## Are you sure?

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

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

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

1

Contents

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

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

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

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

. . . . . . . . . . .

i

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

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

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

. . . . . . . . . .

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

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

. . . . . . . .

ii

. . . . . . . . . . . . . . . . . . . . . . . . . . 11. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 Endogeneity 11. . . . . . . . . . . . . . . . . . . . . 12. . . . . . .2 GMM Estimator . . . . . . .9 Bootstrap GMM Inference . 12. . . . . . .1 Stationarity and Ergodicity . . . . . . . . . . .5 Numerical Computation . . . . .4 Testing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 101 102 103 104 106 106 107 107 108 109 110 111 112 113 114 117 117 119 120 121 121 124 125 126 127 127 128 129 130 133 135 135 137 137 138 138 139 140 140 141 142 142 143 9 Generalized Method of Moments 9. . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .12 8. . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . .6 Bekker Asymptotics . . . . . . . . .8. .4 Lag Operator . . . . . .6 Estimation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3 Identiﬁcation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . . . . . .7 Identiﬁcation Failure . . . . . . . . . . . . . . . . . . . .4 Estimation . . . .9 Trend Stationarity . . . . . . . . . . . .8 Bootstrap for Autoregressions . . 11. . . . . . . . . . . . . . . .1 Instrumental Variables .7 Asymptotic Distribution . . . . . .5 Stationarity of AR(k) . 12 Univariate Time Series 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .10Testing for Omitted Serial Correlation 12. . . . . . . .10 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5 Special Cases: IV and 2SLS 11. . . . . . . . . . . . . . . . . . . . . . . . . .9 8. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2 Autoregressions . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . .2 Asymptotic Distribution of EL Estimator 10. . . . . . . . . . . . . . 10. . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .13 One-Sided Tests . . . . . . . 10 Empirical Likelihood 10.11Model Selection . .3 Overidentifying Restrictions . . . . . . . . . . . . . . . . . . . . . 11. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .10 8. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Symmetric Two-Sided Tests . . . . . . . . . . . . . . . . . . . . . . . . 11. . .2 Reduced Form . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10. . . . . . . . . . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . . . . . . . . 9. . 9. . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . .8 Conditional Moment Restrictions . . . . . . . . . . . . . . . . . . . . . . . . .11 8. . . . . . . . 11. . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . . . . . . . . . 9. . . . . .1 Overidentiﬁed Linear Model . . . . . . . . . . . . . . . .6 Over-Identiﬁcation Test . . . . . . . . iii . . . . . . . . . . . . . . . . . .12Autoregressive Unit Roots . 9. . . . . . .3 Stationarity of AR(1) Process .4 Estimation of the Eﬃcient Weight Matrix . . . . . .1 Non-Parametric Likelihood . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11. . . .5 GMM: The General Case . . . . . . . . . . . . . . . . 10. . . . . . . . .8 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Percentile Conﬁdence Intervals . . . . . . . . 9. . .3 Distribution of GMM Estimator . . . . Bootstrap Methods for Regression Models Exercises . . . . . . . . . . . . . . . .7 Hypothesis Testing: The Distance Statistic 9. . . . . . . . . . . . . . . . 9. . . . . . . . . . .

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

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

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

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

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

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

A k × k identity matrix is denoted as ⎡ ⎤ 1 0 ··· 0 ⎢ 0 1 ··· 0 ⎥ ⎢ ⎥ Ik = ⎢ . ¸ B12 B22 ¸ A11 B12 + A12 B22 A21 B12 + A22 B22 ⎡ B1 B2 . . . ⎥ . which has ones on the diagonal. . ⎦ ⎣ . The columns of a k × r matrix A. 0 0 ··· 1 2. . A square matrix A is called orthogonal if A0 A = Ik . For example. 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 . Also. then AIr = A and Ik A = A.3 Trace The trace of a k × k square matrix A is the sum of its diagonal elements tr (A) = k X i=1 aii Some straightforward properties for square matrices A and B are tr (cA) = c tr (A) ¡ ¢ tr A0 = tr (A) tr (Ik ) = k. ⎤ ⎥ ⎥ ⎥ ⎦ 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. 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. . An important diagonal matrix is the identity matrix. . We say that two vectors a and b are orthogonal if a0 b = 0.

7 Also. . (2. .3) plus the following three conditions A− AA− = A− AA− is symmetric A− A is symmetric For any matrix A. if there is no c 6= 0 such that Ac = 0. The Moore-Penrose generalized inverse A− satisﬁes (2.1) .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 . then # ¡ ¢−1 ¡ ¢−1 ∙ ¸−1 " A − BD−1 C A B − A − BD−1 C BD−1 ¡ ¡ ¢−1 ¢−1 = . 0b 0b ak 1 ak 2 · · · a0 bk 1 a0 bk 2 . 2. If A − BD−1 C and D − CA−1 B are non-singular. In this case there exists a unique matrix B such that AB = BA = Ik . a0 bk k ⎤ ⎥ ⎥ ⎥ ⎦ a0 bi i b0 ai i = = tr (BA) . . The following fact about inverting partitioned matrices is sometimes useful. then A−1 = A. This matrix is called the inverse of A and is denoted by A−1 . .4 Inverse A k × k matrix A has full rank. or is nonsingular. if A is an orthogonal matrix. . we can still deﬁne a generalized inverse A− as a matrix which satisﬁes AA− A = A.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) The matrix A− is not necessarily unique. some properties include AA−1 = A−1 A = Ik ¡ ¢−1 ¡ −1 ¢0 = A0 A Even if a matrix A does not possess an inverse. For non-singular A and C. the Moore-Penrose generalized inverse A− exists and is unique. (2.

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

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

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

In this context it is often convenient These are nonparametric density estimates using a Gaussian kernel with the bandwidth selected by crossvalidation. To illustrate. While it is easy to observe that the two densities are unequal. ⎟ . These are indicated in Figure 3. The two density curves show the eﬀect of gender on the distribution of wages. and that for women is $20.1 displays the density1 of hourly wages for men and women. . m(x) can take any form. holding the other variables constant. xki 3. the conditioning variable.1) xi = ⎜ . Take a closer look at the density functions displayed in Figure 3. from the population of white non-military wage earners with a college degree and 10-15 years of potential work experience. the conditional density of yi given xi . the mean is not necessarily a good summary of the central tendency. which is a common feature of wage distributions. education and experience. In this context we partition the observations into the pair (yi . ⎠ ⎝ . These are conditional density functions — the density of hourly wages conditional on race.2) m(x) = E (yi | xi = x) = −∞ In general.73. the mean wage for men is $27. We call xi alternatively the regressor.22. or the covariates. An important summary measure is the conditional mean Z ∞ yf (y | x) dy. See Chapter 16. You can see that the right tail of then density is much thicker than the left tail. These are asymmetric (skewed) densities. Figure 3.Chapter 3 Regression and Projection The most commonly applied econometric tool is regression. it is useful to have numerical measures of the diﬀerence. (3.1 by the arrows drawn to the x-axis. This is used when the goal is to quantify the impact of one set of variables on another variable.1. gender. The data are from the 2004 Current Population Survey 1 11 .1. and exists so long as E |yi | < ∞. When a distribution is skewed. In the example presented in Figure 3. xi ) where yi is a scalar (real-valued) and xi is a vector. We list the elements of xi in the vector ⎞ ⎛ x1i ⎜ x2i ⎟ ⎟ ⎜ (3.1 Conditional Mean To study how the distribution of yi varies with the variables xi in the population. We call yi the dependent variable. we can focus on f (y | x) .

wage regressions typically use log wages as a dependent variable rather than the level of wages. Assuming for simplicity that this is the true joint distribution.Figure 3. which implies a 30% average wage diﬀerence for this population. The comparison in Figure 3. The main point to be learned from Figure 3. implying an average 36% diﬀerence in wage levels. This is a more robust measure of the typical wage gap between men and women than the diﬀerence in the untransformed wage means. Figure 3. with mean log hourly wages drawn in with the arrows.D. degree in mean log hourly wages is 0.1 is facilitated by the fact that the control variable (gender) is discrete. the solid line displays the conditional expectation of log wages varying with education. By construction. Figure 3.2) evaluated at the observed value of xi : ei = yi − m(xi ).A. Of particular interest to graduate students may be the observation that diﬀerence between a B. For this reason.3 displays a scatter plot2 of log wages against education levels.3 is how the conditional expectation describes an important feature of the conditional distribution. then comparisons become more complicated. 12 . To illustrate. 2 (3.2 Regression Equation The regression error ei is deﬁned to be the diﬀerence between yi and its conditional mean (3. The conditional expectation function is close to linear.2 shows the density of log hourly wages for the same population.36. 3.3) White non-military male wage earners with 10-15 years of potential work experience. this yields the formula yi = m(xi ) + ei . The diﬀerence in the log mean wage between men and women is 0. and a Ph.1: Wage Densities for White College Grads with 10-15 Years Work Experience to transform the data by taking the (natural) logarithm.30. When the distribution of the control variable is continuous.5. the dashed line is a linear projection approximation which will be discussed in the Section 3.

most typically. because no restrictions have been placed on the joint distribution of the data.2. E (ei | xi ) = 0. A regression model imposes further restrictions on the joint distribution. E (ei | xi ) = E ((yi − m(xi )) | xi ) = m(xi ) − m(xi ) = E (yi | xi ) − E (m(xi ) | xi ) = 0. E(xi ei ) = 0. The remaining parts of the Theorem are left as an exercise.Figure 3. not a model. 3. restrictions on the permissible class of regression functions m(x). E (h(xi )ei ) = 0 for any function h (·) . 4. To show the ﬁrst statement. are often stated jointly as the regression framework. 2.1 Properties of the regression error ei 1. These equations hold true by deﬁnition. It is important to understand that this is a framework.2: Log Wage Densities Theorem 3. The equations yi = m(xi ) + ei E (ei | xi ) = 0. E(ei ) = 0. 13 . by the deﬁnition of ei and the linearity of conditional expectations.

In contrast.3. The expected squared error using this prediction function is E (yi − g(xi ))2 = E (ei + m(xi ) − g(xi ))2 = Ee2 + 2E (ei (m(xi ) − g(xi ))) + E (m(xi ) − g(xi ))2 i = Ee2 + E (m(xi ) − g(xi ))2 i ≥ Ee2 i where the second equality uses Theorem 3.3 Conditional Variance Generally. when σ 2 (x) is a constant so that ¢ ¡ (3. A common measure of the dispersion is the conditional variance ¡ ¢ σ 2 (x) = V ar (yi | xi = x) = E e2 | xi = x . in the sense of achieving the lowest mean squared error.Figure 3. and can take any form. the conditional variance of yi is σ 2 = σ 2 (xi ).2. Given the random variable xi . The conditional standard deviation is its square root σ(x) = σ 2 (x). In the general case i where σ 2 (x) depends on x we say that the error ei is heteroskedastic. subject to the restriction p that it is non-negative. let g(x) be an arbitrary predictor of yi given xi = x. it does not provide information about the spread of the distribution.4) E e2 | xi = σ 2 i 14 While the conditional mean is a good measure of the location of a conditional distribution. Thus the mean squared error is minimized by the conditional mean.3: Conditional Mean of Wages Given Education The conditional mean also has the property of being the the best predictor of yi . σ 2 (x) is a non-trivial function of x. To see this. The right-hand-side is minimized by setting g(x) = m(x). 3.1. i .

we assume that x1i = 1. So while men have higher average wages. Instead.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 .9) 3. 3.1 and that for women is 10. Thus (3.8) is called the linear regression model.we say that the error ei is homoskedastic.6) (3. xki When m(x) is linear in x. they are also somewhat more dispersed. We call this the “constant” or “intercept”.8) (3. The conditional standard deviation for men is 12. its functional form is typically unknown. Equation (3. Equivalently.5) xi = ⎜ . βk ⎛ (3.4 Linear Regression An important special case of (3.7) is a k × 1 parameter vector.1). it is more realistic to view the linear speciﬁcation (3.3) is when the conditional mean function m(x) is linear in x (or linear in functions of x). take the conditional wage densities displayed in Figure 3. 15 . ⎟ β=⎝ .1) has been redeﬁned as the k × 1 vector ⎛ ⎞ 1 ⎜ x2i ⎟ ⎜ ⎟ (3. An important special case is homoskedastic linear regression model yi = x0 β + ei i E (ei | xi ) = 0 ¢ ¡ E e2 | xi = σ 2 . Notationally. which we derive in this section. This concept is less helpful than deﬁning heteroskedasticity as the dependence of the conditional variance on the observables xi . ⎠ . i (3. As an example. ⎝ . Some textbooks inappropriately describe heteroskedasticity as the case where “the variance of ei varies across observation i”.6) as an approximation.3) can be writen as yi = x0 β + ei i E (ei | xi ) = 0.5. we can write it as m(x) = x0 β = β 1 + x2i β 2 + · · · + xki β k where ⎞ β1 ⎜ . ⎠ . it is convenient to augment the regressor vector xi by listing the number “1” as an element. In this case (3.1. where x1i is the ﬁrst element of the vector xi deﬁned in (3. ⎟ . and the linear assumption of the previous section is empirically unlikely to accurate.

there cannot i exist a non-zero vector α such that α0 xi = 0 identically. α0 E (xi x0 ) α = E (α0 xi )2 > 0. i 16 .10) exists and is unique as long as the k ×k matrix E (xi x0 ) is invertible. we obtain a decomposition of yi into linear predictor and error yi = x0 β + ei . alternative expressions such as E xixi ) or E (xi yi ) (E (xi x0 ))−1 i ( i 0i ) are incoherent and incorrect. x0 β is the best linear predictor for yi . by “best” we mean the predictor function with lowest mean squared error. E (x0 xi ) < ∞. Therefore. Equivalently. 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 . This occurs when redundant variables are included in xi . E (xi x0 ) is invertible.1. i (3. this situation must be excluded.1 1. The error is i ei = yi − x0 β. The ﬁrst-order condition for minimization (from Section 2. Eyi < ∞. E (xi x0 ) is a mai E(x y trix and E (xi yi ) is a vector. 2 2. For any β ∈ Rk a linear predictor for yi is x0 β with expected squared prediction i error ¢2 ¡ S(β) = E yi − x0 β i ¢ ¢ ¡ ¡ 2 = Eyi − 2E yi x0 β + β 0 E xi x0 β.5.10) It is worth taking the time to understand the notation involved in this expression. i ∂β ¢¢−1 ¡ ¡ E (xi yi ) . Assumption 3. otherwise they are distinct. i 4. The best linear predictor is obtained by selecting β to minimize S(β). written E (xi x0 ) > 0. i which requires that for all non-zero α.7) is 0= Solving for β we ﬁnd ¡ ¢ ∂ S(β) = −2E (xi yi ) + 2E xi x0 β. Given the deﬁnition of β in (3. It is invertible if and only if it is positive deﬁnite. 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. In order for β to be uniquely deﬁned.10). Observe i that for any non-zero α ∈ Rk . 3.11) Notice that the error from the linear prediction equation ei is equal to the error from the regression equation when (and only when) the conditional mean is linear in xi . As before. Rewriting.12) This completes the derivation of the linear projection model.5. xi contains an intercept. We now summarize the assumptions necessary for its derivation and list the implications in Theorem 3. i (3.which is quadratic in β. The vector (3.

3 ensure that the moments in (3.5.1.4 we know that the regression error has the property E (xi ei ) = 0. Using the deﬁnitions (3.1. This means that the equation (3.1.14) holds.1 Under Assumption 3.1.1. i i i Since E (xi ei ) = 0 we say that xi and ei are orthogonal.13) summarize the linear projection model.5. Since from Theorem 3. However. (3. ¥ (3.5.5. (3.1.8)-(3. E (xi ei ) = 0 and E (ei ) = 0.1.13) implies that xi and ei are uncorrelated.12) and (3. x0 β is the i projection of yi on xi since the error ei is orthogonal with xi . Furthermore.1.2 and 3.4 guarantees that the solution β exits. 17 .1.4: Hourly Wage as a Function of Experience The conditions listed in Assumption 3.1.5.11) are well deﬁned.10) and (3.14) Proof.12) can be alternatively interpreted as a projection decomposition.5. By deﬁnition. Assumption 3. Assumption 3.14) follows from (3.4 is required to ensure that β is uniquely deﬁned.5. the converse is not true as the projection error does not necessarily satisfy E (ei | xi ) = 0. the orthogonality restriction (3.13) The two equations (3.9).2 and 3. Since ei is mean zero by (3.Theorem 3.11) and (3.5.13) and Assumption 3. it follows that linear regression is a special case of the projection model.5. Then i i Exi e2 = Ex3 = 0 yet E (ei | xi ) = x2 6= 0. For example. Let’s compare it with the linear regression model (3.1.3 are called regularity conditions. Assumption 3. Equation (3. Figure 3.2.5.14).1 are weak. suppose that for xi ∈ R that Ex3 = 0 and ei = x2 . Assumption 3. The ﬁnite variance Assumptions 3.10) are deﬁned.5.10) ¡ ¡ ¢¢ E (xi ei ) = E xi yi − x0 β i ¡ ¢¡ ¡ ¢¢−1 E (xi yi ) = E (xi yi ) − E xi x0 E xi x0 i i = 0.1 is employed to guarantee that (3.

We have shown that under mild regularity conditions. it is important to not misinterpret the generality of this statement. Returning to the joint distribution displayed in Figure 3.10) may not hold and the implications of Theorem 3. In this example the linear projection is a close approximation to the conditional mean. The linear equation (3.10). for those over 53 in age). In other cases the two may be quite diﬀerent. However.5. The solid line is the conditional mean.12) with the properties listed in Theorem 3. This defect in linear projection can be partially corrected through a careful selection of regressors. xi ) we can deﬁne a linear projection equation (3. and the straight dashed line is the linear projection.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. 18 . Figure 3.1. It over-predicts wages for young and old workers. In this example it is a much better approximation to the conditional mean than the linear projection.3. the dashed line is the linear projection of log wages on eduction. it misses the strong downturn in expected wages for those above 35 years work experience (equivalently.4 we display as well this quadratic projection. In contrast. we can augment the regressor vector xi to include both experience and experience2 .5 for a 3 In the population of Caucasian non-military male wage earners with 12 years of education. We illustrate the issue in Figure 3.4 displays the relationship3 between mean log hourly wages and labor market experience. Other than the redeﬁnition of the regressor vector. Figure 3. since the resulting function is quadratic in experience. In this case (3. Most importantly. for any pair (yi .5. and are discussed in Chapter 11. A projection of log wages on these two variables can be called a quadratic projection. in many economic models the parameter β may be deﬁned within the model. In the example just presented. there are no changes in our methods or analysis. In this case the linear projection is a poor approximation to the conditional mean. No additional assumptions are required. and under-predicts for the rest. These structural models require alternative estimation methods. In Figure 1.12) is deﬁned by projection and the associated coeﬃcient deﬁnition (3.1 may be false.

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

Take the bivariate linear projection model yi = β 0 + β 1 xi + ei E (ei ) = 0 E (xi ei ) = 0 Deﬁne µy = Eyi . Compute the conditional mean m(x) = E (yi | xi = x) . xi ∈ R. xi ∈ R. 3. Are they diﬀerent? Hint: If P (Y = j) = 5. 9. E(ei | xi ) = 0.. If yi = x0 β + ei . Deﬁne µ ¶ ¢ ¡ x−µ 2 g x. 2. Show that x y β 1 = σ xy /σ 2 and β 0 = µy − β 1 µx . If yi = x0 β + ei and E(xi ei ) = 0. i 10. then E(ei | xi ) = 0. Compute E(yi | xi = x) and V ar(yi | xi = x). j! 0 j = 0. True or False. s) = 0 if and only if m = µ and s = σ 2 . If yi = xi β + ei .6 Exercises 1.2. σ = . (x − µ)2 − σ 2 Show that Eg (X. If yi = x0 β + ei and E(ei | xi ) = 0. then E(x2 ei ) = 0. σ 2 = V ar(yi ) and σ xy = Cov(xi . then ei is independent of xi . ¡ ¢ 4.2 Y =1 . and E(e2 | xi ) = σ 2 . then E(x2 ei ) = 0. yi ).3 Find E(Y | X = x). and the conditional distribution of yi given xi is Poisson: P (yi = k | xi = x) = e−x β (x0 β)j . i 11. y) = 3 x2 + y 2 on 0 ≤ x ≤ 1.. and E(ei | xi ) = 0. and have the following joint probability distribution X=0 X=1 Y =0 . E(Y 2 | X = x) and V ar(Y | X = x). True or False. Does this justify a linear regression model of the form yi = x0 β + εi ? i then EY = λ and V ar(Y ) = λ. If yi = xi β + ei . 0 ≤ y ≤ 1. Compute 2 the coeﬃcients of the linear projection yi = β 0 + β 1 xi + ei . σ 2 = V ar(xi ). True or False. Prove parts 2. i 8. e−λ λj j! . 20 . a constant. 1. µ. Suppose that yi is discrete-valued.1 . then ei is i i independent of xi . µx = Exi .4 . Let xi and yi have the joint density f (x.3. Let X be a random variable with µ = EX and σ 2 = V ar(X). 2. 3 and 4 of Theorem 3. and E(xi ei ) = 0. x 6. . Suppose that Y and X only take the values 0 and 1.1. i 7. m. taking values only on the non-negative integers. True or False. True or False.

but for most of the chapter we retain the broader focus on the projection model.4) i i=1 i=1 ˆ Another way to derive β is as follows.3) with the sample moments: ³ ¡ ¢´−1 ˆ ˆ ˆ β = E xi x0 E (xi yi ) i Ã n !−1 n 1X 1X 0 xi xi xi yi = n n i=1 i=1 Ã n !−1 n X X = xi x0 xi yi .Chapter 4 Least Squares Estimation This chapter explores estimation and inference in the linear projection model yi = x0 β + ei i E (xi ei ) = 0 ¡ ¡ ¢¢−1 E (xi yi ) β = E xi x0 i (4.8.1) (4.3) In Sections 4. Observe that (4.2) can be written in the parametric 0 β)) = 0. 4. The function g(β) can be estimated by form g(β) = E (xi (yi − xi g (β) = ˆ ¢ 1X ¡ xi yi − x0 β . i n i=1 n 21 . (4.1 Estimation Equation (4.2) (4. Their moment estimators are the sample moments i ˆ E (xi yi ) = ¢ ¡ ˆ E xi x0 = i 1X xi yi n 1 n i=1 n X i=1 n xi x0 .7 and 4. we narrow the focus to the linear regression model. i It follows that the moment estimator of β replaces the population moments in (4.3) writes the projection coeﬃcient β as an explicit function of population moments E (xi yi ) and E (xi x0 ) .

