) ⎟ = ⎜ E (ei | xi ) ⎟ = 0. Regress Y on X2 . . obtain residuals Y . . .13). In some contexts. obtain residuals X2 . ˆ ˜ ˜ ˆ 3. ˜ 2. In this case. Regress X2 on X1 . .

.8). and (4.. ¡ X 0X ¢−1 ¡ ¢−1 X 0 DX X 0 X while the ij 0 th oﬀ-diagonal element of D is ¢ ¢ ¡ ¡ E e2 | X = E e2 | xi = σ 2 i i i E (ei ej | X) = E (ei | xi ) E (ej | xj ) = 0.19) ˆ and thus the OLS estimator β is unbiased for β.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 . From (4.20) . 0 0 ··· 0 0 . ⎝ . σ 2 } = ⎜ . V ar β | X = X 0 X ⎟ ⎟ ⎟. the properties additional assumption of conditional homoskedasticity E ei i of projection matrices.. ⎠ (4.12). . 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.18). . . Then given (4.. . 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. σ 2 = σ 2 and we have the simplii ﬁcations D = In σ 2 .Using (4. under the of ˆ ¢ 2 | x = σ 2 . the properties of conditional expectations. and the trace operator observe that. for any random vector Z deﬁne the covariance materix V ar(Z) = E (Z − EZ) (Z − EZ)0 = EZZ 0 − (EZ) (EZ)0 . X 0 DX = X 0 Xσ 2 . Thus D is a diagonal matrix with i’th diagonal element σ 2 : i ⎛ 2 σ1 0 · · · ⎜ 0 σ2 · · · 2 ⎜ D = diag{σ 2 . . . σ2 n ⎞ We now calculate the ﬁnite sample bias of the method ¡ moments estimator σ 2 for σ 2 . Next. We have shown that which implies ³ ´ ˆ E β|X =β ³ ´ ˆ E β =β (4.. and ³ ´ ¡ ¢−1 2 ˆ σ . 1 n . .

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

. 4. xi ) is discrete. the class of potential estimators has been restricted to linear unbiased estimators. Suppose that the joint distribution of (yi .. The variance of the least-squares estimator is (X 0 X)−1 σ 2 and that of A0 Y is A0 Aσ 2 . where 1 (·) is the indicator function. The MLE β mle for β is then the analog of (4. but the π j are unknown. . Not only has the class of models has been restricted to homoskedastic linear regressions. That is.3) can be rewritten as ⎞−1 ⎛ ⎞ ⎛ r r X X β=⎝ πj ξ j ξ 0 ⎠ ⎝ πj ξ j τ j ⎠ (4..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 ⎠ .5) as required. 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.. Note that X 0 C = 0. That is. r.. who established that in the projection model the OLS estimator has the smallest asymptotic meansquared error among feasible estimators. . π j is the percentage of the observations ˆ ˆ which fall in each category. and is a strong justiﬁcation for the least-squares estimator. This latter restriction is particularly unsatisfactory. ξ j . but it is quite limited in scope.. As the data are multinomial.) In this discrete setting. for ﬁnite r. but we don’t know the probabilities. ˆ β mle = ⎝ j j=1 j=1 33 . and π j . ¥ The Gauss-Markov theorem is an eﬃciency justiﬁcation for the least-squares estimator. We discuss the intuition behind his result in this section. Set C = A − X (X 0 X)−1 . Assume that the τ j and ξ j are known. (We know the values yi and xi can take.Proof.. 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 ) . ¡ ¢ P yi = τ j . r for some constant vectors τ j . j = 1.21) j j=1 j=1 Thus β is a function of (π 1 . 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. . A broader justiﬁcation is provided in Chamberlain (1987). It is suﬃcient to show that the diﬀerence A0 A − (X 0 X)−1 is positive semi-deﬁnite.. Let A be any n×k function of X such that A0 X = Ik . This property is called semiparametric eﬃciency.9 Semiparametric Eﬃciency In the previous section we presented the Gauss-Markov theorem as a limited eﬃciency justiﬁcation for the least-squares estimator.. xi = ξ j = π j . the deﬁnition (4.

22) 34 .5. He observes that the above argument holds for all multinomial distributions. (4. and thus so is the OLS estimator.10 Omitted Variables xi = µ x1i x2i ¶ . He proves that generically the OLS estimator (4.1. if the data have a discrete distribution. the maximum likelihood estimator is identical to the OLS estimator.9).4) is an asymptotically eﬃcient estimator for the parameter β deﬁned in (3. 1X xi x0 i n i=1 1X xi yi n i=1 n ˆ = β ols 4. Chamberlain (1987) extends this argument to the case of continuously-distributed data.Substituting in the expressions for π j . Since this is a regular parametric model the MLE is asymptotically eﬃcient (see Appendix A. Let the regressors be partitioned as Suppose we are interested in the coeﬃcient on x1i alone in the regression of yi on the full set xi .10) for the class of models satisfying Assumption 3. 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 . 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. and any continuous distribution can be arbitrarily well approximated by a multinomial distribution.

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

In extreme cases it is possible that the reported calculations will be in error due to ﬂoating-point calculation diﬃculties. To investigate the possibility of inﬂuential observations. deﬁne the leave-one-out least-squares estimator of β. it is statistically diﬃcult to disentangle the impact of β 1 from that of β 2 . the precision of individual estimates are reduced. the OLS estimator based on the sample excluding the i’th observation. The hi take values in [0. µ ¶−1 µ ¶ ³ ´ 2 σ2 1 ρ 1 −ρ ˆ|X = σ . ˆ ˆ (4. ˆ i A simple comparison yields that ˆ ei − ei. We derive expression (4.−i = (1 − hi )−1 hi ei .25) below. the worse the precision of the individual coeﬃcient estimates. We can also deﬁne the leave-one-out residual ˆ ˆ ei. This equals ´−1 ³ 0 ˆ X(−i) Y(−i) (4.26) As we can see. What is happening is that when the regressors are highly dependent. since as ρ approaches 1 the matrix becomes singular.25) β (−i) = β − (1 − hi )−1 X 0 X where ¢−1 ¡ xi hi = x0 X 0 X i The i’th observation is inﬂuential on the least-squares estimate if the deletion of the observation ˆ from the sample results in a meaningful change in β. We can see this most simply in a homoskedastic linear regression model with two regressors yi = x1i β 1 + x2i β 2 + ei . and 1 0 XX= n µ 1 ρ ρ 1 ¶ In this case The correlation ρ indexes collinearity.−i = yi − x0 β (−i) = (1 − hi )−1 ei . that is.12 Inﬂuential Observations where X(−i) and Y(−i) are the data matrices omitting the i’th row. Thus the more “collinear” are the estimate σ 2 1 − ρ2 regressors. We can see the eﬀect of collinearity on precision by observing that the asymptotic variance of a coeﬃcient ¡ ¢−1 approaches inﬁnity as ρ approaches 1.27) (4.One implication of near singularity of matrices is that the numerical reliability of the calculations is reduced. As a consequence. 1] and sum to k.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 . If the i’th observation 36 . = V ar β ρ 1 n n (1 − ρ2 ) −ρ 1 4. A more relevant implication of near multicollinearity is that individual coeﬃcient estimates will be imprecise. A convenient alternative expression is ¡ ¢−1 ˆ ˆ xi ei ˆ (4.

Investigations into the presence of inﬂuential observations can plot the values of (4.This implies has a large value of hi . ˆ We now derive equation (4. which is considerably more informative than plots of the uncorrected residuals ei .25).1) in Section 2.27). ¢−1 ¡ 0 ¢−1 ¡ 0 ¢−1 ¡ 0 ¢−1 ¡ = XX + XX xi (1 − hi )−1 x0 X 0 X X X − xi x0 i i ¡ 0 ¢−1 ¡ 0 ¢ X X − xi x0 X Y − xi yi i ¢ ¡ ¡ ¢ ¡ ¢−1 ¡ 0 ¢−1 ¢−1 ¡ 0 X Y − xi yi + (1 − hi )−1 X 0 X X Y − xi yi = X 0X xi x0 X 0 X i ¢−1 ¡ ˆ xi ei . ˆ = β − (1 − hi )−1 X 0 X and thus ˆ β (−i) = 37 . then this observation is a leverage point and has the potential to be an inﬂuential observation.4 which states that ¡ ¢ (A + BCD)−1 = A−1 − A−1 BC C + CDA−1 BC CDA−1 . The key is equation (2.

4.13

Exercises

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

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

Pn

i=1 g

¡ ¢ Xi , µ, σ 2 .

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

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

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

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

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

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

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

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

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

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

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

39

(f) (g) (h)

Pn

Pn

ˆˆ i=1 yi ei ˆ2 i=1 ei R2

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

40

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

Let U = |X|p /E |X|p and V = |Y |q /E |Y |q . Applying expectations. n→∞ lim P (|Zn − Z| > δ) = 0. ¥ Proof of Holder’s Inequality. =E U V p q p q Proof of Markov’s Inequality.Markov’s Inequality. Since g(x) is convex. g(x) ≥ a + bx yet g(EX) = a + bEX since the curve is tangent at EX.2 Weak Law of Large Numbers Let Zn ∈ Rk be a random vector. The WLLN shows that sample averages converge in probability to the population average. If Xi ∈ Rk is iid and E |Xi | < ∞. For any strictly increasing function g(X) ≥ 0. as stated. Let a + bx be the tangent line to g(x) at x = EX. then as n → ∞ n 1X Xn = Xi →p E(X). Since 1 + 1 = 1 an application of Jensen’s inequality shows that p q U Then 1/p V 1/q 1 1 ln U + ln V = exp p q E |XY | ∙ ¸ ≤ 1 1 U V exp (ln U ) + exp (ln V ) = + . n i=1 42 . We say that Zn converges in probability to Z as n → ∞. (5. So for all x. 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}. Theorem 5.1 Weak Law of Large Numbers (WLLN). if for all δ > 0.4) Proof of Jensen’s Inequality.2.3). ¥ 5. tangent lines lie below it. Note EU = EV = 1. denoted Zn →p Z as n → ∞. Eg(X) ≥ a + bEX = g(EX). (E |X|p )1/p (E |Y |q )1/q ¥ µ ¶ ´ ³ U V 1 1 1/p 1/q ≤E + = + = 1. Set Y = g(X) and let f denote the density function of Y. p p p q which is (5. P (g(X) > α) ≤ α−1 Eg(X). This is a probabilistic way of generalizing the mathematical deﬁnition of a limit.

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

it is suﬃcient to consider the case µ = 0 and V = Ik . 1 1 c(λ) = c(0) + cλ (0)0 λ + λ0 cλλ (λ∗ )λ = λ0 cλλ (λ∗ )λ 2 2 (5. Then observe ¡ ¡ ¢¢ ∂ C(λ) = iE X exp iλ0 X ∂λ ¡ ¡ 0 ¢¢ ∂2 2 0 0 C(λ) = i E XX exp iλ X ∂λ∂λ C(0) = 1 ∂ C(0) = iE (X) = 0 ∂λ ¡ ¢ ∂2 0 0 C(0) = −E XX = −Ik . ∂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. the independence of the Xi . For ¡ ¢ λ ∈ Rk . so when evaluated at λ = 0 c(0) = 0 cλ (0) = 0 cλλ (0) = −Ik . let C(λ) = E exp iλ0 X denote the characteristic function of X and set c(λ) = ln C(λ). ¢ ¡ √ √ We now compute Cn (λ) = E exp iλ0 nX n the characteristic function of nX n .8) where λ∗ lies on the line segment joining 0 and λ. the deﬁnition of c(λ) and (5.8) ⎞ ⎛ nλ0 X 1 Xj ⎠ ln Cn (λ) = log E exp ⎝i √ n j=1 µ ¶ n Y 1 exp i √ λ0 Xj = log E n j=1 µ ¶ n Y 1 0 E exp i √ λ Xj = log n i=1 ¶ µ λ = nc √ n 1 0 λ cλλ (λn )λ = 2 44 .Proof: Without loss of generality. By the properties of the exponential function. By a second-order Taylor series expansion of c(λ) about λ = 0.

Theorem 5.√ where λn → 0 lies on the line segment joining 0 and λ/ n. Stacking across elements of g. then g(Zn ) →d g(Z) as n → ∞. ¥ 5. Σ) = N 0.4. k ≤ m. Recall that A ⊂ B implies P (A) ≤ P (B).2 Continuous Mapping Theorem 2. then ¡ ¢ √ 0 n (g (θn ) − g(θ0 )) →d N 0. Hence g(Zn ) →p g(c) as n → ∞. gθ Σgθ where gθ (θ) = ∂ g(θ) ∂θ0 and gθ = gθ (θ0 ). µ ¶ 1 Cn (λ) → exp − λ0 λ 2 the characteristic function of the N (0. Since cλλ (λn ) → cλλ (0) = −Ik . for all ε > 0 we can ﬁnd a δ > 0 such that if |Zn − c| < δ then |g (Zn ) − g (c)| ≤ ε. gθ Σgθ . we see that as n → ∞. 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 . It follows that ajn = gjθ (θ∗ ) − gjθ →p 0. Proof: Since g is continuous at c.1 Continuous Mapping Theorem 1 (CMT).4. Thus P (|g (Zn ) − g (c)| ≤ ε) ≥ P (|Zn − c| < δ) → 1 as n → ∞ by the assumption that Zn →p c. 45 . we ﬁnd jn ¢ ¡ √ √ 0 n (g (θn ) − g(θ0 )) = (gθ + an ) n (θn − θ0 ) →d gθ N (0.4 Asymptotic Transformations Theorem 5.3 Delta Method: If n (θn − θ0 ) →d N (0. If Zn →p c as n → ∞ and g (·) is continuous at c. Ik ) distribution.4. This is suﬃcient to establish the theorem. Σ) . and g(θ) : Rm → Rk . √ Theorem 5. If Zn →d Z as n → ∞ and g (·) is continuous. for each element of g. then g(Zn ) →p g(c) as n → ∞. Proof : By a vector Taylor series expansion. where θ is m × 1 and Σ is m × m.

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

1). (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. n i=1 (6.2) i i n i=1 n From (6.1 and the WLLN (Theorem 5. β →p β as n → ∞.1).2 Consistency ˆ As discussed in Section 6.4.3) Ã where g(A. and the continuous mapping theorem (Theorem 5. we will use the methods of asymptotic approximation.5. To characterize the sampling distribution more fully. Hence by the continuous mapping theorem (Theorem 5. As the sample size increases the density becomes more concentrated about the population coeﬃcient. Assumption 3. the OLS estimator β is has a statistical distribution which is unknown. Ã n ! n X 1X 0 1 ˆ xi xi .5. we can conclude ˆ that β →p β.1 Under Assumption 3. 6.1 by the fact that the sampling densities become more concentrated as n gets larger.2.4. (6.1) and ˆ We now deduce the consistency of β.4 implies that Q−1 exists and thus g(·. b) = A−1 b is a continuous function of A and b at all values of the arguments such that A−1 exist. xi ei = g i n n i=1 i=1 1X xi ei →p E (xi ei ) = 0.1). xi ei →p g (Q. ¥ We can similarly show that the estimators σ 2 and s2 are consistent for σ 2 . ·) is continuous at (Q. This is illustrated in Figure 6.1) imply that n ¡ ¢ 1X xi x0 →p E xi x0 = Q (6.1. For a complete argument.1). First. Asymptotic (large sample) methods approximate sampling distributions based on the limiting experiment that the sample size n tends to inﬁnity.5.From the ﬁgure we can see that the density functions are dispersed and highly non-normal. 0). ˆ Theorem 6. Assumption 3.2). Proof. 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 .1. ˆ 47 .2.8) implies that ˆ β−β = Ã n X i=1 xi x0 i !−1 n X i=1 xi ei . using (6.1. Equation (4.3). (6. 0) = Q−1 0 = 0 β−β =g n n i=1 i=1 ˆ which implies β →p β as stated.

5. We need a strengthening of the moment conditions. Assumption 6. 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 . ´1/2 ¡ ¯ ¯¢ ¯ ³ ¯ ¯2 ´1/2 ¡ ¯ 4 ¯¢1/2 ³ ¯ 1/2 E ¯xi x0 e2 ¯ ≤ E ¯xi x0 ¯ = E |xi |4 < ∞. (6.5.3) and Theorem (6.3.3.1. Thus σ 2 is consistent for σ 2 . since n/(n − k) → 1 as n → ∞. n 1 X √ xi ei →d N (0.2.5) Thus xi ei is iid with mean zero and has covariance matrix Ω.6) n i=1 48 . ˆ Proof. To see this. E ¯ei ¯ E ¯e4 ¯ i i i i (6. ˆ n−k 6.Theorem 6.2. (6. i i Assumption 6.3 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. By the central limit theorem (Theorem 5. it follows that s2 = ¥ n σ 2 →p σ 2 .1.2 Under Assumption 3. (6. σ 2 →p σ 2 and s2 →p σ 2 as n → ∞. ˆ Finally. i Now deﬁne ¡ ¢ Ω = E xi x0 e2 . Ee4 < ∞ and E |xi |4 < ∞.1).1 guarantees that the elements of Ω are ﬁnite.3.2). by the Cauchy-Schwarz inequality (5.1).1 In addition to Assumption 3. Ω) . (6.2).

