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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

. .11 8. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .7 Hypothesis Testing: The Distance Statistic 9. . . . .2 Autoregressions . . . . . . . . . . . . . . .4 Lag Operator . . . . . . . . . . . . . . . . . . . . . . . . . 10. . . . . . . . . . . . . . . . . . . . . 11. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Percentile Conﬁdence Intervals . . 11 Endogeneity 11. . . . . . . . . . . . . . . . . .3 Overidentifying Restrictions . . . . . . . . . . . . . . . . .5 Numerical Computation . . . . . . . . . . . . . .8 Bootstrap for Autoregressions . . . . . . . . . . . . . .3 Distribution of GMM Estimator . . . . . . . . . . . . . . . . . . . . . .2 Asymptotic Distribution of EL Estimator 10. . . . . . . .12Autoregressive Unit Roots . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 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 . . . . . . . . . . . . . . .7 Asymptotic Distribution . . . . . . . . . . . . . . . . . . . . . .8 Conditional Moment Restrictions . . . . . . . . . . . . . . . . . 12. . . . . . . 9. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .11Model Selection . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10. . . . . . . . . . . .6 Bekker Asymptotics . . Symmetric Two-Sided Tests . . . . . .10 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10.9 Bootstrap GMM Inference . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Instrumental Variables . . . . .9 8. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5 Stationarity of AR(k) . . . . . . . . . . . . .1 Non-Parametric Likelihood . . . . . . . . . . . . . . . . . 9. . . . . . . . .6 Estimation . . . . . . . . . . . . . .12 8. . . . . . . . . 12. . . . . . . . . . . . . . . . . . . . 12. . . . . . .1 Stationarity and Ergodicity . . . . . . . . . . . . . . . . . . . . . . . . 11. . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . 11. . . . . . . . . . . . . . . 9. . . . . . . . .1 Overidentiﬁed Linear Model . . 10 Empirical Likelihood 10. . 12. . . . . . . . . . . 12. 11. . .2 GMM Estimator . . . 9. . . . . . . . . . . . . . . .4 Testing . 12. . . . . . . . . .8 Exercises . . . . . . . . . . . . . . . . . . . .5 Special Cases: IV and 2SLS 11. . . . . . . . . . . . . . . . . . . . . . . . . .10 8. . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . .7 Identiﬁcation Failure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9 Trend Stationarity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . . . . .4 Estimation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .6 Over-Identiﬁcation Test . . . . . . . . . . . Bootstrap Methods for Regression Models Exercises . . . . . . . . . . .8. . . . .5 GMM: The General Case . 11. . . . . . . . . . . . . . . . . iii . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9. . . . . . . . . 9. . . . 12 Univariate Time Series 12. . . . . . . . . . . . . . . . . . 12. .3 Stationarity of AR(1) Process . . . . . . . . . . . . . . .2 Reduced Form . . . . . . .3 Identiﬁcation . . .10Testing for Omitted Serial Correlation 12. . . . . . . . . . . . . 11.4 Estimation of the Eﬃcient Weight Matrix . . . . . . . . . . .

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

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

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

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

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

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

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

. (2. then # ¡ ¢−1 ¡ ¢−1 ∙ ¸−1 " A − BD−1 C A B − A − BD−1 C BD−1 ¡ ¡ ¢−1 ¢−1 = .1) . (2. The following fact about inverting partitioned matrices is sometimes useful. . a0 bk k ⎤ ⎥ ⎥ ⎥ ⎦ a0 bi i b0 ai i = = tr (BA) . 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 (2.3) plus the following three conditions A− AA− = A− AA− is symmetric A− A is symmetric For any matrix A. For non-singular A and C. . . we can still deﬁne a generalized inverse A− as a matrix which satisﬁes AA− A = A.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 . .4 Inverse A k × k matrix A has full rank. The Moore-Penrose generalized inverse A− satisﬁes (2. if there is no c 6= 0 such that Ac = 0. 7 Also. . the Moore-Penrose generalized inverse A− exists and is unique. 0b 0b ak 1 ak 2 · · · a0 bk 1 a0 bk 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.3) The matrix A− is not necessarily unique. If A − BD−1 C and D − CA−1 B are non-singular. 2. This matrix is called the inverse of A and is denoted by A−1 . . if A is an orthogonal matrix. or is nonsingular. then A−1 = A.

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

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

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

You can see that the right tail of then density is much thicker than the left tail. the mean wage for men is $27. These are asymmetric (skewed) densities. (3.Chapter 3 Regression and Projection The most commonly applied econometric tool is regression. See Chapter 16. the mean is not necessarily a good summary of the central tendency. or the covariates. In this context it is often convenient These are nonparametric density estimates using a Gaussian kernel with the bandwidth selected by crossvalidation. which is a common feature of wage distributions. An important summary measure is the conditional mean Z ∞ yf (y | x) dy. the conditioning variable. To illustrate.2) m(x) = E (yi | xi = x) = −∞ In general.22. In the example presented in Figure 3. we can focus on f (y | x) . Figure 3. These are indicated in Figure 3. This is used when the goal is to quantify the impact of one set of variables on another variable. Take a closer look at the density functions displayed in Figure 3. .1 by the arrows drawn to the x-axis.1. education and experience. ⎟ . holding the other variables constant. ⎠ ⎝ .1 Conditional Mean To study how the distribution of yi varies with the variables xi in the population. The two density curves show the eﬀect of gender on the distribution of wages.1.1) xi = ⎜ . and that for women is $20. We call xi alternatively the regressor. The data are from the 2004 Current Population Survey 1 11 . In this context we partition the observations into the pair (yi . While it is easy to observe that the two densities are unequal.1 displays the density1 of hourly wages for men and women. We list the elements of xi in the vector ⎞ ⎛ x1i ⎜ x2i ⎟ ⎟ ⎜ (3. the conditional density of yi given xi . m(x) can take any form. gender. When a distribution is skewed.73. xi ) where yi is a scalar (real-valued) and xi is a vector. We call yi the dependent variable. from the population of white non-military wage earners with a college degree and 10-15 years of potential work experience. xki 3. it is useful to have numerical measures of the diﬀerence. These are conditional density functions — the density of hourly wages conditional on race. and exists so long as E |yi | < ∞.

3 is how the conditional expectation describes an important feature of the conditional distribution. wage regressions typically use log wages as a dependent variable rather than the level of wages.2 shows the density of log hourly wages for the same population. the dashed line is a linear projection approximation which will be discussed in the Section 3.A. The main point to be learned from Figure 3.D. implying an average 36% diﬀerence in wage levels.3 displays a scatter plot2 of log wages against education levels. When the distribution of the control variable is continuous. 2 (3. then comparisons become more complicated. Of particular interest to graduate students may be the observation that diﬀerence between a B. Figure 3.5.30. this yields the formula yi = m(xi ) + ei .2 Regression Equation The regression error ei is deﬁned to be the diﬀerence between yi and its conditional mean (3. Figure 3. degree in mean log hourly wages is 0.36.1: Wage Densities for White College Grads with 10-15 Years Work Experience to transform the data by taking the (natural) logarithm. For this reason.3) White non-military male wage earners with 10-15 years of potential work experience.1 is facilitated by the fact that the control variable (gender) is discrete. which implies a 30% average wage diﬀerence for this population.2) evaluated at the observed value of xi : ei = yi − m(xi ). This is a more robust measure of the typical wage gap between men and women than the diﬀerence in the untransformed wage means. To illustrate. By construction.Figure 3. The conditional expectation function is close to linear. 12 . 3. Assuming for simplicity that this is the true joint distribution. with mean log hourly wages drawn in with the arrows. the solid line displays the conditional expectation of log wages varying with education. The diﬀerence in the log mean wage between men and women is 0. and a Ph. The comparison in Figure 3.

not a model. E (ei | xi ) = E ((yi − m(xi )) | xi ) = m(xi ) − m(xi ) = E (yi | xi ) − E (m(xi ) | xi ) = 0.2. most typically. These equations hold true by deﬁnition. restrictions on the permissible class of regression functions m(x). because no restrictions have been placed on the joint distribution of the data. 3.1 Properties of the regression error ei 1. E (h(xi )ei ) = 0 for any function h (·) . 13 .Figure 3. 4. 2. The remaining parts of the Theorem are left as an exercise. The equations yi = m(xi ) + ei E (ei | xi ) = 0. E(ei ) = 0. E (ei | xi ) = 0. It is important to understand that this is a framework. To show the ﬁrst statement. are often stated jointly as the regression framework. E(xi ei ) = 0.2: Log Wage Densities Theorem 3. by the deﬁnition of ei and the linearity of conditional expectations. A regression model imposes further restrictions on the joint distribution.

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

take the conditional wage densities displayed in Figure 3. We call this the “constant” or “intercept”. where x1i is the ﬁrst element of the vector xi deﬁned in (3.3) is when the conditional mean function m(x) is linear in x (or linear in functions of x).1 and that for women is 10. 3. i (3. An important special case is homoskedastic linear regression model yi = x0 β + ei i E (ei | xi ) = 0 ¢ ¡ E e2 | xi = σ 2 . βk ⎛ (3. Instead. This concept is less helpful than deﬁning heteroskedasticity as the dependence of the conditional variance on the observables xi . In this case (3. which we derive in this section. ⎝ .7) is a k × 1 parameter vector. As an example.4 Linear Regression An important special case of (3. The conditional standard deviation for men is 12. Notationally. we assume that x1i = 1. ⎟ β=⎝ . ⎠ .1) has been redeﬁned as the k × 1 vector ⎛ ⎞ 1 ⎜ x2i ⎟ ⎜ ⎟ (3.5) xi = ⎜ . its functional form is typically unknown. Thus (3. it is more realistic to view the linear speciﬁcation (3. ⎟ . we can write it as m(x) = x0 β = β 1 + x2i β 2 + · · · + xki β k where ⎞ β1 ⎜ .1. it is convenient to augment the regressor vector xi by listing the number “1” as an element.5.5 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. So while men have higher average wages.6) (3. Some textbooks inappropriately describe heteroskedasticity as the case where “the variance of ei varies across observation i”.6) as an approximation. xki When m(x) is linear in x.8) is called the linear regression model.9) 3.8) (3. 15 . and the linear assumption of the previous section is empirically unlikely to accurate. ⎠ .3) can be writen as yi = x0 β + ei i E (ei | xi ) = 0. they are also somewhat more dispersed.we say that the error ei is homoskedastic.1). Equivalently.

Equivalently. In order for β to be uniquely deﬁned. i which requires that for all non-zero α. As before. by “best” we mean the predictor function with lowest mean squared error. α0 E (xi x0 ) α = E (α0 xi )2 > 0. i i (3. α0 E (xi x0 ) α = E (α0 xi )2 ≥ 0 so the matrix E (xi x0 ) is by construction i i positive semi-deﬁnite. The vector (3. i 16 .11) Notice that the error from the linear prediction equation ei is equal to the error from the regression equation when (and only when) the conditional mean is linear in xi .1 1.12) This completes the derivation of the linear projection model. i (3. Therefore. i 4. Given the deﬁnition of β in (3. Observe i that for any non-zero α ∈ Rk . Assumption 3. 3. The ﬁrst-order condition for minimization (from Section 2. 2 2.5. 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 . i (3. We now summarize the assumptions necessary for its derivation and list the implications in Theorem 3. E (xi x0 ) is a mai E(x y trix and E (xi yi ) is a vector. we obtain a decomposition of yi into linear predictor and error yi = x0 β + ei . this situation must be excluded.1. there cannot i exist a non-zero vector α such that α0 xi = 0 identically. i ∂β ¢¢−1 ¡ ¡ E (xi yi ) . alternative expressions such as E xixi ) or E (xi yi ) (E (xi x0 ))−1 i ( i 0i ) are incoherent and incorrect. written E (xi x0 ) > 0. otherwise they are distinct.7) is 0= Solving for β we ﬁnd ¡ ¢ ∂ S(β) = −2E (xi yi ) + 2E xi x0 β. It is invertible if and only if it is positive deﬁnite.10). This occurs when redundant variables are included in xi . The error is i ei = yi − x0 β. E (x0 xi ) < ∞. 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. E (xi x0 ) is invertible.5. xi contains an intercept. Rewriting. x0 β is the best linear predictor for yi .10) exists and is unique as long as the k ×k matrix E (xi x0 ) is invertible.10) It is worth taking the time to understand the notation involved in this expression. The best linear predictor is obtained by selecting β to minimize S(β). Eyi < ∞.which is quadratic in β.

14) Proof. Using the deﬁnitions (3.11) and (3.14) holds.1 is employed to guarantee that (3. Assumption 3.2. Let’s compare it with the linear regression model (3.1. This means that the equation (3.1.5. 17 .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. By deﬁnition.5.1. (3.5. For example.14) follows from (3.5. Assumption 3.1.9).5.1 Under Assumption 3. Assumption 3. Since from Theorem 3.5. Assumption 3.1.12) and (3. Figure 3. Since ei is mean zero by (3.4: Hourly Wage as a Function of Experience The conditions listed in Assumption 3. it follows that linear regression is a special case of the projection model.13) and Assumption 3. The ﬁnite variance Assumptions 3.10) are deﬁned. E (xi ei ) = 0 and E (ei ) = 0.3 ensure that the moments in (3. ¥ (3.4 guarantees that the solution β exits.5.10) and (3.2 and 3.12) can be alternatively interpreted as a projection decomposition.13) summarize the linear projection model.14).1.5.8)-(3.5. (3. the orthogonality restriction (3.4 is required to ensure that β is uniquely deﬁned.Theorem 3.5.3 are called regularity conditions.1.5. the converse is not true as the projection error does not necessarily satisfy E (ei | xi ) = 0. Equation (3.1. Then i i Exi e2 = Ex3 = 0 yet E (ei | xi ) = x2 6= 0.2 and 3.11) are well deﬁned. i i i Since E (xi ei ) = 0 we say that xi and ei are orthogonal. Furthermore.1. However. x0 β is the i projection of yi on xi since the error ei is orthogonal with xi .13) implies that xi and ei are uncorrelated.13) The two equations (3. suppose that for xi ∈ R that Ex3 = 0 and ei = x2 .1 are weak.1.1.4 we know that the regression error has the property E (xi ei ) = 0.

10) may not hold and the implications of Theorem 3. In this case the linear projection is a poor 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.1. for those over 53 in age). These structural models require alternative estimation methods. for any pair (yi . and the straight dashed line is the linear projection.12) with the properties listed in Theorem 3. Most importantly. Figure 3. In this example it is a much better approximation to the conditional mean than the linear projection. the dashed line is the linear projection of log wages on eduction. xi ) we can deﬁne a linear projection equation (3.12) is deﬁned by projection and the associated coeﬃcient deﬁnition (3. In other cases the two may be quite diﬀerent. 18 . However.4 we display as well this quadratic projection. A projection of log wages on these two variables can be called a quadratic projection. and are discussed in Chapter 11. Figure 3. it misses the strong downturn in expected wages for those above 35 years work experience (equivalently.5.1 may be false. We illustrate the issue in Figure 3.We have shown that under mild regularity conditions. in many economic models the parameter β may be deﬁned within the model.3. and under-predicts for the rest. In this case (3. The solid line is the conditional mean. In the example just presented.5 for a 3 In the population of Caucasian non-military male wage earners with 12 years of education. The linear equation (3. No additional assumptions are required.5.4 displays the relationship3 between mean log hourly wages and labor market experience. In this example the linear projection is a close approximation to the conditional mean. since the resulting function is quadratic in experience. it is important to not misinterpret the generality of this statement. In Figure 1.10). In contrast. there are no changes in our methods or analysis. This defect in linear projection can be partially corrected through a careful selection of regressors. Returning to the joint distribution displayed in Figure 3. Other than the redeﬁnition of the regressor vector. It over-predicts wages for young and old workers. we can augment the regressor vector xi to include both experience and experience2 .

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

taking values only on the non-negative integers. E(Y 2 | X = x) and V ar(Y | X = x). i 7. e−λ λj j! . xi ∈ R. If yi = xi β + ei . Compute 2 the coeﬃcients of the linear projection yi = β 0 + β 1 xi + ei . µ. If yi = xi β + ei . and have the following joint probability distribution X=0 X=1 Y =0 . σ = . Are they diﬀerent? Hint: If P (Y = j) = 5. 2. and the conditional distribution of yi given xi is Poisson: P (yi = k | xi = x) = e−x β (x0 β)j . Compute E(yi | xi = x) and V ar(yi | xi = x). . and E(xi ei ) = 0. σ 2 = V ar(yi ) and σ xy = Cov(xi .1. i 10.1 .2. i 8. ¡ ¢ 4. Let xi and yi have the joint density f (x. m. If yi = x0 β + ei and E(ei | xi ) = 0. Suppose that yi is discrete-valued. y) = 3 x2 + y 2 on 0 ≤ x ≤ 1.6 Exercises 1. µx = Exi . 0 ≤ y ≤ 1. 20 . True or False. a constant. True or False.4 . (x − µ)2 − σ 2 Show that Eg (X. then E(ei | xi ) = 0. Deﬁne µ ¶ ¢ ¡ x−µ 2 g x. If yi = x0 β + ei . σ 2 = V ar(xi ).2 Y =1 . i 11. Let X be a random variable with µ = EX and σ 2 = V ar(X). True or False.3 Find E(Y | X = x).. 3. Show that x y β 1 = σ xy /σ 2 and β 0 = µy − β 1 µx . j! 0 j = 0. E(ei | xi ) = 0. x 6. 3 and 4 of Theorem 3. 9. True or False. Compute the conditional mean m(x) = E (yi | xi = x) . then E(x2 ei ) = 0. s) = 0 if and only if m = µ and s = σ 2 . then ei is independent of xi . 1. then ei is i i independent of xi .3. Take the bivariate linear projection model yi = β 0 + β 1 xi + ei E (ei ) = 0 E (xi ei ) = 0 Deﬁne µy = Eyi . then E(x2 ei ) = 0. 2. True or False.. yi ). and E(e2 | xi ) = σ 2 . Suppose that Y and X only take the values 0 and 1. Prove parts 2. and E(ei | xi ) = 0. xi ∈ R. If yi = x0 β + ei and E(xi ei ) = 0. Does this justify a linear regression model of the form yi = x0 β + εi ? i then EY = λ and V ar(Y ) = λ.

