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

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

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Contents

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

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

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i

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

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

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

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

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ii

4 Estimation of the Eﬃcient Weight Matrix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3 Distribution of GMM Estimator . . . . . . . . . . . . . .5 Numerical Computation . . . 11. . . 12 Univariate Time Series 12. . . . . . . . . . . . . 12. . . . . . . . . . . . . . . . . . . . . . .6 Estimation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .12Autoregressive Unit Roots . . . . . . . . . . . .2 Asymptotic Distribution of EL Estimator 10. . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Instrumental Variables . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . .6 Bekker Asymptotics . . . . . . . 10. . . . . . .5 Stationarity of AR(k) . . . . . . 12. . . 12. . . . . . . . . . Symmetric Two-Sided Tests . . . . . . . . . . . . . . . . . .5 GMM: The General Case . . . . .5 Special Cases: IV and 2SLS 11. . . . . . . . . . . . . . . . . . . . . . . . 11. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 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 9.13 One-Sided Tests . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4 Testing . . .7 Hypothesis Testing: The Distance Statistic 9. . . . . . . . . . . . . . . . . . . . . . . . . 11. . . . 9. . . . . . . . . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11.10 8. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11. . . . . . . . . . . . . . . . . . . 11 Endogeneity 11. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8. . . . . . . . . . . . . . Percentile Conﬁdence Intervals . . . . . . . . . . . . . . . . . . .8 Exercises . . . . . . . . . . . . . .1 Stationarity and Ergodicity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9. . . . .2 Reduced Form . . . . . 9. . . . . . iii .3 Identiﬁcation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9. . . .1 Overidentiﬁed Linear Model . . . . . . . . .10Testing for Omitted Serial Correlation 12. . . . . . . . . .11 8. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11. . . . . . . . . . . . . . . . . 12. . . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . .8 Bootstrap for Autoregressions . . . . .7 Asymptotic Distribution . . . . . . . 12. . . . . . . . 12. . . . .9 Trend Stationarity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .6 Over-Identiﬁcation Test . . . . . . . . . . . . . . . . . . . . . .10 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3 Stationarity of AR(1) Process . . . . . . . .9 8. . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . . . . 10. . . .2 Autoregressions . . . . . . . . . .7 Identiﬁcation Failure . . . 10 Empirical Likelihood 10. . . . . . . . . . . . . . . . . . . . . .4 Estimation . . . . . . . . . . . . . . . . . .9 Bootstrap GMM Inference . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12.1 Non-Parametric Likelihood . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3 Overidentifying Restrictions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .11Model Selection . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Bootstrap Methods for Regression Models Exercises . . .2 GMM Estimator . . .12 8. . . . . . . . . . . . . . . . . . . . . . . . .8 Conditional Moment Restrictions . . . . . . . 10.4 Lag Operator . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

. . . . . . . . . . . . . . . . . . . . .5 Multivariate Random Variables . . . . . . . . . . B. . . . 157 15. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14.13 Multivariate Time Series 13. . . . B. . . . . .4 Sample Selection . . . . . 15 Panel Data 157 15. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Grid Search . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .6 Selection of Lag Length in an VAR . . .2 Asymptotic MSE for Kernel Estimates . .1 Binary Choice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Kernel Density Estimation . . . . . . . . . . . . . . 13. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3 Derivative-Free Methods . . A. . . . . . . . . . . . . . . . . . A. . . . . . . . . . . . . . . . . . . . . . . . . . 14 Limited Dependent Variables 14. . . . . B Numerical Optimization B. . . 165 165 167 168 169 171 173 175 175 178 183 183 184 185 . . . . . . . . . . . . . . . . . . . . . . . . . . 157 15. . . . . . . . . . . . . . .9 Cointegrated VARs . . . . . .2 Estimation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14. . . . . . . . . . . . . . .8 Normal and Related Distributions . . . . . 14.7 Granger Causality . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8 Cointegration . . . . . . . . . . . . . . . . . . . . .3 Dynamic Panel Regression . . . . . . . . . . . . . . . . . . . . 13. . . . . . .2 Fixed Eﬀects . iv . . . . . . . . . . . . . . . . .1 Vector Autoregressions (VARs) . . . . . .2 Random Variables . . . . . . . . . . . . . .5 Testing for Omitted Serial Correlation 13. . . . . . . . . . . . . . . . . . . . . . . A. . . . . . . . . . . .6 Conditional Distributions and Expectation . . . . . . . . . . . . . . . . . . . . . . . .2 Count Data . . . . . . . . . . . .1 Foundations . . . . .3 Expectation . . . . . . . . . . . . . . . . 13. . . . . . . . . .4 Single Equation from a VAR . . . . . . . . . . . . . . . 145 145 146 146 147 147 148 148 149 149 151 151 153 153 154 . . . . . . . . . . . . . . . . . . . . . . . . . . A. . . . . .1 Individual-Eﬀects Model . . 160 16. . . . . . . . . . . . 162 A Probability A. .4 Common Distributions . . . . . . . . . . . . . . . A. . . . . . . . . . . . . . . . . . . . . . . . . 13. . . . A. . . A. . . . .3 Censored Data . . 159 16 Nonparametrics 160 16. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A. . . . . . . . . . . . . . .3 Restricted VARs . . . . . . . . . . . . . . . . . . . . . . . . 13. . . . . . . . . . . . . . . . . . . . .2 Gradient Methods . . . . . . . . .9 Maximum Likelihood .7 Transformations . . . . . . . . . . . . . . . . .

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

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

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

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

then a0 is a 1 × k row vector. A square matrix is upper (lower) diagonal if all elements below (above) the diagonal equal zero. . . a0 k ⎡ 0 ⎤ a1 b1 a0 b2 · · · a0 bs 1 1 ⎢ a0 b1 a0 b2 · · · a0 bs ⎥ 2 2 ⎢ 2 ⎥ = ⎢ . ⎥ . ⎥ . ⎥ . . . Note that if A is k × r. . ⎦ ⎣ . vectors and/or scalars. . a1r a2r · · · akr £ aj1 aj2 · · · ajr ¤ Thus bij = aji for all i and j. Ak1 Ak2 · · · Akr where the Aij denote matrices. . If a is a k × 1 vector. A matrix is square if k = r. 2. and this is the only case where this product is deﬁned. ⎦ . then their inner product is a0 b = a1 b1 + a2 b2 + · · · + ak bk = aj bj When the number of columns of A equals the number of rows of B. . . we say that A and B. The transpose of a matrix. or the product AB. then we deﬁne their product AB by writing A as a set of row vectors and B as a set of column vectors (each of length r). 5 Note that a0 b = b0 a. which implies aij = aji . . ⎦ ⎣ . Then ⎡ 0 ⎤ a1 ⎢ a0 ⎥ £ ¤ ⎢ 2 ⎥ AB = ⎢ . ⎦ ⎣ . A square matrix is diagonal if the only non-zero elements appear on the diagonal. . . A square matrix is symmetric if A = A0 . If A is k × r and B is r × s. ⎤ ⎡ a11 a21 · · · ak1 ⎢ a12 a22 · · · ak2 ⎥ ⎥ ⎢ B = A0 = ⎢ . . denoted B = A0 . a0 b1 a0 b2 · · · k k a0 bs k . then A0 is r × k.2 Matrix Multiplication k X j=1 If a and b are both k × 1. A partitioned matrix takes the form ⎤ ⎡ A11 A12 · · · A1r ⎢ A21 A22 · · · A2r ⎥ ⎥ ⎢ A=⎢ . ⎥ b1 b2 · · · bs ⎣ . . .are column vectors and α0 = j are row vectors. so that aij = 0 if i 6= j. . . are conformable. . is obtained by ﬂipping the matrix on its diagonal.

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

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

c0 Ac = α0 a ≥ 0 where α = Gc. If A is symmetric. Let λi and hi . and then set B = HΛ1/2 . i = 1. then A − λi Ik is singular so there exists a non-zero vector hi such that (A − λi Ik ) hi = 0 The vector hi is called a latent vector or characteristic vector or eigenvector of A corresponding to λi . • If A has distinct characteristic roots. If A = G0 G. k denote the k eigenvalues and eigenvectors of a square matrix A. We now state some useful properties. The matrix B need not be unique. then A is non-singular and A−1 exists. This is written as A ≥ 0. 2..6 Rank and Positive Deﬁniteness The rank of a square matrix is the number of its non-zero characteristic roots.5 Eigenvalues det (A − λIk ) = 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. which are not necessarily distinct and may be real or complex. and let H = [h1 · · · hk ]. c0 Ac > 0.2. and the characteristic roots are all real. k < n. They are called the latent roots or characteristic roots or eigenvalues of A. Furthermore. • If A is symmetric. A square matrix A is idempotent if AA = A. there exists a nonsingular matrix P such that A = P −1 ΛP and P AP −1 = Λ.. We say that a square matrix A is positive semi-deﬁnite if for all non-zero c. If λi is an eigenvalue of A. 8 . Then A = AA = HΛH 0 HΛH 0 = HΛ2 H 0 .. then A = HΛH 0 and H 0 AH = Λ. One way to construct B is to use the spectral decomposition A = HΛH 0 where Λ is diagonal. We say that X is n × k. note that we can write A = HΛH 0 where H is orthogonal and Λ contains the (real) characteristic roots. This is written as A > 0. 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. . In this case. 1 2 k The decomposition A = HΛH 0 is called the spectral decomposition of a matrix. • The characteristic roots of A−1 are λ−1 . λ−1 . To see this. (For any c 6= 0. then A is positive semi-deﬁnite.) If A is positive deﬁnite. . We call B a matrix square root of A. c0 Ac ≥ 0.. If A > 0 we can ﬁnd a matrix B such that A = BB 0 . λ−1 .. We say that A is positive deﬁnite if for all non-zero c.. A−1 > 0. has full rank k if there is no non-zero c such that Xc = 0. Let Λ be a diagonal matrix with the characteristic roots in the diagonal. then A > 0 if and only if all its characteristic roots are positive. If A is also symmetric (most idempotent matrices are) then all its characteristic roots equal either zero or one. X 0 X is symmetric and positive deﬁnite.

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

. is the matrix ⎡ ⎤ a11 B a12 B a1n B ⎢ a21 B a22 B · · · a2n B ⎥ ⎢ ⎥ A⊗B =⎢ ⎥. . • If A is orthogonal. ⎣ ⎦ . . denoted A ⊗ B. • (A + B) ⊗ C = A ⊗ C + B ⊗ C • (A ⊗ B) (C ⊗ D) = AC ⊗ BD • A ⊗ (B ⊗ C) = (A ⊗ B) ⊗ C • (A ⊗ B)0 = A0 ⊗ B 0 • tr (A ⊗ B) = tr (A) tr (B) • If A is m × m and B is n × n. . The vec of A. ⎠ ⎝ . an Let B be any matrix.• det ∙ A B C D ¸ • det A 6= 0 if and only if A is nonsingular. then det A = ±1 ¢ ¡ = (det D) det A − BD−1 C if det D 6= 0 Qk i=1 aii • If A is triangular (upper or lower). ⎟ . is the mn × 1 vector ⎞ ⎛ a1 ⎜ a2 ⎟ ⎟ ⎜ vec (A) = ⎜ . . These results hold for matrices for which all matrix multiplications are conformable. . am1 B am2 B · · · amn B Some important properties are now summarized. . then det A = 2. The Kronecker product of A and B.9 Kronecker Products and the Vec Operator Let A = [a1 a2 · · · an ] = [aij ] be m × n. det(A ⊗ B) = (det (A))n (det (B))m • (A ⊗ B)−1 = A−1 ⊗ B −1 • If A > 0 and B > 0 then A ⊗ B > 0 • vec (ABC) = (C 0 ⊗ A) vec (B) • tr (ABCD) = vec (D0 )0 (C 0 ⊗ A) vec (B) 10 . . . denoted by vec (A) .

m(x) can take any form. This is used when the goal is to quantify the impact of one set of variables on another variable. xi ) where yi is a scalar (real-valued) and xi is a vector. .1 Conditional Mean To study how the distribution of yi varies with the variables xi in the population. which is a common feature of wage distributions. These are asymmetric (skewed) densities. education and experience. We call xi alternatively the regressor.73. An important summary measure is the conditional mean Z ∞ yf (y | x) dy. and that for women is $20. The two density curves show the eﬀect of gender on the distribution of wages. the conditioning variable. Take a closer look at the density functions displayed in Figure 3.1 by the arrows drawn to the x-axis. the mean wage for men is $27. While it is easy to observe that the two densities are unequal. holding the other variables constant.Chapter 3 Regression and Projection The most commonly applied econometric tool is regression. gender. These are conditional density functions — the density of hourly wages conditional on race. See Chapter 16. The data are from the 2004 Current Population Survey 1 11 . (3.1 displays the density1 of hourly wages for men and women. it is useful to have numerical measures of the diﬀerence.22. We list the elements of xi in the vector ⎞ ⎛ x1i ⎜ x2i ⎟ ⎟ ⎜ (3. the conditional density of yi given xi . we can focus on f (y | x) .2) m(x) = E (yi | xi = x) = −∞ In general. In this context it is often convenient These are nonparametric density estimates using a Gaussian kernel with the bandwidth selected by crossvalidation. Figure 3.1.1) xi = ⎜ . When a distribution is skewed. You can see that the right tail of then density is much thicker than the left tail. from the population of white non-military wage earners with a college degree and 10-15 years of potential work experience. or the covariates. In the example presented in Figure 3. We call yi the dependent variable. These are indicated in Figure 3. the mean is not necessarily a good summary of the central tendency. In this context we partition the observations into the pair (yi . and exists so long as E |yi | < ∞. xki 3. ⎟ .1. ⎠ ⎝ . To illustrate.

This is a more robust measure of the typical wage gap between men and women than the diﬀerence in the untransformed wage means. 3. the solid line displays the conditional expectation of log wages varying with education. wage regressions typically use log wages as a dependent variable rather than the level of wages.2 Regression Equation The regression error ei is deﬁned to be the diﬀerence between yi and its conditional mean (3. Assuming for simplicity that this is the true joint distribution.2 shows the density of log hourly wages for the same population. which implies a 30% average wage diﬀerence for this population. To illustrate. 12 . implying an average 36% diﬀerence in wage levels.2) evaluated at the observed value of xi : ei = yi − m(xi ). and a Ph.Figure 3. the dashed line is a linear projection approximation which will be discussed in the Section 3.A. The diﬀerence in the log mean wage between men and women is 0. 2 (3.3 is how the conditional expectation describes an important feature of the conditional distribution. Figure 3. then comparisons become more complicated. with mean log hourly wages drawn in with the arrows. The conditional expectation function is close to linear. When the distribution of the control variable is continuous. By construction. degree in mean log hourly wages is 0. The comparison in Figure 3. this yields the formula yi = m(xi ) + ei . For this reason.3 displays a scatter plot2 of log wages against education levels. Of particular interest to graduate students may be the observation that diﬀerence between a B.3) White non-military male wage earners with 10-15 years of potential work experience.5.1 is facilitated by the fact that the control variable (gender) is discrete.1: Wage Densities for White College Grads with 10-15 Years Work Experience to transform the data by taking the (natural) logarithm.36.30.D. Figure 3. The main point to be learned from Figure 3.

These equations hold true by deﬁnition.2: Log Wage Densities Theorem 3. 4. E (ei | xi ) = 0. are often stated jointly as the regression framework.1 Properties of the regression error ei 1. A regression model imposes further restrictions on the joint distribution. E(ei ) = 0. because no restrictions have been placed on the joint distribution of the data. To show the ﬁrst statement. 13 . E (ei | xi ) = E ((yi − m(xi )) | xi ) = m(xi ) − m(xi ) = E (yi | xi ) − E (m(xi ) | xi ) = 0.2. E(xi ei ) = 0. most typically. restrictions on the permissible class of regression functions m(x).Figure 3. E (h(xi )ei ) = 0 for any function h (·) . 2. not a model. The equations yi = m(xi ) + ei E (ei | xi ) = 0. It is important to understand that this is a framework. by the deﬁnition of ei and the linearity of conditional expectations. 3. The remaining parts of the Theorem are left as an exercise.

i . To see this. and can take any form.3. subject to the restriction p that it is non-negative.2.4) E e2 | xi = σ 2 i 14 While the conditional mean is a good measure of the location of a conditional distribution. The conditional standard deviation is its square root σ(x) = σ 2 (x). 3.3: Conditional Mean of Wages Given Education The conditional mean also has the property of being the the best predictor of yi . Given the random variable xi . In contrast. let g(x) be an arbitrary predictor of yi given xi = x. when σ 2 (x) is a constant so that ¢ ¡ (3. A common measure of the dispersion is the conditional variance ¡ ¢ σ 2 (x) = V ar (yi | xi = x) = E e2 | xi = x . the conditional variance of yi is σ 2 = σ 2 (xi ). σ 2 (x) is a non-trivial function of x. In the general case i where σ 2 (x) depends on x we say that the error ei is heteroskedastic.3 Conditional Variance Generally. Thus the mean squared error is minimized by the conditional mean. it does not provide information about the spread of the distribution. The expected squared error using this prediction function is E (yi − g(xi ))2 = E (ei + m(xi ) − g(xi ))2 = Ee2 + 2E (ei (m(xi ) − g(xi ))) + E (m(xi ) − g(xi ))2 i = Ee2 + E (m(xi ) − g(xi ))2 i ≥ Ee2 i where the second equality uses Theorem 3. in the sense of achieving the lowest mean squared error. The right-hand-side is minimized by setting g(x) = m(x).1.Figure 3.

we say that the error ei is homoskedastic.3) can be writen as yi = x0 β + ei i E (ei | xi ) = 0. its functional form is typically unknown. In this case (3. they are also somewhat more dispersed. Some textbooks inappropriately describe heteroskedasticity as the case where “the variance of ei varies across observation i”.8) (3.1) has been redeﬁned as the k × 1 vector ⎛ ⎞ 1 ⎜ x2i ⎟ ⎜ ⎟ (3.1 and that for women is 10. which we derive in this section. it is convenient to augment the regressor vector xi by listing the number “1” as an element.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 . ⎠ . Equation (3. We call this the “constant” or “intercept”.1). Notationally. ⎠ . An important special case is homoskedastic linear regression model yi = x0 β + ei i E (ei | xi ) = 0 ¢ ¡ E e2 | xi = σ 2 .5. So while men have higher average wages. where x1i is the ﬁrst element of the vector xi deﬁned in (3. The conditional standard deviation for men is 12. take the conditional wage densities displayed in Figure 3. ⎝ . ⎟ .6) (3. and the linear assumption of the previous section is empirically unlikely to accurate. Instead.6) as an approximation.7) is a k × 1 parameter vector. Equivalently.5) xi = ⎜ . As an example. 3. ⎟ β=⎝ .9) 3. 15 . it is more realistic to view the linear speciﬁcation (3.3) is when the conditional mean function m(x) is linear in x (or linear in functions of x). xki When m(x) is linear in x.4 Linear Regression An important special case of (3. Thus (3.1. we assume that x1i = 1. i (3.8) is called the linear regression model. βk ⎛ (3. This concept is less helpful than deﬁning heteroskedasticity as the dependence of the conditional variance on the observables xi . we can write it as m(x) = x0 β = β 1 + x2i β 2 + · · · + xki β k where ⎞ β1 ⎜ .

β = E xi x0 i In the linear projection model the coeﬃcient β is deﬁned so that the function x0 β is the i best linear predictor of yi .10) exists and is unique as long as the k ×k matrix E (xi x0 ) is invertible. The ﬁrst-order condition for minimization (from Section 2. This occurs when redundant variables are included in xi . Rewriting. We now summarize the assumptions necessary for its derivation and list the implications in Theorem 3. i 16 . written E (xi x0 ) > 0. α0 E (xi x0 ) α = E (α0 xi )2 > 0. E (x0 xi ) < ∞. As before. Therefore. i i (3. Assumption 3. E (xi x0 ) is invertible. It is invertible if and only if it is positive deﬁnite.7) is 0= Solving for β we ﬁnd ¡ ¢ ∂ S(β) = −2E (xi yi ) + 2E xi x0 β. alternative expressions such as E xixi ) or E (xi yi ) (E (xi x0 ))−1 i ( i 0i ) are incoherent and incorrect.1 1. The error is i ei = yi − x0 β.5. E (xi x0 ) is a mai E(x y trix and E (xi yi ) is a vector. 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 .which is quadratic in β. i (3. Equivalently. Given the deﬁnition of β in (3.10) It is worth taking the time to understand the notation involved in this expression. this situation must be excluded. otherwise they are distinct. there cannot i exist a non-zero vector α such that α0 xi = 0 identically.12) This completes the derivation of the linear projection model. α0 E (xi x0 ) α = E (α0 xi )2 ≥ 0 so the matrix E (xi x0 ) is by construction i i positive semi-deﬁnite. i (3. i ∂β ¢¢−1 ¡ ¡ E (xi yi ) . In order for β to be uniquely deﬁned.10). Eyi < ∞. by “best” we mean the predictor function with lowest mean squared error.5. i 4. x0 β is the best linear predictor for yi . The vector (3. 2 2. 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. xi contains an intercept. we obtain a decomposition of yi into linear predictor and error yi = x0 β + ei .1. Observe i that for any non-zero α ∈ Rk . i which requires that for all non-zero α. The best linear predictor is obtained by selecting β to minimize S(β).

