ECONOMETRICS

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

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

1

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

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

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

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

i

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

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

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

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

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

ii

. . . . . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Symmetric Two-Sided Tests . . . .2 GMM Estimator . . . . . . . . . . . . . . . . . . . . .8 Bootstrap for Autoregressions . . . . . . . . .8 Conditional Moment Restrictions . . . . .12Autoregressive Unit Roots . . . . . . . . . . . . . . . . . . . . 12. . . . Percentile Confidence Intervals . . . . . . . . . .9 Trend Stationarity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9. . . . . . .3 Distribution of GMM Estimator . . . . . 10. . . . . .1 Stationarity and Ergodicity . . . . . . . . . . . . . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . . . . . . . . 11. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . . .2 Autoregressions .10Testing for Omitted Serial Correlation 12. .4 Testing . . . . . . . . . 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. . . . . . . . . . . . . . . . . . . . . 11. . . . . . . . . . .8 Exercises . . . . . . . . . . . . . . . . . . . . . . .6 Bekker Asymptotics . . 10 Empirical Likelihood 10. . . . . . . . . . .5 Special Cases: IV and 2SLS 11.11Model Selection . . . . . . . . . . . . . . . . . . . . . . 10. . . . . . . . . . . . . . . . .9 Bootstrap GMM Inference . . . . . . . . . . . . . . . . . . . . . . . . . iii . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3 Overidentifying Restrictions . . . . . . . . . . . . 11. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2 Asymptotic Distribution of EL Estimator 10. . . .1 Overidentified Linear Model . .3 Identification . . . . . . . . . . . . . . . . 12. . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5 GMM: The General Case . . . . . . . . . . . . . . . . . . .5 Stationarity of AR(k) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . . . . 11. . . . . . . . . . 9. . .10 Exercises . . . . . . . . . . . . 9. . . . . . . . . .4 Estimation . . . . . . 12.4 Lag Operator . 9. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Non-Parametric Likelihood . . . . . . 11 Endogeneity 11. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11. . . . .5 Numerical Computation . . . . 9. . . . . . . .1 Instrumental Variables . . . . . . . .6 Over-Identification Test . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .11 8. 12 Univariate Time Series 12. . . . . . . . . . . . . . . . . . . . . . . 10. . . . . . . . . . . . .8. . . . . .12 8.2 Reduced Form . . . . . . . . . . . . . . . . . . . . . 11. . . . . . . . . . . . . . . . . . . . . . . . . . .7 Hypothesis Testing: The Distance Statistic 9. . . . . . . . . . . . . . . . . . . . 9. . . . . . . . . . . .7 Asymptotic Distribution . . . . . . . . . . . . . . . . . . . . . . . . . . . Bootstrap Methods for Regression Models Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .6 Estimation . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . .4 Estimation of the Efficient Weight Matrix . . . . . . . . . . . . . . . . . . . . . . . .3 Stationarity of AR(1) Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .7 Identification Failure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12.10 8. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .13 One-Sided Tests . . . . . . . . . . . . . .9 8. . . . . . . . . . . . . . . . . . . . . . 12. . . . . . .

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A. . . . . . . . . . . . .1 Individual-Effects Model . . . . . . . . . . . . . . . . . . 159 16 Nonparametrics 160 16. . . . . . . . B. . . . . .6 Conditional Distributions and Expectation . . . . . . . . . . . . . . . . . . . . . A. . . . . . . . 13. . . . . . . . . . . . . . . . .1 Foundations . . . . . . . . . . . . . . . . . . . 14 Limited Dependent Variables 14. . . . . . . . . . . . . 157 15. . . . 15 Panel Data 157 15. . 160 16.1 Grid Search . . . . . . . .2 Estimation . . . .7 Granger Causality . . . . . . . . . 13. . . . .9 Maximum Likelihood . A. . . . . . . . . . . .1 Vector Autoregressions (VARs) . . . . . . . . . . . . . . . . . . . . . . . . . .6 Selection of Lag Length in an VAR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3 Derivative-Free Methods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3 Dynamic Panel Regression . . . .13 Multivariate Time Series 13. . . . . . . . . . . . . . . . . . . . . . . 157 15. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A. . 145 145 146 146 147 147 148 148 149 149 151 151 153 153 154 . . . . . . . . . . . . . . . .4 Sample Selection . . . . .1 Binary Choice . . . . . . . . . . . .1 Kernel Density Estimation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A. . . . . . . . . . . . . . . . . . . . . . . . . . . .2 Count Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A. . . . . . . . . . . . 162 A Probability A. . . . . . . . . . . . . . iv . . B Numerical Optimization B. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13. . .4 Single Equation from a VAR . . . 14. . . . . . . . . . . . . . . . . .8 Cointegration . . . . . . . . . . . . . . . . . . . . . . .3 Expectation . . . . .2 Gradient Methods . . . . . . . . . . . . . . . . . . A. . . . . . . . . . . . . . . 13. . . . . . . .2 Asymptotic MSE for Kernel Estimates . . . . . . . . . . . . . . . . . . .5 Testing for Omitted Serial Correlation 13. . . 13. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14. . . . .3 Restricted VARs . . B. . . . . . . . . . . .7 Transformations . . . . . . . . . . . .5 Multivariate Random Variables .8 Normal and Related Distributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . A. . . . . . . . . . . .4 Common Distributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13. . . . . . . . . . . . . . .3 Censored Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2 Random Variables . . . . . . . . . . . . . . . . . . . . . . . . . 13. . . . . . . .2 Fixed Effects . . . . . . . . . . . . . .9 Cointegrated VARs . . . . . . . . . . . . 165 165 167 168 169 171 173 175 175 178 183 183 184 185 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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

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

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

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

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

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

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

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

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

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

73. When a distribution is skewed. it is useful to have numerical measures of the difference. We list the elements of xi in the vector ⎞ ⎛ x1i ⎜ x2i ⎟ ⎟ ⎜ (3. the conditional density of yi given xi . This is used when the goal is to quantify the impact of one set of variables on another variable.1) xi = ⎜ . . (3.1. In the example presented in Figure 3.1.22. In this context we partition the observations into the pair (yi . the mean wage for men is $27. xi ) where yi is a scalar (real-valued) and xi is a vector. The data are from the 2004 Current Population Survey 1 11 . See Chapter 16. holding the other variables constant. or the covariates. m(x) can take any form. we can focus on f (y | x) . These are asymmetric (skewed) densities. To illustrate. ⎠ ⎝ . and that for women is $20. which is a common feature of wage distributions. gender. Take a closer look at the density functions displayed in Figure 3. In this context it is often convenient These are nonparametric density estimates using a Gaussian kernel with the bandwidth selected by crossvalidation.2) m(x) = E (yi | xi = x) = −∞ In general. An important summary measure is the conditional mean Z ∞ yf (y | x) dy.Chapter 3 Regression and Projection The most commonly applied econometric tool is regression. You can see that the right tail of then density is much thicker than the left tail. and exists so long as E |yi | < ∞. the conditioning variable. While it is easy to observe that the two densities are unequal. The two density curves show the effect of gender on the distribution of wages. from the population of white non-military wage earners with a college degree and 10-15 years of potential work experience. We call yi the dependent variable. xki 3. These are conditional density functions — the density of hourly wages conditional on race. the mean is not necessarily a good summary of the central tendency. ⎟ .1 Conditional Mean To study how the distribution of yi varies with the variables xi in the population. These are indicated in Figure 3. Figure 3. education and experience.1 displays the density1 of hourly wages for men and women. We call xi alternatively the regressor.1 by the arrows drawn to the x-axis.

By construction.30. degree in mean log hourly wages is 0.5. which implies a 30% average wage difference for this population.2 shows the density of log hourly wages for the same population. Assuming for simplicity that this is the true joint distribution. Of particular interest to graduate students may be the observation that difference between a B. 3.1: Wage Densities for White College Grads with 10-15 Years Work Experience to transform the data by taking the (natural) logarithm. then comparisons become more complicated. and a Ph. 12 .36. the dashed line is a linear projection approximation which will be discussed in the Section 3. Figure 3.2 Regression Equation The regression error ei is defined to be the difference between yi and its conditional mean (3. wage regressions typically use log wages as a dependent variable rather than the level of wages.3) White non-military male wage earners with 10-15 years of potential work experience. To illustrate.3 is how the conditional expectation describes an important feature of the conditional distribution. The difference in the log mean wage between men and women is 0. with mean log hourly wages drawn in with the arrows. this yields the formula yi = m(xi ) + ei .3 displays a scatter plot2 of log wages against education levels.2) evaluated at the observed value of xi : ei = yi − m(xi ). The comparison in Figure 3.D. the solid line displays the conditional expectation of log wages varying with education.1 is facilitated by the fact that the control variable (gender) is discrete. When the distribution of the control variable is continuous.Figure 3. implying an average 36% difference in wage levels. The conditional expectation function is close to linear.A. 2 (3. For this reason. This is a more robust measure of the typical wage gap between men and women than the difference in the untransformed wage means. The main point to be learned from Figure 3. Figure 3.

most typically. E (ei | xi ) = E ((yi − m(xi )) | xi ) = m(xi ) − m(xi ) = E (yi | xi ) − E (m(xi ) | xi ) = 0. by the definition of ei and the linearity of conditional expectations. not a model. It is important to understand that this is a framework. E(ei ) = 0. E (h(xi )ei ) = 0 for any function h (·) . 2. The remaining parts of the Theorem are left as an exercise. E (ei | xi ) = 0. E(xi ei ) = 0.2. 4.1 Properties of the regression error ei 1. because no restrictions have been placed on the joint distribution of the data. These equations hold true by definition. are often stated jointly as the regression framework.Figure 3. The equations yi = m(xi ) + ei E (ei | xi ) = 0. 13 . To show the first statement. restrictions on the permissible class of regression functions m(x). 3.2: Log Wage Densities Theorem 3. A regression model imposes further restrictions on the joint distribution.

4) E e2 | xi = σ 2 i 14 While the conditional mean is a good measure of the location of a conditional distribution. let g(x) be an arbitrary predictor of yi given xi = x. The conditional standard deviation is its square root σ(x) = σ 2 (x).1. and can take any form.Figure 3. 3. i . To see this.3.2. subject to the restriction p that it is non-negative. Thus the mean squared error is minimized by the conditional mean. A common measure of the dispersion is the conditional variance ¡ ¢ σ 2 (x) = V ar (yi | xi = x) = E e2 | xi = x . In contrast. In the general case i where σ 2 (x) depends on x we say that the error ei is heteroskedastic. 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 3.3: Conditional Mean of Wages Given Education The conditional mean also has the property of being the the best predictor of yi . it does not provide information about the spread of the distribution. in the sense of achieving the lowest mean squared error. The right-hand-side is minimized by setting g(x) = m(x). σ 2 (x) is a non-trivial function of x.3 Conditional Variance Generally. Given the random variable xi . when σ 2 (x) is a constant so that ¢ ¡ (3. the conditional variance of yi is σ 2 = σ 2 (xi ).

As an example. Thus (3. ⎝ . i (3. Some textbooks inappropriately describe heteroskedasticity as the case where “the variance of ei varies across observation i”. Instead. Equivalently. they are also somewhat more dispersed.3) can be writen as yi = x0 β + ei i E (ei | xi ) = 0.8) (3. Equation (3.3) is when the conditional mean function m(x) is linear in x (or linear in functions of x). Notationally. ⎠ . ⎟ . ⎟ β=⎝ . we can write it as m(x) = x0 β = β 1 + x2i β 2 + · · · + xki β k where ⎞ β1 ⎜ . 3. xki When m(x) is linear in x. An important special case is homoskedastic linear regression model yi = x0 β + ei i E (ei | xi ) = 0 ¢ ¡ E e2 | xi = σ 2 . In this case (3. So while men have higher average wages. it is more realistic to view the linear specification (3.1) has been redefined as the k × 1 vector ⎛ ⎞ 1 ⎜ x2i ⎟ ⎜ ⎟ (3. βk ⎛ (3. where x1i is the first element of the vector xi defined in (3.1).5. 15 .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 .8) is called the linear regression model. its functional form is typically unknown. ⎠ . The conditional standard deviation for men is 12.5) xi = ⎜ .1 and that for women is 10.9) 3. we assume that x1i = 1.4 Linear Regression An important special case of (3. This concept is less helpful than defining heteroskedasticity as the dependence of the conditional variance on the observables xi .6) as an approximation. take the conditional wage densities displayed in Figure 3.we say that the error ei is homoskedastic. which we derive in this section. it is convenient to augment the regressor vector xi by listing the number “1” as an element. and the linear assumption of the previous section is empirically unlikely to accurate.1.6) (3. We call this the “constant” or “intercept”.7) is a k × 1 parameter vector.

we obtain a decomposition of yi into linear predictor and error yi = x0 β + ei . The error is i ei = yi − x0 β.7) is 0= Solving for β we find ¡ ¢ ∂ S(β) = −2E (xi yi ) + 2E xi x0 β. this situation must be excluded. Therefore. Assumption 3. 2 2.1 1. x0 β is the best linear predictor for yi . i 4. α0 E (xi x0 ) α = E (α0 xi )2 > 0. E (xi x0 ) is invertible. As before. 3.11) Notice that the error from the linear prediction equation ei is equal to the error from the regression equation when (and only when) the conditional mean is linear in xi . Eyi < ∞. i (3. there cannot i exist a non-zero vector α such that α0 xi = 0 identically. 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. i which requires that for all non-zero α.10) It is worth taking the time to understand the notation involved in this expression. alternative expressions such as E xixi ) or E (xi yi ) (E (xi x0 ))−1 i ( i 0i ) are incoherent and incorrect.10) exists and is unique as long as the k ×k matrix E (xi x0 ) is invertible. xi contains an intercept. i (3. Given the definition of β in (3. Observe i that for any non-zero α ∈ Rk . i i (3. by “best” we mean the predictor function with lowest mean squared error. i 16 .1. The best linear predictor is obtained by selecting β to minimize S(β). written E (xi x0 ) > 0.5. i ∂β ¢¢−1 ¡ ¡ E (xi yi ) . α0 E (xi x0 ) α = E (α0 xi )2 ≥ 0 so the matrix E (xi x0 ) is by construction i i positive semi-definite.5. It is invertible if and only if it is positive definite. Equivalently.which is quadratic in β.10). otherwise they are distinct. This occurs when redundant variables are included in xi . Rewriting.12) This completes the derivation of the linear projection model. We now summarize the assumptions necessary for its derivation and list the implications in Theorem 3. In order for β to be uniquely defined. E (x0 xi ) < ∞. 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 . The vector (3. The first-order condition for minimization (from Section 2. E (xi x0 ) is a mai E(x y trix and E (xi yi ) is a vector.

4: Hourly Wage as a Function of Experience The conditions listed in Assumption 3.3 ensure that the moments in (3.5.13) summarize the linear projection model. Assumption 3.2 and 3.1. However. 17 .11) are well defined. Assumption 3.14).1.13) The two equations (3. E (xi ei ) = 0 and E (ei ) = 0.2. By definition. ¥ (3.5.1 are weak.1. The finite variance Assumptions 3. it follows that linear regression is a special case of the projection model.1.5. (3.5. Since ei is mean zero by (3.4 is required to ensure that β is uniquely defined. Then i i Exi e2 = Ex3 = 0 yet E (ei | xi ) = x2 6= 0.2 and 3.1.5.9).1. Furthermore.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 = 0.3 are called regularity conditions. Equation (3. the converse is not true as the projection error does not necessarily satisfy E (ei | xi ) = 0. the orthogonality restriction (3. Let’s compare it with the linear regression model (3.8)-(3. i i i Since E (xi ei ) = 0 we say that xi and ei are orthogonal.12) can be alternatively interpreted as a projection decomposition.1.10) are defined.5.4 guarantees that the solution β exits.5.12) and (3. This means that the equation (3.10) and (3.14) follows from (3. x0 β is the i projection of yi on xi since the error ei is orthogonal with xi .5.13) implies that xi and ei are uncorrelated. Since from Theorem 3.5.5.1 Under Assumption 3.14) holds. suppose that for xi ∈ R that Ex3 = 0 and ei = x2 . Using the definitions (3.1. (3.14) Proof.5. Figure 3.1.Theorem 3. Assumption 3. Assumption 3.4 we know that the regression error has the property E (xi ei ) = 0.1 is employed to guarantee that (3.1.1.11) and (3.13) and Assumption 3. For example.

it is important to not misinterpret the generality of this statement. In other cases the two may be quite different.5. and the straight dashed line is the linear projection. In this example the linear projection is a close approximation to the conditional mean. It over-predicts wages for young and old workers.We have shown that under mild regularity conditions. Most importantly. This defect in linear projection can be partially corrected through a careful selection of regressors. In this case (3.4 displays the relationship3 between mean log hourly wages and labor market experience. since the resulting function is quadratic in experience.12) is defined by projection and the associated coefficient definition (3.5 for a 3 In the population of Caucasian non-military male wage earners with 12 years of education.1. xi ) we can define a linear projection equation (3. In Figure 1. No additional assumptions are required. In the example just presented. Figure 3. The solid line is the conditional mean.3. for any pair (yi . and under-predicts for the rest. A projection of log wages on these two variables can be called a quadratic projection. In this case the linear projection is a poor approximation to the conditional mean.4 we display as well this quadratic projection. However. we can augment the regressor vector xi to include both experience and experience2 . and are discussed in Chapter 11. for those over 53 in age). Figure 3.10).10) may not hold and the implications of Theorem 3.1 may be false. there are no changes in our methods or analysis.5. the dashed line is the linear projection of log wages on eduction. In contrast. Other than the redefinition of the regressor vector.12) with the properties listed in Theorem 3. We illustrate the issue in Figure 3. in many economic models the parameter β may be defined within the model. 18 . In this example it is a much better approximation to the conditional mean than the linear projection. The linear equation (3.5: Conditional Mean and Two Linear Projections Another defect of linear projection is that it is sensitive to the marginal distribution of the regressors when the conditional mean is non-linear. it misses the strong downturn in expected wages for those above 35 years work experience (equivalently. These structural models require alternative estimation methods. Returning to the joint distribution displayed in Figure 3.