170 37. This sample has 988 observations. To illustrate. 4. Let yi be log wages and xi be an intercept and years of education. Deﬁne the sum-of-squared errors (SSE) function n X¡ ¢2 yi − x0 β Sn (β) = i i=1 = This is a quadratic function of β. 40 2. n X i=1 2 yi − 2β 0 n X i=1 xi yi + β 0 n X i=1 xi x0 β.40 n i=1 1 n Thus ˆ β = n X i=1 xi x0 i = µ 1 14.14 205. Then µ ¶ n 1X 2.71 = −2.30 + 0. excluding military.4).14 205.117 Educationi .95 42. The estimator β is the value which jointly sets these equations equal to zero: 0 = g (β) ˆ ˆ n ´ 1X ³ ˆ xi yi − x0 β = i n i=1 (4. ¶ 2. An interpretation of the estimated equation is that each year of education is associated with an 11.4).37 µ ¶ 1.117 1 14. i 22 .95 xi yi = 42. with 10-15 years of potential work experience. 40 0.83 µ We often write the estimated equation using the format \ log(W agei ) = 1.ˆ This is a set of k equations which are linear in β. consider the data used to generate Figure 3.5) = n n 1X 1X ˆ xi yi − xi x0 β i n n i=1 i=1 whose solution is (4.2 Least Squares There is another classic motivation for the estimator (4. These are white male wage earners from the March 2004 Current Population Survey.83 ¶−1 µ ¶ . 0.7% increase in mean wages. 30 = .40 µ ¶µ ¶ 34.94 −2.14 14.14 14.3.

2 displays the contour lines of the same function — horizontal slices at equally spaced heights. Figure 4. i ˆ ˆ Note that yi = yi + ei . we deﬁne the predicted value ˆ yi = x0 β ˆ i and the residual ˆ ei = yi − yi ˆ ˆ = yi − x0 β. It is important to understand the distinction between the error ei and the residual ei . The error is unobservable.4). Following convention we will call β the OLS estimator of β.7) gives the ﬁrst-order conditions for minimization: 0 = ∂ ˆ Sn (β) ∂β n n X X ˆ = −2 xi yi + 2 xi x0 β i i=1 i=1 ˆ whose solution is (4. the contour lines are ellipses. while the residual is a by-product of estimation.The Ordinary Least Squares (OLS) estimator is the value of β which minimizes Sn (β). Since the function Sn (β) is a quadratic function of β.1 displays an example sum—of-squared errors function Sn (β) for the case k = 2. These two ˆ variables are frequently mislabeled. To visualize the sum-of-squared errors function.1: Sum-of-Squared Errors Function As a by-product of OLS estimation. Figure 4. Figure 4. Matrix calculus (see Appendix 2. 23 . which can cause confusion.

7) A justiﬁcation for the latter choice will be provided in Section 4.7. ˆ n i=1 n Since xi contains a constant. ˆ σ = ˆ n 2 i=1 n (4.2: Sum-of-Squared Error Function Contours Equation (4.6) An alternative estimator uses the formula n 1 X 2 s = ei . These are algebraic results. Its method of moments estimator is the sample average 1X 2 ei . The error variance σ 2 = Ee2 is also a parameter of interest. one implication is that n 1X ei = 0. 24 .Figure 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.5) implies that 1X xi ei = 0. It measures the variation in the i “unexplained” part of the regression. ˆ n−k 2 i=1 (4. and hold true for all linear regression estimates.

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

ˆ ˆˆ ˆ A useful result is obtained by inserting Y = Xβ + e into the formula for β to obtain ¢ ¡ 0 ¢−1 ¡ 0 ˆ X (Xβ + e) β = XX ¡ ¢−1 ¡ 0 ¢ ¡ 0 ¢−1 0 Xe X Xβ + X 0 X = XX ¡ 0 ¢−1 0 X e. σ 2 ) for the normal ˆ regression model are identical to the method of moment estimators. The linear equation (3. one for each observation. n X i=1 Thus the estimator (4. .Maximization with respect to σ 2 yields the ﬁrst-order condition n X ∂ n 1 ˆ ˆ Ln (β. 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. and X is an n × k matrix. . the ˆ OLS estimator β is frequently referred to as the Gaussian MLE. ⎝ ⎝ . ⎠ .4 Model in Matrix Notation convenient to write the model and statistics in x0 1 x0 2 . ⎟. ⎠ xi x0 = X 0 X i xi yi = X 0 Y. yn ⎟ ⎟ ⎟. including computation. ⎠ ⎜ ⎜ e=⎜ ⎝ ⎟ ⎟ ⎟. We deﬁne ⎛ ⎞ ⎛ y1 ⎜ ⎜ y2 ⎟ ⎜ ⎟ ⎜ X=⎜ Y = ⎜ . Due to this equivalence. yn = x0 β + en . residual vector. en ⎞ Observe that Y and e are n × 1 vectors. it is matrix notation. 4. Sample sums can also be written in matrix notation. . n or equivalently Y = Xβ + e. x0 n ⎞ ⎛ e1 e2 . σ 2 ) = − 2 + ¡ ¢2 e2 = 0. ˆi 2 ∂σ 2 2ˆ σ 2 σ ˆ i=1 ˆ ˆ Solving for σ 2 yields the method of moments estimator (4. For example n X i=1 For many purposes. Thus the MLE (β. .8) . . = β+ XX 26 (4.4).12) is a system of n equations.6). . We can stack these n equations together as y1 = x0 β + e1 1 y2 = x0 β + e2 2 .

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

Regress Y on X1 . ⎟ ⎜ ⎟ ⎜ (4. 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. the FWL theorem can be used to speed computation. Regress Y on X2 .Theorem 4. which you may have seen in an introductory econometrics course.9). ¡ ¢−1 0 ι. A common application of the FWL theorem.9). Partition X = [X1 X2 ] where X1 = ι is a vector of ones.8)(3.13). 4. Rather. . 30 . . is the demeaning formula for regression. . In this case. ˜ 2. Regress X2 on X1 . .6. but in most cases there is little computational advantage to using the two-step algorithm. . obtain OLS estimates β 2 and residuals e.1 (Frisch-Waugh-Lovell). . . the primary use is theoretical.14) or via the ˆ following algorithm: ˜ 1. observe that ⎞ ⎛ ⎞ ⎛ . ⎠ ⎝ ⎠ ⎝ . In the model (4.7 Bias and Variance In this and the following section we consider the special case of the linear regression model (3. ˆ ˜ ˜ ˆ 3. 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. .18) E (e | X) = ⎜ E (ei | X) ⎟ = ⎜ E (ei | xi ) ⎟ = 0. obtain residuals X2 . ! Thus the OLS estimator for the slope coeﬃcients is a regression with demeaned data. In some contexts. . . The FWL theorem says that β 2 is the OLS estimate from a regression of ˜ ˜ Y on X2 . By the independence of the observations and (3. obtain residuals Y . or yi − y on x2i − x2 : ˆ β2 = Ã n X i=1 (x2i − x2 ) (x2i − x2 ) 0 !−1 Ã n X i=1 (x2i − x2 ) (yi − y) . In this section we derive the small sample conditional mean and variance of the OLS estimator. and X2 is the vector of observed regressors.

⎠ (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 . for any random vector Z deﬁne the covariance materix V ar(Z) = E (Z − EZ) (Z − EZ)0 = EZZ 0 − (EZ) (EZ)0 . We have shown that which implies ³ ´ ˆ E β|X =β ³ ´ ˆ E β =β (4.19) ˆ and thus the OLS estimator β is unbiased for β.. X 0 DX = X 0 Xσ 2 . . the properties of conditional expectations.8). .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 . ¡ 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. σ 2 = σ 2 and we have the simplii ﬁcations D = In σ 2 . the properties additional assumption of conditional homoskedasticity E ei i of projection matrices. σ 2 } = ⎜ . V ar β | X = X 0 X ⎟ ⎟ ⎟.18). and the trace operator observe that. . From (4.20) . and ³ ´ ¡ ¢−1 2 ˆ σ . . 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 = 0.12). . Next. 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.. . 0 0 ··· 0 0 . σ2 n ⎞ We now calculate the ﬁnite sample bias of the method ¡ moments estimator σ 2 for σ 2 . .Using (4.. 1 n . under the of ˆ ¢ 2 | x = σ 2 . and (4.. ⎝ . Then given (4.

or in the projection model.8)¢ ¡ (3. ˜ β L = A0 Y = A (Xβ + e) = β + Ae. As an alternative. Theorem 4. 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. says that the least-squares estimator is the best choice.8. This is the justiﬁcation for the common s ˆ preference of s2 over σ 2 in empirical practice. and thus can be written as ˜ β = A0 Y where A is an n × k function of X.8 Gauss-Markov Theorem In this section we restrict attention to the homoskedastic linear regression model. Thus σ 2 is biased towards zero. Thus since V ar (e | X) = In σ 2 under homoskedasticity. In this case. which we now present. that this estimator is only unbiased in the special case of the homoskedastic linear regression model.1 Gauss-Markov.7) is unbiased for σ 2 by this calculation. known as the Gauss-Markov theorem. 4.10). By a calculation similar to those of the previous section. ³ ´ ˜ E β | X = A0 Xβ. however. ˜ so β is unbiased if (and only if) A0 X = Ik .9) plus E e2 | xi = σ 2 .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 . ³ ´ ˜ V ar β | X = A0 V ar (e | X) A = A0 Aσ 2 . What is the best choice of A? The Gauss-Markov theorem. the estimator ˆ 2 deﬁned (4. the best (minimumvariance) unbiased linear estimator is OLS. Now consider the class of estimators of β which are linear functions of i the vector Y. 32 . which is (3. = σ2 n the ﬁnal equality by (4. The least-squares estimator is the special case obtained by setting A = X(X 0 X)−1 . is a famous statement of the solution. as it yields the smallest variance among all unbiased linear estimators. In the homoskedastic linear regression model. It is important to remember. It is not unbiased in the absence of homoskedasticity. The following result.

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

the maximum likelihood estimator is identical to the OLS estimator. Let the regressors be partitioned as Suppose we are interested in the coeﬃcient on x1i alone in the regression of yi on the full set xi .1. and thus so is the OLS estimator.5. He proves that generically the OLS estimator (4. 1X xi x0 i n i=1 1X xi yi n i=1 n ˆ = β ols 4. and any continuous distribution can be arbitrarily well approximated by a multinomial distribution. 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. Since this is a regular parametric model the MLE is asymptotically eﬃcient (see Appendix A.22) 34 . We can write the model as yi = x0 β 1 + x0 β 2 + ei 1i 2i E (xi ei ) = 0 where the parameter of interest is β 1 . (4.9). He observes that the above argument holds for all multinomial distributions.Substituting in the expressions for π j .10 Omitted Variables xi = µ x1i x2i ¶ .4) is an asymptotically eﬃcient estimator for the parameter β deﬁned in (3. if the data have a discrete distribution. Chamberlain (1987) extends this argument to the case of continuously-distributed data.10) for the class of models satisfying Assumption 3.

because we have not said what it means for a matrix to be “near singular”. when the columns of X are close to linearly dependent. the general model will be free of the omitted variables problem.23) the short regression to emphasize the distinction. In this case. log(p2 ) and log(p1 /p2 ). This happens when the columns of X are linearly dependent. except in special cases. 4.22) by least-squares. there is some α such that Xα = 0. the possibility of omitted variables bias should be acknowledged and discussed in the course of an empirical investigation. Most commonly. we regress yi on x1i only. log(p1 ). 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. β 1 6= γ 1 .Now suppose that instead of estimating equation (4.23) where is the coeﬃcient from a regression of x2i on x1i . First.22). the regression of x2i on x1i yields a set of zero coeﬃcients (they are uncorrelated). In general. 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 . this is rarely a problem for applied econometric practice. Observe that γ 1 6= β 1 unless Γ = 0 or β 2 = 0. It is the consequence of omission of a relevant correlated variable. least-squares estimation of (4.22) the long regression and (4. To see this.11 Multicollinearity ˆ If rank(X 0 X) < k + 1. This deﬁnition is not precise. Typically there are limits. By construction. Since the error is discovered quickly. and the error as ui rather than ei . When this happens.22) is zero. which is often called “multicollinearity” for brevity.e. Goldberger (1991) calls (4.. This is called strict multicollinearity. the applied researcher quickly discovers the error as the statistical software will be unable to construct (X 0 X)−1 . the coeﬃcient on x2i in (4. this arises when sets of regressors are included which are identically related. i. Thus the short and long regressions have the same coeﬃcient on x1i only under one of two conditions. This is because the model being estimated is diﬀerent than (4. To avoid omitted variables bias the standard advice is to include potentially relevant variables in the estimated model. This is the situation when the X 0 X matrix is near singular. as many desired variables are not available in a given dataset. or second. then β is not deﬁned. if X includes both the logs of two prices and the log of the relative prices. This is one diﬃculty with the deﬁnition and interpretation of multicollinearity. The diﬀerence Γβ 2 is known as omitted variable bias. Typically.23) is an estimate of γ 1 = β 1 + Γβ 2 rather than β 1 . The more relevant issue is near multicollinearity. 35 . For example.

−i = yi − x0 β (−i) = (1 − hi )−1 ei . In extreme cases it is possible that the reported calculations will be in error due to ﬂoating-point calculation diﬃculties. ˆ i A simple comparison yields that ˆ ei − ei.25) below. deﬁne the leave-one-out least-squares estimator of β.One implication of near singularity of matrices is that the numerical reliability of the calculations is reduced. A convenient alternative expression is ¡ ¢−1 ˆ ˆ xi ei ˆ (4.27) (4. it is statistically diﬃcult to disentangle the impact of β 1 from that of β 2 . What is happening is that when the regressors are highly dependent. If the i’th observation 36 . We can see the eﬀect of collinearity on precision by observing that the asymptotic variance of a coeﬃcient ¡ ¢−1 approaches inﬁnity as ρ approaches 1. We can also deﬁne the leave-one-out residual ˆ ˆ ei. ˆ ˆ (4. since as ρ approaches 1 the matrix becomes singular. This equals ´−1 ³ 0 ˆ X(−i) Y(−i) (4. Thus the more “collinear” are the estimate σ 2 1 − ρ2 regressors. the worse the precision of the individual coeﬃcient estimates. A more relevant implication of near multicollinearity is that individual coeﬃcient estimates will be imprecise. and 1 0 XX= n µ 1 ρ ρ 1 ¶ In this case The correlation ρ indexes collinearity.−i = (1 − hi )−1 hi ei . We can see this most simply in a homoskedastic linear regression model with two regressors yi = x1i β 1 + x2i β 2 + ei . As a consequence. 1] and sum to k.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.26) As we can see.12 Inﬂuential Observations where X(−i) and Y(−i) are the data matrices omitting the i’th row.24) β (−i) = X(−i) X(−i) is the i’th diagonal element of the projection matrix X (X 0 X)−1 X 0 . µ ¶−1 µ ¶ ³ ´ 2 σ2 1 ρ 1 −ρ ˆ|X = σ . To investigate the possibility of inﬂuential observations. The hi take values in [0. the change in the coeﬃcient estimate by deletion of the i’th observation depends critically on the magnitude of hi . = V ar β ρ 1 n n (1 − ρ2 ) −ρ 1 4. that is. We derive expression (4. the precision of individual estimates are reduced. the OLS estimator based on the sample excluding the i’th observation.

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

4.13

Exercises

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

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

Pn

i=1 g

¡ ¢ Xi , µ, σ 2 .

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

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

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

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

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

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

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

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

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

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

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

39

(f) (g) (h)

Pn

Pn

ˆˆ i=1 yi ei ˆ2 i=1 ei R2

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

40

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

Let U = |X|p /E |X|p and V = |Y |q /E |Y |q . p p p q which is (5. 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}. ¥ Proof of Holder’s Inequality. We say that Zn converges in probability to Z as n → ∞.1 Weak Law of Large Numbers (WLLN). then as n → ∞ n 1X Xn = Xi →p E(X). n i=1 42 . Eg(X) ≥ a + bEX = g(EX).4) Proof of Jensen’s Inequality. as stated. (5. tangent lines lie below it. For any strictly increasing function g(X) ≥ 0.Markov’s Inequality. if for all δ > 0. g(x) ≥ a + bx yet g(EX) = a + bEX since the curve is tangent at EX. =E U V p q p q Proof of Markov’s Inequality. So for all x. The WLLN shows that sample averages converge in probability to the population average.2 Weak Law of Large Numbers Let Zn ∈ Rk be a random vector. Since g(x) is convex.3). If Xi ∈ Rk is iid and E |Xi | < ∞. Note EU = EV = 1. P (g(X) > α) ≤ α−1 Eg(X). ¥ 5. (E |X|p )1/p (E |Y |q )1/q ¥ µ ¶ ´ ³ U V 1 1 1/p 1/q ≤E + = + = 1. Theorem 5. Since 1 + 1 = 1 an application of Jensen’s inequality shows that p q U Then 1/p V 1/q 1 1 ln U + ln V = exp p q E |XY | ∙ ¸ ≤ 1 1 U V exp (ln U ) + exp (ln V ) = + . Set Y = g(X) and let f denote the density function of Y. Applying expectations. This is a probabilistic way of generalizing the mathematical deﬁnition of a limit. n→∞ lim P (|Zn − Z| > δ) = 0.2. denoted Zn →p Z as n → ∞. Let a + bx be the tangent line to g(x) at x = EX.

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

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

Σ) = N 0. ¥ 5. where θ is m × 1 and Σ is m × m.√ where λn → 0 lies on the line segment joining 0 and λ/ n. Σ) .4. √ Theorem 5. Stacking across elements of g. Since cλλ (λn ) → cλλ (0) = −Ik . Recall that A ⊂ B implies P (A) ≤ P (B). for each element of g. then g(Zn ) →d g(Z) as n → ∞.1 Continuous Mapping Theorem 1 (CMT). Ik ) distribution. gθ Σgθ . Thus P (|g (Zn ) − g (c)| ≤ ε) ≥ P (|Zn − c| < δ) → 1 as n → ∞ by the assumption that Zn →p c. Theorem 5. Hence g(Zn ) →p g(c) as n → ∞. If Zn →p c as n → ∞ and g (·) is continuous at c.2 Continuous Mapping Theorem 2. we ﬁnd jn ¢ ¡ √ √ 0 n (g (θn ) − g(θ0 )) = (gθ + an ) n (θn − θ0 ) →d gθ N (0. for all ε > 0 we can ﬁnd a δ > 0 such that if |Zn − c| < δ then |g (Zn ) − g (c)| ≤ ε. gj (θn ) = gj (θ0 ) + gjθ (θ∗ ) (θn − θ0 ) jn where θnj lies on the line segment between θn and θ0 and therefore converges in probability to θ0 .4.4. It follows that ajn = gjθ (θ∗ ) − gjθ →p 0. µ ¶ 1 Cn (λ) → exp − λ0 λ 2 the characteristic function of the N (0.3 Delta Method: If n (θn − θ0 ) →d N (0. If Zn →d Z as n → ∞ and g (·) is continuous. k ≤ m. Proof : By a vector Taylor series expansion. then ¡ ¢ √ 0 n (g (θn ) − g(θ0 )) →d N 0. Proof: Since g is continuous at c. gθ Σgθ where gθ (θ) = ∂ g(θ) ∂θ0 and gθ = gθ (θ0 ). and g(θ) : Rm → Rk .4 Asymptotic Transformations Theorem 5. then g(Zn ) →p g(c) as n → ∞. we see that as n → ∞. This is suﬃcient to establish the theorem. 45 .