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 .3) In Sections 4.7 and 4.2) can be written in the parametric 0 β)) = 0.3) writes the projection coeﬃcient β as an explicit function of population moments E (xi yi ) and E (xi x0 ) .8. we narrow the focus to the linear regression model. 4. i n i=1 n 21 .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. Observe that (4.4) i i=1 i=1 ˆ Another way to derive β is as follows. The function g(β) can be estimated by form g(β) = E (xi (yi − xi g (β) = ˆ ¢ 1X ¡ xi yi − x0 β . 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 .2) (4. (4.1 Estimation Equation (4. but for most of the chapter we retain the broader focus on the projection model. i It follows that the moment estimator of β replaces the population moments in (4.1) (4.

83 ¶−1 µ ¶ .71 = −2.2 Least Squares There is another classic motivation for the estimator (4. excluding military.4). ¶ 2.40 n i=1 1 n Thus ˆ β = n X i=1 xi x0 i = µ 1 14.7% increase in mean wages.95 42. i 22 . 40 0.3. This sample has 988 observations.5) = n n 1X 1X ˆ xi yi − xi x0 β i n n i=1 i=1 whose solution is (4. with 10-15 years of potential work experience. Deﬁne the sum-of-squared errors (SSE) function n X¡ ¢2 yi − x0 β Sn (β) = i i=1 = This is a quadratic function of β. 0.4). An interpretation of the estimated equation is that each year of education is associated with an 11.40 µ ¶µ ¶ 34. These are white male wage earners from the March 2004 Current Population Survey. 40 2.117 1 14. Then µ ¶ n 1X 2. Let yi be log wages and xi be an intercept and years of education.83 µ We often write the estimated equation using the format \ log(W agei ) = 1. 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 (4.14 205. n X i=1 2 yi − 2β 0 n X i=1 xi yi + β 0 n X i=1 xi x0 β.14 14.94 −2. 4. To illustrate.37 µ ¶ 1.95 xi yi = 42.30 + 0. consider the data used to generate Figure 3.170 37.ˆ This is a set of k equations which are linear in β. 30 = .117 Educationi .14 14.14 205.

which can cause confusion.4). the contour lines are ellipses. while the residual is a by-product of estimation. i ˆ ˆ Note that yi = yi + ei . Figure 4. Following convention we will call β the OLS estimator of β.1 displays an example sum—of-squared errors function Sn (β) for the case k = 2. To visualize the sum-of-squared errors function.The Ordinary Least Squares (OLS) estimator is the value of β which minimizes Sn (β). 23 . we deﬁne the predicted value ˆ yi = x0 β ˆ i and the residual ˆ ei = yi − yi ˆ ˆ = yi − x0 β. Figure 4.7) 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. The error is unobservable.2 displays the contour lines of the same function — horizontal slices at equally spaced heights. It is important to understand the distinction between the error ei and the residual ei . Figure 4. Since the function Sn (β) is a quadratic function of β.1: Sum-of-Squared Errors Function As a by-product of OLS estimation. Matrix calculus (see Appendix 2. These two ˆ variables are frequently mislabeled.

24 . Its method of moments estimator is the sample average 1X 2 ei . ˆ σ = ˆ n 2 i=1 n (4. 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.Figure 4.5) implies that 1X xi ei = 0. and hold true for all linear regression estimates. ˆ n−k 2 i=1 (4.6) An alternative estimator uses the formula n 1 X 2 s = ei . The error variance σ 2 = Ee2 is also a parameter of interest.7.7) A justiﬁcation for the latter choice will be provided in Section 4. It measures the variation in the i “unexplained” part of the regression. These are algebraic results. one implication is that n 1X ei = 0. ˆ n i=1 n Since xi contains a constant.2: Sum-of-Squared Error Function Contours Equation (4.

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

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

4.5

Projection Matrices

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

Deﬁne the matrices and

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

and

PP

=

= M − MP = M

1

A matrix A is idempotent if AA = A.

27

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

r X j=1

(4.9) (4.10)

ajj

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

and

4.6

Residual Regression

X = [X1 X2 ] ¶ .

Partition and β= µ

β1 β2

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

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

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

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

It follows that

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

2

(4.15)

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

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

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

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

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

.9). observe that ⎞ ⎛ ⎞ ⎛ . In this section we derive the small sample conditional mean and variance of the OLS estimator. Rather. obtain OLS estimates β 2 and residuals e. 4. Regress X2 on X1 . 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) . .18) E (e | X) = ⎜ E (ei | X) ⎟ = ⎜ E (ei | xi ) ⎟ = 0. ⎠ ⎝ ⎠ ⎝ . . .9).Theorem 4. and X2 is the vector of observed regressors. 30 . which you may have seen in an introductory econometrics course. By the independence of the observations and (3.7 Bias and Variance In this and the following section we consider the special case of the linear regression model (3. In some contexts. obtain residuals Y . Regress Y on X1 . is the demeaning formula for regression. ˆ which are “demeaned”. the OLS estimator of β 2 and the OLS residuals e may be equivalently computed by either the OLS regression (4. but in most cases there is little computational advantage to using the two-step algorithm. Regress Y on X2 . . obtain residuals X2 . Partition X = [X1 X2 ] where X1 = ι is a vector of ones. In this case. the FWL theorem can be used to speed computation. The FWL theorem says that β 2 is the OLS estimate from a regression of ˜ ˜ Y on X2 . the primary use is theoretical. A common application of the FWL theorem.8)(3. . . ˆ ˜ ˜ ˆ 3. ¡ ¢−1 0 ι.13). . .6. M1 = I − ι ι0 ι Observe that ¡ ¢−1 0 ˜ ι X2 X2 = M1 X2 = X2 − ι ι0 ι = X2 − X 2 and ˜ Y ¡ ¢−1 0 = M1 Y = Y − ι ι0 ι ιY = Y −Y. ⎟ ⎜ ⎟ ⎜ (4. . In the model (4.14) or via the ˆ following algorithm: ˜ 1. ! Thus the OLS estimator for the slope coeﬃcients is a regression with demeaned data.1 (Frisch-Waugh-Lovell). ˜ 2.

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 = 0.18). From (4. .. σ2 = ˆ ¢ 1 ¡ ¢ 1 0 1 1 1 ¡ e e = e0 M M e = e0 M e = tr e0 M e = tr M ee0 ˆˆ n n n n n 31 In the special case of the linear homoskedastic regression model. σ2 n ⎞ We now calculate the ﬁnite sample bias of the method ¡ moments estimator σ 2 for σ 2 .12). V ar β | X = X 0 X ⎟ ⎟ ⎟. .Using (4.. .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 . the properties of conditional expectations. for any random vector Z deﬁne the covariance materix V ar(Z) = E (Z − EZ) (Z − EZ)0 = EZZ 0 − (EZ) (EZ)0 . . ¡ X 0X ¢−1 ¡ ¢−1 X 0 DX X 0 X while the ij 0 th oﬀ-diagonal element of D is ¢ ¢ ¡ ¡ E e2 | X = E e2 | xi = σ 2 i i i E (ei ej | X) = E (ei | xi ) E (ej | xj ) = 0. and the trace operator observe that.19) ˆ and thus the OLS estimator β is unbiased for β. under the of ˆ ¢ 2 | x = σ 2 .8). . and (4. 1 n . σ 2 } = ⎜ . . . . ⎠ (4. Thus D is a diagonal matrix with i’th diagonal element σ 2 : i ⎛ 2 σ1 0 · · · ⎜ 0 σ2 · · · 2 ⎜ D = diag{σ 2 . X 0 DX = X 0 Xσ 2 . Then given (4. and ³ ´ ¡ ¢−1 2 ˆ σ . 0 0 ··· 0 0 . We have shown that which implies ³ ´ ˆ E β|X =β ³ ´ ˆ E β =β (4.. Next..20) . the properties additional assumption of conditional homoskedasticity E ei i of projection matrices. σ 2 = σ 2 and we have the simplii ﬁcations D = In σ 2 . ⎝ .

In the homoskedastic linear regression model. is a famous statement of the solution. This is the justiﬁcation for the common s ˆ preference of s2 over σ 2 in empirical practice. the estimator ˆ 2 deﬁned (4. ˜ so β is unbiased if (and only if) A0 X = Ik . Theorem 4. In this case. What is the best choice of A? The Gauss-Markov theorem.1 Gauss-Markov. says that the least-squares estimator is the best choice.Then ¢ ¡ E σ2 | X = ˆ ¢¤ 1 £ ¡ tr E M ee0 | X n ¡ ¢¤ 1 £ = tr M E ee0 | X n ¤ 1 £ tr M σ 2 = n n−k . 4. ³ ´ ˜ E β | X = A0 Xβ. The following result. Now consider the class of estimators of β which are linear functions of i the vector Y.8 Gauss-Markov Theorem In this section we restrict attention to the homoskedastic linear regression model.10). which is (3. The least-squares estimator is the special case obtained by setting A = X(X 0 X)−1 . 32 . which we now present. or in the projection model.9) plus E e2 | xi = σ 2 . ³ ´ ˜ V ar β | X = A0 V ar (e | X) A = A0 Aσ 2 . It is important to remember. ˜ β L = A0 Y = A (Xβ + e) = β + Ae. that this estimator is only unbiased in the special case of the homoskedastic linear regression model. As an alternative.8. = σ2 n the ﬁnal equality by (4. the best (minimumvariance) unbiased linear estimator is OLS. Thus since V ar (e | X) = In σ 2 under homoskedasticity.8)¢ ¡ (3. we can write The “best” linear estimator is obtained by ﬁnding the matrix A for which this variance is the smallest in the positive deﬁnite sense. however.7) is unbiased for σ 2 by this calculation. By a calculation similar to those of the previous section. and thus can be written as ˜ β = A0 Y where A is an n × k function of X. as it yields the smallest variance among all unbiased linear estimators. known as the Gauss-Markov theorem. It is not unbiased in the absence of homoskedasticity. Thus σ 2 is biased towards zero.

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

Since this is a regular parametric model the MLE is asymptotically eﬃcient (see Appendix A. He proves that generically the OLS estimator (4. and thus so is the OLS estimator. 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 . 1X xi x0 i n i=1 1X xi yi n i=1 n ˆ = β ols 4.22) 34 . and any continuous distribution can be arbitrarily well approximated by a multinomial distribution.1. He observes that the above argument holds for all multinomial distributions. ˆ r X j=1 πj ξ j ξ 0 ˆ j r n X1X ¡ ¢ = 1 (yi = τ j ) 1 xi = ξ j ξ j ξ 0 j n j=1 = 1 n 1 n i=1 n X X r i=1 j=1 n X i=1 ¡ ¢ 1 (yi = τ j ) 1 xi = ξ j xi x0 i = and r X j=1 xi x0 i πj ξ j τ j ˆ r n X1X ¡ ¢ = 1 (yi = τ j ) 1 xi = ξ j ξ j τ j n j=1 i=1 = r n ¡ ¢ 1 XX 1 (yi = τ j ) 1 xi = ξ j xi yi n = Thus ˆ β mle = Ã 1 n n i=1 j=1 n X i=1 xi yi !−1 Ã ! In other words. Let the regressors be partitioned as Suppose we are interested in the coeﬃcient on x1i alone in the regression of yi on the full set xi .10) for the class of models satisfying Assumption 3.5.4) is an asymptotically eﬃcient estimator for the parameter β deﬁned in (3. the maximum likelihood estimator is identical to the OLS estimator. (4.Substituting in the expressions for π j . Chamberlain (1987) extends this argument to the case of continuously-distributed data.9). if the data have a discrete distribution.10 Omitted Variables xi = µ x1i x2i ¶ .

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

We can also deﬁne the leave-one-out residual ˆ ˆ ei. If the i’th observation 36 . ˆ ˆ (4. We can see this most simply in a homoskedastic linear regression model with two regressors yi = x1i β 1 + x2i β 2 + 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. This equals ´−1 ³ 0 ˆ X(−i) Y(−i) (4. µ ¶−1 µ ¶ ³ ´ 2 σ2 1 ρ 1 −ρ ˆ|X = σ . the worse the precision of the individual coeﬃcient estimates. it is statistically diﬃcult to disentangle the impact of β 1 from that of β 2 .24) β (−i) = X(−i) X(−i) is the i’th diagonal element of the projection matrix X (X 0 X)−1 X 0 . that is. What is happening is that when the regressors are highly dependent. = 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. We derive expression (4. since as ρ approaches 1 the matrix becomes singular. As a consequence. the change in the coeﬃcient estimate by deletion of the i’th observation depends critically on the magnitude of hi .−i = (1 − hi )−1 hi ei . A convenient alternative expression is ¡ ¢−1 ˆ ˆ xi ei ˆ (4. A more relevant implication of near multicollinearity is that individual coeﬃcient estimates will be imprecise. The hi take values in [0.27) (4. ˆ i A simple comparison yields that ˆ ei − ei.12 Inﬂuential Observations where X(−i) and Y(−i) are the data matrices omitting the i’th row. Thus the more “collinear” are the estimate σ 2 1 − ρ2 regressors. In extreme cases it is possible that the reported calculations will be in error due to ﬂoating-point calculation diﬃculties.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. To investigate the possibility of inﬂuential observations.26) As we can see.−i = yi − x0 β (−i) = (1 − hi )−1 ei .25) below. 1] and sum to k. the precision of individual estimates are reduced. the OLS estimator based on the sample excluding the i’th observation. deﬁne the leave-one-out least-squares estimator of β. and 1 0 XX= n µ 1 ρ ρ 1 ¶ In this case The correlation ρ indexes collinearity.

This implies has a large value of hi .27).1) in Section 2. Investigations into the presence of inﬂuential observations can plot the values of (4. which is considerably more informative than plots of the uncorrected residuals ei .25). ˆ = β − (1 − hi )−1 X 0 X and thus ˆ β (−i) = 37 . ˆ We now derive equation (4.4 which states that ¡ ¢ (A + BCD)−1 = A−1 − A−1 BC C + CDA−1 BC CDA−1 . 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 .

4.13

Exercises

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

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

Pn

i=1 g

¡ ¢ Xi , µ, σ 2 .

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

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

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

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

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

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

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

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

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

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

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

39

(f) (g) (h)

Pn

Pn

ˆˆ i=1 yi ei ˆ2 i=1 ei R2

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

40

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

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

43 . ¡¯ ¯ P ¯X n ¯ > δ ≤ η. ¯ ¯ E ¯Z n ¯ ≤ E |Zi | ≤ 2ε. Deﬁne the random vectors Wi = Xi 1 (|Xi | ≤ C) − E (Xi 1 (|Xi | ≤ C)) By the triangle inequality. denoted Zn →d Z. We say that Zn converges in distribution to Z as n → ∞. Set ε = δη/3. V ) . ¯ ¯ ¯ ¯ ¯ ¯ ¢ E ¯X n ¯ ¡¯ ¯ E ¯W n ¯ + E ¯Z n ¯ 3ε ≤ ≤ = η. ≤ 2E |Xi | 1 (|Xi | > C) Zi = Xi 1 (|Xi | > C) − E (Xi 1 (|Xi | > C)) . Theorem 5. P ¯X n ¯ > δ ≤ η.3 Convergence in Distribution Let Zn be a random variable with distribution Fn (x) = P (Zn ≤ x) . ¯¢2 ¡ ¯ 2 ≤ EW n E ¯W n ¯ = EWi2 n 4C 2 ≤ n ≤ ε2 (5. P ¯X n ¯ > δ ≤ δ δ δ the equality by the deﬁnition of ε.6) and (5. Fn (x) → F (x) as n → ∞. if for all x at which F (x) is continuous.5) (where 1 (·) is the indicator function) which is possible since E |X| < ∞. Fix δ and η. 5.5). We have shown that for any δ > 0 and η > 0 then for all ¢ ¡¯ ¯ ¥ n ≥ 36C 2 /δ 2 η 2 . we can set E(X) = 0 (by recentering Xi on its expectation). Jensen’s inequality (5. and the bound |Wi | ≤ 2C. as needed. n i=1 0 where µ = EX and V = E (X − µ) (X − µ) . the fact that X n = W n + Z n .4). the fact that the Wi are iid and mean zero.1 Central Limit Theorem (CLT). We need to ¢show that for all δ > 0 and η > 0 there is some N < ∞ so that for all n ≥ N. then as n→∞ n ¢ √ ¡ 1 X n Xn − µ = √ (Xi − µ) →d N (0. (5.3. where Z has distribution F (x) = P (Z ≤ x) . ≤ E |Xi | 1 (|Xi | > C) + |E (Xi 1 (|Xi | > C))| (5.7).7) the ﬁnal inequality holding for n ≥ 4C 2 /ε2 = 36C 2 /δ 2 η 2 . Finally.1) and (5. Pick C < ∞ large enough so that E (|X| 1 (|X| > C)) ≤ ε (5. If Xi ∈ Rk is iid and E |Xi |2 < ∞. by Markov’s inequality (5.Proof: Without loss of generality. the triangle inequality.6) By Jensen’s inequality (5.1).

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

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

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

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 . Ã n ! n X 1X 0 1 ˆ xi xi . (6. Assumption 3.1).1 Under Assumption 3. n i=1 (6.1.From the ﬁgure we can see that the density functions are dispersed and highly non-normal.2.1 and the WLLN (Theorem 5. we will use the methods of asymptotic approximation. For a complete argument. First. b) = A−1 b is a continuous function of A and b at all values of the arguments such that A−1 exist. the OLS estimator β is has a statistical distribution which is unknown. Equation (4.1.5.4. Asymptotic (large sample) methods approximate sampling distributions based on the limiting experiment that the sample size n tends to inﬁnity.4.2.1).2).5.8) implies that ˆ β−β = Ã n X i=1 xi x0 i !−1 n X i=1 xi ei .1).3) Ã where g(A. ˆ 47 . To characterize the sampling distribution more fully.5. As the sample size increases the density becomes more concentrated about the population coeﬃcient. xi ei = g i n n i=1 i=1 1X xi ei →p E (xi ei ) = 0. (6. β →p β as n → ∞.2 Consistency ˆ As discussed in Section 6. we can conclude ˆ that β →p β. using (6.1) imply that n ¡ ¢ 1X xi x0 →p E xi x0 = Q (6. Proof. This is illustrated in Figure 6. A preliminary step in this approach is the demonstration that estimators are consistent — that they converge in probability to the true parameters as the sample size gets large. 0). ˆ Theorem 6. xi ei →p g (Q.1).1) and ˆ We now deduce the consistency of β. 6.1 by the fact that the sampling densities become more concentrated as n gets larger.2) i i n i=1 n From (6. ¥ We can similarly show that the estimators σ 2 and s2 are consistent for σ 2 . (6.4 implies that Q−1 exists and thus g(·. Hence by the continuous mapping theorem (Theorem 5. ·) is continuous at (Q. Assumption 3. 0) = Q−1 0 = 0 β−β =g n n i=1 i=1 ˆ which implies β →p β as stated.1. and the continuous mapping theorem (Theorem 5.3).