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

Show that x y β 1 = σ xy /σ 2 and β 0 = µy − β 1 µx . If yi = x0 β + ei and E(xi ei ) = 0. y) = 3 x2 + y 2 on 0 ≤ x ≤ 1. ¡ ¢ 4.2.4 . taking values only on the non-negative integers.. x 6. Compute the conditional mean m(x) = E (yi | xi = x) . e−λ λj j! . Take the bivariate linear projection model yi = β 0 + β 1 xi + ei E (ei ) = 0 E (xi ei ) = 0 Define µy = Eyi . yi ). 9. True or False. Suppose that Y and X only take the values 0 and 1. 1. σ 2 = V ar(yi ) and σ xy = Cov(xi . . σ 2 = V ar(xi ). Compute 2 the coefficients of the linear projection yi = β 0 + β 1 xi + ei . xi ∈ R. Compute E(yi | xi = x) and V ar(yi | xi = x).1. i 10. σ = . s) = 0 if and only if m = µ and s = σ 2 . µx = Exi . True or False. Let xi and yi have the joint density f (x. 20 . Prove parts 2. µ. then E(ei | xi ) = 0. True or False. 2. Define µ ¶ ¢ ¡ x−µ 2 g x. and E(xi ei ) = 0.3 Find E(Y | X = x). then E(x2 ei ) = 0. 2. m. If yi = x0 β + ei .3. i 7. E(Y 2 | X = x) and V ar(Y | X = x). and have the following joint probability distribution X=0 X=1 Y =0 . Let X be a random variable with µ = EX and σ 2 = V ar(X).1 . E(ei | xi ) = 0. and E(e2 | xi ) = σ 2 .2 Y =1 . then E(x2 ei ) = 0. then ei is i i independent of xi . 3.. (x − µ)2 − σ 2 Show that Eg (X. then ei is independent of xi . and E(ei | xi ) = 0. 3 and 4 of Theorem 3. If yi = xi β + ei . a constant. Suppose that yi is discrete-valued.6 Exercises 1. If yi = xi β + ei . i 8. and the conditional distribution of yi given xi is Poisson: P (yi = k | xi = x) = e−x β (x0 β)j . 0 ≤ y ≤ 1. True or False. j! 0 j = 0. i 11. True or False. Does this justify a linear regression model of the form yi = x0 β + εi ? i then EY = λ and V ar(Y ) = λ. If yi = x0 β + ei and E(ei | xi ) = 0. xi ∈ R. Are they different? Hint: If P (Y = j) = 5.

3) In Sections 4.2) can be written in the parametric 0 β)) = 0. i It follows that the moment estimator of β replaces the population moments in (4.Chapter 4 Least Squares Estimation This chapter explores estimation and inference in the linear projection model yi = x0 β + ei i E (xi ei ) = 0 ¡ ¡ ¢¢−1 E (xi yi ) β = E xi x0 i (4.4) i i=1 i=1 ˆ Another way to derive β is as follows. Observe that (4.3) with the sample moments: ³ ¡ ¢´−1 ˆ ˆ ˆ β = E xi x0 E (xi yi ) i à n !−1 n 1X 1X 0 xi xi xi yi = n n i=1 i=1 à n !−1 n X X = xi x0 xi yi .7 and 4. The function g(β) can be estimated by form g(β) = E (xi (yi − xi g (β) = ˆ ¢ 1X ¡ xi yi − x0 β . but for most of the chapter we retain the broader focus on the projection model. 4. we narrow the focus to the linear regression model. (4.3) writes the projection coefficient β as an explicit function of population moments E (xi yi ) and E (xi x0 ) .1 Estimation Equation (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 . i n i=1 n 21 .2) (4.1) (4.8.

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. 0.117 Educationi .95 42.40 µ ¶µ ¶ 34.40 n i=1 1 n Thus ˆ β = n X i=1 xi x0 i = µ 1 14.5) = n n 1X 1X ˆ xi yi − xi x0 β i n n i=1 i=1 whose solution is (4.83 µ We often write the estimated equation using the format \ log(W agei ) = 1.170 37.117 1 14. Then µ ¶ n 1X 2.4). Let yi be log wages and xi be an intercept and years of education.95 xi yi = 42. with 10-15 years of potential work experience.14 14.4). 30 = . excluding military. This sample has 988 observations.14 205. 40 2.71 = −2.30 + 0.83 ¶−1 µ ¶ . These are white male wage earners from the March 2004 Current Population Survey. n X i=1 2 yi − 2β 0 n X i=1 xi yi + β 0 n X i=1 xi x0 β. 4.2 Least Squares There is another classic motivation for the estimator (4.14 14.37 µ ¶ 1.14 205.ˆ This is a set of k equations which are linear in β.7% increase in mean wages. i 22 . To illustrate.94 −2. An interpretation of the estimated equation is that each year of education is associated with an 11.3. 40 0. ¶ 2. consider the data used to generate Figure 3. The estimator β is the value which jointly sets these equations equal to zero: 0 = g (β) ˆ ˆ n ´ 1X ³ ˆ xi yi − x0 β = i n i=1 (4.

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

These are algebraic results. ˆ n i=1 n Since xi contains a constant. ˆ n i=1 Thus the residuals have a sample mean of zero and the sample correlation between the regressors and the residual is zero. ˆ n−k 2 i=1 (4.7) A justification for the latter choice will be provided in Section 4.5) implies that 1X xi ei = 0. It measures the variation in the i “unexplained” part of the regression. Its method of moments estimator is the sample average 1X 2 ei .6) An alternative estimator uses the formula n 1 X 2 s = ei . and hold true for all linear regression estimates. The error variance σ 2 = Ee2 is also a parameter of interest. 24 .7.Figure 4. ˆ σ = ˆ n 2 i=1 n (4. one implication is that n 1X ei = 0.2: Sum-of-Squared Error Function Contours Equation (4.

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

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

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

. is the demeaning formula for regression.1 (Frisch-Waugh-Lovell).7 Bias and Variance In this and the following section we consider the special case of the linear regression model (3. By the independence of the observations and (3.14) or via the ˆ following algorithm: ˜ 1. .Theorem 4. Regress Y on X1 . ˆ which are “demeaned”.8)(3. Partition X = [X1 X2 ] where X1 = ι is a vector of ones. 4. the primary use is theoretical. 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. ⎟ ⎜ ⎟ ⎜ (4. the FWL theorem can be used to speed computation. but in most cases there is little computational advantage to using the two-step algorithm. 30 .9). Regress X2 on X1 . . the OLS estimator of β 2 and the OLS residuals e may be equivalently computed by either the OLS regression (4. In this case. obtain OLS estimates β 2 and residuals e. Rather. The FWL theorem says that β 2 is the OLS estimate from a regression of ˜ ˜ Y on X2 . . which you may have seen in an introductory econometrics course. In this section we derive the small sample conditional mean and variance of the OLS estimator. obtain residuals Y . and X2 is the vector of observed regressors. ! Thus the OLS estimator for the slope coefficients is a regression with demeaned data. . ˜ 2. . Regress Y on X2 .9). observe that ⎞ ⎛ ⎞ ⎛ .18) E (e | X) = ⎜ E (ei | X) ⎟ = ⎜ E (ei | xi ) ⎟ = 0.6. .13). ⎠ ⎝ ⎠ ⎝ . ¡ ¢−1 0 ι. In some contexts. . obtain residuals X2 . or yi − y on x2i − x2 : ˆ β2 = Ã n X i=1 (x2i − x2 ) (x2i − x2 ) 0 !−1 Ã n X i=1 (x2i − x2 ) (yi − y) . . In the model (4. A common application of the FWL theorem. . ˆ ˜ ˜ ˆ 3.

σ 2 = σ 2 and we have the simplii fications D = In σ 2 .. for any random vector Z define the covariance materix V ar(Z) = E (Z − EZ) (Z − EZ)0 = EZZ 0 − (EZ) (EZ)0 . ¡ 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 ) = 0.18).20) . .. X 0 DX = X 0 Xσ 2 . . V ar β | X = X 0 X ⎟ ⎟ ⎟. 0 0 ··· 0 0 .19) ˆ and thus the OLS estimator β is unbiased for β. 1 n . under the of ˆ ¢ 2 | x = σ 2 . and ³ ´ ¡ ¢−1 2 ˆ σ . σ 2 } = ⎜ . .. 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 = 0.8). 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 = 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.12). ⎝ . We have shown that which implies ³ ´ ˆ E β|X =β ³ ´ ˆ E β =β (4. .Using (4.. . and (4. Next. and the trace operator observe that. the properties additional assumption of conditional homoskedasticity E ei i of projection matrices. σ2 n ⎞ We now calculate the finite sample bias of the method ¡ moments estimator σ 2 for σ 2 .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. the properties of conditional expectations. . ⎠ (4. .

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

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

Substituting in the expressions for π j . Chamberlain (1987) extends this argument to the case of continuously-distributed data. He proves that generically the OLS estimator (4. (4. 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 . the maximum likelihood estimator is identical to the OLS estimator.1. Since this is a regular parametric model the MLE is asymptotically efficient (see Appendix A. and thus so is the OLS estimator.9). He observes that the above argument holds for all multinomial distributions. ˆ r X j=1 πj ξ j ξ 0 ˆ j r n X1X ¡ ¢ = 1 (yi = τ j ) 1 xi = ξ j ξ j ξ 0 j n j=1 = 1 n 1 n i=1 n X X r i=1 j=1 n X i=1 ¡ ¢ 1 (yi = τ j ) 1 xi = ξ j xi x0 i = and r X j=1 xi x0 i πj ξ j τ j ˆ r n X1X ¡ ¢ = 1 (yi = τ j ) 1 xi = ξ j ξ j τ j n j=1 i=1 = r n ¡ ¢ 1 XX 1 (yi = τ j ) 1 xi = ξ j xi yi n = Thus ˆ β mle = Ã 1 n n i=1 j=1 n X i=1 xi yi !−1 Ã ! In other words.10) for the class of models satisfying Assumption 3. and any continuous distribution can be arbitrarily well approximated by a multinomial distribution.22) 34 . We can write the model as yi = x0 β 1 + x0 β 2 + ei 1i 2i E (xi ei ) = 0 where the parameter of interest is β 1 .4) is an asymptotically efficient estimator for the parameter β defined in (3.5. 1X xi x0 i n i=1 1X xi yi n i=1 n ˆ = β ols 4.10 Omitted Variables xi = µ x1i x2i ¶ . if the data have a discrete distribution.

the coefficient on x2i in (4. 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 (4.23) is an estimate of γ 1 = β 1 + Γβ 2 rather than β 1 . This is estimation of the equation yi = x0 γ 1 + ui 1i E (x1i ui ) = 0 Notice that we have written the coefficient on x1i as γ 1 rather than β 1 .23) the short regression to emphasize the distinction. log(p1 ). as many desired variables are not available in a given dataset. First. This is one difficulty with the definition and interpretation of multicollinearity.11 Multicollinearity ˆ If rank(X 0 X) < k + 1. and the error as ui rather than ei . It is the consequence of omission of a relevant correlated variable. Since the error is discovered quickly. the regression of x2i on x1i yields a set of zero coefficients (they are uncorrelated). This happens when the columns of X are linearly dependent. This is the situation when the X 0 X matrix is near singular. Typically.22) the long regression and (4.23) where is the coefficient from a regression of x2i on x1i . When this happens. 4. when the columns of X are close to linearly dependent. For example. there is some α such that Xα = 0. which is often called “multicollinearity” for brevity. if X includes both the logs of two prices and the log of the relative prices.22). i.Now suppose that instead of estimating equation (4. log(p2 ) and log(p1 /p2 ). The more relevant issue is near multicollinearity. The difference Γβ 2 is known as omitted variable bias. Observe that γ 1 6= β 1 unless Γ = 0 or β 2 = 0.. β 1 6= γ 1 .22) is zero. This is called strict multicollinearity. this is rarely a problem for applied econometric practice. the general model will be free of the omitted variables problem. By construction. or second. the applied researcher quickly discovers the error as the statistical software will be unable to construct (X 0 X)−1 . 35 . This is because the model being estimated is different than (4. the possibility of omitted variables bias should be acknowledged and discussed in the course of an empirical investigation. To see this. this arises when sets of regressors are included which are identically related. because we have not said what it means for a matrix to be “near singular”.e. Goldberger (1991) calls (4. except in special cases. Typically there are limits. In this case. Most commonly. In general. we regress yi on x1i only.22) by least-squares. then β is not defined. least-squares estimation of (4. Thus the short and long regressions have the same coefficient on x1i only under one of two conditions. To avoid omitted variables bias the standard advice is to include potentially relevant variables in the estimated model. This definition is not precise.

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

The key is equation (2.This implies has a large value of hi . which is considerably more informative than plots of the uncorrected residuals ei . ˆ We now derive equation (4.25).4 which states that ¡ ¢ (A + BCD)−1 = A−1 − A−1 BC C + CDA−1 BC CDA−1 . ¢−1 ¡ 0 ¢−1 ¡ 0 ¢−1 ¡ 0 ¢−1 ¡ = XX + XX xi (1 − hi )−1 x0 X 0 X X X − xi x0 i i ¡ 0 ¢−1 ¡ 0 ¢ X X − xi x0 X Y − xi yi i ¢ ¡ ¡ ¢ ¡ ¢−1 ¡ 0 ¢−1 ¢−1 ¡ 0 X Y − xi yi + (1 − hi )−1 X 0 X X Y − xi yi = X 0X xi x0 X 0 X i ¢−1 ¡ ˆ xi ei .1) in Section 2.27). ˆ = β − (1 − hi )−1 X 0 X and thus ˆ β (−i) = 37 . then this observation is a leverage point and has the potential to be an influential observation. Investigations into the presence of influential observations can plot the values of (4.

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

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

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

as needed. If Xi ∈ Rk is iid and E |Xi |2 < ∞. Define the random vectors Wi = Xi 1 (|Xi | ≤ C) − E (Xi 1 (|Xi | ≤ C)) By the triangle inequality. ≤ E |Xi | 1 (|Xi | > C) + |E (Xi 1 (|Xi | > C))| (5. Set ε = δη/3. by Markov’s inequality (5. Pick C < ∞ large enough so that E (|X| 1 (|X| > C)) ≤ ε (5. n i=1 0 where µ = EX and V = E (X − µ) (X − µ) .Proof: Without loss of generality. Fix δ and η. the triangle inequality. Jensen’s inequality (5.6) and (5.7) the final inequality holding for n ≥ 4C 2 /ε2 = 36C 2 /δ 2 η 2 .4). ¯ ¯ ¯ ¯ ¯ ¯ ¢ E ¯X n ¯ ¡¯ ¯ E ¯W n ¯ + E ¯Z n ¯ 3ε ≤ ≤ = η. where Z has distribution F (x) = P (Z ≤ x) . P ¯X n ¯ > δ ≤ δ δ δ the equality by the definition of ε.6) By Jensen’s inequality (5. then as n→∞ n ¢ √ ¡ 1 X n Xn − µ = √ (Xi − µ) →d N (0.5). We have shown that for any δ > 0 and η > 0 then for all ¢ ¡¯ ¯ ¥ n ≥ 36C 2 /δ 2 η 2 . ¯ ¯ E ¯Z n ¯ ≤ E |Zi | ≤ 2ε. and the bound |Wi | ≤ 2C.1 Central Limit Theorem (CLT). Fn (x) → F (x) as n → ∞.7). 5.3 Convergence in Distribution Let Zn be a random variable with distribution Fn (x) = P (Zn ≤ x) . P ¯X n ¯ > δ ≤ η. We say that Zn converges in distribution to Z as n → ∞. ≤ 2E |Xi | 1 (|Xi | > C) Zi = Xi 1 (|Xi | > C) − E (Xi 1 (|Xi | > C)) .5) (where 1 (·) is the indicator function) which is possible since E |X| < ∞. the fact that X n = W n + Z n . Finally. 43 . denoted Zn →d Z. we can set E(X) = 0 (by recentering Xi on its expectation). ¯¢2 ¡ ¯ 2 ≤ EW n E ¯W n ¯ = EWi2 n 4C 2 ≤ n ≤ ε2 (5. We need to ¢show that for all δ > 0 and η > 0 there is some N < ∞ so that for all n ≥ N. ¡¯ ¯ P ¯X n ¯ > δ ≤ η. if for all x at which F (x) is continuous. V ) . the fact that the Wi are iid and mean zero. (5.1).1) and (5. Theorem 5.3.

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

√ Theorem 5. If Zn →d Z as n → ∞ and g (·) is continuous. If Zn →p c as n → ∞ and g (·) is continuous at c. gθ Σgθ where gθ (θ) = ∂ g(θ) ∂θ0 and gθ = gθ (θ0 ). Σ) . Thus P (|g (Zn ) − g (c)| ≤ ε) ≥ P (|Zn − c| < δ) → 1 as n → ∞ by the assumption that Zn →p c. Theorem 5. Ik ) distribution. we find jn ¢ ¡ √ √ 0 n (g (θn ) − g(θ0 )) = (gθ + an ) n (θn − θ0 ) →d gθ 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.2 Continuous Mapping Theorem 2. we see that as n → ∞. It follows that ajn = gjθ (θ∗ ) − gjθ →p 0.4. gj (θn ) = gj (θ0 ) + gjθ (θ∗ ) (θn − θ0 ) jn where θnj lies on the line segment between θn and θ0 and therefore converges in probability to θ0 .4.√ where λn → 0 lies on the line segment joining 0 and λ/ n. then g(Zn ) →d g(Z) as n → ∞. Σ) = N 0. Recall that A ⊂ B implies P (A) ≤ P (B). then ¡ ¢ √ 0 n (g (θn ) − g(θ0 )) →d N 0.4 Asymptotic Transformations Theorem 5. where θ is m × 1 and Σ is m × m. k ≤ m. 45 . Proof: Since g is continuous at c. for each element of g.1 Continuous Mapping Theorem 1 (CMT). Stacking across elements of g. and g(θ) : Rm → Rk . Proof : By a vector Taylor series expansion. Hence g(Zn ) →p g(c) as n → ∞.3 Delta Method: If n (θn − θ0 ) →d N (0. µ ¶ 1 Cn (λ) → exp − λ0 λ 2 the characteristic function of the N (0. ¥ 5.4. then g(Zn ) →p g(c) as n → ∞. This is sufficient to establish the theorem. gθ Σgθ .

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

4 implies that Q−1 exists and thus g(·.From the figure we can see that the density functions are dispersed and highly non-normal. 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 .5. n i=1 (6.3) Ã where g(A.1. As the sample size increases the density becomes more concentrated about the population coefficient. A preliminary step in this approach is the demonstration that estimators are consistent — that they converge in probability to the true parameters as the sample size gets large. xi ei →p g (Q. ˆ 47 . Assumption 3. we will use the methods of asymptotic approximation. (6.2.1 and the WLLN (Theorem 5. Proof. and the continuous mapping theorem (Theorem 5. Equation (4. To characterize the sampling distribution more fully.1) and ˆ We now deduce the consistency of β.1).1 Under Assumption 3.5.1). the OLS estimator β is has a statistical distribution which is unknown.2 Consistency ˆ As discussed in Section 6. β →p β as n → ∞. (6.5. ¥ We can similarly show that the estimators σ 2 and s2 are consistent for σ 2 . First. Ã n ! n X 1X 0 1 ˆ xi xi .2. Asymptotic (large sample) methods approximate sampling distributions based on the limiting experiment that the sample size n tends to infinity. Hence by the continuous mapping theorem (Theorem 5. xi ei = g i n n i=1 i=1 1X xi ei →p E (xi ei ) = 0. (6. 0).4.8) implies that ˆ β−β = Ã n X i=1 xi x0 i !−1 n X i=1 xi ei .1. 0) = Q−1 0 = 0 β−β =g n n i=1 i=1 ˆ which implies β →p β as stated. ·) is continuous at (Q.1).1. 6.4. For a complete argument.3). This is illustrated in Figure 6.1).1 by the fact that the sampling densities become more concentrated as n gets larger. Assumption 3.2) i i n i=1 n From (6. b) = A−1 b is a continuous function of A and b at all values of the arguments such that A−1 exist.2).1) imply that n ¡ ¢ 1X xi x0 →p E xi x0 = Q (6. using (6. we can conclude ˆ that β →p β. ˆ Theorem 6.