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

(6.1). 6. n i=1 (6. xi ei = g i n n i=1 i=1 1X xi ei →p E (xi ei ) = 0. As the sample size increases the density becomes more concentrated about the population coeﬃcient. b) = A−1 b is a continuous function of A and b at all values of the arguments such that A−1 exist.5. Equation (4. 0).2. using (6.1 and the WLLN (Theorem 5.3).1 by the fact that the sampling densities become more concentrated as n gets larger. Hence by the continuous mapping theorem (Theorem 5. For a complete argument. ˆ 47 .1) and ˆ We now deduce the consistency of β. Ã n ! n X 1X 0 1 ˆ xi xi . (6. xi ei →p g (Q. the OLS estimator β is has a statistical distribution which is unknown. β →p β as n → ∞. and the continuous mapping theorem (Theorem 5.1).1.2) i i n i=1 n From (6.1). ¥ We can similarly show that the estimators σ 2 and s2 are consistent for σ 2 .2. This is illustrated in Figure 6.4 implies that Q−1 exists and thus g(·. Asymptotic (large sample) methods approximate sampling distributions based on the limiting experiment that the sample size n tends to inﬁnity.4. Assumption 3. (6. To characterize the sampling distribution more fully.1). 0) = Q−1 0 = 0 β−β =g n n i=1 i=1 ˆ which implies β →p β as stated.1.4.3) Ã where g(A. Assumption 3. ·) is continuous at (Q.2). First. we will use the methods of asymptotic approximation.From the ﬁgure we can see that the density functions are dispersed and highly non-normal.8) implies that ˆ β−β = Ã n X i=1 xi x0 i !−1 n X i=1 xi ei . Proof. we can write !−1 Ã n ! n 1X 1X 0 ˆ β−β = xi xi xi ei n n i=1 i=1 Ã n ! n X X 1 1 xi x0 .1) imply that n ¡ ¢ 1X xi x0 →p E xi x0 = Q (6. ˆ Theorem 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.2 Consistency ˆ As discussed in Section 6.5.1 Under Assumption 3.5.1. we can conclude ˆ that β →p β.

2. by the Cauchy-Schwarz inequality (5.3) and Theorem (6. Thus σ 2 is consistent for σ 2 .1. i i Assumption 6. Note that ˆ ei = yi − x0 β ˆ i i Thus and n ˆ = ei + x0 β − x0 β i i ³ ´ ˆ = ei − x0 β − β .2). E ¯ei ¯ E ¯e4 ¯ i i i i (6. ´1/2 ¡ ¯ ¯¢ ¯ ³ ¯ ¯2 ´1/2 ¡ ¯ 4 ¯¢1/2 ³ ¯ 1/2 E ¯xi x0 e2 ¯ ≤ E ¯xi x0 ¯ = E |xi |4 < ∞. ˆ Finally. (6.5. We need a strengthening of the moment conditions. ˆ n−k 6.1). since n/(n − k) → 1 as n → ∞. Ee4 < ∞ and E |xi |4 < ∞. i Now deﬁne ¡ ¢ Ω = E xi x0 e2 . n 1 X √ xi ei →d N (0. ˆ Proof.6) n i=1 48 .3 Asymptotic Normality ˆ We now establish the asymptotic distribution of β after normalization.1. Assumption 6. By the central limit theorem (Theorem 5.2.3.1 In addition to Assumption 3.5) Thus xi ei is iid with mean zero and has covariance matrix Ω.5.3. it follows that s2 = ¥ n σ 2 →p σ 2 . σ 2 →p σ 2 and s2 →p σ 2 as n → ∞. (6. (6. Ω) .3.4) ³ ´ ³ ´0 ³ ´ ˆ ˆ ˆ e2 = e2 − 2ei x0 β − β + β − β xi x0 β − β ˆi i i i σ2 = ˆ 1X 2 ei ˆ n i=1 i=1 →p σ 2 n 1X 2 = ei − 2 n 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.1).2).Theorem 6. (6.2 Under Assumption 3.1 guarantees that the elements of Ω are ﬁnite. To see this.

3. As α approaches 2. after rescaling. 1) asymptotic distibution. e2 ) = 0. 1 X √ xi ei n i=1 n ! the N (0. |ε| ≥ 1.1 Under Assumption 6. as n → ∞ ´ √ ³ ˆ n β − β →d N (0. the normal approximation is arbitrarily poor for some data distribution satisfying the assumptions. i i Condition (6. However. When (6. but this is not a necessary condition. its variance diverges q ³ ´ ˆ to inﬁnity. We call V 0 the homoskedastic covariance matrix. ´ √ ³ˆ As V is the variance of the asymptotic distribution of n β − β . for any ˆ ﬁxed n the sampling distribution of β can be arbitrarily far from the normal distribution.6).3. however. This holds true for all joint distibutions of (yi .Then using (6.1 states that the sampling distribution of the least-squares estimator. xi ) which satisfy the conditions of Assumption 6.2). is approximately normal when the sample size n is suﬃciently large.3. In´Figure 6.9) In (6. there is no simple answer to this reasonable question. Theorem 6.7) Cov(xi x0 . and εi is independent of xi with the Double Pareto density f (ε) = α |ε|−α−1 .7) the asymptotic variance formulas simplify as ¡ ¢ ¡ ¢ (6.1. The asymptotic distribution ´ Theorem 6.2 we display the ﬁnite sample densities of the q ³ ˆ normalized estimator n α−2 β 2 − β 2 . The expression V = Q−1 ΩQ−1 is called a sandwich form. Let yi = β 0 + β 1 xi + εi where xi is N (0. 1).3. There is a special case where Ω and V simplify.1).1 is commonly used to approximate the ﬁnite of √ ³ˆ sample distribution of n β − β . ´ √ ³ ˆ n β−β = Ã 1X xi x0 i n i=1 n !−1 Ã Theorem 6. For α 49 .3. In this context the normalized least-squares slope estimator n α−2 β 2 − β 2 has α →d Q−1 N (0. V ) where V = Q−1 ΩQ−1 . for example.7) holds.9) we deﬁne V 0 = Q−1 σ 2 whether (6. setting n = 100 and varying the parameter α. If α > 2 the 2 error εi has zero mean and variance α/(α − 2).7) is true or false. We say that ei is a Homoskedastic Projection Error when (6. when xi and ei are independent. The trouble is that no matter how large is the sample size.1 we have already seen a simple example where the least-squares estimate is quite asymmetric and non-normal even for reasonably large sample sizes. (6. otherwise V 6= V 0 . and (6.8) Ω = E xi x0 E e2 = Qσ 2 i i V = Q−1 ΩQ−1 = Q−1 σ 2 ≡ V 0 (6. The approximation may be poor when n is small. Q−1 ΩQ−1 . We illustrate this problem using a simulation. V is often referred to as ˆ the asymptotic covariance matrix of β. How large should n be in order for the approximation to be useful? Unfortunately. In Figure 6.7) is true then V = V 0 . Ω) ¡ ¢ = N 0.1. Under (6.

4. The homoskedastic covariance matrix V 0 = Q−1 σ 2 is typically estimated by ˆ ˆ (6. Here the model is yi = β 1 + εi where uk − Euk i i εi = ³ ¡ k ¢2 ´1/2 Eu2k − Eui i ´ √ ³ˆ and ui ∼ N (0.4 Let Covariance Matrix Estimation 1X ˆ xi x0 Q= i n i=1 n be the method of moments estimator for Q. Another example is shown in Figure 6.3.1) it is clear that V 0 →p V 0 . The MME estimator is i i 1X ˆ xi x0 e2 Ω= i ˆi n i=1 n (6. The estimator 2 2 in (6. ˆ ˆ Since Q →p Q and s2 →p σ 2 (see (6.10) V 0 = Q−1 s2 . concentrating most of the probability mass around zero. 6 and 8. for k = 1.2.2) and Theorem 6. As k increases. 1) asymptotic approximation is never guaranteed to be accurate. The lesson from Figures 6.2 and 6.3 is that the N (0.2: Density of Normalized OLS estimator α = 3. 1). σ may also be substituted for s ˆ ¡ ¢ To estimate V = Q−1 ΩQ−1 . We show the sampling distribution of n β 1 − β 1 setting n = 100. As α diminishes the density changes signiﬁcantly. 6.10) without changing this result. the sampling distribution becomes highly skewed and non-normal. 1) density.0 the density is very close to the N (0.11) 50 .Figure 6. we need an estimate of Ω = E xi x0 e2 .

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

n n i=1 52 . From a computational standpoint.4) ˆ Ω = = n n n ³ ´0 ³ ´0 ³ ´ 1X 2X 1X 0 2 0 ˆ ˆ ˆ xi xi ei − xi xi β − β xi ei + xi x0 β − β xi x0 β − β .039 and ˆ V = µ 1 14.6 Therefore the two covariance matrix estimates are µ ¶−1 µ ¶ 1 14.199 2. To illustrate. the standard method to calculate the standard errors is to ˆ ﬁrst calculate n−1 V . First.199 2.3) so by the WLLN ³ ´ ³ ´3/4 ¡ ¯ ¯¢ 1/4 E |xi |3 |ei | ≤ E |xi |4 < ∞.35/988 = .5 Consistency of the White Covariance Matrix Estimate 1X xi x0 e2 i ˆi n i=1 i=1 n ˆ ˆ We now show Ω →p Ω. and then the square roots.1) show that n ¡ ¢ 1X xi x0 e2 →p E xi x0 e2 = Ω.20 −0.085 p ˆ and that for β 1 is .used by an author when studying their work. then take the diagonal elements.117 Educationi . It is also important to understand that a particular standard error may be relevant under one set of model assumptions. (6.30 + 0.493 −0. The standard errors for β 0 are 7.98 −0.493 0.2. by Holder’s inequality (5.14 14. Ω 2. We calculate that s2 = 0.14 6. i i i i n i=1 Second.83 −0.12) i i n n n i=1 i=1 We now examine each sum on the right-hand-side of (6.80 . (. E ¯e4 ¯ i ³ ´ 1X |xi |3 |ei | →p E |xi |3 |ei | . from which it follows that V →p V as n → ∞.14 14.80 2.5) and the WLLN (Theorem 5.12) in turn. We can write the estimated equation with standards errors using the format \ log(W agei ) = 1. we return to the log wage regression of Section 4.20 = V 14. (6.83 ¶−1 µ .2/988 = .14 205.20 and µ ¶ ˆ = 0.020. just as any other estimator. Using (6.1.020) 6.085) (.480 ˆ0 = 0. but not under another set of assumptions.480 .83 ¶−1 = µ 7.80 40.14 205.80 40.6 ¶µ 1 14.035 ¶ .14 205. p ˆ In this case the two estimates are quite similar.

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. Using this substitution.13) Using formula (4. is deﬁned ˆ ˆ by replacing the OLS residual ei in (6.11) with the leave-one-out estimator ei.1 As n → ∞. Recall from Section 4. ¯ ¯n ¯ n i=1 so Together. these establish consistency. ¯ 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. you can show that 1 Xˆ ¯ β= β (−i) . From equation (3. n i=1 n ˆ ˆ Theorem 6. which.−i = (1 − hi )−1 ei ˆ presented in (4. ¯ ¯ ¯ ¯ ¯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 0.25).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. Ω →p Ω and V →p V. the jackknife estimator of the ˆ variance matrix for β is ˆ V ∗ = (n − 1) where n X³ ˆ β i=1 ¯ (−i) − β n ´³ ˆ β ¯ (−i) − β ´0 (6. i=1 Third. Andrews’ proposed estimator is ˆ ˆ ˆ ˆ V ∗∗ = Q−1 Ω∗∗ Q−1 53 . MacKinnon and White (1985) present numerical (simulation) evidence i ˆ ˆ that V ∗ works better than V as an estimator of V .12 the deﬁnition of β (−i) as the least-squares estimator with the i’th observation deleted. Andrews (1991) suggested an similar estimator based on cross-validation.13) of Efron (1982). They also suggest that the scaling factor (n − 1)/n in (??) can be omitted.5.6 Alternative Covariance Matrix Estimators ˆ MacKinnon and White (1985) suggested a small-sample corrected version of V based on the jackˆ knife principle.¯ ¯ ¯ ¯ˆ and thus since ¯β − β ¯ →p 0.26).

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

8. the standard error for ˆ is the square root of n−1 Vθ . s(ˆ = n−1/2 H 0 V Hβ . pivotal statistics are unavailable and so we must rely on asymptotically pivotal statistics. ˆ its estimate and s(ˆ its asymptotic θ θ) standard error. if R is a “selector matrix” R= so that if β = (β 1 . see Section X). Consider the studentized statistic tn (θ) = Theorem 6. By (6. we say that tn (θ) is asymptotically pivotal. s(ˆ θ) (6. ˆ When q = 1q h(β) is real-valued). however.16) ¥ Thus the asymptotic distribution of the t-ratio tn (θ) is the standard normal. the statistic tn has an exact t distribution. Since the standard normal distribution does not depend on the parameters. 1) →d ˆ−θ θ . In this case. In general.8 t tests Let θ = h(β) : Rk → R be any parameter of interest. that (so θ ˆ ˆ ˆ is. θ) β 6. (For example. Vθ ) √ Vθ = N (0.15) tn (θ) = ˆ−θ θ s(ˆ θ) ´ √ ³ˆ n θ−θ q = ˆ Vθ N (0. then θ = R0 β = β 1 and ˆ Vθ = ¡ I 0 ¢ ˆ V µ I 0 ¶ ˆ = V11 .1 tn (θ) →d N (0. β 2 ). θ could be a single element of β). and θ = h(β) is some function of the parameter vector. µ I 0 ¶ ˆ the upper-left block of V . In special cases (such as the normal regression model.For example. we say that tn is an exactly pivotal statistic. 1) Proof. 55 . and is therefore exactly free of unknowns. A simple null and composite hypothesis takes the form H0 : θ = θ0 H1 : θ 6= θ0 where θ0 is some pre-speciﬁed value.

For example. regardless of the complication of the distribution of the original test statistic. That is. The asymptotic p-value for the above statistic is constructed as follows. In a sense. It is designed to cover θ with high probability. associated with Fisher. z. Otherwise the test does not reject. 1].96 and z. so the “unusualness” of the test statistic can be compared to the easy-to-understand uniform distribution. is to report an asymptotic p-value. Another helpful observation is that the p-value function has simply made a unit-free transformation of the test statistic. Either θ ∈ Cn or θ ∈ Cn . 1). or “accepts” H0 . Let zα/2 is the upper α/2 quantile of the standard normal distribution. in contrast to Neyman-Pearson rejection/acceptance reporting where the researcher picks the level. 1]. p-values and hypothesis tests are equivalent since pn < α if and only if |tn | > zα/2 .9 Conﬁdence Intervals A conﬁdence interval Cn is an interval estimate of θ. if Z ∼ N (0. Thus an equivalent statement of a Neyman-Pearson test is to reject at the α% level if and only if pn < α. To see this fact. If the p-value pn is small (close to zero) then the evidence against H0 is strong. note that the asymptotic distribution of |tn | is F (x) = 1 − p(x). Then the asymptotic p-value of the statistic tn is pn = p(tn ). The coverage probability is P (θ ∈ Cn ). 1]. s(ˆ θ) Under H0 . The p-value is more general. The rejection/acceptance dichotomy is associated with the Neyman-Pearson approach to hypothesis testing. Deﬁne the tail probability. pn →d U [0. however. Thus P (1 − pn ≤ u) = = P (F (tn ) ≤ u) ¡ ¢ = P |tn | ≤ F −1 (u) ¡ ¢ → F F −1 (u) = u.The standard test for H0 against H1 is the t-statistic (or studentized statistic) tn = tn (θ0 ) = ˆ − θ0 θ . A test of asymptotic signiﬁcance α rejects H0 if |tn | > zα/2 .025 = 1. or asymptotic p-value function p(t) = P (|Z| > |t|) = 2 (1 − Φ(|t|)) . tn →d N (0.645. This is because ¡ ¢ P (reject H0 | H0 true) = P |tn | > zα/2 | θ = θ0 ¢ ¡ → P |Z| > zα/2 = α. That is. and is a function of the data and hence is / random. under H0 . 1). 6. An alternative approach. in that the reader is allowed to pick the level of signiﬁcance α. from which it follows that pn →d U [0. 56 .05 = 1. P (1 − p(tn ) ≤ u) establishing that 1 − pn →d U [0. then P (Z > zα/2 ) = α/2 and P (|Z| > zα/2 ) = α.

05. The t-test of the previous setion rejects H0 : θ0 = θ if |tn (θ)| > zα/2 where tn (θ) is the t-statistic (6. 6. θ The interval has been constructed so that as n → ∞. and it is desired to test the joint restrictions simultaneously. θ θ) (6. A good method for construction of a conﬁdence interval is the collection of parameter values which are not rejected by a statistical test. We have the null and alternative H0 : θ = θ0 H1 : θ 6= θ0 . In this case the t-statistic approach does not work.18) . However we often can calculate the asymptotic coverage probability limn→∞ P (θ ∈ Cn ). This corresponds to selecting the conﬁdence h i h ˆ ± 1. or α = . and values of θ outside two standard θ errors of the estimated ˆ are considered unlikely or unreasonable candidates for the true value. 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). ˆ + zα/2 s(ˆ . 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.10 Wald Tests Sometimes θ = h(β) is a q × 1 vector. the most common professional choice isi95%. = n h(β) − θ0 Hβ V Hβ 57 (6.96s(ˆ ≈ ˆ ± 2s(ˆ . ¢ ¡ ¢ ¡ P (θ ∈ Cn ) = P |tn (θ)| ≤ zα/2 → P |Z| ≤ zα/2 = 1 − α.We typically cannot calculate the exact coverage probability P (θ ∈ Cn ). 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 .16) and zα/2 is the upper α/2 quantile of the standard normal distribution. We say that Cn has asymptotic (1 − α)% coverage for θ if P (θ ∈ Cn ) → 1 − α as n → ∞. A conﬁdence interval is then constructed as the values of θ for which this test does not reject: © ª Cn = θ : |tn (θ)| ≤ zα/2 ( ) ˆ−θ θ = θ : −zα/2 ≤ ≤ zα/2 s(ˆ θ) i h θ). While there is no hard-and-fast guideline for choosing the coverage probability 1 − α.17) = ˆ − zα/2 s(ˆ θ and Cn is an asymptotic (1 − α)% conﬁdence interval.

15) showed that n ˆ − θ →d Z ∼ N (0.1 showed θ ˆ that V →p V. χ2 (. then the Wald statistic takes the form ´0 ³ ´ ³ ´−1 ³ ˆ ˆ ˆ R0 V R R0 β − θ 0 .3.19) σ2 ˆ where σ2 = ˜ 1 0 e e. Thus Vθ = H 0 V Hβ →p H 0 V Hβ = Vθ > 0 if Hβ has full rank q. q and pn is asymptotically U[0. Hβ (β) →p Hβ . As before. ˆ Wn = n θ θ q θ θ Theorem 6.84 = z. Also h(β) = a selector matrix. then the Wald statistic can be written in the form ¶ µ 2 ˆ σ − σ2 ˜ Wn = n (6. and there are q = k2 restrictions. the test rejects at the α% level iﬀ pn < α. h(β) = R0 β.5.1 Under H0 and Assumption 6. 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. so by the continuous mapping ˆ ˆ ˆ ˆ ˆ theorem. ˜ 58 ¡ 0 ¢−1 0 ˜ β 1 = X1 X1 X1 Y . a chiq square random variable with q degrees of freedom. the upper-α quantile q 2 of the χ2 distribution.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 . For example.025 . Hβ (β) is a continuous function of β.2. 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. ˜˜ n ˜ e = Y − X1 β 1 . An asymptotic Wald test rejects H0 in favor of H1 if Wn exceeds χ2 (α). The asymptotic p-value for Wn is pn = p(Wn ).10. θ = β 2 . if rank(Hβ ) = q. The Wald test fails to reject if Wn is q 1 ¡ ¢ less than χ2 (α). Furthermore. where p(x) = P χ2 ≥ x is the tail q q probability function of the χ2 distribution.05) = 3. We have established: ³ ´0 ³ ´ ˆ − θ0 V −1 ˆ − θ0 →d Z 0 V −1 Z = χ2 . In this case. Vθ ).1. 6. and Theorem 6. Hence β β by Theorem A. The null hypothesis is H0 : β 2 = 0. 1] under H0 . = nβ 2 R0 V R R0 β is linear with R = µ 0 I ¶ ¢−1 ¡ ˆ ˆ ˆ . Wn = n R0 β − θ0 ´ √ ³ The delta method (6. then Wn →d χ2 .When h is a linear function of β.8.

