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# ECONOMETRICS

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

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

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Contents

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

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

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i

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

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

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

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

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ii

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

. . .3 Expectation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13.9 Cointegrated VARs . . . . . . . . . . . . . . . . . . . . . 160 16. . . . . . . . . . .1 Grid Search . .9 Maximum Likelihood . . . . . 14. . . . . . . .8 Normal and Related Distributions . . . . . . . . . . . . . . . . . . . . . . 165 165 167 168 169 171 173 175 175 178 183 183 184 185 . . . . . . . . . . . . . . iv . . . . . . . . . . . . .3 Censored Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .7 Granger Causality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .13 Multivariate Time Series 13. . . 13. . . . . . . . . . . . . . . . . . . . . . . . . .1 Kernel Density Estimation . . A. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 Limited Dependent Variables 14. . . 13. . . . . . . . . . . . . . . . . . . . . . . . . .2 Count Data . . . . . . . . . . . . . . . . . 162 A Probability A. . . . . . . . 14. . . . . . . A. . . . . . . . . . . . . . . . . . . . . . . .6 Selection of Lag Length in an VAR . . . . . . . . . .2 Random Variables . . . . . . . . . .2 Estimation . . . . . . . . .7 Transformations . . . . . . . . . . . . . . . .1 Foundations . . A. . . . . . A. . . . . . . . . . . . . . . . . . . . . . . . . . .1 Individual-Eﬀects Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A. . . . . . . . . . . . .8 Cointegration . . . . . . . . . . . . . . . . .3 Derivative-Free Methods . . . . . . . . . . . . . . . . . . . . . . . . . B. . . . . . . . . . . . . . . . . . 159 16 Nonparametrics 160 16. A. . . . . . .4 Sample Selection . . . . . . . . . .4 Common Distributions . . . . . B Numerical Optimization B. . . . . .5 Testing for Omitted Serial Correlation 13. . . . . . . . . . . . . . . . . . . . .2 Fixed Eﬀects . . . . . .3 Restricted VARs . . . . . . . . . . . . . . . . . . . . . . . A. . B. . . . 13. . . . . . 13. . . . . . . . . . . . . 13.1 Binary Choice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .6 Conditional Distributions and Expectation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157 15. . . . . . . . . . . . . . . . . . . . . . . 157 15. A. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 Panel Data 157 15. . . .3 Dynamic Panel Regression . . . . 14. . . . . . . . . .4 Single Equation from a VAR . . . . . . . . . . . . . . . . . . .1 Vector Autoregressions (VARs) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5 Multivariate Random Variables . . 145 145 146 146 147 147 148 148 149 149 151 151 153 153 154 . . . . 13. . . . . . .2 Asymptotic MSE for Kernel Estimates . . . . . . . . . . . . . . . . . . . . . . . . . . .2 Gradient Methods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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

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

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

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

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

. The columns of a k × r matrix A. . 0 0 ··· 1 2. for k × r A and r × k B we have tr (AB) = tr (BA) tr (A + B) = tr (A) + tr (B) 6 . . ¸ B12 B22 ¸ A11 B12 + A12 B22 A21 B12 + A22 B22 ⎡ B1 B2 .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. . ⎥ . which has ones on the diagonal. For example. then AIr = A and Ik A = A. are said to be orthogonal if A0 A = Ir . . . ⎦ ⎣ . . r ≤ k. We say that two vectors a and b are orthogonal if a0 b = 0. A square matrix A is called orthogonal if A0 A = Ik . A k × k identity matrix is denoted as ⎡ ⎤ 1 0 ··· 0 ⎢ 0 1 ··· 0 ⎥ ⎢ ⎥ Ik = ⎢ . . ⎤ ⎥ ⎥ ⎥ ⎦ 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. Also. An important diagonal matrix is the identity matrix.3 Trace The trace of a k × k square matrix A is the sum of its diagonal elements tr (A) = k X i=1 aii Some straightforward properties for square matrices A and B are tr (cA) = c tr (A) ¡ ¢ tr A0 = tr (A) tr (Ik ) = k.

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

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

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

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

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

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

The equations yi = m(xi ) + ei E (ei | xi ) = 0.1 Properties of the regression error ei 1.Figure 3. 2.2. E(ei ) = 0. 13 . by the deﬁnition of ei and the linearity of conditional expectations. because no restrictions have been placed on the joint distribution of the data. E(xi ei ) = 0. The remaining parts of the Theorem are left as an exercise. To show the ﬁrst statement. These equations hold true by deﬁnition. most typically. E (h(xi )ei ) = 0 for any function h (·) . restrictions on the permissible class of regression functions m(x). It is important to understand that this is a framework. not a model. are often stated jointly as the regression framework. 3. 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. 4. E (ei | xi ) = 0.2: Log Wage Densities Theorem 3.

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

5 Best Linear Predictor While the conditional mean m(x) = E (yi | xi = x) is the best predictor of yi among all functions of xi .8) is called the linear regression model. ⎟ β=⎝ . ⎝ . 3.1. we can write it as m(x) = x0 β = β 1 + x2i β 2 + · · · + xki β k where ⎞ β1 ⎜ . An important special case is homoskedastic linear regression model yi = x0 β + ei i E (ei | xi ) = 0 ¢ ¡ E e2 | xi = σ 2 .3) is when the conditional mean function m(x) is linear in x (or linear in functions of x). As an example. In this case (3.1). ⎠ . Notationally. Instead. xki When m(x) is linear in x. take the conditional wage densities displayed in Figure 3.5) xi = ⎜ .7) is a k × 1 parameter vector. and the linear assumption of the previous section is empirically unlikely to accurate. ⎟ .5. ⎠ .we say that the error ei is homoskedastic. 15 . Thus (3. So while men have higher average wages.9) 3.1 and that for women is 10. its functional form is typically unknown.8) (3.6) (3. it is convenient to augment the regressor vector xi by listing the number “1” as an element. it is more realistic to view the linear speciﬁcation (3. We call this the “constant” or “intercept”.1) has been redeﬁned as the k × 1 vector ⎛ ⎞ 1 ⎜ x2i ⎟ ⎜ ⎟ (3. The conditional standard deviation for men is 12. where x1i is the ﬁrst element of the vector xi deﬁned in (3. which we derive in this section.4 Linear Regression An important special case of (3. Equivalently. i (3. This concept is less helpful than deﬁning heteroskedasticity as the dependence of the conditional variance on the observables xi . we assume that x1i = 1. βk ⎛ (3.3) can be writen as yi = x0 β + ei i E (ei | xi ) = 0. Equation (3.6) as an approximation. they are also somewhat more dispersed. Some textbooks inappropriately describe heteroskedasticity as the case where “the variance of ei varies across observation i”.

Equivalently.7) is 0= Solving for β we ﬁnd ¡ ¢ ∂ S(β) = −2E (xi yi ) + 2E xi x0 β.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 . Assumption 3.1. this situation must be excluded. i 16 . otherwise they are distinct. i (3. Rewriting. E (xi x0 ) is a mai E(x y trix and E (xi yi ) is a vector. We now summarize the assumptions necessary for its derivation and list the implications in Theorem 3. The error is i ei = yi − x0 β. Therefore. The vector (3. xi contains an intercept. alternative expressions such as E xixi ) or E (xi yi ) (E (xi x0 ))−1 i ( i 0i ) are incoherent and incorrect. α0 E (xi x0 ) α = E (α0 xi )2 > 0. i which requires that for all non-zero α.5.5. As before. there cannot i exist a non-zero vector α such that α0 xi = 0 identically. This occurs when redundant variables are included in xi . i i (3. Given the deﬁnition of β in (3.which is quadratic in β. we obtain a decomposition of yi into linear predictor and error yi = x0 β + ei .1 1.10) exists and is unique as long as the k ×k matrix E (xi x0 ) is invertible. i 4. i (3.10) It is worth taking the time to understand the notation involved in this expression. by “best” we mean the predictor function with lowest mean squared error. 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.10). It is invertible if and only if it is positive deﬁnite. Eyi < ∞. 3. 2 2. α0 E (xi x0 ) α = E (α0 xi )2 ≥ 0 so the matrix E (xi x0 ) is by construction i i positive semi-deﬁnite. Observe i that for any non-zero α ∈ Rk . The ﬁrst-order condition for minimization (from Section 2. i ∂β ¢¢−1 ¡ ¡ E (xi yi ) . E (x0 xi ) < ∞. The best linear predictor is obtained by selecting β to minimize S(β). x0 β is the best linear predictor for yi . In order for β to be uniquely deﬁned. written E (xi x0 ) > 0.12) This completes the derivation of the linear projection model. 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 . E (xi x0 ) is invertible.

3 ensure that the moments in (3.13) The two equations (3.4: Hourly Wage as a Function of Experience The conditions listed in Assumption 3.1.5. Furthermore.5.1.5.5. the orthogonality restriction (3.1. This means that the equation (3.1 is employed to guarantee that (3.2.4 is required to ensure that β is uniquely deﬁned.1. The ﬁnite variance Assumptions 3.Theorem 3. suppose that for xi ∈ R that Ex3 = 0 and ei = x2 .5.1.1.14) holds. Since from Theorem 3.14) follows from (3.11) and (3. Assumption 3. Assumption 3.10) ¡ ¡ ¢¢ E (xi ei ) = E xi yi − x0 β i ¡ ¢¡ ¡ ¢¢−1 E (xi yi ) = E (xi yi ) − E xi x0 E xi x0 i i = 0.1. 17 . ¥ (3.13) and Assumption 3. Equation (3.5.9).1 Under Assumption 3.2 and 3.14). it follows that linear regression is a special case of the projection model. Using the deﬁnitions (3. x0 β is the i projection of yi on xi since the error ei is orthogonal with xi .5.5.5. Let’s compare it with the linear regression model (3. For example.1 are weak.12) and (3.11) are well deﬁned.14) Proof.4 guarantees that the solution β exits. By deﬁnition. (3. Then i i Exi e2 = Ex3 = 0 yet E (ei | xi ) = x2 6= 0.13) implies that xi and ei are uncorrelated. However.8)-(3.5. Assumption 3.10) are deﬁned.1.2 and 3. (3.4 we know that the regression error has the property E (xi ei ) = 0.1.3 are called regularity conditions. the converse is not true as the projection error does not necessarily satisfy E (ei | xi ) = 0.13) summarize the linear projection model. E (xi ei ) = 0 and E (ei ) = 0.5.1. Figure 3. Assumption 3. i i i Since E (xi ei ) = 0 we say that xi and ei are orthogonal.1.10) and (3.12) can be alternatively interpreted as a projection decomposition. Since ei is mean zero by (3.

5 for a 3 In the population of Caucasian non-military male wage earners with 12 years of education. In other cases the two may be quite diﬀerent.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. The solid line is the conditional mean. it misses the strong downturn in expected wages for those above 35 years work experience (equivalently.10) may not hold and the implications of Theorem 3.We have shown that under mild regularity conditions. In Figure 1.4 displays the relationship3 between mean log hourly wages and labor market experience. Returning to the joint distribution displayed in Figure 3. in many economic models the parameter β may be deﬁned within the model. since the resulting function is quadratic in experience. it is important to not misinterpret the generality of this statement. we can augment the regressor vector xi to include both experience and experience2 . These structural models require alternative estimation methods. This defect in linear projection can be partially corrected through a careful selection of regressors.5.3.12) is deﬁned by projection and the associated coeﬃcient deﬁnition (3.10). and are discussed in Chapter 11. However. Most importantly. Figure 3. In this case the linear projection is a poor approximation to the conditional mean. In this example it is a much better approximation to the conditional mean than the linear projection. A projection of log wages on these two variables can be called a quadratic projection. We illustrate the issue in Figure 3. In the example just presented.12) with the properties listed in Theorem 3. It over-predicts wages for young and old workers. Other than the redeﬁnition of the regressor vector. the dashed line is the linear projection of log wages on eduction. for any pair (yi . and the straight dashed line is the linear projection. for those over 53 in age). In this case (3. xi ) we can deﬁne a linear projection equation (3.1 may be false.5. In this example the linear projection is a close approximation to the conditional mean. there are no changes in our methods or analysis. The linear equation (3. In contrast.1. Figure 3. 18 .4 we display as well this quadratic projection. and under-predicts for the rest. No additional assumptions are required.

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

and E(xi ei ) = 0. 2.. Deﬁne µ ¶ ¢ ¡ x−µ 2 g x. 20 . i 11. Let xi and yi have the joint density f (x. then ei is independent of xi . Are they diﬀerent? Hint: If P (Y = j) = 5. then E(x2 ei ) = 0. i 7. i 10. Show that x y β 1 = σ xy /σ 2 and β 0 = µy − β 1 µx . True or False. i 8. a constant. σ 2 = V ar(yi ) and σ xy = Cov(xi .4 . If yi = xi β + ei . y) = 3 x2 + y 2 on 0 ≤ x ≤ 1. e−λ λj j! . Compute 2 the coeﬃcients of the linear projection yi = β 0 + β 1 xi + ei . 2.1. σ 2 = V ar(xi ). E(ei | xi ) = 0. xi ∈ R. If yi = x0 β + ei . (x − µ)2 − σ 2 Show that Eg (X. taking values only on the non-negative integers.2. s) = 0 if and only if m = µ and s = σ 2 . Does this justify a linear regression model of the form yi = x0 β + εi ? i then EY = λ and V ar(Y ) = λ. 3. j! 0 j = 0. True or False. 1. x 6. 3 and 4 of Theorem 3. Suppose that yi is discrete-valued. . True or False. ¡ ¢ 4. True or False. m. Prove parts 2.. and the conditional distribution of yi given xi is Poisson: P (yi = k | xi = x) = e−x β (x0 β)j . True or False. σ = . If yi = x0 β + ei and E(xi ei ) = 0. and E(ei | xi ) = 0. Compute the conditional mean m(x) = E (yi | xi = x) . Take the bivariate linear projection model yi = β 0 + β 1 xi + ei E (ei ) = 0 E (xi ei ) = 0 Deﬁne µy = Eyi . and have the following joint probability distribution X=0 X=1 Y =0 . 9. then ei is i i independent of xi . If yi = x0 β + ei and E(ei | xi ) = 0.6 Exercises 1.3. E(Y 2 | X = x) and V ar(Y | X = x). 0 ≤ y ≤ 1. then E(ei | xi ) = 0.2 Y =1 . then E(x2 ei ) = 0. Suppose that Y and X only take the values 0 and 1. Let X be a random variable with µ = EX and σ 2 = V ar(X). yi ). If yi = xi β + ei .1 . µ. µx = Exi . xi ∈ R. and E(e2 | xi ) = σ 2 . Compute E(yi | xi = x) and V ar(yi | xi = x).3 Find E(Y | X = x).

Observe that (4. 4.8. (4. i n i=1 n 21 .4) i i=1 i=1 ˆ Another way to derive β is as follows.3) writes the projection coeﬃcient β as an explicit function of population moments E (xi yi ) and E (xi x0 ) . we narrow the focus to the linear regression model.2) (4. but for most of the chapter we retain the broader focus on the projection model. The function g(β) can be estimated by form g(β) = E (xi (yi − xi g (β) = ˆ ¢ 1X ¡ xi yi − x0 β .Chapter 4 Least Squares Estimation This chapter explores estimation and inference in the linear projection model yi = x0 β + ei i E (xi ei ) = 0 ¡ ¡ ¢¢−1 E (xi yi ) β = E xi x0 i (4.1) (4.7 and 4.1 Estimation Equation (4.2) can be written in the parametric 0 β)) = 0. i It follows that the moment estimator of β replaces the population moments in (4.3) with the sample moments: ³ ¡ ¢´−1 ˆ ˆ ˆ β = E xi x0 E (xi yi ) i Ã n !−1 n 1X 1X 0 xi xi xi yi = n n i=1 i=1 Ã n !−1 n X X = xi x0 xi yi . Their moment estimators are the sample moments i ˆ E (xi yi ) = ¢ ¡ ˆ E xi x0 = i 1X xi yi n 1 n i=1 n X i=1 n xi x0 .3) In Sections 4.

4).94 −2.170 37.117 Educationi . To illustrate.14 205. An interpretation of the estimated equation is that each year of education is associated with an 11.14 14. 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.83 ¶−1 µ ¶ .71 = −2. These are white male wage earners from the March 2004 Current Population Survey. 0.14 205.30 + 0. Then µ ¶ n 1X 2.83 µ We often write the estimated equation using the format \ log(W agei ) = 1.5) = n n 1X 1X ˆ xi yi − xi x0 β i n n i=1 i=1 whose solution is (4. with 10-15 years of potential work experience.3.117 1 14. n X i=1 2 yi − 2β 0 n X i=1 xi yi + β 0 n X i=1 xi x0 β. consider the data used to generate Figure 3.95 xi yi = 42. 40 0. Let yi be log wages and xi be an intercept and years of education.95 42.4).2 Least Squares There is another classic motivation for the estimator (4.40 µ ¶µ ¶ 34. 4.14 14. 40 2.37 µ ¶ 1. 30 = . This sample has 988 observations. i 22 .ˆ This is a set of k equations which are linear in β. 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. excluding military.40 n i=1 1 n Thus ˆ β = n X i=1 xi x0 i = µ 1 14.7% increase in mean wages.

Figure 4. Following convention we will call β the OLS estimator of β. while the residual is a by-product of estimation.2 displays the contour lines of the same function — horizontal slices at equally spaced heights. Figure 4. It is important to understand the distinction between the error ei and the residual ei .The Ordinary Least Squares (OLS) estimator is the value of β which minimizes Sn (β). the contour lines are ellipses. Matrix calculus (see Appendix 2. we deﬁne the predicted value ˆ yi = x0 β ˆ i and the residual ˆ ei = yi − yi ˆ ˆ = yi − x0 β. i ˆ ˆ Note that yi = yi + ei .1: Sum-of-Squared Errors Function As a by-product of OLS estimation. To visualize the sum-of-squared errors function. The error is unobservable.4). Figure 4.7) gives the ﬁrst-order conditions for minimization: 0 = ∂ ˆ Sn (β) ∂β n n X X ˆ = −2 xi yi + 2 xi x0 β i i=1 i=1 ˆ whose solution is (4. 23 .1 displays an example sum—of-squared errors function Sn (β) for the case k = 2. These two ˆ variables are frequently mislabeled. which can cause confusion. Since the function Sn (β) is a quadratic function of β.