(6.3.4) 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 à ! à n ! n ´ ³ ´0 1 X ³ ´ 1 X 0 ³ˆ 0 ˆ ˆ β−β + β−β β−β ei xi xi xi n n i=1 i=1 the last line using the WLLN.Theorem 6.6) n i=1 48 . (6.5) Thus xi ei is iid with mean zero and has covariance matrix Ω. Thus σ 2 is consistent for σ 2 .3.2 Under Assumption 3.1.1 In addition to Assumption 3. ˆ Proof.2. Assumption 6.3) and Theorem (6. E ¯ei ¯ E ¯e4 ¯ i i i i (6.2). ´1/2 ¡ ¯ ¯¢ ¯ ³ ¯ ¯2 ´1/2 ¡ ¯ 4 ¯¢1/2 ³ ¯ 1/2 E ¯xi x0 e2 ¯ ≤ E ¯xi x0 ¯ = E |xi |4 < ∞.1).1.2. since n/(n − k) → 1 as n → ∞.3. it follows that s2 = ¥ n σ 2 →p σ 2 .1 guarantees that the elements of Ω are finite.5.1).2). σ 2 →p σ 2 and s2 →p σ 2 as n → ∞.5. Ω) . 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 . Ee4 < ∞ and E |xi |4 < ∞.3 Asymptotic Normality ˆ We now establish the asymptotic distribution of β after normalization. (6. n 1 X √ xi ei →d N (0. i i Assumption 6. We need a strengthening of the moment conditions. i Now define ¡ ¢ Ω = E xi x0 e2 . (6. ˆ Finally. By the central limit theorem (Theorem 5. ˆ n−k 6. To see this. by the Cauchy-Schwarz inequality (5.

The asymptotic distribution ´ Theorem 6. the normal approximation is arbitrarily poor for some data distribution satisfying the assumptions. 1) asymptotic distibution. We call V 0 the homoskedastic covariance matrix. Theorem 6. there is no simple answer to this reasonable question.9) we define V 0 = Q−1 σ 2 whether (6. The approximation may be poor when n is small. 1 X √ xi ei n i=1 n ! the N (0. Q−1 ΩQ−1 . Under (6. when xi and ei are independent. In Figure 6. In´Figure 6.8) Ω = E xi x0 E e2 = Qσ 2 i i V = Q−1 ΩQ−1 = Q−1 σ 2 ≡ V 0 (6.7) holds. however. How large should n be in order for the approximation to be useful? Unfortunately. for any ˆ fixed n the sampling distribution of β can be arbitrarily far from the normal distribution. However. otherwise V 6= V 0 . after rescaling. The expression V = Q−1 ΩQ−1 is called a sandwich form. We say that ei is a Homoskedastic Projection Error when (6.3. 1).7) is true or false. xi ) which satisfy the conditions of Assumption 6. (6.3. In this context the normalized least-squares slope estimator n α−2 β 2 − β 2 has α →d Q−1 N (0. but this is not a necessary condition.7) the asymptotic variance formulas simplify as ¡ ¢ ¡ ¢ (6. There is a special case where Ω and V simplify.1 is commonly used to approximate the finite of √ ³ˆ sample distribution of n β − β . If α > 2 the 2 error εi has zero mean and variance α/(α − 2). for example. ´ √ ³ˆ As V is the variance of the asymptotic distribution of n β − β . and εi is independent of xi with the Double Pareto density f (ε) = α |ε|−α−1 . As α approaches 2. e2 ) = 0.6). setting n = 100 and varying the parameter α. its variance diverges q ³ ´ ˆ to infinity. i i Condition (6. and (6.7) Cov(xi x0 . We illustrate this problem using a simulation.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.Then using (6.2 we display the finite sample densities of the q ³ ˆ normalized estimator n α−2 β 2 − β 2 . as n → ∞ ´ √ ³ ˆ n β − β →d N (0. When (6. This holds true for all joint distibutions of (yi .1 states that the sampling distribution of the least-squares estimator. V ) where V = Q−1 ΩQ−1 .9) In (6.2). ´ √ ³ ˆ n β−β = à 1X xi x0 i n i=1 n !−1 à Theorem 6.3.1 Under Assumption 6. The trouble is that no matter how large is the sample size.1). For α 49 .3.1.7) is true then V = V 0 . |ε| ≥ 1. Let yi = β 0 + β 1 xi + εi where xi is N (0. Ω) ¡ ¢ = N 0.3.1. is approximately normal when the sample size n is sufficiently large. V is often referred to as ˆ the asymptotic covariance matrix of β.

1) asymptotic approximation is never guaranteed to be accurate. 1).11) 50 . 6 and 8. concentrating most of the probability mass around zero. the sampling distribution becomes highly skewed and non-normal.10) V 0 = Q−1 s2 . 1) density. σ may also be substituted for s ˆ ¡ ¢ To estimate V = Q−1 ΩQ−1 .2 and 6. we need an estimate of Ω = E xi x0 e2 . 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. 6. Another example is shown in Figure 6.2.0 the density is very close to the N (0.3 is that the N (0.2) and Theorem 6.3. As α diminishes the density changes significantly. The lesson from Figures 6. The homoskedastic covariance matrix V 0 = Q−1 σ 2 is typically estimated by ˆ ˆ (6.4 Let Covariance Matrix Estimation 1X ˆ xi x0 Q= i n i=1 n be the method of moments estimator for Q. ˆ ˆ Since Q →p Q and s2 →p σ 2 (see (6. We show the sampling distribution of n β 1 − β 1 setting n = 100. 4. The estimator 2 2 in (6. The MME estimator is i i 1X ˆ xi x0 e2 Ω= i ˆi n i=1 n (6.10) without changing this result.1) it is clear that V 0 →p V 0 .Figure 6. for k = 1. As k increases.2: Density of Normalized OLS estimator α = 3.

.. In most cases. we set s(β) = n−1/2 V ..1 A standard error s(β) for an estimator β is an estimate of the standard ˆ deviation of the distribution of β. A more easily interpretable measure of spread is its square root — the standard deviation. Thus q ˆ ˆ s(β j ) = n−1/2 Vjj . It is therefore important to understand what formula and method is 51 . The methods switched during ˆ the late 1980s and early 1990s. j = 0. and V is an estimator of the variance of n β − β . the “Huber formula”. we focus on individual elements of β one-at-a-time. or that they use a “heteroskedasticity-robust covariance matrix estimator”. This motivates the definition of a standard error.Figure 6.. When reading and reporting applied work. 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). as there may be more than one estimator of the variance of the estimator. and was still the standard choice for much empirical work done in the early 1980s. When β is a vector.3: Sampling distribution where ei are the OLS residuals. standard errors are not unique. ´ p √ ³ˆ ˆ ˆ ˆ When β is scalar. many authors will state that their “standard errors have been corrected for heteroskedasticity”. these all mean the same thing. the “Huber-White formula” or the “GMM covariance matrix”. Generically.. β j . so that by the late 1990s White estimate V emerged as the standard covariance matrix estimator. ˆ ˆ When V is used rather than the traditional choice V 0 . 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”. as it is not always clear which has been computed. k. vis. 1. it is important to pay ˆ ˆ attention to the distinction between V 0 and V . ˆ The estimator V 0 was the dominate covariance estimator used before 1980.4. ˆ ˆ Definition 6. the “Eicker-White formula”.

(6.14 205. (.35/988 = .83 −0.83 ¶−1 = µ 7.98 −0.14 205.80 40.035 ¶ .6 ¶µ 1 14. (6.2/988 = . To illustrate. It is also important to understand that a particular standard error may be relevant under one set of model assumptions.20 and µ ¶ ˆ = 0.6 Therefore the two covariance matrix estimates are µ ¶−1 µ ¶ 1 14. we return to the log wage regression of Section 4.085) (.1.020.12) in turn. We can write the estimated equation with standards errors using the format \ log(W agei ) = 1. From a computational standpoint.1) show that n ¡ ¢ 1X xi x0 e2 →p E xi x0 e2 = Ω. by Holder’s inequality (5.117 Educationi .199 2.80 .80 40.493 0.14 14. just as any other estimator. but not under another set of assumptions.493 −0. p ˆ In this case the two estimates are quite similar.used by an author when studying their work.3) so by the WLLN ³ ´ ³ ´3/4 ¡ ¯ ¯¢ 1/4 E |xi |3 |ei | ≤ E |xi |4 < ∞. then take the diagonal elements.80 2.5 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.085 p ˆ and that for β 1 is .039 and ˆ V = µ 1 14. n n i=1 52 .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 . E ¯e4 ¯ i ³ ´ 1X |xi |3 |ei | →p E |xi |3 |ei | . The standard errors for β 0 are 7. the standard method to calculate the standard errors is to ˆ first calculate n−1 V . and then the square roots. Using (6.480 . We calculate that s2 = 0.14 6. from which it follows that V →p V as n → ∞.480 ˆ0 = 0. i i i i n i=1 Second.20 −0.83 ¶−1 µ .2.020) 6.30 + 0.199 2. Ω 2. First.14 14.20 = V 14.14 205.5) and the WLLN (Theorem 5.12) i i n n n i=1 i=1 We now examine each sum on the right-hand-side of (6.

which.13) of Efron (1982).13) Using formula (4.−i = (1 − hi )−1 ei ˆ presented in (4. ¯ ¯n ¯ n i=1 so Together. 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 (6.11) with the leave-one-out estimator ei.26). these establish consistency. ¯ ¯ ¯ ¯ ¯n ¯ n i=1 i=1 1X |xi |4 →p E |xi |4 . Using this substitution. MacKinnon and White (1985) present numerical (simulation) evidence i ˆ ˆ that V ∗ works better than V as an estimator of V . They also suggest that the scaling factor (n − 1)/n in (??) can be omitted.¯ ¯ ¯ ¯ˆ and thus since ¯β − β ¯ →p 0. From equation (3. Recall from Section 4.1 As n → ∞. n i=1 n ˆ ˆ Theorem 6. Ω →p Ω and V →p V. Andrews’ proposed estimator is ˆ ˆ ˆ ˆ V ∗∗ = Q−1 Ω∗∗ Q−1 53 .12 the definition of β (−i) as the least-squares estimator with the i’th observation deleted. you can show that 1 Xˆ ¯ β= β (−i) . is defined ˆ ˆ by replacing the OLS residual ei in (6. by the WLLN ¯ n ¯ à n ! ¯ 1X ¯1 X ¯ ¯ ³ ´0 ¯ ¯ ¯ ¯ˆ 3 0 ˆ xi xi β − β xi ei ¯ ≤ ¯β − β ¯ |xi | |ei | →p 0.5. i=1 Third. ¯ 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. 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. Andrews (1991) suggested an similar estimator based on cross-validation.25). 6.6 Alternative Covariance Matrix Estimators ˆ MacKinnon and White (1985) suggested a small-sample corrected version of V based on the jackˆ knife principle.14) à 1X (1 − hi )−1 xi ei ˆ n i=1 n !à 1X (1 − hi )−1 xi ei ˆ n i=1 n !0 and hi = x0 (X 0 X)−1 xi .

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

and θ = h(β) is some function of the parameter vector. A simple null and composite hypothesis takes the form H0 : θ = θ0 H1 : θ 6= θ0 where θ0 is some pre-specified value. 1) Proof. (For example. we say that tn (θ) is asymptotically pivotal.8.15) tn (θ) = ˆ−θ θ s(ˆ θ) ´ √ ³ˆ n θ−θ q = ˆ Vθ N (0. β 2 ). if R is a “selector matrix” R= so that if β = (β 1 . however. that (so θ ˆ ˆ ˆ is. 1) →d ˆ−θ θ .16) ¥ Thus the asymptotic distribution of the t-ratio tn (θ) is the standard normal. In this case. then θ = R0 β = β 1 and ˆ Vθ = ¡ I 0 ¢ ˆ V µ I 0 ¶ ˆ = V11 . s(ˆ θ) (6. ˆ its estimate and s(ˆ its asymptotic θ θ) standard error. s(ˆ = n−1/2 H 0 V Hβ . the standard error for ˆ is the square root of n−1 Vθ . 55 . pivotal statistics are unavailable and so we must rely on asymptotically pivotal statistics. ˆ When q = 1q h(β) is real-valued). θ) β 6.1 tn (θ) →d N (0. we say that tn is an exactly pivotal statistic.8 t tests Let θ = h(β) : Rk → R be any parameter of interest. In special cases (such as the normal regression model. Since the standard normal distribution does not depend on the parameters. By (6. µ I 0 ¶ ˆ the upper-left block of V . Vθ ) √ Vθ = N (0. and is therefore exactly free of unknowns.For example. In general. Consider the studentized statistic tn (θ) = Theorem 6. see Section X). θ could be a single element of β). the statistic tn has an exact t distribution.

however. The rejection/acceptance dichotomy is associated with the Neyman-Pearson approach to hypothesis testing. tn →d N (0.The standard test for H0 against H1 is the t-statistic (or studentized statistic) tn = tn (θ0 ) = ˆ − θ0 θ . 1]. Define the tail probability. To see this fact. pn →d U [0.025 = 1. then P (Z > zα/2 ) = α/2 and P (|Z| > zα/2 ) = α. under H0 . Otherwise the test does not reject. That is. For example. Thus P (1 − pn ≤ u) = = P (F (tn ) ≤ u) ¡ ¢ = P |tn | ≤ F −1 (u) ¡ ¢ → F F −1 (u) = u.9 Confidence Intervals A confidence interval Cn is an interval estimate of θ. from which it follows that pn →d U [0.05 = 1. is to report an asymptotic p-value. in contrast to Neyman-Pearson rejection/acceptance reporting where the researcher picks the level. In a sense. An alternative approach.645. s(ˆ θ) Under H0 . That is. associated with Fisher. 1]. P (1 − p(tn ) ≤ u) establishing that 1 − pn →d U [0. 1]. The coverage probability is P (θ ∈ Cn ). Let zα/2 is the upper α/2 quantile of the standard normal distribution. so the “unusualness” of the test statistic can be compared to the easy-to-understand uniform distribution. note that the asymptotic distribution of |tn | is F (x) = 1 − p(x). z. If the p-value pn is small (close to zero) then the evidence against H0 is strong. Another helpful observation is that the p-value function has simply made a unit-free transformation of the test statistic. if Z ∼ N (0. in that the reader is allowed to pick the level of significance α. p-values and hypothesis tests are equivalent since pn < α if and only if |tn | > zα/2 . or “accepts” H0 . The asymptotic p-value for the above statistic is constructed as follows. A test of asymptotic significance α rejects H0 if |tn | > zα/2 . 56 . The p-value is more general. This is because ¡ ¢ P (reject H0 | H0 true) = P |tn | > zα/2 | θ = θ0 ¢ ¡ → P |Z| > zα/2 = α. or asymptotic p-value function p(t) = P (|Z| > |t|) = 2 (1 − Φ(|t|)) . 6. and is a function of the data and hence is / random. It is designed to cover θ with high probability.96 and z. Either θ ∈ Cn or θ ∈ Cn . 1). Then the asymptotic p-value of the statistic tn is pn = p(tn ). 1). regardless of the complication of the distribution of the original test statistic. Thus an equivalent statement of a Neyman-Pearson test is to reject at the α% level if and only if pn < α.

and values of θ outside two standard θ errors of the estimated ˆ are considered unlikely or unreasonable candidates for the true value. or α = . the most common professional choice isi95%. However we often can calculate the asymptotic coverage probability limn→∞ P (θ ∈ Cn ). ˆ + zα/2 s(ˆ . ¢ ¡ ¢ ¡ P (θ ∈ Cn ) = P |tn (θ)| ≤ zα/2 → P |Z| ≤ zα/2 = 1 − α. = n h(β) − θ0 Hβ V Hβ 57 (6. 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. θ The interval has been constructed so that as n → ∞. 6. We say that Cn has asymptotic (1 − α)% coverage for θ if P (θ ∈ Cn ) → 1 − α as n → ∞.05. While there is no hard-and-fast guideline for choosing the coverage probability 1 − α. 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 . The t-test of the previous setion rejects H0 : θ0 = θ if |tn (θ)| > zα/2 where tn (θ) is the t-statistic (6.17) = ˆ − zα/2 s(ˆ θ and Cn is an asymptotic (1 − α)% confidence interval. and it is desired to test the joint restrictions simultaneously.10 Wald Tests Sometimes θ = h(β) is a q × 1 vector.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).16) and zα/2 is the upper α/2 quantile of the standard normal distribution. θ θ) (6.We typically cannot calculate the exact coverage probability P (θ ∈ Cn ). We have the null and alternative H0 : θ = θ0 H1 : θ 6= θ0 . This corresponds to selecting the confidence h i h ˆ ± 1. In this case the t-statistic approach does not work.18) . A good method for construction of a confidence interval is the collection of parameter values which are not rejected by a statistical test.

if rank(Hβ ) = q. The Wald test fails to reject if Wn is q 1 ¡ ¢ less than χ2 (α).When h is a linear function of β.1. Hβ (β) is a continuous function of β. In this case.2.15) showed that n ˆ − θ →d Z ∼ N (0. ˜˜ n ˜ e = Y − X1 β 1 . and there are q = k2 restrictions.10. then Wn →d χ2 . Vθ ). 1] under H0 .84 = z.05) = 3. We know that the Wald statistic takes the form 0 Wn = nˆ Vθ−1 ˆ θ ˆ θ ³ ´−1 ˆ ˆ0 ˆ β 2.5. then the Wald statistic can be written in the form ¶ µ 2 ˆ σ − σ2 ˜ Wn = n (6. The null hypothesis is H0 : β 2 = 0.8. where p(x) = P χ2 ≥ x is the tail q q probability function of the χ2 distribution. the upper-α quantile q 2 of the χ2 distribution. Hβ (β) →p Hβ . h(β) = R0 β. An asymptotic Wald test rejects H0 in favor of H1 if Wn exceeds χ2 (α). = nβ 2 R0 V R R0 β is linear with R = µ 0 I ¶ ¢−1 ¡ ˆ ˆ ˆ . Thus Vθ = H 0 V Hβ →p H 0 V Hβ = Vθ > 0 if Hβ has full rank q. 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 asymptotic p-value for Wn is pn = p(Wn ). q and pn is asymptotically U[0. the test rejects at the α% level iff pn < α. We have established: ³ ´0 ³ ´ ˆ − θ0 V −1 ˆ − θ0 →d Z 0 V −1 Z = χ2 . so by the continuous mapping ˆ ˆ ˆ ˆ ˆ theorem. For example. Also h(β) = a selector matrix.025 . Wn = n R0 β − θ0 ´ √ ³ The delta method (6. then the Wald statistic takes the form ´0 ³ ´ ³ ´−1 ³ ˆ ˆ ˆ R0 V R R0 β − θ 0 .1 showed θ ˆ that V →p V.1 Under H0 and Assumption 6. χ2 (. ˆ Wn = n θ θ q θ θ Theorem 6. 6. As before. Furthermore. θ = β 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 . and Theorem 6.3.19) σ2 ˆ where σ2 = ˜ 1 0 e e. a chiq square random variable with q degrees of freedom. Hence β β by Theorem A. ˜ 58 ¡ 0 ¢−1 0 ˜ β 1 = X1 X1 X1 Y .