1 guarantees that the elements of Ω are ﬁnite. ˆ n−k 6.6) n i=1 48 . n 1 X √ xi ei →d N (0.2). Assumption 6. (6. it follows that s2 = ¥ n σ 2 →p σ 2 .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. (6.2. By the central limit theorem (Theorem 5.3. Thus σ 2 is consistent for σ 2 . ˆ Proof.2). 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 . Ω) .1). ˆ Finally. by the Cauchy-Schwarz inequality (5. σ 2 →p σ 2 and s2 →p σ 2 as n → ∞.1. We need a strengthening of the moment conditions.3 Asymptotic Normality ˆ We now establish the asymptotic distribution of β after normalization. i Now deﬁne ¡ ¢ Ω = E xi x0 e2 . (6. (6.5) Thus xi ei is iid with mean zero and has covariance matrix Ω.1). i i Assumption 6. since n/(n − k) → 1 as n → ∞. To see this.3. Ee4 < ∞ and E |xi |4 < ∞.2 Under Assumption 3.3) and Theorem (6. E ¯ei ¯ E ¯e4 ¯ i i i i (6.5.Theorem 6.1 In addition to Assumption 3.5.3. ´1/2 ¡ ¯ ¯¢ ¯ ³ ¯ ¯2 ´1/2 ¡ ¯ 4 ¯¢1/2 ³ ¯ 1/2 E ¯xi x0 e2 ¯ ≤ E ¯xi x0 ¯ = E |xi |4 < ∞.2.1.

its variance diverges q ³ ´ ˆ to inﬁnity. ´ √ ³ˆ As V is the variance of the asymptotic distribution of n β − β .7) holds. When (6. but this is not a necessary condition. 1) asymptotic distibution. otherwise V 6= V 0 .9) we deﬁne V 0 = Q−1 σ 2 whether (6. We say that ei is a Homoskedastic Projection Error when (6. |ε| ≥ 1.1 is commonly used to approximate the ﬁnite of √ ³ˆ sample distribution of n β − β . and εi is independent of xi with the Double Pareto density f (ε) = α |ε|−α−1 .1 states that the sampling distribution of the least-squares estimator.3.7) Cov(xi x0 . for any ˆ ﬁxed n the sampling distribution of β can be arbitrarily far from the normal distribution.2 we display the ﬁnite sample densities of the q ³ ˆ normalized estimator n α−2 β 2 − β 2 . In Figure 6. there is no simple answer to this reasonable question. The trouble is that no matter how large is the sample size. V is often referred to as ˆ the asymptotic covariance matrix of β. 1 X √ xi ei n i=1 n ! the N (0. Let yi = β 0 + β 1 xi + εi where xi is N (0. the normal approximation is arbitrarily poor for some data distribution satisfying the assumptions.7) is true then V = V 0 . As α approaches 2.6). however.1).1.3. setting n = 100 and varying the parameter α.3.1. for example. Q−1 ΩQ−1 . (6. is approximately normal when the sample size n is suﬃciently large. 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. For α 49 . and (6. as n → ∞ ´ √ ³ ˆ n β − β →d N (0. This holds true for all joint distibutions of (yi .7) the asymptotic variance formulas simplify as ¡ ¢ ¡ ¢ (6.Then using (6. We illustrate this problem using a simulation.1 we have already seen a simple example where the least-squares estimate is quite asymmetric and non-normal even for reasonably large sample sizes. In this context the normalized least-squares slope estimator n α−2 β 2 − β 2 has α →d Q−1 N (0. xi ) which satisfy the conditions of Assumption 6.2). The asymptotic distribution ´ Theorem 6. when xi and ei are independent. Theorem 6. The approximation may be poor when n is small.7) is true or false. 1). Ω) ¡ ¢ = N 0. ´ √ ³ ˆ n β−β = Ã 1X xi x0 i n i=1 n !−1 Ã Theorem 6.9) In (6. However. We call V 0 the homoskedastic covariance matrix. i i Condition (6. In´Figure 6.3. e2 ) = 0. V ) where V = Q−1 ΩQ−1 . The expression V = Q−1 ΩQ−1 is called a sandwich form. If α > 2 the 2 error εi has zero mean and variance α/(α − 2).3. How large should n be in order for the approximation to be useful? Unfortunately.1 Under Assumption 6. Under (6. after rescaling.

11) 50 . The MME estimator is i i 1X ˆ xi x0 e2 Ω= i ˆi n i=1 n (6. The lesson from Figures 6.2) and Theorem 6. 1). 6 and 8.10) V 0 = Q−1 s2 .3. As α diminishes the density changes signiﬁcantly. We show the sampling distribution of n β 1 − β 1 setting n = 100.Figure 6. The estimator 2 2 in (6. Another example is shown in Figure 6.2. 4.2: Density of Normalized OLS estimator α = 3. 6. 1) density.0 the density is very close to the N (0. σ may also be substituted for s ˆ ¡ ¢ To estimate V = Q−1 ΩQ−1 . ˆ ˆ Since Q →p Q and s2 →p σ 2 (see (6. As k increases. for k = 1.2 and 6. we need an estimate of Ω = E xi x0 e2 .4 Let Covariance Matrix Estimation 1X ˆ xi x0 Q= i n i=1 n be the method of moments estimator for Q. 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 (0.10) without changing this result. The homoskedastic covariance matrix V 0 = Q−1 σ 2 is typically estimated by ˆ ˆ (6.3 is that the N (0. 1) asymptotic approximation is never guaranteed to be accurate. concentrating most of the probability mass around zero.1) it is clear that V 0 →p V 0 . the sampling distribution becomes highly skewed and non-normal.

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

2/988 = . We calculate that s2 = 0.480 ˆ0 = 0.14 205.83 −0.80 . First. just as any other estimator.20 −0.98 −0.039 and ˆ V = µ 1 14. the standard method to calculate the standard errors is to ˆ ﬁrst calculate n−1 V . It is also important to understand that a particular standard error may be relevant under one set of model assumptions.12) in turn. (6.1. from which it follows that V →p V as n → ∞.14 14.20 = V 14. We can write the estimated equation with standards errors using the format \ log(W agei ) = 1. From a computational standpoint.117 Educationi . Ω 2.085) (.5) and the WLLN (Theorem 5.14 6.3) so by the WLLN ³ ´ ³ ´3/4 ¡ ¯ ¯¢ 1/4 E |xi |3 |ei | ≤ E |xi |4 < ∞.83 ¶−1 = µ 7.80 40.12) i i n n n i=1 i=1 We now examine each sum on the right-hand-side of (6. To illustrate. p ˆ In this case the two estimates are quite similar.5 Consistency of the White Covariance Matrix Estimate 1X xi x0 e2 i ˆi n i=1 i=1 n ˆ ˆ We now show Ω →p Ω. (6.493 −0.14 205.30 + 0.1) show that n ¡ ¢ 1X xi x0 e2 →p E xi x0 e2 = Ω.used by an author when studying their work.14 205. (.020) 6.6 Therefore the two covariance matrix estimates are µ ¶−1 µ ¶ 1 14. E ¯e4 ¯ i ³ ´ 1X |xi |3 |ei | →p E |xi |3 |ei | .6 ¶µ 1 14.80 40.493 0.20 and µ ¶ ˆ = 0.35/988 = .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 .199 2. we return to the log wage regression of Section 4.480 . then take the diagonal elements.020. by Holder’s inequality (5. i i i i n i=1 Second.035 ¶ .199 2. The standard errors for β 0 are 7.80 2. and then the square roots.14 14. but not under another set of assumptions. n n i=1 52 .83 ¶−1 µ . Using (6.2.085 p ˆ and that for β 1 is .

13) of Efron (1982). Andrews’ proposed estimator is ˆ ˆ ˆ ˆ V ∗∗ = Q−1 Ω∗∗ Q−1 53 . From equation (3.1 As n → ∞. ¯ ¯ ¯ ¯ ¯n ¯ n i=1 i=1 1X |xi |4 →p E |xi |4 . by the WLLN ¯ n ¯ Ã n ! ¯ 1X ¯1 X ¯ ¯ ³ ´0 ¯ ¯ ¯ ¯ˆ 3 0 ˆ xi xi β − β xi ei ¯ ≤ ¯β − β ¯ |xi | |ei | →p 0. ¯ n ¯ n ¯2 X ¯1 X ³ ´0 ³ ´¯ ¯ ¯ 0 ˆ ˆ ˆ − β ¯ ≤ ¯β − β ¯ 1 xi xi β − β xi xi β |xi |4 →p 0. Ω →p Ω and V →p V. Recall from Section 4.14) 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 . 6. i=1 Third. which. 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. Using this substitution.−i = (1 − hi )−1 ei ˆ presented in (4.5. ¯ ¯n ¯ n i=1 so Together. Andrews (1991) suggested an similar estimator based on cross-validation.¯ ¯ ¯ ¯ˆ and thus since ¯β − β ¯ →p 0.26).6 Alternative Covariance Matrix Estimators ˆ MacKinnon and White (1985) suggested a small-sample corrected version of V based on the jackˆ knife principle. these establish consistency. n i=1 n ˆ ˆ Theorem 6.11) with the leave-one-out estimator ei. They also suggest that the scaling factor (n − 1)/n in (??) can be omitted.13) Using formula (4.12 the deﬁnition of β (−i) as the least-squares estimator with the i’th observation deleted. 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 .25). you can show that 1 Xˆ ¯ β= β (−i) . is deﬁned ˆ ˆ by replacing the OLS residual ei in (6.

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

Vθ ) √ Vθ = N (0. In general. if R is a “selector matrix” R= so that if β = (β 1 . s(ˆ = n−1/2 H 0 V Hβ . however. and θ = h(β) is some function of the parameter vector. θ could be a single element of β). (For example. µ I 0 ¶ ˆ the upper-left block of V . 1) →d ˆ−θ θ . s(ˆ θ) (6. 1) Proof.15) tn (θ) = ˆ−θ θ s(ˆ θ) ´ √ ³ˆ n θ−θ q = ˆ Vθ N (0. the standard error for ˆ is the square root of n−1 Vθ . 55 . In this case. θ) β 6.8 t tests Let θ = h(β) : Rk → R be any parameter of interest. A simple null and composite hypothesis takes the form H0 : θ = θ0 H1 : θ 6= θ0 where θ0 is some pre-speciﬁed value.1 tn (θ) →d N (0. pivotal statistics are unavailable and so we must rely on asymptotically pivotal statistics. In special cases (such as the normal regression model. Consider the studentized statistic tn (θ) = Theorem 6.16) ¥ Thus the asymptotic distribution of the t-ratio tn (θ) is the standard normal.For example. that (so θ ˆ ˆ ˆ is. By (6. β 2 ). we say that tn (θ) is asymptotically pivotal. the statistic tn has an exact t distribution. Since the standard normal distribution does not depend on the parameters. we say that tn is an exactly pivotal statistic. ˆ its estimate and s(ˆ its asymptotic θ θ) standard error. see Section X). ˆ When q = 1q h(β) is real-valued).8. then θ = R0 β = β 1 and ˆ Vθ = ¡ I 0 ¢ ˆ V µ I 0 ¶ ˆ = V11 . and is therefore exactly free of unknowns.

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

This corresponds to selecting the conﬁdence h i h ˆ ± 1. In this case the t-statistic approach does not work. A good method for construction of a conﬁdence interval is the collection of parameter values which are not rejected by a statistical test.18) . We say that Cn has asymptotic (1 − α)% coverage for θ if P (θ ∈ Cn ) → 1 − α as n → ∞. The t-test of the previous setion rejects H0 : θ0 = θ if |tn (θ)| > zα/2 where tn (θ) is the t-statistic (6. ¢ ¡ ¢ ¡ P (θ ∈ Cn ) = P |tn (θ)| ≤ zα/2 → P |Z| ≤ zα/2 = 1 − α. the most common professional choice isi95%. and it is desired to test the joint restrictions simultaneously. Thus values of θ within two standard errors of the estimated interval θ θ) θ θ) ˆ are considered “reasonable” candidates for the true value θ.05. While there is no hard-and-fast guideline for choosing the coverage probability 1 − α. and values of θ outside two standard θ errors of the estimated ˆ are considered unlikely or unreasonable candidates for the true value. θ θ) (6. ˆ + zα/2 s(ˆ . ˆ The natural estimate of θ is ˆ = h(β) and has asymptotic covariance matrix estimate θ ˆ0 ˆ ˆ ˆ Vθ = Hβ V Hβ where ∂ ˆ ˆ h(β).16) and zα/2 is the upper α/2 quantile of the standard normal distribution.17) = ˆ − zα/2 s(ˆ θ and Cn is an asymptotic (1 − α)% conﬁdence interval.96s(ˆ ≈ ˆ ± 2s(ˆ .We typically cannot calculate the exact coverage probability P (θ ∈ Cn ). 6.10 Wald Tests Sometimes θ = h(β) is a q × 1 vector. We have the null and alternative H0 : θ = θ0 H1 : θ 6= θ0 . 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 . 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). However we often can calculate the asymptotic coverage probability limn→∞ P (θ ∈ Cn ). θ The interval has been constructed so that as n → ∞. = n h(β) − θ0 Hβ V Hβ 57 (6. or α = .

Hβ (β) →p Hβ . so by the continuous mapping ˆ ˆ ˆ ˆ ˆ theorem. 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. 1] under H0 . and Theorem 6. where p(x) = P χ2 ≥ x is the tail q q probability function of the χ2 distribution. 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. Vθ ). Wn = n R0 β − θ0 ´ √ ³ The delta method (6. then the Wald statistic takes the form ´0 ³ ´ ³ ´−1 ³ ˆ ˆ ˆ R0 V R R0 β − θ 0 . if rank(Hβ ) = q. ˜ 58 ¡ 0 ¢−1 0 ˜ β 1 = X1 X1 X1 Y .05) = 3.5.15) showed that n ˆ − θ →d Z ∼ N (0. ˜˜ n ˜ e = Y − X1 β 1 . then the Wald statistic can be written in the form ¶ µ 2 ˆ σ − σ2 ˜ Wn = n (6. θ = β 2 . the test rejects at the α% level iﬀ pn < α.10.1. The Wald test fails to reject if Wn is q 1 ¡ ¢ less than χ2 (α). ˆ Wn = n θ θ q θ θ Theorem 6. Thus Vθ = H 0 V Hβ →p H 0 V Hβ = Vθ > 0 if Hβ has full rank q. = nβ 2 R0 V R R0 β is linear with R = µ 0 I ¶ ¢−1 ¡ ˆ ˆ ˆ .1 showed θ ˆ that V →p V.025 . h(β) = R0 β. a chiq square random variable with q degrees of freedom. Also h(β) = a selector matrix. 6. An asymptotic Wald test rejects H0 in favor of H1 if Wn exceeds χ2 (α). In this case.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 .3. then Wn →d χ2 . For example. The null hypothesis is H0 : β 2 = 0.19) σ2 ˆ where σ2 = ˜ 1 0 e e. q and pn is asymptotically U[0. χ2 (. Furthermore. Hence β β by Theorem A. The asymptotic p-value for Wn is pn = p(Wn ). and there are q = k2 restrictions. As before.8.When h is a linear function of β.1 Under H0 and Assumption 6. We have established: ³ ´0 ³ ´ ˆ − θ0 V −1 ˆ − θ0 →d Z 0 V −1 Z = χ2 .84 = z. Hβ (β) is a continuous function of β. the upper-α quantile q 2 of the χ2 distribution.2.