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

maximizing the likelihood is identical to minimizing Sn (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 ). Hence the MLE for β equals the OLS estimator. The R2 is frequently mislabeled as a measure of “ﬁt”. and distribution theory. where likelihood methods can be used for estimation. it should be viewed as an estimator of the population parameter ρ2 = σ2 V ar (x0 β) i =1− 2 V ar(yi ) σy where σ 2 = V ar(yi ). Instead. σ 2 ) maximize Ln (β. ˆ Plugging β into the log-likelihood we obtain n ¡ ¢ n 1 X 2 ˆ ei ˆ Ln (β. σ 2 ) = − log 2πσ 2 − 2 2 2σ i=1 25 . It is an ˆ inappropriate label as the value of R2 does not help interpret the parameter estimates β or test statistics concerning β. Pn y2 ˆ σ2 ˆ R2 = Pn i=1 i 2 = 1 − 2 σy ˆ i=1 (yi − y) σ2 = ˆy 1X (yi − y)2 n i=1 n is the sample variance of yi . σ ) = 2σ (2πσ 2 )1/2 i=1 ¡ ¢ n 1 = − log 2πσ 2 − 2 Sn (β) 2 2σ ˆ ˆ The MLE (β.3 Normal Regression Model Another motivation for the least-squares estimator can be obtained from the normal regression model. σ 2 ) is a function of β only through the sum of squared errors Sn (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. 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. testing. and therefore is expected to be a better estimator of ρ2 than the unadjusted estimator R2 . σ 2 ).where A measure of the explained variation relative to the total variation is the coeﬃcient of determination or R-squared. n−1 i=1 Theil’s estimator R is a ratio of adjusted variance estimators. This is a parametric model. 4. Since 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. n or equivalently Y = Xβ + e. σ 2 ) for the normal ˆ regression model are identical to the method of moment estimators. . ˆi 2 ∂σ 2 2ˆ σ 2 σ ˆ i=1 ˆ ˆ Solving for σ 2 yields the method of moments estimator (4. 4.12) is a system of n equations. ⎠ ⎜ ⎜ e=⎜ ⎝ ⎟ ⎟ ⎟. yn ⎟ ⎟ ⎟.4 Model in Matrix Notation convenient to write the model and statistics in x0 1 x0 2 . n X i=1 Thus the estimator (4. . ⎠ . it is matrix notation. the ˆ OLS estimator β is frequently referred to as the Gaussian MLE.Maximization with respect to σ 2 yields the ﬁrst-order condition n X ∂ n 1 ˆ ˆ Ln (β. σ 2 ) = − 2 + ¡ ¢2 e2 = 0. 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. We can stack these n equations together as y1 = x0 β + e1 1 y2 = x0 β + e2 2 .4). residual vector. x0 n ⎞ ⎛ e1 e2 . = β+ XX 26 (4. en ⎞ Observe that Y and e are n × 1 vectors. ⎠ xi x0 = X 0 X i xi yi = X 0 Y. and X is an n × k matrix.8) . one for each observation. Sample sums can also be written in matrix notation. .6). including computation. Thus the MLE (β. Due to this equivalence. We deﬁne ⎛ ⎞ ⎛ y1 ⎜ ⎜ y2 ⎟ ⎜ ⎟ ⎜ X=⎜ Y = ⎜ . . ⎝ ⎝ . . ⎟. . The linear equation (3. For example n X i=1 For many purposes. yn = x0 β + en .

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

.18) E (e | X) = ⎜ E (ei | X) ⎟ = ⎜ E (ei | xi ) ⎟ = 0.9). is the demeaning formula for regression.1 (Frisch-Waugh-Lovell). the FWL theorem can be used to speed computation. A common application of the FWL theorem.9).8)(3.7 Bias and Variance In this and the following section we consider the special case of the linear regression model (3. 30 . . . In the model (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 (4.6. ˜ 2. obtain OLS estimates β 2 and residuals e. ˆ ˜ ˜ ˆ 3. 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) . . and X2 is the vector of observed regressors. Regress Y on X2 . The FWL theorem says that β 2 is the OLS estimate from a regression of ˜ ˜ Y on X2 . Regress X2 on X1 . ¡ ¢−1 0 ι. obtain residuals X2 . but in most cases there is little computational advantage to using the two-step algorithm. By the independence of the observations and (3. ! Thus the OLS estimator for the slope coeﬃcients is a regression with demeaned data. ⎟ ⎜ ⎟ ⎜ (4. . . . observe that ⎞ ⎛ ⎞ ⎛ . Partition X = [X1 X2 ] where X1 = ι is a vector of ones. obtain residuals Y . 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. . In some contexts. ⎠ ⎝ ⎠ ⎝ . In this case. 4. . Regress Y on X1 .13). .Theorem 4. the primary use is theoretical. which you may have seen in an introductory econometrics course.14) or via the ˆ following algorithm: ˜ 1. In this section we derive the small sample conditional mean and variance of the OLS estimator. Rather.

. and ³ ´ ¡ ¢−1 2 ˆ σ . . the properties of conditional expectations.. X 0 DX = X 0 Xσ 2 . 0 0 ··· 0 0 . . . Next. 1 n . .Using (4. σ2 n ⎞ We now calculate the ﬁnite sample bias of the method ¡ moments estimator σ 2 for σ 2 . .8). the properties additional assumption of conditional homoskedasticity E ei i of projection matrices. for any random vector Z deﬁne the covariance materix V ar(Z) = E (Z − EZ) (Z − EZ)0 = EZZ 0 − (EZ) (EZ)0 . Thus D is a diagonal matrix with i’th diagonal element σ 2 : i ⎛ 2 σ1 0 · · · ⎜ 0 σ2 · · · 2 ⎜ D = diag{σ 2 . We have shown that which implies ³ ´ ˆ E β|X =β ³ ´ ˆ E β =β (4. ⎝ . Then given (4. σ2 = ˆ ¢ 1 ¡ ¢ 1 0 1 1 1 ¡ e e = e0 M M e = e0 M e = tr e0 M e = tr M ee0 ˆˆ n n n n n 31 In the special case of the linear homoskedastic regression model. . σ 2 = σ 2 and we have the simplii ﬁcations D = In σ 2 .12).18). and the trace operator observe that.. ⎠ (4. V ar β | X = X 0 X ⎟ ⎟ ⎟. and (4.. From (4.19) ˆ and thus the OLS estimator β is unbiased for β. σ 2 } = ⎜ . under the of ˆ ¢ 2 | x = σ 2 .19) we see that ¶ µ³ ³ ´ ´³ ´0 ˆ ˆ ˆ V ar β | X = E β−β β−β |X = where The i’th diagonal element of D is ¡ ¢ D = E ee0 | X .. . 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. ¡ X 0X ¢−1 ¡ ¢−1 X 0 DX X 0 X while the ij 0 th oﬀ-diagonal element of D is ¢ ¢ ¡ ¡ E e2 | X = E e2 | xi = σ 2 i i i E (ei ej | X) = E (ei | xi ) E (ej | xj ) = 0.20) .

32 .10). Theorem 4. This is the justiﬁcation for the common s ˆ preference of s2 over σ 2 in empirical practice. In the homoskedastic linear regression model. ˜ β L = A0 Y = A (Xβ + e) = β + Ae.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 . that this estimator is only unbiased in the special case of the homoskedastic linear regression model. By a calculation similar to those of the previous section. In this case. as it yields the smallest variance among all unbiased linear estimators.7) is unbiased for σ 2 by this calculation. = σ2 n the ﬁnal equality by (4. 4. or in the projection model. known as the Gauss-Markov theorem. which we now present. which is (3. It is not unbiased in the absence of homoskedasticity. Thus since V ar (e | X) = In σ 2 under homoskedasticity. the best (minimumvariance) unbiased linear estimator is OLS. What is the best choice of A? The Gauss-Markov theorem.8 Gauss-Markov Theorem In this section we restrict attention to the homoskedastic linear regression model. ³ ´ ˜ E β | X = A0 Xβ. As an alternative. is a famous statement of the solution. however.8)¢ ¡ (3. the estimator ˆ 2 deﬁned (4. ˜ so β is unbiased if (and only if) A0 X = Ik . says that the least-squares estimator is the best choice. 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. Thus σ 2 is biased towards zero. The following result.8.1 Gauss-Markov.9) plus E e2 | xi = σ 2 . Now consider the class of estimators of β which are linear functions of i the vector Y. and thus can be written as ˜ β = A0 Y where A is an n × k function of X. It is important to remember. The least-squares estimator is the special case obtained by setting A = X(X 0 X)−1 . ³ ´ ˜ V ar β | X = A0 V ar (e | X) A = A0 Aσ 2 .

¡ ¢ P yi = τ j . . We discuss the intuition behind his result in this section. 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. ˆ β mle = ⎝ j j=1 j=1 33 . where 1 (·) is the indicator function. The MLE β mle for β is then the analog of (4.. the class of potential estimators has been restricted to linear unbiased estimators.. ξ j . π j is the percentage of the observations ˆ ˆ which fall in each category. for ﬁnite r. the deﬁnition (4. Let A be any n×k function of X such that A0 X = Ik . xi ) is discrete.Proof. but it is quite limited in scope. It is suﬃcient to show that the diﬀerence A0 A − (X 0 X)−1 is positive semi-deﬁnite. xi = ξ j = π j .3) can be rewritten as ⎞−1 ⎛ ⎞ ⎛ r r X X β=⎝ πj ξ j ξ 0 ⎠ ⎝ πj ξ j τ j ⎠ (4.. The variance of the least-squares estimator is (X 0 X)−1 σ 2 and that of A0 Y is A0 Aσ 2 . π r ) .. j = 1..9 Semiparametric Eﬃciency In the previous section we presented the Gauss-Markov theorem as a limited eﬃciency justiﬁcation for the least-squares estimator. This property is called semiparametric eﬃciency. but we don’t know the probabilities. r. Set C = A − X (X 0 X)−1 . Note that X 0 C = 0. Assume that the τ j and ξ j are known. This latter restriction is particularly unsatisfactory.5) as required.. That is. who established that in the projection model the OLS estimator has the smallest asymptotic meansquared error among feasible estimators.. and π j .. Suppose that the joint distribution of (yi .21) with the parameters ˆ π j replaced by the estimates π j : ⎞−1 ⎛ ⎞ ⎛ r r X X ˆ πj ξj ξ0 ⎠ ⎝ ˆ πj ξ j τ j ⎠ . ¥ The Gauss-Markov theorem is an eﬃciency justiﬁcation for the least-squares estimator. and is a strong justiﬁcation for the least-squares estimator.21) j j=1 j=1 Thus β is a function of (π 1 . as the theorem leaves open the possibility that a non-linear or biased estimator could have lower mean squared error than the least-squares estimator. but the π j are unknown. Not only has the class of models has been restricted to homoskedastic linear regressions. That is.) In this discrete setting. (We know the values yi and xi can take. . r for some constant vectors τ j . A broader justiﬁcation is provided in Chamberlain (1987). 4. . As the data are multinomial.. the maximum likelihood estimator (MLE) is ¡ ¢ 1X 1 (yi = τ j ) 1 xi = ξ j πj = ˆ n i=1 n for j = 1.

22) 34 . ˆ r X j=1 πj ξ j ξ 0 ˆ j r n X1X ¡ ¢ = 1 (yi = τ j ) 1 xi = ξ j ξ j ξ 0 j n j=1 = 1 n 1 n i=1 n X X r i=1 j=1 n X i=1 ¡ ¢ 1 (yi = τ j ) 1 xi = ξ j xi x0 i = and r X j=1 xi x0 i πj ξ j τ j ˆ r n X1X ¡ ¢ = 1 (yi = τ j ) 1 xi = ξ j ξ j τ j n j=1 i=1 = r n ¡ ¢ 1 XX 1 (yi = τ j ) 1 xi = ξ j xi yi n = Thus ˆ β mle = Ã 1 n n i=1 j=1 n X i=1 xi yi !−1 Ã ! In other words. He observes that the above argument holds for all multinomial distributions. Since this is a regular parametric model the MLE is asymptotically eﬃcient (see Appendix A. the maximum likelihood estimator is identical to the OLS estimator. if the data have a discrete distribution. and any continuous distribution can be arbitrarily well approximated by a multinomial distribution. 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 .Substituting in the expressions for π j .10 Omitted Variables xi = µ x1i x2i ¶ . 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 . 1X xi x0 i n i=1 1X xi yi n i=1 n ˆ = β ols 4.10) for the class of models satisfying Assumption 3.5. and thus so is the OLS estimator.9). He proves that generically the OLS estimator (4. (4. Chamberlain (1987) extends this argument to the case of continuously-distributed data.4) is an asymptotically eﬃcient estimator for the parameter β deﬁned in (3.1.

In general.22). the applied researcher quickly discovers the error as the statistical software will be unable to construct (X 0 X)−1 . β 1 6= γ 1 . Goldberger (1991) calls (4. we calculate γ1 = ¡ ¡ ¢¢−1 E x1i x0 E (x1i yi ) 1i ¡ ¡ ¢¢−1 ¡ ¡ 0 ¢¢ 0 E x1i x1i β 1 + x0 β 2 + ei = E x1i x1i 2i ¢¢−1 ¡ ¢ ¡ ¡ E x1i x0 β 2 = β 1 + E x1i x0 1i 2i = β 1 + Γβ 2 ¢¢−1 ¡ ¢ ¡ ¡ E x1i x0 Γ = E x1i x0 1i 2i (4. there is some α such that Xα = 0. For example. This happens when the columns of X are linearly dependent. the general model will be free of the omitted variables problem. The more relevant issue is near multicollinearity. This is one diﬃculty with the deﬁnition and interpretation of multicollinearity. least-squares estimation of (4. Most commonly. which is often called “multicollinearity” for brevity. we regress yi on x1i only. the regression of x2i on x1i yields a set of zero coeﬃcients (they are uncorrelated). and the error as ui rather than ei . This is called strict multicollinearity. Typically. Typically there are limits. as many desired variables are not available in a given dataset. 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 .. Since the error is discovered quickly. By construction. when the columns of X are close to linearly dependent. log(p2 ) and log(p1 /p2 ). To see this. First.22) is zero.e. This deﬁnition is not precise. log(p1 ).23) is an estimate of γ 1 = β 1 + Γβ 2 rather than β 1 . To avoid omitted variables bias the standard advice is to include potentially relevant variables in the estimated model. except in special cases. When this happens. In this case.23) where is the coeﬃcient from a regression of x2i on x1i . if X includes both the logs of two prices and the log of the relative prices. the coeﬃcient on x2i in (4. Thus the short and long regressions have the same coeﬃcient on x1i only under one of two conditions. the possibility of omitted variables bias should be acknowledged and discussed in the course of an empirical investigation. This is because the model being estimated is diﬀerent than (4. 35 . or second. i. It is the consequence of omission of a relevant correlated variable. Observe that γ 1 6= β 1 unless Γ = 0 or β 2 = 0.Now suppose that instead of estimating equation (4. The diﬀerence Γβ 2 is known as omitted variable bias.22) the long regression and (4. then β is not deﬁned.11 Multicollinearity ˆ If rank(X 0 X) < k + 1. 4. This is the situation when the X 0 X matrix is near singular.22) by least-squares.23) the short regression to emphasize the distinction. this is rarely a problem for applied econometric practice. this arises when sets of regressors are included which are identically related. because we have not said what it means for a matrix to be “near singular”.

the OLS estimator based on the sample excluding the i’th observation.−i = (1 − hi )−1 hi ei .24) β (−i) = X(−i) X(−i) is the i’th diagonal element of the projection matrix X (X 0 X)−1 X 0 . We can see the eﬀect of collinearity on precision by observing that the asymptotic variance of a coeﬃcient ¡ ¢−1 approaches inﬁnity as ρ approaches 1.26) As we can see.−i = yi − x0 β (−i) = (1 − hi )−1 ei .27) (4. As a consequence.25) below. If the i’th observation 36 . since as ρ approaches 1 the matrix becomes singular. and 1 0 XX= n µ 1 ρ ρ 1 ¶ In this case The correlation ρ indexes collinearity. µ ¶−1 µ ¶ ³ ´ 2 σ2 1 ρ 1 −ρ ˆ|X = σ . 1] and sum to k. the worse the precision of the individual coeﬃcient estimates. We can also deﬁne the leave-one-out residual ˆ ˆ ei. This equals ´−1 ³ 0 ˆ X(−i) Y(−i) (4. In extreme cases it is possible that the reported calculations will be in error due to ﬂoating-point calculation diﬃculties. = V ar β ρ 1 n n (1 − ρ2 ) −ρ 1 4.One implication of near singularity of matrices is that the numerical reliability of the calculations is reduced. it is statistically diﬃcult to disentangle the impact of β 1 from that of β 2 . deﬁne the leave-one-out least-squares estimator of β. A more relevant implication of near multicollinearity is that individual coeﬃcient estimates will be imprecise. ˆ ˆ (4.12 Inﬂuential Observations where X(−i) and Y(−i) are the data matrices omitting the i’th row.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. ˆ i A simple comparison yields that ˆ ei − ei. that is. To investigate the possibility of inﬂuential observations. the change in the coeﬃcient estimate by deletion of the i’th observation depends critically on the magnitude of hi . What is happening is that when the regressors are highly dependent. The hi take values in [0. We can see this most simply in a homoskedastic linear regression model with two regressors yi = x1i β 1 + x2i β 2 + ei . A convenient alternative expression is ¡ ¢−1 ˆ ˆ xi ei ˆ (4. Thus the more “collinear” are the estimate σ 2 1 − ρ2 regressors. the precision of individual estimates are reduced. We derive expression (4.

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

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

41 . then (5. If p > 1 and q > 1 and 1 p ⎞1/2 ⎛ m n XX ¡ 0 ¢1/2 |A| = tr A A =⎝ a2 ⎠ .Chapter 5 Asymptotic Theory This chapter reviews the essential components of asymptotic theory. then its Euclidean norm is The following are an important set of inequalities which are used in asymptotic distribution theory. ij i=1 j=1 (5. then g(E(X)) ≤ E(g(X)). |a| = a a i i=1 If A is a m × n matrix. These approximations are bounded through the use of mathematical inequalities. Cauchy-Schwarz Inequality. We list here some of the most critical deﬁnitions and inequalities. 5. Triangle inequality |X + Y | ≤ |X| + |Y | . ´1/2 ³ ´1/2 ³ E |Y |2 E |XY | ≤ E |X|2 Holder’s Inequality.2) + 1 q = 1.3) E |XY | ≤ (E |X|p )1/p (E |Y |q )1/q . If g(·) : R → R is convex.1) (5.1 Inequalities Asymptotic theory is based on a set of approximations. Jensen’s Inequality. The Euclidean norm of an m × 1 vector a is Ã m !1/2 X ¡ 0 ¢1/2 = a2 .