19) only holds if V 0 = σ 2 n−1 X 0 X ˆ .are from OLS of Y on X1 . ˆˆ n ˆ e = Y − X β. First. note that partitioned matrix inversion (2.19) is that it is directly computable from the standard output from two simple OLS regressions. We now derive expression (6. and σ2 = ˆ 1 0 e e. as the sum of squared errors is a typical output from statistical packages. ˜˜ ˆˆ ˆˆ σ 2 = n−1 e0 e ˆ we conclude that Wn = n as claimed. X2 ). the residual is ˜ ˜ e = M1 Y. ˆ ¡ ¢−1 0 ˆ β = X 0X XY are from OLS of Y on X = (X1 . ˜ ˆ ˜ 2 β 2 + e and X 0 e = 0.2) ¢−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 . still this formula often finds good use in reading applied papers. Thus ˜ ˆ e=X ˜ ˆ 2 ³ ´0 ³ ´ ˜ ˆ ˜ ˆ e0 e = X2 β 2 + e ˜˜ ˆ ˆ X2 β 2 + e ˆ0 ˜ 0 ˜ ˆ = β 2 X2 X2 β 2 + e0 e ˆˆ 0 0 ˆ ˆ ˆˆ = β X M1 X2 β + e0 e. 2 σ ˆ To simplify this expression further.19).19) the F form of the Wald statistic. 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 . 59 . Also. µ e0 e − e0 e ˜˜ ˆˆ e0 e ˆˆ ¶ =n µ σ2 − σ2 ˜ ˆ 2 σ ˆ ¶ . By the FWL theorem. The elegant feature about (6. This statistic is typically reported as an “F-statistic” which is defined as ¡ 2 ¢ σ − σ 2 /k2 ˜ ˆ n − k Wn . = F = n k2 σ 2 /(n − k) ˆ ¢−1 ¡ ˆ While it should be emphasized that equality (6. 2 2 2 or alternatively. Because of this connection we call (6. since ˆ0 0 ˆ β 2 X2 M1 X2 β 2 = e0 e − e0 e. note that if we regress Y on X1 alone. Now consider the residual regression of e on X2 = M1 X2 .

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

10) then ´ ³ ˆ • β ∼ N 0. ˆ 2 2 2 ˜ ˜ The MLE of the model under the null hypothesis is (β 1 . β and t are approximately normally distributed. and standard errors are calculated using the homoskedastic formula (6.a chi-square distribution with n − k degrees of freedom. σ 2 ). 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) 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. β 2 . 0.1 and Theorem 6.) Now let us partition β = (β 1 . β has an exact normal distribution and t has an exact t distribution. Theorem 6. if standard errors are calculated using the homoskedastic formula (6. σ 2 ) where β 1 is the OLS estimate from ˜ 2 ˜ a regression of yi on x1i only. the notable distinction is between the N (0. 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. 0. σ2 ˆ 61 . σ 2 ) = − log 2πˆ 2 − 2 e0 e ˆˆ 2 2ˆ σ ¡ ¢ n n n = − log σ 2 − log (2π) − .10) µ h i ¶ 2 (X 0 X)−1 N 0. σ 2 ) − Ln (β 1 .12. so as a practical matter it does not matter which distribution is used.1 we showed that in large samples.12. β 2 .3. σ 2 (X 0 X)−1 • (n−k)s2 σ2 ˆ β j −β j ˆ s(β ) j ∼ χ2 . 1) and tn−k distributions. The critical values are quite close if n − k ≥ 30. σ 2 ) discussed above. Furthermore. In contrast. We summarize these findings Theorem 6. with residual variance σ . The Gaussian log-likelihood at these estimates is ¡ ¢ n 1 ˆ ˆ ˆ σ Ln (β 1 . σ ˆ ˆ βj − βj βj − βj N (0.8. σ 2 ) ¡ ¢¢ ¡ ¡ ¢ ˆ = n log σ 2 − log σ 2 ˜ µ 2¶ σ ˜ = n log . 0. As inference (confidence intervals) are based on the t-ratio. n−k • ∼ tn−k ˆ In Theorem 6. (Unless the sample size is unreasonably small. a good testing procedure is based on the likelihood ratio statistic. The estimator under the alternative is the unrestricted estimator ˆ ˆ ˆ (β 1 .1 If ei is independent of xi and distributed N(0. σ 2 ) = − log σ − log (2π) − . β 2 . which is twice the difference in the log-likelihood function evaluated under the null and alternative hypotheses. The log-likelihood of this model is ¡ 2¢ n n n ˜ ˜ ˜ Ln (β 1 .

8. The decreasing dashed ˆ = 1. In the present context of the Wald statistic. we have plotted in Figure 6. 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. ˆ Let β and σ 2 be the sample mean and variance of yi . σ2 ˆ Now notice that H0 is equivalent to the hypothesis H0 (s) : β s = 1 for any positive integer s.4 the Wald statistic Wn (s) as a function ˆ of s. the statistic Wn (s) varies with s.84 — the probability of a false rejection. setting n/σ 2 = 10. Letting h(β) = β s . they can work quite poorly when the restrictions are nonlinear. as Wn (s) →d χ2 under H0 for 1 any s. This can be seen by a simple example introduced by Lafontaine and White (1986). Through repetition. It is easy to see that in each case there are values of s for which the line is for the case β test statistic is significant relative to asymptotic critical values. The increasing solid line is for the case β = 0. This produces random draws from the sampling distribution of interest. Then the standard Wald test for H0 is ˆ ³ ´2 ˆ β−1 Wn = n . This is distressing since the choice of s seems arbitrary and irrelevant to the actual hypothesis. Take the model yi = β + ei ei ∼ N (0. The method uses random simulation to create an artificial dataset to apply the statistical tools of interest. To demonstrate this effect. while there are other values of s for which test test statistic is insignificant. σ 2 ) and consider the hypothesis H0 : β = 1. we find that the standard Wald test for H0 (s) is ´2 ³ s ˆ β −1 Wn (s) = n 2s−2 .By a first-order Taylor series approximation ¶ µ 2 ¶ µ σ ˜ σ2 ˜ − 1 = Wn .7. This is an unfortunate feature of the Wald statistic. Our first-order asymptotic theory is not useful to help pick s. features of this distribution can be calculated. LR = n log 1 + 2 − 1 ' n σ ˆ σ2 ˆ the F statistic. and noting Hβ = sβ s−1 . one feature of importance is the Type I error of the test using the asymptotic 5% critical value 3. 6. 62 .13 Problems with Tests of NonLinear Hypotheses While the t and Wald tests work well when the hypothesis is a linear restriction on β. σ 2 s2 β ˆ ˆ While the hypothesis β s = 1 is unaffected by the choice of s.

1 we report the results of a Monte Carlo simulation where we vary these three parameters. n is varied among 20. n. Given the simplicity of the model. which is not surprising given the dependence of Wn (s) on s as shown in Figure 6. so these probabilities are Type I error.1 you can also see the impact of variation in sample size. The value of s is varied from 1 to 10.1 reports the simulation estimate of the Type I error probability from 50. These probabilities are calculated as the percentage of the 50. and rarely fall outside of the 3%-8% range. however. Test performance deteriorates as s increases. remember that the ideal Type I error probability is 5% (. 100 and 500.Figure 6. When comparing statistical procedures. In Table 2. To interpret the table. Table 4.000 random samples. There is. and σ 2 . In each case. Any other choice of s leads to a test with unacceptable Type I error probabilities. the Type I error probability improves towards 5% as the sample size n increases. Rates above 20% are unexceptable. Table 4.05) with deviations indicating+ distortion. we compare the rates row by row. For this particular example. no magic choice of n for which all tests perform uniformly well. this probability depends only on s.000 simulated Wald statistics Wn (s) which are larger than 3.1 Type I error Probability of Asymptotic 5% Wn (s) Test 63 . In Table 4. The second through seventh columns contain the Type I error probabilities for different combinations of n and σ.4: Wald Statistic as a function of s P (Wn (s) > 3. Typically. and σ is varied among 1 and 3. the only test which meets this criterion is the conventional Wn = Wn (1) test. Error rates avove 10% are considered excessive.84 | β = 1) .84. The null hypothesis β s = 1 is true. Each row of the table corresponds to a different value of s — and thus corresponds to a particular choice of test statistic.4. Type I error rates between 3% and 8% are considered reasonable. looking for tests for which rate rejection rates are close to 5%.

000 simulated random samples In this example it is not surprising that the choice s = 1 yields the best test statistic.10 .06 .18 .06 .19 . β 1 .08 .21 . define θ = β 1 /β 2 .22 .08 .22 .07 .23 .08 . Other choices are arbitrary and would not be used in practice.05 .05 .11 .13 .05 . in other examples natural choices are not always obvious and the best choices may in fact appear counter-intuitive at first.05 .12 .15 .20 . β 2 ) be the least-squares estimates of (6.15 .25 .07 .06 .25 .10 .06 .15 .06 . This point can be illustrated through another example.09 .05 .07 .24 . 64 .31 .07 . While this is clear in this particular example.06 .10 . Equivalently.15 .14 .14 . let V be an estimate of the ˆ asymptotic variance matrix for β and set ˆ = β 1 /β 2 .12 . Define θ ˆ ˆ ⎞ ⎛ 0 ⎟ ⎜ ⎟ ⎜ ⎜ 1 ⎟ ⎟ ⎜ ⎜ ˆ ⎟ ˆ H1 = ⎜ β 2 ⎟ ⎟ ⎜ ⎟ ⎜ ⎜ β ⎟ ˆ ⎠ ⎝ − 1 ˆ2 β2 ´ s(ˆ θ) −r .07 .20) ³ ´1/2 ˆ0 ˆ ˆ so that the standard error for ˆ is s(ˆ = n−1 H1 V H1 θ θ) . ˆ ˆ ˆ ˆ ˆ Let β = (β 0 .08 .26 .17 . In this case a t-statistic for H0 is t1n = ³ˆ β1 ˆ β2 where r is a known constant.20 .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 .06 .35 . so the hypothesis can be stated as H0 : θ = r.08 . Take the model yi = β 0 + x1i β 1 + x2i β 2 + ei E (xi ei ) = 0 and the hypothesis H0 : β1 =r β2 (6.13 . An alternative statistic can be constructed through reformulating the null hypothesis as H0 : β 1 − rβ 2 = 0.34 .33 .28 .13 .20).05 .16 Rejection frequencies from 50.06 .30 .

05 .06 .02 .05.06 . such as the GMM distance statistic which will be presented in Section 9.05 .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. if the hypothesis can be expressed as a linear restriction on the model parameters.06 .07 .645) P (tn > 1. .05 .50 .7. the rejection rates for the linear t2n statistic are invariant to the value of β 2 . We let x1i and x2i be mutually independent N (0.06 .10 .00 The one-sided Type I error probabilities P (tn < −1. This leaves β 2 as a free parameter.00 .47 .00 .26 .25 . However. this formulation should be used. It is also prudent to consider alternative tests to the Wald statistic. .2 is that the two t-ratios have dramatically different sampling behavior.00 . and normalize β 0 = 0 and β 1 = 1. We vary β 2 among . In all cases. In contrast.645) greatly exceed 5%.10 .09 .645) and P (tn > 1.645) are calculated from 50. especially for small values of β 2 .00 .05 .00 . The results are presented in Table 4. 6.00 .12 .05 β2 .645) are close to zero in most cases.1. 65 . −1 H V H ˆ 2 n 2 ⎞ 0 H2 = ⎝ 1 ⎠ .645) P (tn > 1. In this section we describe the method in more detail.00 . then the “most linear” formulation should be selected. Table 4. .05 .06 . If no linear formulation is feasible.00 . and 1. along with sample size n. The implication of Table 4.05 .06 .000 simulated samples. The common message from both examples is that Wald statistics are sensitive to the algebraic formulation of the null hypothesis. Ideally.06 . and alternatives to asymptotic critical values should be considered.05 .05 . the rejection rates for the t1n statistic diverge greatly from this value. −r ⎛ t2n where To compare t1n and t2n we perform another simple Monte Carlo simulation.06 .A t-statistic based on this formulation of the hypothesis is ´2 ³ ˆ 1 − rβ 2 ˆ β =³ ´1/2 .75.75 1.0 and n among 100 and 500.15 .645) P (tn < −1.00 .05 . and are close to the ideal 5% rate for both sample sizes.50. the entries in the table should be 0.06 .2. σ 2 ) draw with σ = 3. ei be an independent N (0. 1) variables.15 .28 .10 .645) t1n t2n t1n t2n t1n t2n t1n t2n .2 Type I error Probability of Asymptotic 5% t-tests n = 100 n = 500 P (tn < −1. The left tail probabilities P (t1n < −1. while the right tail probabilities P (t1n > 1.25.06 .

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

96) . the choice of B is often guided by the computational demands of the statistical procedure. In practice. We now expand the sample all non-military wage earners. For example. and non-white. Suppose we are interested in the 5% and 95% quantile of Tn = ˆ We then compute the 10% θ.95) /B ' . For regressors we include years of education. experience squared. but requires more computational time. B b=1 (6.21) the percentage of the simulated t-ratios which exceed the asymptotic 5% critical value. and 90% sample quantiles of the sample {Tnb }. Furthermore. The typical purpose of a Monte Carlo simulation is to investigate the performance of a statistical procedure (estimator or test) in realistic settings. It is therefore convenient to pick B so that N is an integer. an estimator or test may perform wonderfully for some values. union member. respectively. Then qα is the N ’th number in this ordered sequence. In particular. B.022.21) is therefore an ³ ´ p ˆ unbiased estimator of P with standard error s P = P (1 − P ) /B.007. female. immigrant. experience squared. Often this is called the number of replications.96) . such as the percentage estimate reported in (6. 1000. A simple way to compute sample quantiles is to sort the sample {Tnb } from low to high. If the standard error is too large to make a reliable inference. then we can set s P = (. Hence the ³ ´ ˆ standard errors for B = 100.Suppose we are interested in the ¯Type I error associated with an asymptotic 5% two-sided ¯ ¯ ¯ θ) θ t-test. and dummy variable indicators for the following: married. As P is unknown. therefore. female. s P = . 6. The random variable 1 (Tnb ≥ 1. it is simple to make inferences about rejection probabilities from statistical tests. where N = (B +1)α. union member. Again our dependent variable is the natural log of wages.15 Estimating a Wage Equation We again return to our wage equation. As discussed above. the researcher must select the number of experiments. hispanic. this may ˆ be approximated by replacing P with P or with an hypothesized value. The average (6. and 5000. potential work experience. Quite simply.05) (. Since the results of a Monte Carlo experiment are estimates computed from a random sample of size B. equalling 1 with probability P = E1 (Tnb ≥ 1.003. For example. We us the sample of wage earners from the March 2004 Current Population Survey.22/ B. for a selection of choices of n and F. if we set B = 999. and hispanic. and . In many cases. and our regressors include years of education. immigrant. so that coefficients may be interpreted as semi-elasticities. .21). We separately estimate equations for white and non-whites. It is therefore useful to conduct a variety of experiments. excluding military. a larger B results in more precise estimates of the features of interest of Gn . The α% sample quantile is a number qα such that α% of the sample are less than qα . potential work experience. we included a dummy 67 . and therefore it is straightforward to calculate standard errors for any quantity of interest. For the dependent variable we use the natural log of wages. Generally.96) is iid Bernoulli. are. if we are ³ ´ p √ ˆ assessing an asymptotic 5% test. then B will have to be increased. and estimate a multivariate regression. then the 5% sample quantile is 50’th sorted value and the 95% sample quantile is the 950’th sorted value. and poorly for others. and dummy variable indicators for the following: married. We would then set Tn = ¯ˆ − θ¯ /s(ˆ and calculate B X ˆ= 1 P 1 (Tnb ≥ 1. the performance will depend on n and F.

232 .4877 18.013 . Table 4. θ ˆ 2β 3 β2 . excluding the coefficients on the state dummy variables. the restricted standard deviation estimate is σ = .070 .1 OLS Estimates of Linear Equation for Log(Wage) ˆ β 1. but not equal. Ignoring the other coefficients.008 .102 −. as the 1% critical value for the χ2 distribution is 76.00002 . 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. we find Wn = 550.027 . Wn = n 1 − 2 = 18.49452 σ ˜ Notice that the two statistics are close. The available sample is 18.033 −.69. 50 Another interesting question which can be addressed from these estimates is the maximal impact of experience on mean wages.102 −.00057 . Using either statistic the hypothesis is easily rejected.014 .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.001 .121 −.097 −. if β 2 > 0 and β 3 < 0 the solution is θ=− From Table 4. The F form of the Wald statistic (6. Computing the Wald statistic (6. reestimating the model with the 50 state dummies excluded. this adds 50 regressors).4945.808 .34 ˆ s(β) .007 .101 .010 .variable for state of residence (including the District of Columbia.18) that the state coefficients are jointly zero. 808 1 − .19) is ˜ µ ¶ µ ¶ σ2 ˆ .1.002 .1 we find the point estimate ˆ ˆ = − β 2 = 28. Alternatively.032 . 2β 3 68 .48772 = 515.808 so the parameter estimates are quite precise and reported in Table 4.

29.Using the Delta Method.0. but it can be found numerically quite easily. Notice that the upper end of the confidence interval is the same as that from the delta method. there is not a simple expression for this set.5].5]. we found better Type I error rates by reformulating the hypothesis as a linear restriction. so we have to go one step further. 69 . 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. In the present context we are interested in forming a confidence interval.9. This set is [27.96. this is a poor choice. but the lower end is substantially lower.40. not testing a hypothesis. Instead. This is the set of θ such that |tn (θ)| ≤ 1. However. as the coverage probability of this confidence interval is one minus the Type I error of the hypothesis test based on the t-test. Our desired confidence interval will be the set of parameter values θ which are not rejected by the hypothesis test. These t-statistics take the form ˆ ˆ β + 2β 3 θ tn (θ) = ³ 2 ´1/2 ˆ h0 V hθ θ hθ = µ −1 2θ ¶ where ˆ ˆ ˆ and V is the covariance matrix for (β 2 β 3 ). 29. we can calculate a standard error of s(ˆ = . Since tn (θ) is a non-linear function of θ.

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

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

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

is the homoskedasticity-formula standard error.