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

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

1 and Theorem 6. σ 2 ).1 we showed that in large samples. if standard errors are calculated using the homoskedastic formula (6. σ ˆ ˆ βj − βj βj − βj N (0.8. The Gaussian log-likelihood at these estimates is ¡ ¢ n 1 ˆ ˆ ˆ σ Ln (β 1 .a chi-square distribution with n − k degrees of freedom. σ 2 ) − Ln (β 1 . β 2 . We summarize these ﬁndings Theorem 6. which is twice the diﬀerence in the log-likelihood function evaluated under the null and alternative hypotheses. 0.) Now let us partition β = (β 1 . β 2 ) and consider tests of the linear restriction H0 : β 2 = 0 H1 : β 2 6= 0 In the context of parametric models. 2 2 2 The LR statistic for H0 is ´ ³ ˆ ˆ ˆ ˜ ˜ LR = 2 Ln (β 1 . β 2 . a good testing procedure is based on the likelihood ratio statistic. σ2 ˆ 61 . and standard errors are calculated using the homoskedastic formula (6.3. In contrast. the notable distinction is between the N (0.10) µ h i ¶ 2 (X 0 X)−1 N 0. Theorem 6.12. σ 2 ) = − log σ − log (2π) − . σ 2 ) discussed above. The estimator under the alternative is the unrestricted estimator ˆ ˆ ˆ (β 1 .1 shows that under the strong assumption of ˆ normality. n−k • ∼ tn−k ˆ In Theorem 6. (Unless the sample size is unreasonably small. The critical values are quite close if n − k ≥ 30. σ 2 ) ¡ ¢¢ ¡ ¡ ¢ ˆ = n log σ 2 − log σ 2 ˜ µ 2¶ σ ˜ = n log . so as a practical matter it does not matter which distribution is used. β 2 . 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.12. The log-likelihood of this model is ¡ 2¢ n n n ˜ ˜ ˜ Ln (β 1 . ˆ 2 2 2 ˜ ˜ The MLE of the model under the null hypothesis is (β 1 .10) then ´ ³ ˆ • β ∼ N 0. β has an exact normal distribution and t has an exact t distribution. with residual variance σ . β and t are approximately normally distributed. σ 2 ) = − log 2πˆ 2 − 2 e0 e ˆˆ 2 2ˆ σ ¡ ¢ n n n = − log σ 2 − log (2π) − . 0. 1) and tn−k distributions.1 If ei is independent of xi and distributed N(0. As inference (conﬁdence intervals) are based on the t-ratio. σ 2 (X 0 X)−1 • (n−k)s2 σ2 ˆ β j −β j ˆ s(β ) j ∼ χ2 . Furthermore. σ 2 ) where β 1 is the OLS estimate from ˜ 2 ˜ a regression of yi on x1i only. 0.

features of this distribution can be calculated. 62 . as Wn (s) →d χ2 under H0 for 1 any s. while there are other values of s for which test test statistic is insigniﬁcant. This is an unfortunate feature of the Wald statistic. Then the standard Wald test for H0 is ˆ ³ ´2 ˆ β−1 Wn = n . they can work quite poorly when the restrictions are nonlinear. This produces random draws from the sampling distribution of interest. This is distressing since the choice of s seems arbitrary and irrelevant to the actual hypothesis.8.84 — the probability of a false rejection. one feature of importance is the Type I error of the test using the asymptotic 5% critical value 3.7. 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. and noting Hβ = sβ s−1 . σ 2 s2 β ˆ ˆ While the hypothesis β s = 1 is unaﬀected by the choice of s. Letting h(β) = β s . To demonstrate this eﬀect. 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. setting n/σ 2 = 10. we have plotted in Figure 6. The method uses random simulation to create an artiﬁcial dataset to apply the statistical tools of interest. σ 2 ) and consider the hypothesis H0 : β = 1. the statistic Wn (s) varies with s. This can be seen by a simple example introduced by Lafontaine and White (1986). σ2 ˆ Now notice that H0 is equivalent to the hypothesis H0 (s) : β s = 1 for any positive integer s. we ﬁnd that the standard Wald test for H0 (s) is ´2 ³ s ˆ β −1 Wn (s) = n 2s−2 .By a ﬁrst-order Taylor series approximation ¶ µ 2 ¶ µ σ ˜ σ2 ˜ − 1 = Wn . The increasing solid line is for the case β = 0. LR = n log 1 + 2 − 1 ' n σ ˆ σ2 ˆ the F statistic. Through repetition. ˆ Let β and σ 2 be the sample mean and variance of yi . In the present context of the Wald statistic. Our ﬁrst-order asymptotic theory is not useful to help pick s. The decreasing dashed ˆ = 1. 6.13 Problems with Tests of NonLinear Hypotheses While the t and Wald tests work well when the hypothesis is a linear restriction on β. Take the model yi = β + ei ei ∼ N (0.4 the Wald statistic Wn (s) as a function ˆ of s.

In each case.05) with deviations indicating+ distortion. Test performance deteriorates as s increases. n is varied among 20. we compare the rates row by row.4. To interpret the table. and rarely fall outside of the 3%-8% range.1 you can also see the impact of variation in sample size. Typically.000 random samples. When comparing statistical procedures.Figure 6. Any other choice of s leads to a test with unacceptable Type I error probabilities. Type I error rates between 3% and 8% are considered reasonable. Given the simplicity of the model. no magic choice of n for which all tests perform uniformly well.4: Wald Statistic as a function of s P (Wn (s) > 3. The null hypothesis β s = 1 is true. There is. Table 4. In Table 4. remember that the ideal Type I error probability is 5% (.84. The value of s is varied from 1 to 10. For this particular example. the only test which meets this criterion is the conventional Wn = Wn (1) test. Table 4. and σ 2 . Rates above 20% are unexceptable. which is not surprising given the dependence of Wn (s) on s as shown in Figure 6. n. looking for tests for which rate rejection rates are close to 5%.1 we report the results of a Monte Carlo simulation where we vary these three parameters. The second through seventh columns contain the Type I error probabilities for diﬀerent combinations of n and σ. and σ is varied among 1 and 3.1 reports the simulation estimate of the Type I error probability from 50. however. 100 and 500. the Type I error probability improves towards 5% as the sample size n increases. Error rates avove 10% are considered excessive. this probability depends only on s.000 simulated Wald statistics Wn (s) which are larger than 3.1 Type I error Probability of Asymptotic 5% Wn (s) Test 63 .84 | β = 1) . In Table 2. Each row of the table corresponds to a diﬀerent value of s — and thus corresponds to a particular choice of test statistic. so these probabilities are Type I error. These probabilities are calculated as the percentage of the 50.

33 . In this case a t-statistic for H0 is t1n = ³ˆ β1 ˆ β2 where r is a known constant. While this is clear in this particular example.30 .10 .05 .05 .15 .25 . ˆ ˆ ˆ ˆ ˆ Let β = (β 0 . β 1 .20 . in other examples natural choices are not always obvious and the best choices may in fact appear counter-intuitive at ﬁrst.19 .07 .28 . let V be an estimate of the ˆ asymptotic variance matrix for β and set ˆ = β 1 /β 2 .17 .06 .10 .08 . An alternative statistic can be constructed through reformulating the null hypothesis as H0 : β 1 − rβ 2 = 0.21 .05 .08 .05 .06 . β 2 ) be the least-squares estimates of (6.05 .07 .06 .08 .23 .14 . Deﬁne θ ˆ ˆ ⎞ ⎛ 0 ⎟ ⎜ ⎟ ⎜ ⎜ 1 ⎟ ⎟ ⎜ ⎜ ˆ ⎟ ˆ H1 = ⎜ β 2 ⎟ ⎟ ⎜ ⎟ ⎜ ⎜ β ⎟ ˆ ⎠ ⎝ − 1 ˆ2 β2 ´ s(ˆ θ) −r .05 . Other choices are arbitrary and would not be used in practice. so the hypothesis can be stated as H0 : θ = r.34 .25 .20 .06 .15 .13 .12 .07 .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) .26 .18 .000 simulated random samples In this example it is not surprising that the choice s = 1 yields the best test statistic.15 .24 . This point can be illustrated through another example.15 .06 .14 .08 . Take the model yi = β 0 + x1i β 1 + x2i β 2 + ei E (xi ei ) = 0 and the hypothesis H0 : β1 =r β2 (6.22 .31 .20).s 1 2 3 4 5 6 7 8 9 10 Note: σ=1 σ=3 n = 20 n = 100 n = 500 n = 20 n = 100 n = 500 . deﬁne θ = β 1 /β 2 .22 .16 Rejection frequencies from 50.06 . Equivalently.13 .11 .35 .07 .09 .12 .06 .13 . 64 .10 .08 .06 .

especially for small values of β 2 . The implication of Table 4.06 . .15 . ei be an independent N (0. The results are presented in Table 4. If no linear formulation is feasible.06 .645) P (tn < −1. Table 4. The left tail probabilities P (t1n < −1. 6. and normalize β 0 = 0 and β 1 = 1. such as the GMM distance statistic which will be presented in Section 9. and are close to the ideal 5% rate for both sample sizes.50 . and 1.10 .00 . It is also prudent to consider alternative tests to the Wald statistic. 1) variables.12 .00 .00 .09 .645) greatly exceed 5%. the rejection rates for the linear t2n statistic are invariant to the value of β 2 . Ideally.645) and P (tn > 1. We vary β 2 among . However.00 .25.06 .06 . the rejection rates for the t1n statistic diverge greatly from this value.000 simulated samples. along with sample size n. 65 .06 .7.00 The one-sided Type I error probabilities P (tn < −1.02 .06 . this formulation should be used.25 .10 .10 .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.15 .28 . the entries in the table should be 0.2 Type I error Probability of Asymptotic 5% t-tests n = 100 n = 500 P (tn < −1.05 β2 .06 . The common message from both examples is that Wald statistics are sensitive to the algebraic formulation of the null hypothesis.05 .06 .645) P (tn > 1. then the “most linear” formulation should be selected.50.05. In all cases. −1 H V H ˆ 2 n 2 ⎞ 0 H2 = ⎝ 1 ⎠ .75 1.05 . . In this section we describe the method in more detail.05 . .00 .2 is that the two t-ratios have dramatically diﬀerent sampling behavior.06 .645) are calculated from 50. We let x1i and x2i be mutually independent N (0.645) are close to zero in most cases.05 . σ 2 ) draw with σ = 3.07 . In contrast.00 .05 . and alternatives to asymptotic critical values should be considered.26 .05 . if the hypothesis can be expressed as a linear restriction on the model parameters.645) P (tn > 1.75.05 .00 .0 and n among 100 and 500.47 . This leaves β 2 as a free parameter. −r ⎛ t2n where To compare t1n and t2n we perform another simple Monte Carlo simulation.00 .2.06 .A t-statistic based on this formulation of the hypothesis is ´2 ³ ˆ 1 − rβ 2 ˆ β =³ ´1/2 .645) t1n t2n t1n t2n t1n t2n t1n t2n .00 . while the right tail probabilities P (t1n > 1.1.05 .

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

As P is unknown.95) /B ' . We us the sample of wage earners from the March 2004 Current Population Survey. The α% sample quantile is a number qα such that α% of the sample are less than qα . are. then the 5% sample quantile is 50’th sorted value and the 95% sample quantile is the 950’th sorted value. then we can set s P = (. It is therefore useful to conduct a variety of experiments. female.05) (. Suppose we are interested in the 5% and 95% quantile of Tn = ˆ We then compute the 10% θ. Then qα is the N ’th number in this ordered sequence. and hispanic.96) . excluding military.96) is iid Bernoulli. experience squared. if we set B = 999. B b=1 (6.21) the percentage of the simulated t-ratios which exceed the asymptotic 5% critical value. Generally. where N = (B +1)α. 1000.Suppose we are interested in the ¯Type I error associated with an asymptotic 5% two-sided ¯ ¯ ¯ θ) θ t-test.15 Estimating a Wage Equation We again return to our wage equation. For the dependent variable we use the natural log of wages. The average (6. s P = . this may ˆ be approximated by replacing P with P or with an hypothesized value. we included a dummy 67 . an estimator or test may perform wonderfully for some values. Since the results of a Monte Carlo experiment are estimates computed from a random sample of size B. and poorly for others. the choice of B is often guided by the computational demands of the statistical procedure. union member. In particular. equalling 1 with probability P = E1 (Tnb ≥ 1. potential work experience. It is therefore convenient to pick B so that N is an integer.22/ B. Again our dependent variable is the natural log of wages. If the standard error is too large to make a reliable inference. it is simple to make inferences about rejection probabilities from statistical tests. the researcher must select the number of experiments. We separately estimate equations for white and non-whites. for a selection of choices of n and F. Furthermore.96) . We would then set Tn = ¯ˆ − θ¯ /s(ˆ and calculate B X ˆ= 1 P 1 (Tnb ≥ 1.21). immigrant. Often this is called the number of replications. The random variable 1 (Tnb ≥ 1. In practice.007. For example. For example. respectively. union member. so that coeﬃcients may be interpreted as semi-elasticities. but requires more computational time. immigrant. 6. hispanic. and our regressors include years of education. The typical purpose of a Monte Carlo simulation is to investigate the performance of a statistical procedure (estimator or test) in realistic settings.21) is therefore an ³ ´ p ˆ unbiased estimator of P with standard error s P = P (1 − P ) /B. and therefore it is straightforward to calculate standard errors for any quantity of interest. such as the percentage estimate reported in (6. and estimate a multivariate regression. We now expand the sample all non-military wage earners. female. B. and dummy variable indicators for the following: married. the performance will depend on n and F. and dummy variable indicators for the following: married. and . Hence the ³ ´ ˆ standard errors for B = 100. In many cases. if we are ³ ´ p √ ˆ assessing an asymptotic 5% test. As discussed above. experience squared. Quite simply. For regressors we include years of education. a larger B results in more precise estimates of the features of interest of Gn . and non-white. therefore. then B will have to be increased.022. potential work experience. and 5000.003. . A simple way to compute sample quantiles is to sort the sample {Tnb } from low to high. and 90% sample quantiles of the sample {Tnb }.

excluding the coeﬃcients on the state dummy variables.102 −.001 . Table 4.49452 σ ˜ Notice that the two statistics are close. but not equal.008 . if β 2 > 0 and β 3 < 0 the solution is θ=− From Table 4.010 . 808 1 − .19) is ˜ µ ¶ µ ¶ σ2 ˆ .variable for state of residence (including the District of Columbia.121 −.102 −.18) that the state coeﬃcients are jointly zero. reestimating the model with the 50 state dummies excluded.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. we ﬁnd Wn = 550.69. The available sample is 18. 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.34 ˆ s(β) .808 . 50 Another interesting question which can be addressed from these estimates is the maximal impact of experience on mean wages.1 OLS Estimates of Linear Equation for Log(Wage) ˆ β 1.00002 .808 so the parameter estimates are quite precise and reported in Table 4. Wn = n 1 − 2 = 18.00057 .014 .007 . this adds 50 regressors).4877 18. Computing the Wald statistic (6.070 .232 . The F form of the Wald statistic (6.027 .033 −.1 we ﬁnd the point estimate ˆ ˆ = − β 2 = 28. 2β 3 68 . θ ˆ 2β 3 β2 .4945. as the 1% critical value for the χ2 distribution is 76.101 .1. Alternatively.013 .097 −. the restricted standard deviation estimate is σ = .002 .48772 = 515.032 . Ignoring the other coeﬃcients. Using either statistic the hypothesis is easily rejected.

not testing a hypothesis.0. Notice that the upper end of the conﬁdence interval is the same as that from the delta method. In the previous section we discovered that such t-tests had very poor Type I error rates. but it can be found numerically quite easily.40.96.9. Our desired conﬁdence interval will be the set of parameter values θ which are not rejected by the hypothesis test. Instead.Using the Delta Method. In the present context we are interested in forming a conﬁdence interval. 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 ). Since tn (θ) is a non-linear function of θ. as the coverage probability of this conﬁdence interval is one minus the Type I error of the hypothesis test based on the t-test. 29. but the lower end is substantially lower. implying a 95% conﬁdence θ) interval of [27. we found better Type I error rates by reformulating the hypothesis as a linear restriction. However. this is a poor choice. This set is [27.5]. This is the set of θ such that |tn (θ)| ≤ 1.5]. we can calculate a standard error of s(ˆ = . there is not a simple expression for this set. so we have to go one step further. 69 . 29.

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

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

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

2

is the homoskedasticity-formula standard error.

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

i=1 i=1

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

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

E (xi ei ) = 0

∗ yi = yi + ui

71

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

∗ E (yi ui ) = 0

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

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

• Qi • Di • Ci

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

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

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

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

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

73

σ 2 } and σ 2 = σ 2 (x ) = E e2 | x . The GLS estimator (7. A ˆ ˆn feasible GLS (FGLS) estimator replaces the unknown D with an estimate D = diag{ˆ 2 . in the linear regression model yi = x0 β + ei i E (ei | xi ) = 0.1) XD Y β = X 0 D−1 X ¡ ¢ 2 . σ1 We now discuss this estimation problem. The GLS estimator is sometimes called where D = diag{σ 1 i i n i i the Aitken estimator.1) infeasible since the matrix D is unknown. Often the functional form is kept simple for parsimony.Chapter 7 Additional Regression Topics 7. z1i are squares (and perhaps levels) of some (or all) elements of xi .. Suppose that we model the conditional variance using the parametric form 0 σ 2 = α0 + z1i α1 i = α0 zi . The error ξ i in this regression error ξ i is generally heteroskedastic and has the conditional variance ¡ ¢ V ar (ξ i | xi ) = V ar e2 | xi i ´ ³¡ ¢¢2 ¡ = E e2 − E e2 | xi | xi i i ¡ 4 ¢ ¡ ¡ 2 ¢¢2 = E ei | xi − E ei | xi .. the least-squares estimator is ineﬃcient.. 74 . σ 2 }. However. 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. 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. ..2) E (ξ i | xi ) = 0.. . where z1i is some q × 1 function of xi . Typically.1 Generalized Least Squares In the projection model.. Let η i = e2 .

Thus ˆ i i η − η i = e2 − e2 ˆ ˆi i = φi . Vα ) α ¡ ¡ 0 ¢¢−1 ¡ 0 2 ¢ ¡ ¡ 0 ¢¢−1 E zi zi ξ i E zi zi .4) the skedastic regression. then the FGLS estimator will force ˜i the regression equation through the point (yi . or FGLS.4) ¡ ¢−1 −1/2 0 √ √ n (˜ − α) = n (ˆ − α) + n−1 Z 0 Z α α n Zφ →d N (0.5) ˆ Thus the fact that η i is replaced with η i is asymptotically irrelevant. Then ˆ ¢−1 0 ¡ Zη ˆ α = Z 0Z ˜ (7. Vα ) (7.6) σ 2 = α0 zi .. σ 2 } σ1 ˜n and ³ ´−1 ˜ ˜ ˜ β = X 0 D−1 X X 0 D−1 Y. there is no guarantee that σ 2 > 0 for all i.Suppose ei (and thus η i ) were observed. This suggests 75 . One typical problem with implementation of FGLS estimation is that in a linear regression ˜i speciﬁcation. Vα = E zi zi (7. estimator of β. Then set ˜i ˜ D = diag{˜ 2 . Since there is not a unique speciﬁcation for the conditional variance the FGLS estimator is not unique.3) ˆ ˆ While ei is not observed.. ˜i Suppose that σ 2 > 0 for all i. we have the OLS residual ei = yi − x0 β = ei − x0 (β − β). then the FGLS ˜i estimator is not well deﬁned. xi ). If σ 2 < 0 for some i. Furthermore.. if σ 2 ≈ 0 for some i. ³ ´ ˆ ˆ ˆ = −2ei x0 β − β + (β − β)0 xi x0 (β − β) i i say. Then we could estimate α by OLS: ¢−1 0 ¡ Z η →p α α = Z 0Z ˆ and where √ n (ˆ − α) →d N (0. We may call (7. We have shown that α is consistently estimated by a simple procedure. . and hence we can estimate 0 σ 2 = zi α by i ˜ (7. This is the feasible GLS. as it is estimating the conditional variance of the regression of yi on xi . 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 . and will depend on the model (and estimation method) for the skedastic regression. which is typically undesirable.