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

5. by Markov’s inequality (5. the triangle inequality. and the bound |Wi | ≤ 2C. 43 . the fact that the Wi are iid and mean zero. then as n→∞ n ¢ √ ¡ 1 X n Xn − µ = √ (Xi − µ) →d N (0. Finally. V ) . P ¯X n ¯ > δ ≤ δ δ δ the equality by the deﬁnition of ε. Jensen’s inequality (5. if for all x at which F (x) is continuous. ¯¢2 ¡ ¯ 2 ≤ EW n E ¯W n ¯ = EWi2 n 4C 2 ≤ n ≤ ε2 (5. n i=1 0 where µ = EX and V = E (X − µ) (X − µ) . the fact that X n = W n + Z n . Theorem 5.3 Convergence in Distribution Let Zn be a random variable with distribution Fn (x) = P (Zn ≤ x) . ≤ 2E |Xi | 1 (|Xi | > C) Zi = Xi 1 (|Xi | > C) − E (Xi 1 (|Xi | > C)) . Set ε = δη/3. Fix δ and η. denoted Zn →d Z. as needed. we can set E(X) = 0 (by recentering Xi on its expectation).6) and (5. where Z has distribution F (x) = P (Z ≤ x) . P ¯X n ¯ > δ ≤ η. ¡¯ ¯ P ¯X n ¯ > δ ≤ η.7) the ﬁnal inequality holding for n ≥ 4C 2 /ε2 = 36C 2 /δ 2 η 2 . ≤ E |Xi | 1 (|Xi | > C) + |E (Xi 1 (|Xi | > C))| (5. (5.4). ¯ ¯ ¯ ¯ ¯ ¯ ¢ E ¯X n ¯ ¡¯ ¯ E ¯W n ¯ + E ¯Z n ¯ 3ε ≤ ≤ = η. Pick C < ∞ large enough so that E (|X| 1 (|X| > C)) ≤ ε (5.6) By Jensen’s inequality (5. We have shown that for any δ > 0 and η > 0 then for all ¢ ¡¯ ¯ ¥ n ≥ 36C 2 /δ 2 η 2 .Proof: Without loss of generality.7). Fn (x) → F (x) as n → ∞. We say that Zn converges in distribution to Z as n → ∞. Deﬁne the random vectors Wi = Xi 1 (|Xi | ≤ C) − E (Xi 1 (|Xi | ≤ C)) By the triangle inequality.5) (where 1 (·) is the indicator function) which is possible since E |X| < ∞.3.5).1) and (5.1).1 Central Limit Theorem (CLT). If Xi ∈ Rk is iid and E |Xi |2 < ∞. We need to ¢show that for all δ > 0 and η > 0 there is some N < ∞ so that for all n ≥ N. ¯ ¯ E ¯Z n ¯ ≤ E |Zi | ≤ 2ε.

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

If Zn →d Z as n → ∞ and g (·) is continuous. √ Theorem 5. Proof: Since g is continuous at c. where θ is m × 1 and Σ is m × m.1 Continuous Mapping Theorem 1 (CMT).3 Delta Method: If n (θn − θ0 ) →d N (0. Σ) . If Zn →p c as n → ∞ and g (·) is continuous at c. Since cλλ (λn ) → cλλ (0) = −Ik . and g(θ) : Rm → Rk . then ¡ ¢ √ 0 n (g (θn ) − g(θ0 )) →d N 0. It follows that ajn = gjθ (θ∗ ) − gjθ →p 0. gθ Σgθ where gθ (θ) = ∂ g(θ) ∂θ0 and gθ = gθ (θ0 ).√ where λn → 0 lies on the line segment joining 0 and λ/ n. 45 . then g(Zn ) →p g(c) as n → ∞. Ik ) distribution. Σ) = N 0. ¥ 5. 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 . for all ε > 0 we can ﬁnd a δ > 0 such that if |Zn − c| < δ then |g (Zn ) − g (c)| ≤ ε. This is suﬃcient to establish the theorem. Recall that A ⊂ B implies P (A) ≤ P (B). for each element of g. Theorem 5. we see that as n → ∞.4. then g(Zn ) →d g(Z) as n → ∞.4. gθ Σgθ .4. µ ¶ 1 Cn (λ) → exp − λ0 λ 2 the characteristic function of the N (0.2 Continuous Mapping Theorem 2. Stacking across elements of g. Proof : By a vector Taylor series expansion.4 Asymptotic Transformations Theorem 5. k ≤ m. we ﬁnd jn ¢ ¡ √ √ 0 n (g (θn ) − g(θ0 )) = (gθ + an ) n (θn − θ0 ) →d gθ N (0. Thus P (|g (Zn ) − g (c)| ≤ ε) ≥ P (|Zn − c| < δ) → 1 as n → ∞ by the assumption that Zn →p c. Hence g(Zn ) →p g(c) as n → ∞.

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

Ã n ! n X 1X 0 1 ˆ xi xi .5. Equation (4.4.1.2. A preliminary step in this approach is the demonstration that estimators are consistent — that they converge in probability to the true parameters as the sample size gets large.1). Proof.5. (6. xi ei →p g (Q.3) Ã where g(A.2.4 implies that Q−1 exists and thus g(·. 0). To characterize the sampling distribution more fully. n i=1 (6.3).1 by the fact that the sampling densities become more concentrated as n gets larger.4.1).2). using (6. 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. As the sample size increases the density becomes more concentrated about the population coeﬃcient. ˆ Theorem 6. 6. ·) is continuous at (Q. ˆ 47 .2 Consistency ˆ As discussed in Section 6. b) = A−1 b is a continuous function of A and b at all values of the arguments such that A−1 exist.2) i i n i=1 n From (6. Assumption 3. Asymptotic (large sample) methods approximate sampling distributions based on the limiting experiment that the sample size n tends to inﬁnity. (6. 0) = Q−1 0 = 0 β−β =g n n i=1 i=1 ˆ which implies β →p β as stated.1) and ˆ We now deduce the consistency of β.1 and the WLLN (Theorem 5. β →p β as n → ∞.1 Under Assumption 3.1) imply that n ¡ ¢ 1X xi x0 →p E xi x0 = Q (6. ¥ We can similarly show that the estimators σ 2 and s2 are consistent for σ 2 . For a complete argument. Assumption 3. Hence by the continuous mapping theorem (Theorem 5. First. xi ei = g i n n i=1 i=1 1X xi ei →p E (xi ei ) = 0.1).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 .1.1). we can conclude ˆ that β →p β. we will use the methods of asymptotic approximation. the OLS estimator β is has a statistical distribution which is unknown.5. This is illustrated in Figure 6. and the continuous mapping theorem (Theorem 5. (6.

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.1.1).5.2.1.Theorem 6.3.3. since n/(n − k) → 1 as n → ∞.1 In addition to Assumption 3.5. by the Cauchy-Schwarz inequality (5. i Now deﬁne ¡ ¢ Ω = E xi x0 e2 .2). Thus σ 2 is consistent for σ 2 .2 Under Assumption 3. it follows that s2 = ¥ n σ 2 →p σ 2 .1). By the central limit theorem (Theorem 5. (6.3 Asymptotic Normality ˆ We now establish the asymptotic distribution of β after normalization. ˆ Proof. i i Assumption 6. Assumption 6. σ 2 →p σ 2 and s2 →p σ 2 as n → ∞.6) n i=1 48 .3) and Theorem (6.2). Note that ˆ ei = yi − x0 β ˆ i i Thus and n ˆ = ei + x0 β − x0 β i i ³ ´ ˆ = ei − x0 β − β . ˆ n−k 6.2.3. To see this. (6. ´1/2 ¡ ¯ ¯¢ ¯ ³ ¯ ¯2 ´1/2 ¡ ¯ 4 ¯¢1/2 ³ ¯ 1/2 E ¯xi x0 e2 ¯ ≤ E ¯xi x0 ¯ = E |xi |4 < ∞. Ω) . We need a strengthening of the moment conditions. E ¯ei ¯ E ¯e4 ¯ i i i i (6.1 guarantees that the elements of Ω are ﬁnite.5) Thus xi ei is iid with mean zero and has covariance matrix Ω. (6. Ee4 < ∞ and E |xi |4 < ∞. ˆ Finally. (6. n 1 X √ xi ei →d N (0.

When (6.9) we deﬁne V 0 = Q−1 σ 2 whether (6.6). Theorem 6. |ε| ≥ 1.3. V ) where V = Q−1 ΩQ−1 . as n → ∞ ´ √ ³ ˆ n β − β →d N (0.1.7) Cov(xi x0 .8) Ω = E xi x0 E e2 = Qσ 2 i i V = Q−1 ΩQ−1 = Q−1 σ 2 ≡ V 0 (6.7) is true then V = V 0 .3. and εi is independent of xi with the Double Pareto density f (ε) = α |ε|−α−1 .1 states that the sampling distribution of the least-squares estimator. for example.2). This holds true for all joint distibutions of (yi .Then using (6. 1). Q−1 ΩQ−1 . In Figure 6.1 is commonly used to approximate the ﬁnite of √ ³ˆ sample distribution of n β − β . setting n = 100 and varying the parameter α. There is a special case where Ω and V simplify. Under (6. its variance diverges q ³ ´ ˆ to inﬁnity. e2 ) = 0.1 Under Assumption 6. when xi and ei are independent.9) In (6. i i Condition (6. ´ √ ³ ˆ n β−β = Ã 1X xi x0 i n i=1 n !−1 Ã Theorem 6. is approximately normal when the sample size n is suﬃciently large. We say that ei is a Homoskedastic Projection Error when (6. ´ √ ³ˆ As V is the variance of the asymptotic distribution of n β − β .1). 1) asymptotic distibution.3. the normal approximation is arbitrarily poor for some data distribution satisfying the assumptions. Ω) ¡ ¢ = N 0.1.2 we display the ﬁnite sample densities of the q ³ ˆ normalized estimator n α−2 β 2 − β 2 . The asymptotic distribution ´ Theorem 6. there is no simple answer to this reasonable question. after rescaling. We call V 0 the homoskedastic covariance matrix. otherwise V 6= V 0 . V is often referred to as ˆ the asymptotic covariance matrix of β. (6. however. and (6.3. but this is not a necessary condition. 1 X √ xi ei n i=1 n ! the N (0.7) the asymptotic variance formulas simplify as ¡ ¢ ¡ ¢ (6. The expression V = Q−1 ΩQ−1 is called a sandwich form. In this context the normalized least-squares slope estimator n α−2 β 2 − β 2 has α →d Q−1 N (0. If α > 2 the 2 error εi has zero mean and variance α/(α − 2). The trouble is that no matter how large is the sample size.7) holds. We illustrate this problem using a simulation. However. In´Figure 6. xi ) which satisfy the conditions of Assumption 6. Let yi = β 0 + β 1 xi + εi where xi is N (0.1 we have already seen a simple example where the least-squares estimate is quite asymmetric and non-normal even for reasonably large sample sizes. for any ˆ ﬁxed n the sampling distribution of β can be arbitrarily far from the normal distribution.3. As α approaches 2. For α 49 .7) is true or false. How large should n be in order for the approximation to be useful? Unfortunately. The approximation may be poor when n is small.

6 and 8. The estimator 2 2 in (6. As α diminishes the density changes signiﬁcantly.10) V 0 = Q−1 s2 . σ may also be substituted for s ˆ ¡ ¢ To estimate V = Q−1 ΩQ−1 . 1) asymptotic approximation is never guaranteed to be accurate. The MME estimator is i i 1X ˆ xi x0 e2 Ω= i ˆi n i=1 n (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. The homoskedastic covariance matrix V 0 = Q−1 σ 2 is typically estimated by ˆ ˆ (6. the sampling distribution becomes highly skewed and non-normal.11) 50 . we need an estimate of Ω = E xi x0 e2 . 4. 1) density. As k increases. The lesson from Figures 6.2 and 6. ˆ ˆ Since Q →p Q and s2 →p σ 2 (see (6.0 the density is very close to the N (0.2.2) and Theorem 6. 6.10) without changing this result.2: Density of Normalized OLS estimator α = 3. 1).1) it is clear that V 0 →p V 0 .3.4 Let Covariance Matrix Estimation 1X ˆ xi x0 Q= i n i=1 n be the method of moments estimator for Q.3 is that the N (0. concentrating most of the probability mass around zero. We show the sampling distribution of n β 1 − β 1 setting n = 100. for k = 1.Figure 6. Another example is shown in Figure 6.

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

E ¯e4 ¯ i ³ ´ 1X |xi |3 |ei | →p E |xi |3 |ei | .14 205. we return to the log wage regression of Section 4. p ˆ In this case the two estimates are quite similar. just as any other estimator.493 −0.1.035 ¶ .480 .35/988 = . From a computational standpoint.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. To illustrate. (6. Ω 2.80 .83 ¶−1 = µ 7.039 and ˆ V = µ 1 14.83 ¶−1 µ .14 6.4) 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 .80 2.used by an author when studying their work.2. by Holder’s inequality (5.6 Therefore the two covariance matrix estimates are µ ¶−1 µ ¶ 1 14. It is also important to understand that a particular standard error may be relevant under one set of model assumptions.14 205.80 40.12) i i n n n i=1 i=1 We now examine each sum on the right-hand-side of (6. We calculate that s2 = 0.14 14. We can write the estimated equation with standards errors using the format \ log(W agei ) = 1.80 40.085) (.98 −0. and then the square roots.2/988 = . The standard errors for β 0 are 7.480 ˆ0 = 0. but not under another set of assumptions.30 + 0. First.14 14. (6.199 2.1) show that n ¡ ¢ 1X xi x0 e2 →p E xi x0 e2 = Ω.6 ¶µ 1 14. the standard method to calculate the standard errors is to ˆ ﬁrst calculate n−1 V .20 −0. from which it follows that V →p V as n → ∞.83 −0. then take the diagonal elements.12) in turn. (.14 205.493 0.5) and the WLLN (Theorem 5.199 2.3) so by the WLLN ³ ´ ³ ´3/4 ¡ ¯ ¯¢ 1/4 E |xi |3 |ei | ≤ E |xi |4 < ∞. n n i=1 52 . i i i i n i=1 Second. Using (6.020) 6.20 and µ ¶ ˆ = 0.117 Educationi .085 p ˆ and that for β 1 is .020.20 = V 14.

1 As n → ∞.25). ¯ 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) . MacKinnon and White (1985) present numerical (simulation) evidence i ˆ ˆ that V ∗ works better than V as an estimator of V . is deﬁned ˆ ˆ by replacing the OLS residual ei in (6.12 the deﬁnition of β (−i) as the least-squares estimator with the i’th observation deleted. 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. 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 (6.13) of Efron (1982). Andrews’ proposed estimator is ˆ ˆ ˆ ˆ V ∗∗ = Q−1 Ω∗∗ Q−1 53 . 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 (6.26).¯ ¯ ¯ ¯ˆ and thus since ¯β − β ¯ →p 0. these establish consistency.5. which.−i = (1 − hi )−1 ei ˆ presented in (4. Using this substitution.13) Using formula (4.11) with the leave-one-out estimator ei. Ω →p Ω and V →p V. n i=1 n ˆ ˆ Theorem 6. ¯ ¯ ¯ ¯ ¯n ¯ n i=1 i=1 1X |xi |4 →p E |xi |4 . 6. From equation (3. Recall from Section 4. They also suggest that the scaling factor (n − 1)/n in (??) can be omitted.6 Alternative Covariance Matrix Estimators ˆ MacKinnon and White (1985) suggested a small-sample corrected version of V based on the jackˆ knife principle. Andrews (1991) suggested an similar estimator based on cross-validation. i=1 Third. ¯ ¯n ¯ n i=1 so Together.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 .

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

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

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

θ θ) (6. 6.05.17) = ˆ − zα/2 s(ˆ θ and Cn is an asymptotic (1 − α)% conﬁdence interval. The t-test of the previous setion rejects H0 : θ0 = θ if |tn (θ)| > zα/2 where tn (θ) is the t-statistic (6. This corresponds to selecting the conﬁdence h i h ˆ ± 1.96s(ˆ ≈ ˆ ± 2s(ˆ . ˆ + zα/2 s(ˆ . and values of θ outside two standard θ errors of the estimated ˆ are considered unlikely or unreasonable candidates for the true value. and it is desired to test the joint restrictions simultaneously. or α = . = n h(β) − θ0 Hβ V Hβ 57 (6.10 Wald Tests Sometimes θ = h(β) is a q × 1 vector. A conﬁdence interval is then constructed as the values of θ for which this test does not reject: © ª Cn = θ : |tn (θ)| ≤ zα/2 ( ) ˆ−θ θ = θ : −zα/2 ≤ ≤ zα/2 s(ˆ θ) i h θ). Thus values of θ within two standard errors of the estimated interval θ θ) θ θ) ˆ are considered “reasonable” candidates for the true value θ. the most common professional choice isi95%. Hβ = ∂β The Wald statistic for H0 against H1 is ´0 ³ ´ ³ ˆ θ θ Wn = n ˆ − θ0 Vθ−1 ˆ − θ0 ´0 ³ ´−1 ³ ´ ³ ˆ ˆ ˆ0 ˆ ˆ h(β) − θ0 . ˆ 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).We typically cannot calculate the exact coverage probability P (θ ∈ Cn ). We have the null and alternative H0 : θ = θ0 H1 : θ 6= θ0 . While there is no hard-and-fast guideline for choosing the coverage probability 1 − α. ¢ ¡ ¢ ¡ P (θ ∈ Cn ) = P |tn (θ)| ≤ zα/2 → P |Z| ≤ zα/2 = 1 − α. A good method for construction of a conﬁdence interval is the collection of parameter values which are not rejected by a statistical test.16) and zα/2 is the upper α/2 quantile of the standard normal distribution. θ The interval has been constructed so that as n → ∞.18) . We say that Cn has asymptotic (1 − α)% coverage for θ if P (θ ∈ Cn ) → 1 − α as n → ∞. In this case the t-statistic approach does not work. However we often can calculate the asymptotic coverage probability limn→∞ P (θ ∈ Cn ).

1 Under H0 and Assumption 6. the test rejects at the α% level iﬀ pn < α. Hence β β by Theorem A.8.11 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 .1 showed θ ˆ that V →p V.025 . then the Wald statistic takes the form ´0 ³ ´ ³ ´−1 ³ ˆ ˆ ˆ R0 V R R0 β − θ 0 . and Theorem 6. Hβ (β) →p Hβ . Vθ ).5.84 = z. Also h(β) = a selector matrix. In this case. ˆ Wn = n θ θ q θ θ Theorem 6. θ = β 2 . then the Wald statistic can be written in the form ¶ µ 2 ˆ σ − σ2 ˜ Wn = n (6. 1] under H0 . where p(x) = P χ2 ≥ x is the tail q q probability function of the χ2 distribution. so by the continuous mapping ˆ ˆ ˆ ˆ ˆ theorem. As before. An asymptotic Wald test rejects H0 in favor of H1 if Wn exceeds χ2 (α). 6. Thus Vθ = H 0 V Hβ →p H 0 V Hβ = Vθ > 0 if Hβ has full rank q. The null hypothesis is H0 : β 2 = 0.When h is a linear function of β. h(β) = R0 β. ˜ 58 ¡ 0 ¢−1 0 ˜ β 1 = X1 X1 X1 Y . The Wald test fails to reject if Wn is q 1 ¡ ¢ less than χ2 (α). Hβ (β) is a continuous function of β. χ2 (.10. if rank(Hβ ) = q.3. a chiq square random variable with q degrees of freedom. For example. and there are q = k2 restrictions. 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. = nβ 2 R0 V R R0 β is linear with R = µ 0 I ¶ ¢−1 ¡ ˆ ˆ ˆ . the upper-α quantile q 2 of the χ2 distribution. q and pn is asymptotically U[0.2.19) σ2 ˆ where σ2 = ˜ 1 0 e e.05) = 3.1. then Wn →d χ2 . We have established: ³ ´0 ³ ´ ˆ − θ0 V −1 ˆ − θ0 →d Z 0 V −1 Z = χ2 .15) showed that n ˆ − θ →d Z ∼ N (0. The asymptotic p-value for Wn is pn = p(Wn ). Wn = n R0 β − θ0 ´ √ ³ The delta method (6. ˜˜ n ˜ e = Y − X1 β 1 . Furthermore. 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.