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

. Let η i = e2 .. 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. σ1 We now discuss this estimation problem. However. σ 2 } and σ 2 = σ 2 (x ) = E e2 | x .2) E (ξ i | xi ) = 0. z1i are squares (and perhaps levels) of some (or all) elements of xi . The error ξ i in this regression error ξ i is generally heteroskedastic and has the conditional variance ¡ ¢ V ar (ξ i | xi ) = V ar e2 | xi i ´ ³¡ ¢¢2 ¡ = E e2 − E e2 | xi | xi i i ¡ 4 ¢ ¡ ¡ 2 ¢¢2 = E ei | xi − E ei | xi . The GLS estimator (7... the least-squares estimator is inefficient. . 74 .. Suppose that we model the conditional variance using the parametric form 0 σ 2 = α0 + z1i α1 i = α0 zi . σ 2 }. Typically. where z1i is some q × 1 function of xi . A ˆ ˆn feasible GLS (FGLS) estimator replaces the unknown D with an estimate D = diag{ˆ 2 . we know that the least-squares estimator is semi-parametrically efficient for the projection coefficient. The GLS estimator is sometimes called where D = diag{σ 1 i i n i i the Aitken estimator.Chapter 7 Additional Regression Topics 7. ..1) XD Y β = X 0 D−1 X ¡ ¢ 2 .1) infeasible since the matrix D is unknown. in the linear regression model yi = x0 β + ei i E (ei | xi ) = 0. Then i 0 E (η i | xi ) = α0 + z1i α1 0 η i = α0 + z1i α1 + ξ i and we have the regression equation (7.1 Generalized Least Squares In the projection model. Often the functional form is kept simple for parsimony.

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

Its asymptotic variance is not that given in Theorem 7. We just state the result without proof. i ˜ 0 is inconsistent for V . In the linear regression model. ¢¢−1 ¡ ¡ . Since the form of the skedastic regression is unknown.1 If the skedastic regression is correctly specified.that there is a need to bound the estimated variances away from zero. This estimator V 0 is appropriate when the skedastic regression (7.. 1992). First. V ).1. A trimming rule might make sense: σ 2 = max[˜ 2 .. FGLS is asymptotically superior to OLS. This is an estimator which is robust to misspecification of the condie1 ˆn tional variance. Unless σ 2 = α0 zi . ´ √ ³ ˜ ˜ n β GLS − β F GLS →p 0. and thus where ´ √ ³ ˜ n β F GLS − β →d N (0. V = E α0 zi i i Examining the asymptotic distribution of Theorem 7.2) is correctly specified. σ 2 ] σi i for some σ 2 > 0.1. V ˜ An appropriate solution is to use a White-type estimator in place of V 0 . ´´−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 . V n n i=1 .. e2 }. This may be written as !−1 à n !à n !−1 à 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 → ∞. the natural estimator of the asympˆ totic variance of β is à n !−1 µ ¶−1 1 X −2 0 1 0 ˜ −1 ˜0 = XD X σ i xi xi ˜ = .1. and was proposed by Cragg (Journal of Econometrics.1.1. . V = E σ −2 xi x0 i i ˆ where D = diag{ˆ2 . It is possible to show that if the skedastic regression is correctly specified. β should perhaps be i i called a quasi-FGLS estimator of β. Theorem 7. but the proof of this can be tricky. There are three reasons. In this case we interpret α0 zi as a linear projection of e2 on zi . Instead. then FGLS is asymptotically equivalent to GLS. 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. similar to the covariance matrix of the OLS estimator. and it may be estimated with considerable 76 V takes a sandwich form√. It may be the case that α0 zi is only an approximation to the true conditional variance σ 2 = i ˜ E(e2 | xi ).

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

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

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

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

let Y be a continuous random variable. Let ¯ 1 X¯ ¯yi − x0 β ¯ Ln (β) = i n i=1 n be the average of absolute deviations. The least absolute deviations (LAD) estimator of β minimizes this function ˆ β = argmin Ln (β) β Equivalently. Let m(x) = M ed (Y | X = x) denote the conditional median of Y given X = x. These facts definitions motivate three estimators of θ.10) The LAD estimator has the asymptotic distribution 81 .To recall the definition and properties of the median. however. Now let’s consider the conditional median of Y given a random variable X.5. 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) . it is a solution to the moment condition ³ ´ 1X ˆ xi sgn yi − x0 β = 0. Two useful facts about the median are that (7. Conditional analogs of the facts about the median are • P (yi ≤ x0 β 0 | xi = x) = P (yi > x0 β | xi = x) = . as i=1 these estimators are indeed identical. The second is the value which minimizes n n |yi − θ| . The linear median regression model takes the form yi = x0 β + ei i M ed (ei | xi ) = 0 In this model. The median θ0 = M ed(Y ) is the value such that P (Y ≤ θ0 ) = P (Y ≥ θ0 ) = . i n n i=1 (7.5 • E (sgn (ei ) | xi ) = 0 • E (xi sgn (ei )) = 0 • β 0 = minβ E |yi − x0 β| i These facts motivate the following estimator. and the substantive assumption is that the median function is linear in x. and let M ed (Y | X) = m(X) be this function evaluated at the random variable X. These distinctions are illusory.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. The first definition is the 50th empirical 1 P quantile.

Exi x0 ) i i=1 since Egi (β 0 )gi (β 0 )0 = Exi x0 . we provide a sketch here for completeness. V ). ˆ Proof of Theorem 7.1) n X √ −1/2 n (g n (β 0 ) − g(β 0 )) = −n gi (β 0 ) →d N (0. This can be done with kernel estimation techniques. and this improves estimation of the median. ∂β 0 so Third. ¢¢−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) . ∂ 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 ) .1 ´ √ ³ˆ n β − β 0 →d N (0. the height of the error density at its median. In the special case where the error is independent of xi . then f (0 | x) = f (0) and the asymptotic variance simplifies V = (Exi x0 )−1 i 4f (0)2 (7.1: Since sgn (a) = 1 − 2 · 1 (a ≤ 0) . Pn −1 0 β)) .5. First. by a Taylor series expansion and the fact g(β 0 ) = 0 82 . Let g(β) = Eg (β). When f (0 | x) is large.5.5.11) This simplification is similar to the simplification of the asymptotic covariance of the OLS estimator under homoskedasticity. Second using the law of iterated expectations and the chain rule of i differentiation.11). While a complete proof of Theorem 7. where V = and f (e | x) is the conditional density of ei given xi = x. Computation of standard error for LAD estimates typically is based on equation (7. by the central limit theorem (Theorm 5.1 is advanced. We need where g n (β) = n i i=1 gi (β) and gi (β) = xi (1 − 2 · 1 (yi ≤ xi three preliminary result.Theorem 7.10) is equivalent to g n (β) = 0. See Chapter 16. The main difficulty is the estimation of f (0).3. ∂β ˆ g(β) ' ´ ³ ∂ ˆ g(β 0 ) β − β 0 . (7. the conditional density of the error at its median. then there are many innovations near to the median.

Exi x0 ) →d i 2 = N (0. As functions of x. (7.9) for the median to all quantiles. then F (Qτ ) = τ .5. The third line follows from an asymptotic empirical process argument. The median is the special case τ = . V ).12) Qτ = argmin Eρτ (U − θ) .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. If the random variable U has τ ’th quantile Qτ . xi ) with conditional distribution function F (y | x) the conditional quantile function qτ (x) is Qτ (x) = inf {y : F (y | x) ≥ τ } . 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)) .13) This generalizes representation (7. then F (Qτ (x) | x) = τ . For τ ∈ [0. For fixed τ . the quantile regression function qτ (x) describes how the τ ’th quantile of the conditional distribution varies with the regressors. For the random variables (yi .6 Quantile Regression The method of quantile regression has become quite popular in recent econometric practice. However for computational convenience it is typical to assume that they are (approximately) linear in x (after suitable transformations). so you can think of the quantile as the inverse of the distribution function. This linear specification assumes that Qτ (x) = β 0 x where the coefficients β τ τ vary across the quantiles τ . Again. when F (y | x) is continuous and strictly monotonic in y. 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. ¥ 7. The quantile Qτ is the value such that τ (percent) of the mass of the distribution is less than Qτ . The following alternative representation is useful. then (7. We then have the linear quantile regression model yi = x0 β τ + ei i 83 . the quantile regression functions can take any shape.

When the error ei is independent of xi .6. and we have the simplification Vτ = τ (1 − τ ) ¡ ¡ 0 ¢¢−1 . A asymptotic distribution theory for the quantile regression estimator can be derived using similar arguments as those for the LAD estimator in Theorem 7.1. fast linear programming methods have been developed for this problem.where ei is the error defined to be the difference between yi and its τ ’th conditional quantile x0 β τ .1 n β τ − β τ →d N (0. n numerical methods are necessary for its minimization. where and f (e | x) is the conditional density of ei given xi = x. and form a Wald statistic i for γ = 0.12). ¡ ¡ ¢¢−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. Furthermore. ˆ Given the representation (7. it is useful to have a general test of the adequacy of the specification. then f (0 | xi ) = f (0) . Another popular approach is the RESET test proposed by Ramsey (1969). Fortunately. since it has discontinuous derivatives.5. and are widely available.13). 7. Since the quanitle regression criterion function Lτ (β) does not have an algebraic solution. ´ √ ³ˆ Theorem 7. the τ ’th conditional quantile of ei is zero. otherwise its properties are unspecified without further restrictions. E xi xi f (0)2 A recent monograph on the details of quantile regression is Koenker (2005). One simple test for neglected nonlinearity is to add nonlinear functions of the regressors to ˆ ˆ the regression. the asymptotic variance depends on the conditional density of the quantile regression error. if the model yi = x0 β + ei has i been fit by OLS. Vτ ).7 Testing for Omitted NonLinearity If the goal is to estimate the conditional expectation E (yi | xi ) . The null model is yi = x0 β + εi i 84 . 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. i By construction. the quantile regression estimator β τ for β τ solves the minimization problem ˆ β τ = argmin Lτ (β) n β∈Rk n where Lτ (β) = n and ρτ (q) is defined in (7. and test their significance using a Wald test. Thus. conventional Newton-type optimization methods are inappropriate. the unconditional density of ei at 0.

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

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

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

β 3 = · · · = β K = 0 . In the latter case.. In the ordered case. log(n) µ LRn > k2 | M2 log(n) ¶ ´ ³ c P M = M2 | M2 = P → 1. Also under M2 .. and 220 = 1. Similarly for ˆ the BIC. . 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 ) = 1.15). a full-blown implementation of the BIC selection criterion would seem computationally prohibitive. . E (εi | xi ) = 0 and the question is which subset of the coefficients are non-zero (equivalently. β 2 6= 0. MK : β 1 6= 0. However. β K 6= 0. there are 2K such models. We have discussed model selection between two models.17). . In the unordered case. For example. . which are nested. . 048. . β 2 = β 3 = · · · = β K = 0 M2 : β 1 6= 0. one can show that thus LRn →p ∞.. which can be a very large number. The AIC selection criteria estimates the K models by OLS. a model consists of any possible subset of the regressors {x1i . the models are M1 : β 1 6= 0. 210 = 1024. selecting based on (7. The general problem is the model yi = β 1 x1i + β 2 x1i + · · · + β K xKi + εi . . xKi }. β 2 6= 0. and then selects the model with the lowest AIC (7. which regressors enter the regression). There are two leading cases: ordered regressors and unordered. 88 . The methods extend readily to the issue of selection among multiple regressors. 576. stores the residual variance σ 2 for each model.

xi ) be a random sample with E(Y | X) = Xβ. V . You wish to forecast an out-of-sample value of y given that ˆ ˆ ˆ ˆ X = x. ˆ (a) Find a point forecast of y. . x. in which situations would you expect that β would perform better than OLS? 89 (a) Why is this a reasonable estimator for σ 2 ? ¡ ¢−1 0 −1 XΩ . Let σ 2 be the estimate of σ 2 . the residuals e. For any predictor g(xi ) for y. and the out-of-sample value of the regressors. In the homoskedastic regression model Y = Xβ + e with E(ei | xi ) = 0 and E(e2 | xi ) = σ 2 . the estimates (β.. Show that the function g(x) which minimizes the MAE is the conditional median M (x). ji ˜ (a) In which contexts would β be a good estimator? ˜ (b) Using your intuition. 5.12). Let θ satisfy Eg(Yi − θ) = 0. In a linear model Y = Xβ + e. where xji is one of the xi . based on a sample of size n. the GLS estimator is ¡ ¢−1 ¡ 0 −1 ¢ ˜ β = X 0 Ω−1 X XΩ Y . Consider the Weighted Least Squares (WLS) estimator of β ¢−1 ¡ 0 ¢ ¡ ˜ X WY β = X 0W X where W = diag(w1 . . 2. Let (yi . σ 2 ). V ar(e | X) = σ 2 Ω with Ω known. Is θ a quantile of the distribution of Yi ? 3. ˜ the residual vector is e = Y − X β. 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 .7... and an estimate of σ 2 is ˆ s2 = 1 e0 Ω−1 e. Thus the available information is the sample (Y. E(e | X) = 0. i ˆ ˆ suppose β is the OLS estimate of β with covariance matrix V . Verify equation (7.10 Exercises 1. ˆ ˆ n−k 6. 4. else equals zero). the mean absolute error (MAE) is E |yi − g(xi )| . Define g(u) = τ − 1 (u < 0) where 1 (·) is the indicator function (takes the value 1 if the argument is true. X). (b) Prove that e = M1 e. wn ) and wi = x−2 . (b) Find an estimate of the variance of this forecast.

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

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

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

1). In general. Notationally. xi ). x∗ ≤ x) = Fn (y. Thus by the WLLN (Theorem 5. the EDF is only a crude approximation to the CDF.8..2.. x)) →d N (0.1). x))) . and 100. but the approximation appears to improve for the large n. To see this. note that for any (y. I have plotted the EDF and true CDF for three random samples of size n = 25. x∗ ) with the i distribution Fn . F (y.1: Empirical Distribution Functions The EDF is a valid discrete probability distribution which puts probability mass 1/n at each ∗ pair (yi . x) →p F (y. x). the EDF step function gets uniformly close to the true CDF. x) = P (yi ≤ y.. Fn (y. where 1(·) is the indicator function. it is helpful to think of a random pair (yi . x) . xi ≤ x) = E (1 (yi ≤ y) 1 (xi ≤ x)) . as the sample size gets larger. in the Figure below. This is a population moment. The EDF is a consistent estimator of the CDF. Fn is by construction a step function. 50. √ n (Fn (y. ∗ P (yi ≤ y. Recall that F (y. To see the effect of sample size on the EDF.3. x) − F (y.2 The Empirical Distribution Function Fn (y. Furthermore. i = 1. x) (1 − F (y. Fn is a nonparametric estimate of F. i 93 . . x) = n i=1 Figure 8. For n = 25. 1 (yi ≤ y) 1 (xi ≤ x) is an iid random variable with expectation F (y. 1) distribution. Note that while F may be either discrete or continuous. by the CLT (Theorem 5. The method of moments estimator is the corresponding sample moment: n 1X 1 (yi ≤ y) 1 (xi ≤ x) . (8. The random draws are from the N (0. x) is called the empirical distribution function (EDF).2) Fn (y. x). n. x). That is.

n X i=1 ∗ h (yi . Fn ) is calculated for each bootstrap sample.) at the sample estimate ˆ θ. in principle the distribution G∗ n ∗ ∗ could be calculated by direct methods. yn . This is i equivalent to sampling a pair (yi . as there are 2n possible samples {(y1 . x∗ . When the statistic Tn³is a function of F. Typically θn = θ. 94 The bias of ˆ is θ ... As the bootstrap statistic replaces F with θ θ) ˆ Fn . However. It is desireable for B to be large. xi ) . x∗ ) . x∗ = xi ) i n 1X h (yi ...2) as the estimate Fn of F. The algorithm is identical to our discussion of Monte Carlo simulation. .. x∗ . so long as the computational costs are reasonable. ∗ ∗ ∗ The bootstrap statistic Tn = Tn (y1 . it similarly replaces θ with θn . ∗ • The random vectors (yi . xi ) P (yi = yi .. yn . Since Fn is a discrete probability distribution putting probability mass 1/n at each sample point. the parameter ˆ estimate. B = 1000 typically suffices.∗ We can easily calculate the moments of functions of (yi .. with the following points of clarification: • The sample size n used for the simulation is the same as the sample size..4 Bootstrap Estimation of Bias and Variance θ τ n = E(ˆ − θ0 ).. Sampling from the EDF is particularly easy. x∗ } will necessarily have some ties and multiple values. Since the EDF Fn is a multinomial (with n support points). the t-ratio ˆ − θ /s(ˆ depends on θ. In consequence. x∗ )}. which is generally n 1 not a problem. it is typically through dependence on a parameter. xi ) randomly from the sample. The popular alternative is to use simulation to approximate the distribution. ´ For example. x) i = = the empirical sample average. (When in doubt use θ. x∗ ) : i Z ∗ Eh (yi . the value of θ implied by Fn . . A theory for the determination of the number of bootstrap replications B has been developed by Andrews and Buchinsky (2000). (yn . x∗ )) = h(y.3 Nonparametric Bootstrap The nonparametric bootstrap is obtained when the bootstrap distribution (8. B is known as the number of bootstrap replications. 8. x∗ ) are drawn randomly from the empirical distribution. a bootstrap ∗ ∗ sample {y1 . n 1 such a calculation is computationally infeasible. sampling from the EDF is equivalent to random sampling a pair (yi . . n i=1 8.1) is defined using the EDF (8. n i This is repeated B times. x∗ . x)dFn (y. xi ) from the observed data with replacement.

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

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

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

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

If θ is a vector. C4 is called the symmetric percentile-t interval. 99 . about the rate v of convergence.3 an = o(n−r ) if nr |an | → 0 as n → ∞. an = O(n−r ) if it declines to zero like n−r . The derivative of an even function is odd. n ´ ³ ∗ ³ ∗ θ θ Note in the simulation that the Wald statistic is a quadratic form in ˆ − ˆ .8. v 2 ). Definition 8. then to test H0 : θ = θ0 against H1 : θ 6= θ0 at size α.8. writing Tn ∼ Gn (x. F ) then ³x´ .8 Asymptotic Expansions Tn →d N (0.3) ´ √ ³ˆ If Tn = n θ − θ0 then v = V while if Tn is a t-ratio then v = 1. A better asymptotic approximation may be obtained through an asymptotic expansion. θ [This is a typical mistake made by practitioners. we would use a Wald statistic ³ ´ ³ ´0 ˆ θ Wn (θ) = n ˆ − θ Vθ−1 ˆ − θ θ or some other asymptotically chi-square statistic. Definition 8.1 an = o(1) if an → 0 as n → ∞ Definition 8. lim Gn (x.∗ where qn (α) is the bootstrap critical value for a two-sided hypothesis test. Basically. Equivalently. F ) = Φ n→∞ v or ³x´ Gn (x. Let an be a sequence. The following notation will be helpful. where qn (α) is the (1 − α)% quantile of the distribution of Wn . The bootstrap test ∗ ∗ rejects if Wn ≥ qn (α). and a function h(x) is odd if h(−x) = −h(x).2 an = O(1) if |an | is uniformly bounded. Thus here Tn (θ) = Wn (θ).4) says that Gn converges to Φ x as n → ∞.4) v ¡ ¢ While (8. and vice-versa. it says nothing. The ideal test rejects if Wn ≥ qn (α). or the size of the divergence for any particular sample size n. not ˆ − θ0 . (8. Let Tn be a statistic such that (8. where qn (α) is the (1 − α)% quantile of the distribution of ³ ∗ ³ ∗ ´0 ´ ∗ Wn = n ˆ − ˆ Vθ∗−1 ˆ − ˆ . We say that a function g(x) is even if g(−x) = g(x).8. It is designed to work well since ³ ´ P (θ0 ∈ C4 ) = P ˆ − s(ˆ n (α) ≤ θ0 ≤ ˆ + s(ˆ n (α) θ θ)q ∗ θ θ)q ∗ ∗ = P (|Tn (θ0 )| < qn (α)) ' P (|Tn (θ0 )| < qn (α)) = 1 − α. however. θ θ θ ˆ θ ∗ ∗ Computationally. the critical value qn (α) is found as the quantile from simulated values of W´ .] 8. F ) = Φ + o (1) .