7) holds. Under (6. i i Condition (6. We call V 0 the homoskedastic covariance matrix. Let yi = β 0 + β 1 xi + εi where xi is N (0.1. For α 49 .7) is true then V = V 0 .3. but this is not a necessary condition. for any ˆ ﬁxed n the sampling distribution of β can be arbitrarily far from the normal distribution. its variance diverges q ³ ´ ˆ to inﬁnity.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.7) is true or false.6). This holds true for all joint distibutions of (yi . V is often referred to as ˆ the asymptotic covariance matrix of β. and εi is independent of xi with the Double Pareto density f (ε) = α |ε|−α−1 . The asymptotic distribution ´ Theorem 6.1 states that the sampling distribution of the least-squares estimator. the normal approximation is arbitrarily poor for some data distribution satisfying the assumptions. 1) asymptotic distibution.9) In (6. However.1). xi ) which satisfy the conditions of Assumption 6.9) we deﬁne V 0 = Q−1 σ 2 whether (6. As α approaches 2. when xi and ei are independent. Ω) ¡ ¢ = N 0. is approximately normal when the sample size n is suﬃciently large.2). The trouble is that no matter how large is the sample size.7) the asymptotic variance formulas simplify as ¡ ¢ ¡ ¢ (6. We illustrate this problem using a simulation. The approximation may be poor when n is small. The expression V = Q−1 ΩQ−1 is called a sandwich form.1 is commonly used to approximate the ﬁnite of √ ³ˆ sample distribution of n β − β . and (6.3. ´ √ ³ˆ As V is the variance of the asymptotic distribution of n β − β . setting n = 100 and varying the parameter α. Theorem 6. after rescaling.Then using (6.8) Ω = E xi x0 E e2 = Qσ 2 i i V = Q−1 ΩQ−1 = Q−1 σ 2 ≡ V 0 (6. We say that ei is a Homoskedastic Projection Error when (6. Q−1 ΩQ−1 .7) Cov(xi x0 .3. How large should n be in order for the approximation to be useful? Unfortunately. for example. |ε| ≥ 1. ´ √ ³ ˆ n β−β = Ã 1X xi x0 i n i=1 n !−1 Ã Theorem 6. In´Figure 6. otherwise V 6= V 0 . 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).1. 1). e2 ) = 0. When (6.2 we display the ﬁnite sample densities of the q ³ ˆ normalized estimator n α−2 β 2 − β 2 .1 Under Assumption 6. V ) where V = Q−1 ΩQ−1 . There is a special case where Ω and V simplify.3. however. In this context the normalized least-squares slope estimator n α−2 β 2 − β 2 has α →d Q−1 N (0. (6. as n → ∞ ´ √ ³ ˆ n β − β →d N (0. In Figure 6.3. there is no simple answer to this reasonable question.

The MME estimator is i i 1X ˆ xi x0 e2 Ω= i ˆi n i=1 n (6.0 the density is very close to the N (0. we need an estimate of Ω = E xi x0 e2 .Figure 6.3. 1) asymptotic approximation is never guaranteed to be accurate. As α diminishes the density changes signiﬁcantly. The estimator 2 2 in (6.10) without changing this result. We show the sampling distribution of n β 1 − β 1 setting n = 100.2 and 6.2: Density of Normalized OLS estimator α = 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 (0.1) it is clear that V 0 →p V 0 .4 Let Covariance Matrix Estimation 1X ˆ xi x0 Q= i n i=1 n be the method of moments estimator for Q. Another example is shown in Figure 6.10) V 0 = Q−1 s2 . 6. As k increases. 1) density.3 is that the N (0. ˆ ˆ Since Q →p Q and s2 →p σ 2 (see (6. The lesson from Figures 6. 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. 6 and 8. 4. for k = 1.2.2) and Theorem 6.11) 50 . 1). σ may also be substituted for s ˆ ¡ ¢ To estimate V = Q−1 ΩQ−1 . the sampling distribution becomes highly skewed and non-normal.

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

14 205.80 40. The standard errors for β 0 are 7. Ω 2. we return to the log wage regression of Section 4.20 = V 14.14 205.085 p ˆ and that for β 1 is .020. Using (6. just as any other estimator. n n i=1 52 . (6.35/988 = .83 −0.480 .199 2.035 ¶ .80 40.493 0. E ¯e4 ¯ i ³ ´ 1X |xi |3 |ei | →p E |xi |3 |ei | . It is also important to understand that a particular standard error may be relevant under one set of model assumptions.83 ¶−1 = µ 7.30 + 0.83 ¶−1 µ .14 6. (.3) so by the WLLN ³ ´ ³ ´3/4 ¡ ¯ ¯¢ 1/4 E |xi |3 |ei | ≤ E |xi |4 < ∞. (6.039 and ˆ V = µ 1 14. We calculate that s2 = 0.199 2.6 Therefore the two covariance matrix estimates are µ ¶−1 µ ¶ 1 14. from which it follows that V →p V as n → ∞.12) i i n n n i=1 i=1 We now examine each sum on the right-hand-side of (6.12) in turn.1) show that n ¡ ¢ 1X xi x0 e2 →p E xi x0 e2 = Ω.493 −0.80 2. and then the square roots. but not under another set of assumptions.480 ˆ0 = 0. p ˆ In this case the two estimates are quite similar.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. the standard method to calculate the standard errors is to ˆ ﬁrst calculate n−1 V .80 .1. We can write the estimated equation with standards errors using the format \ log(W agei ) = 1.085) (. by Holder’s inequality (5. From a computational standpoint.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 .98 −0.20 and µ ¶ ˆ = 0. i i i i n i=1 Second.14 14.6 ¶µ 1 14.used by an author when studying their work.2/988 = . First. To illustrate.14 205.020) 6.14 14.5) and the WLLN (Theorem 5.117 Educationi . then take the diagonal elements.20 −0.2.

is deﬁned ˆ ˆ by replacing the OLS residual ei in (6.¯ ¯ ¯ ¯ˆ and thus since ¯β − β ¯ →p 0. MacKinnon and White (1985) present numerical (simulation) evidence i ˆ ˆ that V ∗ works better than V as an estimator of V .25). Using this substitution.14) Ã 1X (1 − hi )−1 xi ei ˆ n i=1 n !Ã 1X (1 − hi )−1 xi ei ˆ n i=1 n !0 and hi = x0 (X 0 X)−1 xi . Andrews’ proposed estimator is ˆ ˆ ˆ ˆ V ∗∗ = Q−1 Ω∗∗ Q−1 53 . ¯ ¯n ¯ n i=1 so Together.13) of Efron (1982). Andrews (1991) suggested an similar estimator based on cross-validation. From equation (3.26).12 the deﬁnition of β (−i) as the least-squares estimator with the i’th observation deleted. Recall from Section 4. They also suggest that the scaling factor (n − 1)/n in (??) can be omitted. 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. 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. 6. 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 ¯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. these establish consistency.5. n i=1 n ˆ ˆ Theorem 6.1 As n → ∞. Ω →p Ω and V →p V. ¯ ¯ ¯ ¯ ¯n ¯ n i=1 i=1 1X |xi |4 →p E |xi |4 . you can show that 1 Xˆ ¯ β= β (−i) .6 Alternative Covariance Matrix Estimators ˆ MacKinnon and White (1985) suggested a small-sample corrected version of V based on the jackˆ knife principle.11) with the leave-one-out estimator ei. which.−i = (1 − hi )−1 ei ˆ presented in (4.13) Using formula (4. i=1 Third.

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

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

An alternative approach. however. The p-value is more general. A test of asymptotic signiﬁcance α rejects H0 if |tn | > zα/2 . Then the asymptotic p-value of the statistic tn is pn = p(tn ). For example. That is. or “accepts” H0 .025 = 1. from which it follows that pn →d U [0. In a sense. 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|)) . The rejection/acceptance dichotomy is associated with the Neyman-Pearson approach to hypothesis testing. To see this fact. and is a function of the data and hence is / random. 1). 1]. is to report an asymptotic p-value. if Z ∼ N (0. If the p-value pn is small (close to zero) then the evidence against H0 is strong.05 = 1.96 and z. The asymptotic p-value for the above statistic is constructed as follows. Thus an equivalent statement of a Neyman-Pearson test is to reject at the α% level if and only if pn < α. Thus P (1 − pn ≤ u) = = P (F (tn ) ≤ u) ¡ ¢ = P |tn | ≤ F −1 (u) ¡ ¢ → F F −1 (u) = u. This is because ¡ ¢ P (reject H0 | H0 true) = P |tn | > zα/2 | θ = θ0 ¢ ¡ → P |Z| > zα/2 = α. Another helpful observation is that the p-value function has simply made a unit-free transformation of the test statistic. That is. tn →d N (0. associated with Fisher.645. z. Let zα/2 is the upper α/2 quantile of the standard normal distribution. regardless of the complication of the distribution of the original test statistic. in contrast to Neyman-Pearson rejection/acceptance reporting where the researcher picks the level. p-values and hypothesis tests are equivalent since pn < α if and only if |tn | > zα/2 . note that the asymptotic distribution of |tn | is F (x) = 1 − p(x). 1]. It is designed to cover θ with high probability. in that the reader is allowed to pick the level of signiﬁcance α.9 Conﬁdence Intervals A conﬁdence interval Cn is an interval estimate of θ.The standard test for H0 against H1 is the t-statistic (or studentized statistic) tn = tn (θ0 ) = ˆ − θ0 θ . under H0 . 1). then P (Z > zα/2 ) = α/2 and P (|Z| > zα/2 ) = α. Deﬁne the tail probability. s(ˆ θ) Under H0 . P (1 − p(tn ) ≤ u) establishing that 1 − pn →d U [0. Either θ ∈ Cn or θ ∈ Cn . 1]. pn →d U [0. Otherwise the test does not reject. The coverage probability is P (θ ∈ Cn ). 6. 56 .

¢ ¡ ¢ ¡ P (θ ∈ Cn ) = P |tn (θ)| ≤ zα/2 → P |Z| ≤ zα/2 = 1 − α. The t-test of the previous setion rejects H0 : θ0 = θ if |tn (θ)| > zα/2 where tn (θ) is the t-statistic (6.16) and zα/2 is the upper α/2 quantile of the standard normal distribution.17) = ˆ − zα/2 s(ˆ θ and Cn is an asymptotic (1 − α)% conﬁdence interval. and values of θ outside two standard θ errors of the estimated ˆ are considered unlikely or unreasonable candidates for the true value. We say that Cn has asymptotic (1 − α)% coverage for θ if P (θ ∈ Cn ) → 1 − α as n → ∞. θ θ) (6. or α = . This corresponds to selecting the conﬁdence h i h ˆ ± 1. θ The interval has been constructed so that as n → ∞. 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). 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 . We have the null and alternative H0 : θ = θ0 H1 : θ 6= θ0 . A good method for construction of a conﬁdence interval is the collection of parameter values which are not rejected by a statistical test.We typically cannot calculate the exact coverage probability P (θ ∈ Cn ). While there is no hard-and-fast guideline for choosing the coverage probability 1 − α. and it is desired to test the joint restrictions simultaneously.96s(ˆ ≈ ˆ ± 2s(ˆ . 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).18) . Thus values of θ within two standard errors of the estimated interval θ θ) θ θ) ˆ are considered “reasonable” candidates for the true value θ. ˆ + zα/2 s(ˆ . In this case the t-statistic approach does not work.05.10 Wald Tests Sometimes θ = h(β) is a q × 1 vector. the most common professional choice isi95%. 6. = n h(β) − θ0 Hβ V Hβ 57 (6.

1 showed θ ˆ that V →p V. The asymptotic p-value for Wn is pn = p(Wn ). As before. Hβ (β) is a continuous function of β. so by the continuous mapping ˆ ˆ ˆ ˆ ˆ theorem. χ2 (. where p(x) = P χ2 ≥ x is the tail q q probability function of the χ2 distribution. The Wald test fails to reject if Wn is q 1 ¡ ¢ less than χ2 (α). 1] under H0 . the test rejects at the α% level iﬀ pn < α. We have established: ³ ´0 ³ ´ ˆ − θ0 V −1 ˆ − θ0 →d Z 0 V −1 Z = χ2 . if rank(Hβ ) = q.5. For example. = nβ 2 R0 V R R0 β is linear with R = µ 0 I ¶ ¢−1 ¡ ˆ ˆ ˆ .10.15) showed that n ˆ − θ →d Z ∼ N (0. h(β) = R0 β. Thus Vθ = H 0 V Hβ →p H 0 V Hβ = Vθ > 0 if Hβ has full rank q. a chiq square random variable with q degrees of freedom.84 = z. 6. then the Wald statistic takes the form ´0 ³ ´ ³ ´−1 ³ ˆ ˆ ˆ R0 V R R0 β − θ 0 .1. Hence β β by Theorem A. the upper-α quantile q 2 of the χ2 distribution.19) σ2 ˆ where σ2 = ˜ 1 0 e e. then the Wald statistic can be written in the form ¶ µ 2 ˆ σ − σ2 ˜ Wn = n (6.025 . Furthermore. ˜˜ n ˜ e = Y − X1 β 1 . ˜ 58 ¡ 0 ¢−1 0 ˜ β 1 = X1 X1 X1 Y . and there are q = k2 restrictions.8.3. 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. The null hypothesis is H0 : β 2 = 0. Also h(β) = a selector matrix. Hβ (β) →p Hβ . Wn = n R0 β − θ0 ´ √ ³ The delta method (6. We know that the Wald statistic takes the form 0 Wn = nˆ Vθ−1 ˆ θ ˆ θ ³ ´−1 ˆ ˆ0 ˆ β 2. θ = β 2 . and Theorem 6.1 Under H0 and Assumption 6. then Wn →d χ2 .When h is a linear function of β. An asymptotic Wald test rejects H0 in favor of H1 if Wn exceeds χ2 (α). Vθ ).2.11 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 .05) = 3. q and pn is asymptotically U[0. ˆ Wn = n θ θ q θ θ Theorem 6. In this case.

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

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

12.3. σ 2 ) = − log σ − log (2π) − .a chi-square distribution with n − k degrees of freedom. β 2 ) and consider tests of the linear restriction H0 : β 2 = 0 H1 : β 2 6= 0 In the context of parametric models. 1) and tn−k distributions. Furthermore. and standard errors are calculated using the homoskedastic formula (6. σ 2 ) discussed above. σ2 ˆ 61 . a good testing procedure is based on the likelihood ratio statistic. σ 2 ) = − log 2πˆ 2 − 2 e0 e ˆˆ 2 2ˆ σ ¡ ¢ n n n = − log σ 2 − log (2π) − . σ ˆ ˆ βj − βj βj − βj N (0. ˆ 2 2 2 ˜ ˜ The MLE of the model under the null hypothesis is (β 1 . The log-likelihood of this model is ¡ 2¢ n n n ˜ ˜ ˜ Ln (β 1 .1 and Theorem 6. β and t are approximately normally distributed.10) µ h i ¶ 2 (X 0 X)−1 N 0. n−k • ∼ tn−k ˆ In Theorem 6. As inference (conﬁdence intervals) are based on the t-ratio. 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. Theorem 6. 0. 1) jj rh ∼ tn−k = rh i ∼q i = q χ2 ˆ s(β j ) n−k σ2 2 0 X)−1 0 X)−1 (X s (X n−k n−k χn−k jj jj a t distribution with n − k degrees of freedom. The critical values are quite close if n − k ≥ 30.) Now let us partition β = (β 1 . σ 2 ) ¡ ¢¢ ¡ ¡ ¢ ˆ = n log σ 2 − log σ 2 ˜ µ 2¶ σ ˜ = n log . σ 2 ) where β 1 is the OLS estimate from ˜ 2 ˜ a regression of yi on x1i only. β 2 . In contrast. which is twice the diﬀerence in the log-likelihood function evaluated under the null and alternative hypotheses. β 2 . 0.1 we showed that in large samples. the notable distinction is between the N (0. We summarize these ﬁndings Theorem 6. if standard errors are calculated using the homoskedastic formula (6. σ 2 (X 0 X)−1 • (n−k)s2 σ2 ˆ β j −β j ˆ s(β ) j ∼ χ2 . β 2 . The Gaussian log-likelihood at these estimates is ¡ ¢ n 1 ˆ ˆ ˆ σ Ln (β 1 . β has an exact normal distribution and t has an exact t distribution. σ 2 ).12. σ 2 ) − Ln (β 1 .8. 0. The estimator under the alternative is the unrestricted estimator ˆ ˆ ˆ (β 1 . (Unless the sample size is unreasonably small.1 If ei is independent of xi and distributed N(0.10) then ´ ³ ˆ • β ∼ N 0. so as a practical matter it does not matter which distribution is used. with residual variance σ .