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 . X2 ). ˜˜ ˆˆ ˆˆ σ 2 = n−1 e0 e ˆ we conclude that Wn = n as claimed.19) the F form of the Wald statistic. 2 σ ˆ To simplify this expression further.are from OLS of Y on X1 . This statistic is typically reported as an “F-statistic” which is deﬁned as ¡ 2 ¢ σ − σ 2 /k2 ˜ ˆ n − k Wn . as the sum of squared errors is a typical output from statistical packages. 59 . and σ2 = ˆ 1 0 e e. By the FWL theorem. note that partitioned matrix inversion (2. 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. still this formula often ﬁnds good use in reading applied papers. We now derive expression (6. First. ˜ ˆ ˜ 2 β 2 + e and X 0 e = 0.19). ˆ ¡ ¢−1 0 ˆ β = X 0X XY are from OLS of Y on X = (X1 . µ e0 e − e0 e ˜˜ ˆˆ e0 e ˆˆ ¶ =n µ σ2 − σ2 ˜ ˆ 2 σ ˆ ¶ . 2 2 2 or alternatively.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 . Now consider the residual regression of e on X2 = M1 X2 . note that if we regress Y on X1 alone. = F = n k2 σ 2 /(n − k) ˆ ¢−1 ¡ ˆ While it should be emphasized that equality (6. The elegant feature about (6. ˆˆ n ˆ e = Y − X β.19) only holds if V 0 = σ 2 n−1 X 0 X ˆ .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. Also. Because of this connection we call (6. the residual is ˜ ˜ e = M1 Y.

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

12. The log-likelihood of this model is ¡ 2¢ n n n ˜ ˜ ˜ Ln (β 1 . with residual variance σ . The critical values are quite close if n − k ≥ 30. the notable distinction is between the N (0. (Unless the sample size is unreasonably small. σ 2 ) = − log σ − log (2π) − .10) then ´ ³ ˆ • β ∼ N 0.) Now let us partition β = (β 1 .8.1 If ei is independent of xi and distributed N(0. n−k • ∼ tn−k ˆ In Theorem 6. and standard errors are calculated using the homoskedastic formula (6. As inference (conﬁdence intervals) are based on the t-ratio. if standard errors are calculated using the homoskedastic formula (6.a chi-square distribution with n − k degrees of freedom. We summarize these ﬁndings Theorem 6. σ 2 ). β has an exact normal distribution and t has an exact t distribution.12. σ 2 ) discussed above. σ 2 ) where β 1 is the OLS estimate from ˜ 2 ˜ a regression of yi on x1i only. The estimator under the alternative is the unrestricted estimator ˆ ˆ ˆ (β 1 . ˆ 2 2 2 ˜ ˜ The MLE of the model under the null hypothesis is (β 1 . so as a practical matter it does not matter which distribution is used. 2 2 2 The LR statistic for H0 is ´ ³ ˆ ˆ ˆ ˜ ˜ LR = 2 Ln (β 1 . which is twice the diﬀerence in the log-likelihood function evaluated under the null and alternative hypotheses. σ 2 ) = − log 2πˆ 2 − 2 e0 e ˆˆ 2 2ˆ σ ¡ ¢ n n n = − log σ 2 − log (2π) − . 1) jj rh ∼ tn−k = rh i ∼q i = q χ2 ˆ s(β j ) n−k σ2 2 0 X)−1 0 X)−1 (X s (X n−k n−k χn−k jj jj a t distribution with n − k degrees of freedom. β and t are approximately normally distributed. σ 2 (X 0 X)−1 • (n−k)s2 σ2 ˆ β j −β j ˆ s(β ) j ∼ χ2 . The Gaussian log-likelihood at these estimates is ¡ ¢ n 1 ˆ ˆ ˆ σ Ln (β 1 . σ ˆ ˆ βj − βj βj − βj N (0. σ 2 ) ¡ ¢¢ ¡ ¡ ¢ ˆ = n log σ 2 − log σ 2 ˜ µ 2¶ σ ˜ = n log .1 shows that under the strong assumption of ˆ normality. 0. β 2 . Theorem 6. 0. Furthermore.10) µ h i ¶ 2 (X 0 X)−1 N 0. σ 2 ) − Ln (β 1 .3.1 and Theorem 6. 0. β 2 . β 2 . σ2 ˆ 61 .1 we showed that in large samples. β 2 ) and consider tests of the linear restriction H0 : β 2 = 0 H1 : β 2 6= 0 In the context of parametric models. 1) and tn−k distributions. a good testing procedure is based on the likelihood ratio statistic. In contrast.

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

and σ 2 .1 we report the results of a Monte Carlo simulation where we vary these three parameters. Each row of the table corresponds to a diﬀerent value of s — and thus corresponds to a particular choice of test statistic.84 | β = 1) . To interpret the table. so these probabilities are Type I error.4: Wald Statistic as a function of s P (Wn (s) > 3. There is. The second through seventh columns contain the Type I error probabilities for diﬀerent combinations of n and σ. which is not surprising given the dependence of Wn (s) on s as shown in Figure 6. remember that the ideal Type I error probability is 5% (. In Table 4. and rarely fall outside of the 3%-8% range.4. Any other choice of s leads to a test with unacceptable Type I error probabilities.05) with deviations indicating+ distortion.Figure 6. The value of s is varied from 1 to 10. Table 4. In each case. the only test which meets this criterion is the conventional Wn = Wn (1) test. Rates above 20% are unexceptable. Given the simplicity of the model. and σ is varied among 1 and 3. Error rates avove 10% are considered excessive. Test performance deteriorates as s increases. In Table 2. the Type I error probability improves towards 5% as the sample size n increases. Table 4. n.1 Type I error Probability of Asymptotic 5% Wn (s) Test 63 . When comparing statistical procedures. n is varied among 20. For this particular example. we compare the rates row by row. looking for tests for which rate rejection rates are close to 5%.000 simulated Wald statistics Wn (s) which are larger than 3. no magic choice of n for which all tests perform uniformly well. These probabilities are calculated as the percentage of the 50.84.1 reports the simulation estimate of the Type I error probability from 50. The null hypothesis β s = 1 is true.1 you can also see the impact of variation in sample size. however. this probability depends only on s. Type I error rates between 3% and 8% are considered reasonable. Typically. 100 and 500.000 random samples.

08 .08 .23 .11 .20 . let V be an estimate of the ˆ asymptotic variance matrix for β and set ˆ = β 1 /β 2 .06 . Take the model yi = β 0 + x1i β 1 + x2i β 2 + ei E (xi ei ) = 0 and the hypothesis H0 : β1 =r β2 (6.20).07 .25 .08 . Other choices are arbitrary and would not be used in practice. An alternative statistic can be constructed through reformulating the null hypothesis as H0 : β 1 − rβ 2 = 0.07 .18 .000 simulated random samples In this example it is not surprising that the choice s = 1 yields the best test statistic.10 .15 . deﬁne θ = β 1 /β 2 .07 .13 .07 .12 .19 .06 .15 .06 .15 .05 .22 .20) ³ ´1/2 ˆ0 ˆ ˆ so that the standard error for ˆ is s(ˆ = n−1 H1 V H1 θ θ) .33 . Equivalently.05 .08 .13 . While this is clear in this particular example.14 .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 .20 .30 . β 1 . ˆ ˆ ˆ ˆ ˆ Let β = (β 0 .16 Rejection frequencies from 50. in other examples natural choices are not always obvious and the best choices may in fact appear counter-intuitive at ﬁrst. 64 .06 .06 . In this case a t-statistic for H0 is t1n = ³ˆ β1 ˆ β2 where r is a known constant.28 .14 .05 . β 2 ) be the least-squares estimates of (6.34 .13 .10 .05 .09 .10 .06 . Deﬁne θ ˆ ˆ ⎞ ⎛ 0 ⎟ ⎜ ⎟ ⎜ ⎜ 1 ⎟ ⎟ ⎜ ⎜ ˆ ⎟ ˆ H1 = ⎜ β 2 ⎟ ⎟ ⎜ ⎟ ⎜ ⎜ β ⎟ ˆ ⎠ ⎝ − 1 ˆ2 β2 ´ s(ˆ θ) −r .31 .35 .07 .05 .05 . so the hypothesis can be stated as H0 : θ = r.06 .24 .17 .25 .12 .08 .06 .21 .22 . This point can be illustrated through another example.26 .15 .

05 .50 . and 1. the entries in the table should be 0.645) and P (tn > 1.06 .25.2 is that the two t-ratios have dramatically diﬀerent sampling behavior. σ 2 ) draw with σ = 3.00 . −1 H V H ˆ 2 n 2 ⎞ 0 H2 = ⎝ 1 ⎠ .05 . Table 4. the rejection rates for the t1n statistic diverge greatly from this value.10 . . The left tail probabilities P (t1n < −1.00 .02 .05 . 65 . this formulation should be used.645) t1n t2n t1n t2n t1n t2n t1n t2n .00 .05.645) P (tn < −1.28 .05 . .05 .000 simulated samples.26 .15 .06 .06 . In all cases.05 β2 . especially for small values of β 2 .10 .00 .06 .15 .00 . We vary β 2 among .645) greatly exceed 5%. and are close to the ideal 5% rate for both sample sizes.05 .09 .05 .645) are close to zero in most cases. . We let x1i and x2i be mutually independent N (0. ei be an independent N (0. If no linear formulation is feasible.75 1.06 . The results are presented in Table 4.1.10 .05 . The common message from both examples is that Wald statistics are sensitive to the algebraic formulation of the null hypothesis.75.06 . 6.06 . and normalize β 0 = 0 and β 1 = 1.12 .50. along with sample size n. Ideally. then the “most linear” formulation should be selected. if the hypothesis can be expressed as a linear restriction on the model parameters.00 .06 . −r ⎛ t2n where To compare t1n and t2n we perform another simple Monte Carlo simulation. such as the GMM distance statistic which will be presented in Section 9. The implication of Table 4. This leaves β 2 as a free parameter.07 . It is also prudent to consider alternative tests to the Wald statistic.645) P (tn > 1.06 .A t-statistic based on this formulation of the hypothesis is ´2 ³ ˆ 1 − rβ 2 ˆ β =³ ´1/2 . the rejection rates for the linear t2n statistic are invariant to the value of β 2 .7. However.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.00 The one-sided Type I error probabilities P (tn < −1.00 .0 and n among 100 and 500. 1) variables.47 . In contrast. while the right tail probabilities P (t1n > 1.2 Type I error Probability of Asymptotic 5% t-tests n = 100 n = 500 P (tn < −1.06 .2.00 . and alternatives to asymptotic critical values should be considered.25 .645) P (tn > 1.05 . In this section we describe the method in more detail.645) are calculated from 50.00 .

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

this may ˆ be approximated by replacing P with P or with an hypothesized value. The random variable 1 (Tnb ≥ 1. but requires more computational time. where N = (B +1)α. excluding military. Often this is called the number of replications.21) the percentage of the simulated t-ratios which exceed the asymptotic 5% critical value. For regressors we include years of education. The α% sample quantile is a number qα such that α% of the sample are less than qα . such as the percentage estimate reported in (6. A simple way to compute sample quantiles is to sort the sample {Tnb } from low to high. Hence the ³ ´ ˆ standard errors for B = 100. As P is unknown.007. potential work experience. Again our dependent variable is the natural log of wages. experience squared.21) is therefore an ³ ´ p ˆ unbiased estimator of P with standard error s P = P (1 − P ) /B. B b=1 (6. then the 5% sample quantile is 50’th sorted value and the 95% sample quantile is the 950’th sorted value. . potential work experience. equalling 1 with probability P = E1 (Tnb ≥ 1. then we can set s P = (. We now expand the sample all non-military wage earners. It is therefore useful to conduct a variety of experiments. hispanic. then B will have to be increased. female. respectively. a larger B results in more precise estimates of the features of interest of Gn . immigrant. In many cases. Since the results of a Monte Carlo experiment are estimates computed from a random sample of size B. 6. Then qα is the N ’th number in this ordered sequence. we included a dummy 67 . For example. We separately estimate equations for white and non-whites.05) (. In particular. the researcher must select the number of experiments. We would then set Tn = ¯ˆ − θ¯ /s(ˆ and calculate B X ˆ= 1 P 1 (Tnb ≥ 1. and estimate a multivariate regression. union member. 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 ¯Type I error associated with an asymptotic 5% two-sided ¯ ¯ ¯ θ) θ t-test. Generally. therefore. We us the sample of wage earners from the March 2004 Current Population Survey. For example. if we are ³ ´ p √ ˆ assessing an asymptotic 5% test. the choice of B is often guided by the computational demands of the statistical procedure. Quite simply. if we set B = 999. female. For the dependent variable we use the natural log of wages. 1000.21). and therefore it is straightforward to calculate standard errors for any quantity of interest. are.15 Estimating a Wage Equation We again return to our wage equation. the performance will depend on n and F. The average (6. and . experience squared. so that coeﬃcients may be interpreted as semi-elasticities. In practice.96) . It is therefore convenient to pick B so that N is an integer. and non-white. and 5000. and poorly for others. and dummy variable indicators for the following: married.003. immigrant.22/ B.96) is iid Bernoulli. and hispanic. B. union member. an estimator or test may perform wonderfully for some values.022. and 90% sample quantiles of the sample {Tnb }. for a selection of choices of n and F.95) /B ' .96) . As discussed above. Suppose we are interested in the 5% and 95% quantile of Tn = ˆ We then compute the 10% θ. and our regressors include years of education. s P = . it is simple to make inferences about rejection probabilities from statistical tests. Furthermore. and dummy variable indicators for the following: married. If the standard error is too large to make a reliable inference.

1 OLS Estimates of Linear Equation for Log(Wage) ˆ β 1.69. Wn = n 1 − 2 = 18.008 .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.121 −. θ ˆ 2β 3 β2 .49452 σ ˜ Notice that the two statistics are close.1 we ﬁnd the point estimate ˆ ˆ = − β 2 = 28. the restricted standard deviation estimate is σ = .010 . but not equal. Ignoring the other coeﬃcients.014 .070 .19) is ˜ µ ¶ µ ¶ σ2 ˆ .4945.002 . 808 1 − .007 .232 .variable for state of residence (including the District of Columbia. The available sample is 18.808 . as the 1% critical value for the χ2 distribution is 76.001 . Computing the Wald statistic (6.013 . 50 Another interesting question which can be addressed from these estimates is the maximal impact of experience on mean wages.032 . 2β 3 68 . we ﬁnd Wn = 550. excluding the coeﬃcients on the state dummy variables. this adds 50 regressors). The F form of the Wald statistic (6.48772 = 515. Alternatively.18) that the state coeﬃcients are jointly zero.097 −. Using either statistic the hypothesis is easily rejected. if β 2 > 0 and β 3 < 0 the solution is θ=− From Table 4. reestimating the model with the 50 state dummies excluded.34 ˆ s(β) .102 −.00002 . we can write this eﬀect as log(W age) = β 2 Experience + β 3 Experience2 + · · · Our question is: At which level of experience θ do workers achieve the highest wage? In this quadratic model.4877 18.808 so the parameter estimates are quite precise and reported in Table 4.00057 . Table 4.1.102 −.027 .101 .033 −.

0. as the coverage probability of this conﬁdence interval is one minus the Type I error of the hypothesis test based on the t-test. Our desired conﬁdence interval will be the set of parameter values θ which are not rejected by the hypothesis test. this is a poor choice. In the present context we are interested in forming a conﬁdence interval. 29. 29.40. However.9.Using the Delta Method.96. there is not a simple expression for this set. 69 . implying a 95% conﬁdence θ) interval of [27. we can calculate a standard error of s(ˆ = . 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. Notice that the upper end of the conﬁdence interval is the same as that from the delta method. In the previous section we discovered that such t-tests had very poor Type I error rates. This is the set of θ such that |tn (θ)| ≤ 1. but it can be found numerically quite easily.5]. Since tn (θ) is a non-linear function of θ. but the lower end is substantially lower. not testing a hypothesis. so we have to go one step further. we found better Type I error rates by reformulating the hypothesis as a linear restriction. This set is [27.5].

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

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

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

2

is the homoskedasticity-formula standard error.

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

i=1 i=1

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

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

E (xi ei ) = 0

∗ yi = yi + ui

71

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

∗ E (yi ui ) = 0

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

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

• Qi • Di • Ci

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

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

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

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

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

73

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

Since there is not a unique speciﬁcation for the conditional variance the FGLS estimator is not unique. estimator of β. as it is estimating the conditional variance of the regression of yi on xi . Thus ˆ i i η − η i = e2 − e2 ˆ ˆi i = φi . if σ 2 ≈ 0 for some i. then the FGLS ˜i estimator is not well deﬁned. Vα = E zi zi (7.5) ˆ Thus the fact that η i is replaced with η i is asymptotically irrelevant. Then ˆ ¢−1 0 ¡ Zη ˆ α = Z 0Z ˜ (7. This suggests 75 . or FGLS..4) ¡ ¢−1 −1/2 0 √ √ n (˜ − α) = n (ˆ − α) + n−1 Z 0 Z α α n Zφ →d N (0. ³ ´ ˆ ˆ ˆ = −2ei x0 β − β + (β − β)0 xi x0 (β − β) i i say. ˜i Suppose that σ 2 > 0 for all i.Suppose ei (and thus η i ) were observed. Vα ) α ¡ ¡ 0 ¢¢−1 ¡ 0 2 ¢ ¡ ¡ 0 ¢¢−1 E zi zi ξ i E zi zi .. then the FGLS estimator will force ˜i the regression equation through the point (yi . and will depend on the model (and estimation method) for the skedastic regression. . This is the feasible GLS. Then set ˜i ˜ D = diag{˜ 2 . If σ 2 < 0 for some i. We may call (7. Vα ) (7. and hence we can estimate 0 σ 2 = zi α by i ˜ (7. σ 2 } σ1 ˜n and ³ ´−1 ˜ ˜ ˜ β = X 0 D−1 X X 0 D−1 Y. there is no guarantee that σ 2 > 0 for all i. xi ).4) the skedastic regression. Then we could estimate α by OLS: ¢−1 0 ¡ Z η →p α α = Z 0Z ˆ and where √ n (ˆ − α) →d N (0. we have the OLS residual ei = yi − x0 β = ei − x0 (β − β). Furthermore. One typical problem with implementation of FGLS estimation is that in a linear regression ˜i speciﬁcation.3) ˆ ˆ While ei is not observed.6) σ 2 = α0 zi . We have shown that α is consistently estimated by a simple procedure.. Note that n n n ´ 1X √ ³ √ −2 X 1 X ˆ ˆ ˆ √ zi φi = zi ei x0 n β − β + zi (β − β)0 xi x0 (β − β) n i i n n n i=1 i=1 i=1 →p 0 Let be from OLS regression of η i on zi . which is typically undesirable.