´ √ ³ ˜ ˜ n β GLS − β F GLS →p 0. 1992). In the linear regression model.1. 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 ˜ = . In this case we interpret α0 zi as a linear projection of e2 on zi . It is possible to show that if the skedastic regression is correctly speciﬁed. e2 }. V = E α0 zi i i Examining the asymptotic distribution of Theorem 7. This may be written as !−1 Ã n !Ã n !−1 Ã n 1 X −4 2 0 1 X −2 0 1 X −2 0 ˜ σ i xi xi ˜ σ i ei xi xi ˜ ˆ σ i xi xi ˜ V = n n n i=1 i=1 i=1 ³ ´−1 ³ ´³ ´−1 ˜ ˜ ˆ˜ ˜ X 0 D−1 DD−1 X X 0 D−1 X = n X 0 D−1 X ˜ which is consistent for V as n → ∞. and it may be estimated with considerable 76 V takes a sandwich form√. FGLS is asymptotically superior to OLS.. Unless σ 2 = α0 zi . σ 2 ] σi i for some σ 2 > 0.1. There are three reasons. This is an estimator which is robust to misspeciﬁcation of the condie1 ˆn tional variance.1.1. i ˜ 0 is inconsistent for V .2) is correctly speciﬁed. This estimator V 0 is appropriate when the skedastic regression (7. V = E σ −2 xi x0 i i ˆ where D = diag{ˆ2 . Why then do we not exclusively estimate regression models by FGLS? This is a good question. V ). It may be the case that α0 zi is only an approximation to the true conditional variance σ 2 = i ˜ E(e2 | xi )..1. Its asymptotic variance is not that given in Theorem 7. ¢¢−1 ¡ ¡ . similar to the covariance matrix of the OLS estimator.. V n n i=1 . A trimming rule might make sense: σ 2 = max[˜ 2 . Theorem 7.1 If the skedastic regression is correctly speciﬁed. and thus where ´ √ ³ ˜ n β F GLS − β →d N (0. Instead. Since the form of the skedastic regression is unknown. First. but the proof of this can be tricky. β should perhaps be i i called a quasi-FGLS estimator of β. FGLS estimation depends on speciﬁcation and estimation of the skedastic regression. .that there is a need to bound the estimated variances away from zero. We just state the result without proof. ´´−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 . then FGLS is asymptotically equivalent to GLS. and was proposed by Cragg (Journal of Econometrics. V ˜ An appropriate solution is to use a White-type estimator in place of V 0 .

or equivalently that i H0 : α1 = 0 in the regression (7. and this requires trimming to solve. If the equation of interest is a linear projection. as they will be estimating two diﬀerent projections.4) and constructing a Wald statistic.4). on the other hand. in which case ξ i is ˜ independent of xi and the asymptotic variance (7. FGLS will do worse than OLS in practice.error. Third.1 Under H0 and ei independent of xi . And the FGLS probability limit will depend on the particular function selected for the skedastic regression. Theorem 7. This introduces an element of arbitrariness which is unsettling to empirical researchers. the estimated conditional variances may contain more noise than information about the true conditional variances. It is consistent not only in the regression model. its squares. σ 2 ). the Wald test of H0 is asymptotically χ2 . The GLS and FGLS estimators.3 Forecast Intervals m(x) = E (yi | xi = x) = x0 β. Second. Motivated by the form of the asymptotic variance ˆ of the OLS estimator β. we impose the stronger hypothesis and test the hypothesis that ei is independent of xi . In the linear regression model the conditional mean of yi given xi = x is 77 . Typically. The asymptotic distribution (7. require the assumption of a correct conditional mean. and replaced E ξ 2 with 2σ 4 which holds when ei is N(0. White (1980) proposed that the test for heteroskedasticity be based on setting zi to equal all non-redundant elements of xi . the two tests coincide. OLS is a more robust estimator of the parameter vector. The point is that the eﬃciency gains from FGLS are built on the stronger assumption of a correct conditional mean. but the only diﬀerence is that they a ¢ allowed for general choice of zi . q Most tests for heteroskedasticity take this basic form. then the OLS and FGLS estimators will converge in probability to diﬀerent limits. individual estimated conditional variances may be negative. This hypothesis does not imply that ξ i is independent of xi . The main diﬀerences between popular “tests” is which transformations of xi enter zi . and all cross-products. 7.2 Testing for Heteroskedasticity ¢ ¡ The hypothesis of homoskedasticity is that E e2 | xi = σ 2 . and the cost is a reduction of robustness to misspeciﬁcatio 7.7) Hence the standard test of H0 is a classic F (or Wald) test for exclusion of all regressors from the skedastic regression (7. but also under the assumptions of linear projection.5) and the asymptotic variance (7.7) under independence show that this test has an asymptotic chi-square distribution.3) for α simpliﬁes to ¡ ¡ 0 ¢¢−1 ¡ 2 ¢ E ξi . In this case. We may therefore test this hypothesis by the estimation (7. and not a conditional mean. however.2.2). If i this simpliﬁcation is replaced by the standard formula (under independence of the error). Vα = E zi zi (7. BreuschPagan (1979) proposed what might appear to be ¡ distinct test.

we want to estimate m(x) at a particular point x. e. p h i ˆ ˆ x0 β ± 2 n−1 x0 V x . 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. The only special exception is the case where ei has the exact distribution N (0. Notice that this is diﬀerent from the standard ˆ ˆ error for the conditional mean. so p ˆ s(ˆ = n−1 x0 V x. but this turns out to be incorrect.g. 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) . we may want to forecast (guess) yi out-of-sample. σ 2 ). 78 . which is a much more diﬃcult task. the natural estimate of this variance is σ 2 + n−1 x0 V x. many applied forecasters focus h i ˆ on the simple approximate interval x0 β ± 2ˆ(x) . we see that m(x) = ˆ = x0 β and Hβ = x. q 2 0 0 ˆ ˜ ˆ ˜ σ (x) = α z from (7. the width of the conﬁdence set is dependent on x. We describe this setting as non-linear regression. ¡ ¢ ˆ Assuming E e2 | xi = σ 2 .In some cases. s(x) ˆ But no such asymptotic approximation can be made. If we have an estimate of the conditional variance function. so a standard ˆ i p ˆ error for the forecast is s(x) = σ 2 + n−1 x0 V x. We would also like a measure of uncertainty for ˆ the forecast. In the present case. In general. θ) = E (yi | xi = x) which is a non-linear function of the parameters θ. Letting h(β) = x0 β and θ = h(β). which is generally invalid. 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. ³ ´ ˆ ˆ The forecast error is ei = yi − m(x) = ei − x0 β − β . Given the diﬃculty. we need to estimate the conditional distribution of ei given xi = x. To get an accurate forecast interval. As the out-of-sample error ei is ˆ ˆ independent of the in-sample estimate β. the validity of an asymptotic conﬁdence interval is based on the asymptotic normality of the studentized ratio. s 7.6). A reasonable rule is the conditional mean m(x) as it is the mean-square-minimizing forecast. A point forecast ˆ is the estimated conditional mean m(x) = x0 β. Notice that this is a (linear) ˆ ˆ θ function of β. this would require the asymptotic normality of the ratio ³ ´ ˆ ei − x0 β − β .4 NonLinear Least Squares In some cases we might use a parametric regression function m(x. For a given value of xi = x.

θ). The least squares estimator ˆ minimizes the sum-of-squared-errors θ Sn (θ) = n X i=1 (yi − m(xi . θ) = θ1 + θ2 m(x. When the regression function is nonlinear. In the ﬁnal two examples. When it exists. G known x2 − θ5 m(x. we call this the nonlinear least squares (NLLS) θ). ˆ is close to θ θ θ0 for n large. ˆ must be found by numerical θ methods. it must be shown that ˆ →p θ0 . See Appendix E. θ) is diﬀerentiable. ˆ ei . The NLLS residuals are ei = yi − m(xi . θ) = θ1 + θ2 x + θ4 (x − θ3 ) 1 (x > θ3 ) µ ¶ m(x. V ) θ where mθi = mθ (xi . θ) is (generically) diﬀerentiable in the parameters θ. m is not diﬀerentiable with respect to θ3 . θ))2 . estimator. so the minimization of Sn (θ) only needs to be examined for θ close to θ0 . Since ˆ →p θ0 . θ) = G(x0 θ). θ) = (θ1 + θ2 x1 ) 1 (x2 < θ3 ) + (θ4 + θ5 x1 ) 1 (x2 > θ3 ) In the ﬁrst ﬁve examples. θ0 ).Examples of nonlinear regression functions include x 1 + θ3 x m(x. θ))2 Since sum-of-squared-errors function Sn (θ) is not quadratic. When m(x. but we won’t cover that argument here. In other cases. ¢¢−1 ¡ ¡ ¢¢ ¡ ¡ ¢¢−1 ¡ ¡ E mθi m0 e2 E mθi m0 V = E mθi m0 θi θi i θi Sketch of Proof. Let 0 yi = ei + m0 θ0 . θ) is suggested by an economic model. θi 79 . θ) = θ1 + θ2 xθ3 m(x. mθ (x. ´ √ ³ n ˆ − θ0 →d N (0.1 If the model is identiﬁed and m(x. θ) = ∂θ Nonlinear regression is frequently adopted because the functional form m(x. θ) is diﬀerentiable with respect to θ. θ) = θ1 + θ2 x1 + (θ3 + θ4 x1 ) Φ θ6 m(x. First. θ) = θ1 + θ2 exp(θ3 x) m(x.4. θ)ˆ (7. 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 . it is adopted as a ﬂexible approximation to an unknown regression function. then the FOC for minimization are 0= n X i=1 mθ (xi . let ∂ m(x. which alters some of the analysis. m(x. This can be done using arguments θ for optimization estimators.8) Theorem 7.

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

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

∂ g(β) = ∂β 0 ¡ ¡ ¢¢ ∂ 0 0 Exi 1 − 2 · 1 yi ≤ xi β ∂β £ ¡ ¡ ¢ ¢¤ ∂ = −2 0 E xi E 1 ei ≤ x0 β − x0 β 0 | xi i i ∂β " Z 0 # xi β−x0 β 0 i ∂ = −2 0 E xi f (e | xi ) de ∂β −∞ £ ¢¤ ¡ = −2E xi x0 f x0 β − x0 β 0 | xi i i i £ 0 ¤ ∂ 0 g(β 0 ) = −2E xi xi f (0 | xi ) . the height of the error density at its median.11). In the special case where the error is independent of xi . Exi x0 ) i i=1 since Egi (β 0 )gi (β 0 )0 = Exi x0 .1: Since sgn (a) = 1 − 2 · 1 (a ≤ 0) .5.5.1 ´ √ ³ˆ n β − β 0 →d N (0. by the central limit theorem (Theorm 5. the conditional density of the error at its median.3. ˆ Proof of Theorem 7. Computation of standard error for LAD estimates typically is based on equation (7. V ). we provide a sketch here for completeness. ∂β ˆ g(β) ' ´ ³ ∂ ˆ g(β 0 ) β − β 0 .11) This simpliﬁcation is similar to the simpliﬁcation of the asymptotic covariance of the OLS estimator under homoskedasticity. Let g(β) = Eg (β). This can be done with kernel estimation techniques. where V = and f (e | x) is the conditional density of ei given xi = x. then there are many innovations near to the median. While a complete proof of Theorem 7. We need where g n (β) = n i i=1 gi (β) and gi (β) = xi (1 − 2 · 1 (yi ≤ xi three preliminary result. Second using the law of iterated expectations and the chain rule of i diﬀerentiation. and this improves estimation of the median. ¢¢−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) . by a Taylor series expansion and the fact g(β 0 ) = 0 82 . ∂β 0 so Third. See Chapter 16. First.1 is advanced. (7. Pn −1 0 β)) .1) n X √ −1/2 n (g n (β 0 ) − g(β 0 )) = −n gi (β 0 ) →d N (0.5.10) is equivalent to g n (β) = 0. then f (0 | x) = f (0) and the asymptotic variance simpliﬁes V = (Exi x0 )−1 i 4f (0)2 (7. The main diﬃculty is the estimation of f (0).Theorem 7. When f (0 | x) is large.

12) Qτ = argmin Eρτ (U − θ) . The following alternative representation is useful. For τ ∈ [0. The quantile Qτ is the value such that τ (percent) of the mass of the distribution is less than Qτ . ¥ 7.6 Quantile Regression The method of quantile regression has become quite popular in recent econometric practice. then F (Qτ ) = τ .5. V ). If the random variable U has τ ’th quantile Qτ . The median is the special case τ = . However for computational convenience it is typical to assume that they are (approximately) linear in x (after suitable transformations).Together ´ √ ³ ˆ n β − β0 ' ' ¶−1 √ ∂ ˆ ng(β) 0 g(β 0 ) ∂β ´ ¡ £ ¤¢−1 √ ³ ˆ ˆ = −2E xi x0 f (0 | xi ) n g(β) − g n (β) i µ ¤¢−1 √ 1¡ £ 0 n (g n (β 0 ) − g(β 0 )) E xi xi f (0 | xi ) 2 ¤¢−1 1¡ £ 0 E xi xi f (0 | xi ) N (0. For the random variables (yi . Again.13) This generalizes representation (7.9) for the median to all quantiles. This linear speciﬁcation assumes that Qτ (x) = β 0 x where the coeﬃcients β τ τ vary across the quantiles τ . so you can think of the quantile as the inverse of the distribution function. (7. We then have the linear quantile regression model yi = x0 β τ + ei i 83 . then F (Qτ (x) | x) = τ . the quantile regression functions can take any shape. when F (y | x) is continuous and strictly monotonic in y. 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 } . 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. the quantile regression function qτ (x) describes how the τ ’th quantile of the conditional distribution varies with the regressors. As functions of x. then (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)) .

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

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

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

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

β K 6= 0. β 3 = · · · = β K = 0 . which can be a very large number. 576. a model consists of any possible subset of the regressors {x1i . Similarly for ˆ the BIC. and then selects the model with the lowest AIC (7.17). There are two leading cases: ordered regressors and unordered. . and the AIC or BIC in principle can be implemented by estimating all possible subset models.. We have discussed model selection between two models. For example. log(n) µ LRn > k2 | M2 log(n) ¶ ´ ³ c P M = M2 | M2 = P → 1.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. . In the latter case. stores the residual variance σ 2 for each model. . selecting based on (7. 88 . there are 2K such models. which are nested. β 2 = β 3 = · · · = β K = 0 M2 : β 1 6= 0. a full-blown implementation of the BIC selection criterion would seem computationally prohibitive. The methods extend readily to the issue of selection among multiple regressors. 210 = 1024.. The AIC selection criteria estimates the K models by OLS.15). The general problem is the model yi = β 1 x1i + β 2 x1i + · · · + β K xKi + εi . Also under M2 . E (εi | xi ) = 0 and the question is which subset of the coeﬃcients are non-zero (equivalently. . . In the ordered case. β 2 6= 0. the models are M1 : β 1 6= 0. MK : β 1 6= 0. xKi }. . which regressors enter the regression). β 2 6= 0.. 048. one can show that thus LRn →p ∞. In the unordered case. . and 220 = 1.

Verify equation (7. Let (yi . X). Is θ a quantile of the distribution of Yi ? 3.10 Exercises 1. based on a sample of size n. 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 . . Thus the available information is the sample (Y. 4. the mean absolute error (MAE) is E |yi − g(xi )| . In the homoskedastic regression model Y = Xβ + e with E(ei | xi ) = 0 and E(e2 | xi ) = σ 2 . 2. V . the residuals 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 . σ 2 ).. Consider the Weighted Least Squares (WLS) estimator of β ¢−1 ¡ 0 ¢ ¡ ˜ X WY β = X 0W X where W = diag(w1 . wn ) and wi = x−2 .12). else equals zero). and the out-of-sample value of the regressors. where xji is one of the xi . Let θ satisfy Eg(Yi − θ) = 0. Show that the function g(x) which minimizes the MAE is the conditional median M (x).7.. x. Let σ 2 be the estimate of σ 2 . In a linear model Y = Xβ + e. E(e | X) = 0. the estimates (β. ˜ the residual vector is e = Y − X β. 5. . (b) Prove that e = M1 e. 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. V ar(e | X) = σ 2 Ω with Ω known. ˆ (a) Find a point forecast of y. ˆ ˆ n−k 6. xi ) be a random sample with E(Y | X) = Xβ. (b) Find an estimate of the variance of this forecast. Deﬁne g(u) = τ − 1 (u < 0) where 1 (·) is the indicator function (takes the value 1 if the argument is true.. You wish to forecast an out-of-sample value of y given that ˆ ˆ ˆ ˆ X = x. i ˆ ˆ suppose β is the OLS estimate of β with covariance matrix V . For any predictor g(xi ) for y. ji ˜ (a) In which contexts would β be a good estimator? ˜ (b) Using your intuition.

a7 ). The model works best when a7 is selected so that several values (in this example. n xi i=1 (a) Under the stated assumptions. For each value of a7 . For values much above a7 . Do so. The model is yi = xi β + ei E (ei | xi ) = 0 where xi ∈ R.18) (a) Following Nerlove. This model is called a smooth threshold model. 90 . 8. Find an asymptotic 95% conﬁdence interval for g(x). (d) Calculate standard errors for all the parameters (a1 . (c) Estimate the model by non-linear least squares. . The equation you estimated was ln T Ci = β 1 + β 2 ln Qi + β 3 ln P Li + β 4 ln P Ki + β 5 ln P Fi + ei .. at least 10 to 15) of ln Qi are both below and above a7 . the variable ln Qi has a regression slope of a2 .18) plus the extra term a6 zi . are both estimators consistent for β? (b) Are there conditions under which either estimator is eﬃcient? 9.. (iii) BIC criterion. (ii) AIC criterion. and ﬁnd the value of a7 for which the sum of squared errors is minimized. add the variable (ln Qi )2 to the regression. Consider model (7. calculate zi and estimate the model by OLS. For values of ln Qi much below a7 .. and V is the = g(x estimate of V ar ˆ . Consider the two estimators ˆ β = ˜ β = Pn i=1 x y Pn i 2 i i=1 xi n 1 X yi .ˆ ˆ 7. Assess the merits of this new speciﬁcation using (i) a hypothesis test. Suppose that yi ³ ´ i . Examine the data and pick an appropriate range for a7 . the regression slope is a2 + a6 . you estimated a cost function on a cross-section of electric companies. θ) + ei with E (ei | xi ) = 0. Record the sum of squared errors. In Chapter 6. and the model imposes a smooth transition between these regimes. Exercise 13. (7. In addition. where zi = ln Qi (1 + exp (− (ln Qi − a7 )))−1 . I recommend the concentration method: Pick 10 (or more or you like) values of a7 in this range. impose the restriction a3 + a4 + a5 = 1. Do you agree with this modiﬁcation? (b) Now try a non-linear speciﬁcation. You are interested in the conditional mean function E (yi | xi = x) = θ g(x) at some x. The model is non-linear because of the parameter a7 . θ is the NLLS estimator.

