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

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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

. . Percentile Conﬁdence Intervals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8. . . . . . . . .11 8. . .3 Identiﬁcation . . . . . . . . . . . . . . . .8 Conditional Moment Restrictions . . . . .8 Exercises . . . . . . . . . . . . 11 Endogeneity 11. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .7 Asymptotic Distribution . . . . . . . . . . . . . . . . . . . . . . . . . . .9 8. . . . . . . . . . . . 11. . . . .5 GMM: The General Case . . . .4 Estimation . . . . . . . . .12Autoregressive Unit Roots . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11. . . . . .6 Bekker Asymptotics . . . .3 Stationarity of AR(1) Process . . . .4 Lag Operator . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . . . . .9 Bootstrap GMM Inference . . 10 Empirical Likelihood 10. . . . . . . . .2 GMM Estimator . . . . . . . . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Overidentiﬁed Linear Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .7 Hypothesis Testing: The Distance Statistic 9. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5 Special Cases: IV and 2SLS 11.6 Over-Identiﬁcation Test . . . . . . . . . . . . . . . . . . Bootstrap Methods for Regression Models Exercises . . . . . . . . . . . . . . . . 11. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3 Overidentifying Restrictions . . . . . . . . . . . . . . . . . . 100 101 102 103 104 106 106 107 107 108 109 110 111 112 113 114 117 117 119 120 121 121 124 125 126 127 127 128 129 130 133 135 135 137 137 138 138 139 140 140 141 142 142 143 9 Generalized Method of Moments 9. . . . . 12. . . . . . . . . . . . . . . . . . 12. . . . . . . . . . .10 Exercises . . . . .1 Instrumental Variables . . . . . . . . 11. . . . . . . . . . . . . . . .1 Non-Parametric Likelihood . . . . . . . . . . . . . . 11. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9. . . . . . .10Testing for Omitted Serial Correlation 12. . . . . . . . . .10 8. . . . . . . . . . . . . . . . . . . . . . . . . . . .3 Distribution of GMM Estimator . . . .2 Asymptotic Distribution of EL Estimator 10. . . . . . . . . . . . . . . . . 12. . .7 Identiﬁcation Failure . . . . . . .9 Trend Stationarity . . . . . . . . 12. . . . 12. . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . . . . . . 12 Univariate Time Series 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4 Estimation of the Eﬃcient Weight Matrix . . . . . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10. . . . . . . . . 9. . . .5 Numerical Computation . . . . . . . . . . . . . . . . . . . . . . . .5 Stationarity of AR(k) . . . . . . 10. . . . . . . . . . . . . . . . .1 Stationarity and Ergodicity . . . . . . . . . . . . 12. . . . . . . . . . .6 Estimation . . . Symmetric Two-Sided Tests . . . . . . . . .12 8. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . iii . . . . 9. . . . . . .2 Reduced Form . . . . . . . . .8 Bootstrap for Autoregressions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9. . . . . . . . . . 9. . . . . . . . . . . . . . . 12. . . . . .11Model Selection . . . . . . . . . . . . . .2 Autoregressions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . 11. 9. . . . .13 One-Sided Tests . . . . . . . . . . . . . . . . . . . . . . . . . . . .4 Testing . . . . . . . . . . . . . . .