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

In particular. This special F statistic is testing the hypothesis that all slope coeﬃcients (other than the intercept) are zero. there is an exact distribution theory available for the normal linear regression model. when an OLS regression is reported. n−k 60 . under the normality assumption the error vector e is independent of X and ¢ ¡ has distribution N 0.3. Since linear functions of normals are also normal. In ) . This was a popular statistic in the early days of econometric reporting. when sample sizes were very small and researchers wanted to know if there was “any explanatory power” to their regression. an “F statistic” is reported. e ˆ M 0 σ2 M where M = I − X (X 0 X)−1 X 0 . it follows ˆ that β is independent of any function of the OLS residuals.12 Normal Regression Model As an alternative to asymptotic distribution theory. as sample sizes are typically suﬃciently large that this F statistic is highly “signiﬁcant”. 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. σ 2 /(n − k) ˆ σ2 = ˜y 1 (y − y)0 (y − y) n is the sample variance of yi .where In many statistical packages. This is ¢ ¡ 2 ˆ σ y − σ 2 / (k − 1) ˜ F = . Let u = σ −1 H 0 e ∼ N (0. these cases are atypical. While there are special cases where this F statistic is useful. This is rarely an issue today. Since uncorrelated normal variables are independent. σ 2 ) can be be used to calculate a set of exact distribution results. In σ 2 . H 0 H) ∼ N (0. including the estimated error variance 2. s The spectral decomposition of M yields ¸ ∙ In−k−1 0 H0 M =H 0 0 (see equation (2. The modelling assumption that the error ei is independent of xi and N (0.4)) where H 0 H = In . 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 . 6. equivalently the residual variance from an intercept-only model. introduced in Section 4.

a good testing procedure is based on the likelihood ratio statistic. n−k • ∼ tn−k ˆ In Theorem 6. which is twice the diﬀerence in the log-likelihood function evaluated under the null and alternative hypotheses.12. with residual variance σ . The estimator under the alternative is the unrestricted estimator ˆ ˆ ˆ (β 1 . 2 2 2 The LR statistic for H0 is ´ ³ ˆ ˆ ˆ ˜ ˜ LR = 2 Ln (β 1 . The log-likelihood of this model is ¡ 2¢ n n n ˜ ˜ ˜ Ln (β 1 . σ 2 ) where β 1 is the OLS estimate from ˜ 2 ˜ a regression of yi on x1i only. 1) and tn−k distributions.) Now let us partition β = (β 1 .10) µ h i ¶ 2 (X 0 X)−1 N 0.8. We summarize these ﬁndings Theorem 6. 0. β 2 . 0. and standard errors are calculated using the homoskedastic formula (6.10) then ´ ³ ˆ • β ∼ N 0. β 2 . so as a practical matter it does not matter which distribution is used. β 2 .1 If ei is independent of xi and distributed N(0. if standard errors are calculated using the homoskedastic formula (6.1 and Theorem 6. σ 2 ) = − log σ − log (2π) − . (Unless the sample size is unreasonably small. β 2 ) and consider tests of the linear restriction H0 : β 2 = 0 H1 : β 2 6= 0 In the context of parametric models. The critical values are quite close if n − k ≥ 30. σ 2 ) discussed above. In contrast. Theorem 6. σ 2 ). σ 2 ) − Ln (β 1 .12. β has an exact normal distribution and t has an exact t distribution. The Gaussian log-likelihood at these estimates is ¡ ¢ n 1 ˆ ˆ ˆ σ Ln (β 1 . σ 2 ) ¡ ¢¢ ¡ ¡ ¢ ˆ = n log σ 2 − log σ 2 ˜ µ 2¶ σ ˜ = n log . Furthermore. 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. σ 2 ) = − log 2πˆ 2 − 2 e0 e ˆˆ 2 2ˆ σ ¡ ¢ n n n = − log σ 2 − log (2π) − . β and t are approximately normally distributed. ˆ 2 2 2 ˜ ˜ The MLE of the model under the null hypothesis is (β 1 . As inference (conﬁdence intervals) are based on the t-ratio. 0.1 we showed that in large samples. σ ˆ ˆ βj − βj βj − βj N (0.3.1 shows that under the strong assumption of ˆ normality. σ2 ˆ 61 . σ 2 (X 0 X)−1 • (n−k)s2 σ2 ˆ β j −β j ˆ s(β ) j ∼ χ2 . the notable distinction is between the N (0.a chi-square distribution with n − k degrees of freedom.

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

1 you can also see the impact of variation in sample size. Table 4.4: Wald Statistic as a function of s P (Wn (s) > 3. Typically. Each row of the table corresponds to a diﬀerent value of s — and thus corresponds to a particular choice of test statistic. n is varied among 20. this probability depends only on s. There is. Table 4. Type I error rates between 3% and 8% are considered reasonable.84 | β = 1) .84. The null hypothesis β s = 1 is true. so these probabilities are Type I error.1 we report the results of a Monte Carlo simulation where we vary these three parameters. which is not surprising given the dependence of Wn (s) on s as shown in Figure 6. Test performance deteriorates as s increases. To interpret the table. In each case. remember that the ideal Type I error probability is 5% (. Given the simplicity of the model. The value of s is varied from 1 to 10. and σ 2 .000 simulated Wald statistics Wn (s) which are larger than 3.Figure 6. the Type I error probability improves towards 5% as the sample size n increases. the only test which meets this criterion is the conventional Wn = Wn (1) test. In Table 2. The second through seventh columns contain the Type I error probabilities for diﬀerent combinations of n and σ. no magic choice of n for which all tests perform uniformly well.05) with deviations indicating+ distortion.1 Type I error Probability of Asymptotic 5% Wn (s) Test 63 . we compare the rates row by row. These probabilities are calculated as the percentage of the 50.1 reports the simulation estimate of the Type I error probability from 50. 100 and 500. however. Rates above 20% are unexceptable. For this particular example. and rarely fall outside of the 3%-8% range. Error rates avove 10% are considered excessive. n. In Table 4. looking for tests for which rate rejection rates are close to 5%. Any other choice of s leads to a test with unacceptable Type I error probabilities. When comparing statistical procedures. and σ is varied among 1 and 3.4.000 random samples.

20 .08 . Other choices are arbitrary and would not be used in practice.23 . in other examples natural choices are not always obvious and the best choices may in fact appear counter-intuitive at ﬁrst. An alternative statistic can be constructed through reformulating the null hypothesis as H0 : β 1 − rβ 2 = 0.10 .14 .17 .19 .07 .05 . so the hypothesis can be stated as H0 : θ = r.22 .06 .09 .07 .25 . Take the model yi = β 0 + x1i β 1 + x2i β 2 + ei E (xi ei ) = 0 and the hypothesis H0 : β1 =r β2 (6.14 . let V be an estimate of the ˆ asymptotic variance matrix for β and set ˆ = β 1 /β 2 .20). This point can be illustrated through another example.07 .31 .06 .05 .10 .21 .16 Rejection frequencies from 50. Deﬁne θ ˆ ˆ ⎞ ⎛ 0 ⎟ ⎜ ⎟ ⎜ ⎜ 1 ⎟ ⎟ ⎜ ⎜ ˆ ⎟ ˆ H1 = ⎜ β 2 ⎟ ⎟ ⎜ ⎟ ⎜ ⎜ β ⎟ ˆ ⎠ ⎝ − 1 ˆ2 β2 ´ s(ˆ θ) −r .06 .13 .08 .05 .30 .10 .06 .34 . β 2 ) be the least-squares estimates of (6.15 . While this is clear in this particular example.08 .07 .15 . In this case a t-statistic for H0 is t1n = ³ˆ β1 ˆ β2 where r is a known constant. 64 .28 .13 .08 .18 .05 .08 .06 .06 .05 .07 .35 .13 . ˆ ˆ ˆ ˆ ˆ Let β = (β 0 .22 .24 .06 .06 .33 .000 simulated random samples In this example it is not surprising that the choice s = 1 yields the best test statistic.15 .15 . β 1 .12 .20) ³ ´1/2 ˆ0 ˆ ˆ so that the standard error for ˆ is s(ˆ = n−1 H1 V H1 θ θ) . deﬁne θ = β 1 /β 2 . Equivalently.26 .25 .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 .05 .12 .11 .20 .

In this section we describe the method in more detail.05. The common message from both examples is that Wald statistics are sensitive to the algebraic formulation of the null hypothesis.00 . especially for small values of β 2 .0 and n among 100 and 500.00 .75 1.06 .00 . The left tail probabilities P (t1n < −1. This leaves β 2 as a free parameter.06 . . .00 . along with sample size n.00 The one-sided Type I error probabilities P (tn < −1.06 .2 is that the two t-ratios have dramatically diﬀerent sampling behavior.645) are calculated from 50. and 1. It is also prudent to consider alternative tests to the Wald statistic.A t-statistic based on this formulation of the hypothesis is ´2 ³ ˆ 1 − rβ 2 ˆ β =³ ´1/2 .2.05 .06 .50.50 .25 .645) P (tn > 1.7. . ei be an independent N (0.10 . −r ⎛ t2n where To compare t1n and t2n we perform another simple Monte Carlo simulation. while the right tail probabilities P (t1n > 1. and normalize β 0 = 0 and β 1 = 1.00 .00 .26 .645) greatly exceed 5%.645) t1n t2n t1n t2n t1n t2n t1n t2n . However. the entries in the table should be 0.12 . If no linear formulation is feasible.06 .05 . 65 . such as the GMM distance statistic which will be presented in Section 9.15 .07 .00 .06 . σ 2 ) draw with σ = 3.05 .06 . Ideally.25.2 Type I error Probability of Asymptotic 5% t-tests n = 100 n = 500 P (tn < −1.15 .09 .1. The implication of Table 4. and are close to the ideal 5% rate for both sample sizes. Table 4.05 .06 .02 .000 simulated samples.05 . then the “most linear” formulation should be selected. −1 H V H ˆ 2 n 2 ⎞ 0 H2 = ⎝ 1 ⎠ . We let x1i and x2i be mutually independent N (0.05 .645) and P (tn > 1. The results are presented in Table 4.14 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.47 . In all cases. the rejection rates for the linear t2n statistic are invariant to the value of β 2 . We vary β 2 among .645) P (tn > 1.75.00 .10 . 1) variables.05 . the rejection rates for the t1n statistic diverge greatly from this value.05 . this formulation should be used.10 .645) are close to zero in most cases.645) P (tn < −1. 6.00 .06 .06 .05 .28 . and alternatives to asymptotic critical values should be considered. if the hypothesis can be expressed as a linear restriction on the model parameters.05 β2 . In contrast.

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

such as the percentage estimate reported in (6. experience squared. Again our dependent variable is the natural log of wages.007. Generally.21) is therefore an ³ ´ p ˆ unbiased estimator of P with standard error s P = P (1 − P ) /B. it is simple to make inferences about rejection probabilities from statistical tests. The α% sample quantile is a number qα such that α% of the sample are less than qα . an estimator or test may perform wonderfully for some values. Quite simply. It is therefore useful to conduct a variety of experiments. We would then set Tn = ¯ˆ − θ¯ /s(ˆ and calculate B X ˆ= 1 P 1 (Tnb ≥ 1. if we are ³ ´ p √ ˆ assessing an asymptotic 5% test. s P = .96) . and 90% sample quantiles of the sample {Tnb }. and dummy variable indicators for the following: married. We now expand the sample all non-military wage earners.95) /B ' .Suppose we are interested in the ¯Type I error associated with an asymptotic 5% two-sided ¯ ¯ ¯ θ) θ t-test. and . immigrant.96) .21) the percentage of the simulated t-ratios which exceed the asymptotic 5% critical value. As discussed above. B. For example. and estimate a multivariate regression. experience squared. female. then we can set s P = (. are. female. and hispanic. union member.022.22/ B. It is therefore convenient to pick B so that N is an integer. for a selection of choices of n and F. the researcher must select the number of experiments. potential work experience.05) (. a larger B results in more precise estimates of the features of interest of Gn . . We separately estimate equations for white and non-whites. and our regressors include years of education.15 Estimating a Wage Equation We again return to our wage equation. The typical purpose of a Monte Carlo simulation is to investigate the performance of a statistical procedure (estimator or test) in realistic settings. Suppose we are interested in the 5% and 95% quantile of Tn = ˆ We then compute the 10% θ. For regressors we include years of education. the choice of B is often guided by the computational demands of the statistical procedure. 1000. and non-white. Then qα is the N ’th number in this ordered sequence.96) is iid Bernoulli.21). We us the sample of wage earners from the March 2004 Current Population Survey. For the dependent variable we use the natural log of wages. potential work experience. The average (6. where N = (B +1)α. A simple way to compute sample quantiles is to sort the sample {Tnb } from low to high. Furthermore. The random variable 1 (Tnb ≥ 1. then the 5% sample quantile is 50’th sorted value and the 95% sample quantile is the 950’th sorted value. immigrant. therefore. and therefore it is straightforward to calculate standard errors for any quantity of interest. hispanic. In particular. Hence the ³ ´ ˆ standard errors for B = 100. respectively. Since the results of a Monte Carlo experiment are estimates computed from a random sample of size B. excluding military. but requires more computational time. union member. For example. and poorly for others. the performance will depend on n and F. B b=1 (6. and dummy variable indicators for the following: married.003. so that coeﬃcients may be interpreted as semi-elasticities. In practice. In many cases. If the standard error is too large to make a reliable inference. then B will have to be increased. equalling 1 with probability P = E1 (Tnb ≥ 1. we included a dummy 67 . this may ˆ be approximated by replacing P with P or with an hypothesized value. 6. if we set B = 999. As P is unknown. Often this is called the number of replications. and 5000.

013 .1 OLS Estimates of Linear Equation for Log(Wage) ˆ β 1.014 .002 . Ignoring the other coeﬃcients. Wn = n 1 − 2 = 18.027 .808 .19) is ˜ µ ¶ µ ¶ σ2 ˆ . the restricted standard deviation estimate is σ = . reestimating the model with the 50 state dummies excluded.102 −.102 −.18) that the state coeﬃcients are jointly zero. Computing the Wald statistic (6. 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.001 . if β 2 > 0 and β 3 < 0 the solution is θ=− From Table 4.010 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.097 −.101 .070 .007 . as the 1% critical value for the χ2 distribution is 76.008 . 808 1 − . θ ˆ 2β 3 β2 . Using either statistic the hypothesis is easily rejected. The available sample is 18.34 ˆ s(β) .4877 18.033 −.00057 . this adds 50 regressors).00002 .69.4945.121 −.808 so the parameter estimates are quite precise and reported in Table 4. Alternatively.032 .010 . 2β 3 68 . we ﬁnd Wn = 550. Table 4.variable for state of residence (including the District of Columbia.48772 = 515. but not equal.49452 σ ˜ Notice that the two statistics are close.1 we ﬁnd the point estimate ˆ ˆ = − β 2 = 28.1. The F form of the Wald statistic (6.232 . 50 Another interesting question which can be addressed from these estimates is the maximal impact of experience on mean wages. excluding the coeﬃcients on the state dummy variables.

we can calculate a standard error of s(ˆ = .5]. but it can be found numerically quite easily. not testing a hypothesis. so we have to go one step further. as the coverage probability of this conﬁdence interval is one minus the Type I error of the hypothesis test based on the t-test. this is a poor choice. This is the set of θ such that |tn (θ)| ≤ 1. but the lower end is substantially lower.5].40. Since tn (θ) is a non-linear function of θ. 29. In the previous section we discovered that such t-tests had very poor Type I error rates.96. 29. 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 ). Instead. Our desired conﬁdence interval will be the set of parameter values θ which are not rejected by the hypothesis test. However.0. Notice that the upper end of the conﬁdence interval is the same as that from the delta method. we found better Type I error rates by reformulating the hypothesis as a linear restriction.9.Using the Delta Method. 69 . In the present context we are interested in forming a conﬁdence interval. implying a 95% conﬁdence θ) interval of [27. there is not a simple expression for this set. This set is [27.

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

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

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

2

is the homoskedasticity-formula standard error.

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

i=1 i=1

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

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

E (xi ei ) = 0

∗ yi = yi + ui

71

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

∗ E (yi ui ) = 0

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

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

• Qi • Di • Ci

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

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

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

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

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

73

Suppose that we model the conditional variance using the parametric form 0 σ 2 = α0 + z1i α1 i = α0 zi . . A ˆ ˆn feasible GLS (FGLS) estimator replaces the unknown D with an estimate D = diag{ˆ 2 . Typically. the least-squares estimator is ineﬃcient. The GLS estimator (7. σ 2 } and σ 2 = σ 2 (x ) = E e2 | x . 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.Chapter 7 Additional Regression Topics 7.1) infeasible since the matrix D is unknown. in the linear regression model yi = x0 β + ei i E (ei | xi ) = 0.2) E (ξ i | xi ) = 0.. Let η i = e2 ..1 Generalized Least Squares In the projection model.1) XD Y β = X 0 D−1 X ¡ ¢ 2 . Often the functional form is kept simple for parsimony. The GLS estimator is sometimes called where D = diag{σ 1 i i n i i the Aitken estimator.. σ1 We now discuss this estimation problem.. . However. Then i 0 E (η i | xi ) = α0 + z1i α1 0 η i = α0 + z1i α1 + ξ i and we have the regression equation (7. z1i are squares (and perhaps levels) of some (or all) elements of xi .. σ 2 }. 74 . we know that the least-squares estimator is semi-parametrically eﬃcient for the projection coeﬃcient. where z1i is some q × 1 function of xi .. The error ξ i in this regression error ξ i is generally heteroskedastic and has the conditional variance ¡ ¢ V ar (ξ i | xi ) = V ar e2 | xi i ´ ³¡ ¢¢2 ¡ = E e2 − E e2 | xi | xi i i ¡ 4 ¢ ¡ ¡ 2 ¢¢2 = E ei | xi − E ei | xi .

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

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

and the cost is a reduction of robustness to misspeciﬁcatio 7. If i this simpliﬁcation is replaced by the standard formula (under independence of the error). If the equation of interest is a linear projection. on the other hand. This hypothesis does not imply that ξ i is independent of xi .4).4) and constructing a Wald statistic. In the linear regression model the conditional mean of yi given xi = x is 77 .2). White (1980) proposed that the test for heteroskedasticity be based on setting zi to equal all non-redundant elements of xi . Motivated by the form of the asymptotic variance ˆ of the OLS estimator β. the Wald test of H0 is asymptotically χ2 . Third.7) Hence the standard test of H0 is a classic F (or Wald) test for exclusion of all regressors from the skedastic regression (7.7) under independence show that this test has an asymptotic chi-square distribution. The asymptotic distribution (7. and this requires trimming to solve. q Most tests for heteroskedasticity take this basic form. BreuschPagan (1979) proposed what might appear to be ¡ distinct test. and not a conditional mean. require the assumption of a correct conditional mean. The GLS and FGLS estimators. then the OLS and FGLS estimators will converge in probability to diﬀerent limits. Theorem 7. we impose the stronger hypothesis and test the hypothesis that ei is independent of xi . FGLS will do worse than OLS in practice. in which case ξ i is ˜ independent of xi and the asymptotic variance (7.2 Testing for Heteroskedasticity ¢ ¡ The hypothesis of homoskedasticity is that E e2 | xi = σ 2 . And the FGLS probability limit will depend on the particular function selected for the skedastic regression. The point is that the eﬃciency gains from FGLS are built on the stronger assumption of a correct conditional mean. This introduces an element of arbitrariness which is unsettling to empirical researchers. Second.2. OLS is a more robust estimator of the parameter vector. the two tests coincide. Typically. as they will be estimating two diﬀerent projections. 7. The main diﬀerences between popular “tests” is which transformations of xi enter zi . and all cross-products.5) and the asymptotic variance (7.1 Under H0 and ei independent of xi . the estimated conditional variances may contain more noise than information about the true conditional variances.3 Forecast Intervals m(x) = E (yi | xi = x) = x0 β. but the only diﬀerence is that they a ¢ allowed for general choice of zi . In this case. its squares. or equivalently that i H0 : α1 = 0 in the regression (7.3) for α simpliﬁes to ¡ ¡ 0 ¢¢−1 ¡ 2 ¢ E ξi . however. Vα = E zi zi (7. but also under the assumptions of linear projection. It is consistent not only in the regression model. and replaced E ξ 2 with 2σ 4 which holds when ei is N(0. individual estimated conditional variances may be negative. We may therefore test this hypothesis by the estimation (7. σ 2 ).error.

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

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

θ) ' (ei + m(xi . θ) = β 0 zi + β 0 xi (γ). ˆ ˆ θ) ˆ θ). tests of H0 do not have asymptotic normal or chi-square distributions. and this is often a useful hypothesis (sub-model) to consider. Thus the NLLS 0 estimator ˆ has the same asymptotic distribution as the (infeasible) OLS regression of yi on mθi . Furthermore. θi Thus ¡ ¢ yi − m(xi . θi Hence the sum of squared errors function is Sn (θ) = n X i=1 (yi − m(xi . θ0 )) − m(xi . θ0 ) + m0 (θ − θ0 ) θi = ei − m0 (θ − θ0 ) θi 0 = yi − m0 θ. by a ﬁrst-order Taylor series approximation. γ is not identiﬁed. 80 . 7. ¥ Based on Theorem 7. the model is yi = β 0 zi + εi 1 and both β 2 and γ have dropped out. θ) ' m(xi . Thus when the truth is that β 2 = 0. Suppose that m(xi . Hansen shows how to use simulation (similar to the bootstrap) to construct the asymptotic critical values (or p-values) in a given application. Identiﬁcation is often tricky in nonlinear regression models. ˆ and ei = yi − m(xi .1. θ))2 ' n X¡ ¢2 0 yi − m0 θ θi i=1 0 and the right-hand-side is the SSE function for a linear regression of yi on mθi . This renders the distribution theory presented in the previous section invalid. 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 . 1 2 The model is linear when β 2 = 0.5 Least Absolute Deviations We stated that a conventional goal in econometrics is estimation of impact of variation in xi on the central tendency of yi . under H0 .For θ close to the true value θ0 . An alternative good measure is the conditional median. m(xi .4. This means that under H0 . θ0 ) + m0 (θ − θ0 ) . the parameter estimates are not asymptotically normally distributed. However. In particular. The asymptotic theory of such tests have been worked out by Andrews and Ploberger (1994) and B. Thus we want to test H0 : β 2 = 0. but these are not the only measures of central tendency. We have discussed projections and conditional means. Hansen (1996). θ which is that stated in the theorem.