Unless σ 2 = α0 zi . 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 → ∞.1. Since the form of the skedastic regression is unknown. and thus where ´ √ ³ ˜ n β F GLS − β →d N (0.1. β should perhaps be i i called a quasi-FGLS estimator of β. and it may be estimated with considerable 76 V takes a sandwich form√. ´ √ ³ ˜ ˜ n β GLS − β F GLS →p 0. It is possible to show that if the skedastic regression is correctly speciﬁed. FGLS estimation depends on speciﬁcation and estimation of the skedastic regression. Why then do we not exclusively estimate regression models by FGLS? This is a good question. V = E α0 zi i i Examining the asymptotic distribution of Theorem 7. FGLS is asymptotically superior to OLS. This is an estimator which is robust to misspeciﬁcation of the condie1 ˆn tional variance. and was proposed by Cragg (Journal of Econometrics. V n n i=1 . V ). First. A trimming rule might make sense: σ 2 = max[˜ 2 .. i ˜ 0 is inconsistent for V . Instead.. In the linear regression model.1. e2 }. V = E σ −2 xi x0 i i ˆ where D = diag{ˆ2 . This estimator V 0 is appropriate when the skedastic regression (7. In this case we interpret α0 zi as a linear projection of e2 on zi .that there is a need to bound the estimated variances away from zero. then FGLS is asymptotically equivalent to GLS. ¢¢−1 ¡ ¡ . There are three reasons. V ˜ An appropriate solution is to use a White-type estimator in place of V 0 .1.1.2) is correctly speciﬁed. ´´−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 . 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. 1992).. . 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 ˜ = . σ 2 ] σi i for some σ 2 > 0. Theorem 7. Its asymptotic variance is not that given in Theorem 7. We just state the result without proof.1 If the skedastic regression is correctly speciﬁed. similar to the covariance matrix of the OLS estimator.

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

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

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

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

10) The LAD estimator has the asymptotic distribution 81 . Let ¯ 1 X¯ ¯yi − x0 β ¯ Ln (β) = i n i=1 n be the average of absolute deviations. let Y be a continuous random variable.9) θ0 = argmin E |Y − θ| θ and E sgn (Y − θ0 ) = 0 where sgn (u) = ½ 1 −1 if u ≥ 0 if u < 0 is the sign function. Two useful facts about the median are that (7. The least absolute deviations (LAD) estimator of β minimizes this function ˆ β = argmin Ln (β) β Equivalently. and the substantive assumption is that the median function is linear in x.To recall the deﬁnition and properties of the median.5. The ﬁrst deﬁnition is the 50th empirical 1 P quantile. the linear function M ed (yi | xi = x) = x0 β is the conditional median function. These distinctions are illusory. and the third deﬁnition is the i=1 1 P solution to the moment equation n n sgn (yi − θ) . however. and let M ed (Y | X) = m(X) be this function evaluated at the random variable X. Let m(x) = M ed (Y | X = x) denote the conditional median of Y given X = x. it is a solution to the moment condition ³ ´ 1X ˆ xi sgn yi − x0 β = 0. 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) = . The linear median regression model takes the form yi = x0 β + ei i M ed (ei | xi ) = 0 In this model. 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 ) = . Now let’s consider the conditional median of Y given a random variable X. i n n i=1 (7.5 • E (sgn (ei ) | xi ) = 0 • E (xi sgn (ei )) = 0 • β 0 = minβ E |yi − x0 β| i These facts motivate the following estimator. These facts deﬁnitions motivate three estimators of θ.

ˆ Proof of Theorem 7.10) is equivalent to g n (β) = 0.5. ∂ 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 ) . First. This can be done with kernel estimation techniques.5. ¢¢−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) .Theorem 7. When f (0 | x) is large. In the special case where the error is independent of xi . See Chapter 16. We need where g n (β) = n i i=1 gi (β) and gi (β) = xi (1 − 2 · 1 (yi ≤ xi three preliminary result.1: Since sgn (a) = 1 − 2 · 1 (a ≤ 0) . The main diﬃculty is the estimation of f (0).11).1) n X √ −1/2 n (g n (β 0 ) − g(β 0 )) = −n gi (β 0 ) →d N (0.11) This simpliﬁcation is similar to the simpliﬁcation of the asymptotic covariance of the OLS estimator under homoskedasticity. Computation of standard error for LAD estimates typically is based on equation (7.5. Second using the law of iterated expectations and the chain rule of i diﬀerentiation. Exi x0 ) i i=1 since Egi (β 0 )gi (β 0 )0 = Exi x0 . we provide a sketch here for completeness. the height of the error density at its median. (7.1 ´ √ ³ˆ n β − β 0 →d N (0. then f (0 | x) = f (0) and the asymptotic variance simpliﬁes V = (Exi x0 )−1 i 4f (0)2 (7. Pn −1 0 β)) . While a complete proof of Theorem 7. ∂β 0 so Third. by the central limit theorem (Theorm 5. and this improves estimation of the median.3. the conditional density of the error at its median. V ). by a Taylor series expansion and the fact g(β 0 ) = 0 82 . ∂β ˆ g(β) ' ´ ³ ∂ ˆ g(β 0 ) β − β 0 . where V = and f (e | x) is the conditional density of ei given xi = x.1 is advanced. then there are many innovations near to the median. Let g(β) = Eg (β).

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

6. if the model yi = x0 β + ei has i been ﬁt by OLS. Vτ ).7 Testing for Omitted NonLinearity If the goal is to estimate the conditional expectation E (yi | xi ) . and test their signiﬁcance using a Wald test.1. Fortunately. 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 . conventional Newton-type optimization methods are inappropriate. and form a Wald statistic i for γ = 0.1 n β τ − β τ →d N (0. the unconditional density of ei at 0. Since the quanitle regression criterion function Lτ (β) does not have an algebraic solution. ´ √ ³ˆ Theorem 7.13).5. One simple test for neglected nonlinearity is to add nonlinear functions of the regressors to ˆ ˆ the regression. it is useful to have a general test of the adequacy of the speciﬁcation. the quantile regression estimator β τ for β τ solves the minimization problem ˆ β τ = argmin Lτ (β) n β∈Rk n where Lτ (β) = n and ρτ (q) is deﬁned in (7. the τ ’th conditional quantile of ei is zero. where and f (e | x) is the conditional density of ei given xi = x. ¡ ¡ ¢¢−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. 7. and we have the simpliﬁcation Vτ = τ (1 − τ ) ¡ ¡ 0 ¢¢−1 . n numerical methods are necessary for its minimization. the asymptotic variance depends on the conditional density of the quantile regression error. E xi xi f (0)2 A recent monograph on the details of quantile regression is Koenker (2005). i By construction. and are widely available. fast linear programming methods have been developed for this problem. When the error ei is independent of xi . since it has discontinuous derivatives.12). 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.where ei is the error deﬁned to be the diﬀerence between yi and its τ ’th conditional quantile x0 β τ . Another popular approach is the RESET test proposed by Ramsey (1969). Furthermore. Thus. otherwise its properties are unspeciﬁed without further restrictions. ˆ Given the representation (7. then f (0 | xi ) = f (0) .

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

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

15) then where σ 2 is the variance estimate for model m. Another common approach to model selection is to to a selection criterion. n (7. One popular choice is the Akaike Information Criterion (AIC). etc. else select M2 .However. Indeed. Another problem is that if α is held ﬁxed. BIC model selection is consistent. That is. based on Bayesian arguments.17) Since log(n) > 2 (if n > 8). LRn →p 0. Then select M1 if Wn ≤ cα . The model selection rule is as follows. the BIC places a larger penalty than the AIC on the number of estimated parameters and is more parsimonious. His criterion. For some critical level α. known as the BIC. as the rule tends to overﬁt. the most popular to be one proposed by Schwarz. k ´ ³ c P M = M1 | M1 P (AIC1 < AIC2 | M1 ) µ ¶ k1 k1 + k2 2 2 σ | M1 = P log(ˆ 1 ) + 2 < log(ˆ 2 ) + 2 σ n n = P (LRn < 2k2 | M1 ) ¡ ¢ → P χ22 < 2k2 < 1. as ³ ´ c P M = M1 | M1 → 1 − α < 1. depending on the sample size. 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.16) holds under M1 . 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 AIC for model m is ¡ ¢ km ˆm AICm = log σ 2 + 2 . k = While many modiﬁcations of the AIC have been proposed. since under M1 . let cα satisfy ¢ ¡ P χ22 > cα . else select M2 . The rule is to select M1 if AIC1 < AIC2 . A common approach to model selection is to base the decision on a statistical test such as the Wald Wn . log(n) 87 . then P M ´ ³ c 1 − α but P M = M2 | M2 could vary dramatically. n (7. ¢ ¡ ˆ1 ˆ2 (7. then this model selection procedure is inconsistent. is ¡ ¢ km ˆm BICm = log σ 2 + log(n) . M)) between the true density and the model density.16) LRn = n log σ 2 − log σ 2 ' Wn →d χ22 . it is more appropriate to view model selection as determining the best ﬁnite sample approximation. In contrast to the AIC. and km is the number of coeﬃcients in the model. if α is set to be a small number. If the truth is inﬁnite dimensional. since (7. k A major problem with this approach is that the critical level α is indeterminate. AIC selection is inconsistent. this rule only makes sense when the true model is ﬁnite dimensional. Indeed.

Also under M2 . . and the AIC or BIC in principle can be implemented by estimating all possible subset models. β 2 = β 3 = · · · = β K = 0 M2 : β 1 6= 0.15). β 2 6= 0. The methods extend readily to the issue of selection among multiple regressors.. which regressors enter the regression). MK : β 1 6= 0. a full-blown implementation of the BIC selection criterion would seem computationally prohibitive. . 048. . . E (εi | xi ) = 0 and the question is which subset of the coeﬃcients are non-zero (equivalently. which can be a very large number. β K 6= 0. which are nested. For example. The general problem is the model yi = β 1 x1i + β 2 x1i + · · · + β K xKi + εi . β 3 = · · · = β K = 0 . In the ordered case. a model consists of any possible subset of the regressors {x1i .. There are two leading cases: ordered regressors and unordered. one can show that thus LRn →p ∞. 576. there are 2K such models. The AIC selection criteria estimates the K models by OLS. 210 = 1024. In the latter case. . the models are M1 : β 1 6= 0.17). selecting based on (7.so ´ ³ c P M = M1 | M1 = = P (BIC1 < BIC2 | M1 ) P (LRn < log(n)k2 | M1 ) µ ¶ LRn = P < k2 | M1 log(n) → P (0 < k2 ) = 1. stores the residual variance σ 2 for each model. and then selects the model with the lowest AIC (7. β 2 6= 0. xKi }. We have discussed model selection between two models. log(n) µ LRn > k2 | M2 log(n) ¶ ´ ³ c P M = M2 | M2 = P → 1.. and 220 = 1. . . However. In the unordered case. Similarly for ˆ the BIC. 88 .

based on a sample of size n. In the homoskedastic regression model Y = Xβ + e with E(ei | xi ) = 0 and E(e2 | xi ) = σ 2 . For any predictor g(xi ) for y. 2. (b) Prove that e = M1 e. Is θ a quantile of the distribution of Yi ? 3. . Deﬁne g(u) = τ − 1 (u < 0) where 1 (·) is the indicator function (takes the value 1 if the argument is true. You wish to forecast an out-of-sample value of y given that ˆ ˆ ˆ ˆ X = x. Consider the Weighted Least Squares (WLS) estimator of β ¢−1 ¡ 0 ¢ ¡ ˜ X WY β = X 0W X where W = diag(w1 . Show that the function g(x) which minimizes the MAE is the conditional median M (x). and an estimate of σ 2 is ˆ s2 = 1 e0 Ω−1 e. V . wn ) and wi = x−2 . In a linear model Y = Xβ + e.7. the estimates (β. E(e | X) = 0. σ 2 ). 5. ji ˜ (a) In which contexts would β be a good estimator? ˜ (b) Using your intuition. and the out-of-sample value of the regressors. the GLS estimator is ¡ ¢−1 ¡ 0 −1 ¢ ˜ β = X 0 Ω−1 X XΩ Y . Let σ 2 be the estimate of σ 2 . (b) Find an estimate of the variance of this forecast. Let θ satisfy Eg(Yi − θ) = 0.10 Exercises 1. V ar(e | X) = σ 2 Ω with Ω known.12). X). in which situations would you expect that β would perform better than OLS? 89 (a) Why is this a reasonable estimator for σ 2 ? ¡ ¢−1 0 −1 XΩ . 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 .. else equals zero). xi ) be a random sample with E(Y | X) = Xβ. x. Thus the available information is the sample (Y. the mean absolute error (MAE) is E |yi − g(xi )| . 4. where xji is one of the xi .. ˜ the residual vector is e = Y − X β. i ˆ ˆ suppose β is the OLS estimate of β with covariance matrix V .. ˆ (a) Find a point forecast of y. Verify equation (7. . Let (yi . the residuals e. ˆ ˆ n−k 6.

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

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

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

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

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

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

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

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

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

The ideal test rejects if Wn ≥ qn (α). about the rate v of convergence. the critical value qn (α) is found as the quantile from simulated values of W´ . A better asymptotic approximation may be obtained through an asymptotic expansion. where qn (α) is the (1 − α)% quantile of the distribution of Wn . F ) = Φ n→∞ v or ³x´ Gn (x. where qn (α) is the (1 − α)% quantile of the distribution of ³ ∗ ³ ∗ ´0 ´ ∗ Wn = n ˆ − ˆ Vθ∗−1 ˆ − ˆ . If θ is a vector. C4 is called the symmetric percentile-t interval. The derivative of an even function is odd. Deﬁnition 8. θ θ θ ˆ θ ∗ ∗ Computationally. F ) = Φ + o (1) . it says nothing.8 Asymptotic Expansions Tn →d N (0. 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. not ˆ − θ0 . we would use a Wald statistic ³ ´ ³ ´0 ˆ θ Wn (θ) = n ˆ − θ Vθ−1 ˆ − θ θ or some other asymptotically chi-square statistic.3 an = o(n−r ) if nr |an | → 0 as n → ∞. Let Tn be a statistic such that (8. or the size of the divergence for any particular sample size n.2 an = O(1) if |an | is uniformly bounded. n ´ ³ ∗ ³ ∗ θ θ Note in the simulation that the Wald statistic is a quadratic form in ˆ − ˆ . We say that a function g(x) is even if g(−x) = g(x). The bootstrap test ∗ ∗ rejects if Wn ≥ qn (α).] 8. Basically.8.3) ´ √ ³ˆ If Tn = n θ − θ0 then v = V while if Tn is a t-ratio then v = 1. Thus here Tn (θ) = Wn (θ). Deﬁnition 8. Let an be a sequence. writing Tn ∼ Gn (x. then to test H0 : θ = θ0 against H1 : θ 6= θ0 at size α.∗ where qn (α) is the bootstrap critical value for a two-sided hypothesis test. an = O(n−r ) if it declines to zero like n−r . however. and vice-versa. lim Gn (x. 99 . The following notation will be helpful. v 2 ). and a function h(x) is odd if h(−x) = −h(x).4) says that Gn converges to Φ x as n → ∞. θ [This is a typical mistake made by practitioners. F ) then ³x´ . Equivalently.4) v ¡ ¢ While (8.8.8.1 an = o(1) if an → 0 as n → ∞ Deﬁnition 8. (8.

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

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

Fn ) + O(n−3/2 ). Thus a two-sided bootstrap test also achieves an asymptotic reﬁnement. Fn ) = Φ n v ˆ ˆ where V = V (Fn ) is the bootstrap estimate of V. V ).5) to the bootstrap distribution. as it depends on the unknown V. F0 ) = Φ n v ´ ˆ v ³x x (ˆ − v) + O(n−1/2 ) v = −φ v v ˆ ˆ = O(n−1/2 ) 102 . and needs to be determined on a case-by-case basis. This is in contrast to the use of the asymptotic distribution. Gn (x. meaning that the errors in the two directions exactly cancel out.8. Applying (8. whose error is O(n−1 ). but one-sided tests might have more power against alternatives of interest. we ﬁnd Gn (x) = Gn (x. and bootstrap tests have better rates of convergence than asymptotic tests. similar to a one-sided test. the asymptotic two-sided test has a better coverage rate than the asymptotic one-sided test. Fn ) = Φ(x) + ∗ 2 g2 (x. Therefore. and g2 is continuous in F. g1 . and for the bootstrap ³x´ + O(n−1/2 ). Twosided tests will have more accurate size (Reported Type I error). Theorem 8. F0 ) = ∗ 2 (g2 (x.1 shows that a ﬁrst-order approximation ³x´ + O(n−1/2 ). Fn ) − g2 (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 ). Two-sided tests have better rates of convergence than the one-sided tests. set Tn = n ˆ − θ0 . n Thus the diﬀerence between the bootstrap and exact distributions is Gn (x) − Gn (x. Conﬁdence intervals based on the bootstrap can be asymmetric if based on one-sided tests (equal-tailed intervals) and can therefore be more informative and have smaller length than symmetric intervals. F ) = Φ v √ where v = V . A reader might get confused between the two simultaneous eﬀects. which is not pivotal.Interestingly. The diﬀerence is ³x´ ³x´ −Φ + O(n−1/2 ) G∗ (x) − Gn (x. the choice between symmetric and equal-tailed conﬁdence intervals is unclear. G∗ (x) = Gn (x. We know that θ Tn →d N (0. The analysis shows that there may be a trade-oﬀ between one-sided and two-sided tests. is an even function. This is because the ﬁrst term in the asymptotic expansion. 8.11 Percentile Conﬁdence Intervals ´ √ ³ To evaluate the coverage rate of the percentile interval. √ the last equality because Fn converges to F0 at rate n. F0 )) + O(n−3/2 ) n = O(n−3/2 ).

A third approach sets x∗ = xi .g. and is thus an ineﬃcient estimator of the true distribution (when in fact the regression assumption is true. it imposes no conditions. the theoretical literature (e.) One approach to this problem is to impose the very strong assumption that the error εi is independent of the regressor xi . the percentile bootstrap methods provide an attractive inference method.. A parametric i method is to generate the bootstrap errors ε∗ from a parametric distribution. The disadvantage is that the bootstrap distribution may be a poor approximation when the error is not independent of the regressors.. n Any other consistent estimate of F0 may be used to deﬁne a feasible bootstrap estimator. it may be ineﬃcient in contexts where more is known about F. The advantage of the EDF is that it is fully nonparametric. Horowitz.. ∗ The non-parametric bootstrap distribution resamples the observations (yi .. and then create i i ∗ = x∗0 β + ε∗ . i For the regressors x∗ . Therefore if standard errors are available. . The bad news is that the rate of convergence is disappointing. A parametric method is to sample x∗ from an estimated parametric i distribution. There are diﬀerent ways to impose independence. such as the normal i ˆ ε∗ ∼ N (0. It is no better than the rate obtained from an asymptotic one-sided conﬁdence region. it is unclear if there are any beneﬁts from using the percentile bootstrap over simple asymptotic methods. i i The the bootstrap distribution does not impose the regression assumption. 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. xn }. i which implies ∗ ˆ yi = x∗0 β + ε∗ i i E (x∗ ε∗ ) = 0 i i but generally E (ε∗ | x∗ ) 6= 0. . If this is done.. A non-parametric method is ˆ yi i i e ˆ to sample the bootstrap errors ε∗ randomly from the OLS residuals {ˆ1 . But since it is fully nonparametric. Hall. 1992.12 Bootstrap Methods for Regression Models The bootstrap methods we have discussed have set G∗ (x) = Gn (x. The advantage is that in this case it is straightforward to construct bootstrap distributions. This is equivalent to treating the regressors as ﬁxed i in repeated samples. it is suﬃcient to sample the x∗ and ε∗ independently. σ 2 ). where Fn is the EDF. 2002) tends to advocate the use of the percentile-t bootstrap methods rather than percentile methods. √ The good news is that the percentile-type methods (if appropriately used) can yield nconvergent asymptotic inference. en }. a nonparametric method is to sample the x∗ randomly from the EDF i i or sample values {x1 . and works in nearly any context. Based on these arguments. x∗ ) from the EDF. 8.Hence the order of the error is O(n−1/2 ). then all inferential statements are made conditionally on the 103 . We discuss some bootstrap methods appropriate for the case of a regression model where yi = x0 β + εi i E (ei | xi ) = 0. Fn ). To impose independence..