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

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

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

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

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

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

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

The Moore-Penrose generalized inverse A− satisﬁes (2.2) 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. 7 Also. . if A is an orthogonal matrix. 0b 0b ak 1 ak 2 · · · a0 bk 1 a0 bk 2 .3) plus the following three conditions A− AA− = A− AA− is symmetric A− A is symmetric For any matrix A. This matrix is called the inverse of A and is denoted by A−1 . (2. . then # ¡ ¢−1 ¡ ¢−1 ∙ ¸−1 " A − BD−1 C A B − A − BD−1 C BD−1 ¡ ¡ ¢−1 ¢−1 = . (2. The following fact about inverting partitioned matrices is sometimes useful. . In this case there exists a unique matrix B such that AB = BA = Ik . . For non-singular A and C. we can still deﬁne a generalized inverse A− as a matrix which satisﬁes AA− A = A.3) The matrix A− is not necessarily unique. then A−1 = A. If A − BD−1 C and D − CA−1 B are non-singular. or is nonsingular.The can be seen since ⎢ ⎢ tr (AB) = tr ⎢ ⎣ = k X i=1 k X i=1 ⎡ a0 b1 a0 b2 · · · 1 1 a0 b1 a0 b2 · · · 2 2 . . . 2.1) . . the Moore-Penrose generalized inverse A− exists and is unique. some properties include AA−1 = A−1 A = Ik ¡ ¢−1 ¡ −1 ¢0 = A0 A Even if a matrix A does not possess an inverse. a0 bk k ⎤ ⎥ ⎥ ⎥ ⎦ a0 bi i b0 ai i = = tr (BA) .4 Inverse A k × k matrix A has full rank. if there is no c 6= 0 such that 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. which are not necessarily distinct and may be real or complex. 8 . λ−1 . A square matrix A is idempotent if AA = A.2. 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 . We say that X is n × k. We say that A is positive deﬁnite if for all non-zero c. 2... If A is symmetric. . We now state some useful properties. i = 1.. • If A is symmetric. there exists a nonsingular matrix P such that A = P −1 ΛP and P AP −1 = Λ. k < n. A−1 > 0.. k denote the k eigenvalues and eigenvectors of a square matrix A.. and let H = [h1 · · · hk ]. The matrix B need not be unique. λ−1 . If A is also symmetric (most idempotent matrices are) then all its characteristic roots equal either zero or one. and the characteristic roots are all real. If λi is an eigenvalue of A. then A = HΛH 0 and H 0 AH = Λ. (For any c 6= 0.6 Rank and Positive Deﬁniteness The rank of a square matrix is the number of its non-zero characteristic roots. Then A = AA = HΛH 0 HΛH 0 = HΛ2 H 0 . This is written as A > 0. Let Λ be a diagonal matrix with the characteristic roots in the diagonal. • The characteristic roots of A−1 are λ−1 . . One way to construct B is to use the spectral decomposition A = HΛH 0 where Λ is diagonal. c0 Ac = α0 a ≥ 0 where α = Gc.. 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. 1 2 k The decomposition A = HΛH 0 is called the spectral decomposition of a matrix. c0 Ac ≥ 0.) If A is positive deﬁnite. If A > 0 we can ﬁnd a matrix B such that A = BB 0 .5 Eigenvalues det (A − λIk ) = 0. and then set B = HΛ1/2 . Let λi and hi . If A = G0 G. We say that a square matrix A is positive semi-deﬁnite if for all non-zero c. This is written as A ≥ 0. c0 Ac > 0. then A is positive semi-deﬁnite. X 0 X is symmetric and positive deﬁnite. • If A has distinct characteristic roots. has full rank k if there is no non-zero c such that Xc = 0. We call B a matrix square root of A. then A is non-singular and A−1 exists. They are called the latent roots or characteristic roots or eigenvalues of A. note that we can write A = HΛH 0 where H is orthogonal and Λ contains the (real) characteristic roots. In this case. Furthermore. then A > 0 if and only if all its characteristic roots are positive. To see this.

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

• det ∙ A B C D ¸ • det A 6= 0 if and only if A is nonsingular. is the mn × 1 vector ⎞ ⎛ a1 ⎜ a2 ⎟ ⎟ ⎜ vec (A) = ⎜ . is the matrix ⎡ ⎤ a11 B a12 B a1n B ⎢ a21 B a22 B · · · a2n B ⎥ ⎢ ⎥ A⊗B =⎢ ⎥. . ⎣ ⎦ . am1 B am2 B · · · amn B Some important properties are now summarized. • If A is orthogonal. ⎟ . The vec of A. The Kronecker product of A and B. denoted by vec (A) . then det A = ±1 ¢ ¡ = (det D) det A − BD−1 C if det D 6= 0 Qk i=1 aii • If A is triangular (upper or lower). . . • (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. an Let B be any matrix. . then det A = 2.9 Kronecker Products and the Vec Operator Let A = [a1 a2 · · · an ] = [aij ] be m × n. . These results hold for matrices for which all matrix multiplications are conformable. . . denoted A ⊗ B. det(A ⊗ B) = (det (A))n (det (B))m • (A ⊗ B)−1 = A−1 ⊗ B −1 • If A > 0 and B > 0 then A ⊗ B > 0 • vec (ABC) = (C 0 ⊗ A) vec (B) • tr (ABCD) = vec (D0 )0 (C 0 ⊗ A) vec (B) 10 . ⎠ ⎝ . . .