1.1 Under Assumption 3. By deﬁnition.1. Equation (3.5.5.2.13) summarize the linear projection model.1.5. For example.4 is required to ensure that β is uniquely deﬁned.5. the orthogonality restriction (3.4: Hourly Wage as a Function of Experience The conditions listed in Assumption 3.3 are called regularity conditions.10) are deﬁned. Assumption 3.1. suppose that for xi ∈ R that Ex3 = 0 and ei = x2 .5.1 is employed to guarantee that (3.1.9). The ﬁnite variance Assumptions 3.14).5. the converse is not true as the projection error does not necessarily satisfy E (ei | xi ) = 0. Since from Theorem 3. Let’s compare it with the linear regression model (3.2 and 3.12) and (3. Assumption 3.1.14) follows from (3. (3. Then i i Exi e2 = Ex3 = 0 yet E (ei | xi ) = x2 6= 0.4 we know that the regression error has the property E (xi ei ) = 0. Assumption 3.5. E (xi ei ) = 0 and E (ei ) = 0.5. Using the deﬁnitions (3.5. it follows that linear regression is a special case of the projection model.14) holds.8)-(3. x0 β is the i projection of yi on xi since the error ei is orthogonal with xi . Furthermore.11) and (3.10) and (3.11) are well deﬁned.1.1.3 ensure that the moments in (3.5. Assumption 3. This means that the equation (3.10) ¡ ¡ ¢¢ E (xi ei ) = E xi yi − x0 β i ¡ ¢¡ ¡ ¢¢−1 E (xi yi ) = E (xi yi ) − E xi x0 E xi x0 i i = 0.2 and 3.14) Proof.1. Figure 3. i i i Since E (xi ei ) = 0 we say that xi and ei are orthogonal.1. 17 .Theorem 3. ¥ (3.5.12) can be alternatively interpreted as a projection decomposition. Since ei is mean zero by (3.13) and Assumption 3.1 are weak.1. However.4 guarantees that the solution β exits. (3.13) implies that xi and ei are uncorrelated.13) The two equations (3.

for any pair (yi . It over-predicts wages for young and old workers. In this case (3. In this example the linear projection is a close approximation to the conditional mean.5: Conditional Mean and Two Linear Projections Another defect of linear projection is that it is sensitive to the marginal distribution of the regressors when the conditional mean is non-linear. We illustrate the issue in Figure 3. xi ) we can deﬁne a linear projection equation (3.3.12) with the properties listed in Theorem 3.5. Figure 3. Other than the redeﬁnition of the regressor vector. Most importantly. In Figure 1. Figure 3. since the resulting function is quadratic in experience. A projection of log wages on these two variables can be called a quadratic projection.5.4 displays the relationship3 between mean log hourly wages and labor market experience. we can augment the regressor vector xi to include both experience and experience2 . In this example it is a much better approximation to the conditional mean than the linear projection. This defect in linear projection can be partially corrected through a careful selection of regressors. In this case the linear projection is a poor approximation to the conditional mean. In other cases the two may be quite diﬀerent. The solid line is the conditional mean. No additional assumptions are required.10). in many economic models the parameter β may be deﬁned within the model.12) is deﬁned by projection and the associated coeﬃcient deﬁnition (3. In the example just presented. for those over 53 in age). and under-predicts for the rest.1 may be false. and are discussed in Chapter 11. The linear equation (3. However. the dashed line is the linear projection of log wages on eduction. and the straight dashed line is the linear projection. Returning to the joint distribution displayed in Figure 3. In contrast. 18 . it is important to not misinterpret the generality of this statement.1. These structural models require alternative estimation methods.10) may not hold and the implications of Theorem 3. there are no changes in our methods or analysis.4 we display as well this quadratic projection.We have shown that under mild regularity conditions. it misses the strong downturn in expected wages for those above 35 years work experience (equivalently.5 for a 3 In the population of Caucasian non-military male wage earners with 12 years of education.

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

x 6.. Show that x y β 1 = σ xy /σ 2 and β 0 = µy − β 1 µx . and E(ei | xi ) = 0. 0 ≤ y ≤ 1. Compute the conditional mean m(x) = E (yi | xi = x) . then ei is independent of xi . Compute E(yi | xi = x) and V ar(yi | xi = x). If yi = x0 β + ei and E(ei | xi ) = 0. ¡ ¢ 4. 1.1 . True or False. E(ei | xi ) = 0. Deﬁne µ ¶ ¢ ¡ x−µ 2 g x. i 11. µ. True or False. True or False. (x − µ)2 − σ 2 Show that Eg (X. j! 0 j = 0. σ = . µx = Exi . Suppose that Y and X only take the values 0 and 1. and E(e2 | xi ) = σ 2 . If yi = x0 β + ei and E(xi ei ) = 0.6 Exercises 1. s) = 0 if and only if m = µ and s = σ 2 . and have the following joint probability distribution X=0 X=1 Y =0 .2 Y =1 . Does this justify a linear regression model of the form yi = x0 β + εi ? i then EY = λ and V ar(Y ) = λ. Let X be a random variable with µ = EX and σ 2 = V ar(X). Compute 2 the coeﬃcients of the linear projection yi = β 0 + β 1 xi + ei .. Are they diﬀerent? Hint: If P (Y = j) = 5. σ 2 = V ar(xi ). .4 . e−λ λj j! . m. If yi = xi β + ei . Let xi and yi have the joint density f (x. 2. y) = 3 x2 + y 2 on 0 ≤ x ≤ 1. 20 .3. 3. 9.3 Find E(Y | X = x). xi ∈ R.2. 3 and 4 of Theorem 3. then E(x2 ei ) = 0. 2. and the conditional distribution of yi given xi is Poisson: P (yi = k | xi = x) = e−x β (x0 β)j . Prove parts 2. True or False. taking values only on the non-negative integers. Suppose that yi is discrete-valued. yi ). then E(ei | xi ) = 0. i 10. and E(xi ei ) = 0. then ei is i i independent of xi . If yi = xi β + ei . Take the bivariate linear projection model yi = β 0 + β 1 xi + ei E (ei ) = 0 E (xi ei ) = 0 Deﬁne µy = Eyi . True or False. i 7. E(Y 2 | X = x) and V ar(Y | X = x). If yi = x0 β + ei .1. a constant. xi ∈ R. σ 2 = V ar(yi ) and σ xy = Cov(xi . i 8. then E(x2 ei ) = 0.

(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 (4.2) can be written in the parametric 0 β)) = 0.3) In Sections 4. i n i=1 n 21 . The function g(β) can be estimated by form g(β) = E (xi (yi − xi g (β) = ˆ ¢ 1X ¡ xi yi − x0 β .3) with the sample moments: ³ ¡ ¢´−1 ˆ ˆ ˆ β = E xi x0 E (xi yi ) i Ã n !−1 n 1X 1X 0 xi xi xi yi = n n i=1 i=1 Ã n !−1 n X X = xi x0 xi yi . Their moment estimators are the sample moments i ˆ E (xi yi ) = ¢ ¡ ˆ E xi x0 = i 1X xi yi n 1 n i=1 n X i=1 n xi x0 .7 and 4.1 Estimation Equation (4.4) i i=1 i=1 ˆ Another way to derive β is as follows. 4. i It follows that the moment estimator of β replaces the population moments in (4.8.3) writes the projection coeﬃcient β as an explicit function of population moments E (xi yi ) and E (xi x0 ) . we narrow the focus to the linear regression model. but for most of the chapter we retain the broader focus on the projection model.2) (4.1) (4. Observe that (4.

40 0. This sample has 988 observations.117 1 14.ˆ This is a set of k equations which are linear in β.30 + 0. An interpretation of the estimated equation is that each year of education is associated with an 11. consider the data used to generate Figure 3. 4. n X i=1 2 yi − 2β 0 n X i=1 xi yi + β 0 n X i=1 xi x0 β.14 14.4). To illustrate. 40 2.94 −2.71 = −2.7% increase in mean wages.3.2 Least Squares There is another classic motivation for the estimator (4.170 37.37 µ ¶ 1. These are white male wage earners from the March 2004 Current Population Survey.4).95 42.40 µ ¶µ ¶ 34. Let yi be log wages and xi be an intercept and years of education.83 ¶−1 µ ¶ .14 205.40 n i=1 1 n Thus ˆ β = n X i=1 xi x0 i = µ 1 14. ¶ 2.14 205.5) = 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. excluding military. with 10-15 years of potential work experience.14 14. 0. 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. Then µ ¶ n 1X 2. The estimator β is the value which jointly sets these equations equal to zero: 0 = g (β) ˆ ˆ n ´ 1X ³ ˆ xi yi − x0 β = i n i=1 (4.117 Educationi . 30 = .95 xi yi = 42. i 22 .

Figure 4.1 displays an example sum—of-squared errors function Sn (β) for the case k = 2. Figure 4. Matrix calculus (see Appendix 2. To visualize the sum-of-squared errors function. The error is unobservable.2 displays the contour lines of the same function — horizontal slices at equally spaced heights. Figure 4.4). while the residual is a by-product of estimation. i ˆ ˆ Note that yi = yi + ei . It is important to understand the distinction between the error ei and the residual ei . 23 .1: Sum-of-Squared Errors Function As a by-product of OLS estimation. which can cause confusion. the contour lines are ellipses. Since the function Sn (β) is a quadratic function of β. 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. we deﬁne the predicted value ˆ yi = x0 β ˆ i and the residual ˆ ei = yi − yi ˆ ˆ = yi − x0 β. These two ˆ variables are frequently mislabeled.The Ordinary Least Squares (OLS) estimator is the value of β which minimizes Sn (β).

These are algebraic results. 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. 24 . The error variance σ 2 = Ee2 is also a parameter of interest.Figure 4.5) implies that 1X xi ei = 0.7) A justiﬁcation for the latter choice will be provided in Section 4. and hold true for all linear regression estimates. Its method of moments estimator is the sample average 1X 2 ei . ˆ σ = ˆ n 2 i=1 n (4.2: Sum-of-Squared Error Function Contours Equation (4. one implication is that n 1X ei = 0. It measures the variation in the i “unexplained” part of the regression.6) An alternative estimator uses the formula n 1 X 2 s = ei . ˆ n i=1 n Since xi contains a constant.7. ˆ n−k 2 i=1 (4.

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

The linear equation (3. and X is an n × k matrix. Thus the MLE (β. the ˆ OLS estimator β is frequently referred to as the Gaussian MLE.6). .4 Model in Matrix Notation convenient to write the model and statistics in x0 1 x0 2 . . n or equivalently Y = Xβ + e. ⎠ . Due to this equivalence. en ⎞ Observe that Y and e are n × 1 vectors. ⎠ ⎜ ⎜ e=⎜ ⎝ ⎟ ⎟ ⎟. n X i=1 Thus the estimator (4.12) is a system of n equations. one for each observation. residual vector.4). yn ⎟ ⎟ ⎟. including computation. ⎟. . yn = x0 β + en . = β+ XX 26 (4. ⎝ ⎝ . it is matrix notation. . .8) . . ˆi 2 ∂σ 2 2ˆ σ 2 σ ˆ i=1 ˆ ˆ Solving for σ 2 yields the method of moments estimator (4. For example n X i=1 For many purposes. x0 n ⎞ ⎛ e1 e2 . 4. ⎠ xi x0 = X 0 X i xi yi = X 0 Y. We deﬁne ⎛ ⎞ ⎛ y1 ⎜ ⎜ y2 ⎟ ⎜ ⎟ ⎜ X=⎜ Y = ⎜ . 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. 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. σ 2 ) for the normal ˆ regression model are identical to the method of moment estimators. We can stack these n equations together as y1 = x0 β + e1 1 y2 = x0 β + e2 2 .Maximization with respect to σ 2 yields the ﬁrst-order condition n X ∂ n 1 ˆ ˆ Ln (β. σ 2 ) = − 2 + ¡ ¢2 e2 = 0. Sample sums can also be written in matrix notation.

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

observe that ⎞ ⎛ ⎞ ⎛ . ⎠ ⎝ ⎠ ⎝ .6. In the model (4. ¡ ¢−1 0 ι. Regress Y on X1 . which you may have seen in an introductory econometrics course. . .8)(3. ˆ ˜ ˜ ˆ 3. the OLS estimator of β 2 and the OLS residuals e may be equivalently computed by either the OLS regression (4.14) or via the ˆ following algorithm: ˜ 1.9). The FWL theorem says that β 2 is the OLS estimate from a regression of ˜ ˜ Y on X2 . but in most cases there is little computational advantage to using the two-step algorithm. ˜ 2. . obtain residuals Y . . obtain residuals X2 . . and X2 is the vector of observed regressors. ˆ which are “demeaned”. the FWL theorem can be used to speed computation. By the independence of the observations and (3. Regress Y on X2 .Theorem 4.1 (Frisch-Waugh-Lovell). . Rather. A common application of the FWL theorem.13). ! Thus the OLS estimator for the slope coeﬃcients is a regression with demeaned data. In some contexts. . obtain OLS estimates β 2 and residuals e. In this section we derive the small sample conditional mean and variance of the OLS estimator.7 Bias and Variance In this and the following section we consider the special case of the linear regression model (3. 30 . . Regress X2 on X1 . 4.18) E (e | X) = ⎜ E (ei | X) ⎟ = ⎜ E (ei | xi ) ⎟ = 0. the primary use is theoretical. In this case. is the demeaning formula for regression. . 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) . . Partition X = [X1 X2 ] where X1 = ι is a vector of ones. ⎟ ⎜ ⎟ ⎜ (4.9). 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.

Using (4. V ar β | X = X 0 X ⎟ ⎟ ⎟. . 1 n . 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. . . σ2 = ˆ ¢ 1 ¡ ¢ 1 0 1 1 1 ¡ e e = e0 M M e = e0 M e = tr e0 M e = tr M ee0 ˆˆ n n n n n 31 In the special case of the linear homoskedastic regression model. From (4. . ⎠ (4.. for any random vector Z deﬁne the covariance materix V ar(Z) = E (Z − EZ) (Z − EZ)0 = EZZ 0 − (EZ) (EZ)0 . under the of ˆ ¢ 2 | x = 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 . Thus D is a diagonal matrix with i’th diagonal element σ 2 : i ⎛ 2 σ1 0 · · · ⎜ 0 σ2 · · · 2 ⎜ D = diag{σ 2 . and the trace operator observe that.8). We have shown that which implies ³ ´ ˆ E β|X =β ³ ´ ˆ E β =β (4. . . σ2 n ⎞ We now calculate the ﬁnite sample bias of the method ¡ moments estimator σ 2 for σ 2 . and ³ ´ ¡ ¢−1 2 ˆ σ . . 0 0 ··· 0 0 . ⎝ . Next. X 0 DX = X 0 Xσ 2 . ¡ X 0X ¢−1 ¡ ¢−1 X 0 DX X 0 X while the ij 0 th oﬀ-diagonal element of D is ¢ ¢ ¡ ¡ E e2 | X = E e2 | xi = σ 2 i i i E (ei ej | X) = E (ei | xi ) E (ej | xj ) = 0.20) .12). and (4.19) ˆ and thus the OLS estimator β is unbiased for β.18). the properties of conditional expectations. Then given (4.. σ 2 = σ 2 and we have the simplii ﬁcations D = In σ 2 . .. σ 2 } = ⎜ .. the properties additional assumption of conditional homoskedasticity E ei i of projection matrices.

as it yields the smallest variance among all unbiased linear estimators.1 Gauss-Markov. 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. or in the projection model. 32 . and thus can be written as ˜ β = A0 Y where A is an n × k function of X.9) plus E e2 | xi = σ 2 .8)¢ ¡ (3. known as the Gauss-Markov theorem. = σ2 n the ﬁnal equality by (4. In the homoskedastic linear regression model. What is the best choice of A? The Gauss-Markov theorem. In this case. ˜ β L = A0 Y = A (Xβ + e) = β + Ae. The following result. ˜ so β is unbiased if (and only if) A0 X = Ik . the estimator ˆ 2 deﬁned (4. Now consider the class of estimators of β which are linear functions of i the vector Y. Thus σ 2 is biased towards zero. This is the justiﬁcation for the common s ˆ preference of s2 over σ 2 in empirical practice. 4. that this estimator is only unbiased in the special case of the homoskedastic linear regression model.10).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 .8. Theorem 4. As an alternative. which is (3.7) is unbiased for σ 2 by this calculation. By a calculation similar to those of the previous section. ³ ´ ˜ E β | X = A0 Xβ. says that the least-squares estimator is the best choice. It is important to remember. however. Thus since V ar (e | X) = In σ 2 under homoskedasticity. which we now present. It is not unbiased in the absence of homoskedasticity. is a famous statement of the solution. 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. ³ ´ ˜ V ar β | X = A0 V ar (e | X) A = A0 Aσ 2 . the best (minimumvariance) unbiased linear estimator is OLS.

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

and any continuous distribution can be arbitrarily well approximated by a multinomial distribution. 1X xi x0 i n i=1 1X xi yi n i=1 n ˆ = β ols 4.10) for the class of models satisfying Assumption 3. Chamberlain (1987) extends this argument to the case of continuously-distributed data.Substituting in the expressions for π j . Let the regressors be partitioned as Suppose we are interested in the coeﬃcient on x1i alone in the regression of yi on the full set xi . if the data have a discrete distribution. and thus so is the OLS estimator. (4. 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. He observes that the above argument holds for all multinomial distributions.4) is an asymptotically eﬃcient estimator for the parameter β deﬁned in (3.1.9). Since this is a regular parametric model the MLE is asymptotically eﬃcient (see Appendix A.5.22) 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 .10 Omitted Variables xi = µ x1i x2i ¶ . the maximum likelihood estimator is identical to the OLS estimator. He proves that generically the OLS estimator (4.

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

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

The key is equation (2. then this observation is a leverage point and has the potential to be an inﬂuential observation. ¢−1 ¡ 0 ¢−1 ¡ 0 ¢−1 ¡ 0 ¢−1 ¡ = XX + XX xi (1 − hi )−1 x0 X 0 X X X − xi x0 i i ¡ 0 ¢−1 ¡ 0 ¢ X X − xi x0 X Y − xi yi i ¢ ¡ ¡ ¢ ¡ ¢−1 ¡ 0 ¢−1 ¢−1 ¡ 0 X Y − xi yi + (1 − hi )−1 X 0 X X Y − xi yi = X 0X xi x0 X 0 X i ¢−1 ¡ ˆ xi ei . ˆ We now derive equation (4.This implies has a large value of hi . ˆ = β − (1 − hi )−1 X 0 X and thus ˆ β (−i) = 37 . which is considerably more informative than plots of the uncorrected residuals ei .27).1) in Section 2. Investigations into the presence of inﬂuential observations can plot the values of (4.25).4 which states that ¡ ¢ (A + BCD)−1 = A−1 − A−1 BC C + CDA−1 BC CDA−1 .

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

These approximations are bounded through the use of mathematical inequalities. then (5. 41 .1 Inequalities Asymptotic theory is based on a set of approximations. then its Euclidean norm is The following are an important set of inequalities which are used in asymptotic distribution theory. ij i=1 j=1 (5. We list here some of the most critical deﬁnitions and inequalities. If p > 1 and q > 1 and 1 p ⎞1/2 ⎛ m n XX ¡ 0 ¢1/2 |A| = tr A A =⎝ a2 ⎠ . 5. Jensen’s Inequality. If g(·) : R → R is convex. then g(E(X)) ≤ E(g(X)). Cauchy-Schwarz Inequality.Chapter 5 Asymptotic Theory This chapter reviews the essential components of asymptotic theory. Triangle inequality |X + Y | ≤ |X| + |Y | . The Euclidean norm of an m × 1 vector a is Ã m !1/2 X ¡ 0 ¢1/2 = a2 . |a| = a a i i=1 If A is a m × n matrix.2) + 1 q = 1.1) (5.3) E |XY | ≤ (E |X|p )1/p (E |Y |q )1/q . ´1/2 ³ ´1/2 ³ E |Y |2 E |XY | ≤ E |X|2 Holder’s Inequality.

Let a + bx be the tangent line to g(x) at x = EX. g(x) ≥ a + bx yet g(EX) = a + bEX since the curve is tangent at EX. n→∞ lim P (|Zn − Z| > δ) = 0. then as n → ∞ n 1X Xn = Xi →p E(X). (E |X|p )1/p (E |Y |q )1/q ¥ µ ¶ ´ ³ U V 1 1 1/p 1/q ≤E + = + = 1. (5. denoted Zn →p Z as n → ∞. as stated. Note EU = EV = 1.1 Weak Law of Large Numbers (WLLN). We say that Zn converges in probability to Z as n → ∞.3). So for all x. Eg(X) ≥ a + bEX = g(EX). if for all δ > 0.4) Proof of Jensen’s Inequality. If Xi ∈ Rk is iid and E |Xi | < ∞. tangent lines lie below it. P (g(X) > α) ≤ α−1 Eg(X). Then Z ∞ −1 P (Y > α) = α αf (y)dy Zα∞ ≤ α−1 yf (y)dy α Z ∞ ≤ α−1 yf (y)dy = α−1 E(Y ) −∞ the second-to-last inequality using the region of integration {y > α}. Let U = |X|p /E |X|p and V = |Y |q /E |Y |q . Applying expectations. =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. This is a probabilistic way of generalizing the mathematical deﬁnition of a limit. ¥ Proof of Holder’s Inequality. ¥ 5. For any strictly increasing function g(X) ≥ 0.2.Markov’s Inequality. The WLLN shows that sample averages converge in probability to the population average. p p p q which is (5. 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 ) = + . Set Y = g(X) and let f denote the density function of Y. Theorem 5. Since g(x) is convex. n i=1 42 .