This produces random draws from the sampling distribution of interest. This can be seen by a simple example introduced by Lafontaine and White (1986). Our ﬁrst-order asymptotic theory is not useful to help pick s.By a ﬁrst-order Taylor series approximation ¶ µ 2 ¶ µ σ ˜ σ2 ˜ − 1 = Wn . the statistic Wn (s) varies with s. they can work quite poorly when the restrictions are nonlinear. 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. one feature of importance is the Type I error of the test using the asymptotic 5% critical value 3. σ 2 s2 β ˆ ˆ While the hypothesis β s = 1 is unaﬀected by the choice of s. setting n/σ 2 = 10. This is a context where Monte Carlo simulation can be quite useful as a tool to study and compare the exact distributions statistical procedures in ﬁnite samples. Through repetition.7. To demonstrate this eﬀect. σ2 ˆ Now notice that H0 is equivalent to the hypothesis H0 (s) : β s = 1 for any positive integer s.8. Take the model yi = β + ei ei ∼ N (0.4 the Wald statistic Wn (s) as a function ˆ of s. 6. Then the standard Wald test for H0 is ˆ ³ ´2 ˆ β−1 Wn = n . we ﬁnd that the standard Wald test for H0 (s) is ´2 ³ s ˆ β −1 Wn (s) = n 2s−2 .84 — the probability of a false rejection. This is distressing since the choice of s seems arbitrary and irrelevant to the actual hypothesis. ˆ Let β and σ 2 be the sample mean and variance of yi . The method uses random simulation to create an artiﬁcial dataset to apply the statistical tools of interest. The decreasing dashed ˆ = 1. The increasing solid line is for the case β = 0. we have plotted in Figure 6. while there are other values of s for which test test statistic is insigniﬁcant. σ 2 ) and consider the hypothesis H0 : β = 1. as Wn (s) →d χ2 under H0 for 1 any s. 62 . Letting h(β) = β s . LR = n log 1 + 2 − 1 ' n σ ˆ σ2 ˆ the F statistic.13 Problems with Tests of NonLinear Hypotheses While the t and Wald tests work well when the hypothesis is a linear restriction on β. features of this distribution can be calculated. This is an unfortunate feature of the Wald statistic. and noting Hβ = sβ s−1 . In the present context of the Wald statistic.

In Table 4.Figure 6. Each row of the table corresponds to a diﬀerent value of s — and thus corresponds to a particular choice of test statistic. Test performance deteriorates as s increases. and rarely fall outside of the 3%-8% range. Type I error rates between 3% and 8% are considered reasonable. 100 and 500. Any other choice of s leads to a test with unacceptable Type I error probabilities. n. the Type I error probability improves towards 5% as the sample size n increases. Rates above 20% are unexceptable. In each case. looking for tests for which rate rejection rates are close to 5%. Typically.4. The value of s is varied from 1 to 10. this probability depends only on s. The second through seventh columns contain the Type I error probabilities for diﬀerent combinations of n and σ.84.05) with deviations indicating+ distortion.1 reports the simulation estimate of the Type I error probability from 50. no magic choice of n for which all tests perform uniformly well.1 you can also see the impact of variation in sample size. however. For this particular example. In Table 2. Table 4. remember that the ideal Type I error probability is 5% (.84 | β = 1) . To interpret the table.000 simulated Wald statistics Wn (s) which are larger than 3.1 we report the results of a Monte Carlo simulation where we vary these three parameters. Error rates avove 10% are considered excessive. The null hypothesis β s = 1 is true. These probabilities are calculated as the percentage of the 50. Table 4. When comparing statistical procedures.4: Wald Statistic as a function of s P (Wn (s) > 3. so these probabilities are Type I error. n is varied among 20. There is.1 Type I error Probability of Asymptotic 5% Wn (s) Test 63 . and σ is varied among 1 and 3. which is not surprising given the dependence of Wn (s) on s as shown in Figure 6. the only test which meets this criterion is the conventional Wn = Wn (1) test. Given the simplicity of the model. we compare the rates row by row.000 random samples. and σ 2 .

This point can be illustrated through another example.25 .10 . Equivalently.31 . In this case a t-statistic for H0 is t1n = ³ˆ β1 ˆ β2 where r is a known constant.07 .06 . Take the model yi = β 0 + x1i β 1 + x2i β 2 + ei E (xi ei ) = 0 and the hypothesis H0 : β1 =r β2 (6.11 .30 . in other examples natural choices are not always obvious and the best choices may in fact appear counter-intuitive at ﬁrst.20 .19 .05 .26 .05 .21 .08 .13 .23 .22 .07 .06 .05 . β 2 ) be the least-squares estimates of (6.06 . Other choices are arbitrary and would not be used in practice.15 .08 .15 .13 .05 .15 .15 . Deﬁne θ ˆ ˆ ⎞ ⎛ 0 ⎟ ⎜ ⎟ ⎜ ⎜ 1 ⎟ ⎟ ⎜ ⎜ ˆ ⎟ ˆ H1 = ⎜ β 2 ⎟ ⎟ ⎜ ⎟ ⎜ ⎜ β ⎟ ˆ ⎠ ⎝ − 1 ˆ2 β2 ´ s(ˆ θ) −r .16 Rejection frequencies from 50.25 . 64 .07 .12 . so the hypothesis can be stated as H0 : θ = r.14 .28 .20 . deﬁne θ = β 1 /β 2 .08 . let V be an estimate of the ˆ asymptotic variance matrix for β and set ˆ = β 1 /β 2 .07 .10 .06 .34 .33 .08 .06 .22 .10 .07 .000 simulated random samples In this example it is not surprising that the choice s = 1 yields the best test statistic.05 . An alternative statistic can be constructed through reformulating the null hypothesis as H0 : β 1 − rβ 2 = 0.17 .20) ³ ´1/2 ˆ0 ˆ ˆ so that the standard error for ˆ is s(ˆ = n−1 H1 V H1 θ θ) .08 .06 .35 .13 .09 . β 1 .12 .20).05 .14 . ˆ ˆ ˆ ˆ ˆ Let β = (β 0 .06 .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 .18 . While this is clear in this particular example.24 .06 .

15 .00 .15 . . .00 .50. if the hypothesis can be expressed as a linear restriction on the model parameters. We vary β 2 among .06 . and 1.05 .05 .12 . while the right tail probabilities P (t1n > 1.0 and n among 100 and 500.06 .7.02 .05 β2 . The results are presented in Table 4. The implication of Table 4.00 .05.25.47 .645) P (tn > 1. Table 4.25 .00 . Ideally.10 . 6. 65 . especially for small values of β 2 . If no linear formulation is feasible.645) and P (tn > 1.50 .07 .06 .2 Type I error Probability of Asymptotic 5% t-tests n = 100 n = 500 P (tn < −1. this formulation should be used.00 .05 .10 . σ 2 ) draw with σ = 3.10 .06 .645) t1n t2n t1n t2n t1n t2n t1n t2n .06 . ei be an independent N (0. the entries in the table should be 0.645) are close to zero in most cases. However.05 .645) P (tn > 1.14 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.75 1. along with sample size n. In this section we describe the method in more detail. We let x1i and x2i be mutually independent N (0. such as the GMM distance statistic which will be presented in Section 9.26 .06 .00 . then the “most linear” formulation should be selected.00 The one-sided Type I error probabilities P (tn < −1.00 .2.05 .A t-statistic based on this formulation of the hypothesis is ´2 ³ ˆ 1 − rβ 2 ˆ β =³ ´1/2 . and normalize β 0 = 0 and β 1 = 1.645) P (tn < −1.000 simulated samples.645) are calculated from 50. In all cases. −1 H V H ˆ 2 n 2 ⎞ 0 H2 = ⎝ 1 ⎠ .06 . The left tail probabilities P (t1n < −1. the rejection rates for the linear t2n statistic are invariant to the value of β 2 . and are close to the ideal 5% rate for both sample sizes. 1) variables.645) greatly exceed 5%.1.05 .06 .00 . . −r ⎛ t2n where To compare t1n and t2n we perform another simple Monte Carlo simulation. This leaves β 2 as a free parameter.2 is that the two t-ratios have dramatically diﬀerent sampling behavior. It is also prudent to consider alternative tests to the Wald statistic.75. the rejection rates for the t1n statistic diverge greatly from this value. and alternatives to asymptotic critical values should be considered.09 .28 .05 .06 . The common message from both examples is that Wald statistics are sensitive to the algebraic formulation of the null hypothesis.05 . In contrast.00 .06 .05 .

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

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

808 so the parameter estimates are quite precise and reported in Table 4.00057 .014 .007 .027 . reestimating the model with the 50 state dummies excluded.033 −. Wn = n 1 − 2 = 18.070 . 2β 3 68 .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.008 .001 .1.1 OLS Estimates of Linear Equation for Log(Wage) ˆ β 1.1 we ﬁnd the point estimate ˆ ˆ = − β 2 = 28. this adds 50 regressors).121 −. The F form of the Wald statistic (6.232 . 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. θ ˆ 2β 3 β2 .variable for state of residence (including the District of Columbia.48772 = 515.808 . Alternatively.4945. Using either statistic the hypothesis is easily rejected.00002 .69.002 . if β 2 > 0 and β 3 < 0 the solution is θ=− From Table 4. Table 4. the restricted standard deviation estimate is σ = .010 .102 −.34 ˆ s(β) .102 −.4877 18.097 −. 50 Another interesting question which can be addressed from these estimates is the maximal impact of experience on mean wages.49452 σ ˜ Notice that the two statistics are close. The available sample is 18. Computing the Wald statistic (6.18) that the state coeﬃcients are jointly zero. but not equal. Ignoring the other coeﬃcients.013 .19) is ˜ µ ¶ µ ¶ σ2 ˆ . as the 1% critical value for the χ2 distribution is 76.101 . excluding the coeﬃcients on the state dummy variables. we ﬁnd Wn = 550. 808 1 − .032 .

Using the Delta Method. However. so we have to go one step further. implying a 95% conﬁdence θ) interval of [27. In the previous section we discovered that such t-tests had very poor Type I error rates. we found better Type I error rates by reformulating the hypothesis as a linear restriction. this is a poor choice.5].5].9. Since tn (θ) is a non-linear function of θ. 29. Instead. but it can be found numerically quite easily. but the lower end is substantially lower. This is the set of θ such that |tn (θ)| ≤ 1.96. 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 ). as the coverage probability of this conﬁdence interval is one minus the Type I error of the hypothesis test based on the t-test. In the present context we are interested in forming a conﬁdence interval. This set is [27. not testing a hypothesis. Notice that the upper end of the conﬁdence interval is the same as that from the delta method. 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 = . there is not a simple expression for this set. 69 .40. 29.0.

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

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

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

2

is the homoskedasticity-formula standard error.

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

i=1 i=1

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

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

E (xi ei ) = 0

∗ yi = yi + ui

71

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

∗ E (yi ui ) = 0

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

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

• Qi • Di • Ci

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

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

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

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

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

73

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

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

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

White (1980) proposed that the test for heteroskedasticity be based on setting zi to equal all non-redundant elements of xi . Second. Theorem 7.4) and constructing a Wald statistic. its squares. the Wald test of H0 is asymptotically χ2 . If i this simpliﬁcation is replaced by the standard formula (under independence of the error). in which case ξ i is ˜ independent of xi and the asymptotic variance (7. require the assumption of a correct conditional mean. but also under the assumptions of linear projection.5) and the asymptotic variance (7. as they will be estimating two diﬀerent projections. The asymptotic distribution (7. σ 2 ). we impose the stronger hypothesis and test the hypothesis that ei is independent of xi .7) under independence show that this test has an asymptotic chi-square distribution. q Most tests for heteroskedasticity take this basic form. but the only diﬀerence is that they a ¢ allowed for general choice of zi .4).3) for α simpliﬁes to ¡ ¡ 0 ¢¢−1 ¡ 2 ¢ E ξi .1 Under H0 and ei independent of xi . We may therefore test this hypothesis by the estimation (7. If the equation of interest is a linear projection. Third. however. and replaced E ξ 2 with 2σ 4 which holds when ei is N(0. Motivated by the form of the asymptotic variance ˆ of the OLS estimator β. Vα = E zi zi (7.3 Forecast Intervals m(x) = E (yi | xi = x) = x0 β. OLS is a more robust estimator of the parameter vector.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. FGLS will do worse than OLS in practice. and this requires trimming to solve. The point is that the eﬃciency gains from FGLS are built on the stronger assumption of a correct conditional mean. BreuschPagan (1979) proposed what might appear to be ¡ distinct test. individual estimated conditional variances may be negative. 7. and the cost is a reduction of robustness to misspeciﬁcatio 7.2. The main diﬀerences between popular “tests” is which transformations of xi enter zi . In the linear regression model the conditional mean of yi given xi = x is 77 .2). the two tests coincide. then the OLS and FGLS estimators will converge in probability to diﬀerent limits.7) Hence the standard test of H0 is a classic F (or Wald) test for exclusion of all regressors from the skedastic regression (7. the estimated conditional variances may contain more noise than information about the true conditional variances. Typically. This hypothesis does not imply that ξ i is independent of xi . and not a conditional mean. The GLS and FGLS estimators. and all cross-products. It is consistent not only in the regression model.error. on the other hand. This introduces an element of arbitrariness which is unsettling to empirical researchers. In this case. or equivalently that i H0 : α1 = 0 in the regression (7.

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

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

Thus when the truth is that β 2 = 0. The asymptotic theory of such tests have been worked out by Andrews and Ploberger (1994) and B.1.5 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 . θi Thus ¡ ¢ yi − m(xi . but these are not the only measures of central tendency. Thus we want to test H0 : β 2 = 0. This renders the distribution theory presented in the previous section invalid. In particular. 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 . We have discussed projections and conditional means. θi Hence the sum of squared errors function is Sn (θ) = n X i=1 (yi − m(xi . θ) ' (ei + m(xi . the parameter estimates are not asymptotically normally distributed. An alternative good measure is the conditional median. θ) = β 0 zi + β 0 xi (γ). and this is often a useful hypothesis (sub-model) to consider. 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 . θ0 ) + m0 (θ − θ0 ) . Hansen shows how to use simulation (similar to the bootstrap) to construct the asymptotic critical values (or p-values) in a given application. θ which is that stated in the theorem. θ0 )) − m(xi . m(xi . 7. This means that under H0 .4. ˆ and ei = yi − m(xi . γ is not identiﬁed. 80 . 1 2 The model is linear when β 2 = 0. However. ˆ ˆ θ) ˆ θ). Suppose that m(xi . by a ﬁrst-order Taylor series approximation. Thus the NLLS 0 estimator ˆ has the same asymptotic distribution as the (infeasible) OLS regression of yi on mθi . θ0 ) + m0 (θ − θ0 ) θi = ei − m0 (θ − θ0 ) θi 0 = yi − m0 θ. tests of H0 do not have asymptotic normal or chi-square distributions. Furthermore. Hansen (1996). θ) ' m(xi . Identiﬁcation is often tricky in nonlinear regression models. the model is yi = β 0 zi + εi 1 and both β 2 and γ have dropped out.For θ close to the true value θ0 . ¥ Based on Theorem 7. under H0 .

The median θ0 = M ed(Y ) is the value such that P (Y ≤ θ0 ) = P (Y ≥ θ0 ) = . Two useful facts about the median are that (7. the linear function M ed (yi | xi = x) = x0 β is the conditional median function. and the third deﬁnition is the i=1 1 P solution to the moment equation n n sgn (yi − θ) . let Y be a continuous random variable. Conditional analogs of the facts about the median are • P (yi ≤ x0 β 0 | xi = x) = P (yi > x0 β | xi = x) = . The ﬁrst deﬁnition is the 50th empirical 1 P quantile. Let m(x) = M ed (Y | X = x) denote the conditional median of Y given X = x. These distinctions are illusory. and let M ed (Y | X) = m(X) be this function evaluated at the random variable X. as i=1 these estimators are indeed identical. Now let’s consider the conditional median of Y given a random variable X.To recall the deﬁnition and properties of the median. Let ¯ 1 X¯ ¯yi − x0 β ¯ Ln (β) = i n i=1 n be the average of absolute deviations.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. however. The linear median regression model takes the form yi = x0 β + ei i M ed (ei | xi ) = 0 In this model. These facts deﬁnitions motivate three estimators of θ. i n n i=1 (7. it is a solution to the moment condition ³ ´ 1X ˆ xi sgn yi − x0 β = 0. The second is the value which minimizes n n |yi − θ| .5.10) The LAD estimator has the asymptotic distribution 81 . and the substantive assumption is that the median function is linear in x. The least absolute deviations (LAD) estimator of β minimizes this function ˆ β = argmin Ln (β) β Equivalently.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.

where V = and f (e | x) is the conditional density of ei given xi = x.5. ∂ 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 ) . by the central limit theorem (Theorm 5.1) n X √ −1/2 n (g n (β 0 ) − g(β 0 )) = −n gi (β 0 ) →d N (0.10) is equivalent to g n (β) = 0. ∂β 0 so Third.5.1: Since sgn (a) = 1 − 2 · 1 (a ≤ 0) .11) This simpliﬁcation is similar to the simpliﬁcation of the asymptotic covariance of the OLS estimator under homoskedasticity. While a complete proof of Theorem 7.3. the conditional density of the error at its median.1 ´ √ ³ˆ n β − β 0 →d N (0. See Chapter 16. Second using the law of iterated expectations and the chain rule of i diﬀerentiation. then there are many innovations near to the median. Computation of standard error for LAD estimates typically is based on equation (7. then f (0 | x) = f (0) and the asymptotic variance simpliﬁes V = (Exi x0 )−1 i 4f (0)2 (7. In the special case where the error is independent of xi .11).1 is advanced. by a Taylor series expansion and the fact g(β 0 ) = 0 82 . ¢¢−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) . V ). We need where g n (β) = n i i=1 gi (β) and gi (β) = xi (1 − 2 · 1 (yi ≤ xi three preliminary result. ˆ Proof of Theorem 7. (7. First. Pn −1 0 β)) .5. and this improves estimation of the median. The main diﬃculty is the estimation of f (0). we provide a sketch here for completeness. This can be done with kernel estimation techniques. Exi x0 ) i i=1 since Egi (β 0 )gi (β 0 )0 = Exi x0 . Let g(β) = Eg (β). the height of the error density at its median. When f (0 | x) is large. ∂β ˆ g(β) ' ´ ³ ∂ ˆ g(β 0 ) β − β 0 .Theorem 7.