These are indicated in Figure 3. ⎠ ⎝ . the conditioning variable. To illustrate. You can see that the right tail of then density is much thicker than the left tail.1 Conditional Mean To study how the distribution of yi varies with the variables xi in the population. We list the elements of xi in the vector ⎞ ⎛ x1i ⎜ x2i ⎟ ⎟ ⎜ (3. . An important summary measure is the conditional mean Z ∞ yf (y | x) dy.Chapter 3 Regression and Projection The most commonly applied econometric tool is regression.1 by the arrows drawn to the x-axis. it is useful to have numerical measures of the diﬀerence. and exists so long as E |yi | < ∞.73. the conditional density of yi given xi . While it is easy to observe that the two densities are unequal. which is a common feature of wage distributions. education and experience. and that for women is $20.2) m(x) = E (yi | xi = x) = −∞ In general. the mean wage for men is $27. Take a closer look at the density functions displayed in Figure 3. gender. (3. These are asymmetric (skewed) densities. This is used when the goal is to quantify the impact of one set of variables on another variable. ⎟ .1 displays the density1 of hourly wages for men and women.1. or the covariates. When a distribution is skewed. See Chapter 16. We call yi the dependent variable.22. We call xi alternatively the regressor. These are conditional density functions — the density of hourly wages conditional on race. xki 3. xi ) where yi is a scalar (real-valued) and xi is a vector. The data are from the 2004 Current Population Survey 1 11 . m(x) can take any form. Figure 3.1.1) xi = ⎜ . In this context it is often convenient These are nonparametric density estimates using a Gaussian kernel with the bandwidth selected by crossvalidation. the mean is not necessarily a good summary of the central tendency. holding the other variables constant. 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. from the population of white non-military wage earners with a college degree and 10-15 years of potential work experience. we can focus on f (y | x) . In the example presented in Figure 3.

the solid line displays the conditional expectation of log wages varying with education. wage regressions typically use log wages as a dependent variable rather than the level of wages. The conditional expectation function is close to linear.3 displays a scatter plot2 of log wages against education levels.D. with mean log hourly wages drawn in with the arrows. To illustrate.2 shows the density of log hourly wages for the same population.3 is how the conditional expectation describes an important feature of the conditional distribution. degree in mean log hourly wages is 0. The diﬀerence in the log mean wage between men and women is 0. and a Ph. The comparison in Figure 3. 2 (3. this yields the formula yi = m(xi ) + ei .3) White non-military male wage earners with 10-15 years of potential work experience.1: Wage Densities for White College Grads with 10-15 Years Work Experience to transform the data by taking the (natural) logarithm. When the distribution of the control variable is continuous. the dashed line is a linear projection approximation which will be discussed in the Section 3.30. By construction. 12 .36.5.2) evaluated at the observed value of xi : ei = yi − m(xi ). Figure 3. This is a more robust measure of the typical wage gap between men and women than the diﬀerence in the untransformed wage means. The main point to be learned from Figure 3.2 Regression Equation The regression error ei is deﬁned to be the diﬀerence between yi and its conditional mean (3. Of particular interest to graduate students may be the observation that diﬀerence between a B. then comparisons become more complicated. which implies a 30% average wage diﬀerence for this population.A. implying an average 36% diﬀerence in wage levels. Figure 3. For this reason.1 is facilitated by the fact that the control variable (gender) is discrete. 3.Figure 3. Assuming for simplicity that this is the true joint distribution.

not a model. E(ei ) = 0. by the deﬁnition of ei and the linearity of conditional expectations. To show the ﬁrst statement. E (h(xi )ei ) = 0 for any function h (·) . These equations hold true by deﬁnition.2. 4. restrictions on the permissible class of regression functions m(x). 3. because no restrictions have been placed on the joint distribution of the data. E(xi ei ) = 0. It is important to understand that this is a framework. most typically.2: Log Wage Densities Theorem 3. E (ei | xi ) = 0.1 Properties of the regression error ei 1. 2. 13 . E (ei | xi ) = E ((yi − m(xi )) | xi ) = m(xi ) − m(xi ) = E (yi | xi ) − E (m(xi ) | xi ) = 0. are often stated jointly as the regression framework. The equations yi = m(xi ) + ei E (ei | xi ) = 0.Figure 3. A regression model imposes further restrictions on the joint distribution. The remaining parts of the Theorem are left as an exercise.