43 . Theorem 5. and the bound |Wi | ≤ 2C.Proof: Without loss of generality. the fact that the Wi are iid and mean zero.3. If Xi ∈ Rk is iid and E |Xi |2 < ∞. Fix δ and η. if for all x at which F (x) is continuous. We have shown that for any δ > 0 and η > 0 then for all ¢ ¡¯ ¯ ¥ n ≥ 36C 2 /δ 2 η 2 . then as n→∞ n ¢ √ ¡ 1 X n Xn − µ = √ (Xi − µ) →d N (0.7). we can set E(X) = 0 (by recentering Xi on its expectation).7) the ﬁnal inequality holding for n ≥ 4C 2 /ε2 = 36C 2 /δ 2 η 2 . denoted Zn →d Z. ¡¯ ¯ P ¯X n ¯ > δ ≤ η. We say that Zn converges in distribution to Z as n → ∞. Fn (x) → F (x) as n → ∞. Set ε = δη/3. Jensen’s inequality (5.4). n i=1 0 where µ = EX and V = E (X − µ) (X − µ) . (5. Pick C < ∞ large enough so that E (|X| 1 (|X| > C)) ≤ ε (5. 5.3 Convergence in Distribution Let Zn be a random variable with distribution Fn (x) = P (Zn ≤ x) . Finally. ¯ ¯ ¯ ¯ ¯ ¯ ¢ E ¯X n ¯ ¡¯ ¯ E ¯W n ¯ + E ¯Z n ¯ 3ε ≤ ≤ = η. V ) .1) and (5. where Z has distribution F (x) = P (Z ≤ x) . by Markov’s inequality (5. We need to ¢show that for all δ > 0 and η > 0 there is some N < ∞ so that for all n ≥ N. ¯¢2 ¡ ¯ 2 ≤ EW n E ¯W n ¯ = EWi2 n 4C 2 ≤ n ≤ ε2 (5. ≤ 2E |Xi | 1 (|Xi | > C) Zi = Xi 1 (|Xi | > C) − E (Xi 1 (|Xi | > C)) . the triangle inequality. the fact that X n = W n + Z n .1).1 Central Limit Theorem (CLT).6) and (5. P ¯X n ¯ > δ ≤ η. P ¯X n ¯ > δ ≤ δ δ δ the equality by the deﬁnition of ε.5). ≤ E |Xi | 1 (|Xi | > C) + |E (Xi 1 (|Xi | > C))| (5. Deﬁne the random vectors Wi = Xi 1 (|Xi | ≤ C) − E (Xi 1 (|Xi | ≤ C)) By the triangle inequality. as needed.6) By Jensen’s inequality (5.5) (where 1 (·) is the indicator function) which is possible since E |X| < ∞. ¯ ¯ E ¯Z n ¯ ≤ E |Zi | ≤ 2ε.

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

gθ Σgθ . 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 . Σ) .4. Proof: Since g is continuous at c. This is suﬃcient to establish the theorem. Since cλλ (λn ) → cλλ (0) = −Ik . If Zn →d Z as n → ∞ and g (·) is continuous. then g(Zn ) →p g(c) as n → ∞. where θ is m × 1 and Σ is m × m. we ﬁnd jn ¢ ¡ √ √ 0 n (g (θn ) − g(θ0 )) = (gθ + an ) n (θn − θ0 ) →d gθ N (0. Σ) = N 0. for all ε > 0 we can ﬁnd a δ > 0 such that if |Zn − c| < δ then |g (Zn ) − g (c)| ≤ ε. It follows that ajn = gjθ (θ∗ ) − gjθ →p 0. Theorem 5. then ¡ ¢ √ 0 n (g (θn ) − g(θ0 )) →d N 0. Hence g(Zn ) →p g(c) as n → ∞.4 Asymptotic Transformations Theorem 5. Ik ) distribution. and g(θ) : Rm → Rk . Stacking across elements of g. for each element of g. gθ Σgθ where gθ (θ) = ∂ g(θ) ∂θ0 and gθ = gθ (θ0 ). ¥ 5. we see that as n → ∞.4.2 Continuous Mapping Theorem 2.1 Continuous Mapping Theorem 1 (CMT). Proof : By a vector Taylor series expansion. Recall that A ⊂ B implies P (A) ≤ P (B). µ ¶ 1 Cn (λ) → exp − λ0 λ 2 the characteristic function of the N (0. Thus P (|g (Zn ) − g (c)| ≤ ε) ≥ P (|Zn − c| < δ) → 1 as n → ∞ by the assumption that Zn →p c. 45 .√ where λn → 0 lies on the line segment joining 0 and λ/ n.3 Delta Method: If n (θn − θ0 ) →d N (0. then g(Zn ) →d g(Z) as n → ∞. If Zn →p c as n → ∞ and g (·) is continuous at c. k ≤ m. √ Theorem 5.4.

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

For a complete argument.1). β →p β as n → ∞. Equation (4. ·) is continuous at (Q.8) implies that ˆ β−β = Ã n X i=1 xi x0 i !−1 n X i=1 xi ei . This is illustrated in Figure 6. First. Assumption 3.5.5. ¥ We can similarly show that the estimators σ 2 and s2 are consistent for σ 2 .1 and the WLLN (Theorem 5.1 Under Assumption 3.1). n i=1 (6.1. (6.4 implies that Q−1 exists and thus g(·.5. Asymptotic (large sample) methods approximate sampling distributions based on the limiting experiment that the sample size n tends to inﬁnity. 0). using (6. we can conclude ˆ that β →p β.1. xi ei = g i n n i=1 i=1 1X xi ei →p E (xi ei ) = 0. 0) = Q−1 0 = 0 β−β =g n n i=1 i=1 ˆ which implies β →p β as stated. Ã n ! n X 1X 0 1 ˆ xi xi . ˆ 47 .2. To characterize the sampling distribution more fully.3) Ã where g(A.1) and ˆ We now deduce the consistency of β.1).2 Consistency ˆ As discussed in Section 6.4.2. As the sample size increases the density becomes more concentrated about the population coeﬃcient.2). 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. Assumption 3. ˆ Theorem 6. we will use the methods of asymptotic approximation. 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 . (6.1) imply that n ¡ ¢ 1X xi x0 →p E xi x0 = Q (6.From the ﬁgure we can see that the density functions are dispersed and highly non-normal.1 by the fact that the sampling densities become more concentrated as n gets larger. Hence by the continuous mapping theorem (Theorem 5.2) 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. and the continuous mapping theorem (Theorem 5.1).4.3). (6. the OLS estimator β is has a statistical distribution which is unknown. xi ei →p g (Q. 6.1. Proof.

1.1).2). since n/(n − k) → 1 as n → ∞. ˆ Proof. (6. by the Cauchy-Schwarz inequality (5.3) and Theorem (6. By the central limit theorem (Theorem 5.1.5.2). Assumption 6. Ee4 < ∞ and E |xi |4 < ∞.2. (6. ˆ Finally.3.2 Under Assumption 3.1 In addition to Assumption 3. E ¯ei ¯ E ¯e4 ¯ i i i i (6. n 1 X √ xi ei →d N (0. 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 . To see this.3 Asymptotic Normality ˆ We now establish the asymptotic distribution of β after normalization.6) n i=1 48 . Ω) .4) ³ ´ ³ ´0 ³ ´ ˆ ˆ ˆ e2 = e2 − 2ei x0 β − β + β − β xi x0 β − β ˆi i i i σ2 = ˆ 1X 2 ei ˆ n i=1 i=1 →p σ 2 n 1X 2 = ei − 2 n Ã ! Ã n ! n ´ ³ ´0 1 X ³ ´ 1 X 0 ³ˆ 0 ˆ ˆ β−β + β−β β−β ei xi xi xi n n i=1 i=1 the last line using the WLLN.3. it follows that s2 = ¥ n σ 2 →p σ 2 .5) Thus xi ei is iid with mean zero and has covariance matrix Ω.3.5.1 guarantees that the elements of Ω are ﬁnite. ˆ n−k 6.2.1). i i Assumption 6. Thus σ 2 is consistent for σ 2 . (6. σ 2 →p σ 2 and s2 →p σ 2 as n → ∞. i Now deﬁne ¡ ¢ Ω = E xi x0 e2 . We need a strengthening of the moment conditions. ´1/2 ¡ ¯ ¯¢ ¯ ³ ¯ ¯2 ´1/2 ¡ ¯ 4 ¯¢1/2 ³ ¯ 1/2 E ¯xi x0 e2 ¯ ≤ E ¯xi x0 ¯ = E |xi |4 < ∞.Theorem 6. (6.

If α > 2 the 2 error εi has zero mean and variance α/(α − 2).3. V ) where V = Q−1 ΩQ−1 . and (6.1. How large should n be in order for the approximation to be useful? Unfortunately. Theorem 6. V is often referred to as ˆ the asymptotic covariance matrix of β.1 we have already seen a simple example where the least-squares estimate is quite asymmetric and non-normal even for reasonably large sample sizes.6). ´ √ ³ ˆ n β−β = Ã 1X xi x0 i n i=1 n !−1 Ã Theorem 6. i i Condition (6.1 states that the sampling distribution of the least-squares estimator.3. after rescaling. The asymptotic distribution ´ Theorem 6.2). (6. In this context the normalized least-squares slope estimator n α−2 β 2 − β 2 has α →d Q−1 N (0.2 we display the ﬁnite sample densities of the q ³ ˆ normalized estimator n α−2 β 2 − β 2 . Under (6.3. However.7) is true or false. This holds true for all joint distibutions of (yi .9) we deﬁne V 0 = Q−1 σ 2 whether (6.9) In (6.1. its variance diverges q ³ ´ ˆ to inﬁnity. There is a special case where Ω and V simplify.8) Ω = E xi x0 E e2 = Qσ 2 i i V = Q−1 ΩQ−1 = Q−1 σ 2 ≡ V 0 (6.Then using (6.7) holds. ´ √ ³ˆ As V is the variance of the asymptotic distribution of n β − β .3. 1) asymptotic distibution. there is no simple answer to this reasonable question.1). |ε| ≥ 1. When (6. For α 49 . Q−1 ΩQ−1 .7) Cov(xi x0 . for example.1 is commonly used to approximate the ﬁnite of √ ³ˆ sample distribution of n β − β . otherwise V 6= V 0 . as n → ∞ ´ √ ³ ˆ n β − β →d N (0. 1 X √ xi ei n i=1 n ! the N (0.3. for any ˆ ﬁxed n the sampling distribution of β can be arbitrarily far from the normal distribution. when xi and ei are independent. Let yi = β 0 + β 1 xi + εi where xi is N (0.7) is true then V = V 0 . Ω) ¡ ¢ = N 0. In Figure 6. We call V 0 the homoskedastic covariance matrix. is approximately normal when the sample size n is suﬃciently large. and εi is independent of xi with the Double Pareto density f (ε) = α |ε|−α−1 . 1). The expression V = Q−1 ΩQ−1 is called a sandwich form. The approximation may be poor when n is small. however. The trouble is that no matter how large is the sample size. xi ) which satisfy the conditions of Assumption 6. We illustrate this problem using a simulation. We say that ei is a Homoskedastic Projection Error when (6.1 Under Assumption 6.7) the asymptotic variance formulas simplify as ¡ ¢ ¡ ¢ (6. the normal approximation is arbitrarily poor for some data distribution satisfying the assumptions. In´Figure 6. e2 ) = 0. As α approaches 2. but this is not a necessary condition. setting n = 100 and varying the parameter α.

We show the sampling distribution of n β 1 − β 1 setting n = 100. ˆ ˆ Since Q →p Q and s2 →p σ 2 (see (6. for k = 1.3 is that the N (0. The homoskedastic covariance matrix V 0 = Q−1 σ 2 is typically estimated by ˆ ˆ (6.2. concentrating most of the probability mass around zero.Figure 6. σ may also be substituted for s ˆ ¡ ¢ To estimate V = Q−1 ΩQ−1 .10) V 0 = Q−1 s2 . we need an estimate of Ω = E xi x0 e2 . Another example is shown in Figure 6.11) 50 . The MME estimator is i i 1X ˆ xi x0 e2 Ω= i ˆi n i=1 n (6.2 and 6.0 the density is very close to the N (0.3.10) without changing this result.2: Density of Normalized OLS estimator α = 3. 6 and 8. 1) asymptotic approximation is never guaranteed to be accurate. As α diminishes the density changes signiﬁcantly. Here the model is yi = β 1 + εi where uk − Euk i i εi = ³ ¡ k ¢2 ´1/2 Eu2k − Eui i ´ √ ³ˆ and ui ∼ N (0. The lesson from Figures 6. 4.2) and Theorem 6. 1) density.4 Let Covariance Matrix Estimation 1X ˆ xi x0 Q= i n i=1 n be the method of moments estimator for Q. 1). The estimator 2 2 in (6. the sampling distribution becomes highly skewed and non-normal. 6. As k increases.1) it is clear that V 0 →p V 0 .

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

We can write the estimated equation with standards errors using the format \ log(W agei ) = 1. We calculate that s2 = 0.98 −0.020) 6. (.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.30 + 0. the standard method to calculate the standard errors is to ˆ ﬁrst calculate n−1 V .199 2. by Holder’s inequality (5. n n i=1 52 .20 = V 14.83 ¶−1 = µ 7. Ω 2.493 0.80 40.2. Using (6.80 2.6 Therefore the two covariance matrix estimates are µ ¶−1 µ ¶ 1 14.35/988 = .020. from which it follows that V →p V as n → ∞.20 −0. To illustrate.12) in turn. It is also important to understand that a particular standard error may be relevant under one set of model assumptions.14 14. but not under another set of assumptions.12) i i n n n i=1 i=1 We now examine each sum on the right-hand-side of (6.14 205. we return to the log wage regression of Section 4.2/988 = .used by an author when studying their work.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 .6 ¶µ 1 14.5) and the WLLN (Theorem 5.480 .1. First.14 205.493 −0.83 −0.035 ¶ . then take the diagonal elements.480 ˆ0 = 0.085 p ˆ and that for β 1 is .80 40.199 2. i i i i n i=1 Second.80 . E ¯e4 ¯ i ³ ´ 1X |xi |3 |ei | →p E |xi |3 |ei | .039 and ˆ V = µ 1 14.3) so by the WLLN ³ ´ ³ ´3/4 ¡ ¯ ¯¢ 1/4 E |xi |3 |ei | ≤ E |xi |4 < ∞.83 ¶−1 µ . p ˆ In this case the two estimates are quite similar.14 14. and then the square roots. (6.14 6. (6.117 Educationi . just as any other estimator.1) show that n ¡ ¢ 1X xi x0 e2 →p E xi x0 e2 = Ω. The standard errors for β 0 are 7.14 205.085) (.20 and µ ¶ ˆ = 0. From a computational standpoint.

Recall from Section 4.12 the deﬁnition of β (−i) as the least-squares estimator with the i’th observation deleted. From equation (3.13) Using formula (4. They also suggest that the scaling factor (n − 1)/n in (??) can be omitted.14) Ã 1X (1 − hi )−1 xi ei ˆ n i=1 n !Ã 1X (1 − hi )−1 xi ei ˆ n i=1 n !0 and hi = x0 (X 0 X)−1 xi . Andrews’ proposed estimator is ˆ ˆ ˆ ˆ V ∗∗ = Q−1 Ω∗∗ Q−1 53 .1 As n → ∞. Andrews (1991) suggested an similar estimator based on cross-validation.−i = (1 − hi )−1 ei ˆ presented in (4. i=1 Third. Ω →p Ω and V →p V.13) of Efron (1982). these establish consistency.25).5. n i=1 n − 1 ˆ −1 ˆ ∗ ˆ −1 ˆ V∗ = Q Ω Q n where 1X ˆ (1 − hi )−2 xi x0 e2 − Ω∗ = i ˆi n i=1 n (6. MacKinnon and White (1985) present numerical (simulation) evidence i ˆ ˆ that V ∗ works better than V as an estimator of V . Using this substitution.6 Alternative Covariance Matrix Estimators ˆ MacKinnon and White (1985) suggested a small-sample corrected version of V based on the jackˆ knife principle. 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.¯ ¯ ¯ ¯ˆ and thus since ¯β − β ¯ →p 0. by the WLLN ¯ n ¯ Ã n ! ¯ 1X ¯1 X ¯ ¯ ³ ´0 ¯ ¯ ¯ ¯ˆ 3 0 ˆ xi xi β − β xi ei ¯ ≤ ¯β − β ¯ |xi | |ei | →p 0. 6.11) with the leave-one-out estimator ei. is deﬁned ˆ ˆ by replacing the OLS residual ei in (6. which.26). n i=1 n ˆ ˆ Theorem 6. ¯ ¯n ¯ n i=1 so Together. you can show that 1 Xˆ ¯ β= β (−i) . ¯ ¯ ¯ ¯ ¯n ¯ n i=1 i=1 1X |xi |4 →p E |xi |4 . ¯ 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.

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

θ) β 6. the statistic tn has an exact t distribution. A simple null and composite hypothesis takes the form H0 : θ = θ0 H1 : θ 6= θ0 where θ0 is some pre-speciﬁed value. (For example. 55 . µ I 0 ¶ ˆ the upper-left block of V . then θ = R0 β = β 1 and ˆ Vθ = ¡ I 0 ¢ ˆ V µ I 0 ¶ ˆ = V11 . In special cases (such as the normal regression model. θ could be a single element of β).1 tn (θ) →d N (0. s(ˆ = n−1/2 H 0 V Hβ . however. the standard error for ˆ is the square root of n−1 Vθ . In this case. Since the standard normal distribution does not depend on the parameters. we say that tn (θ) is asymptotically pivotal. β 2 ). In general. pivotal statistics are unavailable and so we must rely on asymptotically pivotal statistics. and is therefore exactly free of unknowns. 1) Proof. and θ = h(β) is some function of the parameter vector.8. ˆ When q = 1q h(β) is real-valued).For example. By (6. ˆ its estimate and s(ˆ its asymptotic θ θ) standard error. Vθ ) √ Vθ = N (0. that (so θ ˆ ˆ ˆ is.8 t tests Let θ = h(β) : Rk → R be any parameter of interest. s(ˆ θ) (6.15) tn (θ) = ˆ−θ θ s(ˆ θ) ´ √ ³ˆ n θ−θ q = ˆ Vθ N (0. Consider the studentized statistic tn (θ) = Theorem 6. 1) →d ˆ−θ θ .16) ¥ Thus the asymptotic distribution of the t-ratio tn (θ) is the standard normal. see Section X). we say that tn is an exactly pivotal statistic. if R is a “selector matrix” R= so that if β = (β 1 .

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

and it is desired to test the joint restrictions simultaneously. We say that Cn has asymptotic (1 − α)% coverage for θ if P (θ ∈ Cn ) → 1 − α as n → ∞. A good method for construction of a conﬁdence interval is the collection of parameter values which are not rejected by a statistical test. θ The interval has been constructed so that as n → ∞. ¢ ¡ ¢ ¡ P (θ ∈ Cn ) = P |tn (θ)| ≤ zα/2 → P |Z| ≤ zα/2 = 1 − α.16) and zα/2 is the upper α/2 quantile of the standard normal distribution.17) = ˆ − zα/2 s(ˆ θ and Cn is an asymptotic (1 − α)% conﬁdence interval. In this case the t-statistic approach does not work. = n h(β) − θ0 Hβ V Hβ 57 (6. However we often can calculate the asymptotic coverage probability limn→∞ P (θ ∈ Cn ). While there is no hard-and-fast guideline for choosing the coverage probability 1 − α. θ θ) (6. Hβ = ∂β The Wald statistic for H0 against H1 is ´0 ³ ´ ³ ˆ θ θ Wn = n ˆ − θ0 Vθ−1 ˆ − θ0 ´0 ³ ´−1 ³ ´ ³ ˆ ˆ ˆ0 ˆ ˆ h(β) − θ0 . ˆ + zα/2 s(ˆ . and values of θ outside two standard θ errors of the estimated ˆ are considered unlikely or unreasonable candidates for the true value.18) . 6.10 Wald Tests Sometimes θ = h(β) is a q × 1 vector.05. We have the null and alternative H0 : θ = θ0 H1 : θ 6= θ0 . the most common professional choice isi95%.We typically cannot calculate the exact coverage probability P (θ ∈ Cn ). A conﬁdence interval is then constructed as the values of θ for which this test does not reject: © ª Cn = θ : |tn (θ)| ≤ zα/2 ( ) ˆ−θ θ = θ : −zα/2 ≤ ≤ zα/2 s(ˆ θ) i h θ). 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. or α = . ˆ The natural estimate of θ is ˆ = h(β) and has asymptotic covariance matrix estimate θ ˆ0 ˆ ˆ ˆ Vθ = Hβ V Hβ where ∂ ˆ ˆ h(β). This corresponds to selecting the conﬁdence h i h ˆ ± 1.96s(ˆ ≈ ˆ ± 2s(ˆ . The t-test of the previous setion rejects H0 : θ0 = θ if |tn (θ)| > zα/2 where tn (θ) is the t-statistic (6.

Vθ ). χ2 (. and there are q = k2 restrictions. Furthermore.3. the upper-α quantile q 2 of the χ2 distribution. ˜ 58 ¡ 0 ¢−1 0 ˜ β 1 = X1 X1 X1 Y .1 showed θ ˆ that V →p V. In this case.15) showed that n ˆ − θ →d Z ∼ N (0. 6. ˆ Wn = n θ θ q θ θ Theorem 6. and Theorem 6. 1] under H0 .8.10. Thus Vθ = H 0 V Hβ →p H 0 V Hβ = Vθ > 0 if Hβ has full rank q.025 . Hβ (β) →p Hβ . so by the continuous mapping ˆ ˆ ˆ ˆ ˆ theorem. where p(x) = P χ2 ≥ x is the tail q q probability function of the χ2 distribution. The Wald test fails to reject if Wn is q 1 ¡ ¢ less than χ2 (α).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 . An asymptotic Wald test rejects H0 in favor of H1 if Wn exceeds χ2 (α). then Wn →d χ2 . Wn = n R0 β − θ0 ´ √ ³ The delta method (6. q and pn is asymptotically U[0. As before. Hβ (β) is a continuous function of β.5. 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.05) = 3. ˜˜ n ˜ e = Y − X1 β 1 . then the Wald statistic can be written in the form ¶ µ 2 ˆ σ − σ2 ˜ Wn = n (6. The asymptotic p-value for Wn is pn = p(Wn ). if rank(Hβ ) = q.19) σ2 ˆ where σ2 = ˜ 1 0 e e. the test rejects at the α% level iﬀ pn < α. θ = β 2 .When h is a linear function of β. a chiq square random variable with q degrees of freedom.1 Under H0 and Assumption 6. For example.1. We know that the Wald statistic takes the form 0 Wn = nˆ Vθ−1 ˆ θ ˆ θ ³ ´−1 ˆ ˆ0 ˆ β 2.2. h(β) = R0 β. Hence β β by Theorem A. Also h(β) = a selector matrix.84 = z. The null hypothesis is H0 : β 2 = 0. then the Wald statistic takes the form ´0 ³ ´ ³ ´−1 ³ ˆ ˆ ˆ R0 V R R0 β − θ 0 . We have established: ³ ´0 ³ ´ ˆ − θ0 V −1 ˆ − θ0 →d Z 0 V −1 Z = χ2 . = nβ 2 R0 V R R0 β is linear with R = µ 0 I ¶ ¢−1 ¡ ˆ ˆ ˆ .