The least absolute deviations (LAD) estimator of β minimizes this function ˆ β = argmin Ln (β) β Equivalently.5. The ﬁrst deﬁnition is the 50th empirical 1 P quantile. The second is the value which minimizes n n |yi − θ| . 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 ¯ 1 X¯ ¯yi − x0 β ¯ Ln (β) = i n i=1 n be the average of absolute deviations. the linear function M ed (yi | xi = x) = x0 β is the conditional median function.10) The LAD estimator has the asymptotic distribution 81 . and let M ed (Y | X) = m(X) be this function evaluated at the random variable X. i n n i=1 (7. Two useful facts about the median are that (7. let Y be a continuous random variable. and the substantive assumption is that the median function is linear in x. These distinctions are illusory. and the third deﬁnition is the i=1 1 P solution to the moment equation n n sgn (yi − θ) . Now let’s consider the conditional median of Y given a random variable X. Let m(x) = M ed (Y | X = x) denote the conditional median of Y given X = x.To recall the deﬁnition and properties of the median. it is a solution to the moment condition ³ ´ 1X ˆ xi sgn yi − x0 β = 0. however.9) θ0 = argmin E |Y − θ| θ and E sgn (Y − θ0 ) = 0 where sgn (u) = ½ 1 −1 if u ≥ 0 if u < 0 is the sign function. The linear median regression model takes the form yi = x0 β + ei i M ed (ei | xi ) = 0 In this model. These facts deﬁnitions motivate three estimators of θ.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.

1: Since sgn (a) = 1 − 2 · 1 (a ≤ 0) . Exi x0 ) i i=1 since Egi (β 0 )gi (β 0 )0 = Exi x0 . ¢¢−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) . First. where V = and f (e | x) is the conditional density of ei given xi = x. When f (0 | x) is large. (7. V ).5. Pn −1 0 β)) . the conditional density of the error at its median. Computation of standard error for LAD estimates typically is based on equation (7. then there are many innovations near to the median. then f (0 | x) = f (0) and the asymptotic variance simpliﬁes V = (Exi x0 )−1 i 4f (0)2 (7. by the central limit theorem (Theorm 5. ∂ g(β) = ∂β 0 ¡ ¡ ¢¢ ∂ 0 0 Exi 1 − 2 · 1 yi ≤ xi β ∂β £ ¡ ¡ ¢ ¢¤ ∂ = −2 0 E xi E 1 ei ≤ x0 β − x0 β 0 | xi i i ∂β " Z 0 # xi β−x0 β 0 i ∂ = −2 0 E xi f (e | xi ) de ∂β −∞ £ ¢¤ ¡ = −2E xi x0 f x0 β − x0 β 0 | xi i i i £ 0 ¤ ∂ 0 g(β 0 ) = −2E xi xi f (0 | xi ) .11). The main diﬃculty is the estimation of f (0). While a complete proof of Theorem 7. Second using the law of iterated expectations and the chain rule of i diﬀerentiation.11) This simpliﬁcation is similar to the simpliﬁcation of the asymptotic covariance of the OLS estimator under homoskedasticity.1 ´ √ ³ˆ n β − β 0 →d N (0. the height of the error density at its median. In the special case where the error is independent of xi .1) n X √ −1/2 n (g n (β 0 ) − g(β 0 )) = −n gi (β 0 ) →d N (0. See Chapter 16. and this improves estimation of the median.1 is advanced. We need where g n (β) = n i i=1 gi (β) and gi (β) = xi (1 − 2 · 1 (yi ≤ xi three preliminary result.Theorem 7. by a Taylor series expansion and the fact g(β 0 ) = 0 82 . ˆ Proof of Theorem 7. Let g(β) = Eg (β). we provide a sketch here for completeness.3. ∂β 0 so Third. This can be done with kernel estimation techniques.10) is equivalent to g n (β) = 0. ∂β ˆ g(β) ' ´ ³ ∂ ˆ g(β 0 ) β − β 0 .5.5.

5. V ). 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. then F (Qτ (x) | x) = τ . then F (Qτ ) = τ . so you can think of the quantile as the inverse of the distribution function. 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 .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. ¥ 7. We then have the linear quantile regression model yi = x0 β τ + ei i 83 . For τ ∈ [0. However for computational convenience it is typical to assume that they are (approximately) linear in x (after suitable transformations). the quantile regression functions can take any shape. The following alternative representation is useful. The quantile Qτ is the value such that τ (percent) of the mass of the distribution is less than Qτ .12) Qτ = argmin Eρτ (U − θ) . the quantile regression function qτ (x) describes how the τ ’th quantile of the conditional distribution varies with the regressors. Exi x0 ) →d i 2 = N (0. As functions of x. The median is the special case τ = . θ where ρτ (q) is the piecewise linear function ½ −q (1 − τ ) q<0 ρτ (q) = qτ q≥0 = q (τ − 1 (q < 0)) .13) This generalizes representation (7. This linear speciﬁcation assumes that Qτ (x) = β 0 x where the coeﬃcients β τ τ vary across the quantiles τ . when F (y | x) is continuous and strictly monotonic in y.9) for the median to all quantiles. then (7. Again. If the random variable U has τ ’th quantile Qτ .6 Quantile Regression The method of quantile regression has become quite popular in recent econometric practice. (7. The third line follows from an asymptotic empirical process argument. For the random variables (yi .

and are widely available.5.1 n β τ − β τ →d N (0. and form a Wald statistic i for γ = 0. where and f (e | x) is the conditional density of ei given xi = x. since it has discontinuous derivatives.12). Furthermore. Fortunately. then f (0 | xi ) = f (0) . otherwise its properties are unspeciﬁed without further restrictions. Since the quanitle regression criterion function Lτ (β) does not have an algebraic solution. E xi xi f (0)2 A recent monograph on the details of quantile regression is Koenker (2005). i By construction. the quantile regression estimator β τ for β τ solves the minimization problem ˆ β τ = argmin Lτ (β) n β∈Rk n where Lτ (β) = n and ρτ (q) is deﬁned in (7. When the error ei is independent of xi . and we have the simpliﬁcation Vτ = τ (1 − τ ) ¡ ¡ 0 ¢¢−1 . Another popular approach is the RESET test proposed by Ramsey (1969). fast linear programming methods have been developed for this problem. the unconditional density of ei at 0. 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. ´ √ ³ˆ Theorem 7. n numerical methods are necessary for its minimization. the asymptotic variance depends on the conditional density of the quantile regression error.6. One simple test for neglected nonlinearity is to add nonlinear functions of the regressors to ˆ ˆ the regression. and test their signiﬁcance using a Wald test. 7.where ei is the error deﬁned to be the diﬀerence between yi and its τ ’th conditional quantile x0 β τ . if the model yi = x0 β + ei has i been ﬁt by OLS. conventional Newton-type optimization methods are inappropriate. ¡ ¡ ¢¢−1 ¡ ¢¢−1 ¢¡ ¡ Exi x0 E xi x0 f (0 | xi ) Vτ = τ (1 − τ ) E xi x0 f (0 | xi ) i i i ¢ 1X ¡ ρτ yi − x0 β i n i=1 In general.1. A asymptotic distribution theory for the quantile regression estimator can be derived using similar arguments as those for the LAD estimator in Theorem 7. The null model is yi = x0 β + εi i 84 .7 Testing for Omitted NonLinearity If the goal is to estimate the conditional expectation E (yi | xi ) .13). Vτ ). ˆ Given the representation (7. Thus. it is useful to have a general test of the adequacy of the speciﬁcation. the τ ’th conditional quantile of ei is zero.

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

In many cases the problem of model selection can be reduced to the comparison of two nested models. and β 1 0 (The least-squares estimate with the intercept omitted. E (ε | X1 .˜ ˆ This means that β 1 has a lower asymptotic variance matrix than β 1 . this result can be reversed when the error is conditionally heteroskedastic. To be concrete. . n→∞ σx ˜ When µ 6= 0. we will on ˆ1 ¡ occasion use the homoskedasticity assumption E e2 | x1i . In the absence of the homoskedasticity assumption. xKi = xK )?” is well posed. with residual vectors e1 and e2 . x Then under (6. In contrast. How does a researcher go about selecting an econometric speciﬁcation. that it selects the true model with probability one if the sample is suﬃciently large. One useful property is consistency. For example. There are many possible desirable properties for a model selection procedure. i A model selection procedure is a data-dependent rule which selects one of the two models. “Which subset of (x1 . as the larger problem can be written as a sequence of such comparisons.. Y = X1 β 1 + X2 β 2 + ε. . xK ) enters the regression function E(yi | x1i = x1 . We thus consider the question of the inclusion of X2 in the linear regression Y = X1 β 1 + X2 β 2 + ε. We c can write this as M. we say that M2 is true if β 2 6= 0. estimated ˆ ˆ ˆ2 the variances σ 2 and σ 2 . X2 ) = 0. However.. because it does not make clear the conditioning set. It is important that the model selection question be well-posed. A model selection procedure is consistent if ´ ³ c → 1 P M = M1 | M1 ³ ´ c P M = M2 | M2 → 1 86 . X2 ) = 0 Note that M1 ⊂ M2 . models 1 and 2 are estimated by OLS. ˆ For example. Let β 1 be the ˜ be the estimate under the constraint β = 0.9 Model Selection In earlier sections we discussed the costs and beneﬁts of inclusion/exclusion of variables.. etc. 7.7). To simplify some of ¢ statistical discussion. Let Exi = µ... the question.. we see that β 1 has a lower asymptotic variance. σ2 ˜ lim nV ar( β 1 ) = 2 n→∞ σ x + µ2 while σ2 ˆ lim nV ar( β 1 )−1 = 2 . We conclude that the inclusion of irrelevant variable reduces estimation eﬃciency if these variables are correlated with the relevant variables. respectively. where X1 is n × k1 and X2 is n × k2 .. and E (xi − µ)2 = σ 2 . take the model yi = β 0 + β 1 xi + ei and suppose that β 0 = 0. there is no clear ranking of the eﬃciency of the ˜ restricted estimator β 1 versus the unrestricted estimator. To ﬁx notation.). This is equivalent to the comparison of the two models M1 : M2 : Y = X1 β 1 + ε. when economic theory does not provide complete guidance? This is the question of model selection. estimate of β 1 from the unconstrained model. E (ε | X1 . the question: “What is the right model for y?” is not well posed. x2i = σ 2 .

AIC selection is inconsistent. based on Bayesian arguments.16) LRn = n log σ 2 − log σ 2 ' Wn →d χ22 .However. depending on the sample size. Another common approach to model selection is to to a selection criterion. His criterion. etc. In contrast to the AIC. this rule only makes sense when the true model is ﬁnite dimensional. 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. For some critical level α. Indeed. 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. A common approach to model selection is to base the decision on a statistical test such as the Wald Wn . k = While many modiﬁcations of the AIC have been proposed. let cα satisfy ¢ ¡ P χ22 > cα .17) Since log(n) > 2 (if n > 8). Then select M1 if Wn ≤ cα . then P M ´ ³ c 1 − α but P M = M2 | M2 could vary dramatically. That is. LRn →p 0. BIC model selection is consistent. as the rule tends to overﬁt. else select M2 . as ³ ´ c P M = M1 | M1 → 1 − α < 1. The model selection rule is as follows. M)) between the true density and the model density. The rule is to select M1 if AIC1 < AIC2 . else select M2 . Indeed. then this model selection procedure is inconsistent. since (7. and km is the number of coeﬃcients in the model. ¢ ¡ ˆ1 ˆ2 (7. it is more appropriate to view model selection as determining the best ﬁnite sample approximation. Another problem is that if α is held ﬁxed. n (7.16) holds under M1 . n (7. is ¡ ¢ km ˆm BICm = log σ 2 + log(n) . One popular choice is the Akaike Information Criterion (AIC). k A major problem with this approach is that the critical level α is indeterminate. If the truth is inﬁnite dimensional. the most popular to be one proposed by Schwarz.15) then where σ 2 is the variance estimate for model m. since under M1 . The AIC for model m is ¡ ¢ km ˆm AICm = log σ 2 + 2 . known as the BIC. log(n) 87 . 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. the BIC places a larger penalty than the AIC on the number of estimated parameters and is more parsimonious. if α is set to be a small number.

576.. In the ordered case.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. In the latter case. a model consists of any possible subset of the regressors {x1i . β 2 6= 0. and 220 = 1.17).. . . β 2 = β 3 = · · · = β K = 0 M2 : β 1 6= 0. β K 6= 0. There are two leading cases: ordered regressors and unordered. 048. there are 2K such models. Also under M2 . However. . β 3 = · · · = β K = 0 . . The methods extend readily to the issue of selection among multiple regressors. which are nested. We have discussed model selection between two models. one can show that thus LRn →p ∞. For example.15). β 2 6= 0. selecting based on (7. The AIC selection criteria estimates the K models by OLS. 210 = 1024. . E (εi | xi ) = 0 and the question is which subset of the coeﬃcients are non-zero (equivalently. log(n) µ LRn > k2 | M2 log(n) ¶ ´ ³ c P M = M2 | M2 = P → 1. . 88 . xKi }. . and the AIC or BIC in principle can be implemented by estimating all possible subset models.. Similarly for ˆ the BIC. stores the residual variance σ 2 for each model. which can be a very large number. a full-blown implementation of the BIC selection criterion would seem computationally prohibitive. which regressors enter the regression). In the unordered case. and then selects the model with the lowest AIC (7. The general problem is the model yi = β 1 x1i + β 2 x1i + · · · + β K xKi + εi . the models are M1 : β 1 6= 0. MK : β 1 6= 0.

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

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

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

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

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

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

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

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

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

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

4) v ¡ ¢ While (8. about the rate v of convergence. it says nothing. 99 . Thus here Tn (θ) = Wn (θ). Let an be a sequence. n ´ ³ ∗ ³ ∗ θ θ Note in the simulation that the Wald statistic is a quadratic form in ˆ − ˆ . (8. θ θ θ ˆ θ ∗ ∗ Computationally. The bootstrap test ∗ ∗ rejects if Wn ≥ qn (α).4) says that Gn converges to Φ x as n → ∞. F ) = Φ n→∞ v or ³x´ Gn (x. It is designed to work well since ³ ´ P (θ0 ∈ C4 ) = P ˆ − s(ˆ n (α) ≤ θ0 ≤ ˆ + s(ˆ n (α) θ θ)q ∗ θ θ)q ∗ ∗ = P (|Tn (θ0 )| < qn (α)) ' P (|Tn (θ0 )| < qn (α)) = 1 − α.3) ´ √ ³ˆ If Tn = n θ − θ0 then v = V while if Tn is a t-ratio then v = 1. v 2 ). writing Tn ∼ Gn (x.] 8. The derivative of an even function is odd. We say that a function g(x) is even if g(−x) = g(x). If θ is a vector. or the size of the divergence for any particular sample size n. θ [This is a typical mistake made by practitioners. A better asymptotic approximation may be obtained through an asymptotic expansion. where qn (α) is the (1 − α)% quantile of the distribution of ³ ∗ ³ ∗ ´0 ´ ∗ Wn = n ˆ − ˆ Vθ∗−1 ˆ − ˆ . and a function h(x) is odd if h(−x) = −h(x). an = O(n−r ) if it declines to zero like n−r .8. not ˆ − θ0 . Deﬁnition 8. The ideal test rejects if Wn ≥ qn (α). lim Gn (x. however.8.∗ where qn (α) is the bootstrap critical value for a two-sided hypothesis test. F ) then ³x´ . F ) = Φ + o (1) . Equivalently. Basically. and vice-versa. where qn (α) is the (1 − α)% quantile of the distribution of Wn .2 an = O(1) if |an | is uniformly bounded. Let Tn be a statistic such that (8.1 an = o(1) if an → 0 as n → ∞ Deﬁnition 8.8. then to test H0 : θ = θ0 against H1 : θ 6= θ0 at size α. we would use a Wald statistic ³ ´ ³ ´0 ˆ θ Wn (θ) = n ˆ − θ Vθ−1 ˆ − θ θ or some other asymptotically chi-square statistic. Deﬁnition 8.8 Asymptotic Expansions Tn →d N (0. The following notation will be helpful. the critical value qn (α) is found as the quantile from simulated values of W´ . C4 is called the symmetric percentile-t interval.3 an = o(n−r ) if nr |an | → 0 as n → ∞.

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

The “derivative” ∂ ∂F g1 (x. F ) n n µ ¶ 1 1 − Φ(−x) + 1/2 g1 (−x.5) where the simpliﬁcations are because g1 is even and g2 is odd. F ) = Gn (x. and exact critical values are taken from the Gn (x. Since Tn →d Z. F ) is only heuristic. n or ∗ P (Tn ≤ x) = P (Tn ≤ x) + O(n−1 ). we can calculate that Gn (x. which is an improved rate of convergence over the asymptotic test (which converged at rate O(n−1/2 )). then |Tn | has the distribution function Gn (x. F ) + O(n−3/2 ). F0 ) distribution. n . F ) − Gn (−x. n (8. F0 ) = The order of the error is O(n−1 ). = P (X ≤ x) − P (X ≤ −x) For example. F ). A two-sided hypothesis test rejects H0 for large values of |Tn | . if Z ∼ N (0. F ). Thus asymptotic critical values are taken from the Φ distribution. Similarly. 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. From Theorem 8. then |Z| has distribution function Φ(x) = Φ(x) − Φ(−x) = 2Φ(x) − 1. 1). then |Tn | →d |Z| ∼ Φ. F ) + g2 (x. F ) ¶ µ 1 1 = Φ(x) + 1/2 g1 (x. Hence the diﬀerence between the asymptotic distribution and the exact distribution is Φ(x) − Gn (x.1.10 Symmetric Two-Sided Tests If a random variable X has distribution function H(x) = P (X ≤ x). then the random variable |X| has distribution function H(x) = H(x) − H(−x) since P (|X| ≤ x) = P (−x ≤ X ≤ x) = H(x) − H(−x). F ) + O(n−3/2 ) n n 2 = Φ(x) + g2 (x. F0 ) + O(n−3/2 ) = O(n−1 ). We conclude that G∗ (x) − Gn (x. if Tn has exact distribution Gn (x.8. F ) = Gn (x. 101 2 g2 (x. as F is a function. F ) − Gn (−x. F0 ) = O(n−1 ). F ) + g2 (−x. 8.

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

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

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

you generate bootstrap samples. Let qn (. θ θ)q ∗ θ θ)q ∗ θ/s(θ) 5.05) and qn (. The ˆ are sorted.75 and 1. 105 . and deﬁne the bootstrap conﬁdence interval h i C = ˆ − s(ˆ n (. Using the non-parametric bootstrap. calculate the estimates ˆ on these samples and θ then calculate ∗ ∗ ∗ θ θ Tn = ˆ /s(ˆ ). You want to test H0 : θ = 0 against H1 : θ > 0.95). and ˆ is calculated on each θ ∗ ∗ θ sample. You do this as follows. (b) Report the 95% Alternative Percentile interval for θ.95) denote the 95% quantile of Tn . size of house.95). lot size. and the 2.Show that C exactly equals the Alternative percentile interval (not the percentile-t interval). Calculate 95% conﬁdence intervals for the regression coeﬃcients using both the asymptotic normal approximation and the percentile-t bootstrap. θ θ) ∗ 1000 samples are generated from the bootstrap distribution. and the colonial dummy.95) denote the 5% θ) ∗ and 95% quantiles of Tn .05) . (c) With the given information.2. Suppose that in an application. θ respectively. ˆ − s(ˆ n (. You replace c with qn (. ˆ = 1.pdf. ∗ ∗ where s(ˆ is the standard error in the original data. with variables listed in the ﬁle hprice1.3. Estimate a linear regression of price on the number of bedrooms.2 and s(ˆ = . The dataﬁle hprice1.5% quantiles of the ˆ are .95). ∗ ∗ ∗ Let qn (. and thus reject H0 if ˆ ˆ > q ∗ (. What is wrong with this procedure? Tn = θ/s(θ) n 6.5% and 97.dat contains data on house prices (sales). The test for H0 is to reject if Tn = ˆ ˆ > c where c is picked so that Type I error is α. (a) Report the 95% Efron Percentile interval for θ. can you report the 95% Percentile-t interval for θ? 7. Using the non-parametric ∗ bootstrap.