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

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

. 1) distribution. x) = P (yi ≤ y. That is. x))) . i = 1. F (y. x)) →d N (0. .3. To see this. In general. x∗ ) with the i distribution Fn . xi ). Notationally. xi ≤ x) = E (1 (yi ≤ y) 1 (xi ≤ x)) . (8. √ n (Fn (y. it is helpful to think of a random pair (yi . For n = 25. x) = n i=1 Figure 8. x) (1 − F (y. Furthermore. x) is called the empirical distribution function (EDF). Fn (y. Recall that F (y. i 93 . 1 (yi ≤ y) 1 (xi ≤ x) is an iid random variable with expectation F (y. and 100. I have plotted the EDF and true CDF for three random samples of size n = 25. x). n.1).2 The Empirical Distribution Function Fn (y. This is a population moment. Fn is by construction a step function. 50. note that for any (y. in the Figure below. x) →p F (y. The method of moments estimator is the corresponding sample moment: n 1X 1 (yi ≤ y) 1 (xi ≤ x) .2) Fn (y. Thus by the WLLN (Theorem 5...8. x) − F (y. ∗ P (yi ≤ y. Fn is a nonparametric estimate of F. The EDF is a consistent estimator of the CDF. x). as the sample size gets larger.1: Empirical Distribution Functions The EDF is a valid discrete probability distribution which puts probability mass 1/n at each ∗ pair (yi . the EDF step function gets uniformly close to the true CDF. the EDF is only a crude approximation to the CDF. by the CLT (Theorem 5. x). Note that while F may be either discrete or continuous. x∗ ≤ x) = Fn (y.1). The random draws are from the N (0.2. x) . where 1(·) is the indicator function. but the approximation appears to improve for the large n. To see the eﬀect of sample size on the EDF.

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

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

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

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

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

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

the exact distribution is P (Tn < x) = Gn (x. g1 and g2 are diﬀerentiable functions of x and continuous in F relative to the supremum norm on the space of distribution functions. so the order of the error is O(n−1/2 ). F ) + n−1 g2 (x. F ) ≈ Φ + n−1/2 g1 (x. ³x´ Gn (x. To a third order of approximation. we can assess the accuracy of one-sided hypothesis tests and conﬁdence regions based on an asymptotically normal t-ratio Tn . v Since the derivative of g1 is odd. 100 .1 as follows.8.8. the diﬀerence between the bootstrap distribution and the true distribution is G∗ (x) − Gn (x. where g1 is an even function of x. First. F0 )) + O(n−1 ). the density function is skewed. g1 (x. F0 )) converges to 0 at rate n. Moreover. F0 ) ≈ ∂ g1 (x. F0 ) (Fn − F0 ) ∂F = O(n−1/2 ). Heuristically. ³x´ 1 1 + 1/2 g1 (x. F0 ) = Φ(x) + since v = 1. F ) + g2 (x. Fn ) − g1 (x. F0 ) = 1 g (x.1.1 Under regularity conditions and (8. F ) + O(n−3/2 ) Gn (x. Gn (x. Theorem 8. An asymptotic test is based on Φ(x). 1/2 1 n Because Φ(x) appears in both expansions. F0 ) + O(n−1 ) 1/2 1 n = O(n−1/2 ).uniformly over x. F0 ) = n 1 n1/2 (g1 (x. F0 ) + O(n−1 ) 1/2 1 n 1 g (x. F ) v which adds a symmetric non-normal component to the approximate density (for example.1 has the expansion n G∗ (x) = Gn (x. Fn ) = Φ(x) + n 1 g (x. The diﬀerence is Φ(x) − Gn (x.8. F ) converges to the normal limit at rate n1/2 . We can interpret Theorem 8. ³x´ Gn (x. Fn ) − g1 (x.9 One-Sided Tests Using the expansion of Theorem 8. and g2 is an odd function of x. and g1 is continuous with respect to F.8. F ) ≈ Φ + n−1/2 g1 (x. the diﬀerence √ (g1 (x.3). F ). A bootstrap test is based on G∗ (x). F ) = Φ v n n 8. Fn ) − g1 (x. which from Theorem 8. To a second order of approximation. Fn ) + O(n−1 ). To the second order. √ Since Fn converges to F at rate n. adding leptokurtosis).

Since Tn →d Z. which is an improved rate of convergence over the asymptotic test (which converged at rate O(n−1/2 )). F ) + g2 (−x. F0 ) = O(n−1 ). then |Tn | has the distribution function Gn (x. then |Tn | →d |Z| ∼ Φ.1. F ) − Gn (−x. n or ∗ P (Tn ≤ x) = P (Tn ≤ x) + O(n−1 ). and exact critical values are taken from the Gn (x. Hence the diﬀerence between the asymptotic distribution and the exact distribution is Φ(x) − Gn (x. then |Z| has distribution function Φ(x) = Φ(x) − Φ(−x) = 2Φ(x) − 1. F ). We conclude that G∗ (x) − Gn (x. 1). n . F ) = Gn (x. 8. F ) is only heuristic. 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. F ) ¶ µ 1 1 = Φ(x) + 1/2 g1 (x. F0 ) distribution. if Tn has exact distribution Gn (x. F0 ) + O(n−3/2 ) = O(n−1 ). = P (X ≤ x) − P (X ≤ −x) For example. n (8. From Theorem 8. as F is a function. Thus asymptotic critical values are taken from the Φ distribution.5) where the simpliﬁcations are because g1 is even and g2 is odd.The “derivative” ∂ ∂F g1 (x. F ) + g2 (x. 101 2 g2 (x. F ) + O(n−3/2 ). F0 ) = The order of the error is O(n−1 ). then the random variable |X| has distribution function H(x) = H(x) − H(−x) since P (|X| ≤ x) = P (−x ≤ X ≤ x) = H(x) − H(−x). Similarly. F ).8.10 Symmetric Two-Sided Tests If a random variable X has distribution function H(x) = P (X ≤ x). we can calculate that Gn (x. F ) = Gn (x. A two-sided hypothesis test rejects H0 for large values of |Tn | . F ) − Gn (−x. F ) n n µ ¶ 1 1 − Φ(−x) + 1/2 g1 (−x. F ) + O(n−3/2 ) n n 2 = Φ(x) + g2 (x. if Z ∼ N (0.

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

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

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

∗ ∗ where s(ˆ is the standard error in the original data. θ θ) ∗ 1000 samples are generated from the bootstrap distribution. Using the non-parametric bootstrap. What is wrong with this procedure? Tn = θ/s(θ) n 6.05) and qn (. You do this as follows.3. You replace c with qn (. Let qn (. and ˆ is calculated on each θ ∗ ∗ θ sample. and the 2. The dataﬁle hprice1. (a) Report the 95% Efron Percentile interval for θ. lot size. 105 . ˆ = 1. You want to test H0 : θ = 0 against H1 : θ > 0. Using the non-parametric ∗ bootstrap. and deﬁne the bootstrap conﬁdence interval h i C = ˆ − s(ˆ n (.75 and 1.95).95). with variables listed in the ﬁle hprice1. (b) Report the 95% Alternative Percentile interval for θ. and thus reject H0 if ˆ ˆ > q ∗ (. ˆ − s(ˆ n (. θ respectively. Suppose that in an application.95) denote the 95% quantile of Tn .95).dat contains data on house prices (sales).5% and 97. Calculate 95% conﬁdence intervals for the regression coeﬃcients using both the asymptotic normal approximation and the percentile-t bootstrap. The ˆ are sorted.5% quantiles of the ˆ are . size of house.95) denote the 5% θ) ∗ and 95% quantiles of Tn .2 and s(ˆ = . Estimate a linear regression of price on the number of bedrooms. calculate the estimates ˆ on these samples and θ then calculate ∗ ∗ ∗ θ θ Tn = ˆ /s(ˆ ). can you report the 95% Percentile-t interval for θ? 7. ∗ ∗ ∗ Let qn (.pdf. and the colonial dummy. you generate bootstrap samples. θ θ)q ∗ θ θ)q ∗ θ/s(θ) 5.05) .2. (c) With the given information. The test for H0 is to reject if Tn = ˆ ˆ > c where c is picked so that Type I error is α.Show that C exactly equals the Alternative percentile interval (not the percentile-t interval).

This is a special case of a more general class of moment condition models. We call r the number of overidentifying restrictions. β) = x(y − x0 β). 1 this class of models are called moment condition models. This model falls in the class (9. We know that without further restrictions. In this case. β 0 ) = 0 (9. This method. which can be written as 0 yi = zi β + ei Consider the linear model E (xi ei ) = 0. however. but this is not required. z. otherwise it is overidentiﬁed. as their are restrictions in E (xi ei ) = 0. z. with ≥ k. Now suppose that we are given the information that β 2 = 0.2) . x. while β 1 is of dimension k < .1) where β 0 is the true value of β. xi . β 0 ) = x(y − z 0 β) 106 (9. If k = the model is just identiﬁed. g(y. how should β 1 be estimated? One method is OLS regression of yi on x1i alone. 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 . This situation is called overidentiﬁed. zi . an asymptotically eﬃcient estimator of β is the OLS estimator.Chapter 9 Generalized Method of Moments 9.1) by setting g(y. There are − k = r more moment restrictions than free parameters. where the dimensions of zi and xi are k × 1 and × 1 . β) be an × 1 function of a k × 1 parameter β with ≥ k such that Eg(yi . Let g(y. In our previous example. x. these are known as estimating equations.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. Now we can write the model as yi = x0 β 1 + ei 1i E (xi ei ) = 0. is not necessarily eﬃcient. In econometrics. x. In the statistics literature.

if Wn = I. the dependence is only up to scale.1 β GMM = argmin Jn (β). then. β ˆ Note that if k = .1 ˆ 2Z 0 XWn X 0 Z β = 2Z 0 XWn X 0 Y While the estimator depends on Wn . i i . β GMM does not change. This is a non-negative measure of the “length” of the vector g n (β). The GMM estimator minimizes Jn (β). and the GMM estimator is the MME.2. The idea of the generalized method of moments (GMM) is to deﬁne an estimator which sets g n (β) “close” to zero. ˆ Deﬁnition 9. but this is generally not possible when > k. for if Wn is replaced ˆ by cWn for some c > 0.3 Distribution of GMM Estimator ¡ 0¢ Q = E xi zi Assume that Wn →p W > 0. then g n (β) = 0.2.9. β GMM = Z 0 XWn X 0 Z 9. The ﬁrst order conditions for the GMM estimator are 0 = ∂ ˆ Jn (β) ∂β ∂ ˆ ˆ = 2 g n (β)0 Wn g n (β) ∂β ´ 1 1 ³ ˆ = −2 Z 0 XWn X 0 Y − Z β n n so which establishes the following. Proposition 9. Then µ ¶ ¶ µ 1 0 1 0 Z X Wn X Z →p Q0 W Q n n 107 ¡ ¢ ¡ 0¢ Ω = E xi x0 e2 = E gi gi . the square of the Euclidean length. gi (β) = xi yi − zi β = n n n i=1 i=1 Deﬁne the sample analog of (9.2 GMM Estimator n n ¢ 1¡ 0 ¢ 1X 1X ¡ 0 X Y − X 0 Zβ . For example. let Jn (β) = n · g n (β)0 Wn g n (β).3) The method of moments estimator for β is deﬁned as the parameter value which sets g n (β) = 0. ¡ ¢−1 0 ˆ Z XWn X 0 Y.2) g n (β) = (9. For some × weight matrix Wn > 0. Jn (β) = n · g n (β)0 g n (β) = n · |g n (β)|2 . Let and where gi = xi ei .

it is semiparametrically eﬃcient. ˆ∗ ˆ 108 . we can deﬁne the residuals ei = yi −zi β and moment equations gi = xi ei = g(wi .3. 9. as shown by Gary Chamberlain (1987). GMM estimators are asymptotically normal with “sandwich form” asymptotic variances. where In general. If it is known that E (gi (β)) = 0. This yields the eﬃcient GMM estimator: ¢−1 0 ¡ ˆ Z XΩ−1 X 0 Y. Given any such ﬁrst0ˆ ˆ ˆ ˆ step estimator. This turns out to be W0 = Ω−1 . However. and this is all that is known. but it can be estimated consistently. For example. Ω) . without imposing additional assumptions. no semiparametric estimator (one which is consistent globally for the class of models considered) ¢−1 ¡ .4 Estimation of the Eﬃcient Weight Matrix ˆ Given any weight matrix Wn > 0.2 For the eﬃcient GMM estimator. In the linear model. This is a weak concept of optimality. No estimator can do better (in this ﬁrst-order asymptotic sense). as we are only considering alternative weight matrices Wn . ˆ we still call β the eﬃcient GMM estimator.1 ´ √ ³ˆ n β − β →d N (0. we can set Wn = I . Since the GMM estimator has this can have a smaller asymptotic variance than G0 Ω−1 G asymptotic variance. as it has the same asymptotic distribution. Chamberlain showed that in this context. The proof is left as an exercise. Q0 Ω−1 Q ¢−1 ¡ 0 ¢¡ ¢−1 ¡ . Q W ΩW Q Q0 W Q V = Q0 W Q Thus we have Theorem 9. a better choice is Wn = (X 0 X)−1 . ˆ We have described the estimator β as “eﬃcient GMM” if the optimal (variance minimizing) weight matrix is selected. This results shows that in the linear model. n n We conclude: Theorem 9. The optimal weight matrix W0 is one which minimizes V. β = Z 0 XΩ−1 X 0 Z ´ ³ ¡ ¢−1 ´ √ ³ˆ . ˆ Construct n 1X ˆ g n = g n (β) = gi . it turns out that the GMM estimator is semiparametrically eﬃcient. no estimator has greater asymptotic eﬃciency than the eﬃcient linear GMM estimator. 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. V ) . ˆ n i=1 gi = gi − g n .3. For any Wn →p W0 . the GMM estimator β is consistent yet ineﬃcient. this is a semi-parametric problem. W0 = Ω−1 is not known in practice. n β − β →d N 0. as the distribution of the data is unknown.and µ µ ¶ ¶ 1 0 1 0 Z X Wn X e →d Q0 W N (0. β).

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

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

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

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

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

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

VR ) where ¡ ¢−1 0 R V. Vn = X X i=1 ˜ and hence R0 β = r. The observed data is (yi . 115 . the distance statistic D in (9.6) equals the Wald statistic. subject ˆ i ˆi i=1 to the restriction h(β) = 0. zi is l × 1 and β is k × 1. zi ). λ) = 1 Jn (β) + λ0 (R0 β − r) where λ is 2 s × 1. The equation of interest is yi = g(xi . xi . h(β)=0 The GMM test statistic (the distance statistic) of the hypothesis h(β) = 0 is ˜ D = Jn (β) = min Jn (β). Thus ˜ β = argmin Jn (β) R0 β−r Ã n ! ¡ 0 ¢−1 ¡ 0 ¢−1 X 0 2 ˆ XX xi xi ei ˆ . l ≥ k.6) (a) Show that you can rewrite Jn (β) in (9.5. λ = R0 Vn R (c) Show that if R0 β = r then ´ √ ³˜ n β − β →d N (0. the Generalized Method of Moments (GMM) criterion function for β is deﬁned as 1 ˆn (Y − Xβ)0 X Ω−1 X (Y − Xβ) (9. β) + ei E (zi ei ) = 0. The GMM estimator of β.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. Show how to construct an eﬃcient GMM estimator for 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 . is deﬁned as Jn (β) = ˜ β = argmin Jn (β).5) n 1 P ˆ where ei are the OLS residuals and Ωn = n n xi x0 e2 . VR = V − V R R0 V R (d) Show that in this setting. In the linear model Y = Xβ + e with E(xi ei ) = 0. Deﬁne the Lagrangian L(β. 6. h(β)=0 (9.

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 .. l−k Hint: Il − R (R0 R)−1 R0 is a projection matrix. 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. 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 (0.7. 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. 116 .