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

In σ 2 . when sample sizes were very small and researchers wanted to know if there was “any explanatory power” to their regression. This is ¢ ¡ 2 ˆ σ y − σ 2 / (k − 1) ˜ F = . introduced in Section 4. 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 . an “F statistic” is reported. including the estimated error variance 2.12 Normal Regression Model As an alternative to asymptotic distribution theory. 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. these cases are atypical.where In many statistical packages. when an OLS regression is reported. 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. Since uncorrelated normal variables are independent. n−k 60 . The modelling assumption that the error ei is independent of xi and N (0. e ˆ M 0 σ2 M where M = I − X (X 0 X)−1 X 0 . σ 2 /(n − k) ˆ σ2 = ˜y 1 (y − y)0 (y − y) n is the sample variance of yi . equivalently the residual variance from an intercept-only model.3. This is rarely an issue today. Let u = σ −1 H 0 e ∼ N (0. there is an exact distribution theory available for the normal linear regression model. H 0 H) ∼ N (0. This special F statistic is testing the hypothesis that all slope coeﬃcients (other than the intercept) are zero. 6. In particular.4)) where H 0 H = In . as sample sizes are typically suﬃciently large that this F statistic is highly “signiﬁcant”. 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. While there are special cases where this F statistic is useful. This was a popular statistic in the early days of econometric reporting. s The spectral decomposition of M yields ¸ ∙ In−k−1 0 H0 M =H 0 0 (see equation (2. In ) .

1 If ei is independent of xi and distributed N(0.a chi-square distribution with n − k degrees of freedom. β has an exact normal distribution and t has an exact t distribution. 0. Theorem 6. The estimator under the alternative is the unrestricted estimator ˆ ˆ ˆ (β 1 . σ 2 ) where β 1 is the OLS estimate from ˜ 2 ˜ a regression of yi on x1i only. 1) and tn−k distributions. (Unless the sample size is unreasonably small. σ2 ˆ 61 .1 we showed that in large samples.8.10) then ´ ³ ˆ • β ∼ N 0. σ ˆ ˆ βj − βj βj − βj N (0. 0. The critical values are quite close if n − k ≥ 30. and standard errors are calculated using the homoskedastic formula (6. β 2 . β and t are approximately normally distributed. Furthermore. a good testing procedure is based on the likelihood ratio statistic. ˆ 2 2 2 ˜ ˜ The MLE of the model under the null hypothesis is (β 1 . σ 2 ) = − log 2πˆ 2 − 2 e0 e ˆˆ 2 2ˆ σ ¡ ¢ n n n = − log σ 2 − log (2π) − . σ 2 ) ¡ ¢¢ ¡ ¡ ¢ ˆ = n log σ 2 − log σ 2 ˜ µ 2¶ σ ˜ = n log .1 and Theorem 6. β 2 .1 shows that under the strong assumption of ˆ normality. 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. 0. n−k • ∼ tn−k ˆ In Theorem 6. β 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. σ 2 (X 0 X)−1 • (n−k)s2 σ2 ˆ β j −β j ˆ s(β ) j ∼ χ2 . 2 2 2 The LR statistic for H0 is ´ ³ ˆ ˆ ˆ ˜ ˜ LR = 2 Ln (β 1 .) Now let us partition β = (β 1 .3. σ 2 ) discussed above. with residual variance σ .12. σ 2 ) − Ln (β 1 . if standard errors are calculated using the homoskedastic formula (6. which is twice the diﬀerence in the log-likelihood function evaluated under the null and alternative hypotheses. so as a practical matter it does not matter which distribution is used.10) µ h i ¶ 2 (X 0 X)−1 N 0. the notable distinction is between the N (0. The log-likelihood of this model is ¡ 2¢ n n n ˜ ˜ ˜ Ln (β 1 . We summarize these ﬁndings Theorem 6. As inference (conﬁdence intervals) are based on the t-ratio.12. In contrast. The Gaussian log-likelihood at these estimates is ¡ ¢ n 1 ˆ ˆ ˆ σ Ln (β 1 . σ 2 ) = − log σ − log (2π) − . σ 2 ).

as Wn (s) →d χ2 under H0 for 1 any s. the statistic Wn (s) varies with s. Our ﬁrst-order asymptotic theory is not useful to help pick s.4 the Wald statistic Wn (s) as a function ˆ of s. This is distressing since the choice of s seems arbitrary and irrelevant to the actual hypothesis. This produces random draws from the sampling distribution of interest. This is an unfortunate feature of the Wald statistic.13 Problems with Tests of NonLinear Hypotheses While the t and Wald tests work well when the hypothesis is a linear restriction on β.7. To demonstrate this eﬀect. The method uses random simulation to create an artiﬁcial dataset to apply the statistical tools of interest. ˆ Let β and σ 2 be the sample mean and variance of yi . 6.84 — the probability of a false rejection. σ 2 s2 β ˆ ˆ While the hypothesis β s = 1 is unaﬀected by the choice of s. they can work quite poorly when the restrictions are nonlinear. Then the standard Wald test for H0 is ˆ ³ ´2 ˆ β−1 Wn = n . The increasing solid line is for the case β = 0. features of this distribution can be calculated. one feature of importance is the Type I error of the test using the asymptotic 5% critical value 3. Take the model yi = β + ei ei ∼ N (0. In the present context of the Wald statistic. 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.By a ﬁrst-order Taylor series approximation ¶ µ 2 ¶ µ σ ˜ σ2 ˜ − 1 = Wn . Letting h(β) = β s . This is a context where Monte Carlo simulation can be quite useful as a tool to study and compare the exact distributions statistical procedures in ﬁnite samples. while there are other values of s for which test test statistic is insigniﬁcant. The decreasing dashed ˆ = 1. 62 . This can be seen by a simple example introduced by Lafontaine and White (1986). setting n/σ 2 = 10. σ 2 ) and consider the hypothesis H0 : β = 1.8. we ﬁnd that the standard Wald test for H0 (s) is ´2 ³ s ˆ β −1 Wn (s) = n 2s−2 . and noting Hβ = sβ s−1 . we have plotted in Figure 6. σ2 ˆ Now notice that H0 is equivalent to the hypothesis H0 (s) : β s = 1 for any positive integer s. LR = n log 1 + 2 − 1 ' n σ ˆ σ2 ˆ the F statistic.

4: Wald Statistic as a function of s P (Wn (s) > 3. we compare the rates row by row. n.Figure 6. remember that the ideal Type I error probability is 5% (. Given the simplicity of the model. In Table 4. The second through seventh columns contain the Type I error probabilities for diﬀerent combinations of n and σ. this probability depends only on s. Each row of the table corresponds to a diﬀerent value of s — and thus corresponds to a particular choice of test statistic. The null hypothesis β s = 1 is true. In Table 2. These probabilities are calculated as the percentage of the 50.1 reports the simulation estimate of the Type I error probability from 50. Table 4. no magic choice of n for which all tests perform uniformly well. looking for tests for which rate rejection rates are close to 5%. which is not surprising given the dependence of Wn (s) on s as shown in Figure 6. Any other choice of s leads to a test with unacceptable Type I error probabilities. Typically.1 we report the results of a Monte Carlo simulation where we vary these three parameters. so these probabilities are Type I error. Table 4. however. To interpret the table.1 Type I error Probability of Asymptotic 5% Wn (s) Test 63 . the Type I error probability improves towards 5% as the sample size n increases. Rates above 20% are unexceptable.4. 100 and 500.1 you can also see the impact of variation in sample size. There is. Type I error rates between 3% and 8% are considered reasonable.84 | β = 1) .05) with deviations indicating+ distortion. and rarely fall outside of the 3%-8% range. and σ 2 .84. the only test which meets this criterion is the conventional Wn = Wn (1) test. The value of s is varied from 1 to 10. Test performance deteriorates as s increases. When comparing statistical procedures. For this particular example. and σ is varied among 1 and 3. Error rates avove 10% are considered excessive. n is varied among 20.000 random samples. In each case.000 simulated Wald statistics Wn (s) which are larger than 3.

let V be an estimate of the ˆ asymptotic variance matrix for β and set ˆ = β 1 /β 2 .06 .33 . Equivalently.12 . Other choices are arbitrary and would not be used in practice.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 .30 .12 .25 .10 .09 .31 . Take the model yi = β 0 + x1i β 1 + x2i β 2 + ei E (xi ei ) = 0 and the hypothesis H0 : β1 =r β2 (6.05 .13 .11 .05 .17 .34 .15 .23 . β 2 ) be the least-squares estimates of (6.05 . so the hypothesis can be stated as H0 : θ = r.26 . deﬁne θ = β 1 /β 2 .10 . This point can be illustrated through another example.20).13 .19 . Deﬁne θ ˆ ˆ ⎞ ⎛ 0 ⎟ ⎜ ⎟ ⎜ ⎜ 1 ⎟ ⎟ ⎜ ⎜ ˆ ⎟ ˆ H1 = ⎜ β 2 ⎟ ⎟ ⎜ ⎟ ⎜ ⎜ β ⎟ ˆ ⎠ ⎝ − 1 ˆ2 β2 ´ s(ˆ θ) −r .10 .06 .08 .14 . While this is clear in this particular example.06 . β 1 .06 .22 . ˆ ˆ ˆ ˆ ˆ Let β = (β 0 .15 .24 . In this case a t-statistic for H0 is t1n = ³ˆ β1 ˆ β2 where r is a known constant.08 . in other examples natural choices are not always obvious and the best choices may in fact appear counter-intuitive at ﬁrst.06 . An alternative statistic can be constructed through reformulating the null hypothesis as H0 : β 1 − rβ 2 = 0.15 .08 .05 .13 .20 .20 .06 .14 .07 .07 .08 .05 .07 .28 .18 . 64 .35 .000 simulated random samples In this example it is not surprising that the choice s = 1 yields the best test statistic.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) .08 .21 .25 .22 .07 .05 .06 .15 .16 Rejection frequencies from 50.

26 .12 . . then the “most linear” formulation should be selected.50. In all cases.05 .02 .05 . σ 2 ) draw with σ = 3.1.00 .06 .28 . such as the GMM distance statistic which will be presented in Section 9.00 . In contrast. the rejection rates for the linear t2n statistic are invariant to the value of β 2 . In this section we describe the method in more detail.10 .00 . The implication of Table 4. 1) variables.06 . We vary β 2 among .645) and P (tn > 1.00 The one-sided Type I error probabilities P (tn < −1. The left tail probabilities P (t1n < −1.645) P (tn > 1.75 1.06 .0 and n among 100 and 500.05 β2 .07 .15 .2. 65 .47 .00 .50 .05 . along with sample size n.05 . −r ⎛ t2n where To compare t1n and t2n we perform another simple Monte Carlo simulation. Table 4. the rejection rates for the t1n statistic diverge greatly from this value. if the hypothesis can be expressed as a linear restriction on the model parameters. However.2 is that the two t-ratios have dramatically diﬀerent sampling behavior. If no linear formulation is feasible. and normalize β 0 = 0 and β 1 = 1.645) P (tn > 1. The results are presented in Table 4.2 Type I error Probability of Asymptotic 5% t-tests n = 100 n = 500 P (tn < −1.75.00 .06 .05 .00 .00 .09 . this formulation should be used.25.06 .10 . while the right tail probabilities P (t1n > 1.06 .10 .05 . especially for small values of β 2 .000 simulated samples.A t-statistic based on this formulation of the hypothesis is ´2 ³ ˆ 1 − rβ 2 ˆ β =³ ´1/2 .645) are close to zero in most cases. We let x1i and x2i be mutually independent N (0. This leaves β 2 as a free parameter. 6.645) P (tn < −1.00 . . It is also prudent to consider alternative tests to the Wald statistic.7.25 . −1 H V H ˆ 2 n 2 ⎞ 0 H2 = ⎝ 1 ⎠ .645) t1n t2n t1n t2n t1n t2n t1n t2n .645) are calculated from 50.15 .00 . The common message from both examples is that Wald statistics are sensitive to the algebraic formulation of the null hypothesis.06 . ei be an independent N (0.05.05 .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. and are close to the ideal 5% rate for both sample sizes. the entries in the table should be 0. and alternatives to asymptotic critical values should be considered.06 .05 . .06 .645) greatly exceed 5%.06 .05 . Ideally. and 1.

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

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

014 .4877 18.808 . as the 1% critical value for the χ2 distribution is 76.variable for state of residence (including the District of Columbia. The F form of the Wald statistic (6. 808 1 − .00057 .00002 .032 .48772 = 515.070 .232 .808 so the parameter estimates are quite precise and reported in Table 4.101 .097 −.008 .033 −.49452 σ ˜ Notice that the two statistics are close.102 −. if β 2 > 0 and β 3 < 0 the solution is θ=− From Table 4.18) that the state coeﬃcients are jointly zero. excluding the coeﬃcients on the state dummy variables. we ﬁnd Wn = 550.001 .1.010 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.002 . the restricted standard deviation estimate is σ = .010 . The available sample is 18.69.013 . Using either statistic the hypothesis is easily rejected.007 . θ ˆ 2β 3 β2 .1 we ﬁnd the point estimate ˆ ˆ = − β 2 = 28. 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. 50 Another interesting question which can be addressed from these estimates is the maximal impact of experience on mean wages.121 −. but not equal.102 −. Computing the Wald statistic (6.027 .4945.34 ˆ s(β) . 2β 3 68 . Alternatively. Table 4. Ignoring the other coeﬃcients. this adds 50 regressors).1 OLS Estimates of Linear Equation for Log(Wage) ˆ β 1. Wn = n 1 − 2 = 18. reestimating the model with the 50 state dummies excluded.19) is ˜ µ ¶ µ ¶ σ2 ˆ .

9. implying a 95% conﬁdence θ) interval of [27. Notice that the upper end of the conﬁdence interval is the same as that from the delta method.0. This set is [27.40.5]. we can calculate a standard error of s(ˆ = .96. However. 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. but it can be found numerically quite easily. we found better Type I error rates by reformulating the hypothesis as a linear restriction. This is the set of θ such that |tn (θ)| ≤ 1. 29. 69 . this is a poor choice. Instead. as the coverage probability of this conﬁdence interval is one minus the Type I error of the hypothesis test based on the t-test. there is not a simple expression for this set. Our desired conﬁdence interval will be the set of parameter values θ which are not rejected by the hypothesis test. In the previous section we discovered that such t-tests had very poor Type I error rates.Using the Delta Method. Since tn (θ) is a non-linear function of θ.5]. but the lower end is substantially lower. In the present context we are interested in forming a conﬁdence interval. so we have to go one step further. not testing a hypothesis.

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

i=1 i=1

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

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

E (xi ei ) = 0

∗ yi = yi + ui

71

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

∗ E (yi ui ) = 0

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

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

• Qi • Di • Ci

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

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

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

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

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

73

1) infeasible since the matrix D is unknown. 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. in the linear regression model yi = x0 β + ei i E (ei | xi ) = 0.2) E (ξ i | xi ) = 0. Typically. Let η i = e2 .1) XD Y β = X 0 D−1 X ¡ ¢ 2 . The GLS estimator (7. The GLS estimator is sometimes called where D = diag{σ 1 i i n i i the Aitken estimator. Often the functional form is kept simple for parsimony. A ˆ ˆn feasible GLS (FGLS) estimator replaces the unknown D with an estimate D = diag{ˆ 2 . z1i are squares (and perhaps levels) of some (or all) elements of xi .... 74 .. σ1 We now discuss this estimation problem. . .. the least-squares estimator is ineﬃcient.1 Generalized Least Squares In the projection model.. Then i 0 E (η i | xi ) = α0 + z1i α1 0 η i = α0 + z1i α1 + ξ i and we have the regression equation (7. we know that the least-squares estimator is semi-parametrically eﬃcient for the projection coeﬃcient. where z1i is some q × 1 function of xi . However. Suppose that we model the conditional variance using the parametric form 0 σ 2 = α0 + z1i α1 i = α0 zi . σ 2 }. The error ξ i in this regression error ξ i is generally heteroskedastic and has the conditional variance ¡ ¢ V ar (ξ i | xi ) = V ar e2 | xi i ´ ³¡ ¢¢2 ¡ = E e2 − E e2 | xi | xi i i ¡ 4 ¢ ¡ ¡ 2 ¢¢2 = E ei | xi − E ei | xi .Chapter 7 Additional Regression Topics 7. σ 2 } and σ 2 = σ 2 (x ) = E e2 | x .

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

β should perhaps be i i called a quasi-FGLS estimator of β.that there is a need to bound the estimated variances away from zero.1. FGLS is asymptotically superior to OLS..1. and thus where ´ √ ³ ˜ n β F GLS − β →d N (0. There are three reasons.2) is correctly speciﬁed. V n n i=1 . A trimming rule might make sense: σ 2 = max[˜ 2 . First. This is an estimator which is robust to misspeciﬁcation of the condie1 ˆn tional variance. σ 2 ] σi i for some σ 2 > 0. Since the form of the skedastic regression is unknown. Why then do we not exclusively estimate regression models by FGLS? This is a good question. This estimator V 0 is appropriate when the skedastic regression (7. It may be the case that α0 zi is only an approximation to the true conditional variance σ 2 = i ˜ E(e2 | xi ). Theorem 7.. We just state the result without proof. and it may be estimated with considerable 76 V takes a sandwich form√. FGLS estimation depends on speciﬁcation and estimation of the skedastic regression. ´ √ ³ ˜ ˜ n β GLS − β F GLS →p 0. V ). ¢¢−1 ¡ ¡ .1. then FGLS is asymptotically equivalent to GLS. the natural estimator of the asympˆ totic variance of β is Ã n !−1 µ ¶−1 1 X −2 0 1 0 ˜ −1 ˜0 = XD X σ i xi xi ˜ = . This may be written as !−1 Ã n !Ã n !−1 Ã n 1 X −4 2 0 1 X −2 0 1 X −2 0 ˜ σ i xi xi ˜ σ i ei xi xi ˜ ˆ σ i xi xi ˜ V = n n n i=1 i=1 i=1 ³ ´−1 ³ ´³ ´−1 ˜ ˜ ˆ˜ ˜ X 0 D−1 DD−1 X X 0 D−1 X = n X 0 D−1 X ˜ which is consistent for V as n → ∞. V ˜ An appropriate solution is to use a White-type estimator in place of V 0 .1 If the skedastic regression is correctly speciﬁed. similar to the covariance matrix of the OLS estimator. 1992).. In this case we interpret α0 zi as a linear projection of e2 on zi . Its asymptotic variance is not that given in Theorem 7. Unless σ 2 = α0 zi . It is possible to show that if the skedastic regression is correctly speciﬁed. and was proposed by Cragg (Journal of Econometrics. ´´−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 . i ˜ 0 is inconsistent for V . V = E σ −2 xi x0 i i ˆ where D = diag{ˆ2 . Instead. In the linear regression model. V = E α0 zi i i Examining the asymptotic distribution of Theorem 7.1. . e2 }.1. but the proof of this can be tricky.

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

³ ´ ˆ ˆ The forecast error is ei = yi − m(x) = ei − x0 β − β . which is a much more diﬃcult task. we want to estimate m(x) at a particular point x.g. The only special exception is the case where ei has the exact distribution N (0. 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. A reasonable rule is the conditional mean m(x) as it is the mean-square-minimizing forecast. the natural estimate of this variance is σ 2 + n−1 x0 V x. Given the diﬃculty. then the forecast standard error is s(x) = σ 2 (x) + n−1 x0 V x ˜ It would appear natural to conclude that an asymptotic 95% forecast interval for yi is i h ˆ s x0 β ± 2ˆ(x) . which is generally invalid. we need to estimate the conditional distribution of ei given xi = x. In general. so p ˆ s(ˆ = n−1 x0 V x. We describe this setting as non-linear regression. s 7. so a standard ˆ i p ˆ error for the forecast is s(x) = σ 2 + n−1 x0 V x. we may want to forecast (guess) yi out-of-sample. We would also like a measure of uncertainty for ˆ the forecast. To get an accurate forecast interval. θ) = E (yi | xi = x) which is a non-linear function of the parameters θ.6). the width of the conﬁdence set is dependent on x. 78 . many applied forecasters focus h i ˆ on the simple approximate interval x0 β ± 2ˆ(x) . s(x) ˆ But no such asymptotic approximation can be made. this would require the asymptotic normality of the ratio ³ ´ ˆ ei − x0 β − β . If we have an estimate of the conditional variance function. the validity of an asymptotic conﬁdence interval is based on the asymptotic normality of the studentized ratio. ¡ ¢ ˆ Assuming E e2 | xi = σ 2 . For a given value of xi = x. Notice that this is diﬀerent from the standard ˆ ˆ error for the conditional mean. Notice that this is a (linear) ˆ ˆ θ function of β. e. we see that m(x) = ˆ = x0 β and Hβ = x. but this turns out to be incorrect. As the out-of-sample error ei is ˆ ˆ independent of the in-sample estimate β.In some cases. p h i ˆ ˆ x0 β ± 2 n−1 x0 V x . q 2 0 0 ˆ ˜ ˆ ˜ σ (x) = α z from (7. In the present case.4 NonLinear Least Squares In some cases we might use a parametric regression function m(x. this has variance ³ ´³ ´0 ¡ ¢ ˆ ˆ Eˆ2 = E e2 | xi = x + x0 E β − β β − β x ei i = σ 2 (x) + n−1 x0 V x. σ 2 ). Letting h(β) = x0 β and θ = h(β). A point forecast ˆ is the estimated conditional mean m(x) = x0 β.