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

For example. ˆ Deﬁnition 9. let Jn (β) = n · g n (β)0 Wn g n (β). gi (β) = xi yi − zi β = n n n i=1 i=1 Deﬁne the sample analog of (9.2. if Wn = I.1 ˆ 2Z 0 XWn X 0 Z β = 2Z 0 XWn X 0 Y While the estimator depends on Wn . 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. Jn (β) = n · g n (β)0 g n (β) = n · |g n (β)|2 . Proposition 9. β GMM does not change. For some × weight matrix Wn > 0. then g n (β) = 0. i i . 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 . This is a non-negative measure of the “length” of the vector g n (β). the square of the Euclidean length.2. for if Wn is replaced ˆ by cWn for some c > 0. the dependence is only up to scale.2) g n (β) = (9.2 GMM Estimator n n ¢ 1¡ 0 ¢ 1X 1X ¡ 0 X Y − X 0 Zβ . ¡ ¢−1 0 ˆ Z XWn X 0 Y. then.9.3 Distribution of GMM Estimator ¡ 0¢ Q = E xi zi Assume that Wn →p W > 0. but this is generally not possible when > k. The GMM estimator minimizes Jn (β). and the GMM estimator is the MME.1 β GMM = argmin Jn (β).3) The method of moments estimator for β is deﬁned as the parameter value which sets g n (β) = 0. Let and where gi = xi ei . The idea of the generalized method of moments (GMM) is to deﬁne an estimator which sets g n (β) “close” to zero. β GMM = Z 0 XWn X 0 Z 9. β ˆ Note that if k = .

we can set Wn = I . Ω) . and this is all that is known. n β − β →d N 0.2 For the eﬃcient GMM estimator. This yields the eﬃcient GMM estimator: ¢−1 0 ¡ ˆ Z XΩ−1 X 0 Y. β = Z 0 XΩ−1 X 0 Z ´ ³ ¡ ¢−1 ´ √ ³ˆ . 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. it is semiparametrically eﬃcient. ˆ Construct n 1X ˆ g n = g n (β) = gi . as we are only considering alternative weight matrices Wn . but it can be estimated consistently. For any Wn →p W0 . this is a semi-parametric problem. 9. Since the GMM estimator has this can have a smaller asymptotic variance than G0 Ω−1 G asymptotic variance. ˆ∗ ˆ 108 . V ) . where In general. β). Chamberlain showed that in this context. ˆ we still call β the eﬃcient GMM estimator. n n We conclude: Theorem 9. ˆ n i=1 gi = gi − g n . we can deﬁne the residuals ei = yi −zi β and moment equations gi = xi ei = g(wi . a better choice is Wn = (X 0 X)−1 .and µ µ ¶ ¶ 1 0 1 0 Z X Wn X e →d Q0 W N (0. no estimator has greater asymptotic eﬃciency than the eﬃcient linear GMM estimator. it turns out that the GMM estimator is semiparametrically eﬃcient. If it is known that E (gi (β)) = 0. as the distribution of the data is unknown. Q0 Ω−1 Q ¢−1 ¡ 0 ¢¡ ¢−1 ¡ . no semiparametric estimator (one which is consistent globally for the class of models considered) ¢−1 ¡ . as it has the same asymptotic distribution.3. The proof is left as an exercise. W0 = Ω−1 is not known in practice. In the linear model.4 Estimation of the Eﬃcient Weight Matrix ˆ Given any weight matrix Wn > 0.1 ´ √ ³ˆ n β − β →d N (0. This is a weak concept of optimality. Given any such ﬁrst0ˆ ˆ ˆ ˆ step estimator. the GMM estimator β is consistent yet ineﬃcient. No estimator can do better (in this ﬁrst-order asymptotic sense). The optimal weight matrix W0 is one which minimizes V.3. However. GMM estimators are asymptotically normal with “sandwich form” asymptotic variances. Q W ΩW Q Q0 W Q V = Q0 W Q Thus we have Theorem 9. 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. This turns out to be W0 = Ω−1 . as shown by Gary Chamberlain (1987). For example. without imposing additional assumptions.

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

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

If the statistic J exceeds the chi-square critical value. Based on this information alone. but it is typically cause for concern. If h is non-linear. a better approach is to directly use the GMM criterion function. and it is advisable to report the statistic J whenever GMM is the estimation method. 1. The GMM overidentiﬁcation test is a very useful by-product of the GMM methodology. it is unclear what is wrong. D →d χ2 r 3.7 Hypothesis Testing: The Distance Statistic We described before how to construct estimates of the asymptotic covariance matrix of the GMM estimates. the Wald statistic can work quite poorly. If h is linear in β. The degrees of freedom of the asymptotic distribution are the number of overidentifying restrictions. h(β)=0 ˆ ˜ The two minimizing criterion functions are J(β) and J(β). The idea was ﬁrst put forward by Newey and West (1987). we can reject the model. Proposition 9. If the hypothesis is non-linear. D ≥ 0 2. When over-identiﬁed models are estimated by GMM. This reasoning is not compelling.1 If the same weight matrix Wn is used for both null and alternative. 9. This is sometimes called the GMM Distance statistic. then D equals the Wald statistic. current evidence suggests that the D statistic appears to have quite good sampling properties. it is customary to report the J statistic as a general test of model adequacy.The proof of the theorem is left as an exercise. The estimates under H1 are ˆ β = argmin J(β) β and those under H0 are ˜ β = argmin J(β). The GMM distance statistic is the diﬀerence ˜ ˆ D = J(β) − J(β). For a given weight matrix Wn . 111 . and is the preferred test statistic. This test shares the useful feature of LR tests in that it is a natural by-product of the computation of alternative models. and sometimes called a LR-like statistic (the LR is for likelihood-ratio). Newey and West (1987) suggested to use the same weight matrix Wn for both null and alternative. the hypothesis is H0 : h(β) = 0.7. as this ensures that D ≥ 0. In contrast. Hansen (1982) for the general case. and some current research suggests that this restriction is not necessary for good performance of the test. the GMM criterion function is J(β) = n · g n (β)0 Wn g n (β) For h : Rk → Rr . This result was established by Sargan (1958) for a specialized case. and by L. These may be used to construct Wald tests of statistical hypotheses. however.

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

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

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

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

Take the linear model 0 yi = zi β + ei E (xi ei ) = 0. Il ) ³ ´ (f) Jn →d N 0 Il − R (R0 R)−1 R0 N ³ ´ (g) N 0 Il − R (R0 R)−1 R0 N ∼ χ2 . Let ˆ ˆ ˆ Jn = ng n (β)0 Ω−1 g n (β) denote the test of overidentifying restrictions.7. 116 . l−k Hint: Il − R (R0 R)−1 R0 is a projection matrix. ˆ and consider the GMM estimator β of β. Deﬁne ¶µ ¶−1 µ 1 0 ˆ −1 1 0 1 0 ˆ −1 0−1 0 1 0 XZ Z XΩ XZ Z XΩ C Dn = Il − C n n n n 1 0 Xe g n (β 0 ) = n ¡ ¢ 0 R = C 0 E xi zi Show that Jn →d χ2 as n → ∞ by demonstrating each of the following: l−k (a) Since Ω > 0. we can write Ω−1 = CC 0 and Ω = C 0−1 C −1 ³ ´0 ³ ´−1 ˆ ˆ ˆ C 0 ΩC (b) Jn = n C 0 g n (β) C 0 g n (β) ˆ (c) C 0 g n (β) = Dn C 0 g n (β 0 ) (d) Dn →p Il − R (R0 R)−1 R0 (e) n1/2 C 0 g n (β 0 ) →d N ∼ N (0..

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

. λ) is a convex function of λ. we ﬁnd µ = n and 1 ¢. the Lagrange multiplier λ(β) minimizes Rn (β. λ.1) and (10.3). p (10.5) This minimization problem is the dual of the constrained maximization problem.. The Lagrangian for this maximization problem is Ã n ! n n X X X ln(pi ) − µ pi − 1 − nλ0 pi gi (β) L∗ (β. λ). λ ¡ ¢ ln 1 + λ0 gi (β) .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. (10. or equivalently minimizes its negative ˆ (10. summing over i. λ(β)) = −n ln (n) − n X i=1 ˆ The EL estimate β is the value which maximizes Ln (β). The solution (when it exists) is well deﬁned since Rn (β. but must be obtained numerically (see section 6. pi = ¡ n 1 + λ0 gi (β) Substituting into L∗ we ﬁnd n Rn (β. Ln (β) = Rn (β. pi = ³ ˆ ˆ ˆ0 n 1 + λ gi β ˆ Ln = n X i=1 ln (ˆi ) . µ. (see section 6. Multiplying the ﬁrst equation by pi . µ) = n i=1 i=1 i=1 L∗ n with respect to pi . probabilities 1 ³ ´´ .. λ) : λ(β) = argmin Rn (β.4) (10. pn . The ﬁrst-order-conditions of and λ are 1 = µ + nλ0 gi (β) pi n X pi = 1 i=1 n X i=1 The empirical likelihood estimator is the value of β which maximizes the multinomial loglikelihood (10. The solution cannot be obtained explicitly. This yields the (proﬁle) empirical log-likelihood function for β. we also obtain the Lagrange multiplier λ = λ(β).5) ˆ ˆ As a by-product of estimation. p1 . pi gi (β) = 0. and using the second and third equations.2) subject to the restrictions (10. λ) = −n ln (n) − n X i=1 For given β..where λ and µ are Lagrange multipliers.7) 118 .5).

9) (10. i i Theorem 10. and Ω = E xi x0 e2 . n (10.11) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ ˆ 0 ' −g n − Gn β − β 0 + Ωn λ (10. ´ √ ³ ˆ n β − β 0 →d √ ˆ nλ →d N (0. λ) jointly solve ³ ´ ˆ n gi β X ∂ ³ ³ ´´ Rn (β. λ) = − (10.12) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ 0 ' G0 λ − λ0 . Gi (. i=1 i=1 i=1i Expanding (10. and n β − β 0 and nλ are asymptotically independent.1 Under regularity conditions. Thus the EL estimator is asymptotically eﬃcient.9) and (10.13) Premultiplying by G0 Ω−1 and using (10. g n = n n gi (β 0 ) and Ωn = n n g (β 0 ) gi (β 0 )0 . (β.11) 0 = ∂λ ˆ0 ˆ i=1 1 + λ gi β ³ ´0 ˆ n X Gi . ˆ ˆ Proof. 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. β) = −xi zi .8) and ¢ 0 0 For example.2.10) ¡ Ω−1 N (0. ˆ The asymptotic variance V for β is the same as for eﬃcient GMM.2 Deﬁne Asymptotic Distribution of EL Estimator Gi (β) = ∂ gi (β) ∂β 0 (10. λ) = − (10. 0 = Rn (β.14) ³ ´ ˆ ˆ 0 ' −G0 Ω−1 g n − G0 Ω−1 Gn β − β 0 + G0 Ω−1 Ωn λ n n n n n n ³ ´ ˆ = −G0 Ω−1 g n − G0 Ω−1 Gn β − β 0 n n n n 119 .10).10. β λ ∂ ³ ´. in the linear model. G = −E (xi zi ).13) yields n n Expanding (10.12) ∂β ˆ ˆ0 i=1 1 + λ gi β 1 P 1 P 1 P Let Gn = n n Gi (β 0 ) . Vλ ) ´ √ ˆ √ ³ˆ where V and Vλ are deﬁned in (10.

3. ¥ Chamberlain (1987) showed that V is the semiparametric eﬃciency bound for β in the overidentiﬁed moment condition model. tests are based on the diﬀerence in the log likelihood functions. and it is advisable to report the statistic LRn whenever EL is the estimation method. First. They are asymptotically ﬁrst-order equivalent. Ω) GΩ G →d = N (0. (10. n ³ ´´ ´ √ ³ 1 X ³ ˆ ˆ √ g wi . This means that no consistent estimator for this class of models can have a lower asymptotic variance than V . The overidentiﬁcation test is a very useful by-product of EL estimation.14) for λ and using (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. since ³ ¡ ¢−1 0 ´ G0 I − Ω−1 G G0 Ω−1 G G =0 (10. Since the EL estimator achieves this bound. V ) ˆ Solving (10. The same statistic can be constructed for empirical likelihood.17) 2 ln 1 + λ gi β . it is an asymptotically eﬃcient estimator for β.1 If Eg(wi .16) ´ √ ˆ √ ³ˆ n β − β 0 and nλ are asymptotically uncorrelated and hence independent. by a Taylor expansion.15) (10. Ω) →d Ω−1 I − G G Ω G GΩ = Ω−1 N (0. The EL overidentiﬁcation test is similar to the GMM overidentiﬁcation test. Vλ ) Furthermore. LRn = i=1 Theorem 10.15). Proof. and have the same interpretation. 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. 120 .ˆ Solving for β and using the WLLN and CLT yields ´ ¢−1 0 −1 √ ¡ √ ³ ˆ ' − G0 Ω−1 Gn n β − β0 Gn Ωn ng n n n ¡ 0 −1 ¢−1 0 −1 G Ω N (0. β 0 ) = 0 then LRn →d χ2−k . and (10.7) is n ³ ´´ ³ X ˆ ˆ0 (10.3 Overidentifying Restrictions In a parametric likelihood context. Twice the diﬀerence between the unrestricted empirical likelihood −n log (n) and the maximized empirical likelihood for the model (10.16). 10.

By “maintained” we mean that the overidentfying restrictions contained in (10.edu/~bhansen/progs/elike.18). a The proof of this result is more challenging and is omitted.Second.4 Testing Egi (β) = 0 (10. 10.wisc. To test the hypothesis h(β) while maintaining (10.18) and H0 : h(β) = 0. h(β)=0 ˜ Fundamentally. The restricted EL estimator and likelihood are the values which solve ˜ β = argmax Ln (β) h(β)=0 ˜ ˜ Ln = Ln (β) = max Ln (β). since ln(1 + x) ' x − x2 /2 for x small. 10.18) Let the maintained model be where g is × 1 and β is k × 1. the restricted EL estimator β is simply an EL estimator with − k + a overidenti˜ ˆ fying restrictions. Instead we use the diﬀerence in log-likelihoods: ³ ´ ˆ ˜ LRn = 2 Ln − Ln . The hypothesis of interest is h(β) = 0.5 Numerical Computation Gauss code which implements the methods discussed below can be found at http://www.1 Under (10. so there is no fundamental change in the distribution theory for β relative to β. Theorem 10.4. This test statistic is a natural analog of the GMM distance statistic. the simple overidentifying restrictions test (10.18) are assumed to hold and are not being challenged (at least for the test discussed in this section). LRn →d χ2 . LRn = n X i=1 ˆ0 ' 2λ →d ˆ0 ˆ ' nλ Ωn λ = χ2−k n X i=1 ³ ´´ ³ ˆ ˆ0 2 ln 1 + λ gi β i=1 n ³ ´ X ³ ´ ³ ´0 ˆ − λ0 ˆ ˆ ˆ ˆ gi β gi β gi β λ N (0.17) is not appropriate. Vλ ) ¥ where the proof of the ﬁnal equality is left as an exercise.prc 121 . Vλ )0 Ω−1 N (0.ssc. where h : Rk → Ra .

λj ) . λ) = − ∂β n X i=1 G∗ (β..19) is continued until the gradient 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. Deﬁne ∗ gi (β. The modiﬁed Newton method takes a quadratic approximation to Rn (β. λ) = i ∂λ∂β 0 1 + λ0 gi (β) i=1 ⎞ ⎛ ¡ 0 ¢ ∂2 n 2 X 0 gi (β) λ ∂ ⎠ ⎝G∗ (β. λj ))−1 Rλ (β. λp ) A quadratic function can be ﬁt exactly through these three points. λj ))−1 Rλ (β. λ) gi (β. λ) .4). Set δ 0 = 0.20) . set 2 λp = λj − δ p (Rλλ (β. λ) = − gi (β. λ)0 0 Rn (β. λ)0 − Rn (β. λ) yielding the iteration rule λj+1 = λj − δ (Rλλ (β. The starting value λ1 can be set to the zero vector. λ) = i The ﬁrst derivatives of (10. The iteration (10.19).5) for given β. λ) = i i ∂β∂β 0 1 + λ0 gi (β) i=1 n where δ > 0 is a scalar steplength (to be discussed next). λ) ∂λ i=1 n ∂ Rn (β. i Rββ = Inner Loop The so-called “inner loop” solves (10. λj ) is smaller than some prespeciﬁed tolerance. λ) = ∂λ∂λ i=1 ¶ n 2 Xµ ∂ Gi (β) ∗ gi (β. λ) G∗ (β. λj )) Rp = Rn (β. Eﬃcient convergence requires a good choice of steplength δ. (10. 1. The value of δ which minimizes this quadratic is ˆ = R2 + 3R0 − 4R1 . λ) = G∗ (β. δ 1 = 1 and δ 2 = 1. λ) G∗ (β.19) X ∂2 ∗ ∗ gi (β. A complication is that λ must be constrained so that 0 ≤ pi ≤ 1 which holds if ¢ ¡ n 1 + λ0 gi (β) ≥ 1 122 (10. For p = 0. One method uses the following quadratic approximation.Derivatives The numerical calculations depend on derivatives of the dual likelihood function (10. δ 4R2 + 4R0 − 8R1 yielding the steplength to be plugged into (10. λ)0 − ∂β∂β Rn (β. 2.

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

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

Thus we make the partition ¶ µ k1 z1i (11. Deﬁnition 11. β →p β ∗ .1 Instrumental Variables 0 yi = zi β + ei Let the equation of interest be (11. so should be included in xi . We call z1i exogenous and z2i endogenous. By the above deﬁnition.1 The × 1 random vector xi is an instrumental variable for (11. and x2i are the excluded exogenous variables. (11.1. and assume that E(zi ei ) 6= 0 so there is endogeneity. That is x2i are variables which could be included in the equation for yi (in the sense 125 .4) xi = x2i 2 where z1i = x1i are the included exogenous variables. z1i is an instrumental variable for (11. So we have the partition µ ¶ z1i k1 (11. This is called simultaneous equations bias.1) where zi is k × 1. In matrix notation. which does not equal either β 1 or β 2 .1) if E (xi ei ) = 0. this can be written as Y = Zβ + e. We call (11. 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 ¶ .2) Any solution to the problem of endogeneity requires additional information which we call instruments. at least the intercept).3) zi = z2i k2 where E(z1i ei ) = 0 yet E(z2i ei ) 6= 0.1).1) the structural equation. some regressors in zi will be uncorrelated with ei (for example. In a typical set-up. ¶ µ ∙ β2 β1 1 −1 β 2 e1i + β 1 e2i (e1i − e2i ) ¸µ e1i e2i ¶ ˆ Hence if it is estimated by OLS.

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

11.2

Reduced Form

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

Substituting (11.6) into (11.2), we ﬁnd

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

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

11.3

Identiﬁcation

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

11.4

Estimation

0 yi = zi β + ei

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

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

11.5

Special Cases: IV and 2SLS

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

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

which again is the IV estimator.

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

then

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

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

13) which is zero only when S21 = 0 (when Z is exogenous).6 Bekker Asymptotics Bekker (1994) used an alternative asymptotic framework to analyze the ﬁnite-sample bias in the 2SLS estimator. We now derive a similar result for the 2SLS estimator.11). So only the endogenous variables Z2 are replaced by their ﬁtted values: ˆ ˆ ˆ Z2 = X1 Γ12 + X2 Γ22 .12) Z = XΓ + u ξ = (e.12). 11. let’s analyze the approximate bias of OLS applied to (11. Thus in the second stage. Then i h ˆ ˆ ˆ Z = Z1 . In our notation. ¡ ¢−1 ¡ 0 ¢ ˆ β 2SLS = Z 0 PX Z Z PX Y . ˆ since Z1 lies in the span of X. X2 ]. 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. we regress Y on Z1 and Z2 . First. Z = [Z1 . PX Z2 ] = [Z1 . X is n × l so there are l instruments.11) (11. Here we present a simpliﬁed version of one of his results.ˆ It is useful to scrutinize the projection Z. PX Z2 ] h i ˆ = Z1 . ¶ µ 1 0 Z e = E (zi ei ) = Γ0 E (xi ei ) + E (ui ei ) = S21 E n and E µ 1 0 ZZ n ¶ ¡ 0¢ = E zi zi ¢ ¡ ¢ ¢ ¡ ¢ ¡ ¡ = Γ0 E xi x0 Γ + E ui x0 Γ + Γ0 E xi u0 + E ui u0 i i i i = Γ0 QΓ + S22 where Q = E (xi x0 ) . Z2 = [PX Z1 . the model is Y = Zβ + e (11. 129 . Z2 . Recall. Z2 ] and X = [Z1 . Using (11. u) E (ξ | X) = 0 ¢ ¡ E ξξ 0 | X = S As before.