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

5) ˆ ˆ As a by-product of estimation. the Lagrange multiplier λ(β) minimizes Rn (β. pi gi (β) = 0. λ) is a convex function of λ. pn . λ(β)) = −n ln (n) − n X i=1 ˆ The EL estimate β is the value which maximizes Ln (β). p (10. Multiplying the ﬁrst equation by pi . λ) : λ(β) = argmin Rn (β. probabilities 1 ³ ´´ . The solution cannot be obtained explicitly. or equivalently minimizes its negative ˆ (10.5). . λ). λ. The Lagrangian for this maximization problem is Ã n ! n n X X X ln(pi ) − µ pi − 1 − nλ0 pi gi (β) L∗ (β.2) subject to the restrictions (10. λ ¡ ¢ ln 1 + λ0 gi (β) . (see section 6. but must be obtained numerically (see section 6.. 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. and using the second and third equations. Ln (β) = Rn (β. This yields the (proﬁle) empirical log-likelihood function for β. (10. The solution (when it exists) is well deﬁned since Rn (β.where λ and µ are Lagrange multipliers..4) (10. pi = ¡ n 1 + λ0 gi (β) Substituting into L∗ we ﬁnd n Rn (β. λ) = −n ln (n) − n X i=1 For given β.7) 118 . µ. p1 .3). we also obtain the Lagrange multiplier λ = λ(β).. µ) = n i=1 i=1 i=1 L∗ n with respect to pi .1) and (10. we ﬁnd µ = n and 1 ¢. pi = ³ ˆ ˆ ˆ0 n 1 + λ gi β ˆ Ln = n X i=1 ln (ˆi ) .6) β = argmin [−Ln (β)] β ¡ ¢ ln 1 + λ(β)0 gi (β) and maximized empirical likelihood ˆ Numerical methods are required for calculation of β.5) This minimization problem is the dual of the constrained maximization problem. summing over i.

i=1 i=1 i=1i Expanding (10. Vλ ) ´ √ ˆ √ ³ˆ where V and Vλ are deﬁned in (10.10. V ) ¢−1 ¡ V = G0 Ω−1 G ¡ ¢−1 0 Vλ = Ω − G G0 Ω−1 G G G = EGi (β 0 ) ¡ ¢ Ω = E gi (β 0 ) gi (β 0 )0 (10.13) Premultiplying by G0 Ω−1 and using (10. λ) jointly solve ³ ´ ˆ n gi β X ∂ ³ ³ ´´ Rn (β. Gi (.11) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ ˆ 0 ' −g n − Gn β − β 0 + Ωn λ (10. ˆ The asymptotic variance V for β is the same as for eﬃcient GMM.12) ∂β ˆ ˆ0 i=1 1 + λ gi β 1 P 1 P 1 P Let Gn = n n Gi (β 0 ) . (β. β λ ∂ ³ ´.2 Deﬁne Asymptotic Distribution of EL Estimator Gi (β) = ∂ gi (β) ∂β 0 (10. Thus the EL estimator is asymptotically eﬃcient. ´ √ ³ ˆ n β − β 0 →d √ ˆ nλ →d N (0.11) 0 = ∂λ ˆ0 ˆ i=1 1 + λ gi β ³ ´0 ˆ n X Gi . and Ω = E xi x0 e2 .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 . 0 = Rn (β. λ) = − (10.1 Under regularity conditions.9) (10.2. ˆ ˆ Proof. λ) = − (10. and n β − β 0 and nλ are asymptotically independent.12) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ 0 ' G0 λ − λ0 .10) ¡ Ω−1 N (0.13) yields n n Expanding (10. β) = −xi zi . n (10.9) and (10. i i Theorem 10.10). G = −E (xi zi ). g n = n n gi (β 0 ) and Ωn = n n g (β 0 ) gi (β 0 )0 . in the linear model.8) and ¢ 0 0 For example.

10. Since the EL estimator achieves this bound. Ω) GΩ G →d = N (0. since ³ ¡ ¢−1 0 ´ G0 I − Ω−1 G G0 Ω−1 G G =0 (10.15) 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. The overidentiﬁcation test is a very useful by-product of EL estimation. β ' n g n + Gn β − β 0 n i=1 ³ ¡ ¢−1 0 −1 ´ √ Gn Ωn ng n ' I − Gn G0 Ω−1 Gn n n √ ˆ ' Ωn nλ. The EL overidentiﬁcation test is similar to the GMM overidentiﬁcation test.15).15) (10.16). This means that no consistent estimator for this class of models can have a lower asymptotic variance than V .3 Overidentifying Restrictions In a parametric likelihood context. (10. and (10. Ω) →d Ω−1 I − G G Ω G GΩ = Ω−1 N (0.14) for λ and using (10. First. The same statistic can be constructed for empirical likelihood. n ³ ´´ ´ √ ³ 1 X ³ ˆ ˆ √ g wi . They are asymptotically ﬁrst-order equivalent. and have the same interpretation. Proof. LRn = i=1 Theorem 10. Twice the diﬀerence between the unrestricted empirical likelihood −n log (n) and the maximized empirical likelihood for the model (10.7) is n ³ ´´ ³ X ˆ ˆ0 (10. β 0 ) = 0 then LRn →d χ2−k .1 If Eg(wi .16) ´ √ ˆ √ ³ˆ n β − β 0 and nλ are asymptotically uncorrelated and hence independent. and it is advisable to report the statistic LRn whenever EL is the estimation method.17) 2 ln 1 + λ gi β . ¥ Chamberlain (1987) showed that V is the semiparametric eﬃciency bound for β in the overidentiﬁed moment condition model. it is an asymptotically eﬃcient estimator for β. Vλ ) Furthermore. 120 . tests are based on the diﬀerence in the log likelihood functions.3. V ) ˆ Solving (10.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. by a Taylor expansion.

The restricted EL estimator and likelihood are the values which solve ˜ β = argmax Ln (β) h(β)=0 ˜ ˜ Ln = Ln (β) = max Ln (β).18) Let the maintained model be where g is × 1 and β is k × 1.18) are assumed to hold and are not being challenged (at least for the test discussed in this section).18). This test statistic is a natural analog of the GMM distance statistic.17) is not appropriate. To test the hypothesis h(β) while maintaining (10. Instead we use the diﬀerence in log-likelihoods: ³ ´ ˆ ˜ LRn = 2 Ln − Ln . the restricted EL estimator β is simply an EL estimator with − k + a overidenti˜ ˆ fying restrictions. 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. LRn →d χ2 .edu/~bhansen/progs/elike.Second. Vλ )0 Ω−1 N (0. h(β)=0 ˜ Fundamentally.wisc. 10. 10. Theorem 10. a The proof of this result is more challenging and is omitted. the simple overidentifying restrictions test (10. so there is no fundamental change in the distribution theory for β relative to β.5 Numerical Computation Gauss code which implements the methods discussed below can be found at http://www. By “maintained” we mean that the overidentfying restrictions contained in (10.4 Testing Egi (β) = 0 (10. where h : Rk → Ra .1 Under (10. Vλ ) ¥ where the proof of the ﬁnal equality is left as an exercise.prc 121 .18) and H0 : h(β) = 0.4. since ln(1 + x) ' x − x2 /2 for x small.ssc. The hypothesis of interest is h(β) = 0.

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

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

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

11.1.1) if E (xi ei ) = 0.1) where zi is k × 1. We call z1i exogenous and z2i endogenous. some regressors in zi will be uncorrelated with ei (for example. and assume that E(zi ei ) 6= 0 so there is endogeneity. Thus we make the partition ¶ µ k1 z1i (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 ¶ . We call (11.2) Any solution to the problem of endogeneity requires additional information which we call instruments. Deﬁnition 11. This is called simultaneous equations bias.4) xi = x2i 2 where z1i = x1i are the included exogenous variables. which does not equal either β 1 or β 2 .3) zi = z2i k2 where E(z1i ei ) = 0 yet E(z2i ei ) 6= 0. By the above deﬁnition. so should be included in xi . (11. ¶ µ ∙ β2 β1 1 −1 β 2 e1i + β 1 e2i (e1i − e2i ) ¸µ e1i e2i ¶ ˆ Hence if it is estimated by OLS. β →p β ∗ . In matrix notation.1). z1i is an instrumental variable for (11. In a typical set-up. That is x2i are variables which could be included in the equation for yi (in the sense 125 .1 The × 1 random vector xi is an instrumental variable for (11. this can be written as Y = Zβ + e.1) the structural equation.1 Instrumental Variables 0 yi = zi β + ei Let the equation of interest be (11. and x2i are the excluded exogenous variables. So we have the partition µ ¶ z1i k1 (11. at least the intercept).

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

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

the expression in (11. The parameter β fails to be identiﬁed if Γ22 has deﬁcient rank.14) In general this is non-zero. indicating that the bias in 2SLS approaches that of OLS as the number of instruments increases. the bias in the 2SLS estimator will be large.7 Identiﬁcation Failure Recall the reduced form equation Z2 = X1 Γ12 + X2 Γ22 + u2 . 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. 0). ¢ 1 ¡ ¢ 1 ¡ ¢ 1 ¡ 0 E Z PX e = E Γ0 X 0 e + E u0 PX e = αS21 . 130 .12) and this result.Let PX = X (X 0 X)−1 X 0 . Bekker (1994) pointed out that it also has the reverse implication — that when α = l/n is large. n and (11. except when S21 = 0 (when Z is exogenous).14) is the probability limit of β 2SLS − β 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 (11.13). l . Indeed as α → 1. The consequences of identiﬁcation failure for inference are quite severe.14) approaches that in (11. 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 . P = HΛH 0 0 0 where Λ = diag(Il . n n n ¢ ¡ ¡ ¢ ¢ ¢ 1 ¡ 0 1 ¡ E Z PX Z = Γ0 E xi x0 Γ + Γ0 E (xi ui ) + E ui x0 Γ + E u0 PX u i i n n = Γ0 QΓ + αS22 . Let q = H 0 ξS −1/2 which satisﬁes Eqq 0 = In and partition q = (q1 q2 ) where q1 is l × 1. By the spectral decomposition of an idempotent matrix.

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

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

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

in years.. in years. We want to estimate a wage equation log(W age) = β 0 + β 1 Educ + β 2 Exper + β 3 Exper2 + β 4 South + β 5 Black + e where Educ = Eduation (Years) Exper = Experience (Years). Report the estimates and standard errors. How does this diﬀer from OLS? (c) Find the eﬃcient GMM estimator of β based on the moment condition E (zi (yi − xi β)) = 0. and the remaining variables as exogenous. 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. Estimate the model by 2SLS. are the parameters identiﬁed? 8. 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. of the father) and motheduc (the education. Report estimates and standard errors. (a) Estimate the model by OLS.(b) Deﬁne the 2SLS estimator of β. (b) Now treat Education as endogenous. In this model. Does this diﬀer from 2SLS and/or OLS? 7. listed in card. (c) Re-estimate by 2SLS (report estimates and standard errors) adding three additional instruments: near2 (a dummy indicating that the observation lives near a 2-year college). f atheduc (the education. I suggest that you use the 2SLS estimates as the ﬁrst-step to get the weight matrix. (f) Discuss your ﬁndings.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). a dummy indicating that the observation lives near a 4-year college. and South and Black are regional and racial dummy variables. (e) Calculate and report the J statistic for overidentiﬁcation. using the instrument near4. (d) Re-estimate the model by eﬃcient GMM. 134 . The data ﬁle card. There are 2215 observations with 19 variables. using zi as an instrument for xi .pdf. Report estimates and standard errors. and then calculate the GMM estimator from this weight matrix without further iteration. of the mother).

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

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

Y1 .3 Stationarity of AR(1) Process Yt = ρYt−1 + et . Yt−2 . For example. Yt−k ) . as it is diﬃcult to derive distribution theories without this property. should be a MDS.. . . some versions of the life-cycle hypothesis imply that either changes in consumption... the series {. This occurs when |ρ| < 1.2 Autoregressions In time-series.. Thus for k > 0.} is the past history of the series. The MDS property for the regression error plays the same role in a time-series regression as does the conditional mean-zero property for the regression error in a cross-section regression. . Regression errors are naturally a MDS. ∞ X = ρk et−k . The last property deﬁnes a special time-series process. we ﬁnd Yt = et + ρet−1 + ρ2 et−2 + ... In fact.. Most asset pricing models imply that asset returns should be the sum of a constant plus a MDS.. 137 . this series converges if the sequence ρk et−k gets small as k → ∞. 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 . Deﬁnition 12. k=0 Loosely speaking. A useful property of a MDS is that et is uncorrelated with any function of the lagged information It−1 .. it is even more important in the time-series context. then we have the autoregressive model Yt = α + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et E (et | It−1 ) = 0.. Letting et = Yt − E (Yt | It−1 ) . 12. Some time-series processes may be a MDS as a consequence of optimizing behavior... Y2 . An autoregressive (AR) model speciﬁes that only a ﬁnite number of past lags matter: E (Yt | It−1 ) = E (Yt | Yt−1 . A mean-zero AR(1) is Assume that et is iid.1 et is a martingale diﬀerence sequence (MDS) if E (et | It−1 ) = 0.} are jointly random.. YT . We consider the conditional expectation E (Yt | It−1 ) where It−1 = {Yt−1 .12.. E(Yt−k et ) = 0. or consumption growth rates. .2.. t By back-substitution. E(et ) = 0 and Ee2 = σ 2 < ∞.

Yt − ρ1 LYt − ρ2 L2 Yt − · · · − ρk Lk Yt = et . We call ρ(L) the autoregressive polynomial of Yt . The AR(1) model can be written in the format Yt − ρYt−1 + et or (1 − ρL) Yt−1 = et . Deﬁnition 12. We can compute the moments of Yt using the inﬁnite sum: EYt = ∞ X k=0 ρk E (et−k ) = 0 σ2 . Lk Yt = Yt−k . and solving for EYt = EYt−1 we ﬁnd EYt = α/(1 − ρ).5 Stationarity of AR(k) Yt = ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et . We call ρ(L) the autoregressive polynomial of Yt . From Theorem 12. In general. we see that L2 Yt = LYt−1 = Yt−2 . Deﬁning L2 = LL. or ρ(L)Yt = et where ρ(L) = 1 − ρ1 L − ρ2 L2 − · · · − ρk Lk . ∞ X k=0 ρ2k V ar (et−k ) = 12.3. since ρ(z) = 0 when z = 1/ρ. 138 . The operator ρ(L) = (1 − ρL) is a polynomial in the operator L. The AR(k) model is Using the lag operator. the above results are unchanged.3. 1 − ρ2 V ar(Yt ) = If the equation for Yt has an intercept. We say that the root of the polynomial is 1/ρ.1 If |ρ| < 1 then Yt is strictly stationary and ergodic.4 Lag Operator An algebraic construct which is useful for the analysis of autoregressive models is the lag operator.1.4.Theorem 12. 12. an AR(1) is stationary iﬀ |ρ| < 1. 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).1 The lag operator L satisﬁes LYt = Yt−1 . except that the mean of Yt can be computed from the relationship EYt = α + ρEYt−1 .

it is helpful to deﬁne the process ut = xt et . .. For an AR(k). This is a special case of non-stationarity.1.5. λk are the complex roots of ρ(z).1. it is also strictly stationary and ergodic.1) and the continuous mapping theorem. Thus t by the Ergodic Theorem. since E (ut | It−1 ) = E (xt et | It−1 ) = xt E (et | It−1 ) = 0.. The Fundamental Theorem of Algebra says that any polynomial can be factored as ¢¡ ¢ ¡ ¢ ¡ ρ(z) = 1 − λ−1 z 1 − λ−1 z · · · 1 − λ−1 z 1 2 k 12.. we see that Ã !−1 Ã ! T T 1X 1X ˆ β=β+ xt x0 xt et →p Q−1 0 = 0. t Yt−k ¢0 ρk . which satisfy ρ(λj ) = 0.6 Let Estimation xt = β = ¡ 1 Yt−1 Yt−2 · · · α ρ1 ρ2 · · · yt = x0 β + et . so is xt x0 . Proof. ¢0 Then the model can be written as The OLS estimator is ¡ ˆ To study β. Theorem 12.1 If the AR(k) process Yt is strictly stationary and ergodic and EYt2 < ∞. The vector xt is strictly stationary and ergodic. β = X 0X (12. the requirement is that all roots are larger than one. By Theorem 12. and hence Yt .1. we say that ρ(L). We know that an AR(1) is stationary iﬀ the absolute value of the root of its autoregressive polynomial is larger than one.where the λ1 .1) Theorem 12. One way of stating this is that “All roots lie outside the unit circle. T t=1 T t=1 ¢−1 0 ¡ ˆ X Y. T ¢ ¡ 1X xt x0 →p E xt x0 = Q. and by Theorem 12.1. Let |λ| denote the modulus of a complex number λ. and is of great interest in applied time series.1 The AR(k) is strictly stationary and ergodic if and only if |λj | > 1 for all j. Note that ut is a MDS.6. “has a unit root”. Thus T T 1X 1X xt et = ut →p E (ut ) = 0.” If one of the roots equals 1. t T t=1 T t=1 139 . then ˆ β →p β as T → ∞. t t T t=1 ¥ Combined with (12.

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

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

AR(k) on this (uniﬁed) sample. The best remedy is to ﬁx a upper value k. T where σ 2 (k) is the estimated residual variance from an AR(k) ˆ One ambiguity in deﬁning the AIC criterion is that the sample available for estimation changes as k changes. We model this as an AR(1): ut = θut−1 + et with et a MDS. and this is equivalent to the restriction that the coeﬃcients on Yt−k−1 . or Yt = α(1 − θ) + (ρ + θ) Yt−1 − θρYt−2 + et = AR(2). H0 may be expressed as the restriction that the coeﬃcient on Yt−2 is zero.11 Model Selection What is the appropriate choice of k in practice? This is a problem of model selection. (12.6). (A simple exclusion test).5) and lag the equation once: Yt−1 = α + ρYt−2 + ut−1 .. One approach to model selection is to choose k based on a Wald tests. An appropriate test is the Wald test of this restriction.5). AIC(k) = log σ 2 (k) + ˆ 2k . (If you increase k. Another is to minimize the AIC or BIC information criterion.5) We are interested in the question if the error ut is serially correlated.. Yt−k−m are jointly zero. this is the same as saying that under the alternative Yt is an AR(k+m). to ﬁnd Yt − θYt−1 = α − θα + ρYt−1 − θρYt−1 + ut − θut−1 . .5) and (12. AR(2). Thus under H0 . and then estimate the models AR(1). and under H1 it is an AR(2). In general. and then reserve the ﬁrst k as initial conditions.) This can induce strange behavior in the AIC.. To combine (12. e. An appropriate test of H0 against H1 is therefore a Wald test that the coeﬃcient on Yt−2 is zero.6) 12.10 Testing for Omitted Serial Correlation For simplicity. . Yt is an AR(1). We want to test H0 against H1 . you need more initial conditions.12. We then multiply this by θ and subtract from (12. (12. and the alternative is that the error is an AR(m). 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 .g. if the null hypothesis is that Yt is an AR(k). we take (12.... 142 .