1 If the model is identiﬁed and m(x. V ) θ where mθi = mθ (xi . ´ √ ³ n ˆ − θ0 →d N (0.8) Theorem 7. ¢¢−1 ¡ ¡ ¢¢ ¡ ¡ ¢¢−1 ¡ ¡ E mθi m0 e2 E mθi m0 V = E mθi m0 θi θi i θi Sketch of Proof. This can be done using arguments θ for optimization estimators. The least squares estimator ˆ minimizes the sum-of-squared-errors θ Sn (θ) = n X i=1 (yi − m(xi . it must be shown that ˆ →p θ0 . G known x2 − θ5 m(x. The NLLS residuals are ei = yi − m(xi . θ) = (θ1 + θ2 x1 ) 1 (x2 < θ3 ) + (θ4 + θ5 x1 ) 1 (x2 > θ3 ) In the ﬁrst ﬁve examples. θi 79 . θ) = θ1 + θ2 x + θ4 (x − θ3 ) 1 (x > θ3 ) µ ¶ m(x. so the minimization of Sn (θ) only needs to be examined for θ close to θ0 . ˆ must be found by numerical θ methods. θ) = G(x0 θ).4. θ0 ). In other cases. but we won’t cover that argument here. θ) = θ1 + θ2 m(x. let ∂ m(x. Since ˆ →p θ0 . θ) = θ1 + θ2 exp(θ3 x) m(x. then the FOC for minimization are 0= n X i=1 mθ (xi . estimator.Examples of nonlinear regression functions include x 1 + θ3 x m(x. Let 0 yi = ei + m0 θ0 . which alters some of the analysis. m(x. First. θ)ˆ (7. θ) = ∂θ Nonlinear regression is frequently adopted because the functional form m(x. θ). See Appendix E. ˆ ei . mθ (x. m is not diﬀerentiable with respect to θ3 . θ))2 Since sum-of-squared-errors function Sn (θ) is not quadratic. ˆ is close to θ θ θ0 for n large. θ) is diﬀerentiable with respect to θ. In the ﬁnal two examples. θ) = θ1 + θ2 xθ3 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 . θ) is diﬀerentiable. When m(x. When the regression function is nonlinear. it is adopted as a ﬂexible approximation to an unknown regression function. θ) = θ1 + θ2 x1 + (θ3 + θ4 x1 ) Φ θ6 m(x. θ) is (generically) diﬀerentiable in the parameters θ. we call this the nonlinear least squares (NLLS) θ). When it exists. θ) is suggested by an economic model. θ))2 .

This means that under H0 . Hansen (1996). θ) ' m(xi . ¥ Based on Theorem 7. ˆ and ei = yi − m(xi . θ0 )) − m(xi . 7. Suppose that m(xi . ˆ ˆ θ) ˆ θ). Thus we want to test H0 : β 2 = 0. 1 2 The model is linear when β 2 = 0. θi Hence the sum of squared errors function is Sn (θ) = n X i=1 (yi − m(xi .1.4. 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 . An alternative good measure is the conditional median.For θ close to the true value θ0 . This renders the distribution theory presented in the previous section invalid. the model is yi = β 0 zi + εi 1 and both β 2 and γ have dropped out. 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. but these are not the only measures of central tendency. The asymptotic theory of such tests have been worked out by Andrews and Ploberger (1994) and B. In particular. an estimate of the asymptotic variance V is ˆ V = Ã 1X mθi m0 ˆ ˆ θi n i=1 n !−1 Ã 1X mθi m0 e2 ˆ ˆ θi ˆi n i=1 n !Ã 1X mθi m0 ˆ ˆ θi n i=1 n !−1 where mθi = mθ (xi . by a ﬁrst-order Taylor series approximation. m(xi . Thus the NLLS 0 estimator ˆ has the same asymptotic distribution as the (infeasible) OLS regression of yi on mθi .5 Least Absolute Deviations We stated that a conventional goal in econometrics is estimation of impact of variation in xi on the central tendency of yi . θ) ' (ei + m(xi . tests of H0 do not have asymptotic normal or chi-square distributions. and this is often a useful hypothesis (sub-model) to consider. θi Thus ¡ ¢ yi − m(xi . γ is not identiﬁed. Furthermore. 80 . Thus when the truth is that β 2 = 0. However. θ) = β 0 zi + β 0 xi (γ). We have discussed projections and conditional means. θ0 ) + m0 (θ − θ0 ) θi = ei − m0 (θ − θ0 ) θi 0 = yi − m0 θ. Identiﬁcation is often tricky in nonlinear regression models. θ which is that stated in the theorem. the parameter estimates are not asymptotically normally distributed. θ0 ) + m0 (θ − θ0 ) .

it is a solution to the moment condition ³ ´ 1X ˆ xi sgn yi − x0 β = 0. Conditional analogs of the facts about the median are • P (yi ≤ x0 β 0 | xi = x) = P (yi > x0 β | xi = x) = . i n n i=1 (7.10) The LAD estimator has the asymptotic distribution 81 . Let ¯ 1 X¯ ¯yi − x0 β ¯ Ln (β) = i n i=1 n be the average of absolute deviations. Two useful facts about the median are that (7. let Y be a continuous random variable. The second is the value which minimizes n n |yi − θ| . The least absolute deviations (LAD) estimator of β minimizes this function ˆ β = argmin Ln (β) β Equivalently. The linear median regression model takes the form yi = x0 β + ei i M ed (ei | xi ) = 0 In this model. Now let’s consider the conditional median of Y given a random variable X. Let m(x) = M ed (Y | X = x) denote the conditional median of Y given X = x. The median θ0 = M ed(Y ) is the value such that P (Y ≤ θ0 ) = P (Y ≥ θ0 ) = . The ﬁrst deﬁnition is the 50th empirical 1 P quantile. and let M ed (Y | X) = m(X) be this function evaluated at the random variable X.To recall the deﬁnition and properties of the median. as i=1 these estimators are indeed identical.5.9) θ0 = argmin E |Y − θ| θ and E sgn (Y − θ0 ) = 0 where sgn (u) = ½ 1 −1 if u ≥ 0 if u < 0 is the sign function.5 • E (sgn (ei ) | xi ) = 0 • E (xi sgn (ei )) = 0 • β 0 = minβ E |yi − x0 β| i These facts motivate the following estimator. however. These facts deﬁnitions motivate three estimators of θ. These distinctions are illusory. the linear function M ed (yi | xi = x) = x0 β is the conditional median function. and the substantive assumption is that the median function is linear in x. and the third deﬁnition is the i=1 1 P solution to the moment equation n n sgn (yi − θ) .

by the central limit theorem (Theorm 5. then there are many innovations near to the median. the height of the error density at its median. See Chapter 16. we provide a sketch here for completeness.3.1 is advanced.1) n X √ −1/2 n (g n (β 0 ) − g(β 0 )) = −n gi (β 0 ) →d N (0.10) is equivalent to g n (β) = 0. This can be done with kernel estimation techniques. where V = and f (e | x) is the conditional density of ei given xi = x. the conditional density of the error at its median.1 ´ √ ³ˆ n β − β 0 →d N (0.11). Exi x0 ) i i=1 since Egi (β 0 )gi (β 0 )0 = Exi x0 . then f (0 | x) = f (0) and the asymptotic variance simpliﬁes V = (Exi x0 )−1 i 4f (0)2 (7.Theorem 7. V ). ∂ 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 ) .5.11) This simpliﬁcation is similar to the simpliﬁcation of the asymptotic covariance of the OLS estimator under homoskedasticity. When f (0 | x) is large. The main diﬃculty is the estimation of f (0).1: Since sgn (a) = 1 − 2 · 1 (a ≤ 0) .5. While a complete proof of Theorem 7. ˆ Proof of Theorem 7. (7. ∂β ˆ g(β) ' ´ ³ ∂ ˆ g(β 0 ) β − β 0 . ¢¢−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) . In the special case where the error is independent of xi . by a Taylor series expansion and the fact g(β 0 ) = 0 82 . Pn −1 0 β)) . First. We need where g n (β) = n i i=1 gi (β) and gi (β) = xi (1 − 2 · 1 (yi ≤ xi three preliminary result.5. ∂β 0 so Third. Second using the law of iterated expectations and the chain rule of i diﬀerentiation. and this improves estimation of the median. Let g(β) = Eg (β). Computation of standard error for LAD estimates typically is based on equation (7.

V ). If the random variable U has τ ’th quantile Qτ . For the random variables (yi . The median is the special case τ = . As functions of x. This linear speciﬁcation assumes that Qτ (x) = β 0 x where the coeﬃcients β τ τ vary across the quantiles τ .5.9) for the median to all quantiles. the quantile regression function qτ (x) describes how the τ ’th quantile of the conditional distribution varies with the regressors. then F (Qτ ) = τ . then F (Qτ (x) | x) = τ . The quantile Qτ is the value such that τ (percent) of the mass of the distribution is less than Qτ . For ﬁxed τ . 1] the τ ’th quantile Qτ of a random variable with distribution function F (u) is deﬁned as Qτ = inf {u : F (u) ≥ τ } When F (u) is continuous and strictly monotonic. Exi x0 ) →d i 2 = N (0. We then have the linear quantile regression model yi = x0 β τ + ei i 83 .6 Quantile Regression The method of quantile regression has become quite popular in recent econometric practice.12) Qτ = argmin Eρτ (U − θ) . then (7. (7. For τ ∈ [0. The third line follows from an asymptotic empirical process argument. xi ) with conditional distribution function F (y | x) the conditional quantile function qτ (x) is Qτ (x) = inf {y : F (y | x) ≥ τ } . However for computational convenience it is typical to assume that they are (approximately) linear in x (after suitable transformations). the quantile regression functions can take any shape. The following alternative representation is useful. ¥ 7. θ where ρτ (q) is the piecewise linear function ½ −q (1 − τ ) q<0 ρτ (q) = qτ q≥0 = q (τ − 1 (q < 0)) . so you can think of the quantile as the inverse of the distribution function.13) This generalizes representation (7. Again. when F (y | x) is continuous and strictly monotonic in y.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.

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

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

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

and km is the number of coeﬃcients in the model. the BIC places a larger penalty than the AIC on the number of estimated parameters and is more parsimonious. else select M2 . since (7. Then select M1 if Wn ≤ cα . His criterion. The rule is to select M1 if AIC1 < AIC2 . A common approach to model selection is to base the decision on a statistical test such as the Wald Wn . The 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. That is. if α is set to be a small number. k = While many modiﬁcations of the AIC have been proposed. Another problem is that if α is held ﬁxed. If the truth is inﬁnite dimensional. else select M2 . AIC selection is inconsistent. k A major problem with this approach is that the critical level α is indeterminate. known as the BIC. n (7. since under M1 . n (7. as ³ ´ c P M = M1 | M1 → 1 − α < 1.15) then where σ 2 is the variance estimate for model m. the most popular to be one proposed by Schwarz. 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.16) holds under M1 . LRn →p 0.17) Since log(n) > 2 (if n > 8). For some critical level α. this rule only makes sense when the true model is ﬁnite dimensional. The model selection rule is as follows. The AIC for model m is ¡ ¢ km ˆm AICm = log σ 2 + 2 . as the rule tends to overﬁt. based on Bayesian arguments. it is more appropriate to view model selection as determining the best ﬁnite sample approximation. M)) between the true density and the model density. 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. BIC model selection is consistent. log(n) 87 . Another common approach to model selection is to to a selection criterion. One popular choice is the Akaike Information Criterion (AIC). In contrast to the AIC.However. ¢ ¡ ˆ1 ˆ2 (7. depending on the sample size. then P M ´ ³ c 1 − α but P M = M2 | M2 could vary dramatically. etc. Indeed. then this model selection procedure is inconsistent. let cα satisfy ¢ ¡ P χ22 > cα . is ¡ ¢ km ˆm BICm = log σ 2 + log(n) . Indeed.16) LRn = n log σ 2 − log σ 2 ' Wn →d χ22 .

β 2 6= 0. and the AIC or BIC in principle can be implemented by estimating all possible subset models.. . selecting based on (7.so ´ ³ c P M = M1 | M1 = = P (BIC1 < BIC2 | M1 ) P (LRn < log(n)k2 | M1 ) µ ¶ LRn = P < k2 | M1 log(n) → P (0 < k2 ) = 1. . . However. stores the residual variance σ 2 for each model.15). one can show that thus LRn →p ∞. In the unordered case. a model consists of any possible subset of the regressors {x1i . and then selects the model with the lowest AIC (7. The methods extend readily to the issue of selection among multiple regressors. Similarly for ˆ the BIC. 88 . In the ordered case. There are two leading cases: ordered regressors and unordered. β 2 = β 3 = · · · = β K = 0 M2 : β 1 6= 0. there are 2K such models. the models are M1 : β 1 6= 0. . β 3 = · · · = β K = 0 .. E (εi | xi ) = 0 and the question is which subset of the coeﬃcients are non-zero (equivalently. Also under M2 . 210 = 1024. which can be a very large number. For example. β 2 6= 0.. In the latter case. . which regressors enter the regression). MK : β 1 6= 0.17). The general problem is the model yi = β 1 x1i + β 2 x1i + · · · + β K xKi + εi . β K 6= 0. xKi }. which are nested. and 220 = 1. The AIC selection criteria estimates the K models by OLS. We have discussed model selection between two models. log(n) µ LRn > k2 | M2 log(n) ¶ ´ ³ c P M = M2 | M2 = P → 1. 576. . 048. . a full-blown implementation of the BIC selection criterion would seem computationally prohibitive.

the residuals e. . E(e | X) = 0. Let (yi . ˆ ˆ n−k 6. For any predictor g(xi ) for y. (b) Prove that e = M1 e. X).12). σ 2 ). You wish to forecast an out-of-sample value of y given that ˆ ˆ ˆ ˆ X = x. ˜ the residual vector is e = Y − X β. Is θ a quantile of the distribution of Yi ? 3. 4. Thus the available information is the sample (Y. else equals zero).. where xji is one of the xi . Show that the function g(x) which minimizes the MAE is the conditional median M (x). 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 . In the homoskedastic regression model Y = Xβ + e with E(ei | xi ) = 0 and E(e2 | xi ) = σ 2 . the estimates (β. the mean absolute error (MAE) is E |yi − g(xi )| . ˆ (a) Find a point forecast of y. 2.7. Deﬁne g(u) = τ − 1 (u < 0) where 1 (·) is the indicator function (takes the value 1 if the argument is true. i ˆ ˆ suppose β is the OLS estimate of β with covariance matrix V .. Consider the Weighted Least Squares (WLS) estimator of β ¢−1 ¡ 0 ¢ ¡ ˜ X WY β = X 0W X where W = diag(w1 . based on a sample of size n.. (b) Find an estimate of the variance of this forecast. V ar(e | X) = σ 2 Ω with Ω known. V . 5. Let θ satisfy Eg(Yi − θ) = 0. the GLS estimator is ¡ ¢−1 ¡ 0 −1 ¢ ˜ β = X 0 Ω−1 X XΩ Y . and an estimate of σ 2 is ˆ s2 = 1 e0 Ω−1 e. x. Verify equation (7. wn ) and wi = x−2 .10 Exercises 1. In a linear model Y = Xβ + e. in which situations would you expect that β would perform better than OLS? 89 (a) Why is this a reasonable estimator for σ 2 ? ¡ ¢−1 0 −1 XΩ . . ji ˜ (a) In which contexts would β be a good estimator? ˜ (b) Using your intuition. Let σ 2 be the estimate of σ 2 . and the out-of-sample value of the regressors. xi ) be a random sample with E(Y | X) = Xβ.

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

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

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

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

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

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

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

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

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

Thus here Tn (θ) = Wn (θ). Equivalently. θ θ θ ˆ θ ∗ ∗ Computationally. θ [This is a typical mistake made by practitioners. A better asymptotic approximation may be obtained through an asymptotic expansion. 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. n ´ ³ ∗ ³ ∗ θ θ Note in the simulation that the Wald statistic is a quadratic form in ˆ − ˆ .3 an = o(n−r ) if nr |an | → 0 as n → ∞. however. Basically. Let Tn be a statistic such that (8. v 2 ). the critical value qn (α) is found as the quantile from simulated values of W´ . then to test H0 : θ = θ0 against H1 : θ 6= θ0 at size α. and a function h(x) is odd if h(−x) = −h(x). about the rate v of convergence. F ) then ³x´ . Deﬁnition 8. and vice-versa. where qn (α) is the (1 − α)% quantile of the distribution of ³ ∗ ³ ∗ ´0 ´ ∗ Wn = n ˆ − ˆ Vθ∗−1 ˆ − ˆ .] 8.3) ´ √ ³ˆ If Tn = n θ − θ0 then v = V while if Tn is a t-ratio then v = 1. lim Gn (x.8.8.4) v ¡ ¢ While (8.2 an = O(1) if |an | is uniformly bounded. 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. C4 is called the symmetric percentile-t interval. The bootstrap test ∗ ∗ rejects if Wn ≥ qn (α). The following notation will be helpful. or the size of the divergence for any particular sample size n. We say that a function g(x) is even if g(−x) = g(x). (8.8 Asymptotic Expansions Tn →d N (0.∗ where qn (α) is the bootstrap critical value for a two-sided hypothesis test. 99 . The derivative of an even function is odd. where qn (α) is the (1 − α)% quantile of the distribution of Wn . writing Tn ∼ Gn (x. an = O(n−r ) if it declines to zero like n−r .4) says that Gn converges to Φ x as n → ∞.1 an = o(1) if an → 0 as n → ∞ Deﬁnition 8. If θ is a vector. Let an be a sequence. F ) = Φ n→∞ v or ³x´ Gn (x. it says nothing. F ) = Φ + o (1) . Deﬁnition 8.8. not ˆ − θ0 . The ideal test rejects if Wn ≥ qn (α).

F ) + O(n−3/2 ) Gn (x. Fn ) = Φ(x) + n 1 g (x. To a third order of approximation. F0 ) = n 1 n1/2 (g1 (x. 100 . where g1 is an even function of x. 1/2 1 n Because Φ(x) appears in both expansions. so the order of the error is O(n−1/2 ). F ) converges to the normal limit at rate n1/2 .1 as follows. we can assess the accuracy of one-sided hypothesis tests and conﬁdence regions based on an asymptotically normal t-ratio Tn . First. the diﬀerence between the bootstrap distribution and the true distribution is G∗ (x) − Gn (x. F0 ) + O(n−1 ) 1/2 1 n 1 g (x.8. and g2 is an odd function of x. the exact distribution is P (Tn < x) = Gn (x. F ).uniformly over x. which from Theorem 8. ³x´ Gn (x. F ) + n−1 g2 (x. F0 )) converges to 0 at rate n.3). F ) = Φ v n n 8. adding leptokurtosis). A bootstrap test is based on G∗ (x). F0 ) (Fn − F0 ) ∂F = O(n−1/2 ). Fn ) − g1 (x. Fn ) − g1 (x. The diﬀerence is Φ(x) − Gn (x. Theorem 8. F0 ) = 1 g (x. Fn ) + O(n−1 ). v Since the derivative of g1 is odd. Gn (x.8.1. F ) ≈ Φ + n−1/2 g1 (x. F ) ≈ Φ + n−1/2 g1 (x. An asymptotic test is based on Φ(x). Fn ) − g1 (x. g1 (x.8. and g1 is continuous with respect to F.1 Under regularity conditions and (8. To the second order. F0 )) + O(n−1 ). F0 ) + O(n−1 ) 1/2 1 n = O(n−1/2 ). F ) v which adds a symmetric non-normal component to the approximate density (for example. the density function is skewed. F0 ) = Φ(x) + since v = 1. F0 ) ≈ ∂ g1 (x.9 One-Sided Tests Using the expansion of Theorem 8.8. To a second order of approximation. We can interpret Theorem 8. F ) + g2 (x. the diﬀerence √ (g1 (x. Moreover. Heuristically. g1 and g2 are diﬀerentiable functions of x and continuous in F relative to the supremum norm on the space of distribution functions. √ Since Fn converges to F at rate n. ³x´ 1 1 + 1/2 g1 (x. ³x´ Gn (x.1 has the expansion n G∗ (x) = Gn (x.