The quantile Qτ is the value such that τ (percent) of the mass of the distribution is less than Qτ . However for computational convenience it is typical to assume that they are (approximately) linear in x (after suitable transformations). (7. V ). For τ ∈ [0. We then have the linear quantile regression model yi = x0 β τ + ei i 83 . The third line follows from an asymptotic empirical process argument. As functions of x. For ﬁxed τ .6 Quantile Regression The method of quantile regression has become quite popular in recent econometric practice.Together ´ √ ³ ˆ n β − β0 ' ' ¶−1 √ ∂ ˆ ng(β) 0 g(β 0 ) ∂β ´ ¡ £ ¤¢−1 √ ³ ˆ ˆ = −2E xi x0 f (0 | xi ) n g(β) − g n (β) i µ ¤¢−1 √ 1¡ £ 0 n (g n (β 0 ) − g(β 0 )) E xi xi f (0 | xi ) 2 ¤¢−1 1¡ £ 0 E xi xi f (0 | xi ) N (0. the quantile regression functions can take any shape.5. so you can think of the quantile as the inverse of the distribution function. the quantile regression function qτ (x) describes how the τ ’th quantile of the conditional distribution varies with the regressors. If the random variable U has τ ’th quantile Qτ . For the random variables (yi . xi ) with conditional distribution function F (y | x) the conditional quantile function qτ (x) is Qτ (x) = inf {y : F (y | x) ≥ τ } . 1] the τ ’th quantile Qτ of a random variable with distribution function F (u) is deﬁned as Qτ = inf {u : F (u) ≥ τ } When F (u) is continuous and strictly monotonic. Exi x0 ) →d i 2 = N (0.12) Qτ = argmin Eρτ (U − θ) . Again. 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)) . The median is the special case τ = .9) for the median to all quantiles. then F (Qτ (x) | x) = τ .13) This generalizes representation (7. The following alternative representation is useful. then F (Qτ ) = 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 . then (7. ¥ 7.

E xi xi f (0)2 A recent monograph on the details of quantile regression is Koenker (2005). since it has discontinuous derivatives. n numerical methods are necessary for its minimization. Thus. then f (0 | xi ) = f (0) .where ei is the error deﬁned to be the diﬀerence between yi and its τ ’th conditional quantile x0 β τ . and form a Wald statistic i for γ = 0. and are widely available. the unconditional density of ei at 0. Furthermore. A asymptotic distribution theory for the quantile regression estimator can be derived using similar arguments as those for the LAD estimator in Theorem 7.6. 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. where and f (e | x) is the conditional density of ei given xi = x. otherwise its properties are unspeciﬁed without further restrictions.1. and test their signiﬁcance using a Wald test.1 n β τ − β τ →d N (0. ¡ ¡ ¢¢−1 ¡ ¢¢−1 ¢¡ ¡ Exi x0 E xi x0 f (0 | xi ) Vτ = τ (1 − τ ) E xi x0 f (0 | xi ) i i i ¢ 1X ¡ ρτ yi − x0 β i n i=1 In general. The null model is yi = x0 β + εi i 84 . fast linear programming methods have been developed for this problem. the asymptotic variance depends on the conditional density of the quantile regression error. Another popular approach is the RESET test proposed by Ramsey (1969).12). if the model yi = x0 β + ei has i been ﬁt by OLS. and we have the simpliﬁcation Vτ = τ (1 − τ ) ¡ ¡ 0 ¢¢−1 . conventional Newton-type optimization methods are inappropriate. i By construction. ´ √ ³ˆ Theorem 7. Since the quanitle regression criterion function Lτ (β) does not have an algebraic solution.5.13). One simple test for neglected nonlinearity is to add nonlinear functions of the regressors to ˆ ˆ the regression. it is useful to have a general test of the adequacy of the speciﬁcation. 7. When the error ei is independent of xi . Fortunately. the τ ’th conditional quantile of ei is zero.7 Testing for Omitted NonLinearity If the goal is to estimate the conditional expectation E (yi | xi ) . 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. Vτ ). ˆ Given the representation (7.

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

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

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

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

where xji is one of the xi . ˆ ˆ n−k 6. 5. wn ) and wi = x−2 . the estimates (β.. x. In the homoskedastic regression model Y = Xβ + e with E(ei | xi ) = 0 and E(e2 | xi ) = σ 2 . In a linear model Y = Xβ + e.. (b) Find an estimate of the variance of this forecast. Thus the available information is the sample (Y. Deﬁne g(u) = τ − 1 (u < 0) where 1 (·) is the indicator function (takes the value 1 if the argument is true.10 Exercises 1. Consider the Weighted Least Squares (WLS) estimator of β ¢−1 ¡ 0 ¢ ¡ ˜ X WY β = X 0W X where W = diag(w1 . (b) Prove that e = M1 e. V . based on a sample of size n. and the out-of-sample value of the regressors. 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 . else equals zero). . You wish to forecast an out-of-sample value of y given that ˆ ˆ ˆ ˆ X = x. V ar(e | X) = σ 2 Ω with Ω known. 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 . ˆ (a) Find a point forecast of y.7. E(e | X) = 0.12). the mean absolute error (MAE) is E |yi − g(xi )| . Let (yi . 2. and an estimate of σ 2 is ˆ s2 = 1 e0 Ω−1 e. the residuals e. For any predictor g(xi ) for y. ji ˜ (a) In which contexts would β be a good estimator? ˜ (b) Using your intuition. Show that the function g(x) which minimizes the MAE is the conditional median M (x).. 4. . Verify equation (7. ˜ the residual vector is e = Y − X β. i ˆ ˆ suppose β is the OLS estimate of β with covariance matrix V . σ 2 ). Let θ satisfy Eg(Yi − θ) = 0. xi ) be a random sample with E(Y | X) = Xβ. Is θ a quantile of the distribution of Yi ? 3. X). the GLS estimator is ¡ ¢−1 ¡ 0 −1 ¢ ˜ β = X 0 Ω−1 X XΩ Y . Let σ 2 be the estimate of σ 2 .

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

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

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

This is a population moment. x). ∗ P (yi ≤ y. 1 (yi ≤ y) 1 (xi ≤ x) is an iid random variable with expectation F (y. i 93 . x∗ ≤ x) = Fn (y. I have plotted the EDF and true CDF for three random samples of size n = 25.2 The Empirical Distribution Function Fn (y. To see the eﬀect of sample size on the EDF. i = 1.1). That is. x)) →d N (0. Notationally.. xi ). Fn (y. note that for any (y. To see this. Fn is by construction a step function. x) (1 − F (y. it is helpful to think of a random pair (yi . Recall that F (y. the EDF is only a crude approximation to the CDF. For n = 25. 50. xi ≤ x) = E (1 (yi ≤ y) 1 (xi ≤ x)) . x) = P (yi ≤ y. Note that while F may be either discrete or continuous. where 1(·) is the indicator function. in the Figure below.1). but the approximation appears to improve for the large n.. The method of moments estimator is the corresponding sample moment: n 1X 1 (yi ≤ y) 1 (xi ≤ x) . x∗ ) with the i distribution Fn . and 100.2) Fn (y. The random draws are from the N (0. 1) distribution. n. . Thus by the WLLN (Theorem 5. x) = n i=1 Figure 8. x) . √ n (Fn (y.8. The EDF is a consistent estimator of the CDF. In general. x) is called the empirical distribution function (EDF). x) →p F (y. Furthermore. as the sample size gets larger. Fn is a nonparametric estimate of F. F (y.3.. x))) .1: Empirical Distribution Functions The EDF is a valid discrete probability distribution which puts probability mass 1/n at each ∗ pair (yi . the EDF step function gets uniformly close to the true CDF. by the CLT (Theorem 5. (8. x) − F (y. x). x).2.

Fn ) is calculated for each bootstrap sample. xi ) . . . It is desireable for B to be large. n X i=1 ∗ h (yi . x∗ = xi ) i n 1X h (yi . x∗ ) are drawn randomly from the empirical distribution.. as there are 2n possible samples {(y1 . the parameter ˆ estimate. 8. (yn .. yn .∗ We can easily calculate the moments of functions of (yi . B = 1000 typically suﬃces. However.. As the bootstrap statistic replaces F with θ θ) ˆ Fn .2) as the estimate Fn of F.. x∗ . x∗ . x∗ ) : i Z ∗ Eh (yi . xi ) randomly from the sample. B is known as the number of bootstrap replications.) at the sample estimate ˆ θ. it similarly replaces θ with θn . x∗ )) = h(y.. n 1 such a calculation is computationally infeasible. n i This is repeated B times. the value of θ implied by Fn . x∗ } will necessarily have some ties and multiple values. which is generally n 1 not a problem. with the following points of clariﬁcation: • The sample size n used for the simulation is the same as the sample size. n i=1 8. x∗ )}. sampling from the EDF is equivalent to random sampling a pair (yi . xi ) from the observed data with replacement. x∗ ) .1) is deﬁned using the EDF (8.3 Nonparametric Bootstrap The nonparametric bootstrap is obtained when the bootstrap distribution (8. x)dFn (y. x∗ . A theory for the determination of the number of bootstrap replications B has been developed by Andrews and Buchinsky (2000).. When the statistic Tn³is a function of F. Since Fn is a discrete probability distribution putting probability mass 1/n at each sample point. 94 The bias of ˆ is θ . (When in doubt use θ. xi ) P (yi = yi . x) i = = the empirical sample average.4 Bootstrap Estimation of Bias and Variance θ τ n = E(ˆ − θ0 )... Sampling from the EDF is particularly easy. Typically θn = θ. so long as the computational costs are reasonable. The algorithm is identical to our discussion of Monte Carlo simulation. The popular alternative is to use simulation to approximate the distribution. yn . in principle the distribution G∗ n ∗ ∗ could be calculated by direct methods. In consequence. it is typically through dependence on a parameter. . ∗ • The random vectors (yi . This is i equivalent to sampling a pair (yi . ´ For example. Since the EDF Fn is a multinomial (with n support points). a bootstrap ∗ ∗ sample {y1 . the t-ratio ˆ − θ /s(ˆ depends on θ. ∗ ∗ ∗ The bootstrap statistic Tn = Tn (y1 ..

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

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

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

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

n ´ ³ ∗ ³ ∗ θ θ Note in the simulation that the Wald statistic is a quadratic form in ˆ − ˆ . The following notation will be helpful. Thus here Tn (θ) = Wn (θ). The derivative of an even function is odd.4) says that Gn converges to Φ x as n → ∞. about the rate v of convergence. where qn (α) is the (1 − α)% quantile of the distribution of Wn . and a function h(x) is odd if h(−x) = −h(x). or the size of the divergence for any particular sample size n. C4 is called the symmetric percentile-t interval. Let Tn be a statistic such that (8. Deﬁnition 8. we would use a Wald statistic ³ ´ ³ ´0 ˆ θ Wn (θ) = n ˆ − θ Vθ−1 ˆ − θ θ or some other asymptotically chi-square statistic.3) ´ √ ³ˆ If Tn = n θ − θ0 then v = V while if Tn is a t-ratio then v = 1. Let an be a sequence.] 8.3 an = o(n−r ) if nr |an | → 0 as n → ∞. θ [This is a typical mistake made by practitioners. an = O(n−r ) if it declines to zero like n−r . Deﬁnition 8. the critical value qn (α) is found as the quantile from simulated values of W´ . lim Gn (x. 99 . The bootstrap test ∗ ∗ rejects if Wn ≥ qn (α).8.4) v ¡ ¢ While (8. F ) = Φ n→∞ v or ³x´ Gn (x. it says nothing. A better asymptotic approximation may be obtained through an asymptotic expansion. (8. v 2 ).2 an = O(1) if |an | is uniformly bounded. F ) then ³x´ .8. writing Tn ∼ Gn (x. however. Basically. and vice-versa.∗ where qn (α) is the bootstrap critical value for a two-sided hypothesis test.8. then to test H0 : θ = θ0 against H1 : θ 6= θ0 at size α.8 Asymptotic Expansions Tn →d N (0. The ideal test rejects if Wn ≥ qn (α). F ) = Φ + o (1) . θ θ θ ˆ θ ∗ ∗ Computationally. Equivalently. If θ is a vector. where qn (α) is the (1 − α)% quantile of the distribution of ³ ∗ ³ ∗ ´0 ´ ∗ Wn = n ˆ − ˆ Vθ∗−1 ˆ − ˆ . not ˆ − θ0 . We say that a function g(x) is even if g(−x) = g(x). 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.1 an = o(1) if an → 0 as n → ∞ Deﬁnition 8.

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

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

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

en }. the percentile bootstrap methods provide an attractive inference method. A parametric method is to sample x∗ from an estimated parametric i distribution. We discuss some bootstrap methods appropriate for the case of a regression model where yi = x0 β + εi i E (ei | xi ) = 0. Based on these arguments. i For the regressors x∗ .. The advantage of the EDF is that it is fully nonparametric. and then create i i ∗ = x∗0 β + ε∗ . 8. The advantage is that in this case it is straightforward to construct bootstrap distributions.. i i The the bootstrap distribution does not impose the regression assumption. it is unclear if there are any beneﬁts from using the percentile bootstrap over simple asymptotic methods. σ 2 ). If this is done. and is thus an ineﬃcient estimator of the true distribution (when in fact the regression assumption is true. and works in nearly any context. x∗ ) from the EDF. it is suﬃcient to sample the x∗ and ε∗ independently. The disadvantage is that the bootstrap distribution may be a poor approximation when the error is not independent of the regressors. i which implies ∗ ˆ yi = x∗0 β + ε∗ i i E (x∗ ε∗ ) = 0 i i but generally E (ε∗ | x∗ ) 6= 0.12 Bootstrap Methods for Regression Models The bootstrap methods we have discussed have set G∗ (x) = Gn (x.) One approach to this problem is to impose the very strong assumption that the error εi is independent of the regressor xi . To impose independence. it may be ineﬃcient in contexts where more is known about F. it imposes no conditions.g. 1992. . It is no better than the rate obtained from an asymptotic one-sided conﬁdence region. 2002) tends to advocate the use of the percentile-t bootstrap methods rather than percentile methods. Hall. such as the normal i ˆ ε∗ ∼ N (0. There are diﬀerent ways to impose independence. a nonparametric method is to sample the x∗ randomly from the EDF i i or sample values {x1 . 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.Hence the order of the error is O(n−1/2 ). A non-parametric method is ˆ yi i i e ˆ to sample the bootstrap errors ε∗ randomly from the OLS residuals {ˆ1 . The bad news is that the rate of convergence is disappointing... the theoretical literature (e. √ The good news is that the percentile-type methods (if appropriately used) can yield nconvergent asymptotic inference. This is equivalent to treating the regressors as ﬁxed i in repeated samples. But since it is fully nonparametric. A third approach sets x∗ = xi . A parametric i method is to generate the bootstrap errors ε∗ from a parametric distribution.. Therefore if standard errors are available. Fn ). where Fn is the EDF.. . Horowitz. ∗ The non-parametric bootstrap distribution resamples the observations (yi . xn }. then all inferential statements are made conditionally on the 103 . n Any other consistent estimate of F0 may be used to deﬁne a feasible bootstrap estimator.

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

You want to test H0 : θ = 0 against H1 : θ > 0. can you report the 95% Percentile-t interval for θ? 7.95).05) . ˆ − s(ˆ n (.5% and 97. (a) Report the 95% Efron Percentile interval for θ. you generate bootstrap samples. ∗ ∗ ∗ Let qn (. and thus reject H0 if ˆ ˆ > q ∗ (.5% quantiles of the ˆ are . ∗ ∗ where s(ˆ is the standard error in the original data.Show that C exactly equals the Alternative percentile interval (not the percentile-t interval). You replace c with qn (. (c) With the given information.2. with variables listed in the ﬁle hprice1.pdf. size of house.05) and qn (.3. θ respectively.95).2 and s(ˆ = . The test for H0 is to reject if Tn = ˆ ˆ > c where c is picked so that Type I error is α.75 and 1.95) denote the 5% θ) ∗ and 95% quantiles of Tn . The ˆ are sorted. ˆ = 1. Let qn (. Using the non-parametric bootstrap.95) denote the 95% quantile of Tn .95). and deﬁne the bootstrap conﬁdence interval h i C = ˆ − s(ˆ n (. 105 .dat contains data on house prices (sales). Using the non-parametric ∗ bootstrap. What is wrong with this procedure? Tn = θ/s(θ) n 6. lot size. Estimate a linear regression of price on the number of bedrooms. and ˆ is calculated on each θ ∗ ∗ θ sample. Calculate 95% conﬁdence intervals for the regression coeﬃcients using both the asymptotic normal approximation and the percentile-t bootstrap. θ θ) ∗ 1000 samples are generated from the bootstrap distribution. and the colonial dummy. Suppose that in an application. and the 2. (b) Report the 95% Alternative Percentile interval for θ. The dataﬁle hprice1. calculate the estimates ˆ on these samples and θ then calculate ∗ ∗ ∗ θ θ Tn = ˆ /s(ˆ ). You do this as follows. θ θ)q ∗ θ θ)q ∗ θ/s(θ) 5.