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

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

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

There are different ways to impose independence.Hence the order of the error is O(n−1/2 ). A parametric i method is to generate the bootstrap errors ε∗ from a parametric distribution.. and works in nearly any context. and then create i i ∗ = x∗0 β + ε∗ .. . Therefore if standard errors are available. en }. Fn ). 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. 2002) tends to advocate the use of the percentile-t bootstrap methods rather than percentile methods. where Fn is the EDF. ∗ The non-parametric bootstrap distribution resamples the observations (yi . Hall. such as the normal i ˆ ε∗ ∼ N (0. But since it is fully nonparametric. it is unclear if there are any benefits from using the percentile bootstrap over simple asymptotic methods. the theoretical literature (e. x∗ ) from the EDF. A non-parametric method is ˆ yi i i e ˆ to sample the bootstrap errors ε∗ randomly from the OLS residuals {ˆ1 . i i The the bootstrap distribution does not impose the regression assumption. a nonparametric method is to sample the x∗ randomly from the EDF i i or sample values {x1 . This is equivalent to treating the regressors as fixed i in repeated samples. It is no better than the rate obtained from an asymptotic one-sided confidence region.) One approach to this problem is to impose the very strong assumption that the error εi is independent of the regressor xi . i which implies ∗ ˆ yi = x∗0 β + ε∗ i i E (x∗ ε∗ ) = 0 i i but generally E (ε∗ | x∗ ) 6= 0. it is 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. and is thus an inefficient estimator of the true distribution (when in fact the regression assumption is true. σ 2 ). the percentile bootstrap methods provide an attractive inference method. We discuss some bootstrap methods appropriate for the case of a regression model where yi = x0 β + εi i E (ei | xi ) = 0. If this is done. xn }. A parametric method is to sample x∗ from an estimated parametric i distribution. A third approach sets x∗ = xi . Based on these arguments. 8.12 Bootstrap Methods for Regression Models The bootstrap methods we have discussed have set G∗ (x) = Gn (x. it imposes no conditions.. 1992.. i For the regressors x∗ . then all inferential statements are made conditionally on the 103 .g. n Any other consistent estimate of F0 may be used to define a feasible bootstrap estimator. √ The good news is that the percentile-type methods (if appropriately used) can yield nconvergent asymptotic inference. To impose independence. Horowitz.. it may be inefficient in contexts where more is known about F. The advantage of the EDF is that it is fully nonparametric. . The bad news is that the rate of convergence is disappointing. The advantage is that in this case it is straightforward to construct bootstrap distributions..

F0 (x) (1 − F0 (x))) . whether or not the xi are really “fixed” or random. yn } with µ = Eyi and σ 2 = V ar(yi ). 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 ... Take a random sample {y1 . . Tn = (ˆ − ˆ 104 . creating a random bootstrap data set (Y ∗ ... Using the non-parametric bootstrap. ˆ 3. Let Fn (x) denote the EDF of a random sample. yielding OLS estimates β and any other statistic of interest. Let the statistic of interest be the sample mean Tn = y n . Show that √ n (Fn (x) − F0 (x)) →d N (0.13 Exercises 1.. This can be achieved using a two-point distribution of the form à à √ ! ! √ 1+ 5 5−1 ∗ √ ei ˆ = P εi = 2 2 5 à à √ ! ! √ 1− 5 5+1 ∗ √ P εi = = ei ˆ 2 2 5 For each xi . One proposal which imposes the regression condition without independence is the Wild Bootstrap. Unfortunately this is a harder problem. ˆi A conditional distribution with these features will preserve the main important features of the data. which is a valid statistical approach.observed values of the regressors. 2. you sample ε∗ using this two-point distribution. Let β denote the ˆ the OLS residuals. Find the bootstrap moments ETn and V ar(Tn ). calculate the estimate ˆ on these samples and then calculate θ ∗ ∗ θ θ)/s(ˆ θ). Consider the following bootstrap procedure. OLS estimator from the regression of Y on X.. Set y∗ = x∗0 β + e∗ . It does not really matter. . Typically what is desirable is to impose only the regression condition E (εi | xi ) = 0.. ei ) : i = 1. 2. ˆ∗ (b) Regress Y ∗ on X ∗ .. . . however.. yn } be a random sample from the empirical distribution function and let Tn = y ∗ be n ∗ ∗ its sample mean. e∗ ) from the pair {(xi . Show that this bootstrap procedure is (numerically) identical to the non-parametric bootstrap.. and set x∗ = xi0 and e∗ = ei0 . Let ∗ ∗ ∗ {y1 . ˆ Draw (with replacement) n such vectors. That is. Find the population moments ETn and V ar(Tn ). generate ∗ bootstrap samples. and e = Y − X β ˆ (a) Draw a random vector (x∗ . n} . n]. 4.. Consider the following bootstrap procedure for a regression of yi on xi .. draw a ˆ ˆ random integer i0 from [1. The methods discussed above are unattractive for most applications in econometrics because they impose the stringent assumption that xi and εi are independent. i 8. X ∗ ).

dat contains data on house prices (sales). Calculate 95% confidence intervals for the regression coefficients using both the asymptotic normal approximation and the percentile-t bootstrap. Estimate a linear regression of price on the number of bedrooms. ˆ = 1.2.95). The datafile hprice1. You do this as follows. You replace c with qn (. Using the non-parametric bootstrap.05) and qn (.3. Suppose that in an application. and the 2. (b) Report the 95% Alternative Percentile interval for θ.95) denote the 95% quantile of Tn . you generate bootstrap samples.95). Using the non-parametric ∗ bootstrap. with variables listed in the file hprice1.5% quantiles of the ˆ are . θ respectively. can you report the 95% Percentile-t interval for θ? 7.95). ˆ − s(ˆ n (. and the colonial dummy. (c) With the given information. 105 . lot size. What is wrong with this procedure? Tn = θ/s(θ) n 6. Let qn (.5% and 97. ∗ ∗ ∗ Let qn (.95) denote the 5% θ) ∗ and 95% quantiles of Tn . (a) Report the 95% Efron Percentile interval for θ. θ θ)q ∗ θ θ)q ∗ θ/s(θ) 5.Show that C exactly equals the Alternative percentile interval (not the percentile-t interval). ∗ ∗ where s(ˆ is the standard error in the original data. calculate the estimates ˆ on these samples and θ then calculate ∗ ∗ ∗ θ θ Tn = ˆ /s(ˆ ). and define the bootstrap confidence interval h i C = ˆ − s(ˆ n (. size of house. and thus reject H0 if ˆ ˆ > q ∗ (. You want to test H0 : θ = 0 against H1 : θ > 0.2 and s(ˆ = .05) .75 and 1. θ θ) ∗ 1000 samples are generated from the bootstrap distribution. and ˆ is calculated on each θ ∗ ∗ θ sample. The test for H0 is to reject if Tn = ˆ ˆ > c where c is picked so that Type I error is α. The ˆ are sorted.pdf.

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

2. 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 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. the square of the Euclidean length. β ˆ Note that if k = . Proposition 9. β GMM = Z 0 XWn X 0 Z 9. The GMM estimator minimizes Jn (β). but this is generally not possible when > k. Let and where gi = xi ei . for if Wn is replaced ˆ by cWn for some c > 0. ˆ Definition 9.9.1 β GMM = argmin Jn (β). For some × weight matrix Wn > 0. The idea of the generalized method of moments (GMM) is to define an estimator which sets g n (β) “close” to zero. Jn (β) = n · g n (β)0 g n (β) = n · |g n (β)|2 . β GMM does not change. and the GMM estimator is the MME. the dependence is only up to scale. This is a non-negative measure of the “length” of the vector g n (β).2. let Jn (β) = n · g n (β)0 Wn g n (β). ¡ ¢−1 0 ˆ Z XWn X 0 Y. if Wn = I. i i .3 Distribution of GMM Estimator ¡ 0¢ Q = E xi zi Assume that Wn →p W > 0.2) g n (β) = (9. For example.2 GMM Estimator n n ¢ 1¡ 0 ¢ 1X 1X ¡ 0 X Y − X 0 Zβ . 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 .1 ˆ 2Z 0 XWn X 0 Z β = 2Z 0 XWn X 0 Y While the estimator depends on Wn . then.3) The method of moments estimator for β is defined as the parameter value which sets g n (β) = 0.

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

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

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

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

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

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

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

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

116 . Take the linear model 0 yi = zi β + ei E (xi ei ) = 0.7. Let ˆ ˆ ˆ Jn = ng n (β)0 Ω−1 g n (β) denote the test of overidentifying restrictions. 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 . ˆ and consider the GMM estimator β of β. 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. l−k Hint: Il − R (R0 R)−1 R0 is a projection matrix..

1) i=1 First let us consider a just-identified model.. The maximum likelihood estimator of the probabilities (p1 ..2) Ln (p1 .1 Non-Parametric Likelihood Since each observation is observed once in the sample. It is a non-parametric analog of likelihood estimation. The multinomial distribution which places probability pi at each observation (yi . pn ) = i=1 An alternative to GMM is empirical likelihood. In this case the moment condition places no additional restrictions on the multinomial distribution.Chapter 10 Empirical Likelihood 10.. (10.. β). . .. . zi ) will satisfy this condition if and only if n X pi gi (β) = 0 (10. xi .. pn ) are those which maximize the log-likelihood subject to the constraint (10.1). xi . The idea is due to Art Owen (1988. The n first order conditions are 0 = p−1 − µ. 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) we find that the MLE is pi = n−1 yielding the log-likelihood −n log(n). To be a valid multinomial distribution.. This is equivalent to maximizing à n ! n X X log(pi ) − µ pi − 1 i=1 i=1 where µ is a Lagrange multiplier. zi . The idea is to construct a multinomial distribution F (p1 . Combined with i the constraint (10.3) i=1 117 . (10. 2001) and has been extended to moment condition models by Qin and Lawless (1994). pn ) which places probability pi at each observation. the log-likelihood function for this multinomial distribution is n X ln(pi ). these probabilities must satisfy the requirements that pi ≥ 0 and n X pi = 1..

summing over i. The solution (when it exists) is well defined since Rn (β.5) This minimization problem is the dual of the constrained maximization problem. λ) is a convex function of λ.3). Ln (β) = Rn (β. we find µ = n and 1 ¢. λ ¡ ¢ ln 1 + λ0 gi (β) . the Lagrange multiplier λ(β) minimizes Rn (β. or equivalently minimizes its negative ˆ (10. λ). (see section 6. λ(β)) = −n ln (n) − n X i=1 ˆ The EL estimate β is the value which maximizes Ln (β). p1 . λ. pn . probabilities 1 ³ ´´ .5).2) subject to the restrictions (10. pi = ³ ˆ ˆ ˆ0 n 1 + λ gi β ˆ Ln = n X i=1 ln (ˆi ) .5) ˆ ˆ As a by-product of estimation. we also obtain the Lagrange multiplier λ = λ(β). (10.4) (10.1) and (10. λ) = −n ln (n) − n X i=1 For given β. p (10. The solution cannot be obtained explicitly. Multiplying the first equation by pi . 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. This yields the (profile) empirical log-likelihood function for β. The Lagrangian for this maximization problem is à n ! n n X X X ln(pi ) − µ pi − 1 − nλ0 pi gi (β) L∗ (β.7) 118 .. µ) = n i=1 i=1 i=1 L∗ n with respect to pi .. but must be obtained numerically (see section 6..6) β = argmin [−Ln (β)] β ¡ ¢ ln 1 + λ(β)0 gi (β) and maximized empirical likelihood ˆ Numerical methods are required for calculation of β. pi = ¡ n 1 + λ0 gi (β) Substituting into L∗ we find n Rn (β. and using the second and third equations.where λ and µ are Lagrange multipliers. . pi gi (β) = 0. µ. λ) : λ(β) = argmin Rn (β.

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 (10.14) 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 . λ) = − (10. Gi (. ˆ ˆ Proof. i i Theorem 10.10). g n = n n gi (β 0 ) and Ωn = n n g (β 0 ) gi (β 0 )0 . 0 = Rn (β. λ) jointly solve ³ ´ ˆ n gi β X ∂ ³ ³ ´´ Rn (β.13) Premultiplying by G0 Ω−1 and using (10. ´ √ ³ ˆ n β − β 0 →d √ ˆ nλ →d N (0.2 Define Asymptotic Distribution of EL Estimator Gi (β) = ∂ gi (β) ∂β 0 (10.9) (10. G = −E (xi zi ). (β.10) ¡ Ω−1 N (0.12) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ 0 ' G0 λ − λ0 . β) = −xi zi .13) yields n n Expanding (10. β λ ∂ ³ ´.1 Under regularity conditions.11) 0 = ∂λ ˆ0 ˆ i=1 1 + λ gi β ³ ´0 ˆ n X Gi . Thus the EL estimator is asymptotically efficient.10. in the linear model. Vλ ) ´ √ ˆ √ ³ˆ where V and Vλ are defined in (10. and Ω = E xi x0 e2 . n (10. λ) = − (10.2.9) and (10.8) and ¢ 0 0 For example. and n β − β 0 and nλ are asymptotically independent. ˆ The asymptotic variance V for β is the same as for efficient GMM.12) ∂β ˆ ˆ0 i=1 1 + λ gi β 1 P 1 P 1 P Let Gn = n n Gi (β 0 ) .11) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ ˆ 0 ' −g n − Gn β − β 0 + Ωn λ (10. i=1 i=1 i=1i Expanding (10.

since ³ ¡ ¢−1 0 ´ G0 I − Ω−1 G G0 Ω−1 G G =0 (10. (10. β ' n g n + Gn β − β 0 n i=1 ³ ¡ ¢−1 0 −1 ´ √ Gn Ωn ng n ' I − Gn G0 Ω−1 Gn n n √ ˆ ' Ωn nλ. LRn = i=1 Theorem 10. The overidentification test is a very useful by-product of EL estimation. β 0 ) = 0 then LRn →d χ2−k . Since the EL estimator achieves this bound. Twice the difference between the unrestricted empirical likelihood −n log (n) and the maximized empirical likelihood for the model (10. and it is advisable to report the statistic LRn whenever EL is the estimation method. Vλ ) Furthermore. tests are based on the difference in the log likelihood functions. 120 . and have the same interpretation.15).15) (10. by a Taylor expansion.16) ´ √ ˆ √ ³ˆ n β − β 0 and nλ are asymptotically uncorrelated and hence independent.1 If Eg(wi . ¥ Chamberlain (1987) showed that V is the semiparametric efficiency bound for β in the overidentified moment condition model. The EL overidentification test is similar to the GMM overidentification test.3 Overidentifying Restrictions In a parametric likelihood context.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. This means that no consistent estimator for this class of models can have a lower asymptotic variance than V . n ³ ´´ ´ √ ³ 1 X ³ ˆ ˆ √ g wi . Ω) →d Ω−1 I − G G Ω G GΩ = Ω−1 N (0. V ) ˆ Solving (10.7) is n ³ ´´ ³ X ˆ ˆ0 (10. it is an asymptotically efficient estimator for β.14) for λ and using (10.16). Proof.ˆ Solving for β and using the WLLN and CLT yields ´ ¢−1 0 −1 √ ¡ √ ³ ˆ ' − G0 Ω−1 Gn n β − β0 Gn Ωn ng n n n ¡ 0 −1 ¢−1 0 −1 G Ω N (0.3. Ω) GΩ G →d = N (0. First. and (10. They are asymptotically first-order equivalent.17) 2 ln 1 + λ gi β . 10. The same statistic can be constructed for empirical likelihood.

prc 121 . The hypothesis of interest is h(β) = 0.5 Numerical Computation Gauss code which implements the methods discussed below can be found at http://www.1 Under (10.4. 10.wisc. The restricted EL estimator and likelihood are the values which solve ˜ β = argmax Ln (β) h(β)=0 ˜ ˜ Ln = Ln (β) = max Ln (β). To test the hypothesis h(β) while maintaining (10.17) is not appropriate.18) and H0 : h(β) = 0.Second. Theorem 10. where h : Rk → Ra . since ln(1 + x) ' x − x2 /2 for x small. so there is no fundamental change in the distribution theory for β relative to β. the simple overidentifying restrictions test (10.18) Let the maintained model be where g is × 1 and β is k × 1. Vλ )0 Ω−1 N (0. 10.18). Vλ ) ¥ where the proof of the final equality is left as an exercise. 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. a The proof of this result is more challenging and is omitted. This test statistic is a natural analog of the GMM distance statistic.ssc. LRn →d χ2 . Instead we use the difference in log-likelihoods: ³ ´ ˆ ˜ LRn = 2 Ln − Ln . By “maintained” we mean that the overidentfying restrictions contained in (10.4 Testing Egi (β) = 0 (10.18) are assumed to hold and are not being challenged (at least for the test discussed in this section). the restricted EL estimator β is simply an EL estimator with − k + a overidenti˜ ˆ fying restrictions.edu/~bhansen/progs/elike. h(β)=0 ˜ Fundamentally.