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

1 (Dickey-Fuller Theorem). But the theorem does not require an assumption of homoskedasticity. but diﬀerent critical values are required.12. and may be used for testing the hypothesis H0 . the ADF test rejects H0 in favor of H1 when ADF < c. as the AR model cannot conceivably describe this data. 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. where c is the critical value from the ADF table. then the series itself is nonstationary.8). When conducting the ADF test. T α0 →d (1 − α1 − α2 − · · · − αk−1 ) DFα ˆ ADF = α0 ˆ → DFt . All we can say is that there is insuﬃcient evidence to conclude whether the data are stationary or not.8) This is natural when the alternative hypothesis is that the series is stationary about a linear time trend. The ﬁrst result states that α0 converges to its true value (of zero) at rate T. As T → ∞. Note: The standard error s(ˆ 0 ) is the conventional (“homoskedastic”) standard error. and a diﬀerent table should be consulted. If the series has a linear trend (e. This is called a “super-consistent” rate of convergence. the test procedure is the same. GDP. Assume α0 = 0. (12. rather than the ˆ 1/2 . If the test does not reject H0 . This model is ∆Yt = µ1 + µ2 t + α0 Yt−1 + α1 ∆Yt−1 + · · · + αk−1 ∆Yt−(k−1) + et . The natural solution is to include a time trend in the ﬁtted OLS equation. Thus the Dickey-Fuller test is robust to heteroskedasticity. Since the alternative hypothesis is one-sided. a common conclusion is that the data suggests that Yt is non-stationary. s(ˆ 0 ) α The limit distributions DFα and DFt are non-normal. Most texts include as well the critical values for the extreme polar case where the intercept has been omitted from the model. If a time trend is included.Theorem 12. We have described the test for the setting of with an intercept. however. conventional rate of T The second result states that the t-statistic for α0 converges to a limit distribution which is ˆ non-normal. This distribution has been extensively α tabulated. this means that the evidence points to Yt being stationary. Stock Prices). If the test rejects H0 . it is a silly waste of time to ﬁt an AR model to the level of the series without a time trend. 144 . and have negative means. In this context. This is not really a correct conclusion. but it may be stationary around the linear time trend.g. this means that it is computed as the t-ratio for α0 from OLS estimation of (12. but does not depend on the parameters α. Another popular setting includes as well a linear time trend. The ADF test has a diﬀerent distribution when the time trend has been included.

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

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

t and et is iid N (0.3) which is a valid regression model. t t−1 (13. In this case.2) Take the equation yt = x0 β + et . Then yt = x0 β + et t et = θet−1 + ut E (ut | It−1 ) = 0. the model (13. t or yt = θyt−1 + x0 β + x0 γ + ut . This takes the form 0 and xt consists of lagged values of Yjt and the other Ylt s. You may have heard of the Durbin-Watson test for omitted serial correlation. and is still routinely reported by conventional regression packages.) Since the common factor restriction appears arbitrary. If valid. h¡ 1 Yt−1 · · · 0 Yt−k Zt−1 · · · 0 Zt−k ¢0 i . and Zt be the other variables.2) is uncommon in recent applications.2) may be estimated by iterated GLS. Another interesting fact is that (13.1). general.5 Testing for Omitted Serial Correlation Consider the problem of testing for omitted serial correlation in equation (13. may be tested if desired. t and xt = This is just a conventional regression.2) is a special case of (13. direct estimation of (13. xt−1 ) to the regression. it is convenient to re-deﬁne the variables. Otherwise it is invalid. 147 . which is called a common factor restriction.3). with time series data. This can be done by a Wald test. (A simple version of this estimator is called Cochrane-Orcutt. under the restriction γ = −βθ. Then the null and alternative are H0 : θ = 0 H1 : θ 6= 0.13.4 Single Equation from a VAR Yjt = a0 xt + et . This restriction. and subtract oﬀ the equation once lagged multiplied by θ. So testing H0 versus H1 is equivalent to testing for the signiﬁcance of adding (yt−1 . The DW test is appropriate only when regression yt = x0 β + et is not dynamic (has no lagged values on the RHS). 1).1) yt = x0 β + et . j Often. Let et = ejt and β = aj . (13. we are only interested in a single equation out of a VAR system. We see that an appropriate. 13. Let yt = Yjt . which once was very popular. and simple way to test for omitted serial correlation is to test the signiﬁcance of extra lagged values of the dependent variable and regressors. 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 . Then the single equation takes the form (13. and is typically rejected empirically. Suppose that et is an AR(1).

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

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

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

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

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 ). 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 . Standard errors and test statistics are computed by asymptotic approximations. otherwise Estimation is by maximum likelihood. −1 . To construct the likelihood. y = 0. Thus i the conditional density is f (yi xi ) = pyi (1 − pi )1−yi i ¡ 0 ¢yi ¡ ¢ = F xi β (1 − F x0 β )1−yi . In the Binary choice model. we need the conditional distribution of an individual observation. Details of such calculations are left to more advanced courses. If F is logistic. 152 .• Logistic: F (u) = (1 + e−u ) • Normal: F (u) = Φ(u). we call this the probit model. then we can write the density of Y as f (y) = py (1 − p)1−y . we call this the logit model. i i yi =0 ˆ The MLE β is the value of β which maximizes ln (β). Recall that if Y is Bernoulli. such that P (Y = 1) = p and P (Y = 0) = 1 − p. and if F is normal. i if Yi∗ > 0 . 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 !) . i i i=1 ˆ The MLE is the value β which maximizes ln (β). This model (now called the Tobit) speciﬁes that the latent (or ideal) value of consumption may be negative (the household 153 . An example of a data collection censoring is top-coding of income. 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. 14.” Also observe that the model implies that V ar (Yi | xi ) = λi = exp(x0 β).. 2. In surveys.3 Censored Data The idea of “censoring” is that some data above or below a threshold are mis-reported at the ∗ threshold. 0 if yi (This is written for the case of the threshold being zero. σ 2 ) with the observed variable yi generated by the censoring equation (14. a typical approach is to employ Poisson regression.1). .. Thus the model is that there is some latent process yi with unbounded support.. this motivates the label Poisson “regression.. the consumption level (purchases) in a particular period was zero. The ﬁrst censored regression model was developed by Tobin (1958) to explain consumption of durable goods. 2.14. i so the model imposes the restriction that the conditional mean and variance of Yi are the same. A generalization is the negative binomial. or it may be a by-product of economic constraints.}. 1.1) yi = ∗ <0 . This model speciﬁes that P (Yi = k | xi ) = λi k = 0. Tobin observed that for many households. incomes above a threshold are typically reported at the threshold. The functional form for λi has been picked to ensure that λi > 0. i If Y = {0. 1. He proposed the latent variable model ∗ yi = x0 β + ei i ei ∼ iid N (0. . any known value can substitute.) The observed data yi therefore come from a mixed continuous/discrete distribution. This may be considered restrictive.2 Count Data exp (−λi ) λk i . Since E (Yi | xi ) = λi = exp(x0 β) i is the conditional mean. but we observe only ½ ∗ ∗ yi if yi ≥ 0 (14. The conditional density is the Poisson with parameter λi . The censoring process may be explicit in data collection. k! = exp(x0 β).

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

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

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

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

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

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

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

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

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

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

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

Distributive Laws: A∩(B ∪ C) = (A ∩ B)∪(A ∩ C) . The following are elementary set operations: Union: A ∪ B = {x : x ∈ A or x ∈ B}. We now can give the axiomatic deﬁnition of probability. including S itself and the null set ∅. T T }.. a probability function P satisﬁes P (S) = 1.1 Foundations The set S of all possible outcomes of an experiment is called the sample space for the experiment. An event A is any collection of possible outcomes of an experiment. P (A) ≥ 0 for all A ∈ B. T H. A2 . A2 . so we can write S = {H.. We say that A and B are disjoint or mutually exclusive if A ∩ B = ∅. A ∈ B implies Ac ∈ B.. ∈ B are pairwise disjoint. we can write the four outcomes as S = {HH. and A1 . then P P (∪∞ Ai ) = ∞ P (Ai ). HT.. and if A1 . DeMorgan’s Laws: (A ∪ B)c = Ac ∩ B c . A simple example is {∅. Intersection: A ∩ B = {x : x ∈ A and x ∈ B}. when S is uncountable we must be somewhat more careful. the event that the ﬁrst coin is heads. the sets {HH. . We only deﬁne probabilities for events contained in B. Furthermore. A ∩ (B ∩ C) = (A ∩ B) ∩ C. heads and tails. . B is simply the collection of all subsets of S. (A ∩ B)c = Ac ∪ B c . . . A probability function assigns probabilities (numbers between 0 and 1) to events A in S. There are two outcomes. Associativity: A ∪ (B ∪ C) = (A ∪ B) ∪ C. is called a partition i=1 of S.. For any sample space S.. When S is the real line. A∪(B ∩ C) = (A ∪ B)∩(A ∪ C) . Communtatitivity: A ∪ B = B ∪ A.Appendix A Probability A. Continuing the two coin example. T }. When S is countable. then the collection A1 . one event is A = {HH. HT }... We call B the sigma algebra associated with S. Given S and B. The following are useful properties of set operations. A2 . Take the simple example of tossing a coin. If two coins are tossed in sequence. i=1 i=1 Some important properties of the probability function include the following • P (∅) = 0 165 . For example. A2 . including ∅ and S. S} which is known as the trivial sigma i=1 algebra.A set B is called a sigma algebra (or Borel ﬁeld) if ∅ ∈ B . then B is the collection of all open and closed intervals. let B be the smallest sigma algebra which contains all of the open sets in S. This is straightforward when S is countable. ∈ B implies ∪∞ Ai ∈ B. An event is a subset of S. HT } and {T H} are disjoint. A ∩ B = B ∩ A. / Complement: Ac = {x : x ∈ A}. if the sets A1 . are pairwise disjoint and ∪∞ Ai = S.

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

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

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

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

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

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

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

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

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

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

Theorem A. A) with A > 0. x ∈ Rk . Σ) and Y = a + BX with B an invertible matrix. k/2 1/2 2 (2π) det (ΣY ) where µY = a+Bµ and ΣY = BΣB 0 . Another useful fact is that if X ∼ N (µ. then Z 0 A−1 Z ∼ χ2 . exp − f (x) = k/2 1/2 2 (2π) det (Σ) The mean and covariance matrix of the distribution are µ and Σ. Q has the density f (y) = Γ 1 ¡r¢ 2 2r/2 yr/2−1 exp (−y/2) . the multivariate normal density is ¶ µ (x − µ)0 Σ−1 (x − µ) 1 . denoted χ2 . 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. 1). respectively. and it is conventional to write X ∼ N(µ. The mean and variance of the distribution are µ and σ 2 . then Σ = diag{σ 2 } is a diagonal matrix. then using the change-of-variables formula. where we used the fact that det (BΣB 0 )1/2 = det (Σ)1/2 det (B) . y ≥ 0. Ir ) and set Q = X 0 X. x ∈ Rk . (A. q × q.11) and is known as the chi-square density with r degrees of freedom.This density has all moments ﬁnite. ¢ ¡ 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 . the density of Y is Ã ! (y − µY )0 Σ−1 (y − µY ) 1 Y exp − f (y) = . The latter has no closed-form solution. Theorem A. and to denote the standard normal density function by φ(x) and its distribution function by Φ(x). we can also show that EX 2 = 1 and EX 4 = 3. Its mean and r variance are µ = r and σ 2 = 2r. then by the change-of-variables formula. then they are mutually independent.8. If Z is standard normal and X = µ + σZ. Σ). By iterated integration by parts. For x ∈ Rk . σ 2 ). Since it is symmetric about zero all odd moments are zero. This shows that if X is multivariate normal with uncorrelated elements. It is conventional to write X ∼ N (0.8. X has density Ã ! (x − µ)2 1 exp − . This shows that linear transformations of normals are also normal. q 176 .1 Let X ∼ N (0.2 If Z ∼ N(0. f (x) = √ 2σ 2 2πσ which is the univariate normal density. and it is conventional to write X ∼ N (µ. −∞ < x < ∞. If X ∈ Rk is multivariate normal and the elements of X are mutually uncorrelated.

For Z ∼ N(0. which we showed in (A.8. Set r Z .8.3 Let Z ∼ N (0. 1) the distribution of Z 2 is ¡ ¢ √ P Z 2 ≤ y = 2P (0 ≤ Z ≤ y) µ 2¶ Z √y 1 x √ exp − dx = 2 2 2π 0 Z y ³ s´ 1 ¡1¢ = s−1/2 exp − ds 1/2 2 0 Γ 2 2 1 ¡r¢ 2 2r/2 y r/2−1 exp (ty) exp (−y/2) dy of Q is (1 − 2t)−r/2 . 1). q Proof of Theorem A. Thus the density of Z 2 is (A. From (A. Then A−1 = C −10 C −1 and C −1 Z ∼ N (0.6) can be used to show that the MGF j=1 ¥ Proof of Theorem A.12) E exp (tQ) = 0 Γ (A.1. Proof of Theorem A.11) is Z ∞ ¢ ¡ Γ r+1 2 f (x) = ´ r+1 ¡r¢ ³ √ 2 2 πrΓ 2 1 + x r (A. tr = p Q/r The density of tr is and is known as the student’s t distribution with r degrees of freedom.11) 2 with r = 1. C −1 CC 0 C −10 ) = N (0. Thus ¥ ¡ ¢0 ¡ ¢ Z 0 A−1 Z = Z 0 C −10 C −1 Z = C −1 Z C −1 Z ∼ χ2 . (A. 1) and Q ∼ χ2 be independent.8. Using the simple law of iterated expectations.2. Since we can write Q = P 2 X 0 X = r Zj where the Zj are independent N(0. C −1 AC −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). tr has distribution 177 . which can be found by applying change-of-variables to the gamma function. The fact that A > 0 means that we can write A = CC 0 where C is non-singular. ¡ ¢ √ using the change—of-variables s = x2 and the fact Γ 1 = π. Iq ).3. The MGF for the density (A.11).8.13).Theorem A. we see that the MGF of Z 2 is (1 − 2t)−1/2 .

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

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

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

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

(Technically.9. θ0 ) →d N (0.3 Taking the ﬁrst-order condition for maximization of Ln (θ). θ0 ) + ' 0 ln f (Yi . ˆ = θ ∂θ i=1 n n ´ ³ X ∂ X ∂2 ˆ ln f (Yi . θ) . ¥ 182 . the ﬁnal equality using Theorem A. Together. θn ) = ln f (Yi . Ω) . then since θn →p θ0 we ﬁnd H(θn ) →p H and so ¶ n n µ ∂2 1X 1 X ∂2 − ln f (Yi . the speciﬁc value of θn varies by row in this expansion. ∂θ ∂θ∂θ i=1 i=1 θ where θn lies on a line segment joining ˆ and θ0 . ¯ ¯ ∂ Ln (θ)¯ 0 = ¯ ˆ ∂θ θ=θ n ³ ´ X ∂ ln f Yi . Let ∂2 H(θ) = − ∂θ∂θ0 ln f (Yi . − ln f (Yi . an application of the CLT yields 1 X ∂ √ ln f (Yi . θn ) ∂θ ∂θ∂θ0 i=1 i=1 ln f (Yi .9. θ0 ) . If it is continuous in θ.) Rewriting this equation.1 . Ω) = N 0.Proof of Theorem A. we ﬁnd ´ ³ ˆ − θ0 = θ Since ∂ ∂θ Ã !−1 Ã n ! n X ∂2 X ∂ ln f (Yi . ∂θ n i=1 n The analysis of the sample Hessian is somewhat more complicated due to the presence of θn . θ n ) θ − θ 0 . and making a ﬁrst-order Taylor series expansion. H −1 ΩH −1 = N 0. ´ ¡ ¢ ¡ ¢ √ ³ˆ n θ − θ0 →d H −1 N (0. H −1 . θn ) − H(θn ) + H(θn ) − n n ∂θ∂θ0 ∂θ∂θ0 i=1 i=1 →p H by an application of a uniform WLLN. θ0 ) is mean-zero with covariance matrix Ω.

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

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

A quadratic approximation evaluates the ﬁrst and second derivatives of Q(λ) with respect to λ. Furthermore.. For a review see Goﬀe. At each iteration. 1/4. Two popular methods are do to Davidson-Fletcher-Powell (DFP) and Broyden-Fletcher-Goldfarb-Shanno (BFGS). The half-step method considers the sequence λ = 1. The latter property is needed to keep the algorithm from selecting a local minimum. These methods are called Quasi-Newton methods. The SA method is a sophisticated random search. Let ∆gi = gi − gi−1 ∆θi = θi − θi−1 and . Newton’s method does not perform well if Q(θ) is irregular. Ferrier. 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 + + . In these cases. One example is the simplex method of Nelder-Mead (1965). Like the gradient methods. As the iterations continue. ¢2 0 ∆θ0 ∆gi ∆θ0 ∆gi ∆θ0 ∆gi ∆θi ∆gi i i i 0 ∆θi ∆θ0 Di−1 ∆gi ∆gi Di−1 i + . the methods are not well deﬁned when Q(θ) is non-diﬀerentiable. and Rodgers (1994). B. otherwise move to the next element in the sequence. This can be deﬁned by examining whether |θi − θi−1 | . . The SA method has been found to be successful at locating global minima. a random variable is drawn and added to the current value of the parameter. The SA algorithm stops when a large number of iterations is unable to improve the criterion. 0 0 ∆gi Di−1 ∆gi ∆θi ∆gi For any of the gradient methods. . 185 . 1/2.a one-dimensional optimization problem. use this value. 1/8.3 Derivative-Free Methods All gradient methods can be quite poor in locating the global minimum when Q(θ) has several local minima. If the criterion has improved over Q(θi ). The downside is that it can take considerable computer time to execute. the iterations continue until the sequence has converged in some sense. If the resulting criterion is decreased. There are two common methods to perform a line search. it relies on an iterative sequence. and it can be quite computationally costly if H(θ) is not analytically available. If the criterion is increased. |Q (θi ) − Q (θi−1 )| or |g(θi )| has become small. Each value in the sequence is considered and the criterion Q(θi + Di gi λ) evaluated.. A more recent innovation is the method of simulated annealing (SA). the variance of the random innovations is shrunk. alternative optimization methods are required. this new value is accepted. These problems have motivated alternative choices for the weight matrix Di . and picks λi as the value minimizing this approximation. it may still be accepted depending on the extent of the increase and another randomization.

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