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

g1 . F0 )) + O(n−3/2 ) n = O(n−3/2 ). We know that θ Tn →d N (0. This is in contrast to the use of the asymptotic distribution. This is because the ﬁrst term in the asymptotic expansion. G∗ (x) = Gn (x. Fn ) = Φ(x) + ∗ 2 g2 (x. and needs to be determined on a case-by-case basis. Theorem 8.5) to the bootstrap distribution. Twosided tests will have more accurate size (Reported Type I error). the asymptotic two-sided test has a better coverage rate than the asymptotic one-sided test. √ the last equality because Fn converges to F0 at rate n. Conﬁdence intervals based on the bootstrap can be asymmetric if based on one-sided tests (equal-tailed intervals) and can therefore be more informative and have smaller length than symmetric intervals. and for the bootstrap ³x´ + O(n−1/2 ). Gn (x. Fn ) + O(n−3/2 ). Fn ) = Φ n v ˆ ˆ where V = V (Fn ) is the bootstrap estimate of V.11 Percentile Conﬁdence Intervals ´ √ ³ To evaluate the coverage rate of the percentile interval.1 shows that a ﬁrst-order approximation ³x´ + O(n−1/2 ). Applying (8. A reader might get confused between the two simultaneous eﬀects. set Tn = n ˆ − θ0 . meaning that the errors in the two directions exactly cancel out. and g2 is continuous in F. the choice between symmetric and equal-tailed conﬁdence intervals is unclear. similar to a one-sided test. as it depends on the unknown V. Thus a two-sided bootstrap test also achieves an asymptotic reﬁnement. F0 ) = ∗ 2 (g2 (x. Therefore. which is not pivotal. we ﬁnd Gn (x) = Gn (x. 8. V ).Interestingly. F ) = Φ v √ where v = V . and bootstrap tests have better rates of convergence than asymptotic tests. whose error is O(n−1 ). Fn ) − g2 (x. is an even function. Two-sided tests have better rates of convergence than the one-sided tests. The diﬀerence is ³x´ ³x´ −Φ + O(n−1/2 ) G∗ (x) − Gn (x. F0 ) = Φ n v ´ ˆ v ³x x (ˆ − v) + O(n−1/2 ) v = −φ v v ˆ ˆ = O(n−1/2 ) 102 . but one-sided tests might have more power against alternatives of interest. The analysis shows that there may be a trade-oﬀ between one-sided and two-sided tests. n Thus the diﬀerence between the bootstrap and exact distributions is Gn (x) − Gn (x.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 ).

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

yielding OLS estimates β and any other statistic of interest. draw a ˆ ˆ random integer i0 from [1.. ˆ 3. yn } with µ = Eyi and σ 2 = V ar(yi ). 4. creating a random bootstrap data set (Y ∗ . This can be achieved using a two-point distribution of the form Ã Ã √ ! ! √ 1+ 5 5−1 ∗ √ ei ˆ = P εi = 2 2 5 Ã Ã √ ! ! √ 1− 5 5+1 ∗ √ P εi = = ei ˆ 2 2 5 For each xi . Let Fn (x) denote the EDF of a random sample. OLS estimator from the regression of Y on X. X ∗ ). It does not really matter..observed values of the regressors.. n} . whether or not the xi are really “ﬁxed” or random.13 Exercises 1. Let β denote the ˆ the OLS residuals. Find the population moments ETn and V ar(Tn ). 2. . . 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 . generate ∗ bootstrap samples. Consider the following bootstrap procedure.. however. Using the non-parametric bootstrap. That is.. n]. Show that √ n (Fn (x) − F0 (x)) →d N (0. ˆ Draw (with replacement) n such vectors. . ˆ∗ (b) Regress Y ∗ on X ∗ . which is a valid statistical approach.. calculate the estimate ˆ on these samples and then calculate θ ∗ ∗ θ θ)/s(ˆ θ). Show that this bootstrap procedure is (numerically) identical to the non-parametric bootstrap. Let ∗ ∗ ∗ {y1 . ˆi A conditional distribution with these features will preserve the main important features of the data. yn } be a random sample from the empirical distribution function and let Tn = y ∗ be n ∗ ∗ its sample mean. i 8. Typically what is desirable is to impose only the regression condition E (εi | xi ) = 0. you sample ε∗ using this two-point distribution. and e = Y − X β ˆ (a) Draw a random vector (x∗ . Consider the following bootstrap procedure for a regression of yi on xi . Set y∗ = x∗0 β + e∗ .. Find the bootstrap moments ETn and V ar(Tn ). e∗ ) from the pair {(xi . and set x∗ = xi0 and e∗ = ei0 . One proposal which imposes the regression condition without independence is the Wild Bootstrap.. Unfortunately this is a harder problem. The methods discussed above are unattractive for most applications in econometrics because they impose the stringent assumption that xi and εi are independent. ... F0 (x) (1 − F0 (x))) . Let the statistic of interest be the sample mean Tn = y n . ei ) : i = 1. 2..

you generate bootstrap samples. Using the non-parametric bootstrap. can you report the 95% Percentile-t interval for θ? 7.dat contains data on house prices (sales). ∗ ∗ where s(ˆ is the standard error in the original data. θ θ)q ∗ θ θ)q ∗ θ/s(θ) 5. You want to test H0 : θ = 0 against H1 : θ > 0.05) . lot size.95) denote the 95% quantile of Tn . and the 2. ∗ ∗ ∗ Let qn (.95). Using the non-parametric ∗ bootstrap.95) denote the 5% θ) ∗ and 95% quantiles of Tn . ˆ = 1.2. ˆ − s(ˆ n (. You replace c with qn (.95). 105 .95). Calculate 95% conﬁdence intervals for the regression coeﬃcients using both the asymptotic normal approximation and the percentile-t bootstrap. The test for H0 is to reject if Tn = ˆ ˆ > c where c is picked so that Type I error is α.3. and the colonial dummy. Let qn (.75 and 1.5% quantiles of the ˆ are .05) and qn (. (b) Report the 95% Alternative Percentile interval for θ.Show that C exactly equals the Alternative percentile interval (not the percentile-t interval). size of house. (c) With the given information. (a) Report the 95% Efron Percentile interval for θ.2 and s(ˆ = . θ θ) ∗ 1000 samples are generated from the bootstrap distribution. and ˆ is calculated on each θ ∗ ∗ θ sample. Estimate a linear regression of price on the number of bedrooms. What is wrong with this procedure? Tn = θ/s(θ) n 6. and deﬁne the bootstrap conﬁdence interval h i C = ˆ − s(ˆ n (. θ respectively.pdf. with variables listed in the ﬁle hprice1. The dataﬁle hprice1.5% and 97. Suppose that in an application. You do this as follows. calculate the estimates ˆ on these samples and θ then calculate ∗ ∗ ∗ θ θ Tn = ˆ /s(ˆ ). and thus reject H0 if ˆ ˆ > q ∗ (. The ˆ are sorted.

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

1 ˆ 2Z 0 XWn X 0 Z β = 2Z 0 XWn X 0 Y While the estimator depends on Wn . Jn (β) = n · g n (β)0 g n (β) = n · |g n (β)|2 . β ˆ Note that if k = . Proposition 9.2. 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. Let and where gi = xi ei . This is a non-negative measure of the “length” of the vector g n (β). i i . For example. for if Wn is replaced ˆ by cWn for some c > 0.2 GMM Estimator n n ¢ 1¡ 0 ¢ 1X 1X ¡ 0 X Y − X 0 Zβ . and the GMM estimator is the MME. if Wn = I. then.3 Distribution of GMM Estimator ¡ 0¢ Q = E xi zi Assume that Wn →p W > 0. gi (β) = xi yi − zi β = n n n i=1 i=1 Deﬁne the sample analog of (9. For some × weight matrix Wn > 0. but this is generally not possible when > k. The idea of the generalized method of moments (GMM) is to deﬁne an estimator which sets g n (β) “close” to zero. let Jn (β) = n · g n (β)0 Wn g n (β). ¡ ¢−1 0 ˆ Z XWn X 0 Y. β GMM = Z 0 XWn X 0 Z 9.2) g n (β) = (9. The GMM estimator minimizes Jn (β). β GMM does not change. then g n (β) = 0. Then µ ¶ ¶ µ 1 0 1 0 Z X Wn X Z →p Q0 W Q n n 107 ¡ ¢ ¡ 0¢ Ω = E xi x0 e2 = E gi gi . the dependence is only up to scale.9.1 β GMM = argmin Jn (β).2.3) The method of moments estimator for β is deﬁned as the parameter value which sets g n (β) = 0. ˆ Deﬁnition 9. the square of the Euclidean length.

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

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

However. Under the hypothesis of correct speciﬁcation. n β − β →d N 0. often the weight ˆ matrix Wn is updated. Since the GMM estimator depends upon the ﬁrst-stage estimator. For example. Hansen (1982). this is all that is known. 1 2 It is possible that β 2 = 0.1 Under general regularity conditions. and thus g n can be used to assess whether or not the hypothesis that Egi = 0 is true or not.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 . Thus the model — the overidentifying restrictions — are testable. This estimator can be iterated if needed. ´ ³ ¡ ¢−1 ´ √ ³ˆ Theorem 9. take the linear model yi = β 0 x1i + β 0 x2i + ei with E (x1i ei ) = 0 and E (x2i ei ) = 0. i i i i ∂β 1X 0 gi gi − g n g 0 ˆˆ n n i=1 n !−1 . 110 . 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 if the weight matrix is asymptotically eﬃcient. Theorem 9.6. where ³ ´−1 ∂ 0 ˆ ˆ ˆ ˆ Ω = (E (gi gi ))−1 and G = E ∂β 0 gi (β). Identiﬁcation requires l ≥ k = dim(β). ˆˆ n is a quadratic form in g n . G0 Ω−1 G . and then β recomputed. perhaps obtained by ﬁrst ˆ setting Wn = I. Note that g n →p Egi . The GMM estimator minimizes J(β) = n · g n (β)0 Wn g n (β) where g n (β) = and Wn = Ã 1X gi (β) n i=1 n ˜ ˜ with gi = gi (β) constructed using a preliminary consistent estimator β.Often. so that the linear equation may be written as yi = β 0 x1i + ei . and is thus a natural test statistic for H0 : Egi = 0.5. 1 it is possible that β 2 6= 0. ˆ J = J(β) →d χ2−k . In this sense an 1i 1i exclusion restriction can be seen as an overidentifying restriction. 9. 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 . The general theory of GMM estimation and testing was exposited by L. β) = 0 holds.1 (Sargan-Hansen). 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.

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

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

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

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

h(β)=0 The GMM test statistic (the distance statistic) of the hypothesis h(β) = 0 is ˜ D = Jn (β) = min Jn (β). λ = R0 Vn R (c) Show that if R0 β = r then ´ √ ³˜ n β − β →d N (0.5. l ≥ k. h(β)=0 (9. is deﬁned as Jn (β) = ˜ β = argmin Jn (β). The GMM estimator of β. xi . Deﬁne the Lagrangian L(β. Show that the minimizer is ³ ´−1 ³ ´ ˆ ˜ ˆ ˆ ˆ R0 β − r β = β − Vn R R0 Vn R ´ ´−1 ³ ³ ˆ ˆ ˆ R0 β − r . Show how to construct an eﬃcient GMM estimator for β. β) + ei E (zi ei ) = 0. 6. Thus ˜ β = argmin Jn (β) R0 β−r Ã n ! ¡ 0 ¢−1 ¡ 0 ¢−1 X 0 2 ˆ XX xi xi ei ˆ . the Generalized Method of Moments (GMM) criterion function for β is deﬁned as 1 ˆn (Y − Xβ)0 X Ω−1 X (Y − Xβ) (9. The equation of interest is yi = g(xi .5) n 1 P ˆ where ei are the OLS residuals and Ωn = n n xi x0 e2 . The observed data is (yi .6) (a) Show that you can rewrite Jn (β) in (9.5) 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. zi ). Vn = X X i=1 ˜ and hence R0 β = r. λ) = 1 Jn (β) + λ0 (R0 β − r) where λ is 2 s × 1. VR ) where ¡ ¢−1 0 R V. the distance statistic D in (9. VR = V − V R R0 V R (d) Show that in this setting. zi is l × 1 and β is k × 1. In the linear model Y = Xβ + e with E(xi ei ) = 0. subject ˆ i ˆi i=1 to the restriction h(β) = 0. 115 .6) equals the Wald statistic.

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. l−k Hint: Il − R (R0 R)−1 R0 is a projection matrix. 116 .. Take the linear model 0 yi = zi β + ei E (xi ei ) = 0. 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 .7. 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.

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

7) 118 .. pn . The solution cannot be obtained explicitly. µ) = n i=1 i=1 i=1 L∗ n with respect to pi . p (10. λ) = −n ln (n) − n X i=1 For given β. probabilities 1 ³ ´´ . Multiplying the ﬁrst equation by pi .6) β = argmin [−Ln (β)] β ¡ ¢ ln 1 + λ(β)0 gi (β) and maximized empirical likelihood ˆ Numerical methods are required for calculation of β.5). but must be obtained numerically (see section 6. we ﬁnd µ = n and 1 ¢. Ln (β) = Rn (β. .2) subject to the restrictions (10. The solution (when it exists) is well deﬁned since Rn (β.where λ and µ are Lagrange multipliers. summing over i. pi gi (β) = 0. λ). pi = ¡ n 1 + λ0 gi (β) Substituting into L∗ we ﬁnd n Rn (β. λ(β)) = −n ln (n) − n X i=1 ˆ The EL estimate β is the value which maximizes Ln (β). we also obtain the Lagrange multiplier λ = λ(β).5) This minimization problem is the dual of the constrained maximization problem.3). p1 .5) ˆ ˆ As a by-product of estimation. pi = ³ ˆ ˆ ˆ0 n 1 + λ gi β ˆ Ln = n X i=1 ln (ˆi ) . µ.4) (10. The Lagrangian for this maximization problem is Ã n ! n n X X X ln(pi ) − µ pi − 1 − nλ0 pi gi (β) L∗ (β.. λ) : λ(β) = argmin Rn (β. λ ¡ ¢ ln 1 + λ0 gi (β) . or equivalently minimizes its negative ˆ (10. λ) is a convex function of λ. and using the second and third equations. 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. the Lagrange multiplier λ(β) minimizes Rn (β. This yields the (proﬁle) empirical log-likelihood function for β.1) and (10. (see section 6.. (10. λ.

in the linear model.2 Deﬁne Asymptotic Distribution of EL Estimator Gi (β) = ∂ gi (β) ∂β 0 (10. λ) = − (10. ˆ The asymptotic variance V for β is the same as for eﬃcient GMM.11) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ ˆ 0 ' −g n − Gn β − β 0 + Ωn λ (10.11) 0 = ∂λ ˆ0 ˆ i=1 1 + λ gi β ³ ´0 ˆ n X Gi .10. i i Theorem 10.12) ∂β ˆ ˆ0 i=1 1 + λ gi β 1 P 1 P 1 P Let Gn = n n Gi (β 0 ) . Thus the EL estimator is asymptotically eﬃcient.10). ˆ ˆ Proof. Vλ ) ´ √ ˆ √ ³ˆ where V and Vλ are deﬁned in (10.12) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ 0 ' G0 λ − λ0 . n (10. 0 = Rn (β.10) ¡ Ω−1 N (0.13) yields n n Expanding (10. β) = −xi zi . g n = n n gi (β 0 ) and Ωn = n n g (β 0 ) gi (β 0 )0 . 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. λ) = − (10. and Ω = E xi x0 e2 . and n β − β 0 and nλ are asymptotically independent.8) and ¢ 0 0 For example. G = −E (xi zi ). Gi (. ´ √ ³ ˆ n β − β 0 →d √ ˆ nλ →d N (0.2.13) Premultiplying by G0 Ω−1 and using (10.1 Under regularity conditions.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) jointly solve ³ ´ ˆ n gi β X ∂ ³ ³ ´´ Rn (β. β λ ∂ ³ ´.9) and (10. (β.9) (10. i=1 i=1 i=1i Expanding (10.

The EL overidentiﬁcation test is similar to the GMM overidentiﬁcation test. They are asymptotically ﬁrst-order equivalent.16). tests are based on the diﬀerence in the log likelihood functions. This means that no consistent estimator for this class of models can have a lower asymptotic variance than V . ¥ Chamberlain (1987) showed that V is the semiparametric eﬃciency bound for β in the overidentiﬁed moment condition model. First. V ) ˆ Solving (10.7) is n ³ ´´ ³ X ˆ ˆ0 (10. Vλ ) Furthermore.15). LRn = i=1 Theorem 10. and it is advisable to report the statistic LRn whenever EL is the estimation method. and have the same interpretation. n ³ ´´ ´ √ ³ 1 X ³ ˆ ˆ √ g wi . Twice the diﬀerence between the unrestricted empirical likelihood −n log (n) and the maximized empirical likelihood for the model (10.14) for λ and using (10. Ω) →d Ω−1 I − G G Ω G GΩ = Ω−1 N (0.3. it is an asymptotically eﬃcient estimator for β. Proof. The overidentiﬁcation test is a very useful by-product of EL estimation. since ³ ¡ ¢−1 0 ´ G0 I − Ω−1 G G0 Ω−1 G G =0 (10.17) 2 ln 1 + λ gi β .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 (0.1 If Eg(wi .16) ´ √ ˆ √ ³ˆ n β − β 0 and nλ are asymptotically uncorrelated and hence independent. and (10.3 Overidentifying Restrictions In a parametric likelihood context. β 0 ) = 0 then LRn →d χ2−k . 120 . 10.15) (10. by a Taylor expansion.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. 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. Ω) GΩ G →d = N (0. The same statistic can be constructed for empirical likelihood. Since the EL estimator achieves this bound. (10.

the simple overidentifying restrictions test (10. To test the hypothesis h(β) while maintaining (10.1 Under (10.18) are assumed to hold and are not being challenged (at least for the test discussed in this section).prc 121 .18).edu/~bhansen/progs/elike.18) Let the maintained model be where g is × 1 and β is k × 1. the restricted EL estimator β is simply an EL estimator with − k + a overidenti˜ ˆ fying restrictions.Second. Vλ )0 Ω−1 N (0. Theorem 10. By “maintained” we mean that the overidentfying restrictions contained in (10. Vλ ) ¥ where the proof of the ﬁnal equality is left as an exercise.5 Numerical Computation Gauss code which implements the methods discussed below can be found at http://www. 10. 10. h(β)=0 ˜ Fundamentally.17) is not appropriate. The restricted EL estimator and likelihood are the values which solve ˜ β = argmax Ln (β) h(β)=0 ˜ ˜ Ln = Ln (β) = max Ln (β). where h : Rk → Ra .ssc.wisc. a The proof of this result is more challenging and is omitted.4.18) and H0 : h(β) = 0. This test statistic is a natural analog of the GMM distance statistic. 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. LRn →d χ2 . LRn = n X i=1 ˆ0 ' 2λ →d ˆ0 ˆ ' nλ Ωn λ = χ2−k n X i=1 ³ ´´ ³ ˆ ˆ0 2 ln 1 + λ gi β i=1 n ³ ´ X ³ ´ ³ ´0 ˆ − λ0 ˆ ˆ ˆ ˆ gi β gi β gi β λ N (0. Instead we use the diﬀerence in log-likelihoods: ³ ´ ˆ ˜ LRn = 2 Ln − Ln .4 Testing Egi (β) = 0 (10. The hypothesis of interest is h(β) = 0.

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

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

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

1.2) Any solution to the problem of endogeneity requires additional information which we call instruments. 11. this can be written as Y = Zβ + e.1 The × 1 random vector xi is an instrumental variable for (11.so µ qi pi ¶ = = = The projection of qi on pi yields qi = β ∗ pi + εi E (pi εi ) = 0 where β∗ = β − β1 E (pi qi ) ¡ 2¢ = 2 2 E pi ∙ 1 β1 1 −β 2 ¸−1 µ e1i e2i ¶ . By the above deﬁnition.1 Instrumental Variables 0 yi = zi β + ei Let the equation of interest be (11. We call z1i exogenous and z2i endogenous. That is x2i are variables which could be included in the equation for yi (in the sense 125 . Deﬁnition 11. which does not equal either β 1 or β 2 . ¶ µ ∙ β2 β1 1 −1 β 2 e1i + β 1 e2i (e1i − e2i ) ¸µ e1i e2i ¶ ˆ Hence if it is estimated by OLS. and x2i are the excluded exogenous variables. (11.4) xi = x2i 2 where z1i = x1i are the included exogenous variables. In a typical set-up. and assume that E(zi ei ) 6= 0 so there is endogeneity. β →p β ∗ .1).1) the structural equation. This is called simultaneous equations bias. So we have the partition µ ¶ z1i k1 (11.3) zi = z2i k2 where E(z1i ei ) = 0 yet E(z2i ei ) 6= 0.1) if E (xi ei ) = 0. at least the intercept). Thus we make the partition ¶ µ k1 z1i (11. In matrix notation. z1i is an instrumental variable for (11.1) where zi is k × 1. so should be included in xi . some regressors in zi will be uncorrelated with ei (for example. We call (11.

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

11.2

Reduced Form

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

Substituting (11.6) into (11.2), we ﬁnd

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

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

11.3

Identiﬁcation

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

11.4

Estimation

0 yi = zi β + ei

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

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

11.5

Special Cases: IV and 2SLS

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

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

which again is the IV estimator.

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

then

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

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

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

Bekker (1994) showed further that under the alternative asymptotic approximation that α is ﬁxed as n → ∞ (so that the number of instruments goes to inﬁnity proportionately with sample ˆ size) then the expression in (11.7 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.14) is the probability limit of β 2SLS − β 11.13). It is also close to zero when α = 0. 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 . 0). Let q = H 0 ξS −1/2 which satisﬁes Eqq 0 = In and partition q = (q1 q2 ) where q1 is l × 1. indicating that the bias in 2SLS approaches that of OLS as the number of instruments increases. The consequences of identiﬁcation failure for inference are quite severe. 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 (11.12) and this result.Let PX = X (X 0 X)−1 X 0 .14) In general this is non-zero. ¢ 1 ¡ ¢ 1 ¡ ¢ 1 ¡ 0 E Z PX e = E Γ0 X 0 e + E u0 PX e = αS21 . the expression in (11. except when S21 = 0 (when Z is exogenous). the bias in the 2SLS estimator will be large. 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 . Indeed as α → 1. 130 . By the spectral decomposition of an idempotent matrix. n and (11.14) approaches that in (11. P = HΛH 0 0 0 where Λ = diag(Il . The parameter β fails to be identiﬁed if Γ22 has deﬁcient rank. l .