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

ˆ = 1. The dataﬁle hprice1.5% and 97.05) and qn (. you generate bootstrap samples.95).05) . Suppose that in an application. and the colonial dummy. What is wrong with this procedure? Tn = θ/s(θ) n 6. (c) With the given information. (b) Report the 95% Alternative Percentile interval for θ. θ θ)q ∗ θ θ)q ∗ θ/s(θ) 5. The ˆ are sorted.2 and s(ˆ = .75 and 1.5% quantiles of the ˆ are . and the 2.95). You want to test H0 : θ = 0 against H1 : θ > 0. and ˆ is calculated on each θ ∗ ∗ θ sample. Using the non-parametric ∗ bootstrap. Estimate a linear regression of price on the number of bedrooms.95). ˆ − s(ˆ n (. θ respectively. You replace c with qn (.3.2. You do this as follows. calculate the estimates ˆ on these samples and θ then calculate ∗ ∗ ∗ θ θ Tn = ˆ /s(ˆ ). size of house. lot size.95) denote the 5% θ) ∗ and 95% quantiles of Tn . Calculate 95% conﬁdence intervals for the regression coeﬃcients using both the asymptotic normal approximation and the percentile-t bootstrap. Let qn (. The test for H0 is to reject if Tn = ˆ ˆ > c where c is picked so that Type I error is α. ∗ ∗ where s(ˆ is the standard error in the original data.dat contains data on house prices (sales). (a) Report the 95% Efron Percentile interval for θ. 105 . ∗ ∗ ∗ Let qn (. can you report the 95% Percentile-t interval for θ? 7. with variables listed in the ﬁle hprice1.pdf.Show that C exactly equals the Alternative percentile interval (not the percentile-t interval). Using the non-parametric bootstrap. θ θ) ∗ 1000 samples are generated from the bootstrap distribution. and deﬁne the bootstrap conﬁdence interval h i C = ˆ − s(ˆ n (.95) denote the 95% quantile of Tn . and thus reject H0 if ˆ ˆ > q ∗ (.

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

3) The method of moments estimator for β is deﬁned as the parameter value which sets g n (β) = 0. Jn (β) = n · g n (β)0 g n (β) = n · |g n (β)|2 .2 GMM Estimator n n ¢ 1¡ 0 ¢ 1X 1X ¡ 0 X Y − X 0 Zβ .2. β GMM does not change.2. but this is generally not possible when > k.1 β GMM = argmin Jn (β). 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 . β ˆ Note that if k = . This is a non-negative measure of the “length” of the vector g n (β). For some × weight matrix Wn > 0.1 ˆ 2Z 0 XWn X 0 Z β = 2Z 0 XWn X 0 Y While the estimator depends on Wn .3 Distribution of GMM Estimator ¡ 0¢ Q = E xi zi Assume that Wn →p W > 0. then. the dependence is only up to scale. 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. if Wn = I. the square of the Euclidean length. ˆ Deﬁnition 9. The idea of the generalized method of moments (GMM) is to deﬁne an estimator which sets g n (β) “close” to zero. for if Wn is replaced ˆ by cWn for some c > 0. For example. let Jn (β) = n · g n (β)0 Wn g n (β). ¡ ¢−1 0 ˆ Z XWn X 0 Y. The GMM estimator minimizes Jn (β). gi (β) = xi yi − zi β = n n n i=1 i=1 Deﬁne the sample analog of (9. i i . then g n (β) = 0. Proposition 9. and the GMM estimator is the MME. Let and where gi = xi ei .2) g n (β) = (9.9. β GMM = Z 0 XWn X 0 Z 9.

Given any such ﬁrst0ˆ ˆ ˆ ˆ step estimator. where In general. The proof is left as an exercise. we can deﬁne the residuals ei = yi −zi β and moment equations gi = xi ei = g(wi . No estimator can do better (in this ﬁrst-order asymptotic sense). ˆ Construct n 1X ˆ g n = g n (β) = gi . Q W ΩW Q Q0 W Q V = Q0 W Q Thus we have Theorem 9. If it is known that E (gi (β)) = 0. This estimator is eﬃcient only in the sense that it is the best (asymptotically) in the class of GMM estimators with this set of moment conditions. For any Wn →p W0 . no semiparametric estimator (one which is consistent globally for the class of models considered) ¢−1 ¡ . GMM estimators are asymptotically normal with “sandwich form” asymptotic variances.4 Estimation of the Eﬃcient Weight Matrix ˆ Given any weight matrix Wn > 0. without imposing additional assumptions. V ) . it is semiparametrically eﬃcient.3. ˆ n i=1 gi = gi − g n . n n We conclude: Theorem 9. For example. and this is all that is known.and µ µ ¶ ¶ 1 0 1 0 Z X Wn X e →d Q0 W N (0. This yields the eﬃcient GMM estimator: ¢−1 0 ¡ ˆ Z XΩ−1 X 0 Y. Q0 Ω−1 Q ¢−1 ¡ 0 ¢¡ ¢−1 ¡ . Chamberlain showed that in this context. a better choice is Wn = (X 0 X)−1 . β).2 For the eﬃcient GMM estimator. Ω) . no estimator has greater asymptotic eﬃciency than the eﬃcient linear GMM estimator. the GMM estimator β is consistent yet ineﬃcient. The optimal weight matrix W0 is one which minimizes V. ˆ We have described the estimator β as “eﬃcient GMM” if the optimal (variance minimizing) weight matrix is selected. it turns out that the GMM estimator is semiparametrically eﬃcient. we can set Wn = I . β = Z 0 XΩ−1 X 0 Z ´ ³ ¡ ¢−1 ´ √ ³ˆ . This results shows that in the linear model. this is a semi-parametric problem.3.1 ´ √ ³ˆ n β − β →d N (0. In the linear model. However. ˆ∗ ˆ 108 . Since the GMM estimator has this can have a smaller asymptotic variance than G0 Ω−1 G asymptotic variance. 9. but it can be estimated consistently. W0 = Ω−1 is not known in practice. as it has the same asymptotic distribution. This turns out to be W0 = Ω−1 . n β − β →d N 0. ˆ we still call β the eﬃcient GMM estimator. as shown by Gary Chamberlain (1987). This is a weak concept of optimality. as the distribution of the data is unknown. as we are only considering alternative weight matrices Wn .

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

n β − β →d N 0. 9. For example. In this sense an 1i 1i exclusion restriction can be seen as an overidentifying restriction. and is thus a natural test statistic for H0 : Egi = 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). 110 . 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 . perhaps obtained by ﬁrst ˆ setting Wn = I. Theorem 9. this is all that is known.Often. However. The general theory of GMM estimation and testing was exposited by L. Since the GMM estimator depends upon the ﬁrst-stage estimator. Thus the model — the overidentifying restrictions — are testable. often the weight ˆ matrix Wn is updated.5. so that the linear equation may be written as yi = β 0 x1i + ei . 1 2 It is possible that β 2 = 0. 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. ´ ³ ¡ ¢−1 ´ √ ³ˆ Theorem 9.1 Under general regularity conditions. ˆ J = J(β) →d χ2−k . and thus g n can be used to assess whether or not the hypothesis that Egi = 0 is true or not. and if the weight matrix is asymptotically eﬃcient. Under the hypothesis of correct speciﬁcation. Note that g n →p Egi . This estimator can be iterated if needed. 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. 1 it is possible that β 2 6= 0. ˆˆ n is a quadratic form in g n . Identiﬁcation requires l ≥ k = dim(β). G0 Ω−1 G .6.1 (Sargan-Hansen). i i i i ∂β 1X 0 gi gi − g n g 0 ˆˆ n n i=1 n !−1 . 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.6 Over-Identiﬁcation Test Overidentiﬁed models ( > k) are special in the sense that there may not be a parameter value β such that the moment condition Eg(wi . and then β recomputed. where ³ ´−1 ∂ 0 ˆ ˆ ˆ ˆ Ω = (E (gi gi ))−1 and G = E ∂β 0 gi (β). Hansen (1982).

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

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

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

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

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. 115 .6) equals the Wald statistic.5. l ≥ k. is deﬁned as Jn (β) = ˜ β = argmin Jn (β). λ) = 1 Jn (β) + λ0 (R0 β − r) where λ is 2 s × 1. Thus ˜ β = argmin Jn (β) R0 β−r Ã n ! ¡ 0 ¢−1 ¡ 0 ¢−1 X 0 2 ˆ XX xi xi ei ˆ . Vn = X X i=1 ˜ and hence R0 β = r. zi ). Show how to construct an eﬃcient GMM estimator for β. λ = R0 Vn R (c) Show that if R0 β = r then ´ √ ³˜ n β − β →d N (0.5) 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. VR = V − V R R0 V R (d) Show that in this setting. h(β)=0 The GMM test statistic (the distance statistic) of the hypothesis h(β) = 0 is ˜ D = Jn (β) = min Jn (β). xi . β) + ei E (zi ei ) = 0.6) (a) Show that you can rewrite Jn (β) in (9. 6. In the linear model Y = Xβ + e with E(xi ei ) = 0. Deﬁne the Lagrangian L(β. zi is l × 1 and β is k × 1.5) n 1 P ˆ where ei are the OLS residuals and Ωn = n n xi x0 e2 . 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 distance statistic D in (9. VR ) where ¡ ¢−1 0 R V. subject ˆ i ˆi i=1 to the restriction h(β) = 0. h(β)=0 (9. The GMM estimator of β. The equation of interest is yi = g(xi . The observed data is (yi .

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

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

λ) : λ(β) = argmin Rn (β. (10. but must be obtained numerically (see section 6. λ). Multiplying the ﬁrst equation by pi . This yields the (proﬁle) empirical log-likelihood function for β. and using the second and third equations. p1 . summing over i. µ) = n i=1 i=1 i=1 L∗ n with respect to pi . p (10.4) (10. 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 (when it exists) is well deﬁned since Rn (β. probabilities 1 ³ ´´ . λ(β)) = −n ln (n) − n X i=1 ˆ The EL estimate β is the value which maximizes Ln (β).3). (see section 6. The solution cannot be obtained explicitly.5). we ﬁnd µ = n and 1 ¢.1) and (10.where λ and µ are Lagrange multipliers. we also obtain the Lagrange multiplier λ = λ(β). the Lagrange multiplier λ(β) minimizes Rn (β. λ) is a convex function of λ.5) This minimization problem is the dual of the constrained maximization problem. µ. pi = ³ ˆ ˆ ˆ0 n 1 + λ gi β ˆ Ln = n X i=1 ln (ˆi ) . .. 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. pn ..5) ˆ ˆ As a by-product of estimation.7) 118 . λ) = −n ln (n) − n X i=1 For given β.. or equivalently minimizes its negative ˆ (10. λ. pi = ¡ n 1 + λ0 gi (β) Substituting into L∗ we ﬁnd n Rn (β. 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. pi gi (β) = 0.2) subject to the restrictions (10. Ln (β) = Rn (β.

13) Premultiplying by G0 Ω−1 and using (10.11) 0 = ∂λ ˆ0 ˆ i=1 1 + λ gi β ³ ´0 ˆ n X Gi .9) (10. 0 = Rn (β. n (10. in the linear model. i i Theorem 10.10). λ) = − (10. Gi (.2. G = −E (xi zi ). g n = n n gi (β 0 ) and Ωn = n n g (β 0 ) gi (β 0 )0 .12) ∂β ˆ ˆ0 i=1 1 + λ gi β 1 P 1 P 1 P Let Gn = n n Gi (β 0 ) .8) and ¢ 0 0 For example. Thus the EL estimator is asymptotically eﬃcient. λ) = − (10.1 Under regularity conditions.14) ³ ´ ˆ ˆ 0 ' −G0 Ω−1 g n − G0 Ω−1 Gn β − β 0 + G0 Ω−1 Ωn λ n n n n n n ³ ´ ˆ = −G0 Ω−1 g n − G0 Ω−1 Gn β − β 0 n n n n 119 . ˆ The asymptotic variance V for β is the same as for eﬃcient GMM. (β. β) = −xi zi .9) and (10. λ) jointly solve ³ ´ ˆ n gi β X ∂ ³ ³ ´´ Rn (β.10.13) yields n n Expanding (10.10) ¡ Ω−1 N (0. and Ω = E xi x0 e2 . Vλ ) ´ √ ˆ √ ³ˆ where V and Vλ are deﬁned in (10. ´ √ ³ ˆ n β − β 0 →d √ ˆ nλ →d N (0. β λ ∂ ³ ´.11) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ ˆ 0 ' −g n − Gn β − β 0 + Ωn λ (10. V ) ¢−1 ¡ V = G0 Ω−1 G ¡ ¢−1 0 Vλ = Ω − G G0 Ω−1 G G G = EGi (β 0 ) ¡ ¢ Ω = E gi (β 0 ) gi (β 0 )0 (10.2 Deﬁne Asymptotic Distribution of EL Estimator Gi (β) = ∂ gi (β) ∂β 0 (10. ˆ ˆ Proof. i=1 i=1 i=1i Expanding (10.12) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ 0 ' G0 λ − λ0 . and n β − β 0 and nλ are asymptotically independent.

Vλ ) Furthermore. and have the same interpretation. Ω) →d Ω−1 I − G G Ω G GΩ = Ω−1 N (0.16) ´ √ ˆ √ ³ˆ n β − β 0 and nλ are asymptotically uncorrelated and hence independent. β 0 ) = 0 then LRn →d χ2−k . it is an asymptotically eﬃcient estimator for β.14) for λ and using (10. Twice the diﬀerence between the unrestricted empirical likelihood −n log (n) and the maximized empirical likelihood for the model (10. ¥ Chamberlain (1987) showed that V is the semiparametric eﬃciency bound for β in the overidentiﬁed moment condition model. by a Taylor expansion.ˆ Solving for β and using the WLLN and CLT yields ´ ¢−1 0 −1 √ ¡ √ ³ ˆ ' − G0 Ω−1 Gn n β − β0 Gn Ωn ng n n n ¡ 0 −1 ¢−1 0 −1 G Ω N (0.15) (10.17) 2 ln 1 + λ gi β .7) is n ³ ´´ ³ X ˆ ˆ0 (10. and (10. since ³ ¡ ¢−1 0 ´ G0 I − Ω−1 G G0 Ω−1 G G =0 (10. β ' n g n + Gn β − β 0 n i=1 ³ ¡ ¢−1 0 −1 ´ √ Gn Ωn ng n ' I − Gn G0 Ω−1 Gn n n √ ˆ ' Ωn nλ. The same statistic can be constructed for empirical likelihood. The overidentiﬁcation test is a very useful by-product of EL estimation. Proof.16).1 If Eg(wi . They are asymptotically ﬁrst-order equivalent. First. and it is advisable to report the statistic LRn whenever EL is the estimation method. (10. Since the EL estimator achieves this bound. Ω) GΩ G →d = N (0.15). 10.3 Overidentifying Restrictions In a parametric likelihood context. 120 . V ) ˆ Solving (10.3. tests are based on the diﬀerence in the log likelihood functions. n ³ ´´ ´ √ ³ 1 X ³ ˆ ˆ √ g wi . LRn = i=1 Theorem 10. The EL overidentiﬁcation test is similar to the GMM overidentiﬁcation test. This means that no consistent estimator for this class of models can have a lower asymptotic variance than V .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.

5 Numerical Computation Gauss code which implements the methods discussed below can be found at http://www. The restricted EL estimator and likelihood are the values which solve ˜ β = argmax Ln (β) h(β)=0 ˜ ˜ Ln = Ln (β) = max Ln (β). Instead we use the diﬀerence in log-likelihoods: ³ ´ ˆ ˜ LRn = 2 Ln − Ln . the restricted EL estimator β is simply an EL estimator with − k + a overidenti˜ ˆ fying restrictions. 10.4. Vλ ) ¥ where the proof of the ﬁnal equality is left as an exercise. where h : Rk → Ra . the simple overidentifying restrictions test (10. To test the hypothesis h(β) while maintaining (10. LRn = n X i=1 ˆ0 ' 2λ →d ˆ0 ˆ ' nλ Ωn λ = χ2−k n X i=1 ³ ´´ ³ ˆ ˆ0 2 ln 1 + λ gi β i=1 n ³ ´ X ³ ´ ³ ´0 ˆ − λ0 ˆ ˆ ˆ ˆ gi β gi β gi β λ N (0. h(β)=0 ˜ Fundamentally. The hypothesis of interest is h(β) = 0. since ln(1 + x) ' x − x2 /2 for x small.18) and H0 : h(β) = 0.18).1 Under (10.wisc. Vλ )0 Ω−1 N (0.18) are assumed to hold and are not being challenged (at least for the test discussed in this section). Theorem 10.4 Testing Egi (β) = 0 (10.edu/~bhansen/progs/elike. 10. This test statistic is a natural analog of the GMM distance statistic.ssc. so there is no fundamental change in the distribution theory for β relative to β.18) Let the maintained model be where g is × 1 and β is k × 1.prc 121 . a The proof of this result is more challenging and is omitted. By “maintained” we mean that the overidentfying restrictions contained in (10.Second.17) is not appropriate. LRn →d χ2 .

4). λj ))−1 Rλ (β. λ) = i ∂λ∂β 0 1 + λ0 gi (β) i=1 ⎞ ⎛ ¡ 0 ¢ ∂2 n 2 X 0 gi (β) λ ∂ ⎠ ⎝G∗ (β.5) for given β. A complication is that λ must be constrained so that 0 ≤ pi ≤ 1 which holds if ¢ ¡ n 1 + λ0 gi (β) ≥ 1 122 (10.20) .19). For p = 0. λ) G∗ (β. One method uses the following quadratic approximation.Derivatives The numerical calculations depend on derivatives of the dual likelihood function (10. λ) = − ∂β n X i=1 G∗ (β. 1.19) X ∂2 ∗ ∗ gi (β. λj ) is smaller than some prespeciﬁed tolerance. λ) ∂λ i=1 n ∂ Rn (β.19) is continued until the gradient Rλ (β. 2. Eﬃcient convergence requires a good choice of steplength δ. Set δ 0 = 0. λ) = − gi (β. λ) = G∗ (β. λ) = i i ∂β∂β 0 1 + λ0 gi (β) i=1 n where δ > 0 is a scalar steplength (to be discussed next). δ 4R2 + 4R0 − 8R1 yielding the steplength to be plugged into (10. λ)0 0 Rn (β. δ 1 = 1 and δ 2 = 1. λp ) A quadratic function can be ﬁt exactly through these three points. λ)0 − ∂β∂β Rn (β. λ) = ∂λ∂λ i=1 ¶ n 2 Xµ ∂ Gi (β) ∗ gi (β. i Rββ = Inner Loop The so-called “inner loop” solves (10. λ) yielding the iteration rule λj+1 = λj − δ (Rλλ (β. λj )) Rp = Rn (β. λ) G∗ (β. The starting value λ1 can be set to the zero vector. λ) . set 2 λp = λj − δ p (Rλλ (β. (10. λ) gi (β. The iteration (10. The value of δ which minimizes this quadratic is ˆ = R2 + 3R0 − 4R1 . The modiﬁed Newton method takes a quadratic approximation to Rn (β.. λj ) . λ)0 − Rn (β. λj ))−1 Rλ (β. Deﬁne ∗ gi (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. λ) = i The ﬁrst derivatives of (10.