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

The ﬁrst order conditions for the GMM estimator are 0 = ∂ ˆ Jn (β) ∂β ∂ ˆ ˆ = 2 g n (β)0 Wn g n (β) ∂β ´ 1 1 ³ ˆ = −2 Z 0 XWn X 0 Y − Z β n n so which establishes the following.3 Distribution of GMM Estimator ¡ 0¢ Q = E xi zi Assume that Wn →p W > 0. then. ¡ ¢−1 0 ˆ Z XWn X 0 Y. This is a non-negative measure of the “length” of the vector g n (β). and the GMM estimator is the MME. β GMM does not change. the square of the Euclidean length.2. Proposition 9. Jn (β) = n · g n (β)0 g n (β) = n · |g n (β)|2 .1 β GMM = argmin Jn (β).2) g n (β) = (9. ˆ Deﬁnition 9. let Jn (β) = n · g n (β)0 Wn g n (β). if Wn = I.2. for if Wn is replaced ˆ by cWn for some c > 0. i i .1 ˆ 2Z 0 XWn X 0 Z β = 2Z 0 XWn X 0 Y While the estimator depends on Wn . The GMM estimator minimizes Jn (β). β ˆ Note that if k = . For some × weight matrix Wn > 0.2 GMM Estimator n n ¢ 1¡ 0 ¢ 1X 1X ¡ 0 X Y − X 0 Zβ .3) The method of moments estimator for β is deﬁned as the parameter value which sets g n (β) = 0.9. but this is generally not possible when > k. 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 . then g n (β) = 0. gi (β) = xi yi − zi β = n n n i=1 i=1 Deﬁne the sample analog of (9. the dependence is only up to scale. β GMM = Z 0 XWn X 0 Z 9. The idea of the generalized method of moments (GMM) is to deﬁne an estimator which sets g n (β) “close” to zero. For example. Let and where gi = xi ei .

it turns out that the GMM estimator is semiparametrically eﬃcient.3. This is a weak concept of optimality. However. For any Wn →p W0 . but it can be estimated consistently. and this is all that is known. Given any such ﬁrst0ˆ ˆ ˆ ˆ step estimator. we can deﬁne the residuals ei = yi −zi β and moment equations gi = xi ei = g(wi . no estimator has greater asymptotic eﬃciency than the eﬃcient linear GMM estimator. Chamberlain showed that in this context.and µ µ ¶ ¶ 1 0 1 0 Z X Wn X e →d Q0 W N (0. a better choice is Wn = (X 0 X)−1 . If it is known that E (gi (β)) = 0. ˆ∗ ˆ 108 . we can set Wn = I . as we are only considering alternative weight matrices Wn . Since the GMM estimator has this can have a smaller asymptotic variance than G0 Ω−1 G asymptotic variance. ˆ Construct n 1X ˆ g n = g n (β) = gi .2 For the eﬃcient GMM estimator. This turns out to be W0 = Ω−1 . as shown by Gary Chamberlain (1987). ˆ We have described the estimator β as “eﬃcient GMM” if the optimal (variance minimizing) weight matrix is selected. Q0 Ω−1 Q ¢−1 ¡ 0 ¢¡ ¢−1 ¡ . the GMM estimator β is consistent yet ineﬃcient. β = Z 0 XΩ−1 X 0 Z ´ ³ ¡ ¢−1 ´ √ ³ˆ . where In general. it is semiparametrically eﬃcient. For example. The optimal weight matrix W0 is one which minimizes V. ˆ n i=1 gi = gi − g n . W0 = Ω−1 is not known in practice. GMM estimators are asymptotically normal with “sandwich form” asymptotic variances. The proof is left as an exercise. No estimator can do better (in this ﬁrst-order asymptotic sense). n β − β →d N 0.1 ´ √ ³ˆ n β − β →d N (0. without imposing additional assumptions. This yields the eﬃcient GMM estimator: ¢−1 0 ¡ ˆ Z XΩ−1 X 0 Y. 9. this is a semi-parametric problem. as it has the same asymptotic distribution. ˆ we still call β the eﬃcient GMM estimator. no semiparametric estimator (one which is consistent globally for the class of models considered) ¢−1 ¡ . as the distribution of the data is unknown. V ) . This results shows that in the linear model. This estimator is eﬃcient only in the sense that it is the best (asymptotically) in the class of GMM estimators with this set of moment conditions. Q W ΩW Q Q0 W Q V = Q0 W Q Thus we have Theorem 9.4 Estimation of the Eﬃcient Weight Matrix ˆ Given any weight matrix Wn > 0. In the linear model. β). n n We conclude: Theorem 9. Ω) .3.

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

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

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

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

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

Letting H = CQ and G = C 0−1 W Q. 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. In the linear model estimated by GMM with general weight matrix W.g. Show that Wn →p Ω i i i 4. (b) We want to show that for any W. Take the model E (zi ηi ) = 0. i 0 0ˆ ˆ 3. From matrix algebra. and therefore positive semideﬁnite. Show that if β is estimated by GMM with weight matrix Wn = i 0 X)−1 . γ ) for (β. 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. A = H 0 I − G G0 G (d) Show that A is positive semideﬁnite.9. Take the single equation Y E(e = Zβ + e | X) = 0 ˆ Assume E(e2 | xi ) = σ 2 . a GMM estimator with arbitrary weight matrix). Show that V0 = Q0 Ω−1 Q . there exists a nonsingular matrix C such that C 0 C = Ω−1 . 2. Wn = n i=1 ¡ ¢ −1 where Ω = E x x0 e2 . ˆ ˆ Find the method of moments estimators (β. then (X ´ ¢−1 ¡ √ ³ ˆ n β − β →d N (0. Write out the matrix A. Hint: The matrix I −G (G0 G)−1 G0 is symmetric and idempotent. Deﬁne the estimate of the optimal GMM weight matrix Ã n !−1 1X 0 2 xi xi ei ˆ . 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 . we know that V − V0 is positive semi-deﬁnite if and only if V0−1 − V −1 = A is positive semi-deﬁnite. Take the model yi = zi β + ei with E (xi ei ) = 0.10 Exercises yi = x0 β + ei i E (xi ei ) = 0 0 e2 = zi γ + η i i 1. 114 . γ). (c) Since Ω is positive deﬁnite.

λ = R0 Vn R (c) Show that if R0 β = r then ´ √ ³˜ n β − β →d N (0. l ≥ k. the distance statistic D in (9. The equation of interest is yi = g(xi . VR = V − V R R0 V R (d) Show that in this setting. xi . β) + ei E (zi ei ) = 0. zi ).5) n 1 P ˆ where ei are the OLS residuals and Ωn = n n xi x0 e2 . h(β)=0 (9. zi is l × 1 and β is k × 1. h(β)=0 The GMM test statistic (the distance statistic) of the hypothesis h(β) = 0 is ˜ D = Jn (β) = min Jn (β). the Generalized Method of Moments (GMM) criterion function for β is deﬁned as 1 ˆn (Y − Xβ)0 X Ω−1 X (Y − Xβ) (9. Vn = X X i=1 ˜ and hence R0 β = r. The GMM estimator of β. Deﬁne the Lagrangian L(β. In the linear model Y = Xβ + e with E(xi ei ) = 0. Show how to construct an eﬃcient GMM estimator for β. λ) = 1 Jn (β) + λ0 (R0 β − r) where λ is 2 s × 1.6) equals the Wald statistic.5.5) 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. subject ˆ i ˆi i=1 to the restriction h(β) = 0. 115 . Thus ˜ β = argmin Jn (β) R0 β−r Ã n ! ¡ 0 ¢−1 ¡ 0 ¢−1 X 0 2 ˆ XX xi xi ei ˆ . 6. VR ) where ¡ ¢−1 0 R V. The observed data is (yi .6) (a) Show that you can rewrite Jn (β) in (9. 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 . is deﬁned as Jn (β) = ˜ β = argmin Jn (β).

116 . l−k Hint: Il − R (R0 R)−1 R0 is a projection matrix. Il ) ³ ´ (f) Jn →d N 0 Il − R (R0 R)−1 R0 N ³ ´ (g) N 0 Il − R (R0 R)−1 R0 N ∼ χ2 .7. 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.. Take the linear model 0 yi = zi β + ei E (xi ei ) = 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. 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.

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

where λ and µ are Lagrange multipliers. Multiplying the ﬁrst equation by pi . The solution (when it exists) is well deﬁned since Rn (β. pi gi (β) = 0. µ) = n i=1 i=1 i=1 L∗ n with respect to pi . λ). (10. p (10. λ) : λ(β) = argmin Rn (β.1) and (10.4) (10. λ) is a convex function of λ. Ln (β) = Rn (β. λ.5) ˆ ˆ As a by-product of estimation. but must be obtained numerically (see section 6. 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.3). (see section 6. the Lagrange multiplier λ(β) minimizes Rn (β. The ﬁrst-order-conditions of and λ are 1 = µ + nλ0 gi (β) pi n X pi = 1 i=1 n X i=1 The empirical likelihood estimator is the value of β which maximizes the multinomial loglikelihood (10.5).2) subject to the restrictions (10. p1 . λ(β)) = −n ln (n) − n X i=1 ˆ The EL estimate β is the value which maximizes Ln (β). . pi = ³ ˆ ˆ ˆ0 n 1 + λ gi β ˆ Ln = n X i=1 ln (ˆi ) . and using the second and third equations. summing over i.. we ﬁnd µ = n and 1 ¢.6) β = argmin [−Ln (β)] β ¡ ¢ ln 1 + λ(β)0 gi (β) and maximized empirical likelihood ˆ Numerical methods are required for calculation of β.5) This minimization problem is the dual of the constrained maximization problem. The solution cannot be obtained explicitly. µ. λ ¡ ¢ ln 1 + λ0 gi (β) . or equivalently minimizes its negative ˆ (10.7) 118 . probabilities 1 ³ ´´ . we also obtain the Lagrange multiplier λ = λ(β).. pn .. pi = ¡ n 1 + λ0 gi (β) Substituting into L∗ we ﬁnd n Rn (β. This yields the (proﬁle) empirical log-likelihood function for β. λ) = −n ln (n) − n X i=1 For given β.

1 Under regularity conditions.12) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ 0 ' G0 λ − λ0 . in the linear model. β λ ∂ ³ ´. Vλ ) ´ √ ˆ √ ³ˆ where V and Vλ are deﬁned in (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. ˆ ˆ Proof. ˆ The asymptotic variance V for β is the same as for eﬃcient GMM.2 Deﬁne Asymptotic Distribution of EL Estimator Gi (β) = ∂ gi (β) ∂β 0 (10. i=1 i=1 i=1i Expanding (10.14) ³ ´ ˆ ˆ 0 ' −G0 Ω−1 g n − G0 Ω−1 Gn β − β 0 + G0 Ω−1 Ωn λ n n n n n n ³ ´ ˆ = −G0 Ω−1 g n − G0 Ω−1 Gn β − β 0 n n n n 119 . G = −E (xi zi ). (β. n (10. λ) = − (10. β) = −xi zi .13) Premultiplying by G0 Ω−1 and using (10.9) (10. λ) = − (10.10).12) ∂β ˆ ˆ0 i=1 1 + λ gi β 1 P 1 P 1 P Let Gn = n n Gi (β 0 ) . Gi (. 0 = Rn (β. g n = n n gi (β 0 ) and Ωn = n n g (β 0 ) gi (β 0 )0 . i i Theorem 10.2. and n β − β 0 and nλ are asymptotically independent. λ) jointly solve ³ ´ ˆ n gi β X ∂ ³ ³ ´´ Rn (β. Thus the EL estimator is asymptotically eﬃcient.10) ¡ Ω−1 N (0. ´ √ ³ ˆ n β − β 0 →d √ ˆ nλ →d N (0.11) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ ˆ 0 ' −g n − Gn β − β 0 + Ωn λ (10.10.13) yields n n Expanding (10. and Ω = E xi x0 e2 .9) and (10.8) and ¢ 0 0 For example.11) 0 = ∂λ ˆ0 ˆ i=1 1 + λ gi β ³ ´0 ˆ n X Gi .

16) ´ √ ˆ √ ³ˆ n β − β 0 and nλ are asymptotically uncorrelated and hence independent.3 Overidentifying Restrictions In a parametric likelihood context.7) is n ³ ´´ ³ X ˆ ˆ0 (10. since ³ ¡ ¢−1 0 ´ G0 I − Ω−1 G G0 Ω−1 G G =0 (10. V ) ˆ Solving (10. by a Taylor expansion. The overidentiﬁcation test is a very useful by-product of EL estimation. β ' n g n + Gn β − β 0 n i=1 ³ ¡ ¢−1 0 −1 ´ √ Gn Ωn ng n ' I − Gn G0 Ω−1 Gn n n √ ˆ ' Ωn nλ. Twice the diﬀerence between the unrestricted empirical likelihood −n log (n) and the maximized empirical likelihood for the model (10. Proof. 120 . They are asymptotically ﬁrst-order equivalent. (10. LRn = i=1 Theorem 10.14) for λ and using (10.16).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. and (10. it is an asymptotically eﬃcient estimator for β. and have the same interpretation. First. and it is advisable to report the statistic LRn whenever EL is the estimation method.3.17) 2 ln 1 + λ gi β . β 0 ) = 0 then LRn →d χ2−k .15) (10. The EL overidentiﬁcation test is similar to the GMM overidentiﬁcation test. Vλ ) Furthermore.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. n ³ ´´ ´ √ ³ 1 X ³ ˆ ˆ √ g wi . Ω) GΩ G →d = N (0.15). This means that no consistent estimator for this class of models can have a lower asymptotic variance than V . tests are based on the diﬀerence in the log likelihood functions. The same statistic can be constructed for empirical likelihood.1 If Eg(wi . Ω) →d Ω−1 I − G G Ω G GΩ = Ω−1 N (0. Since the EL estimator achieves this bound. 10. ¥ Chamberlain (1987) showed that V is the semiparametric eﬃciency bound for β in the overidentiﬁed moment condition model.

The restricted EL estimator and likelihood are the values which solve ˜ β = argmax Ln (β) h(β)=0 ˜ ˜ Ln = Ln (β) = max Ln (β). so there is no fundamental change in the distribution theory for β relative to β.prc 121 . To test the hypothesis h(β) while maintaining (10. 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. h(β)=0 ˜ Fundamentally.edu/~bhansen/progs/elike.18) are assumed to hold and are not being challenged (at least for the test discussed in this section). By “maintained” we mean that the overidentfying restrictions contained in (10.4 Testing Egi (β) = 0 (10. Theorem 10. This test statistic is a natural analog of the GMM distance statistic. Vλ ) ¥ where the proof of the ﬁnal equality is left as an exercise. Instead we use the diﬀerence in log-likelihoods: ³ ´ ˆ ˜ LRn = 2 Ln − Ln .18). a The proof of this result is more challenging and is omitted.18) and H0 : h(β) = 0.18) Let the maintained model be where g is × 1 and β is k × 1.1 Under (10. the restricted EL estimator β is simply an EL estimator with − k + a overidenti˜ ˆ fying restrictions. where h : Rk → Ra . the simple overidentifying restrictions test (10.5 Numerical Computation Gauss code which implements the methods discussed below can be found at http://www. 10.17) is not appropriate. 10.wisc. Vλ )0 Ω−1 N (0.4.Second. since ln(1 + x) ' x − x2 /2 for x small.ssc. LRn →d χ2 . The hypothesis of interest is h(β) = 0.