14) In general this is non-zero. the bias in the 2SLS estimator will be large.7 Identiﬁcation Failure Recall the reduced form equation Z2 = X1 Γ12 + X2 Γ22 + u2 . 130 .12) and this result. the expression in (11. 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 . Indeed as α → 1. Hence µ ¶ 1 0 1 1/20 ¡ 0 ¢ 1/2 ξ PX ξ S E q Λq S E = n n µ ¶ 1 0 1 1/20 S E q q1 S 1/2 = n n 1 l 1/20 1/2 S S = n = αS where α= Using (11.14) approaches that in (11. By the spectral decomposition of an idempotent matrix.Let PX = X (X 0 X)−1 X 0 .14) is the probability limit of β 2SLS − β 11. P = HΛH 0 0 0 where Λ = diag(Il . Bekker (1994) pointed out that it also has the reverse implication — that when α = l/n is large. Let q = H 0 ξS −1/2 which satisﬁes Eqq 0 = In and partition q = (q1 q2 ) where q1 is l × 1. ¢ 1 ¡ ¢ 1 ¡ ¢ 1 ¡ 0 E Z PX e = E Γ0 X 0 e + E u0 PX e = αS21 . It is also close to zero when α = 0. 0). n n n ¢ ¡ ¡ ¢ ¢ ¢ 1 ¡ 0 1 ¡ E Z PX Z = Γ0 E xi x0 Γ + Γ0 E (xi ui ) + E ui x0 Γ + E u0 PX u i i n n = Γ0 QΓ + αS22 . Bekker (1994) showed further that under the alternative asymptotic approximation that α is ﬁxed as n → ∞ (so that the number of instruments goes to inﬁnity proportionately with sample ˆ size) then the expression in (11. l .13). except when S21 = 0 (when Z is exogenous). The parameter β fails to be identiﬁed if Γ22 has deﬁcient rank. The consequences of identiﬁcation failure for inference are quite severe. indicating that the bias in 2SLS approaches that of OLS as the number of instruments increases. n and (11.

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

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

In the structural model Y = Zβ + e Z = XΓ + u with Γ l × k. 2. In the linear model 0 yi = zi β + ei E (ei | zi ) = 0 ¡ 2 ¢ suppose σ 2 = E ei | zi is known. we claim that β is identiﬁed (can be recovered from the reduced form) if rank(Γ) = k.) 3. ˜ 0 e < e0 e. u is n × k. X is n × l. in the sense that e ˜ ˜ least in large samples? 4. xi is l × 1. where xi and β are 1 × 1. Take the linear model Y = Zβ + e. Z is n × k. That is. show that if rank(Γ) < k then β cannot be identiﬁed.8 Exercises yi = zi β + ei . Let β denote the IV estimator of β using as an instrument a dummy variable di (takes only the values 0 and 1).11. 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. 133 . Show that the GLS estimator of β can be written as an i IV estimator using some instrument xi . Explain why this is true. Take the linear model yi = xi β + ei E (ei | xi ) = 0. and Γ is l × k. will IV “ﬁt” better than OLS. ˆ ˆ Let the OLS estimator for β be β and the OLS residual be e = Y − Z β. Consider the single equation model ˆ where yi and zi are both real-valued (1 × 1). ˆ ˜ ˜ Let the IV estimator for β using some instrument X be β and the IV residual be e = Y − Z β. at ˆˆ If X is indeed endogeneous. 6. 1. l ≥ k. 5. (Find an expression for xi . Find a simple expression for the IV estimator in this context. The parameter Γ is deﬁned by the population moment condition ¡ ¢ E xi u0 = 0 i ˆ Show that the method of moments estimator for Γ is Γ = (X 0 X)−1 (X 0 Z) .

in years. using the instrument near4. 134 . 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). 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. 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. There are 2215 observations with 19 variables. in years. and then calculate the GMM estimator from this weight matrix without further iteration. and South and Black are regional and racial dummy variables. Report estimates and standard errors. Is zi = (xi i for estimation of β? x2 ) a valid instrumental variable i where income (Y ) and wage (W ) are determined outside the market.pdf. (a) Estimate the model by OLS. (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). (b) Now treat Education as endogenous. I suggest that you use the 2SLS estimates as the ﬁrst-step to get the weight matrix.. and the remaining variables as exogenous. listed in card. of the mother). In this model. Report estimates and standard errors. (d) Re-estimate the model by eﬃcient GMM. (e) Calculate and report the J statistic for overidentiﬁcation. Report the estimates and standard errors. The data ﬁle card. f atheduc (the education. Estimate the model by 2SLS. (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). using zi as an instrument for xi . are the parameters identiﬁed? 8. of the father) and motheduc (the education. Does this diﬀer from 2SLS and/or OLS? 7.(b) Deﬁne the 2SLS estimator of β. a dummy indicating that the observation lives near a 4-year college.

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

T t=1 This allows us to consistently estimate parameters using time-series moments: The sample mean: T 1X µ= ˆ Yt T t=1 The sample autocovariance T 1X (Yt − µ) (Yt−k − µ) . ˆ Proof. 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 . γ (0) ˆ Theorem 12. ˆ 2. For Part (2). γ (k) →p γ(k). then as T → ∞. 1.1.1 above. the sequence Yt Yt−k is strictly stationary and ergodic. ˆ 3.2 (Ergodic Theorem). If Xt is strictly stationary and ergodic and E |Xt | < ∞.Theorem 12. ˆ ˆ T t=1 γ (k) = ˆ The sample autocorrelation ρ(k) = ˆ γ (k) ˆ . ρ(k) →p ρ(k).1. ˆ ˆ T t=1 T t=1 T t=1 By Theorem 12.3 If Yt is strictly stationary and ergodic and EYt2 < ∞.1. µ →p E(Yt ). ˆ ˆ γ ¥ 136 . Part (1) is a direct consequence of the Ergodic theorem. then as T → ∞. T 1X Xt →p E(Xt ). Thus an application of the Ergodic Theorem yields T 1X Yt Yt−k →p E(Yt Yt−k ). T t=1 Thus γ (k) →p E(Yt Yt−k ) − µ2 − µ2 + µ2 = E(Yt Yt−k ) − µ2 = γ(k). and it has a ﬁnite mean by the assumption that EYt2 < ∞. ˆ Part (3) follows by the continuous mapping theorem: ρ(k) = γ (k)/ˆ (0) →p γ(k)/γ(0) = ρ(k).

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

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

Thus t by the Ergodic Theorem.1 The AR(k) is strictly stationary and ergodic if and only if |λj | > 1 for all j.” If one of the roots equals 1.. Thus T T 1X 1X xt et = ut →p E (ut ) = 0. . This is a special case of non-stationarity.1) Theorem 12.6 Let Estimation xt = β = ¡ 1 Yt−1 Yt−2 · · · α ρ1 ρ2 · · · yt = x0 β + et . Let |λ| denote the modulus of a complex number λ. it is also strictly stationary and ergodic. For an AR(k). so is xt x0 .. By Theorem 12.1 If the AR(k) process Yt is strictly stationary and ergodic and EYt2 < ∞. “has a unit root”. T t=1 T t=1 ¢−1 0 ¡ ˆ X Y. λk are the complex roots of ρ(z). The vector xt is strictly stationary and ergodic. T ¢ ¡ 1X xt x0 →p E xt x0 = Q.5.where the λ1 . t T t=1 T t=1 139 .1. and hence Yt . the requirement is that all roots are larger than one. t Yt−k ¢0 ρk . Theorem 12.. The Fundamental Theorem of Algebra says that any polynomial can be factored as ¢¡ ¢ ¡ ¢ ¡ ρ(z) = 1 − λ−1 z 1 − λ−1 z · · · 1 − λ−1 z 1 2 k 12. since E (ut | It−1 ) = E (xt et | It−1 ) = xt E (et | It−1 ) = 0. then ˆ β →p β as T → ∞. ¢0 Then the model can be written as The OLS estimator is ¡ ˆ To study β. which satisfy ρ(λj ) = 0. t t T t=1 ¥ Combined with (12. we see that Ã !−1 Ã ! T T 1X 1X ˆ β=β+ xt x0 xt et →p Q−1 0 = 0.6. One way of stating this is that “All roots lie outside the unit circle.1) and the continuous mapping theorem. 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. and is of great interest in applied time series. β = X 0X (12.1. it is helpful to deﬁne the process ut = xt et .1. Note that ut is a MDS. Proof.1. and by Theorem 12.

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

6.4) There are two essentially equivalent ways to estimate the autoregressive parameters (ρ1 .4) by OLS.3) replacing St with St . Seasonal Eﬀects There are three popular methods to deal with seasonal data. (12. The seasonal adjustment. But the long-run trend is also eliminated. and then perform regression (12.2)-(12. ﬁrst estimate (12. however.. Paste the blocks together to create the bootstrap time-series Yt∗ . or the season-to-season change. Thus the seasonally adjusted data is a “ﬁltered” series. 4.3) sequentially by OLS. • Use “seasonally adjusted” data. This allows for arbitrary stationary serial correlation. heteroskedasticity. Resample complete blocks.2).. • Include dummy variables for each season. and for modelmisspeciﬁcation. also alters the time-series correlations of the data. and perhaps this was of relevance. 12. May not work well in small samples. 3. The reason why these two procedures are (essentially) the same is the Frisch-Waugh-Lovell theorem. For each simulated sample. If s is the number of seasons (typically s = 4 or s = 12). get the ˆ ˆ residual St .3) or Yt = α0 + α1 t + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et . That is.9 Trend Stationarity Yt = µ0 + µ1 t + St St = ρ1 St−1 + ρ2 St−2 + · · · + ρk St−l + et . ∆s Yt = Yt − Yt−s . (12. This is a ﬂexible approach which can extract a wide range of seasonal factors. and the way that the data are partitioned into blocks.2.. 141 . This presumes that “seasonality” does not change over the sample. This procedure is sometimes called Detrending.2) (12. ρk ). The series ∆s Yt is clearly free of seasonality. 5. • First apply a seasonal diﬀerencing operator. The results may be sensitive to the block length. The seasonal factor is typically estimated by a two-sided weighted average of the data for that season in neighboring years. draw T /m blocks. . • You can estimate (12. • You can estimate (12.

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

observe that the lag polynomial for the Yt computed from (12. Thus ρ(1) = (1 − 1) − α0 − (1 − 1) − · · · − (1 − 1) = −α0 . Indeed. Because of this property. under H0 . the hypothesis of a unit root in Yt can be stated as H0 : α0 = 0. but simply assert the main results. An alternative asymptotic framework has been developed to deal with non-stationary data. and test statistics are asymptotically non-normal. The DF parameterization is convenient because the parameter α0 summarizes the information about the unit root. Note that the model is stationary if α0 < 0. this is the most popular unit root test. the model for Yt is ∆Yt = µ + α1 ∆Yt−1 + · · · + αk−1 ∆Yt−(k−1) + et . 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 . since ρ(1) = −α0 . then Yt is “integrated of order d”.12 Autoregressive Unit Roots The AR(k) model is ρ(L)Yt = µ + et ρ(L) = 1 − ρ1 L − · · · − ρk Lk .12. (12. It would seem natural to assess the signiﬁcance of the ADF statistic using the normal table. or ρ1 + ρ2 + · · · + ρk = 1.7) is (1 − L) − α0 L − α1 (L − L2 ) − · · · − αk−1 (Lk−1 − Lk ) But this must equal ρ(L). then ∆Yt is a stationary AR process. as the models are equivalent. Yt is non-stationary. Yt has a unit root when ρ(1) = 0. To see this. which is an AR(k-1) in the ﬁrst-diﬀerence ∆Yt . we say that if Yt is non-stationary but ∆d Yt is stationary. Since α0 is the parameter of a linear regression. Under H0 . The ergodic theorem and MDS CLT do not apply. or I(d). Yt is non-stationary. and is called the Augmented Dickey-Fuller (ADF) test for a unit root. 143 . Thus a time series with unit root is I(1).7) These models are equivalent linear transformations of one another.7). so conventional normal asymptotics are invalid. As we discussed before. Hence. In this case. So the natural alternative is H1 : α0 < 0. We do not have the time to develop this theory in detail. However. the natural test statistic is the t-statistic for H0 from OLS estimation of (12. Thus if Yt has a (single) unit root.

and may be used for testing the hypothesis H0 . This distribution has been extensively α tabulated. a common conclusion is that the data suggests that Yt is non-stationary. Most texts include as well the critical values for the extreme polar case where the intercept has been omitted from the model. Note: The standard error s(ˆ 0 ) is the conventional (“homoskedastic”) standard error. then the series itself is nonstationary. The ﬁrst result states that α0 converges to its true value (of zero) at rate T. Assume α0 = 0. All we can say is that there is insuﬃcient evidence to conclude whether the data are stationary or not. But the theorem does not require an assumption of homoskedasticity. If the test does not reject H0 . As T → ∞. but diﬀerent critical values are required. this means that the evidence points to Yt being stationary. where c is the critical value from the ADF table. Another popular setting includes as well a linear time trend. 144 .g. the ADF test rejects H0 in favor of H1 when ADF < c. Stock Prices). When conducting the ADF test. The ADF test has a diﬀerent distribution when the time trend has been included.12. If a time trend is included. as the AR model cannot conceivably describe this data. and have negative means. s(ˆ 0 ) α The limit distributions DFα and DFt are non-normal. This is called a “super-consistent” rate of convergence.8) This is natural when the alternative hypothesis is that the series is stationary about a linear time trend. T α0 →d (1 − α1 − α2 − · · · − αk−1 ) DFα ˆ ADF = α0 ˆ → DFt . The natural solution is to include a time trend in the ﬁtted OLS equation. In this context. Thus the Dickey-Fuller test is robust to heteroskedasticity. Since the alternative hypothesis is one-sided. 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 is not really a correct conclusion. If the test rejects H0 . but it may be stationary around the linear time trend. and a diﬀerent table should be consulted. rather than the ˆ 1/2 . If the series has a linear trend (e. however. (12.8). this means that it is computed as the t-ratio for α0 from OLS estimation of (12. We have described the test for the setting of with an intercept. but does not depend on the parameters α. it is a silly waste of time to ﬁt an AR model to the level of the series without a time trend. These are included for completeness (from a pedagogical perspective) but have no relevance for empirical practice where intercepts are always included. the test procedure is the same.Theorem 12. This model is ∆Yt = µ1 + µ2 t + α0 Yt−1 + α1 ∆Yt−1 + · · · + αk−1 ∆Yt−(k−1) + et .1 (Dickey-Fuller Theorem). They are skewed to the left. GDP.

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

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

This restriction.5 Testing for Omitted Serial Correlation Consider the problem of testing for omitted serial correlation in equation (13. t and et is iid N (0. with time series data. We see that an appropriate. Then the single equation takes the form (13. 13.1). Suppose that et is an AR(1).2) is uncommon in recent applications. t and xt = This is just a conventional regression.2) is a special case of (13. Let yt = Yjt . This can be done by a Wald test. and is typically rejected empirically. Otherwise it is invalid. In this case. xt−1 ) to the regression.3) which is a valid regression model. This takes the form 0 and xt consists of lagged values of Yjt and the other Ylt s. under the restriction γ = −βθ.1) yt = x0 β + et . which once was very popular.) Since the common factor restriction appears arbitrary.13. t or yt = θyt−1 + x0 β + x0 γ + ut . h¡ 1 Yt−1 · · · 0 Yt−k Zt−1 · · · 0 Zt−k ¢0 i . which is called a common factor restriction. 1). t t−1 (13. Then the null and alternative are H0 : θ = 0 H1 : θ 6= 0. If valid. direct estimation of (13. general. the model (13.3).2) may be estimated by iterated GLS. may be tested if desired. it is convenient to re-deﬁne the variables. (13. and is still routinely reported by conventional regression packages. and subtract oﬀ the equation once lagged multiplied by θ. Then yt = x0 β + et t et = θet−1 + ut E (ut | It−1 ) = 0. we are only interested in a single equation out of a VAR system. (A simple version of this estimator is called Cochrane-Orcutt. So testing H0 versus H1 is equivalent to testing for the signiﬁcance of adding (yt−1 . and Zt be the other variables.2) Take the equation yt = x0 β + et . The DW test is appropriate only when regression yt = x0 β + et is not dynamic (has no lagged values on the RHS). You may have heard of the Durbin-Watson test for omitted serial correlation. Another interesting fact is that (13. and simple way to test for omitted serial correlation is to test the signiﬁcance of extra lagged values of the dependent variable and regressors. Let et = ejt and β = aj . 147 . to get t ¡ ¢ ¡ ¢ yt − θyt−1 = x0 β + et − θ x0 β + et−1 t t−1 = x0 β − θxt−1 β + et − θet−1 .4 Single Equation from a VAR Yjt = a0 xt + et . j Often.

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

Yt is I(1) and cointegrated. m × r. it may be believed that β is known a priori. then β = (1 − 1)0 speciﬁes that log(Consumption/Income) is stationary. If the series Yt is not cointegrated. Often. from OLS of Y1t on Y2t . so the ADF critical values are not appropriate. the asymptotic distribution of the test is aﬀected by the presence of the time trend. For example. Engle and Granger (1987) suggested using an ADF test on the estimated ˆ0 ˆ residual zt = β Yt . Then β 2 = (Y20 Y2 )−1 Y2 Y1 →p β 2 . β may not be known. Hansen (1992). then it turns out that β can be consistently estimated by an OLS regression of one component of Yt on the others. however. if Yt is a pair of interest rates. Deﬁnition 13. as ﬁrst shown by Stock (1987). in general.13. Thus H0 can be tested using a univariate ADF test on zt . of rank r. Under H0 . In other cases.9 Cointegrated VARs A(L)Yt = et A(L) = I − A1 L − A2 L2 − · · · − Ak Lk We can write a VAR as or alternatively as ∆Yt = ΠYt−1 + D(L)∆Yt−1 + et where Π = −A(1) = −I + A1 + A2 + · · · + Ak . Y2t ) and β = (β 1 β 2 ) and normalize β 1 = 1.8. The r vectors in β are called the cointegrating vectors. so zt = β 0 Yt is known. but it is useful in the construction of alternative estimators and tests. In some cases.8 Cointegration The idea of cointegration is due to Granger (1981). The asymptotic distribution was worked out in B. Whether or not the time trend is included. If r = m. If Y = (log(Consumption) log(Income))0 . 13. then r = 0. When β is unknown. then β = (1 − 1)0 speciﬁes that the spread (the diﬀerence in returns) is stationary.1 The m × 1 series Yt is cointegrated if Yt is I(1) yet there exists β. When the data have time trends. such that zt = β 0 Yt is I(0). For 0 < r < m. Suppose that β is known. β is not consistent. Their justiﬁcation was Stock’s result that β is superˆ ˆ consistent under H1 . We are often interested in testing the hypothesis of no cointegration: H0 : r = 0 H1 : r > 0. it may be necessary to include a time trend in the estimated cointegrating regression. Furthermore ˆ this estimation is super-consistent: T (β 2 − β 2 ) →d Limit. and was articulated in detail by Engle and Granger (1987). yet under H1 zt is I(0). The asymptotic distribution was worked out by Phillips and Ouliaris (1990). a good method to estimate β. β = (1 − 1)0 . Then under H0 zt is I(1). This is not. If Yt is cointegrated with a single cointegrating vector (r = 1). 149 . Thus Yt = ˆ (Y1t . 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 .Theorem 13. this can be estimated by OLS of ∆Yt on zt−1 and the lags of ∆Yt . then estimation is done by “reduced rank regression”. Yt is cointegrated with m × r β if and only if rank(Π) = r and Π = αβ 0 where α is m × r. which is least-squares subject to the stated restriction. When r = 1. If β is unknown. this is the MLE of the restricted parameters under the assumption that et is iid N (0. 1991. they are typically called the “Johansen Max and Trace” tests. Thus cointegration imposes a restriction upon the parameters of a VAR. Equivalently. If β is known. we typically just normalize one element to equal unity. Their asymptotic distributions are non-standard. and diﬀerent authors have adopted diﬀerent identiﬁcation schemes.1 (Granger Representation Theorem). One diﬃculty is that β is not identiﬁed without normalization. rank(α) = r. 1995).9. As they were discovered by Johansen (1988. In the context of a cointegrated VAR estimated by reduced rank regression. this does not work. 150 . When r > 1. and are similar to the Dickey-Fuller distributions. These tests are constructed as likelihood ratio (LR) tests. it is simple to test for cointegration by testing the rank of Π. Ω).

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

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

Thus the model is that there is some latent process yi with unbounded support. 0 if yi (This is written for the case of the threshold being zero. Censored models are typically applied when the data set has a meaningful proportion (say 5% or higher) of data at the boundary of the sample support.. The functional form for λi has been picked to ensure that λi > 0. but we observe only ½ ∗ ∗ yi if yi ≥ 0 (14.}. this motivates the label Poisson “regression.. Since E (Yi | xi ) = λi = exp(x0 β) i is the conditional mean.” Also observe that the model implies that V ar (Yi | xi ) = λi = exp(x0 β). i so the model imposes the restriction that the conditional mean and variance of Yi are the same. The conditional density is the Poisson with parameter λi . i i i=1 ˆ The MLE is the value β which maximizes ln (β). The log-likelihood function is ln (β) = n X i=1 log f (yi | xi ) = n X¡ ¢ − exp(x0 β) + yi x0 β − log(yi !) . any known value can substitute. The censoring process may be explicit in data collection.1). i If Y = {0.14. The ﬁrst censored regression model was developed by Tobin (1958) to explain consumption of durable goods. 2. or it may be a by-product of economic constraints.1) yi = ∗ <0 . This model (now called the Tobit) speciﬁes that the latent (or ideal) value of consumption may be negative (the household 153 ..3 Censored Data The idea of “censoring” is that some data above or below a threshold are mis-reported at the ∗ threshold. This may be considered restrictive. An example of a data collection censoring is top-coding of income. 2. . a typical approach is to employ Poisson regression. 14. σ 2 ) with the observed variable yi generated by the censoring equation (14. incomes above a threshold are typically reported at the threshold. the consumption level (purchases) in a particular period was zero. In surveys.. .) The observed data yi therefore come from a mixed continuous/discrete distribution. A generalization is the negative binomial. This model speciﬁes that P (Yi = k | xi ) = λi k = 0. 1. Tobin observed that for many households. He proposed the latent variable model ∗ yi = x0 β + ei i ei ∼ iid N (0. 1.2 Count Data exp (−λi ) λk i . k! = exp(x0 β).