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

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

at ˆˆ If X is indeed endogeneous. u is n × k. In the structural model Y = Zβ + e Z = XΓ + u with Γ l × k. Explain why this is true. 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) . 1. will IV “ﬁt” better than OLS. xi is l × 1. 6. The reduced form between the regressors zi and instruments xi takes the form zi = x0 Γ + ui i or Z = XΓ + u where zi is k × 1. ˜ 0 e < e0 e. Find a simple expression for the IV estimator in this context. That is.11. ˆ ˆ Let the OLS estimator for β be β and the OLS residual be e = Y − Z β. Consider the single equation model ˆ where yi and zi are both real-valued (1 × 1). 133 . where xi and β are 1 × 1. in the sense that e ˜ ˜ least in large samples? 4. Take the linear model Y = Zβ + e. ˆ ˜ ˜ Let the IV estimator for β using some instrument X be β and the IV residual be e = Y − Z β. l ≥ k. (Find an expression for xi . 5.) 3. Show that the GLS estimator of β can be written as an i IV estimator using some instrument xi . Let β denote the IV estimator of β using as an instrument a dummy variable di (takes only the values 0 and 1). we claim that β is identiﬁed (can be recovered from the reduced form) if rank(Γ) = k. X is n × l. and Γ is l × k. show that if rank(Γ) < k then β cannot be identiﬁed. In the linear model 0 yi = zi β + ei E (ei | zi ) = 0 ¡ 2 ¢ suppose σ 2 = E ei | zi is known.8 Exercises yi = zi β + ei . 2. Z is n × k. Take the linear model yi = xi β + ei E (ei | xi ) = 0.

(f) Discuss your ﬁndings. Report the estimates and standard errors. In this model. of the father) and motheduc (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. using zi as an instrument for xi . 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). f atheduc (the education. and South and Black are regional and racial dummy variables. of the mother). (b) Now treat Education as endogenous. Does this diﬀer from 2SLS and/or OLS? 7.. Report estimates and standard errors. in years.(b) Deﬁne the 2SLS estimator of β. (a) Estimate the model by OLS. a dummy indicating that the observation lives near a 4-year college. Estimate the model by 2SLS. and the remaining variables as exogenous.pdf. Report estimates and standard errors. 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. (d) Re-estimate the model by eﬃcient GMM. (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). listed in card.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). and then calculate the GMM estimator from this weight matrix without further iteration. in years. (e) Calculate and report the J statistic for overidentiﬁcation. are the parameters identiﬁed? 8. 134 . There are 2215 observations with 19 variables. The data ﬁle card. using the instrument near4. I suggest that you use the 2SLS estimates as the ﬁrst-step to get the weight matrix. How does this diﬀer from OLS? (c) Find the eﬃcient GMM estimator of β based on the moment condition E (zi (yi − xi β)) = 0.

. we adopt new notation. and T to denote the number of observations. we expect that Yt and Yt−1 are not independent. and Cov (Yt .1. The primary model for multivariate time series is vector autoregressions (VARs).. To indicate the dependence on time. Deﬁnition 12.1. . and multivariate (yt ∈ Rm is vector-valued).1.. and use the subscript t to denote the individual observation.4 (loose). t = 1. The primary model for univariate time series is autoregressions (ARs). The following two theorems are essential to the analysis of stationary time series.. Yt−k ) = γ(k) is independent of t for all k. so classical assumptions are not valid.. however. then Xt is strictly stationary and ergodic. We can separate time series into two categories: univariate (yt ∈ R is scalar).Chapter 12 Univariate Time Series A time series yt is a process observed in sequence over time. Yt−1 . A stationary time series is ergodic if γ(k) → 0 as k → ∞. 12.. T . Deﬁnition 12. Because of the sequential nature of time series.1 {Yt } is covariance (weakly) stationary if E(Yt ) = µ is independent of t. Deﬁnition 12.2 {Yt } is strictly stationary if the joint distribution of (Yt . Yt−k ) is independent of t for all k. There proofs are rather diﬃcult. . 135 .) is a random variable. . Yt−k ) is the autocorrelation function. Theorem 12. γ(k) is called the autocovariance function.1 If Yt is strictly stationary and ergodic and Xt = f (Yt ..1.3 ρ(k) = γ(k)/γ(0) = Corr(Yt .1 Stationarity and Ergodicity Deﬁnition 12.1..

γ (0) ˆ Theorem 12. 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) .Theorem 12.1. For Part (2). γ (k) →p γ(k). and it has a ﬁnite mean by the assumption that EYt2 < ∞. ˆ ˆ T t=1 γ (k) = ˆ The sample autocorrelation ρ(k) = ˆ γ (k) ˆ . 1. ρ(k) →p ρ(k). the sequence Yt Yt−k is strictly stationary and ergodic.2 (Ergodic Theorem). ˆ ˆ T t=1 T t=1 T t=1 By 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 2.1 above. ˆ Proof. then as T → ∞. then as T → ∞. T t=1 Thus γ (k) →p E(Yt Yt−k ) − µ2 − µ2 + µ2 = E(Yt Yt−k ) − µ2 = γ(k). Part (1) is a direct consequence of the Ergodic theorem. ˆ Part (3) follows by the continuous mapping theorem: ρ(k) = γ (k)/ˆ (0) →p γ(k)/γ(0) = ρ(k).3 If Yt is strictly stationary and ergodic and EYt2 < ∞. If Xt is strictly stationary and ergodic and E |Xt | < ∞.1. Thus an application of the Ergodic Theorem yields T 1X Yt Yt−k →p E(Yt Yt−k ). T 1X Xt →p E(Xt ). µ →p E(Yt ). ˆ ˆ γ ¥ 136 . ˆ 3.1.

A useful property of a MDS is that et is uncorrelated with any function of the lagged information It−1 . E(Yt−k et ) = 0.} are jointly random. Most asset pricing models imply that asset returns should be the sum of a constant plus a MDS. For example. some versions of the life-cycle hypothesis imply that either changes in consumption. 12. We consider the conditional expectation E (Yt | It−1 ) where It−1 = {Yt−1 . it is even more important in the time-series context. Some time-series processes may be a MDS as a consequence of optimizing behavior. An autoregressive (AR) model speciﬁes that only a ﬁnite number of past lags matter: E (Yt | It−1 ) = E (Yt | Yt−1 . this series converges if the sequence ρk et−k gets small as k → ∞. Letting et = Yt − E (Yt | It−1 ) .1 et is a martingale diﬀerence sequence (MDS) if E (et | It−1 ) = 0... . YT . t By back-substitution.. . This occurs when |ρ| < 1. Yt−k ) . 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.. Yt−2 .. should be a MDS. 137 . Regression errors are naturally a MDS. Y2 . ∞ X = ρk et−k ...} is the past history of the series.. Thus for k > 0. .. the series {.3 Stationarity of AR(1) Process Yt = ρYt−1 + et . we ﬁnd Yt = et + ρet−1 + ρ2 et−2 + . as it is diﬃcult to derive distribution theories without this property.. A linear AR model (the most common type used in practice) speciﬁes linearity: E (Yt | It−1 ) = α + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k . A mean-zero AR(1) is Assume that et is iid. Y1 . .2 Autoregressions In time-series.. E(et ) = 0 and Ee2 = σ 2 < ∞.2. The last property deﬁnes a special time-series process.. or consumption growth rates.... then we have the autoregressive model Yt = α + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et E (et | It−1 ) = 0.12. Deﬁnition 12. In fact. k=0 Loosely speaking.

From Theorem 12. We can compute the moments of Yt using the inﬁnite sum: EYt = ∞ X k=0 ρk E (et−k ) = 0 σ2 . and solving for EYt = EYt−1 we ﬁnd EYt = α/(1 − ρ).3. 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).4.Theorem 12. We call ρ(L) the autoregressive polynomial of Yt . ∞ X k=0 ρ2k V ar (et−k ) = 12.1 If |ρ| < 1 then Yt is strictly stationary and ergodic. The operator ρ(L) = (1 − ρL) is a polynomial in the operator L. Deﬁning L2 = LL. we see that L2 Yt = LYt−1 = Yt−2 .5 Stationarity of AR(k) Yt = ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et . Deﬁnition 12. We say that the root of the polynomial is 1/ρ. Yt − ρ1 LYt − ρ2 L2 Yt − · · · − ρk Lk Yt = et . 12. or ρ(L)Yt = et where ρ(L) = 1 − ρ1 L − ρ2 L2 − · · · − ρk Lk . 1 − ρ2 V ar(Yt ) = If the equation for Yt has an intercept. an AR(1) is stationary iﬀ |ρ| < 1.1. The AR(k) model is Using the lag operator. the above results are unchanged. except that the mean of Yt can be computed from the relationship EYt = α + ρEYt−1 .1 The lag operator L satisﬁes LYt = Yt−1 . Lk Yt = Yt−k . 138 . In general. We call ρ(L) the autoregressive polynomial of Yt . since ρ(z) = 0 when z = 1/ρ. The AR(1) model can be written in the format Yt − ρYt−1 + et or (1 − ρL) Yt−1 = et .3.4 Lag Operator An algebraic construct which is useful for the analysis of autoregressive models is the lag operator.

the requirement is that all roots are larger than one. it is also strictly stationary and ergodic. t t T t=1 ¥ Combined with (12. “has a unit root”.6 Let Estimation xt = β = ¡ 1 Yt−1 Yt−2 · · · α ρ1 ρ2 · · · yt = x0 β + et . so is xt x0 .. One way of stating this is that “All roots lie outside the unit circle.1 The AR(k) is strictly stationary and ergodic if and only if |λj | > 1 for all j.6. The vector xt is strictly stationary and ergodic. t Yt−k ¢0 ρk . Thus t by the Ergodic Theorem. it is helpful to deﬁne the process ut = xt et . Theorem 12.1.1) Theorem 12. Proof. Note that ut is a MDS.1.. and is of great interest in applied time series. λk are the complex roots of ρ(z). . and hence Yt . we say that ρ(L). β = X 0X (12. T ¢ ¡ 1X xt x0 →p E xt x0 = Q. which satisfy ρ(λj ) = 0. and by Theorem 12. By Theorem 12. The Fundamental Theorem of Algebra says that any polynomial can be factored as ¢¡ ¢ ¡ ¢ ¡ ρ(z) = 1 − λ−1 z 1 − λ−1 z · · · 1 − λ−1 z 1 2 k 12. t T t=1 T t=1 139 .1.. since E (ut | It−1 ) = E (xt et | It−1 ) = xt E (et | It−1 ) = 0. Let |λ| denote the modulus of a complex number λ. This is a special case of non-stationarity. ¢0 Then the model can be written as The OLS estimator is ¡ ˆ To study β.where the λ1 . T t=1 T t=1 ¢−1 0 ¡ ˆ X Y. Thus T T 1X 1X xt et = ut →p E (ut ) = 0. then ˆ β →p β as T → ∞. We know that an AR(1) is stationary iﬀ the absolute value of the root of its autoregressive polynomial is larger than one.” If one of the roots equals 1.5.1) and the continuous mapping theorem.1. For an AR(k).1 If the AR(k) process Yt is strictly stationary and ergodic and EYt2 < ∞. we see that Ã !−1 Ã ! T T 1X 1X ˆ β=β+ xt x0 xt et →p Q−1 0 = 0.

Divide the sample into T /m blocks of length m. T t=1 where Ω = E(xt x0 e2 ). .. Brieﬂy. Ω) .2 If the AR(k) process Yt is strictly stationary and ergodic and EYt4 < ∞. This is identical in form to the asymptotic distribution of OLS in cross-section regression. there are two popular methods to implement bootstrap resampling for time-series data. Y−k+2 .1 to see that T 1 X √ xt et →d N (0. T 1 X √ ut →d N (0. Estimate β and residuals et . . T t=1 Since xt et is a MDS. as this imposes inappropriate independence. we can apply Theorem 12. It also presumes that the AR(k) structure is the truth. then as T → ∞.7. which may be diﬀerent than the i properties of the actual ei . Clearly..7. Y0 ). t t Theorem 12.. i 4. we constructed the bootstrap sample by randomly resampling from the data values {yt . ˆ 2. This creates an iid bootstrap sample. 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∗ . this cannot work in a time-series application.. 12. ˆ 1. In particular.. t then as T → ∞. Method 1: Model-Based (Parametric) Bootstrap. If ut is a strictly stationary and ergodic MDS and E(ut u0 ) = Ω < ∞. Ω) . Method 2: Block Resampling 1.7 Asymptotic Distribution Theorem 12.8 Bootstrap for Autoregressions In the non-parametric bootstrap. 140 .. Fix an initial condition (Y−k+1 . t This construction imposes homoskedasticity on the errors e∗ . Q−1 ΩQ−1 . the asymptotic covariance matrix is estimated just as in the cross-section case. Simulate iid draws e∗ from the empirical distribution of the residuals {ˆ1 .1 MDS CLT.12.7. ´ √ ³ ¡ ¢ ˆ T β − β →d N 0. The implication is that asymptotic inference is the same. eT }. xt }. e ˆ 3.

May not work well in small samples.2)-(12.3) or Yt = α0 + α1 t + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et . get the ˆ ˆ residual St .4) There are two essentially equivalent ways to estimate the autoregressive parameters (ρ1 . ∆s Yt = Yt − Yt−s . heteroskedasticity. draw T /m blocks. Paste the blocks together to create the bootstrap time-series Yt∗ .3) replacing St with St . and the way that the data are partitioned into blocks. But the long-run trend is also eliminated.9 Trend Stationarity Yt = µ0 + µ1 t + St St = ρ1 St−1 + ρ2 St−2 + · · · + ρk St−l + et . Resample complete blocks. 3..2) (12.. however. or the season-to-season change. • You can estimate (12. If s is the number of seasons (typically s = 4 or s = 12). • You can estimate (12. 6. This allows for arbitrary stationary serial correlation. and for modelmisspeciﬁcation. 12. This procedure is sometimes called Detrending. ρk ). The series ∆s Yt is clearly free of seasonality. This is a ﬂexible approach which can extract a wide range of seasonal factors. (12. • Include dummy variables for each season. That is. Thus the seasonally adjusted data is a “ﬁltered” series. This presumes that “seasonality” does not change over the sample. (12.4) by OLS. 141 . 4. For each simulated sample. ﬁrst estimate (12. The seasonal factor is typically estimated by a two-sided weighted average of the data for that season in neighboring years.2). The seasonal adjustment.3) sequentially by OLS. and perhaps this was of relevance. • Use “seasonally adjusted” data. 5. also alters the time-series correlations of the data. . The reason why these two procedures are (essentially) the same is the Frisch-Waugh-Lovell theorem. The results may be sensitive to the block length.. and then perform regression (12. • First apply a seasonal diﬀerencing operator. Seasonal Eﬀects There are three popular methods to deal with seasonal data.2.

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

Under H0 . we say that if Yt is non-stationary but ∆d Yt is stationary. Hence. Thus if Yt has a (single) unit root. Thus ρ(1) = (1 − 1) − α0 − (1 − 1) − · · · − (1 − 1) = −α0 . We do not have the time to develop this theory in detail. To see this. Since α0 is the parameter of a linear regression. so conventional normal asymptotics are invalid. then Yt is “integrated of order d”. the hypothesis of a unit root in Yt can be stated as H0 : α0 = 0. So the natural alternative is H1 : α0 < 0. since ρ(1) = −α0 . Thus a time series with unit root is I(1).7). Because of this property. In this case. Yt is non-stationary. Yt is non-stationary. The DF parameterization is convenient because the parameter α0 summarizes the information about the unit root. or I(d). As we discussed before. the model for Yt is ∆Yt = µ + α1 ∆Yt−1 + · · · + αk−1 ∆Yt−(k−1) + et . 143 . as the models are equivalent.7) These models are equivalent linear transformations of one another. However. Yt has a unit root when ρ(1) = 0.7) is (1 − L) − α0 L − α1 (L − L2 ) − · · · − αk−1 (Lk−1 − Lk ) But this must equal ρ(L). and test statistics are asymptotically non-normal. It would seem natural to assess the signiﬁcance of the ADF statistic using the normal table. but simply assert the main results. observe that the lag polynomial for the Yt computed from (12. or ρ1 + ρ2 + · · · + ρk = 1.12 Autoregressive Unit Roots The AR(k) model is ρ(L)Yt = µ + et ρ(L) = 1 − ρ1 L − · · · − ρk Lk . The ergodic theorem and MDS CLT do not apply. Note that the model is stationary if α0 < 0. (12. the natural test statistic is the t-statistic for H0 from OLS estimation of (12. A helpful way to write the equation is the so-called Dickey-Fuller reparameterization: ∆Yt = µ + α0 Yt−1 + α1 ∆Yt−1 + · · · + αk−1 ∆Yt−(k−1) + et . under H0 . this is the most popular unit root test. then ∆Yt is a stationary AR process.12. and is called the Augmented Dickey-Fuller (ADF) test for a unit root. which is an AR(k-1) in the ﬁrst-diﬀerence ∆Yt . An alternative asymptotic framework has been developed to deal with non-stationary data. Indeed.

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

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

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

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

. and the information set I2t is generated by both Yt and Zt . such as a futures price. The latter has more information. In this equation. Yt−2 .13. We say that Zt does not Granger-cause Yt if E (Yt | I1. 13. The formula for the AIC and BIC are ³ ´ p ˆ AIC(k) = log det Ω(k) + 2 T ³ ´ p log(T ) ˆ BIC(k) = log det Ω(k) + T T X 1 ˆ et (k)ˆt (k)0 ˆ e Ω(k) = T t=1 p = m(km + 1) where p is the number of parameters in the model. This may be tested using an exclusion (Wald) test. Zt−1 . If Zt is some sort of forecast of the future. Deﬁne the two information sets I1t = (Yt . or an information criterion approach. Zt−2 . Yt−1 .) The information set I1t is generated only by the history of Yt . The log determinant is the criterion from the multivariate normal likelihood. The hypothesis can be tested by using the appropriate multivariate Wald test.) I2t = (Yt . then we say that Zt Granger-causes Yt .t−1 ) . for example. then we deduce that our time-series model of E (Yt | It−1 ) does not require the use of Zt . that Zt may still be useful to explain other features of Yt . Note.. the Wald statistic).7 Granger Causality Partition the data vector into (Yt . That is. the equation for Yt is 0 0 Yt = α + ρ1 Yt−1 + · · · + ρk Yt−k + Zt−1 γ 1 + · · · + Zt−k γ k + et . Yt−1 . 148 . If it is found that Zt does not Granger-cause Yt . lagged Zt does not help to forecast Yt . Zt ). Yt and/or Zt can be vectors. conditional on information in lagged Yt . This idea can be applied to blocks of variables. then Zt may help to forecast Yt even though it does not “cause” Yt . . In a linear VAR. Zt .6 Selection of Lag Length in an VAR If you want a data-dependent rule to pick the lag length k in a VAR.. This deﬁnition of causality was developed by Granger (1969) and Sims (1972). you may either use a testingbased approach (using. and et (k) is the OLS residual vector from the ˆ model with k lags. Yt−2 . such as the conditional variance. . however. Zt does not Granger-cause Yt if and only if H0 : γ 1 = γ 2 = · · · = γ k = 0.t−1 ) = E (Yt | I2. The reason why we call this “Granger Causality” rather than “causality” is because this is not a physical or structure deﬁnition of causality. If this condition does not hold. That is.. .

β may not be known. If the series Yt is not cointegrated.8 Cointegration The idea of cointegration is due to Granger (1981). In other cases. however. from OLS of Y1t on Y2t . such that zt = β 0 Yt is I(0). Then under H0 zt is I(1). β is not consistent. as ﬁrst shown by Stock (1987). Engle and Granger (1987) suggested using an ADF test on the estimated ˆ0 ˆ residual zt = β Yt . Hansen (1992). Often. Their justiﬁcation was Stock’s result that β is superˆ ˆ consistent under H1 . If Yt is cointegrated with a single cointegrating vector (r = 1). Thus Yt = ˆ (Y1t . then Yt is I(0). Then β 2 = (Y20 Y2 )−1 Y2 Y1 →p β 2 . of rank r. 149 . if Yt is a pair of interest rates. Y2t ) and β = (β 1 β 2 ) and normalize β 1 = 1. For 0 < r < m. the asymptotic distribution of the test is aﬀected by the presence of the time trend. Suppose that β is known. Under H0 . Whether or not the time trend is included. m × r. then it turns out that β can be consistently estimated by an OLS regression of one component of Yt on the others. in general. When the data have time trends. it may be believed that β is known a priori.13. yet under H1 zt is I(0). 13. The asymptotic distribution was worked out in B. Deﬁnition 13. so zt = β 0 Yt is known. The r vectors in β are called the cointegrating vectors. β = (1 − 1)0 . so the ADF critical values are not appropriate. For example. Yt is I(1) and cointegrated. a good method to estimate β. Thus H0 can be tested using a univariate ADF test on zt . but it is useful in the construction of alternative estimators and tests. then r = 0. We are often interested in testing the hypothesis of no cointegration: H0 : r = 0 H1 : r > 0. then β = (1 − 1)0 speciﬁes that the spread (the diﬀerence in returns) is stationary. then β = (1 − 1)0 speciﬁes that log(Consumption/Income) is stationary. In some cases. This is not. The asymptotic distribution was worked out by Phillips and Ouliaris (1990). If r = m.8.9 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 . and was articulated in detail by Engle and Granger (1987). If Y = (log(Consumption) log(Income))0 . When β is unknown.1 The m × 1 series Yt is cointegrated if Yt is I(1) yet there exists β. Furthermore ˆ this estimation is super-consistent: T (β 2 − β 2 ) →d Limit. it may be necessary to include a time trend in the estimated cointegrating regression.