λ)0 − ∂β∂β Rn (β. λp ) A quadratic function can be ﬁt exactly through these three points. Set δ 0 = 0. λ) ∂λ i=1 n ∂ Rn (β. λj ) is smaller than some prespeciﬁed tolerance.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. 2.19) X ∂2 ∗ ∗ gi (β. λ) = i The ﬁrst derivatives of (10. λj )) Rp = Rn (β. (10. The modiﬁed Newton method takes a quadratic approximation to Rn (β. set 2 λp = λj − δ p (Rλλ (β. One method uses the following quadratic approximation.4). λj ) . λ) = ∂λ∂λ i=1 ¶ n 2 Xµ ∂ Gi (β) ∗ gi (β. δ 4R2 + 4R0 − 8R1 yielding the steplength to be plugged into (10. The iteration (10. λ) G∗ (β. λ) gi (β. λ)0 − Rn (β. λj ))−1 Rλ (β. λ) = − ∂β n X i=1 G∗ (β. The value of δ which minimizes this quadratic is ˆ = R2 + 3R0 − 4R1 . λ)0 0 Rn (β. λj ))−1 Rλ (β.19).5) for given β. The starting value λ1 can be set to the zero vector.Derivatives The numerical calculations depend on derivatives of the dual likelihood function (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). Deﬁne ∗ gi (β. λ) yielding the iteration rule λj+1 = λj − δ (Rλλ (β.19) is continued until the gradient Rλ (β. λ) = i ∂λ∂β 0 1 + λ0 gi (β) i=1 ⎞ ⎛ ¡ 0 ¢ ∂2 n 2 X 0 gi (β) λ ∂ ⎠ ⎝G∗ (β. δ 1 = 1 and δ 2 = 1. λ) = − gi (β. 1. Eﬃcient convergence requires a good choice of steplength δ. λ) = G∗ (β. A complication is that λ must be constrained so that 0 ≤ pi ≤ 1 which holds if ¢ ¡ n 1 + λ0 gi (β) ≥ 1 122 (10. For p = 0.. λ) . λ) G∗ (β. i Rββ = Inner Loop The so-called “inner loop” solves (10.20) .

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

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

1) if E (xi ei ) = 0. Thus we make the partition ¶ µ k1 z1i (11. and assume that E(zi ei ) 6= 0 so there is endogeneity. That is x2i are variables which could be included in the equation for yi (in the sense 125 . so should be included in xi .4) xi = x2i 2 where z1i = x1i are the included exogenous variables. β →p β ∗ .2) Any solution to the problem of endogeneity requires additional information which we call instruments.1) where zi is k × 1. which does not equal either β 1 or β 2 .1). z1i is an instrumental variable for (11.1) the structural equation. at least the intercept). Deﬁnition 11.1 The × 1 random vector xi is an instrumental variable for (11. and x2i are the excluded exogenous variables. So we have the partition µ ¶ z1i k1 (11.1.3) zi = z2i k2 where E(z1i ei ) = 0 yet E(z2i ei ) 6= 0. some regressors in zi will be uncorrelated with ei (for example. 11. In a typical set-up. By the above deﬁnition. (11. We call (11. this can be written as Y = Zβ + e. In matrix notation. We call z1i exogenous and z2i endogenous.so µ qi pi ¶ = = = The projection of qi on pi yields qi = β ∗ pi + εi E (pi εi ) = 0 where β∗ = β − β1 E (pi qi ) ¡ 2¢ = 2 2 E pi ∙ 1 β1 1 −β 2 ¸−1 µ e1i e2i ¶ .1 Instrumental Variables 0 yi = zi β + ei Let the equation of interest be (11. This is called simultaneous equations bias. ¶ µ ∙ β2 β1 1 −1 β 2 e1i + β 1 e2i (e1i − e2i ) ¸µ e1i e2i ¶ ˆ Hence if it is estimated by OLS.

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

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

14) approaches that in (11. l .Let PX = X (X 0 X)−1 X 0 .13). It is also close to zero when α = 0. 130 . the bias in the 2SLS estimator will be large. 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. indicating that the bias in 2SLS approaches that of OLS as the number of instruments increases. The consequences of identiﬁcation failure for inference are quite severe. Bekker (1994) pointed out that it also has the reverse implication — that when α = l/n is large. 0). except when S21 = 0 (when Z is exogenous). P = HΛH 0 0 0 where Λ = diag(Il . By the spectral decomposition of an idempotent matrix.12) and this result. Together µ µ ¶¶−1 µ ¶ ³ ´ 1 0 1 0 ˆ 2SLS − β E β Z PX Z Z PX e ≈ E E n n ¡ ¢−1 = α Γ0 QΓ + αS22 S21 . The parameter β fails to be identiﬁed if Γ22 has deﬁcient rank. ¢ 1 ¡ ¢ 1 ¡ ¢ 1 ¡ 0 E Z PX e = E Γ0 X 0 e + E u0 PX e = αS21 .14) is the probability limit of β 2SLS − β 11. Indeed as α → 1.7 Identiﬁcation Failure Recall the reduced form equation Z2 = X1 Γ12 + X2 Γ22 + u2 .14) In general this is non-zero. n and (11. Bekker (1994) showed further that under the alternative asymptotic approximation that α is ﬁxed as n → ∞ (so that the number of instruments goes to inﬁnity proportionately with sample ˆ size) then the expression in (11. n n n ¢ ¡ ¡ ¢ ¢ ¢ 1 ¡ 0 1 ¡ E Z PX Z = Γ0 E xi x0 Γ + Γ0 E (xi ui ) + E ui x0 Γ + E u0 PX u i i n n = Γ0 QΓ + αS22 . the expression in (11. Let q = H 0 ξS −1/2 which satisﬁes Eqq 0 = In and partition q = (q1 q2 ) where q1 is l × 1.

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

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

Take the linear model Y = Zβ + e. Show that the GLS estimator of β can be written as an i IV estimator using some instrument xi . X is n × l. In the linear model 0 yi = zi β + ei E (ei | zi ) = 0 ¡ 2 ¢ suppose σ 2 = E ei | zi is known. we claim that β is identiﬁed (can be recovered from the reduced form) if rank(Γ) = k. (Find an expression for xi . Take the linear model yi = xi β + ei E (ei | xi ) = 0. show that if rank(Γ) < k then β cannot be identiﬁed. l ≥ k. Find a simple expression for the IV estimator in this context.) 3. ˆ ˜ ˜ Let the IV estimator for β using some instrument X be β and the IV residual be e = Y − Z β. 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. Consider the single equation model ˆ where yi and zi are both real-valued (1 × 1). That is.11. where xi and β are 1 × 1. ˜ 0 e < e0 e. Z is n × k. In the structural model Y = Zβ + e Z = XΓ + u with Γ l × k. u is n × k. 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) . ˆ ˆ Let the OLS estimator for β be β and the OLS residual be e = Y − Z β. 2.8 Exercises yi = zi β + ei . in the sense that e ˜ ˜ least in large samples? 4. and Γ is l × k. Let β denote the IV estimator of β using as an instrument a dummy variable di (takes only the values 0 and 1). 6. 5. will IV “ﬁt” better than OLS. xi is l × 1. Explain why this is true. 133 . at ˆˆ If X is indeed endogeneous.

listed in card. (c) Re-estimate by 2SLS (report estimates and standard errors) adding three additional instruments: near2 (a dummy indicating that the observation lives near a 2-year college). Report the estimates and standard errors. (e) Calculate and report the J statistic for overidentiﬁcation. in years. 134 .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).. in years. of the mother). and then calculate the GMM estimator from this weight matrix without further iteration. of the father) and motheduc (the education. In this model. 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. using the instrument near4. 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). 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. (b) Now treat Education as endogenous. (d) Re-estimate the model by eﬃcient GMM. (a) Estimate the model by OLS. and the remaining variables as exogenous. There are 2215 observations with 19 variables. Does this diﬀer from 2SLS and/or OLS? 7. The data ﬁle card. a dummy indicating that the observation lives near a 4-year college. Estimate the model by 2SLS. (f) Discuss your ﬁndings. are the parameters identiﬁed? 8. Report estimates and standard errors.(b) Deﬁne the 2SLS estimator of β. using zi as an instrument for xi .pdf. Report estimates and standard errors. and South and Black are regional and racial dummy variables. 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. I suggest that you use the 2SLS estimates as the ﬁrst-step to get the weight matrix.

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

If Xt is strictly stationary and ergodic and E |Xt | < ∞. and it has a ﬁnite mean by the assumption that EYt2 < ∞. For Part (2).3 If Yt is strictly stationary and ergodic and EYt2 < ∞. ˆ 3. γ (k) →p γ(k). 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) . Thus an application of the Ergodic Theorem yields T 1X Yt Yt−k →p E(Yt Yt−k ).1. then as T → ∞. µ →p E(Yt ).1.Theorem 12. ˆ Proof. ρ(k) →p ρ(k). then as T → ∞. 1. γ (0) ˆ Theorem 12. T t=1 Thus γ (k) →p E(Yt Yt−k ) − µ2 − µ2 + µ2 = E(Yt Yt−k ) − µ2 = γ(k). ˆ 2.1. T 1X Xt →p E(Xt ).1 above. ˆ ˆ T t=1 γ (k) = ˆ The sample autocorrelation ρ(k) = ˆ γ (k) ˆ . ˆ ˆ T t=1 T t=1 T t=1 By Theorem 12. Part (1) is a direct consequence of the Ergodic theorem.2 (Ergodic Theorem). ˆ ˆ γ ¥ 136 . ˆ Part (3) follows by the continuous mapping theorem: ρ(k) = γ (k)/ˆ (0) →p γ(k)/γ(0) = ρ(k). the sequence Yt Yt−k is strictly stationary and ergodic. 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 .

the series {. YT . E(Yt−k et ) = 0. The last property deﬁnes a special time-series process. it is even more important in the time-series context. An autoregressive (AR) model speciﬁes that only a ﬁnite number of past lags matter: E (Yt | It−1 ) = E (Yt | Yt−1 . then we have the autoregressive model Yt = α + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et E (et | It−1 ) = 0. or consumption growth rates. k=0 Loosely speaking. t By back-substitution. For example.. 137 . A mean-zero AR(1) is Assume that et is iid.12. Most asset pricing models imply that asset returns should be the sum of a constant plus a MDS. 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.. E(et ) = 0 and Ee2 = σ 2 < ∞.. we ﬁnd Yt = et + ρet−1 + ρ2 et−2 + . We consider the conditional expectation E (Yt | It−1 ) where It−1 = {Yt−1 .. Letting et = Yt − E (Yt | It−1 ) .} is the past history of the series. Regression errors are naturally a MDS. ∞ X = ρk et−k . Y1 . In fact... Deﬁnition 12. A useful property of a MDS is that et is uncorrelated with any function of the lagged information 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 → ∞. Thus for k > 0... Yt−k ) . ..2.2 Autoregressions In time-series.1 et is a martingale diﬀerence sequence (MDS) if E (et | It−1 ) = 0.3 Stationarity of AR(1) Process Yt = ρYt−1 + et . should be a MDS.. . . as it is diﬃcult to derive distribution theories without this property. Yt−2 ... 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 . 12. some versions of the life-cycle hypothesis imply that either changes in consumption.} are jointly random. This occurs when |ρ| < 1... Y2 .

The operator ρ(L) = (1 − ρL) is a polynomial in the operator L. since ρ(z) = 0 when z = 1/ρ.Theorem 12. an AR(1) is stationary iﬀ |ρ| < 1. The AR(1) model can be written in the format Yt − ρYt−1 + et or (1 − ρL) Yt−1 = et . We call ρ(L) the autoregressive polynomial of Yt .3.4 Lag Operator An algebraic construct which is useful for the analysis of autoregressive models is the lag operator. 1 − ρ2 V ar(Yt ) = If the equation for Yt has an intercept. We call ρ(L) the autoregressive polynomial of Yt . 138 . The AR(k) model is Using the lag operator. Yt − ρ1 LYt − ρ2 L2 Yt − · · · − ρk Lk Yt = et . We say that the root of the polynomial is 1/ρ.5 Stationarity of AR(k) Yt = ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et .4. Note that an equivalent way to say this is that an AR(1) is stationary iﬀ the root of the autoregressive polynomial is larger than one (in absolute value). 12. and solving for EYt = EYt−1 we ﬁnd EYt = α/(1 − ρ). Lk Yt = Yt−k . Deﬁnition 12. the above results are unchanged. 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 . Deﬁning L2 = LL. or ρ(L)Yt = et where ρ(L) = 1 − ρ1 L − ρ2 L2 − · · · − ρk Lk .3.1 If |ρ| < 1 then Yt is strictly stationary and ergodic. From Theorem 12.1. except that the mean of Yt can be computed from the relationship EYt = α + ρEYt−1 . ∞ X k=0 ρ2k V ar (et−k ) = 12.1 The lag operator L satisﬁes LYt = Yt−1 . In general.

so is xt x0 .1) Theorem 12. and hence Yt . . T t=1 T t=1 ¢−1 0 ¡ ˆ X Y.where the λ1 .1. t T t=1 T t=1 139 .1.1) and the continuous mapping theorem. By Theorem 12. Thus t by the Ergodic Theorem.1..” If one of the roots equals 1.1 The AR(k) is strictly stationary and ergodic if and only if |λj | > 1 for all j.6.1 If the AR(k) process Yt is strictly stationary and ergodic and EYt2 < ∞. λk are the complex roots of ρ(z). This is a special case of non-stationarity. the requirement is that all roots are larger than one.5. Let |λ| denote the modulus of a complex number λ. and is of great interest in applied time series. Thus T T 1X 1X xt et = ut →p E (ut ) = 0.6 Let Estimation xt = β = ¡ 1 Yt−1 Yt−2 · · · α ρ1 ρ2 · · · yt = x0 β + et . 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. we say that ρ(L).1. since E (ut | It−1 ) = E (xt et | It−1 ) = xt E (et | It−1 ) = 0. it is also strictly stationary and ergodic. and by Theorem 12. We know that an AR(1) is stationary iﬀ the absolute value of the root of its autoregressive polynomial is larger than one. T ¢ ¡ 1X xt x0 →p E xt x0 = Q. it is helpful to deﬁne the process ut = xt et . β = X 0X (12. One way of stating this is that “All roots lie outside the unit circle. “has a unit root”. Note that ut is a MDS. ¢0 Then the model can be written as The OLS estimator is ¡ ˆ To study β. which satisfy ρ(λj ) = 0. The vector xt is strictly stationary and ergodic.. t t T t=1 ¥ Combined with (12.. we see that Ã !−1 Ã ! T T 1X 1X ˆ β=β+ xt x0 xt et →p Q−1 0 = 0. Theorem 12. t Yt−k ¢0 ρk . then ˆ β →p β as T → ∞. Proof. For an AR(k).

t t Theorem 12. It also presumes that the AR(k) structure is the truth. Y−k+2 . Brieﬂy.. 12.7.12. we constructed the bootstrap sample by randomly resampling from the data values {yt . as this imposes inappropriate independence. Ω) . Estimate β and residuals et . 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∗ . there are two popular methods to implement bootstrap resampling for time-series data. Method 1: Model-Based (Parametric) Bootstrap. T t=1 Since xt et is a MDS.. xt }. t This construction imposes homoskedasticity on the errors e∗ . t then as T → ∞. . then as T → ∞. Q−1 ΩQ−1 . this cannot work in a time-series application. . T t=1 where Ω = E(xt x0 e2 ). eT }. Simulate iid draws e∗ from the empirical distribution of the residuals {ˆ1 . If ut is a strictly stationary and ergodic MDS and E(ut u0 ) = Ω < ∞. Ω) ... ˆ 1. T 1 X √ ut →d N (0. e ˆ 3. i 4. This is identical in form to the asymptotic distribution of OLS in cross-section regression. Y0 ).1 to see that T 1 X √ xt et →d N (0.2 If the AR(k) process Yt is strictly stationary and ergodic and EYt4 < ∞.7. we can apply Theorem 12. Method 2: Block Resampling 1.7. which may be diﬀerent than the i properties of the actual ei .7 Asymptotic Distribution Theorem 12. In particular.8 Bootstrap for Autoregressions In the non-parametric bootstrap.. 140 .. The implication is that asymptotic inference is the same. ´ √ ³ ¡ ¢ ˆ T β − β →d N 0. This creates an iid bootstrap sample. Clearly. ˆ 2. Divide the sample into T /m blocks of length m.1 MDS CLT. Fix an initial condition (Y−k+1 . the asymptotic covariance matrix is estimated just as in the cross-section case.

Thus the seasonally adjusted data is a “ﬁltered” series. however. 6. ρk ). and for modelmisspeciﬁcation. 4. • Include dummy variables for each season. ﬁrst estimate (12.2)-(12. For each simulated sample. also alters the time-series correlations of the data. May not work well in small samples. and the way that the data are partitioned into blocks. • First apply a seasonal diﬀerencing operator. The results may be sensitive to the block length. or the season-to-season change. 3. But the long-run trend is also eliminated. . and then perform regression (12. get the ˆ ˆ residual St .. 12. ∆s Yt = Yt − Yt−s .. This procedure is sometimes called Detrending. This allows for arbitrary stationary serial correlation. The seasonal adjustment.3) or Yt = α0 + α1 t + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et .2. If s is the number of seasons (typically s = 4 or s = 12). • Use “seasonally adjusted” data. The seasonal factor is typically estimated by a two-sided weighted average of the data for that season in neighboring years. The reason why these two procedures are (essentially) the same is the Frisch-Waugh-Lovell theorem. 141 . Paste the blocks together to create the bootstrap time-series Yt∗ . 5.4) by OLS. heteroskedasticity. Resample complete blocks. • You can estimate (12.2).2) (12. (12. That is. draw T /m blocks. This presumes that “seasonality” does not change over the sample. The series ∆s Yt is clearly free of seasonality.4) There are two essentially equivalent ways to estimate the autoregressive parameters (ρ1 .. • You can estimate (12. Seasonal Eﬀects There are three popular methods to deal with seasonal data. (12.3) replacing St with St . and perhaps this was of relevance.3) sequentially by OLS.9 Trend Stationarity Yt = µ0 + µ1 t + St St = ρ1 St−1 + ρ2 St−2 + · · · + ρk St−l + et . This is a ﬂexible approach which can extract a wide range of seasonal factors.