λ(β)) + Rλβ λβ + λ0 Rλβ + λ0 Rλλ λβ β β −1 0 = Rλβ Rλλ Rλβ − Rββ . If (10. The Hessian for (10. The gradient for (10. λ(β)) + λ0 Rλ (β. λ) = 0 at λ = λ(β). the stepsize δ needs to be decreased. λ(β)) β ∂β ¡ ¢ 0 = − Rββ (β. and the rule is iterated until convergence. Outer Loop The outer loop is the minimization (10. λ(β)) = 0.6). the eigenvalues of Lββ should be adjusted so that all are positive.20) fails. It is not guaranteed that Lββ > 0. λ) = Rβ + λ0 Rλ = Rβ β ∂β ∂β since Rλ (β.for all i. 123 .6) is Lββ = − ∂ Ln (β) ∂β∂β 0 ¤ ∂ £ = − 0 Rβ (β. The Newton iteration rule is β j+1 = β j − δL−1 Lβ ββ where δ is a scalar stepsize.6) is Lβ = ∂ ∂ Ln (β) = Rn (β. ∂β 0 the second equality following from the implicit function theorem applied to Rλ (β. where λβ = ∂ −1 λ(β) = −Rλλ Rλβ . This can be done by the modiﬁed Newton method described in the previous section. If not.

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

and assume that E(zi ei ) 6= 0 so there is endogeneity. some regressors in zi will be uncorrelated with ei (for example.2) Any solution to the problem of endogeneity requires additional information which we call instruments. this can be written as Y = Zβ + e. We call (11.1 Instrumental Variables 0 yi = zi β + ei Let the equation of interest be (11.1) the structural equation. This is called simultaneous equations bias. ¶ µ ∙ β2 β1 1 −1 β 2 e1i + β 1 e2i (e1i − e2i ) ¸µ e1i e2i ¶ ˆ Hence if it is estimated by OLS. which does not equal either β 1 or β 2 . Deﬁnition 11. So we have the partition µ ¶ z1i k1 (11. so should be included in xi . z1i is an instrumental variable for (11. In a typical set-up. and x2i are the excluded exogenous variables.so µ qi pi ¶ = = = The projection of qi on pi yields qi = β ∗ pi + εi E (pi εi ) = 0 where β∗ = β − β1 E (pi qi ) ¡ 2¢ = 2 2 E pi ∙ 1 β1 1 −β 2 ¸−1 µ e1i e2i ¶ .1 The × 1 random vector xi is an instrumental variable for (11. In matrix notation.4) xi = x2i 2 where z1i = x1i are the included exogenous variables.1.1).1) if E (xi ei ) = 0. We call z1i exogenous and z2i endogenous. at least the intercept).1) where zi is k × 1.3) zi = z2i k2 where E(z1i ei ) = 0 yet E(z2i ei ) 6= 0. Thus we make the partition ¶ µ k1 z1i (11. 11. (11. By the above deﬁnition. That is x2i are variables which could be included in the equation for yi (in the sense 125 . β →p β ∗ .

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

Then i h ˆ ˆ ˆ Z = Z1 . ˆ since Z1 lies in the span of X. Using (11. Z2 ] and X = [Z1 . X2 ].ˆ It is useful to scrutinize the projection Z. Z = [Z1 . In our notation.11) (11. 129 . So only the endogenous variables Z2 are replaced by their ﬁtted values: ˆ ˆ ˆ Z2 = X1 Γ12 + X2 Γ22 . u) E (ξ | X) = 0 ¢ ¡ E ξξ 0 | X = S As before. Recall.12). PX Z2 ] h i ˆ = Z1 . ¡ ¢−1 ¡ 0 ¢ ˆ β 2SLS = Z 0 PX Z Z PX Y . 11. X is n × l so there are l instruments.11). Z2 .6 Bekker Asymptotics Bekker (1994) used an alternative asymptotic framework to analyze the ﬁnite-sample bias in the 2SLS estimator. Hence by a ﬁrst-order approximation i µ µ ¶¶−1 µ ¶ ³ ´ 1 0 1 0 ˆ OLS − β E β ZZ Ze ≈ E E n n ¡ ¢−1 = Γ0 QΓ + S22 S21 (11. we regress Y on Z1 and Z2 . We now derive a similar result for the 2SLS estimator. Thus in the second stage. let’s analyze the approximate bias of OLS applied to (11. the model is Y = Zβ + e (11.12) Z = XΓ + u ξ = (e. ¶ µ 1 0 Z e = E (zi ei ) = Γ0 E (xi ei ) + E (ui ei ) = S21 E n and E µ 1 0 ZZ n ¶ ¡ 0¢ = E zi zi ¢ ¡ ¢ ¢ ¡ ¢ ¡ ¡ = Γ0 E xi x0 Γ + E ui x0 Γ + Γ0 E xi u0 + E ui u0 i i i i = Γ0 QΓ + S22 where Q = E (xi x0 ) . Here we present a simpliﬁed version of one of his results. Z2 = [PX Z1 . First. PX Z2 ] = [Z1 .13) which is zero only when S21 = 0 (when Z is exogenous).

except when S21 = 0 (when Z is exogenous). n and (11. n n n ¢ ¡ ¡ ¢ ¢ ¢ 1 ¡ 0 1 ¡ E Z PX Z = Γ0 E xi x0 Γ + Γ0 E (xi ui ) + E ui x0 Γ + E u0 PX u i i n n = Γ0 QΓ + αS22 .12) and this result. Indeed as α → 1. The parameter β fails to be identiﬁed if Γ22 has deﬁcient rank. indicating that the bias in 2SLS approaches that of OLS as the number of instruments increases. l . the bias in the 2SLS estimator will be large.14) In general this is non-zero.Let PX = X (X 0 X)−1 X 0 . Together µ µ ¶¶−1 µ ¶ ³ ´ 1 0 1 0 ˆ 2SLS − β E β Z PX Z Z PX e ≈ E E n n ¡ ¢−1 = α Γ0 QΓ + αS22 S21 . ¢ 1 ¡ ¢ 1 ¡ ¢ 1 ¡ 0 E Z PX e = E Γ0 X 0 e + E u0 PX e = αS21 . 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. 0). the expression in (11. P = HΛH 0 0 0 where Λ = diag(Il . 130 .7 Identiﬁcation Failure Recall the reduced form equation Z2 = X1 Γ12 + X2 Γ22 + u2 . It is also close to zero when α = 0. By the spectral decomposition of an idempotent matrix.14) approaches that in (11. Bekker (1994) pointed out that it also has the reverse implication — that when α = l/n is large.13). Let q = H 0 ξS −1/2 which satisﬁes Eqq 0 = In and partition q = (q1 q2 ) where q1 is l × 1.14) is the probability limit of β 2SLS − β 11. The consequences of identiﬁcation failure for inference are quite severe. Hence µ ¶ 1 0 1 1/20 ¡ 0 ¢ 1/2 ξ PX ξ S E q Λq S E = n n µ ¶ 1 0 1 1/20 S E q q1 S 1/2 = n n 1 l 1/20 1/2 S S = n = αS where α= Using (11.

but is weak. Suppose this condition fails. In addition. which occurs i when E (zi xi ) 6= 0. we ﬁnd that β is inconsistent for β and the ˆ is non-normal. Then the model may be written as yi = zi β + ei zi = xi γ + ui and Γ22 = γ = E (xi zi ) /Ex2 . This occurs when Γ22 is full rank. 131 . the instrument xi is weak for zi if γ = n−1/2 c. and was examined by Phillips (1989) and Choi and Phillips (1992). but (11. E x2 u2 i i n n i=1 i=1 n n (11. Qc + N2 ˆ As in the case of complete identiﬁcation failure. E x2 e2 i i n i=1 n (11. but small. viz Γ22 = n−1/2 C. This result carries over to more general settings. once again take the simple case k = l = 1.15) therefore ¢¢ ¡ ¡ 1 X 1 X √ xi zi = √ xi ui →d N2 ∼ N 0.Take the simplest case where k = l = 1 (so there is no X1 ). Then (11.15) is unaﬀected. Here. Thus identiﬁcation hinges on the existence of correlation between the excluded exogenous variable and the included endogenous variable. as the Cauchy distribution does not have a ﬁnite mean. N2 since the ratio of two normals is Cauchy. Suppose that identiﬁcation does not complete fail. The n−1/2 is picked because it provides just the right balancing to allow a rich distribution theory. where C is a full rank matrix. standard test statistics have non-standard asymptotic distribution of β distributions.16) ˆ β−β = 1 √ n 1 √ n Pn Pn i=1 xi ei i=1 xi zi →d N1 ∼ Cauchy. To see the consequences. meaning that inferences about parameters of interest can be misleading. This is particularly nasty. This can be handled in an asymptotic analysis by modeling it as local-to-zero.16) instead takes the form 1 X √ xi zi n i=1 n = = 1 X 2 1 X √ xi γ + √ xi ui n n 1 n i=1 n X x2 c + i i=1 n n 1 √ n →d Qc + N2 therefore ˆ β − β →d i=1 n X i=1 xi ui N1 . Then by the CLT ¡ ¡ ¢¢ 1 X √ xi ei →d N1 ∼ N 0. so E (zi xi ) = 0. We see that β is identiﬁed if and only if Γ22 = γ 6= 0.

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

ˆ ˜ ˜ Let the IV estimator for β using some instrument X be β and the IV residual be e = Y − Z β. xi is l × 1.8 Exercises yi = zi β + ei . in the sense that e ˜ ˜ least in large samples? 4. Find a simple expression for the IV estimator in this context.11. ˜ 0 e < e0 e.) 3. 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) . 5. and Γ is l × k. ˆ ˆ Let the OLS estimator for β be β and the OLS residual be e = Y − Z β. (Find an expression for xi . Z is n × k. where xi and β are 1 × 1. will IV “ﬁt” better than OLS. In the linear model 0 yi = zi β + ei E (ei | zi ) = 0 ¡ 2 ¢ suppose σ 2 = E ei | zi is known. l ≥ k. In the structural model Y = Zβ + e Z = XΓ + u with Γ l × k. 2. Let β denote the IV estimator of β using as an instrument a dummy variable di (takes only the values 0 and 1). X is n × l. Consider the single equation model ˆ where yi and zi are both real-valued (1 × 1). Take the linear model yi = xi β + ei E (ei | xi ) = 0. Take the linear model Y = Zβ + e. Show that the GLS estimator of β can be written as an i IV estimator using some instrument xi . 6. at ˆˆ If X is indeed endogeneous. 1. That is. 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. we claim that β is identiﬁed (can be recovered from the reduced form) if rank(Γ) = k. Explain why this is true. u is n × k. show that if rank(Γ) < k then β cannot be identiﬁed. 133 .

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

T . then Xt is strictly stationary and ergodic..1. Yt−k ) is the autocorrelation function.1.. we adopt new notation.. A stationary time series is ergodic if γ(k) → 0 as k → ∞. and Cov (Yt . We can separate time series into two categories: univariate (yt ∈ R is scalar). γ(k) is called the autocovariance function. Deﬁnition 12.2 {Yt } is strictly stationary if the joint distribution of (Yt . There proofs are rather diﬃcult.. we expect that Yt and Yt−1 are not independent. The following two theorems are essential to the analysis of stationary time series. Yt−1 . and multivariate (yt ∈ Rm is vector-valued).Chapter 12 Univariate Time Series A time series yt is a process observed in sequence over time. Deﬁnition 12.1 Stationarity and Ergodicity Deﬁnition 12. however. and T to denote the number of observations. Theorem 12.1 If Yt is strictly stationary and ergodic and Xt = f (Yt ..1. t = 1. Because of the sequential nature of time series. The primary model for multivariate time series is vector autoregressions (VARs). .1. Yt−k ) = γ(k) is independent of t for all k... so classical assumptions are not valid. To indicate the dependence on time. . 135 . 12.. .1.) is a random variable. Deﬁnition 12. and use the subscript t to denote the individual observation.3 ρ(k) = γ(k)/γ(0) = Corr(Yt . Yt−k ) is independent of t for all k.4 (loose).1 {Yt } is covariance (weakly) stationary if E(Yt ) = µ is independent of t. The primary model for univariate time series is autoregressions (ARs).

ˆ ˆ γ ¥ 136 . 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) .1. and it has a ﬁnite mean by the assumption that EYt2 < ∞. µ →p E(Yt ).3 If Yt is strictly stationary and ergodic and EYt2 < ∞. For Part (2). If Xt is strictly stationary and ergodic and E |Xt | < ∞. ρ(k) →p ρ(k). T t=1 Thus γ (k) →p E(Yt Yt−k ) − µ2 − µ2 + µ2 = E(Yt Yt−k ) − µ2 = γ(k). Thus an application of the Ergodic Theorem yields T 1X Yt Yt−k →p E(Yt Yt−k ). the sequence Yt Yt−k is strictly stationary and ergodic. ˆ 3.2 (Ergodic Theorem). Part (1) is a direct consequence of the Ergodic theorem.1 above. ˆ ˆ T t=1 γ (k) = ˆ The sample autocorrelation ρ(k) = ˆ γ (k) ˆ . ˆ Part (3) follows by the continuous mapping theorem: ρ(k) = γ (k)/ˆ (0) →p γ(k)/γ(0) = ρ(k). ˆ Proof. 1. then as T → ∞. γ (0) ˆ Theorem 12.1.1. T 1X Xt →p E(Xt ). ˆ 2. γ (k) →p γ(k). ˆ ˆ T t=1 T t=1 T t=1 By Theorem 12. then as T → ∞. note that γ (k) = ˆ T 1X (Yt − µ) (Yt−k − µ) ˆ ˆ T t=1 = T T T 1X 1X 1X Yt Yt−k − Yt µ − ˆ Yt−k µ + µ2 .Theorem 12.

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

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

” If one of the roots equals 1. The Fundamental Theorem of Algebra says that any polynomial can be factored as ¢¡ ¢ ¡ ¢ ¡ ρ(z) = 1 − λ−1 z 1 − λ−1 z · · · 1 − λ−1 z 1 2 k 12. λk are the complex roots of ρ(z).1. which satisfy ρ(λj ) = 0.1. ¢0 Then the model can be written as The OLS estimator is ¡ ˆ To study β.5. since E (ut | It−1 ) = E (xt et | It−1 ) = xt E (et | It−1 ) = 0. the requirement is that all roots are larger than one. it is helpful to deﬁne the process ut = xt et . One way of stating this is that “All roots lie outside the unit circle. and hence Yt .1. and is of great interest in applied time series. we see that Ã !−1 Ã ! T T 1X 1X ˆ β=β+ xt x0 xt et →p Q−1 0 = 0.1) Theorem 12. Thus t by the Ergodic Theorem. Proof. For an AR(k). By Theorem 12. We know that an AR(1) is stationary iﬀ the absolute value of the root of its autoregressive polynomial is larger than one. it is also strictly stationary and ergodic.. and by Theorem 12. . T t=1 T t=1 ¢−1 0 ¡ ˆ X Y. t Yt−k ¢0 ρk ..1.6. Thus T T 1X 1X xt et = ut →p E (ut ) = 0. we say that ρ(L). “has a unit root”. Theorem 12. β = X 0X (12. Let |λ| denote the modulus of a complex number λ. The vector xt is strictly stationary and ergodic. t t T t=1 ¥ Combined with (12. T ¢ ¡ 1X xt x0 →p E xt x0 = Q..1 The AR(k) is strictly stationary and ergodic if and only if |λj | > 1 for all j.1) and the continuous mapping theorem. This is a special case of non-stationarity.where the λ1 . Note that ut is a MDS.6 Let Estimation xt = β = ¡ 1 Yt−1 Yt−2 · · · α ρ1 ρ2 · · · yt = x0 β + et . t T t=1 T t=1 139 . then ˆ β →p β as T → ∞.1 If the AR(k) process Yt is strictly stationary and ergodic and EYt2 < ∞. so is xt x0 .

. we can apply Theorem 12. This creates an iid bootstrap sample. Method 1: Model-Based (Parametric) Bootstrap.. 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∗ . 140 . Divide the sample into T /m blocks of length m.7. t t Theorem 12.12. Y0 ). ˆ 2. e ˆ 3. Clearly.7. Ω) .1 to see that T 1 X √ xt et →d N (0. 12. This is identical in form to the asymptotic distribution of OLS in cross-section regression. T t=1 where Ω = E(xt x0 e2 ).. xt }. as this imposes inappropriate independence. In particular. there are two popular methods to implement bootstrap resampling for time-series data. Ω) .. T 1 X √ ut →d N (0. Q−1 ΩQ−1 . t This construction imposes homoskedasticity on the errors e∗ .. then as T → ∞. the asymptotic covariance matrix is estimated just as in the cross-section case.. t then as T → ∞. Estimate β and residuals et . ˆ 1. i 4. Simulate iid draws e∗ from the empirical distribution of the residuals {ˆ1 . .8 Bootstrap for Autoregressions In the non-parametric bootstrap. The implication is that asymptotic inference is the same. T t=1 Since xt et is a MDS. eT }.7 Asymptotic Distribution Theorem 12. Brieﬂy. ´ √ ³ ¡ ¢ ˆ T β − β →d N 0.1 MDS CLT.2 If the AR(k) process Yt is strictly stationary and ergodic and EYt4 < ∞. If ut is a strictly stationary and ergodic MDS and E(ut u0 ) = Ω < ∞. we constructed the bootstrap sample by randomly resampling from the data values {yt . Method 2: Block Resampling 1. It also presumes that the AR(k) structure is the truth.7.. this cannot work in a time-series application. Fix an initial condition (Y−k+1 . Y−k+2 . which may be diﬀerent than the i properties of the actual ei .