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

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

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

An example of a data collection censoring is top-coding of income. or it may be a by-product of economic constraints. i If Y = {0. . the consumption level (purchases) in a particular period was zero. The censoring process may be explicit in data collection. incomes above a threshold are typically reported at the threshold.. but we observe only ½ ∗ ∗ yi if yi ≥ 0 (14. This model (now called the Tobit) speciﬁes that the latent (or ideal) value of consumption may be negative (the household 153 . This model speciﬁes that P (Yi = k | xi ) = λi k = 0.1) yi = ∗ <0 . 0 if yi (This is written for the case of the threshold being zero. 14. this motivates the label Poisson “regression.1).. The functional form for λi has been picked to ensure that λi > 0. any known value can substitute. σ 2 ) with the observed variable yi generated by the censoring equation (14. In surveys. 1. The log-likelihood function is ln (β) = n X i=1 log f (yi | xi ) = n X¡ ¢ − exp(x0 β) + yi x0 β − log(yi !) . 1. 2. a typical approach is to employ Poisson regression. . Since E (Yi | xi ) = λi = exp(x0 β) i is the conditional mean.” Also observe that the model implies that V ar (Yi | xi ) = λi = exp(x0 β).3 Censored Data The idea of “censoring” is that some data above or below a threshold are mis-reported at the ∗ threshold..}. This may be considered restrictive. 2. Tobin observed that for many households. A generalization is the negative binomial. The ﬁrst censored regression model was developed by Tobin (1958) to explain consumption of durable goods.2 Count Data exp (−λi ) λk i . Thus the model is that there is some latent process yi with unbounded support. i i i=1 ˆ The MLE is the value β which maximizes ln (β).. i so the model imposes the restriction that the conditional mean and variance of Yi are the same. k! = exp(x0 β). He proposed the latent variable model ∗ yi = x0 β + ei i ei ∼ iid N (0.) The observed data yi therefore come from a mixed continuous/discrete distribution.14. The conditional density is the Poisson with parameter λi . 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.

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

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

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

(15. .. ti ..1) is called the random eﬀects hypothesis. . If (15. xit } : t = 1.1) fails if the individual-speciﬁc unobserved eﬀect ui is correlated with the observed explanatory variables xit . OLS appears a poor estimation choice. it The typical maintained assumptions are that the individuals i are mutually independent. . In either event.. and the t subscript denotes time.. n. T . i = 1.2 Fixed Eﬀects This is the most common technique for estimation of non-dynamic linear panel regressions. OLS of yit on xit is called pooled estimation... and have arbitrary correlated with xi .. This is often believed to be plausible if ui is an omitted variable. however. It is a strong assumption. or unbalanced : {yit . and most applied researchers try to avoid its use. n. collected over time. An observation is the pair {yit .. and that eit is uncorrelated with xit . that ui and eit are independent.. There are several derivations of the estimator. OLS can be improved upon via a GLS technique. that eit is iid across individuals and time. where the i subscript denotes the individual. The motivation is to allow ui to be arbitrary. then OLS is inconsistent.. The goal is to eliminate ui from the estimator. 15.1 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 . Condition (15. A panel may be balanced : {yit . It is consistent if E (xit ui ) = 0 (15. 15. xit }. and thus achieve invariance.1) If this condition fails. xit } : For i = 1. t = ti .Chapter 15 Panel Data A panel is a set of observations on individuals.1) is true.. 157 . ..

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

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

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

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

The last expression shows that the expected value is an average of f (z) locally about x. The bias results from this smoothing. nh (x)2 dx is called the roughness of K. ˆ the greater the bias. which is valid as h → 0. ˆ We now examine the variance of f (x). Since it is an average of iid random variables. 162 . The sharper the derivative. 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). and is larger the greater the curvature in f (x). Intuitively. Thus 1 f (x + hu) ' f (x) + f 0 (x)hu + f 00 (x)h2 u2 2 and therefore µ ¶ 1 00 0 2 2 K (u) f (x) + f (x)hu + f (x)h u du EKh (X − x) ' 2 −∞ Z ∞ Z ∞ Z ∞ 1 = f (x) K (u) du + f 0 (x)h K (u) udu + f 00 (x)h2 K (u) u2 du 2 −∞ −∞ −∞ 1 00 2 2 = f (x) + f (x)h σ K . so is estimating a smoothed version of f (x). 2 Z ∞ ˆ The bias of f (x) is then 1 1X ˆ EKh (Xi − x) − f (x) = f 00 (x)h2 σ 2 .16. 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 estimator f (x) smooths data local to Xi = x. so we approximate it using a second order Taylor expansion of f (x + hu) in the argument hu about hu = 0. This integral (typically) is not analytically solvable.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.

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 . but not of n. h must tend to zero. R∞ R∞ K σ 2 = −∞ x2 K (x) dx R(K) = −∞ K (x)2 dx K √ Gaussian 1 1/(2 π) Epanechnikov 1/5 1/5 Biweight 1/7 5/7 An obvious diﬃculty is that R(f 00 ) is unknown.06n−1/5 163 . This choice for h gives an optimal rule when f (x) is ˆ normal. We can calculate that √ R(φ00 ) = 3/ (8 π) . but at a slower rate than n−1 . Together with the above table. and R(f 00 ).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 . We thus say that the optimal bandwidth is of order O(n−1/5 ). We deﬁne the asymptotically optimal bandwidth h0 as the value which minimizes this approximate MSE. 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 + . σ 2 . That is. That is. (16.2) but replaces R(f 00 ) with σ −5 R(φ00 ). Thus for the AMISE to decline with n.Together. ˆ It uses formula (16. Gaussian Kernel: hrule = 1.2) This solution takes the form h0 = cn−1/5 where c is a function of K and f. the rule-of-thumb h can be quite ineﬃcient. The asymptotically optimal choice given in (16.2) depends on R(K). but at a very slow rate. A classic simple solution proposed by Silverman (1986)has come to be known as the reference bandwidth or Silverman’s Rule-of-Thumb. we ﬁnd the reference rules for the three kernel functions introduced earlier. In practice. 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) . Notice that the ﬁrst term (the squared bias) is increasing in h and the second term (the variance) is decreasing in nh. how should the bandwidth be selected? This is a diﬃcult problem. (16. where φ is the N (0. Their K values for the three functions introduced in the previous section are given here. we need h → 0 but nh → ∞. and gives a nearly optimal rule when f (x) is close to normal. Note that this h declines to zero. The downside is that if the density is very far from normal. Equation (16. 1) distribution and σ 2 is an estimate of σ 2 = V ar(X). and there is a large and continuing literature on the subject. The ﬁrst two are determined by the kernel function.1) is an asymptotic approximation to the MSE.

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

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

. 983. We can say that the occurrence of B has no information about the likelihood of event A when P (A | B) = P (A). we can write P (A ∩ B) = P (A | B) P (B) which is often quite useful... ¢ counting is unordered and without replacement. r r! (n − r)! When counting the number of objects in a set. If P (B) > 0 the conditional probability of the event A given the event B is P (A | B) = P (A ∩ B) . we say that the collection of events A1 . Without Replacement Ordered Unordered n! (n−r)! ¡n¢ r In the lottery example. Counting may be ordered or unordered. n ≥ r. we have four expressions for the number of objects (possible arrangements) of size r from n objects. the conditional probability function is a valid probability function where S has been replaced by B. . and is with replacement if this is allowed. Furthermore.. it is useful to have simple rules to count the number of objects in a set. Ã ! \ Y P Ai = P (Ai ) . Ak are mutually independent when for any subset {Ai : i ∈ I}. Counting is ordered or not depending on whether the sequential order of the numbers is relevant to winning the lottery. 49. consider a lottery where you pick six numbers from the set 1. 816. Rearranging the deﬁnition. the number of ¡49 if potential combinations is 6 = 13.1) We say that the events A and B are statistically independent when (A. These counting rules are facilitated by using the binomial coeﬃcients which are deﬁned for nonnegative integers n and r.. This selection is without replacement if you are not allowed to select the same number twice. 2. i∈I i∈I 166 . . P (B) With Replacement nr ¡n+r−1¢ r For any B.. there are two important distinctions.1) holds. For example. Depending on these two distinctions.• 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. as µ ¶ n n! = . Counting may be with replacement or without replacement. in which case we ﬁnd P (A ∩ B) = P (A) P (B) (A.

r (A. then for each i = 1. (A.. Instead.. ... the range of X consists of a countable set of real numbers τ 1 . 167 . 2.Theorem 2 (Bayes’ Rule). Typically. and use lower case letters such as x for potential values and realized values. A function F (x) is a CDF if and only if the following three properties hold: 1.. In this case P (X = τ ) = 0 for all τ ∈ R so the representation (A.... .. .2 Random Variables A random variable X is a function from a sample space S into the real line. τ r . P (B | Ai ) P (Ai ) P (Ai | B) = P∞ j=1 P (B | Aj ) P (Aj ) A. limx→−∞ F (x) = 0 and limx→∞ F (x) = 1 2. For a random variable X we deﬁne its cumulative distribution function (CDF) as F (x) = P (X ≤ x) . F (x) is nondecreasing in x 3. Pr where 0 ≤ π j ≤ 1 and j=1 π j = 1. For any set B and any partition A1 . a These expressions only make sense if F (x) is diﬀerentiable. We say that the random variable X is continuous if F (x) is continuous in x. 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. these cases are unusualRand are typically ignored.3) is unavailable. In the latter case. The probability function for X takes the form j = 1. 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. .2) Sometimes we write this as FX (x) to denote that it is the CDF of X. we denote random variables by uppercase letters such as X.. A2 . This induces a new sample space — the real line — and a new probability function on the real line.3) P (X = τ j ) = π j . of the sample space. ∞ A function f (x) is a PDF if and only if f (x) ≥ 0 for all x ∈ R and −∞ f (x)dx.

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

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

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

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

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

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

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

(A. an exponential density. 1]. but its justiﬁcation requires deeper results from analysis. Let h(y) denote the inverse of g(x). If g(x) is an increasing function. that for Y is [0. A. . As one example.A. 0 ≤ y ≤ ∞. As the range of X is [0. g(x) = − ln(x) and h(y) = exp(−y) so the Jacobian is J(y) = − exp(y). then g(X) ≤ Y if and only if X ≥ h(Y ). This same formula (A. dy dy If g(x) is a decreasing function. dy This is known as the change-of-variables formula. 1] and Y = − ln(X). Since fX (x) = 1 for 0 ≤ x ≤ 1 (A.10) holds for k > 1.10) d h(y).∞). The Jacobian is ¶ µ ∂ h(y) . 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). J(y) = det ∂y 0 Consider the univariate case k = 1. take the case X ∼ U [0.10) shows that fY (y) = exp(−y). 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). Let Y = g(X) where g(x) : Rk → Rk is one-to-one.8 Normal and Related Distributions µ 2¶ 1 x . and invertible. then g(X) ≤ Y if and only if X ≤ h(Y ). Here. 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)| . diﬀerentiable.

respectively. If X ∈ Rk is multivariate normal and the elements of X are mutually uncorrelated. In this case the density function can be written as j Ã Ã !! (x1 − µ1 )2 /σ 2 + · · · + (xk − µk )2 /σ 2 1 1 k f (x) = exp − 2 (2π)k/2 σ 1 · · · σ k Ã ¡ ¢2 ! k Y xj − µj 1 = exp − 2σ 2 (2π)1/2 σ j j j=1 which is the product of marginal univariate normal densities. then Z 0 A−1 Z ∼ χ2 .This density has all moments ﬁnite. X has density Ã ! (x − µ)2 1 exp − . y ≥ 0. and it is conventional to write X ∼ N (µ. the multivariate normal density is ¶ µ (x − µ)0 Σ−1 (x − µ) 1 . and to denote the standard normal density function by φ(x) and its distribution function by Φ(x).1 Let X ∼ N (0. x ∈ Rk . The mean and variance of the distribution are µ and σ 2 .11) and is known as the chi-square density with r degrees of freedom. we can also show that EX 2 = 1 and EX 4 = 3. It is conventional to write X ∼ N (0. Q has the density f (y) = Γ 1 ¡r¢ 2 2r/2 yr/2−1 exp (−y/2) . the density of Y is Ã ! (y − µY )0 Σ−1 (y − µY ) 1 Y exp − f (y) = . and it is conventional to write X ∼ N(µ. By iterated integration by parts. Σ). exp − f (x) = k/2 1/2 2 (2π) det (Σ) The mean and covariance matrix of the distribution are µ and Σ. then they are mutually independent. k/2 1/2 2 (2π) det (ΣY ) where µY = a+Bµ and ΣY = BΣB 0 . x ∈ Rk . q × q. 1). This shows that if X is multivariate normal with uncorrelated elements. This shows that linear transformations of normals are also normal. A) with A > 0. then by the change-of-variables formula. Theorem A. The latter has no closed-form solution. ¢ ¡ It useful to observe ¢ that the MGF and CF of the multivariate normal are exp λ0 µ + λ0 Σλ/2 ¡ 0 and exp iλ µ − λ0 Σλ/2 . If Z is standard normal and X = µ + σZ. where we used the fact that det (BΣB 0 )1/2 = det (Σ)1/2 det (B) . denoted χ2 . q 176 . (A. Its mean and r variance are µ = r and σ 2 = 2r. then using the change-of-variables formula.8. then Σ = diag{σ 2 } is a diagonal matrix. Σ) and Y = a + BX with B an invertible matrix.8. Theorem A. −∞ < x < ∞. Another useful fact is that if X ∼ N (µ. σ 2 ). Ir ) and set Q = X 0 X. Since it is symmetric about zero all odd moments are zero. f (x) = √ 2σ 2 2πσ which is the univariate normal density.2 If Z ∼ N(0. For x ∈ Rk .

Proof of Theorem A. Using the simple law of iterated expectations. C −1 CC 0 C −10 ) = N (0.13) is the MGF of the density (A.13) = (1 − 2t)−r/2 R∞ where the second equality uses the fact that 0 y a−1 exp (−by) dy = b−a Γ(a).1. we see that the MGF of Z 2 is (1 − 2t)−1/2 .8. which we showed in (A.8. 1) the distribution of Z 2 is ¡ ¢ √ P Z 2 ≤ y = 2P (0 ≤ Z ≤ y) µ 2¶ Z √y 1 x √ exp − dx = 2 2 2π 0 Z y ³ s´ 1 ¡1¢ = s−1/2 exp − ds 1/2 2 0 Γ 2 2 1 ¡r¢ 2 2r/2 y r/2−1 exp (ty) exp (−y/2) dy of Q is (1 − 2t)−r/2 . Thus the density of Z 2 is (A.12) E exp (tQ) = 0 Γ (A.8.Theorem A. Set r Z . The MGF for the density (A. tr = p Q/r The density of tr is and is known as the student’s t distribution with r degrees of freedom. From (A.11) 2 with r = 1.6) can be used to show that the MGF j=1 ¥ Proof of Theorem A. (A. 1) and Q ∼ χ2 be independent.8.13). The fact that A > 0 means that we can write A = CC 0 where C is non-singular. For Z ∼ N(0. Iq ).11). Thus ¥ ¡ ¢0 ¡ ¢ Z 0 A−1 Z = Z 0 C −10 C −1 Z = C −1 Z C −1 Z ∼ χ2 . 1). ¡ ¢ √ using the change—of-variables s = x2 and the fact Γ 1 = π.3 Let Z ∼ N (0.11) is Z ∞ ¢ ¡ Γ r+1 2 f (x) = ´ r+1 ¡r¢ ³ √ 2 2 πrΓ 2 1 + x r (A. which can be found by applying change-of-variables to the gamma function. tr has distribution 177 . C −1 AC −10 ) = N (0. Since we can write Q = P 2 X 0 X = r Zj where the Zj are independent N(0. Then A−1 = C −10 C −1 and C −1 Z ∼ N (0.3.2. q Proof of Theorem A.

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

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

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

θ) f (˜. θ0 ) ln f (Yi . θ0 ) (Yi . θ)¯ = ¯ ∂θ θ=θ0 = = = Similarly. θ0 )0 .1) has mean zero and variance nH. ¯ ¯ ∂ E ln f (Yi . θ0 ) f (Yi . y y θ(˜ y y y θS 1 = θ(˜ ∂θ ∂θ By the Cauchy-Schwarz inequality ¯ ³ ´¯2 ³ ´ ¯ ¯ θS θ 1 = ¯E ˜ ¯ ≤ V ar (S) V ar ˜ ³ ´ V ar ˜ ≥ θ 1 1 = . S= ∂2 f ∂θ∂θ0 ∂2 f ∂θ∂θ0 ∂ ∂θ Z Ã ∂2 f ∂θ∂θ0 ¯ ¯ ln f (y. θ0 ) dy ¯ ¯ ¯ θ=θ0 f (y.16). θ) dy ¯ ∂θ f (y. Diﬀerentiating with respect to θ and evaluating at θ0 yields ˜ Z Z ³ ´ ˜ y ) ∂ f (˜. θ0 ) − f (Yi . θ0 ) ∂ ∂θ f ∂ (Yi . f (Yi . θ0 ) ¯ ∂ f (y. θ) dy ¯ ¯ ∂θ θ=θ0 ¯ ∂ ¯ 1¯ = 0.1. θ0 = ln f (Yi . yn ). θ0 ) ∂θ ∂θ n i=1 which by Theorem (A. θ0 )0 f (Yi . Since θ Z ˜ = ˜ y)f (˜. θ0 ) ∂θ f (Yi . θ0 )2 (Yi . θ0 ) = ∂θ∂θ0 = Taking expectations yields (A. function of the data. ∂2 ln f (Yi . θ0 ) d˜ = E ˜ .2.17). .. θ) d˜ = ˜ y ) ∂ ln f (˜.. Write the estimator ˜ = ˜ Y ) as a θ θ( ˜ ˜ is unbiased for any θ.Proof of Theorem A.9.9. θ) d˜ θ = Eθ θ(˜ y y where y = (y1 . we can show that E By direction computation. ∂θ ¯θ=θ0 Z ! = 0. θ0 ) ∂ ∂ − ln f (Yi . (Yi . θ0 ) ∂θ ∂θ ¥ ³ ´ X ∂ ∂ ˜ ln fn Y . θ) ¯θ=θ0 ¯ Z ¯ ∂ f (y. θ) f (y..9. To see (A. V ar (S) nH so ¥ 181 . Proof of Theorem A.

Ω) . θn ) = ln f (Yi . θ0 ) →d N (0. ´ ¡ ¢ ¡ ¢ √ ³ˆ n θ − θ0 →d H −1 N (0.Proof of Theorem A. θn ) − H(θn ) + H(θn ) − n n ∂θ∂θ0 ∂θ∂θ0 i=1 i=1 →p H by an application of a uniform WLLN. θ) . Ω) = N 0.9. If it is continuous in θ. then since θn →p θ0 we ﬁnd H(θn ) →p H and so ¶ n n µ ∂2 1X 1 X ∂2 − ln f (Yi . ∂θ ∂θ∂θ i=1 i=1 θ where θn lies on a line segment joining ˆ and θ0 . − ln f (Yi . ¯ ¯ ∂ Ln (θ)¯ 0 = ¯ ˆ ∂θ θ=θ n ³ ´ X ∂ ln f Yi . ˆ = θ ∂θ i=1 n n ´ ³ X ∂ X ∂2 ˆ ln f (Yi . θ0 ) . an application of the CLT yields 1 X ∂ √ ln f (Yi . the speciﬁc value of θn varies by row in this expansion. the ﬁnal equality using Theorem A.3 Taking the ﬁrst-order condition for maximization of Ln (θ). θ n ) θ − θ 0 . H −1 ΩH −1 = N 0. and making a ﬁrst-order Taylor series expansion. ∂θ n i=1 n The analysis of the sample Hessian is somewhat more complicated due to the presence of θn . Let ∂2 H(θ) = − ∂θ∂θ0 ln f (Yi . H −1 . (Technically.) Rewriting this equation. ¥ 182 . Together. θ0 ) is mean-zero with covariance matrix Ω. θn ) ∂θ ∂θ∂θ0 i=1 i=1 ln f (Yi . we ﬁnd ´ ³ ˆ − θ0 = θ Since ∂ ∂θ Ã !−1 Ã n ! n X ∂2 X ∂ ln f (Yi .9.1 . θ0 ) + ' 0 ln f (Yi .

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

numerical derivatives can be quite unstable. Take the j 0 th element of g(θ). they can be calculated numerically. In some cases. Most gradient methods are a variant of Newton’s method which is based on a quadratic approximation.B. 2. θ where One problem with Newton’s method is that it will send the iterations in the wrong direction if H(θi ) is not positive deﬁnite. 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. and all require the computation θ. To pick λi write the criterion function as a function of λ Q(λ) = Q(θi + Di gi λ) 184 . of the gradient of Q(θ) ∂ Q(θ) g(θ) = ∂θ and some require the Hessian ∂2 H(θ) = Q(θ). numerical derivatives can work well but can be computationally costly relative to analytic derivatives. Allowing the steplength to be a free parameter allows for a line search. ∂θ∂θ 0 If the functions g(θ) and H(θ) are not analytically available. θ This suggests the iteration rule ˆi+1 = θi − H(θi )−1 g(θi ).. One modiﬁcation to prevent this possibility is quadratic hill-climbing which sets ˆi+1 = θi − (H(θi ) + αi Im )−1 g(θi ). however. Let δ j be the j 0 th unit vector (zeros everywhere except for a one in the j 0 th row). In this case the iteration rule takes the form (B.2 Gradient Methods Gradient Methods are iterative methods which produce a sequence θi : i = 1.2) θi+1 = θi − Di gi λi Q(θ + δ j ε) − Q(θ) . 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). Q(θ + δ j ε + δ k ε) − Q(θ + δ k ε) − Q(θ + δ j ε) + Q(θ) ε2 In many cases. which are designed to converge to ˆ All require the choice of a starting value θ1 .. . a one-dimensional optimization. Then for ε small gj (θ) ' Similarly. Another productive modiﬁcation is to add a scalar steplength λi . θ where αi is set just above the smallest eigenvalue of H(θi ) if H(θ) is not positive deﬁnite.

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

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