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

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

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

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

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

Then the single equation takes the form (13. This restriction. j Often.3) which is a valid regression model. which is called a common factor restriction.5 Testing for Omitted Serial Correlation Consider the problem of testing for omitted serial correlation in equation (13. (A simple version of this estimator is called Cochrane-Orcutt. may be tested if desired. xt−1 ) to the regression. Suppose that et is an AR(1). You may have heard of the Durbin-Watson test for omitted serial correlation. So testing H0 versus H1 is equivalent to testing for the signiﬁcance of adding (yt−1 . t or yt = θyt−1 + x0 β + x0 γ + ut . 147 .4 Single Equation from a VAR Yjt = a0 xt + et . 1).1) yt = x0 β + et . which once was very popular. general. and simple way to test for omitted serial correlation is to test the signiﬁcance of extra lagged values of the dependent variable and regressors. and Zt be the other variables. and subtract oﬀ the equation once lagged multiplied by θ. and is typically rejected empirically. Otherwise it is invalid. If valid. t and xt = This is just a conventional regression. In this case. (13. This takes the form 0 and xt consists of lagged values of Yjt and the other Ylt s. h¡ 1 Yt−1 · · · 0 Yt−k Zt−1 · · · 0 Zt−k ¢0 i .2) Take the equation yt = x0 β + et .3). Then the null and alternative are H0 : θ = 0 H1 : θ 6= 0. The DW test is appropriate only when regression yt = x0 β + et is not dynamic (has no lagged values on the RHS). We see that an appropriate. and is still routinely reported by conventional regression packages. t t−1 (13.) Since the common factor restriction appears arbitrary. Let yt = Yjt .1).13. 13. Let et = ejt and β = aj . Then yt = x0 β + et t et = θet−1 + ut E (ut | It−1 ) = 0. direct estimation of (13.2) is uncommon in recent applications. the model (13. This can be done by a Wald test. 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 . we are only interested in a single equation out of a VAR system.2) may be estimated by iterated GLS. under the restriction γ = −βθ. t and et is iid N (0. Another interesting fact is that (13. with time series data. it is convenient to re-deﬁne the variables.2) is a special case of (13.

Yt−1 . you may either use a testingbased approach (using. or an information criterion approach. Yt−2 . Zt−2 . The reason why we call this “Granger Causality” rather than “causality” is because this is not a physical or structure deﬁnition of causality. lagged Zt does not help to forecast Yt . that Zt may still be useful to explain other features of Yt . Zt . We say that Zt does not Granger-cause Yt if E (Yt | I1. If it is found that Zt does not Granger-cause Yt . 148 . If Zt is some sort of forecast of the future.t−1 ) . .7 Granger Causality Partition the data vector into (Yt . then we say that Zt Granger-causes Yt . The hypothesis can be tested by using the appropriate multivariate Wald test. .. In this equation. and et (k) is the OLS residual vector from the ˆ model with k lags. That is. for example. 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−1 . Zt ). Note. Yt−2 . The latter has more information.6 Selection of Lag Length in an VAR If you want a data-dependent rule to pick the lag length k in a VAR. Yt−1 . That is. such as a futures price.. Yt and/or Zt can be vectors. however. the Wald statistic).) The information set I1t is generated only by the history of Yt .t−1 ) = E (Yt | I2. such as the conditional variance. The formula for the AIC and BIC are ³ ´ p ˆ AIC(k) = log det Ω(k) + 2 T ³ ´ p log(T ) ˆ BIC(k) = log det Ω(k) + T T X 1 ˆ et (k)ˆt (k)0 ˆ e Ω(k) = T t=1 p = m(km + 1) where p is the number of parameters in the model. then Zt may help to forecast Yt even though it does not “cause” Yt .) I2t = (Yt . 13.13.. This idea can be applied to blocks of variables. Deﬁne the two information sets I1t = (Yt . Zt does not Granger-cause Yt if and only if H0 : γ 1 = γ 2 = · · · = γ k = 0. This may be tested using an exclusion (Wald) test. and the information set I2t is generated by both Yt and Zt . If this condition does not hold. . The log determinant is the criterion from the multivariate normal likelihood. In a linear VAR. This deﬁnition of causality was developed by Granger (1969) and Sims (1972).. 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 .

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

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

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

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

1. 2.14.. Since E (Yi | xi ) = λi = exp(x0 β) i is the conditional mean.. this motivates the label Poisson “regression. a typical approach is to employ Poisson regression. . The ﬁrst censored regression model was developed by Tobin (1958) to explain consumption of durable goods. . This model (now called the Tobit) speciﬁes that the latent (or ideal) value of consumption may be negative (the household 153 . the consumption level (purchases) in a particular period was zero. This model speciﬁes that P (Yi = k | xi ) = λi k = 0. i so the model imposes the restriction that the conditional mean and variance of Yi are the same. 1. σ 2 ) with the observed variable yi generated by the censoring equation (14. i If Y = {0. Thus the model is that there is some latent process yi with unbounded support. 0 if yi (This is written for the case of the threshold being zero.3 Censored Data The idea of “censoring” is that some data above or below a threshold are mis-reported at the ∗ threshold. An example of a data collection censoring is top-coding of income. 2. 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. The censoring process may be explicit in data collection. The conditional density is the Poisson with parameter λi . 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 !) . but we observe only ½ ∗ ∗ yi if yi ≥ 0 (14.}. Tobin observed that for many households. k! = exp(x0 β). He proposed the latent variable model ∗ yi = x0 β + ei i ei ∼ iid N (0.. 14.1). This may be considered restrictive.” Also observe that the model implies that V ar (Yi | xi ) = λi = exp(x0 β). In surveys.. The functional form for λi has been picked to ensure that λi > 0.2 Count Data exp (−λi ) λk i . incomes above a threshold are typically reported at the threshold. A generalization is the negative binomial. any known value can substitute. or it may be a by-product of economic constraints.) The observed data yi therefore come from a mixed continuous/discrete distribution.1) yi = ∗ <0 . i i i=1 ˆ The MLE is the value β which maximizes ln (β).

For example. not just on the volunteers. Thus OLS will be biased i for the parameter of interest β. 14.4 Sample Selection The problem of sample selection arises when the sample is a non-random selection of potential observations. This does not work because regression estimates E (Yi | xi ) . To construct the likelihood. Hence the log-likelihood is a mixture of the probit and the normal: ln (β) = n X i=1 ¶¸ µ 0 ¶ X ∙ µ xi β yi − x0 β −1 i + . 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. The Tobit framework postulates that this is not inherently interesting. and the latter is of interest.] Consistent estimation will be achieved by the MLE. All that is reported is that the household purchased zero units of the good. ¶¸ µ 0 ¶1(y=0) ∙ µ z − x0 β 1(y>0) xi β −1 i f (y | xi ) = Φ − . σ φ σ σ where 1 (·) is the indicator function. 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.would prefer to sell than buy). not E (Yi∗ | xi ) = x0 β. observe that the probability of being censored is ∗ P (yi = 0 | xi ) = P (yi < 0 | xi ) ¢ ¡ 0 = P xi β + ei < 0 | xi ¶ µ x0 β ei i <− | xi = P σ σ µ 0 ¶ xβ = Φ − i . P (yi = y | xi ) = σ φ σ 0 Therefore. where the goal is to assess the eﬀect of “training” on the general population. 154 . the density function can be written as y > 0. This occurs when the observed data is systematically diﬀerent from the population of interest. The naive approach to estimate β is to regress yi on xi . [Note: it is still possible to estimate E (Yi | xi ) by LS techniques. σ The conditional distribution function above zero is Gaussian: ¶ µ Z y z − x0 β −1 i dz. if you ask for volunteers for an experiment. you should worry that the people who volunteer may be systematically diﬀerent from the general population.

where Hence ¡ 0 ¢ e1i = ρλ zi γ + ui . Else it is unobserved. i • The OLS standard errors will be incorrect. if γ were known. The model is often completed by specifying that the errors are jointly normal ¶ µ µ ¶¶ µ 1 ρ e0i ∼ N 0. Zi ) = E e1i | {e0i > −zi γ}. using regressors zi . alternatively. ¡ ¢ 0 E (e1i | Ti = 1. Under the normality assumption. e1i ρ σ2 It is presumed that we observe {xi . The “Heckit” estimator is thus calculated as follows • Estimate γ from a Probit. which is non-zero. It is unknown. 1). Zi ) = 0. Zi + E vi | {e0i > −zi γ}. . They can be corrected using a more complicated formula. Or. Ti } for all observations. zi . yi could be a wage. E (e0i | e0i > −x) = λ(x) = Φ(x) and the function λ(x) is called the inverse Mills ratio. which can be observed only if a person is employed. Zi ¢ ¡ ¢ ¡ 0 0 = ρE e0i | {e0i > −zi γ}. The naive estimator of β is OLS regression of yi on xi for those observations for which yi is available. e1i = ρe0i + vi . ˆ ³ ´ ˆ ˆ ˆ • Estimate β. The equation for Ti is an equation specifying the probability that the person is employed. A useful fact about the standard normal distribution is that φ(x) . The dependent variable yi is observed if (and only if) Ti = 1. For example. The problem is that this is equivalent to conditioning on the event {Ti = 1}. 155 . However. The binary dependent variable is Ti . ρ from OLS of yi on xi and λ(z 0 γ ). Heckman (1979) observed that we could consistently estimate β and ρ from this equation. as this is a two-step estimator. Thus E (ui | Ti = 1. where vi is independent of e0i ∼ N (0.2) is a valid regression equation for the observations for which Ti = 1. by viewing the Probit/OLS estimation equations as a large joint GMM problem. Zi ¡ 0 ¢ = ρλ zi γ .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. but also can be consistently estimated by a Probit model for selection. ¡ 0 ¢ yi = x0 β + ρλ zi γ + ui i (14.

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

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

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

This is because the sample mean of yit−1 is correlated with that of eit . Taking ﬁrst-diﬀerences of (15. A more sophisticated GMM estimator recognizes that for time-periods later in the sample. Thus values of yit−k . two periods back. The standard approach to estimate a dynamic panel is to combine ﬁrst-diﬀerencing with IV or GMM. e So OLS on (15.4) by IV using yt−2 as an instrument for ∆yt−1 (which is just identiﬁed). Typically. but loses a time-series observation). Hence a valid estimator of α and β is to estimate (15. 15. it it which is free of the individual-eﬀect ui . we use lags of the dependent variable. at least if T is held ﬁnite as n → ∞. so the instrument list should be diﬀerent for each equation. Alternatively.3) eliminates the individual-speciﬁc eﬀect: ∆yit = α∆yit−1 + ∆x0 β + ∆eit . are valid instruments. it (15. as this enables the moments from the diﬀerent timeperiods to be stacked together to create a list of all the moment conditions. then IV or GMM can be used to estimate the equation. the dependent variable and regressors in deviationit from-mean form.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 . But if there are valid instruments. k ≥ 2. GMM using yt−2 and yt−3 as instruments (which is overidentiﬁed.4) . ∗ ˆ The ﬁxed eﬀects estimator β is OLS of yit on x∗ .4) will be inconsistent.Since the regression of yit on di is a regression onto individual-speciﬁc dummies. A simple application of GMM yields the parameter estimates and standard errors. 159 (15. there are more instruments available. if eit is iid. the ﬁxed eﬀects estimator is inconsistent. we ﬁnd y i = x0 β + ui + ei . then it will be correlated with ∆yit−1 : E (∆yit−1 ∆eit ) = E ((yit−1 − yit−2 ) (eit − eit−1 )) = −E (yit−1 eit−1 ) = −σ 2 . the predicted value from these regressions is the individual speciﬁc mean y i . it However. i ∗ yit = x∗0 β + e∗ . and the residual is the demean value ∗ yit = yit − yi . Unfortunately. 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. Another derivation of the estimator is to take the equation yit = x0 β + ui + eit . as yt−2 is uncorrelated with ∆eit . This is conveniently organized by the GMM principle.

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

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. where the second-to-last equality used the change-of-variables u = (Xi − x)/h which has Jacobian h. then the weights are small and f ˆ ˆ Interestingly. ˆ We can also calculate the moments of the density f (x). and Z ∞ ˆ f (x)dx = −∞ Z ∞ −∞ 1X 1X Kh (Xi − x) dx = n n i=1 i=1 n n Z ∞ −∞ Kh (Xi − x) dx = 1X n i=1 n Z ∞ K (u) du = 1 −∞ where the second-to-last equality makes the change-of-variables u = (Xi − x)/h. 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. Conversely. 161 . ˆ(x) is small. then the weights are relatively large and f (x) is larger. The bandwidth h controls the meaning of “near”. f (x) is a valid density. If a large number of the observations Xi are near ˆ 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 . That is. f (x) ≥ 0 for all x. if only a few Xi are near x.This estimator is the average of a set of weights.

Since it is an average of iid random variables.16.2 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. so we approximate it using a second order Taylor expansion of f (x + hu) in the argument hu about hu = 0. 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 is estimating a smoothed version of f (x). This integral (typically) is not analytically solvable. the estimator f (x) smooths data local to Xi = x. Thus 1 f (x + hu) ' f (x) + f 0 (x)hu + f 00 (x)h2 u2 2 and therefore µ ¶ 1 00 0 2 2 K (u) f (x) + f (x)hu + f (x)h u du EKh (X − x) ' 2 −∞ Z ∞ Z ∞ Z ∞ 1 = f (x) K (u) du + f 0 (x)h K (u) udu + f 00 (x)h2 K (u) u2 du 2 −∞ −∞ −∞ 1 00 2 2 = f (x) + f (x)h σ K . 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 . nh (x)2 dx is called the roughness of K. The sharper the derivative. The bias results from this smoothing. Intuitively. ˆ the greater the bias. which is valid as h → 0. 162 . The last expression shows that the expected value is an average of f (z) locally about x. and is larger the greater the curvature in f (x). using ﬁrst-order Taylor approximations and the fact that n−1 is of smaller order than (nh)−1 V ar (x) = = ' = ' = where R(K) = R∞ −∞ K 1 V ar (Kh (Xi − x)) n 1 1 EKh (Xi − x)2 − (EKh (Xi − x))2 n n ¶ Z ∞ µ z−x 2 1 1 K f (z)dz − f (x)2 2 nh −∞ h n Z ∞ 1 K (u)2 f (x + hu) du nh −∞ Z f (x) ∞ K (u)2 du nh −∞ f (x) R(K) .

how should the bandwidth be selected? This is a diﬃcult problem. we need h → 0 but nh → ∞. Their K values for the three functions introduced in the previous section are given here. h0 = argmin AM ISEh h It can be found by solving the ﬁrst order condition d R(K) AM ISEh = h3 σ 4 R(f 00 ) − =0 K dh nh2 yielding h0 = µ R(K) 4 R(f 00 ) σK ¶1/5 n−1/2 . 1) distribution and σ 2 is an estimate of σ 2 = V ar(X). That is. 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.06n−1/5 163 . 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) . That is. but not of n. and R(f 00 ). We can calculate that √ R(φ00 ) = 3/ (8 π) . Notice that the ﬁrst term (the squared bias) is increasing in h and the second term (the variance) is decreasing in nh. Equation (16. but at a very slow rate. Thus for the AMISE to decline with n. and gives a nearly optimal rule when f (x) is close to normal. A classic simple solution proposed by Silverman (1986)has come to be known as the reference bandwidth or Silverman’s Rule-of-Thumb. σ 2 . (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 + . h must tend to zero. The downside is that if the density is very far from normal. This choice for h gives an optimal rule when f (x) is ˆ normal. Note that this h declines to zero. Together with the above table.2) This solution takes the form h0 = cn−1/5 where c is a function of K and f. we ﬁnd the reference rules for the three kernel functions introduced earlier. We deﬁne the asymptotically optimal bandwidth h0 as the value which minimizes this approximate MSE.1) AM ISEh = AM SEh (x)dx = 4 nh R where R(f 00 ) = (f 00 (x))2 dx is the roughness of f 00 .Together. We thus say that the optimal bandwidth is of order O(n−1/5 ). Gaussian Kernel: hrule = 1.2) but replaces R(f 00 ) with σ −5 R(φ00 ).1) is an asymptotic approximation to the MSE. In practice.2) depends on R(K). but at a slower rate than n−1 . The asymptotically optimal choice given in (16. (16. where φ is the N (0. and there is a large and continuing literature on the subject. ˆ It uses formula (16. the rule-of-thumb h can be quite ineﬃcient. The ﬁrst two are determined by the kernel function.

as the optimal h for estimation of the roughness R(f 00 ) is quite diﬀerent than the optimal h for estimation of f (x). Another popular choice for selection of h is cross-validation. There are some desirable properties of cross-validation bandwidths.Epanechnikov Kernel: hrule = 2. This works by constructing an estimate of the MISE using leave-one-out estimators.34n−1/5 Biweight (Quartic) Kernel: hrule = 2.2). However. There are other approaches. in which case the cross-validation rule can sometimes select very small bandwidths leading to dramatically undersmoothed estimates.78n−1/5 Unless you delve more deeply into kernel estimation methods the rule-of-thumb bandwidth is a good practical bandwidth choice. perhaps adjusted by visual inspection of the resulting estimate ˆ f (x). The plug-in approach is to estimate R(f 00 ) in a ﬁrst step. 164 . but implementation can be delicate. but they are also known to converge very slowly to the optimal values. in particular the iterative method of Sheather and Jones (1991). This is more treacherous than may ﬁrst appear. which are known as smoothed cross-validation which is a close cousin of the bootstrap. They are also quite ill-behaved when the data has some discretization (as is common in economics). I now discuss some of these choices. there are modern versions of this estimator work well. Fortunately there are remedies. and then plug this estimate into the formula (16.