∆s Yt = Yt − Yt−s . 4.. ρk ). . • First apply a seasonal diﬀerencing operator.2). (12. (12. Paste the blocks together to create the bootstrap time-series Yt∗ . 12.3) replacing St with St . and perhaps this was of relevance. May not work well in small samples. This is a ﬂexible approach which can extract a wide range of seasonal factors. That is. The seasonal factor is typically estimated by a two-sided weighted average of the data for that season in neighboring years. This procedure is sometimes called Detrending.4) by OLS. or the season-to-season change. The series ∆s Yt is clearly free of seasonality.3) sequentially by OLS. • Use “seasonally adjusted” data. 3. heteroskedasticity. The results may be sensitive to the block length. The reason why these two procedures are (essentially) the same is the Frisch-Waugh-Lovell theorem. • You can estimate (12. The seasonal adjustment.. If s is the number of seasons (typically s = 4 or s = 12).2)-(12. ﬁrst estimate (12.2) (12. For each simulated sample. and the way that the data are partitioned into blocks. get the ˆ ˆ residual St .. and then perform regression (12. Thus the seasonally adjusted data is a “ﬁltered” series. This allows for arbitrary stationary serial correlation. Resample complete blocks. This presumes that “seasonality” does not change over the sample.2. 141 . • Include dummy variables for each season. 6. Seasonal Eﬀects There are three popular methods to deal with seasonal data. 5. however. also alters the time-series correlations of the data. draw T /m blocks.3) or Yt = α0 + α1 t + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et .9 Trend Stationarity Yt = µ0 + µ1 t + St St = ρ1 St−1 + ρ2 St−2 + · · · + ρk St−l + et .4) There are two essentially equivalent ways to estimate the autoregressive parameters (ρ1 . But the long-run trend is also eliminated. • You can estimate (12. and for modelmisspeciﬁcation.

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

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

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

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

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

t t−1 (13. and Zt be the other variables. (A simple version of this estimator is called Cochrane-Orcutt. This takes the form 0 and xt consists of lagged values of Yjt and the other Ylt s. Then yt = x0 β + et t et = θet−1 + ut E (ut | It−1 ) = 0. 1). which is called a common factor restriction. under the restriction γ = −βθ. it is convenient to re-deﬁne the variables. (13. Then the single equation takes the form (13.5 Testing for Omitted Serial Correlation Consider the problem of testing for omitted serial correlation in equation (13. Suppose that et is an AR(1).2) is uncommon in recent applications. Let yt = Yjt . Another interesting fact is that (13. which once was very popular. h¡ 1 Yt−1 · · · 0 Yt−k Zt−1 · · · 0 Zt−k ¢0 i . and simple way to test for omitted serial correlation is to test the signiﬁcance of extra lagged values of the dependent variable and regressors. In this case. t and xt = This is just a conventional regression. t and et is iid N (0. direct estimation of (13.1) yt = x0 β + et . we are only interested in a single equation out of a VAR system. This restriction. Then the null and alternative are H0 : θ = 0 H1 : θ 6= 0. If valid.) Since the common factor restriction appears arbitrary. 13. may be tested if desired.2) may be estimated by iterated GLS.1). We see that an appropriate. So testing H0 versus H1 is equivalent to testing for the signiﬁcance of adding (yt−1 . The DW test is appropriate only when regression yt = x0 β + et is not dynamic (has no lagged values on the RHS). with time series data. 147 . and is still routinely reported by conventional regression packages. Let et = ejt and β = aj .2) Take the equation yt = x0 β + et . the model (13. and subtract oﬀ the equation once lagged multiplied by θ. j Often.3) which is a valid regression model. and is typically rejected empirically. 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 . You may have heard of the Durbin-Watson test for omitted serial correlation. Otherwise it is invalid. xt−1 ) to the regression. This can be done by a Wald test.2) is a special case of (13.4 Single Equation from a VAR Yjt = a0 xt + et . general.3). t or yt = θyt−1 + x0 β + x0 γ + ut .13.

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

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

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

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

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

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

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

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

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

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

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

Taking ﬁrst-diﬀerences of (15. it (15.4) by IV using yt−2 as an instrument for ∆yt−1 (which is just identiﬁed).3) eliminates the individual-speciﬁc eﬀect: ∆yit = α∆yit−1 + ∆x0 β + ∆eit .4) . if eit is iid. 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. e So OLS on (15.3 Dynamic Panel Regression yit = αyit−1 + x0 β + ui + eit . k ≥ 2. Hence a valid estimator of α and β is to estimate (15. GMM using yt−2 and yt−3 as instruments (which is overidentiﬁed. we ﬁnd y i = x0 β + ui + ei . two periods back. as yt−2 is uncorrelated with ∆eit . it However. and the residual is the demean value ∗ yit = yit − yi . i ∗ yit = x∗0 β + e∗ . then IV or GMM can be used to estimate the equation. Thus values of yit−k . we use lags of the dependent variable. but loses a time-series observation). Typically.4) will be inconsistent. This is because the sample mean of yit−1 is correlated with that of eit . it it which is free of the individual-eﬀect ui . so the instrument list should be diﬀerent for each equation. The standard approach to estimate a dynamic panel is to combine ﬁrst-diﬀerencing with IV or GMM.Since the regression of yit on di is a regression onto individual-speciﬁc dummies. the ﬁxed eﬀects estimator is inconsistent. the dependent variable and regressors in deviationit from-mean form. A simple application of GMM yields the parameter estimates and standard errors. 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 .3) A dynamic panel regression has a lagged dependent variable This is a model suitable for studying dynamic behavior of individual agents. Unfortunately. are valid instruments. Another derivation of the estimator is to take the equation yit = x0 β + ui + eit . 159 (15. at least if T is held ﬁnite as n → ∞. the predicted value from these regressions is the individual speciﬁc mean y i . Alternatively. 15. ∗ ˆ The ﬁxed eﬀects estimator β is OLS of yit on x∗ . there are more instruments available. as this enables the moments from the diﬀerent timeperiods to be stacked together to create a list of all the moment conditions. But if there are valid instruments. This is conveniently organized by the GMM principle. A more sophisticated GMM estimator recognizes that for time-periods later in the sample.

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

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

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

how should the bandwidth be selected? This is a diﬃcult problem. but at a slower rate than n−1 . Note that this h declines to zero. We deﬁne the asymptotically optimal bandwidth h0 as the value which minimizes this approximate MSE. A classic simple solution proposed by Silverman (1986)has come to be known as the reference bandwidth or Silverman’s Rule-of-Thumb. Together with the above table. (16. we need h → 0 but nh → ∞. 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 . σ 2 . The ﬁrst two are determined by the kernel function. The asymptotically optimal choice given in (16. That is. 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) . and R(f 00 ). Their K values for the three functions introduced in the previous section are given here. where φ is the N (0. but at a very slow rate. Gaussian Kernel: hrule = 1.Together. Notice that the ﬁrst term (the squared bias) is increasing in h and the second term (the variance) is decreasing in nh. This choice for h gives an optimal rule when f (x) is ˆ normal. We thus say that the optimal bandwidth is of order O(n−1/5 ). and there is a large and continuing literature on the subject. The downside is that if the density is very far from normal.06n−1/5 163 .2) This solution takes the form h0 = cn−1/5 where c is a function of K and f. 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. We can calculate that √ R(φ00 ) = 3/ (8 π) . ˆ It uses formula (16. AM SEh (x) = f 00 (x)2 h4 σ 4 + K 4 nh A global measure of precision is the asymptotic mean integrated squared error (AMISE) Z h4 σ 4 R(f 00 ) R(K) K + . In practice. but not of n. (16.2) but replaces R(f 00 ) with σ −5 R(φ00 ). the rule-of-thumb h can be quite ineﬃcient.2) depends on R(K). we ﬁnd the reference rules for the three kernel functions introduced earlier.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 .1) is an asymptotic approximation to the MSE. Equation (16. 1) distribution and σ 2 is an estimate of σ 2 = V ar(X). Thus for the AMISE to decline with n. and gives a nearly optimal rule when f (x) is close to normal. h must tend to zero. That is.

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

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

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

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

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

. x = 1. .... 1. m x1 !x2 ! · · · xm ! 1 2 = n. Xm = xm ) = x1 + · · · + xm n! px1 px2 · · · pxm . 2. λ>0 x = 1. 0≤p≤1 x = 0. 0≤p≤1 p1 + · · · + pm = 1 EX = V ar(X) = Negative Binomial µ ¶ r+x−1 P (X = x) = p(1 − p)x−1 . we now list some important discrete distribution function. X2 = x2 . 2. 1. 169 . x EX = np V ar(X) = np(1 − p) Geometric P (X = x) = p(1 − p)x−1 .. EX = p V ar(X) = p(1 − p) Binomial µ ¶ n x P (X = x) = p (1 − p)n−x ... Bernoulli P (X = x) = px (1 − p)1−x .. ....4 Common Distributions For reference. 1 EX = p 1−p V ar(X) = p2 Multinomial P (X1 = x1 . x EX = V ar(X) = Poisson P (X = x) = exp (−λ) λx ... n. 1. 2. 0≤p≤1 V ar(X) = λ We now list some important continuous distributions.... 0≤p≤1 x = 0. x! EX = λ x = 0. . .A.

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

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

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

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

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

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

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

The MGF for the density (A.11). tr = p Q/r The density of tr is and is known as the student’s t distribution with r degrees of freedom.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).12) E exp (tQ) = 0 Γ (A.11) is Z ∞ ¢ ¡ Γ r+1 2 f (x) = ´ r+1 ¡r¢ ³ √ 2 2 πrΓ 2 1 + x r (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 . For Z ∼ N(0. Set r Z .8.11) 2 with r = 1.8.8.13). q Proof of Theorem A. ¡ ¢ √ using the change—of-variables s = x2 and the fact Γ 1 = π. tr has distribution 177 . The fact that A > 0 means that we can write A = CC 0 where C is non-singular. which we showed in (A. C −1 CC 0 C −10 ) = N (0. (A. Using the simple law of iterated expectations. Thus the density of Z 2 is (A. From (A.8.13) is the MGF of the density (A.2. Iq ). which can be found by applying change-of-variables to the gamma function.6) can be used to show that the MGF j=1 ¥ Proof of Theorem A. Since we can write Q = P 2 X 0 X = r Zj where the Zj are independent N(0. we see that the MGF of Z 2 is (1 − 2t)−1/2 . 1). Then A−1 = C −10 C −1 and C −1 Z ∼ N (0. Thus ¥ ¡ ¢0 ¡ ¢ Z 0 A−1 Z = Z 0 C −10 C −1 Z = C −1 Z C −1 Z ∼ χ2 . Proof of Theorem A.3 Let Z ∼ N (0.1. C −1 AC −10 ) = N (0.Theorem A. 1) and Q ∼ χ2 be independent.3.

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

The maximum likelihood estimator or MLE ˆ is the parameter value which maximizes θ the likelihood (equivalently. θ θ∈Θ ˆ In some simple cases. θ Theorem A.17) The matrix I0 is called the information.3 Under regularity conditions. However. and the equality (A. θ) →p E ln f (Yi .16) (A. More typically. then θ V ar(˜ ≥ (nI0 )−1 .2 Cramer-Rao Lower Bound. θ) ≡ L(θ). θ) The Cramer-Rao Theorem gives a lower bound for estimation.9. θ0 ) . which maximizes the log-likelihood). the log-likelihood is a sample average 1X 1 Ln (θ) = ln f (Yi .17) is often called the information matrix equality.9.1 ¯ ¯ ∂ E ln f (Yi . but these ˆ must be found by numerical methods. 179 . ´ ¡ −1 ¢ √ ³ˆ n θ − θ0 →d N 0.14) ¶ ∂ ∂ 0 ln f (Yi . under conventional regularity conditions. we can ﬁnd an explicit expression for θ as a function of the data. cases are rare. the MLE θ Why do we believe that the MLE ˆ is estimating the parameter θ? Observe that when stanθ dardized. θ0 ) ln f (Yi . n n i=1 n As the MLE ˆ maximizes the left-hand-side. ˆ →p θ0 as n → ∞. ˆ is consistent θ for this value. Theorem A. ∂θ ∂θ (A. θ)¯ =0 ¯ ∂θ θ=θ0 H = Ω ≡ I0 (A. the restriction to unbiased estimators means that the theorem has little direct relevance for ﬁnite sample eﬃciency. θ) ∂θ ∂θ which holds at θ = θ0 by (A.16). The ﬁrst-order condition for the latter problem is 0= ∂ ∂ L(θ) = E ln f (Yi .15) Two important features of the likelihood are Theorem A.9.Deﬁne the Hessian H = −E and the outer product matrix Ω=E µ ∂2 ln f (Yi . In fact. I0 . We can write this as ˆ = argmax Ln (θ). If ˜ is an unbiased estimator of θ ∈ R. θ0 ) ∂θ∂θ 0 (A. we can see that it is an estimator of the maximizer θ of the right-hand-side.

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

θ0 ) − f (Yi . θ) f (y. θ0 )0 . θ) f (˜. θ0 ) ln f (Yi .Proof of Theorem A. Write the estimator ˜ = ˜ Y ) as a θ θ( ˜ ˜ is unbiased for any θ. θ) dy ¯ ¯ ∂θ θ=θ0 ¯ ∂ ¯ 1¯ = 0. function of the data.17). we can show that E By direction computation. yn ). Diﬀerentiating with respect to θ and evaluating at θ0 yields ˜ Z Z ³ ´ ˜ y ) ∂ f (˜. (Yi . Since θ Z ˜ = ˜ y)f (˜..9. θ0 = ln f (Yi . θ0 )2 (Yi . θ0 ) dy ¯ ¯ ¯ θ=θ0 f (y. . θ0 ) d˜ = E ˜ .. θ) d˜ = ˜ y ) ∂ ln f (˜.1. ¯ ¯ ∂ E ln f (Yi . S= ∂2 f ∂θ∂θ0 ∂2 f ∂θ∂θ0 ∂ ∂θ Z Ã ∂2 f ∂θ∂θ0 ¯ ¯ ln f (y.2. θ) d˜ θ = Eθ θ(˜ y y where y = (y1 . θ) ¯θ=θ0 ¯ Z ¯ ∂ f (y. θ0 ) (Yi .16). θ0 )0 f (Yi .9. f (Yi . Proof of Theorem A. θ0 ) ∂ ∂ − ln f (Yi . θ0 ) ∂θ f (Yi . To see (A. V ar (S) nH so ¥ 181 .9. θ0 ) ∂ ∂θ f ∂ (Yi . θ0 ) ∂θ ∂θ ¥ ³ ´ X ∂ ∂ ˜ ln fn Y . θ0 ) = ∂θ∂θ0 = Taking expectations yields (A. ∂θ ¯θ=θ0 Z ! = 0.1) has mean zero and variance nH. θ0 ) f (Yi .. θ)¯ = ¯ ∂θ θ=θ0 = = = Similarly. ∂2 ln f (Yi . θ0 ) ∂θ ∂θ n i=1 which by Theorem (A. θ) dy ¯ ∂θ 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 ) ¯ ∂ f (y.

then since θn →p θ0 we ﬁnd H(θn ) →p H and so ¶ n n µ ∂2 1X 1 X ∂2 − ln f (Yi .Proof of Theorem A. ¯ ¯ ∂ Ln (θ)¯ 0 = ¯ ˆ ∂θ θ=θ n ³ ´ X ∂ ln f Yi . ˆ = θ ∂θ i=1 n n ´ ³ X ∂ X ∂2 ˆ ln f (Yi . θ0 ) + ' 0 ln f (Yi .9. θn ) = ln f (Yi . If it is continuous in θ. ¥ 182 . H −1 . θ) . θ0 ) . H −1 ΩH −1 = N 0. the ﬁnal equality using Theorem A. ´ ¡ ¢ ¡ ¢ √ ³ˆ n θ − θ0 →d H −1 N (0. Ω) . θn ) − H(θn ) + H(θn ) − n n ∂θ∂θ0 ∂θ∂θ0 i=1 i=1 →p H by an application of a uniform WLLN.) Rewriting this equation. ∂θ n i=1 n The analysis of the sample Hessian is somewhat more complicated due to the presence of θn . θ n ) θ − θ 0 . and making a ﬁrst-order Taylor series expansion. we ﬁnd ´ ³ ˆ − θ0 = θ Since ∂ ∂θ Ã !−1 Ã n ! n X ∂2 X ∂ ln f (Yi . ∂θ ∂θ∂θ i=1 i=1 θ where θn lies on a line segment joining ˆ and θ0 . − ln f (Yi . Ω) = N 0.1 . an application of the CLT yields 1 X ∂ √ ln f (Yi .9. Together. θn ) ∂θ ∂θ∂θ0 i=1 i=1 ln f (Yi . θ0 ) →d N (0. (Technically. Let ∂2 H(θ) = − ∂θ∂θ0 ln f (Yi .3 Taking the ﬁrst-order condition for maximization of Ln (θ). the speciﬁc value of θn varies by row in this expansion. θ0 ) is mean-zero with covariance matrix Ω.

the ﬁrst-step grid may not bracket ˆ θ which thus would be missed... b] be an interval. .. the approximation error is bounded by ε. In most cases.1 Grid Search Many optimization problems are either one dimensional (m = 1) or involve one-dimensional optimization as a sub-problem (for example. which is θ(ˆ) j j θ. This value θ(ˆ) is the gridpoint estimate of ˆ If the grid is ˆ suﬃciently ﬁne ¯ capture small oscillations in Q(θ). b] with G gridpoints.. Let Θ = [a. The gridsearch method can be reﬁned by a two-step execution. GLS. Let k = argmin0≤k≤G Q(θ0 (k)). ¯θ(ˆ) − θ¯ method is quite robust but potentially costly. Construct an equally spaced grid on the region [a. . In this context grid search may be employed. numerical methods are required to θ obtain ˆ θ. The estimate of ˆ is j 0 ˆ θ (k).. Pick some ε > 0 and set G = (b − a)/ε to be the number of gridpoints. which is {θ(j) = a + j(b − a)/G : j = 0. a line search). . G}. where j = argmin0≤j≤G Q(θ(j))... B. The advantage of the two-step method over a one-step grid search is that the number of p function evaluations has been reduced from (b − a)/ε to 2 (b − a)/ε which can be substantial. The disadvantage is that if the function Q(θ) is irregular. but ˆ is not available in closed form. MLE and GMM estimators take this form.. Two-Step Grid Search. G}. For the second ˆ step deﬁne an equally spaced grid on [θ(ˆ − 1).. Q(θ) can be computed for given θ. G}. b] with G gridpoints. which is {θ(j) = a + j(b − a)/G : j = 0.1) where the parameter is θ ∈ Θ ⊂ Rm and the criterion function is Q(θ) : Θ → R. In this case. which is {θ0 (k) = j j ˆ θ θ(ˆ − 1) + 2k(b − a)/G2 : k = 0. For example NLLS. At each point evaluate the criterion function and let j = argmin0≤j≤G Q(θ(j)). 183 . At each point evaluate the criterion function and ﬁnd the gridpoint which yields the smallest value of the criterion. Grid Search. This j that is. For an error bound of ε pick G so that G2 = (b − a)/ε For the ﬁrst step deﬁne an equally spaced grid on the region [a. to ¯ ¯ ˆ¯ ≤ ε.Appendix B Numerical Optimization Many econometric estimators are deﬁned by an optimization problem of the form ˆ = argmin Q(θ) θ θ∈Θ (B. θ(ˆ + 1)] with G gridpoints. Plots of Q(θ(j)) against θ(j) can help diagnose errors in grid selection.

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

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

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