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

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

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

and that eit is uncorrelated with xit .. ... It is consistent if E (xit ui ) = 0 (15. then OLS is inconsistent. If (15.1 Individual-Eﬀects Model The standard panel data speciﬁcation is that there is an individual-speciﬁc eﬀect which enters linearly in the regression yit = x0 β + ui + eit . In either event.. . that eit is iid across individuals and time.Chapter 15 Panel Data A panel is a set of observations on individuals.. it The typical maintained assumptions are that the individuals i are mutually independent. i = 1.2 Fixed Eﬀects This is the most common technique for estimation of non-dynamic linear panel regressions. and the t subscript denotes time. Condition (15. or unbalanced : {yit . xit }. The goal is to eliminate ui from the estimator. .1) is called the random eﬀects hypothesis. An observation is the pair {yit . and thus achieve invariance.. where the i subscript denotes the individual.. OLS appears a poor estimation choice. 15. xit } : For i = 1. A panel may be balanced : {yit . . n. OLS can be improved upon via a GLS technique. that ui and eit are independent.. T . t = ti . xit } : t = 1. ti . This is often believed to be plausible if ui is an omitted variable. however. (15.1) If this condition fails. It is a strong assumption. There are several derivations of the estimator. collected over time...1) is true.. and most applied researchers try to avoid its use. and have arbitrary correlated with xi . The motivation is to allow ui to be arbitrary. OLS of yit on xit is called pooled estimation.. 15. n. 157 .1) fails if the individual-speciﬁc unobserved eﬀect ui is correlated with the observed explanatory variables xit .

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

it it which is free of the individual-eﬀect ui . it However.Since the regression of yit on di is a regression onto individual-speciﬁc dummies. the predicted value from these regressions is the individual speciﬁc mean y i . Thus values of yit−k . GMM using yt−2 and yt−3 as instruments (which is overidentiﬁed. at least if T is held ﬁnite as n → ∞. e So OLS on (15. it (15. the ﬁxed eﬀects estimator is inconsistent. as this enables the moments from the diﬀerent timeperiods to be stacked together to create a list of all the moment conditions. we ﬁnd y i = x0 β + ui + ei . the dependent variable and regressors in deviationit from-mean form. but loses a time-series observation).3 Dynamic Panel Regression yit = αyit−1 + x0 β + ui + eit .3) eliminates the individual-speciﬁc eﬀect: ∆yit = α∆yit−1 + ∆x0 β + ∆eit . A more sophisticated GMM estimator recognizes that for time-periods later in the sample. Alternatively. This is because the sample mean of yit−1 is correlated with that of eit . Typically. so the instrument list should be diﬀerent for each equation. Hence a valid estimator of α and β is to estimate (15. Taking ﬁrst-diﬀerences of (15. ∗ ˆ The ﬁxed eﬀects estimator β is OLS of yit on x∗ .3) A dynamic panel regression has a lagged dependent variable This is a model suitable for studying dynamic behavior of individual agents. Another derivation of the estimator is to take the equation yit = x0 β + ui + eit . This is conveniently organized by the GMM principle. if eit is iid. and the residual is the demean value ∗ yit = yit − yi . then IV or GMM can be used to estimate the equation. But if there are valid instruments.4) by IV using yt−2 as an instrument for ∆yt−1 (which is just identiﬁed). i ∗ yit = x∗0 β + e∗ . 15. The standard approach to estimate a dynamic panel is to combine ﬁrst-diﬀerencing with IV or GMM. two periods back. 159 (15. as yt−2 is uncorrelated with ∆eit . we use lags of the dependent variable.4) will be inconsistent. k ≥ 2.4) . there are more instruments available. are valid instruments. Unfortunately. A simple application of GMM yields the parameter estimates and standard errors. it and then take individual-speciﬁc means by taking the average for the i0 th individual: ti ti ti 1 X 1 X 0 1 X yit = x β + ui + eit Ti t=t Ti t=t it Ti t=t i i i or Subtracting. then it will be correlated with ∆yit−1 : E (∆yit−1 ∆eit ) = E ((yit−1 − yit−2 ) (eit − eit−1 )) = −E (yit−1 eit−1 ) = −σ 2 .

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

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

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

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

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

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

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

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

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

0≤p≤1 V ar(X) = λ We now list some important continuous distributions..A. 1. we now list some important discrete distribution function. Bernoulli P (X = x) = px (1 − p)1−x . 0≤p≤1 x = 0.. n.. 1.. X2 = x2 . 1. x! EX = λ x = 0. 2...... . 169 . 0≤p≤1 p1 + · · · + pm = 1 EX = V ar(X) = Negative Binomial µ ¶ r+x−1 P (X = x) = p(1 − p)x−1 .. .4 Common Distributions For reference. x EX = V ar(X) = Poisson P (X = x) = exp (−λ) λx .. 2. 0≤p≤1 x = 0.. ... . EX = p V ar(X) = p(1 − p) Binomial µ ¶ n x P (X = x) = p (1 − p)n−x . 2. . Xm = xm ) = x1 + · · · + xm n! px1 px2 · · · pxm . x = 1. 1 EX = p 1−p V ar(X) = p2 Multinomial P (X1 = x1 . m x1 !x2 ! · · · xm ! 1 2 = n.. x EX = np V ar(X) = np(1 − p) Geometric P (X = x) = p(1 − p)x−1 . λ>0 x = 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 < ∞. α > 0. exp θ θ EX = θ 0 ≤ x < ∞. α > 0.Beta f (x) = µ = V ar(X) = Cauchy f (x) = 1 . V ar(X) = R1 0 x−2 dx Z ∞ 0 exp (−x) dx (1 + exp (−x))2 Lognormal Ã ! (ln x − µ)2 1 exp − f (x) = √ . β>1 β−1 βα2 . Γ(α)Γ(β) α α+β αβ (α + β + 1) (α + β)2 0 ≤ x ≤ 1. (1 + exp (−x))2 EX = 0 −∞ < x < ∞. π (1 + x2 ) EX = ∞ −∞ < x < ∞ Γ(α + β) α−1 x (1 − x)β−1 . σ>0 Pareto βαβ . θ>0 V ar(X) = θ2 Logistic f (x) = exp (−x) . β>2 (β − 1)2 (β − 2) 170 β>0 . β > 0 V ar(X) = ∞ ExponentiaI f (x) = ³x´ 1 .

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

however. X and Y are independent if and only if there exist functions g(x) and h(y) such that f (x. then Z Z E (g(X)h(Y )) = g(x)h(y)f (y.5) is that if X and Y are independent and Z = X + Y. The correlation between X and Y is Corr(X. X 2 ) = 0. is not true. If X and Y are independent. y) = g(x)h(y). If X and Y are independent. then V ar (X + Y ) = V ar(X) + V ar(Y ). x)dydx Z Z = g(x)h(y)fY (y)fX (x)dydx Z Z = g(x)fX (x)dx h(y)fY (y)dy = Eg (X) Eh (Y ) . if X and Y are independent then E(XY ) = EXEY. 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). For example. Furthermore. 172 . Y ) = σ XY = E ((X − EX) (Y − EY )) = EXY − EXEY. An implication is that if X and Y are independent. The reverse. A useful fact is that V ar (X + Y ) = V ar(X) + V ar(Y ) + 2Cov(X. if EX = 0 and EX 3 = 0.5) if the expectations exist. then Cov(X. Y ) = ρXY = σ XY .The correlation is a measure of linear dependence. (A. σxσY (A. For example. y) = fX (x)fY (y). y)dx.Similarly. then σ XY = 0 and ρXY = 0. −∞ The random variables X and Y are deﬁned to be independent if f (x.6) The Cauchy-Schwarz Inequality implies that |ρXY | ≤ 1. the marginal density of Y is fY (y) = Z ∞ f (x. Another implication of (A. the variance of the sum is the sum of the variances. free of units of measurement. The covariance between X and Y is Cov(X. Y ).

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

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

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

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

C −1 AC −10 ) = N (0. tr = p Q/r The density of tr is and is known as the student’s t distribution with r degrees of freedom. The MGF for the density (A.11).11) is Z ∞ ¢ ¡ Γ r+1 2 f (x) = ´ r+1 ¡r¢ ³ √ 2 2 πrΓ 2 1 + x r (A.3. Set r Z .8. tr has distribution 177 . Since we can write Q = P 2 X 0 X = r Zj where the Zj are independent N(0.3 Let Z ∼ N (0. which we showed in (A.8. ¡ ¢ √ using the change—of-variables s = x2 and the fact Γ 1 = π.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). we see that the MGF of Z 2 is (1 − 2t)−1/2 . The fact that A > 0 means that we can write A = CC 0 where C is non-singular.2.6) can be used to show that the MGF j=1 ¥ Proof of Theorem A.Theorem A. 1).1. From (A. 1) the distribution of Z 2 is ¡ ¢ √ P Z 2 ≤ y = 2P (0 ≤ Z ≤ y) µ 2¶ Z √y 1 x √ exp − dx = 2 2 2π 0 Z y ³ s´ 1 ¡1¢ = s−1/2 exp − ds 1/2 2 0 Γ 2 2 1 ¡r¢ 2 2r/2 y r/2−1 exp (ty) exp (−y/2) dy of Q is (1 − 2t)−r/2 . Then A−1 = C −10 C −1 and C −1 Z ∼ N (0. Using the simple law of iterated expectations.12) E exp (tQ) = 0 Γ (A.8. (A. C −1 CC 0 C −10 ) = N (0.13). For Z ∼ N(0.11) 2 with r = 1. 1) and Q ∼ χ2 be independent.13) is the MGF of the density (A. which can be found by applying change-of-variables to the gamma function. Thus the density of Z 2 is (A. Proof of Theorem A. Thus ¥ ¡ ¢0 ¡ ¢ Z 0 A−1 Z = Z 0 C −10 C −1 Z = C −1 Z C −1 Z ∼ χ2 . Iq ).8. q Proof of Theorem A.

θ) and the joint ˜ density of a random sample Y = (Y1 . 178 . θ) where F is a known distribution function and θ ∈ Θ is an unknown m × 1 vector. If the distribution F is discrete. θ) . . In this setting the method of maximum likelihood is the appropriate technique for estimation and inference on 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¡ ¢ . θ) .θ = fn Y f (Yi .. θ) . i=1 The likelihood of the sample is this joint density evaluated at the observed sample values. If the distribution F is continuous then the density of Yi can be written as f (y..9 Maximum Likelihood If the distribution of Yi is F (y. viewed as a function of θ. Yn ) is n ³ ´ Y ˜. we say that the distribution is parametric and that θ is the parameter of the distribution F. θ) = P (Y = y. The space Θ is the set of permissible value for θ. The log-likelihood function is its natural log Ln (θ) = n X i=1 ln f (Yi . the likelihood and log-likelihood are constructed by setting f (y. 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..

If ˜ is an unbiased estimator of θ ∈ R.16).Deﬁne the Hessian H = −E and the outer product matrix Ω=E µ ∂2 ln f (Yi .9. θ) ∂θ ∂θ which holds at θ = θ0 by (A. θ θ∈Θ ˆ In some simple cases. 179 . Theorem A.14) ¶ ∂ ∂ 0 ln f (Yi . which maximizes the log-likelihood). We can write this as ˆ = argmax Ln (θ). θ)¯ =0 ¯ ∂θ θ=θ0 H = Ω ≡ I0 (A. θ) ≡ L(θ). then θ V ar(˜ ≥ (nI0 )−1 . In fact.15) Two important features of the likelihood are Theorem A. θ) →p E ln f (Yi . The ﬁrst-order condition for the latter problem is 0= ∂ ∂ L(θ) = E ln f (Yi . ˆ is consistent θ for this value. ´ ¡ −1 ¢ √ ³ˆ n θ − θ0 →d N 0. ˆ →p θ0 as n → ∞.17) The matrix I0 is called the information. the restriction to unbiased estimators means that the theorem has little direct relevance for ﬁnite sample eﬃciency. I0 .9.17) is often called the information matrix equality.3 Under regularity conditions. n n i=1 n As the MLE ˆ maximizes the left-hand-side. θ0 ) . we can ﬁnd an explicit expression for θ as a function of the data. θ0 ) ln f (Yi . More typically.16) (A. and the equality (A. However.2 Cramer-Rao Lower Bound.1 ¯ ¯ ∂ E ln f (Yi . we can see that it is an estimator of the maximizer θ of the right-hand-side. θ) The Cramer-Rao Theorem gives a lower bound for estimation. the MLE θ Why do we believe that the MLE ˆ is estimating the parameter θ? Observe that when stanθ dardized. under conventional regularity conditions. but these ˆ must be found by numerical methods. θ Theorem A. θ0 ) ∂θ∂θ 0 (A. the log-likelihood is a sample average 1X 1 Ln (θ) = ln f (Yi . ∂θ ∂θ (A. The maximum likelihood estimator or MLE ˆ is the parameter value which maximizes θ the likelihood (equivalently.9. cases are rare.

θ) θ In this case. In this case there is not a “true” value of the parameter θ. Instead we deﬁne the pseudo-true value θ0 as the maximizer of Z E ln f (Yi .ˆ ˆ−1 θ We then set I0 = H −1 . A minor adjustment to Theorem (A. θ). Thus the QMLE θ0 is the value which makes the parametric density “closest” to the true value according to this measure of distance. 180 . Thus in large samples the MLE has approximately the best possible variance. Therefore the MLE is called asymptotically eﬃcient. Typically. but has a diﬀerent covariance matrix than in the pure MLE case. θ) is necessarily the true density. V ) .9.17) does not hold. θ) is used to approximate the true unknown density f (y). θ (A. ˆ . θ V = H −1 ΩH −1 The moment estimator for V is ˆ where H is given in (A.18) and ³ ³ ´ ∂ ´0 1X ∂ ˆ ln f Yi . θ) dy which is the same as the minimizer of KLIC = Z f (y) ln µ f (y) f (y.14) n ³ ´ 1 X ∂2 ˆ ˆ ln f Yi .18) H =− n ∂θ∂θ0 i=1 the Kullback-Leibler information distance between the true density f (y) and the parametric density f (y. the approximate variance of the MLE is (nI0 )−1 which is the CramerRao lower bound. The QMLE is consistent for the pseudo-true value. θ) = f (y) ln 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 . since the information matrix equality (A. ˆ ln f Yi . but it is not literally believed that the model f (y. to estimate the asymptotic variance of the MLE we use an estimate based on the Hessian formula (A. we refer to Ln (ˆ as a quasi-likelihood and the its maximizer ˆ as a quasi-mle or QMLE. ˆ elements of n 0 Sometimes a parametric density function f (y. θ) ¶ dy Thus in large samples. Asymptotic standard errors for ˆ are then the square roots of the diagonal −1 I −1 .3) yields the asymptotic distribution of the QMLE: ´ √ ³ n ˆ − θ0 →d N (0.

θ0 ) − f (Yi . Proof of Theorem A.. θ) ¯θ=θ0 ¯ Z ¯ ∂ f (y. θ0 = ln f (Yi . θ) f (y. θ0 ) dy ¯ ¯ ¯ θ=θ0 f (y. y y θ(˜ y y y θS 1 = θ(˜ ∂θ ∂θ By the Cauchy-Schwarz inequality ¯ ³ ´¯2 ³ ´ ¯ ¯ θS θ 1 = ¯E ˜ ¯ ≤ V ar (S) V ar ˜ ³ ´ V ar ˜ ≥ θ 1 1 = . θ0 ) ∂ ∂ − ln f (Yi . Since θ Z ˜ = ˜ y)f (˜.1. Diﬀerentiating with respect to θ and evaluating at θ0 yields ˜ Z Z ³ ´ ˜ y ) ∂ f (˜. θ0 )0 . . θ0 )2 (Yi .9.17). ∂2 ln f (Yi .2. Write the estimator ˜ = ˜ Y ) as a θ θ( ˜ ˜ is unbiased for any θ. θ0 ) ¯ ∂ f (y. we can show that E By direction computation. θ0 )0 f (Yi . ∂θ ¯θ=θ0 Z ! = 0. θ) dy ¯ ∂θ f (y.1) has mean zero and variance nH. θ) d˜ = ˜ y ) ∂ ln f (˜. θ0 ) = ∂θ∂θ0 = Taking expectations yields (A. yn ). θ0 ) ln f (Yi .9.. θ0 ) ∂ ∂θ f ∂ (Yi .16). θ0 ) ∂θ ∂θ ¥ ³ ´ X ∂ ∂ ˜ ln fn Y . θ0 ) (Yi . θ0 ) d˜ = E ˜ . (Yi . θ0 ) ∂θ f (Yi . θ) dy ¯ ¯ ∂θ θ=θ0 ¯ ∂ ¯ 1¯ = 0. ¯ ¯ ∂ E ln f (Yi . To see (A. θ0 ) f (Yi . θ) d˜ θ = Eθ θ(˜ y y where y = (y1 .Proof of Theorem A.. θ) f (˜. θ0 ) ∂θ ∂θ n i=1 which by Theorem (A. S= ∂2 f ∂θ∂θ0 ∂2 f ∂θ∂θ0 ∂ ∂θ Z Ã ∂2 f ∂θ∂θ0 ¯ ¯ ln f (y. θ)¯ = ¯ ∂θ θ=θ0 = = = Similarly. function of the data. f (Yi . V ar (S) nH so ¥ 181 .9.

Together. θn ) − H(θn ) + H(θn ) − n n ∂θ∂θ0 ∂θ∂θ0 i=1 i=1 →p H by an application of a uniform WLLN.Proof of Theorem A. ˆ = θ ∂θ i=1 n n ´ ³ X ∂ X ∂2 ˆ ln f (Yi . we ﬁnd ´ ³ ˆ − θ0 = θ Since ∂ ∂θ Ã !−1 Ã n ! n X ∂2 X ∂ ln f (Yi . ¯ ¯ ∂ Ln (θ)¯ 0 = ¯ ˆ ∂θ θ=θ n ³ ´ X ∂ ln f Yi . ´ ¡ ¢ ¡ ¢ √ ³ˆ n θ − θ0 →d H −1 N (0. − ln f (Yi . Ω) . Let ∂2 H(θ) = − ∂θ∂θ0 ln f (Yi . θn ) = ln f (Yi . then since θn →p θ0 we ﬁnd H(θn ) →p H and so ¶ n n µ ∂2 1X 1 X ∂2 − ln f (Yi . Ω) = N 0. an application of the CLT yields 1 X ∂ √ ln f (Yi . θ0 ) .3 Taking the ﬁrst-order condition for maximization of Ln (θ). (Technically. θ0 ) →d N (0. θ n ) θ − θ 0 .1 . and making a ﬁrst-order Taylor series expansion. ∂θ n i=1 n The analysis of the sample Hessian is somewhat more complicated due to the presence of θn .9.9. H −1 . 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 .) Rewriting this equation. θ0 ) is mean-zero with covariance matrix Ω. ¥ 182 . If it is continuous in θ. θn ) ∂θ ∂θ∂θ0 i=1 i=1 ln f (Yi . θ) . the ﬁnal equality using Theorem A. H −1 ΩH −1 = N 0. θ0 ) + ' 0 ln f (Yi .

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

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

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

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

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

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

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

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

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

- none
- B.L.R. Multivariate Survey
- Lessons 34 40
- Math Intro
- GMM_2
- 3 13h - all systems go
- linalg
- Linear Algebra
- First Course Linear Algebra-3.40-Flashcards
- Chapter 4 Matrices Student Notes Pwe
- PC Matrices 3
- Bravo, Marín - 2008 - Banco Central de Chile Documentos de Trabajo Central Bank of Chile Working Papers EXPLORING THE RELATIONSHIP BETWEEN R & D AND PRODUCTIVITY A COUNTRY-LEVEL STUD
- Using YACAS
- City Vologiannidis
- State Space and Control Theory
- Eigenvalues and Eigenvectors
- Econometrics
- Chapter 1 Logic
- Rr210101 Mathematics II
- +23 Vibrations and Impedances of Rectangular Plates With Free Boundaries
- Gate Ece Previous Papers 1996-2013 by Kanodia
- 2 Applications of Eignvalues and Eignvectors
- Matrices, Determinant and Inverse
- MS221-201010
- Analysis of Oscillations With Eigenanalysis And
- robot interactive
- 7D178B01d01
- chow1998phase.pdf
- MScdiagquiz
- MAT115-Difference Differential Eqns

Read Free for 30 Days

Cancel anytime.

Close Dialog## Are you sure?

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

Loading