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

r r! (n − r)! When counting the number of objects in a set. Counting is ordered or not depending on whether the sequential order of the numbers is relevant to winning the lottery. Without Replacement Ordered Unordered n! (n−r)! ¡n¢ r In the lottery example. We can say that the occurrence of B has no information about the likelihood of event A when P (A | B) = P (A). we have four expressions for the number of objects (possible arrangements) of size r from n objects. we say that the collection of events A1 . Depending on these two distinctions. Rearranging the deﬁnition.1) We say that the events A and B are statistically independent when (A.. . 49. i∈I i∈I 166 . . 2. Counting may be ordered or unordered. as µ ¶ n n! = . there are two important distinctions. it is useful to have simple rules to count the number of objects in a set. 983. consider a lottery where you pick six numbers from the set 1.1) holds. the number of ¡49 if potential combinations is 6 = 13. and is with replacement if this is allowed. ¢ counting is unordered and without replacement.. the conditional probability function is a valid probability function where S has been replaced by B.. P (B) With Replacement nr ¡n+r−1¢ r For any B.. in which case we ﬁnd P (A ∩ B) = P (A) P (B) (A. Furthermore.. This selection is without replacement if you are not allowed to select the same number twice. n ≥ r. Counting may be with replacement or without replacement. For example. 816. we can write P (A ∩ B) = P (A | B) P (B) which is often quite useful. Ã ! \ Y P Ai = P (Ai ) .. Ak are mutually independent when for any subset {Ai : i ∈ I}. If P (B) > 0 the conditional probability of the event A given the event B is P (A | B) = P (A ∩ B) . These counting rules are facilitated by using the binomial coeﬃcients which are deﬁned for nonnegative integers n and r.• P (A) ≤ 1 • P (Ac ) = 1 − P (A) • P (B ∩ Ac ) = P (B) − P (A ∩ B) • P (A ∪ B) = P (A) + P (B) − P (A ∩ B) • If A ⊂ B then P (A) ≤ P (B) • Bonferroni’s Inequality: P (A ∩ B) ≥ P (A) + P (B) − 1 • Boole’s Inequality: P (A ∪ B) ≤ P (A) + P (B) For some elementary probability models.

Pr where 0 ≤ π j ≤ 1 and j=1 π j = 1. Typically. of the sample space. 2. For any set B and any partition A1 .. τ r .2) Sometimes we write this as FX (x) to denote that it is the CDF of X. r (A..3) P (X = τ j ) = π j . a These expressions only make sense if F (x) is diﬀerentiable. We say that the random variable X is continuous if F (x) is continuous in x. Instead. F (x) is nondecreasing in x 3.3) is unavailable.. then for each i = 1. (A. we represent the relative probabilities by the probability density function (PDF) f (x) = so that F (x) = and P (a ≤ X ≤ b) = Z d F (x) dx x f (u)du Z b −∞ f (x)dx. . 167 ... ∞ A function f (x) is a PDF if and only if f (x) ≥ 0 for all x ∈ R and −∞ f (x)dx. A2 . these cases are unusualRand are typically ignored. .. In the latter case.2 Random Variables A random variable X is a function from a sample space S into the real line.. In this case P (X = τ ) = 0 for all τ ∈ R so the representation (A. P (B | Ai ) P (Ai ) P (Ai | B) = P∞ j=1 P (B | Aj ) P (Aj ) A. the range of X consists of a countable set of real numbers τ 1 .. . and use lower case letters such as x for potential values and realized values. F (x) is right-continuous We say that the random variable X is discrete if F (x) is a step function. .. we denote random variables by uppercase letters such as X. For a random variable X we deﬁne its cumulative distribution function (CDF) as F (x) = P (X ≤ x) . This induces a new sample space — the real line — and a new probability function on the real line.. A function F (x) is a CDF if and only if the following three properties hold: 1. While there are examples of continuous random variables which do not possess a PDF.Theorem 2 (Bayes’ Rule). The probability function for X takes the form j = 1. limx→−∞ F (x) = 0 and limx→∞ F (x) = 1 2.

this allows the convenient expression V ar(a + bX) = b2 V ar(X). 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. √ where i = −1 is the imaginary unit. evaluate I1 = Z Z ∞ g(x)f (x)dx. 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) = ∞. We can also write σ 2 = V ar(X). we say that expectation is a linear operator. Eg(X) = j=1 and if X is continuous Eg(X) = The latter is well deﬁned and ﬁnite if Z If (A. −∞ ∞ −∞ |g(x)| f (x)dx < ∞. The MGF does not necessarily exist. of the random variable X is kXkp = (E |X|p )1/p .A. (A. Since E (a + bX) = a + bEX. We √ call σ = σ 2 the standard deviation of X. If both I1 = ∞ and I2 = ∞ then Eg(X) is undeﬁned. we deﬁne the m0 th moment of X as EX m and the m0 th central moment as E (X − EX)m . However. For example. Two special moments are the mean µ = EX and variance σ 2 = E (X − µ)2 = EX 2 − µ2 . 168 . The CF always exists. p ≥ 1. If X is discrete. The moment generating function (MGF) of X is M (λ) = E exp (λX) . If I1 < ∞ and I2 = ∞ then we deﬁne Eg(X) = −∞. and when E |X|m < ∞ ¯ ¯ dm ¯ = im E (X m ) . More generally. For m > 0.3 Expectation For any measurable real function g. r X g(τ j )π j . m C(λ)¯ dλ λ=0 The Lp norm.4) does not hold. the characteristic function (CF) of X is C(λ) = E exp (iλX) .

x! EX = λ x = 0. x EX = V ar(X) = Poisson P (X = x) = exp (−λ) λx . Xm = xm ) = x1 + · · · + xm n! px1 px2 · · · pxm . x = 1.A. x EX = np V ar(X) = np(1 − p) Geometric P (X = x) = p(1 − p)x−1 . 2.... 1 EX = p 1−p V ar(X) = p2 Multinomial P (X1 = x1 . 169 . . . we now list some important discrete distribution function. 0≤p≤1 V ar(X) = λ We now list some important continuous distributions.. 1.. 0≤p≤1 x = 0. . 0≤p≤1 x = 0.. 2. X2 = x2 . 2.. 0≤p≤1 p1 + · · · + pm = 1 EX = V ar(X) = Negative Binomial µ ¶ r+x−1 P (X = x) = p(1 − p)x−1 . n.... 1. λ>0 x = 1. . 1.4 Common Distributions For reference. . m x1 !x2 ! · · · xm ! 1 2 = n.... Bernoulli P (X = x) = px (1 − p)1−x ... EX = p V ar(X) = p(1 − p) Binomial µ ¶ n x P (X = x) = p (1 − p)n−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) = √ . β>2 (β − 1)2 (β − 2) 170 β>0 . θ>0 V ar(X) = θ2 Logistic f (x) = exp (−x) . β > 0 V ar(X) = ∞ ExponentiaI f (x) = ³x´ 1 . π (1 + x2 ) EX = ∞ −∞ < x < ∞ Γ(α + β) α−1 x (1 − x)β−1 .Beta f (x) = µ = V ar(X) = Cauchy f (x) = 1 . α > 0. β>1 β−1 βα2 . α ≤ x < ∞. (1 + exp (−x))2 EX = 0 −∞ < x < ∞. σ>0 Pareto βαβ . Γ(α)Γ(β) α α+β αβ (α + β + 1) (α + β)2 0 ≤ x ≤ 1. 2σ 2 2πσx ¢ ¡ EX = exp µ + σ 2 /2 ¡ ¢ ¡ ¢ V ar(X) = exp 2µ + 2σ 2 − exp 2µ + σ 2 f (x) = EX = V ar(X) = 0 ≤ x < ∞. exp θ θ EX = θ 0 ≤ x < ∞. α > 0.

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

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

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

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

10) holds for k > 1. A. As one example. dy This is known as the change-of-variables formula.8 Normal and Related Distributions µ 2¶ 1 x . As the range of X is [0. an exponential density. φ(x) = √ exp − 2 2π 175 The standard normal density is −∞ < x < ∞. The Jacobian is ¶ µ ∂ h(y) . Since fX (x) = 1 for 0 ≤ x ≤ 1 (A. and invertible. 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). 1] and Y = − ln(X). take the case X ∼ U [0. J(y) = det ∂y 0 Consider the univariate case k = 1.7 Transformations Suppose that X ∈ Rk with continuous distribution function FX (x) and density fX (x). then g(X) ≤ Y if and only if X ≥ h(Y ). 1]. so FY (y) = P (g(X) ≤ y) = 1 − P (X ≥ h(Y )) = 1 − FX (h(Y )) and the density of Y is fY (y) = −fX (h(Y )) We can write these two cases jointly as fY (y) = fX (h(Y )) |J(y)| . but its justiﬁcation requires deeper results from analysis.A. then g(X) ≤ Y if and only if X ≤ h(Y ). This same formula (A. If g(x) is an increasing function. that for Y is [0. dy dy If g(x) is a decreasing function. g(x) = − ln(x) and h(y) = exp(−y) so the Jacobian is J(y) = − exp(y).10) d h(y). Here.∞). 0 ≤ y ≤ ∞. diﬀerentiable. (A. Let h(y) denote the inverse of g(x).10) shows that fY (y) = exp(−y). Let Y = g(X) where g(x) : Rk → Rk is one-to-one. .

the multivariate normal density is ¶ µ (x − µ)0 Σ−1 (x − µ) 1 . and it is conventional to write X ∼ N (µ. and it is conventional to write X ∼ N(µ. the density of Y is Ã ! (y − µY )0 Σ−1 (y − µY ) 1 Y exp − f (y) = . (A. x ∈ Rk .This density has all moments ﬁnite. It is conventional to write X ∼ N (0. y ≥ 0.11) and is known as the chi-square density with r degrees of freedom. denoted χ2 . respectively. then Z 0 A−1 Z ∼ χ2 .8. then they are mutually independent. Theorem A. If Z is standard normal and X = µ + σZ. f (x) = √ 2σ 2 2πσ which is the univariate normal density. The latter has no closed-form solution. 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.8. then using the change-of-variables formula. This shows that linear transformations of normals are also normal. This shows that if X is multivariate normal with uncorrelated elements. If X ∈ Rk is multivariate normal and the elements of X are mutually uncorrelated. Σ). ¢ ¡ 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 . X has density Ã ! (x − µ)2 1 exp − . x ∈ Rk . 1). then Σ = diag{σ 2 } is a diagonal matrix. Q has the density f (y) = Γ 1 ¡r¢ 2 2r/2 yr/2−1 exp (−y/2) . Since it is symmetric about zero all odd moments are zero. exp − f (x) = k/2 1/2 2 (2π) det (Σ) The mean and covariance matrix of the distribution are µ and Σ. Another useful fact is that if X ∼ N (µ.1 Let X ∼ N (0. then by the change-of-variables formula. Theorem A. Ir ) and set Q = X 0 X. For x ∈ Rk . q 176 . The mean and variance of the distribution are µ and σ 2 . −∞ < x < ∞.2 If Z ∼ N(0. By iterated integration by parts. A) with A > 0. q × q. σ 2 ). Σ) and Y = a + BX with B an invertible matrix. Its mean and r variance are µ = r and σ 2 = 2r. and to denote the standard normal density function by φ(x) and its distribution function by Φ(x). where we used the fact that det (BΣB 0 )1/2 = det (Σ)1/2 det (B) . we can also show that EX 2 = 1 and EX 4 = 3. k/2 1/2 2 (2π) det (ΣY ) where µY = a+Bµ and ΣY = BΣB 0 .

Set r Z . Thus ¥ ¡ ¢0 ¡ ¢ Z 0 A−1 Z = Z 0 C −10 C −1 Z = C −1 Z C −1 Z ∼ χ2 . which we showed in (A. which can be found by applying change-of-variables to the gamma function. Then A−1 = C −10 C −1 and C −1 Z ∼ N (0.2. From (A.13). The fact that A > 0 means that we can write A = CC 0 where C is non-singular. Using the simple law of iterated expectations.Theorem A.3. tr has distribution 177 . (A.8. C −1 AC −10 ) = N (0.3 Let Z ∼ N (0. 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 .1.11).13) = (1 − 2t)−r/2 R∞ where the second equality uses the fact that 0 y a−1 exp (−by) dy = b−a Γ(a). 1) and Q ∼ χ2 be independent.8. Since we can write Q = P 2 X 0 X = r Zj where the Zj are independent N(0. 1). Iq ).12) E exp (tQ) = 0 Γ (A. The MGF for the density (A.11) is Z ∞ ¢ ¡ Γ r+1 2 f (x) = ´ r+1 ¡r¢ ³ √ 2 2 πrΓ 2 1 + x r (A.8.13) is the MGF of the density (A. For 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. q Proof of Theorem A. Thus the density of Z 2 is (A.11) 2 with r = 1. Proof of Theorem A. C −1 CC 0 C −10 ) = N (0. ¡ ¢ √ using the change—of-variables s = x2 and the fact Γ 1 = π.8.6) can be used to show that the MGF j=1 ¥ Proof of Theorem A. we see that the MGF of Z 2 is (1 − 2t)−1/2 .

Yn ) is n ³ ´ Y ˜.θ = fn Y f (Yi .. . If the distribution F is continuous then the density of Yi can be written as f (y. The log-likelihood function is its natural log Ln (θ) = n X i=1 ln f (Yi . we say that the distribution is parametric and that θ is the parameter of the distribution F. θ) . If the distribution F is discrete. θ) where F is a known distribution function and θ ∈ Θ is an unknown m × 1 vector.. viewed as a function of θ.. In this setting the method of maximum likelihood is the appropriate technique for estimation and inference on θ. θ) . i=1 The likelihood of the sample is this joint density evaluated at the observed sample values.function F (x) = = = = Thus its density is f (x) = = = Ã r ! Q d E Φ x dx r Ã Ã r !r ! Q Q E φ x r r ! µ ¶¶ r Ã Z ∞µ qx2 1 q 1 r/2−1 ¡r¢ √ exp − q exp (−q/2) dq 2r r Γ 2 2r/2 2π 0 ¢ µ ¡ ¶− r+1 Γ r+1 x2 ( 2 ) 2¡ ¢ . The space Θ is the set of permissible value for θ. θ) . the likelihood and log-likelihood are constructed by setting f (y. θ) and the joint ˜ density of a random sample Y = (Y1 . θ) = P (Y = y.9 Maximum Likelihood If the distribution of Yi is F (y. 178 . 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 is a sample average 1X 1 Ln (θ) = ln f (Yi .2 Cramer-Rao Lower Bound. θ) ∂θ ∂θ which holds at θ = θ0 by (A.16) (A. the MLE θ Why do we believe that the MLE ˆ is estimating the parameter θ? Observe that when stanθ dardized. the restriction to unbiased estimators means that the theorem has little direct relevance for ﬁnite sample eﬃciency.16). we can see that it is an estimator of the maximizer θ of the right-hand-side. If ˜ is an unbiased estimator of θ ∈ R. θ) The Cramer-Rao Theorem gives a lower bound for estimation.Deﬁne the Hessian H = −E and the outer product matrix Ω=E µ ∂2 ln f (Yi . I0 . We can write this as ˆ = argmax Ln (θ). ˆ is consistent θ for this value.14) ¶ ∂ ∂ 0 ln f (Yi . which maximizes the log-likelihood). under conventional regularity conditions. θ Theorem A.9. then θ V ar(˜ ≥ (nI0 )−1 . 179 . θ0 ) ∂θ∂θ 0 (A. θ) →p E ln f (Yi . we can ﬁnd an explicit expression for θ as a function of the data.17) is often called the information matrix equality. Theorem A.15) Two important features of the likelihood are Theorem A. n n i=1 n As the MLE ˆ maximizes the left-hand-side. ∂θ ∂θ (A. More typically. θ)¯ =0 ¯ ∂θ θ=θ0 H = Ω ≡ I0 (A.17) The matrix I0 is called the information.3 Under regularity conditions. The maximum likelihood estimator or MLE ˆ is the parameter value which maximizes θ the likelihood (equivalently. but these ˆ must be found by numerical methods. ˆ →p θ0 as n → ∞.9. In fact.1 ¯ ¯ ∂ E ln f (Yi . cases are rare. θ0 ) . θ0 ) ln f (Yi . ´ ¡ −1 ¢ √ ³ˆ n θ − θ0 →d N 0. θ θ∈Θ ˆ In some simple cases. The ﬁrst-order condition for the latter problem is 0= ∂ ∂ L(θ) = E ln f (Yi .9. and the equality (A. However. θ) ≡ L(θ).

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

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

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

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

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

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

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