19). λ) = i The first derivatives of (10. λ) gi (β. The iteration (10. λ) G∗ (β. The modified Newton method takes a quadratic approximation to Rn (β.4). δ 4R2 + 4R0 − 8R1 yielding the steplength to be plugged into (10. Efficient convergence requires a good choice of steplength δ. λj ) is smaller than some prespecified tolerance. i Rββ = Inner Loop The so-called “inner loop” solves (10. 1. λ) = − gi (β.20) . The value of δ which minimizes this quadratic is ˆ = R2 + 3R0 − 4R1 . λ) = ∂λ∂λ i=1 ¶ n 2 Xµ ∂ Gi (β) ∗ gi (β. λ) ∂λ i=1 n ∂ Rn (β. λ)0 − Rn (β. 2. λ) = i ∂λ∂β 0 1 + λ0 gi (β) i=1 ⎞ ⎛ ¡ 0 ¢ ∂2 n 2 X 0 gi (β) λ ∂ ⎠ ⎝G∗ (β. λ) = i i ∂β∂β 0 1 + λ0 gi (β) i=1 n where δ > 0 is a scalar steplength (to be discussed next). λ) . (10. λ) yielding the iteration rule λj+1 = λj − δ (Rλλ (β. λj )) Rp = Rn (β. λ)0 0 Rn (β. λj ) . λ) = G∗ (β.4) are Rλ = Rβ = The second derivatives are Rλλ = Rλβ = ¡ Gi (β)0 λ 1 + λ0 gi (β) gi (β) ¢ 1 + λ0 gi (β) X ∂ ∗ Rn (β. One method uses the following quadratic approximation.Derivatives The numerical calculations depend on derivatives of the dual likelihood function (10. λj ))−1 Rλ (β.5) for given β. set 2 λp = λj − δ p (Rλλ (β. Define ∗ gi (β. δ 1 = 1 and δ 2 = 1. λp ) A quadratic function can be fit exactly through these three points. A complication is that λ must be constrained so that 0 ≤ pi ≤ 1 which holds if ¢ ¡ n 1 + λ0 gi (β) ≥ 1 122 (10. λj ))−1 Rλ (β. λ) = − ∂β n X i=1 G∗ (β. λ)0 − ∂β∂β Rn (β. Set δ 0 = 0. The starting value λ1 can be set to the zero vector. λ) G∗ (β..19) X ∂2 ∗ ∗ gi (β. For p = 0.19) is continued until the gradient Rλ (β.

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

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

¶ µ ∙ β2 β1 1 −1 β 2 e1i + β 1 e2i (e1i − e2i ) ¸µ e1i e2i ¶ ˆ Hence if it is estimated by OLS.3) zi = z2i k2 where E(z1i ei ) = 0 yet E(z2i ei ) 6= 0.1) where zi is k × 1. We call (11. So we have the partition µ ¶ z1i k1 (11.4) xi = x2i 2 where z1i = x1i are the included exogenous variables. Thus we make the partition ¶ µ k1 z1i (11. 11. Definition 11. so should be included in xi .2) Any solution to the problem of endogeneity requires additional information which we call instruments. In a typical set-up.1) if E (xi ei ) = 0. We call z1i exogenous and z2i endogenous. (11. That is x2i are variables which could be included in the equation for yi (in the sense 125 .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 ¶ . and x2i are the excluded exogenous variables. this can be written as Y = Zβ + e.1. which does not equal either β 1 or β 2 .1). and assume that E(zi ei ) 6= 0 so there is endogeneity. In matrix notation. β →p β ∗ .1) the structural equation. some regressors in zi will be uncorrelated with ei (for example. By the above definition. z1i is an instrumental variable for (11.1 The × 1 random vector xi is an instrumental variable for (11. at least the intercept).1 Instrumental Variables 0 yi = zi β + ei Let the equation of interest be (11. This is called simultaneous equations bias.

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

11.2

Reduced Form

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

Substituting (11.6) into (11.2), we find

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

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

11.3

Identification

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

11.4

Estimation
0 yi = zi β + ei

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

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

11.5

Special Cases: IV and 2SLS

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

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

which again is the IV estimator.

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

then

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

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

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

By the spectral decomposition of an idempotent matrix. It is also close to zero when α = 0. ¢ 1 ¡ ¢ 1 ¡ ¢ 1 ¡ 0 E Z PX e = E Γ0 X 0 e + E u0 PX e = αS21 . 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 . n and (11. the expression in (11. 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. l . 130 .13). Let q = H 0 ξS −1/2 which satisfies Eqq 0 = In and partition q = (q1 q2 ) where q1 is l × 1.14) In general this is non-zero. The parameter β fails to be identified if Γ22 has deficient rank. 0).12) and this result.14) is the probability limit of β 2SLS − β 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 . Bekker (1994) showed further that under the alternative asymptotic approximation that α is fixed as n → ∞ (so that the number of instruments goes to infinity proportionately with sample ˆ size) then the expression in (11.14) approaches that in (11.7 Identification Failure Recall the reduced form equation Z2 = X1 Γ12 + X2 Γ22 + u2 . Bekker (1994) pointed out that it also has the reverse implication — that when α = l/n is large. except when S21 = 0 (when Z is exogenous).Let PX = X (X 0 X)−1 X 0 . indicating that the bias in 2SLS approaches that of OLS as the number of instruments increases. P = HΛH 0 0 0 where Λ = diag(Il . Indeed as α → 1. the bias in the 2SLS estimator will be large. The consequences of identification failure for inference are quite severe.

as the Cauchy distribution does not have a finite mean. so E (zi xi ) = 0. In addition. meaning that inferences about parameters of interest can be misleading. This occurs when Γ22 is full rank. and was examined by Phillips (1989) and Choi and Phillips (1992). The n−1/2 is picked because it provides just the right balancing to allow a rich distribution theory. We see that β is identified if and only if Γ22 = γ 6= 0. viz Γ22 = n−1/2 C. which occurs i when E (zi xi ) 6= 0.15) therefore ¢¢ ¡ ¡ 1 X 1 X √ xi zi = √ xi ui →d N2 ∼ N 0. but small. This can be handled in an asymptotic analysis by modeling it as local-to-zero. Qc + N2 ˆ As in the case of complete identification failure. N2 since the ratio of two normals is Cauchy. once again take the simple case k = l = 1.16) 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 . we find that β is inconsistent for β and the ˆ is non-normal. the instrument xi is weak for zi if γ = n−1/2 c.16) ˆ β−β = 1 √ n 1 √ n Pn Pn i=1 xi ei i=1 xi zi →d N1 ∼ Cauchy. Here. E x2 u2 i i n n i=1 i=1 n n (11. 131 . Suppose that identification does not complete fail. Then (11. This result carries over to more general settings.Take the simplest case where k = l = 1 (so there is no X1 ). Thus identification hinges on the existence of correlation between the excluded exogenous variable and the included endogenous variable. This is particularly nasty. Suppose this condition fails. but (11. Then by the CLT ¡ ¡ ¢¢ 1 X √ xi ei →d N1 ∼ N 0. where C is a full rank matrix. E x2 e2 i i n i=1 n (11. Then the model may be written as yi = zi β + ei zi = xi γ + ui and Γ22 = γ = E (xi zi ) /Ex2 . To see the consequences.15) is unaffected. but is weak. standard test statistics have non-standard asymptotic distribution of β distributions.

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

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

In this model. (a) Estimate the model by OLS. (b) Now treat Education as endogenous. Estimate the model by 2SLS. (e) Calculate and report the J statistic for overidentification. f atheduc (the education. 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. in years. and the remaining variables as exogenous. of the mother). 134 . (f) Discuss your findings. Does this differ from 2SLS and/or OLS? 7. a dummy indicating that the observation lives near a 4-year college. Report estimates and standard errors.dat is taken from David Card “Using Geographic Variation in College Proximity to Estimate the Return to Schooling” in Aspects of Labour Market Behavior (1995)..pdf. (d) Re-estimate the model by efficient GMM. Report estimates and standard errors. We want to estimate a wage equation log(W age) = β 0 + β 1 Educ + β 2 Exper + β 3 Exper2 + β 4 South + β 5 Black + e where Educ = Eduation (Years) Exper = Experience (Years). I suggest that you use the 2SLS estimates as the first-step to get the weight matrix. and South and Black are regional and racial dummy variables. and then calculate the GMM estimator from this weight matrix without further iteration. Report the estimates and standard errors. of the father) and motheduc (the education. in years. There are 2215 observations with 19 variables. using the instrument near4. 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). are the parameters identified? 8.(b) Define the 2SLS estimator of β. 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 zi as an instrument for xi . 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. The data file card.

12. Because of the sequential nature of time series. then Xt is strictly stationary and ergodic. . Yt−1 .1.. A stationary time series is ergodic if γ(k) → 0 as k → ∞. γ(k) is called the autocovariance function. Definition 12..3 ρ(k) = γ(k)/γ(0) = Corr(Yt .1 Stationarity and Ergodicity Definition 12.1. The primary model for univariate time series is autoregressions (ARs). we expect that Yt and Yt−1 are not independent. 135 . The primary model for multivariate time series is vector autoregressions (VARs).. Yt−k ) is independent of t for all k. t = 1.1 {Yt } is covariance (weakly) stationary if E(Yt ) = µ is independent of t.1. so classical assumptions are not valid. however.Chapter 12 Univariate Time Series A time series yt is a process observed in sequence over time.2 {Yt } is strictly stationary if the joint distribution of (Yt . T .. and use the subscript t to denote the individual observation.1 If Yt is strictly stationary and ergodic and Xt = f (Yt . and multivariate (yt ∈ Rm is vector-valued). Definition 12.. and Cov (Yt .) is a random variable. .. To indicate the dependence on time... There proofs are rather difficult. Definition 12. We can separate time series into two categories: univariate (yt ∈ R is scalar).1. The following two theorems are essential to the analysis of stationary time series.4 (loose). Yt−k ) is the autocorrelation function. Theorem 12. and T to denote the number of observations. . we adopt new notation.1. Yt−k ) = γ(k) is independent of t for all k.

1. ˆ 2.3 If Yt is strictly stationary and ergodic and EYt2 < ∞.1. T t=1 This allows us to consistently estimate parameters using time-series moments: The sample mean: T 1X µ= ˆ Yt T t=1 The sample autocovariance T 1X (Yt − µ) (Yt−k − µ) . T 1X Xt →p E(Xt ). γ (0) ˆ Theorem 12. ρ(k) →p ρ(k). ˆ 3. T t=1 Thus γ (k) →p E(Yt Yt−k ) − µ2 − µ2 + µ2 = E(Yt Yt−k ) − µ2 = γ(k).Theorem 12. note that γ (k) = ˆ T 1X (Yt − µ) (Yt−k − µ) ˆ ˆ T t=1 = T T T 1X 1X 1X Yt Yt−k − Yt µ − ˆ Yt−k µ + µ2 . ˆ Part (3) follows by the continuous mapping theorem: ρ(k) = γ (k)/ˆ (0) →p γ(k)/γ(0) = ρ(k). and it has a finite mean by the assumption that EYt2 < ∞. For Part (2).1. ˆ ˆ γ ¥ 136 . γ (k) →p γ(k). Part (1) is a direct consequence of the Ergodic theorem. then as T → ∞. ˆ ˆ T t=1 T t=1 T t=1 By Theorem 12.2 (Ergodic Theorem).1 above. the sequence Yt Yt−k is strictly stationary and ergodic. If Xt is strictly stationary and ergodic and E |Xt | < ∞. Thus an application of the Ergodic Theorem yields T 1X Yt Yt−k →p E(Yt Yt−k ). ˆ Proof. ˆ ˆ T t=1 γ (k) = ˆ The sample autocorrelation ρ(k) = ˆ γ (k) ˆ . µ →p E(Yt ). then as T → ∞.1.

} is the past history of the series. The MDS property for the regression error plays the same role in a time-series regression as does the conditional mean-zero property for the regression error in a cross-section regression.. Thus for k > 0.. Yt−2 . An autoregressive (AR) model specifies that only a finite number of past lags matter: E (Yt | It−1 ) = E (Yt | Yt−1 .. A useful property of a MDS is that et is uncorrelated with any function of the lagged information It−1 . Regression errors are naturally a MDS. A linear AR model (the most common type used in practice) specifies linearity: E (Yt | It−1 ) = α + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k . we find Yt = et + ρet−1 + ρ2 et−2 + .. We consider the conditional expectation E (Yt | It−1 ) where It−1 = {Yt−1 .12.3 Stationarity of AR(1) Process Yt = ρYt−1 + et . . YT . The last property defines a special time-series process... Some time-series processes may be a MDS as a consequence of optimizing behavior. .2 Autoregressions In time-series... Yt−k ) ..1 et is a martingale difference sequence (MDS) if E (et | It−1 ) = 0. then we have the autoregressive model Yt = α + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et E (et | It−1 ) = 0. In fact. this series converges if the sequence ρk et−k gets small as k → ∞. This occurs when |ρ| < 1. Y2 . t By back-substitution. E(Yt−k et ) = 0. 12. it is even more important in the time-series context.} are jointly random. Definition 12. Letting et = Yt − E (Yt | It−1 ) . Most asset pricing models imply that asset returns should be the sum of a constant plus a MDS. Y1 . the series {. For example. ∞ X = ρk et−k .. . E(et ) = 0 and Ee2 = σ 2 < ∞.. some versions of the life-cycle hypothesis imply that either changes in consumption. should be a MDS. or consumption growth rates. 137 .. k=0 Loosely speaking.2.... . as it is difficult to derive distribution theories without this property. A mean-zero AR(1) is Assume that et is iid.

since ρ(z) = 0 when z = 1/ρ. Lk Yt = Yt−k . Definition 12. we see that L2 Yt = LYt−1 = Yt−2 . 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 . except that the mean of Yt can be computed from the relationship EYt = α + ρEYt−1 . From Theorem 12.1.4. The operator ρ(L) = (1 − ρL) is a polynomial in the operator L. Defining L2 = LL. or ρ(L)Yt = et where ρ(L) = 1 − ρ1 L − ρ2 L2 − · · · − ρk Lk . Yt − ρ1 LYt − ρ2 L2 Yt − · · · − ρk Lk Yt = et . We can compute the moments of Yt using the infinite sum: EYt = ∞ X k=0 ρk E (et−k ) = 0 σ2 . 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). 138 . The AR(k) model is Using the lag operator. 1 − ρ2 V ar(Yt ) = If the equation for Yt has an intercept. ∞ X k=0 ρ2k V ar (et−k ) = 12. We call ρ(L) the autoregressive polynomial of Yt .1 If |ρ| < 1 then Yt is strictly stationary and ergodic.3.5 Stationarity of AR(k) Yt = ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et . 12.3. the above results are unchanged. We call ρ(L) the autoregressive polynomial of Yt .4 Lag Operator An algebraic construct which is useful for the analysis of autoregressive models is the lag operator. and solving for EYt = EYt−1 we find EYt = α/(1 − ρ). In general.Theorem 12. We say that the root of the polynomial is 1/ρ.1 The lag operator L satisfies LYt = Yt−1 .

By Theorem 12.. ¢0 Then the model can be written as The OLS estimator is ¡ ˆ To study β..” If one of the roots equals 1. and is of great interest in applied time series. Thus T T 1X 1X xt et = ut →p E (ut ) = 0.5. Proof. since E (ut | It−1 ) = E (xt et | It−1 ) = xt E (et | It−1 ) = 0. t T t=1 T t=1 139 . For an AR(k). Thus t by the Ergodic Theorem.where the λ1 . so is xt x0 .1. . The Fundamental Theorem of Algebra says that any polynomial can be factored as ¢¡ ¢ ¡ ¢ ¡ ρ(z) = 1 − λ−1 z 1 − λ−1 z · · · 1 − λ−1 z 1 2 k 12. and hence Yt .1 The AR(k) is strictly stationary and ergodic if and only if |λj | > 1 for all j. Let |λ| denote the modulus of a complex number λ. the requirement is that all roots are larger than one. then ˆ β →p β as T → ∞. β = X 0X (12.6 Let Estimation xt = β = ¡ 1 Yt−1 Yt−2 · · · α ρ1 ρ2 · · · yt = x0 β + et . Note that ut is a MDS.1 If the AR(k) process Yt is strictly stationary and ergodic and EYt2 < ∞. The vector xt is strictly stationary and ergodic. t Yt−k ¢0 ρk . 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 t T t=1 ¥ Combined with (12.1) and the continuous mapping theorem. T t=1 T t=1 ¢−1 0 ¡ ˆ X Y. λk are the complex roots of ρ(z). we say that ρ(L). it is helpful to define the process ut = xt et . and by Theorem 12. T ¢ ¡ 1X xt x0 →p E xt x0 = Q.1.1.6. which satisfy ρ(λj ) = 0.1.1) Theorem 12. it is also strictly stationary and ergodic. “has a unit root”. One way of stating this is that “All roots lie outside the unit circle. This is a special case of non-stationarity.. we see that à !−1 à ! T T 1X 1X ˆ β=β+ xt x0 xt et →p Q−1 0 = 0.

as this imposes inappropriate independence.12. t t Theorem 12..7 Asymptotic Distribution Theorem 12. this cannot work in a time-series application. 12. ˆ 1. the asymptotic covariance matrix is estimated just as in the cross-section case. . This is identical in form to the asymptotic distribution of OLS in cross-section regression. Fix an initial condition (Y−k+1 . In particular.7.7.. eT }. Estimate β and residuals et ..8 Bootstrap for Autoregressions In the non-parametric bootstrap. which may be different than the i properties of the actual ei . Method 1: Model-Based (Parametric) Bootstrap. . Briefly. T t=1 Since xt et is a MDS. Ω) . This creates an iid bootstrap sample.1 MDS CLT. xt }. Ω) . Simulate iid draws e∗ from the empirical distribution of the residuals {ˆ1 . Divide the sample into T /m blocks of length m. It also presumes that the AR(k) structure is the truth. T 1 X √ ut →d N (0. there are two popular methods to implement bootstrap resampling for time-series data.2 If the AR(k) process Yt is strictly stationary and ergodic and EYt4 < ∞.. t This construction imposes homoskedasticity on the errors e∗ . ´ √ ³ ¡ ¢ ˆ T β − β →d N 0. we constructed the bootstrap sample by randomly resampling from the data values {yt . 140 .. ˆ 2. we can apply Theorem 12. Y0 ). Method 2: Block Resampling 1.. then as T → ∞. i 4. If ut is a strictly stationary and ergodic MDS and E(ut u0 ) = Ω < ∞.7. t then as T → ∞. e ˆ 3.1 to see that T 1 X √ xt et →d N (0. Clearly. T t=1 where Ω = E(xt x0 e2 ). Y−k+2 . 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∗ . Q−1 ΩQ−1 . The implication is that asymptotic inference is the same.

.2.2) (12.9 Trend Stationarity Yt = µ0 + µ1 t + St St = ρ1 St−1 + ρ2 St−2 + · · · + ρk St−l + et . For each simulated sample. The reason why these two procedures are (essentially) the same is the Frisch-Waugh-Lovell theorem. Paste the blocks together to create the bootstrap time-series Yt∗ . draw T /m blocks. • Include dummy variables for each season.3) sequentially by OLS. and for modelmisspecification. Resample complete blocks. and then perform regression (12. The results may be sensitive to the block length.. 5. ρk ). also alters the time-series correlations of the data. get the ˆ ˆ residual St . . or the season-to-season change. 4. That is. however. 141 . ∆s Yt = Yt − Yt−s . This procedure is sometimes called Detrending.2)-(12. first estimate (12. This allows for arbitrary stationary serial correlation. But the long-run trend is also eliminated. 12. This is a flexible approach which can extract a wide range of seasonal factors. and perhaps this was of relevance.4) There are two essentially equivalent ways to estimate the autoregressive parameters (ρ1 .2).4) by OLS. • First apply a seasonal differencing operator. Thus the seasonally adjusted data is a “filtered” series. heteroskedasticity. • Use “seasonally adjusted” data. (12. 3. • You can estimate (12. • You can estimate (12.3) or Yt = α0 + α1 t + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et . This presumes that “seasonality” does not change over the sample. and the way that the data are partitioned into blocks. The seasonal factor is typically estimated by a two-sided weighted average of the data for that season in neighboring years. The seasonal adjustment. 6. May not work well in small samples. (12. If s is the number of seasons (typically s = 4 or s = 12).. Seasonal Effects There are three popular methods to deal with seasonal data.3) replacing St with St . The series ∆s Yt is clearly free of seasonality.

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

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

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

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

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

This can be done by a Wald test. Then the single equation takes the form (13. In this case. So testing H0 versus H1 is equivalent to testing for the significance of adding (yt−1 . Then yt = x0 β + et t et = θet−1 + ut E (ut | It−1 ) = 0.2) Take the equation yt = x0 β + et . may be tested if desired.2) may be estimated by iterated GLS. which is called a common factor restriction. (A simple version of this estimator is called Cochrane-Orcutt. 13. it is convenient to re-define the variables. we are only interested in a single equation out of a VAR system. t or yt = θyt−1 + x0 β + x0 γ + ut . The DW test is appropriate only when regression yt = x0 β + et is not dynamic (has no lagged values on the RHS).1) yt = x0 β + et .1). If valid.2) is uncommon in recent applications. which once was very popular. You may have heard of the Durbin-Watson test for omitted serial correlation. 1). t and xt = This is just a conventional regression.) Since the common factor restriction appears arbitrary. j Often. t and et is iid N (0.3) which is a valid regression model. Suppose that et is an AR(1). with time series data. xt−1 ) to the regression. under the restriction γ = −βθ. t t−1 (13. 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 .4 Single Equation from a VAR Yjt = a0 xt + et . Otherwise it is invalid. general. Let yt = Yjt . 147 . Let et = ejt and β = aj . (13. This restriction. and is still routinely reported by conventional regression packages. and Zt be the other variables.2) is a special case of (13. 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 subtract off the equation once lagged multiplied by θ. h¡ 1 Yt−1 · · · 0 Yt−k Zt−1 · · · 0 Zt−k ¢0 i . Then the null and alternative are H0 : θ = 0 H1 : θ 6= 0.5 Testing for Omitted Serial Correlation Consider the problem of testing for omitted serial correlation in equation (13. the model (13.13. This takes the form 0 and xt consists of lagged values of Yjt and the other Ylt s. direct estimation of (13.3). and is typically rejected empirically. Another interesting fact is that (13. We see that an appropriate.

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

the asymptotic distribution of the test is affected by the presence of the time trend. 149 . β may not be known. Then β 2 = (Y20 Y2 )−1 Y2 Y1 →p β 2 . then it turns out that β can be consistently estimated by an OLS regression of one component of Yt on the others. if Yt is a pair of interest rates. Then under H0 zt is I(1). Under H0 . a good method to estimate β. however. as first shown by Stock (1987).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 . Y2t ) and β = (β 1 β 2 ) and normalize β 1 = 1. Whether or not the time trend is included. For 0 < r < m. The asymptotic distribution was worked out in B. If Y = (log(Consumption) log(Income))0 . Furthermore ˆ this estimation is super-consistent: T (β 2 − β 2 ) →d Limit. If r = m. then Yt is I(0). it may be believed that β is known a priori. In some cases. This is not. The r vectors in β are called the cointegrating vectors.13. from OLS of Y1t on Y2t . yet under H1 zt is I(0). Engle and Granger (1987) suggested using an ADF test on the estimated ˆ0 ˆ residual zt = β Yt . If the series Yt is not cointegrated. m × r. then β = (1 − 1)0 specifies that log(Consumption/Income) is stationary. then β = (1 − 1)0 specifies that the spread (the difference in returns) is stationary. The asymptotic distribution was worked out by Phillips and Ouliaris (1990). it may be necessary to include a time trend in the estimated cointegrating regression.8.8 Cointegration The idea of cointegration is due to Granger (1981). Their justification was Stock’s result that β is superˆ ˆ consistent under H1 . β = (1 − 1)0 . When the data have time trends. β is not consistent. If Yt is cointegrated with a single cointegrating vector (r = 1). Definition 13. Hansen (1992). Thus Yt = ˆ (Y1t . and was articulated in detail by Engle and Granger (1987). so zt = β 0 Yt is known. of rank r. but it is useful in the construction of alternative estimators and tests. then r = 0.1 The m × 1 series Yt is cointegrated if Yt is I(1) yet there exists β. Thus H0 can be tested using a univariate ADF test on zt . Often. We are often interested in testing the hypothesis of no cointegration: H0 : r = 0 H1 : r > 0. so the ADF critical values are not appropriate. In other cases. When β is unknown. Suppose that β is known. in general. 13. For example. Yt is I(1) and cointegrated. such that zt = β 0 Yt is I(0).

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

If. 1} • Multinomial: Y = {0.. allowing the construction of the likelihood function. 14. The linear probability model specifies that P (Yi = 1 | xi ) = x0 β. Given some regressors xi . as this is the full conditional distribution. 1. typically assumed to be symmetric about zero. They still constitute the majority of LDV applications. you would be advised to consider employing a semi-parametric estimation approach. due to time constraints. 1}. .. 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. the goal is to describe P (Yi = 1 | xi ) . For the parametric approach. you were to write a thesis involving LDV estimation. The two standard choices for F are 151 . estimation is by MLE. 1. 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. however. . k} • Integer: Y = {0.1 Binary Choice The dependent variable Yi = {0. The most common cases are • Binary: Y = {0. 2.. A parametric model is constructed.} • Censored: Y = {x : x ≥ 0} The traditional approach to the estimation of limited dependent variable (LDV) models is parametric maximum likelihood. We will discuss only the first (parametric) approach. A more modern approach is semi-parametric. Even so estimation of a linear probability model is a useful starting point for subsequent analysis. this yields the regression: Yi = x0 β + ei which can be estimated by i OLS. This represents a Yes/No outcome. eliminating the dependence on a parametric distributional assumption.Chapter 14 Limited Dependent Variables A “limited dependent variable” Y is one which takes a “limited” set of values. 2.. However.. so that F (z) = 1 − F (−z). i As P (Yi = 1 | xi ) = E (Yi | xi ) .

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

The conditional density is the Poisson with parameter λi . any known value can substitute. . A generalization is the negative binomial. In surveys. Tobin observed that for many households.1). This may be considered restrictive. i so the model imposes the restriction that the conditional mean and variance of Yi are the same. this motivates the label Poisson “regression. σ 2 ) with the observed variable yi generated by the censoring equation (14.2 Count Data exp (−λi ) λk i . k! = exp(x0 β). 14. An example of a data collection censoring is top-coding of income.1) yi = ∗ <0 . Since E (Yi | xi ) = λi = exp(x0 β) i is the conditional mean.. The censoring process may be explicit in data collection. 1. Thus the model is that there is some latent process yi with unbounded support. a typical approach is to employ Poisson regression.14. but we observe only ½ ∗ ∗ yi if yi ≥ 0 (14..” Also observe that the model implies that V ar (Yi | xi ) = λi = exp(x0 β). The log-likelihood function is ln (β) = n X i=1 log f (yi | xi ) = n X¡ ¢ − exp(x0 β) + yi x0 β − log(yi !) .. i i i=1 ˆ The MLE is the value β which maximizes ln (β). 0 if yi (This is written for the case of the threshold being zero.) The observed data yi therefore come from a mixed continuous/discrete distribution. incomes above a threshold are typically reported at the threshold.3 Censored Data The idea of “censoring” is that some data above or below a threshold are mis-reported at the ∗ threshold. the consumption level (purchases) in a particular period was zero. 2. He proposed the latent variable model ∗ yi = x0 β + ei i ei ∼ iid N (0. 2. 1. i If Y = {0. or it may be a by-product of economic constraints. The functional form for λi has been picked to ensure that λi > 0. The first censored regression model was developed by Tobin (1958) to explain consumption of durable goods. This model specifies that P (Yi = k | xi ) = λi k = 0. . This model (now called the Tobit) specifies that the latent (or ideal) value of consumption may be negative (the household 153 . Censored models are typically applied when the data set has a meaningful proportion (say 5% or higher) of data at the boundary of the sample support..}.

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

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

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

An observation is the pair {yit . 15. In either event... xit } : For i = 1.1 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 .. t = ti . (15. and most applied researchers try to avoid its use. OLS appears a poor estimation choice. There are several derivations of the estimator. i = 1.. . Condition (15. however. T . and the t subscript denotes time. n.. collected over time. 15. If (15.2 Fixed Effects This is the most common technique for estimation of non-dynamic linear panel regressions. or unbalanced : {yit . n. then OLS is inconsistent.1) is called the random effects hypothesis. and that eit is uncorrelated with xit . it The typical maintained assumptions are that the individuals i are mutually independent.. .. It is consistent if E (xit ui ) = 0 (15. 157 .. xit } : t = 1. and have arbitrary correlated with xi . that eit is iid across individuals and time. It is a strong assumption.. .. A panel may be balanced : {yit . where the i subscript denotes the individual.1) fails if the individual-specific unobserved effect ui is correlated with the observed explanatory variables xit . ti . OLS can be improved upon via a GLS technique. ..1) is true. OLS of yit on xit is called pooled estimation. xit }.. and thus achieve invariance. The motivation is to allow ui to be arbitrary. This is often believed to be plausible if ui is an omitted variable. The goal is to eliminate ui from the estimator.Chapter 15 Panel Data A panel is a set of observations on individuals. that ui and eit are independent.1) If this condition fails.

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

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

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

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

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) . The bias results from this smoothing. 2 Z ∞ ˆ The bias of f (x) is then 1 1X ˆ EKh (Xi − x) − f (x) = f 00 (x)h2 σ 2 . 162 . This integral (typically) is not analytically solvable. the estimator f (x) smooths data local to Xi = x.16. 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 . and is larger the greater the curvature in f (x). so we approximate it using a second order Taylor expansion of f (x + hu) in the argument hu about hu = 0. ˆ We now examine the variance of f (x). Since it is an average of iid random variables. The sharper the derivative. nh (x)2 dx is called the roughness of K. which is valid as h → 0.2 Asymptotic MSE for Kernel Estimates ∞ For fixed x and bandwidth h observe that Z ∞ Z Kh (z − x) f (z)dz = EKh (X − x) = −∞ Kh (uh) f (x + hu)hdu = −∞ Z ∞ K (u) f (x + hu)du −∞ The second equality uses the change-of variables u = (z − x)/h. Intuitively. The last expression shows that the expected value is an average of f (z) locally about x. so is estimating a smoothed version of f (x). Bias(x) = E f (x) − f (x) = K n 2 i=1 n ˆ We see that the bias of f (x) at x depends on the second derivative f 00 (x). ˆ the greater the bias.

but not of n. (16.06n−1/5 163 . the rule-of-thumb h can be quite inefficient.1) is an asymptotic approximation to the MSE. ˆ It uses formula (16. We define the asymptotically optimal bandwidth h0 as the value which minimizes this approximate MSE. In practice. Notice that the first term (the squared bias) is increasing in h and the second term (the variance) is decreasing in nh. Together with the above table. 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) . 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.Together. σ 2 . but at a very slow rate.2) This solution takes the form h0 = cn−1/5 where c is a function of K and f. We can calculate that √ R(φ00 ) = 3/ (8 π) .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 . Equation (16. and there is a large and continuing literature on the subject. The asymptotically optimal choice given in (16. The downside is that if the density is very far from normal. we find the reference rules for the three kernel functions introduced earlier. We thus say that the optimal bandwidth is of order O(n−1/5 ). and R(f 00 ). we need h → 0 but nh → ∞. Note that this h declines to zero. but at a slower rate than n−1 . (16. 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. h0 = argmin AM ISEh h It can be found by solving the first order condition d R(K) AM ISEh = h3 σ 4 R(f 00 ) − =0 K dh nh2 yielding h0 = µ R(K) 4 R(f 00 ) σK ¶1/5 n−1/2 . The first two are determined by the kernel function. where φ is the N (0.2) depends on R(K).2) but replaces R(f 00 ) with σ −5 R(φ00 ). h must tend to zero. Their K values for the three functions introduced in the previous section are given here. That is. That is. This choice for h gives an optimal rule when f (x) is ˆ normal. Thus for the AMISE to decline with n. how should the bandwidth be selected? This is a difficult problem. 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 + . 1) distribution and σ 2 is an estimate of σ 2 = V ar(X). Gaussian Kernel: hrule = 1.

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

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

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

Theorem 2 (Bayes’ Rule). of the sample space.3) P (X = τ j ) = π j . .. then for each i = 1.. Instead. A2 . Pr where 0 ≤ π j ≤ 1 and j=1 π j = 1. . . For any set B and any partition A1 . F (x) is nondecreasing in x 3. (A. 167 . For a random variable X we define its cumulative distribution function (CDF) as F (x) = P (X ≤ x) . A function F (x) is a CDF if and only if the following three properties hold: 1.2) Sometimes we write this as FX (x) to denote that it is the CDF of X. While there are examples of continuous random variables which do not possess a PDF. F (x) is right-continuous We say that the random variable X is discrete if F (x) is a step function. This induces a new sample space — the real line — and a new probability function on the real line. In this case P (X = τ ) = 0 for all τ ∈ R so the representation (A.. Typically.... the range of X consists of a countable set of real numbers τ 1 . limx→−∞ F (x) = 0 and limx→∞ F (x) = 1 2. we represent the relative probabilities by the probability density function (PDF) f (x) = so that F (x) = and P (a ≤ X ≤ b) = Z d F (x) dx x f (u)du Z b −∞ f (x)dx... The probability function for X takes the form j = 1. ∞ A function f (x) is a PDF if and only if f (x) ≥ 0 for all x ∈ R and −∞ f (x)dx. . τ r . and use lower case letters such as x for potential values and realized values. P (B | Ai ) P (Ai ) P (Ai | B) = P∞ j=1 P (B | Aj ) P (Aj ) A.2 Random Variables A random variable X is a function from a sample space S into the real line. 2.3) is unavailable. We say that the random variable X is continuous if F (x) is continuous in x. r (A. In the latter case.. these cases are unusualRand are typically ignored. a These expressions only make sense if F (x) is differentiable. we denote random variables by uppercase letters such as X..

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

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

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

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

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

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

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

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

σ 2 ). It is conventional to write X ∼ N (0. For x ∈ Rk . q × q.11) and is known as the chi-square density with r degrees of freedom. where we used the fact that det (BΣB 0 )1/2 = det (Σ)1/2 det (B) . and it is conventional to write X ∼ N (µ. This shows that if X is multivariate normal with uncorrelated elements. then they are mutually independent. ¢ ¡ 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 . and to denote the standard normal density function by φ(x) and its distribution function by Φ(x). The latter has no closed-form solution. Ir ) and set Q = X 0 X. Σ). Theorem A. Another useful fact is that if X ∼ N (µ. (A. respectively. we can also show that EX 2 = 1 and EX 4 = 3. denoted χ2 . 1). If Z is standard normal and X = µ + σZ. A) with A > 0. If X ∈ Rk is multivariate normal and the elements of X are mutually uncorrelated. This shows that linear transformations of normals are also normal. y ≥ 0. −∞ < x < ∞. The mean and variance of the distribution are µ and σ 2 . x ∈ Rk .8. then Z 0 A−1 Z ∼ χ2 . In this case the density function can be written as j à à !! (x1 − µ1 )2 /σ 2 + · · · + (xk − µk )2 /σ 2 1 1 k f (x) = exp − 2 (2π)k/2 σ 1 · · · σ k à ¡ ¢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. Its mean and r variance are µ = r and σ 2 = 2r. exp − f (x) = k/2 1/2 2 (2π) det (Σ) The mean and covariance matrix of the distribution are µ and Σ. the multivariate normal density is ¶ µ (x − µ)0 Σ−1 (x − µ) 1 . X has density à ! (x − µ)2 1 exp − . the density of Y is à ! (y − µY )0 Σ−1 (y − µY ) 1 Y exp − f (y) = . k/2 1/2 2 (2π) det (ΣY ) where µY = a+Bµ and ΣY = BΣB 0 . By iterated integration by parts.1 Let X ∼ N (0. f (x) = √ 2σ 2 2πσ which is the univariate normal density.8. then Σ = diag{σ 2 } is a diagonal matrix. and it is conventional to write X ∼ N(µ. x ∈ Rk .2 If Z ∼ N(0. then by the change-of-variables formula. Σ) and Y = a + BX with B an invertible matrix. Q has the density f (y) = Γ 1 ¡r¢ 2 2r/2 yr/2−1 exp (−y/2) . then using the change-of-variables formula. Theorem A.This density has all moments finite. q 176 . Since it is symmetric about zero all odd moments are zero.

11). Proof of Theorem A. which we showed in (A.8.11) 2 with r = 1.8. tr = p Q/r The density of tr is and is known as the student’s t distribution with r degrees of freedom.6) can be used to show that the MGF j=1 ¥ Proof of Theorem A.3.13) = (1 − 2t)−r/2 R∞ where the second equality uses the fact that 0 y a−1 exp (−by) dy = b−a Γ(a). C −1 CC 0 C −10 ) = N (0. For Z ∼ N(0. Set r Z . Iq ). The MGF for the density (A.13) is the MGF of the density (A.13). The fact that A > 0 means that we can write A = CC 0 where C is non-singular. ¡ ¢ √ using the change—of-variables s = x2 and the fact Γ 1 = π.3 Let Z ∼ N (0.Theorem A. Thus ¥ ¡ ¢0 ¡ ¢ Z 0 A−1 Z = Z 0 C −10 C −1 Z = C −1 Z C −1 Z ∼ χ2 . C −1 AC −10 ) = N (0. we see that the MGF of Z 2 is (1 − 2t)−1/2 . tr has distribution 177 . q Proof of Theorem A. Since we can write Q = P 2 X 0 X = r Zj where the Zj are independent N(0.8. Then A−1 = C −10 C −1 and C −1 Z ∼ N (0.8. Thus the density of Z 2 is (A. 1). 1) the distribution of Z 2 is ¡ ¢ √ P Z 2 ≤ y = 2P (0 ≤ Z ≤ y) µ 2¶ Z √y 1 x √ exp − dx = 2 2 2π 0 Z y ³ s´ 1 ¡1¢ = s−1/2 exp − ds 1/2 2 0 Γ 2 2 1 ¡r¢ 2 2r/2 y r/2−1 exp (ty) exp (−y/2) dy of Q is (1 − 2t)−r/2 .12) E exp (tQ) = 0 Γ (A. 1) and Q ∼ χ2 be independent. Using the simple law of iterated expectations. (A.1. which can be found by applying change-of-variables to the gamma function. From (A.11) is Z ∞ ¢ ¡ Γ r+1 2 f (x) = ´ r+1 ¡r¢ ³ √ 2 2 πrΓ 2 1 + x r (A.2.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Sign up to vote on this title
UsefulNot useful

Master Your Semester with Scribd & The New York Times

Special offer for students: Only $4.99/month.

Master Your Semester with a Special Offer from Scribd & The New York Times

Cancel anytime.