in the sense of achieving the lowest mean squared error. and can take any form. σ 2 (x) is a non-trivial function of x. Given the random variable xi .4) E e2 | xi = σ 2 i 14 While the conditional mean is a good measure of the location of a conditional distribution. The conditional standard deviation is its square root σ(x) = σ 2 (x).3 Conditional Variance Generally.3: Conditional Mean of Wages Given Education The conditional mean also has the property of being the the best predictor of yi . The right-hand-side is minimized by setting g(x) = m(x). let g(x) be an arbitrary predictor of yi given xi = x. the conditional variance of yi is σ 2 = σ 2 (xi ). 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. subject to the restriction p that it is non-negative. In contrast. Thus the mean squared error is minimized by the conditional mean. To see this. it does not provide information about the spread of the distribution. when σ 2 (x) is a constant so that ¢ ¡ (3. i . In the general case i where σ 2 (x) depends on x we say that the error ei is heteroskedastic. A common measure of the dispersion is the conditional variance ¡ ¢ σ 2 (x) = V ar (yi | xi = x) = E e2 | xi = x . 3.Figure 3.2.3.1.

8) is called the linear regression model. Thus (3. Some textbooks inappropriately describe heteroskedasticity as the case where “the variance of ei varies across observation i”. it is more realistic to view the linear speciﬁcation (3.9) 3.8) (3.we say that the error ei is homoskedastic. its functional form is typically unknown. ⎠ . we assume that x1i = 1. 15 .1) has been redeﬁned as the k × 1 vector ⎛ ⎞ 1 ⎜ x2i ⎟ ⎜ ⎟ (3. ⎠ . which we derive in this section.4 Linear Regression An important special case of (3. they are also somewhat more dispersed. Instead.7) is a k × 1 parameter vector. and the linear assumption of the previous section is empirically unlikely to accurate.1 and that for women is 10. 3. In this case (3.6) as an approximation. we can write it as m(x) = x0 β = β 1 + x2i β 2 + · · · + xki β k where ⎞ β1 ⎜ . where x1i is the ﬁrst element of the vector xi deﬁned in (3.6) (3. Equivalently.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 .1. take the conditional wage densities displayed in Figure 3. Notationally. The conditional standard deviation for men is 12.3) can be writen as yi = x0 β + ei i E (ei | xi ) = 0. An important special case is homoskedastic linear regression model yi = x0 β + ei i E (ei | xi ) = 0 ¢ ¡ E e2 | xi = σ 2 . ⎟ β=⎝ . Equation (3. ⎟ .5. As an example. i (3.5) xi = ⎜ . ⎝ . So while men have higher average wages. it is convenient to augment the regressor vector xi by listing the number “1” as an element. xki When m(x) is linear in x.1). This concept is less helpful than deﬁning heteroskedasticity as the dependence of the conditional variance on the observables xi . βk ⎛ (3.3) is when the conditional mean function m(x) is linear in x (or linear in functions of x). We call this the “constant” or “intercept”.

xi contains an intercept. E (x0 xi ) < ∞. The vector (3. there cannot i exist a non-zero vector α such that α0 xi = 0 identically. i ∂β ¢¢−1 ¡ ¡ E (xi yi ) . E (xi x0 ) is a mai E(x y trix and E (xi yi ) is a vector. otherwise they are distinct. 3.5.10) exists and is unique as long as the k ×k matrix E (xi x0 ) is invertible. 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 .7) is 0= Solving for β we ﬁnd ¡ ¢ ∂ S(β) = −2E (xi yi ) + 2E xi x0 β. Assumption 3.10) It is worth taking the time to understand the notation involved in this expression. α0 E (xi x0 ) α = E (α0 xi )2 ≥ 0 so the matrix E (xi x0 ) is by construction i i positive semi-deﬁnite. The best linear predictor is obtained by selecting β to minimize S(β). Observe i that for any non-zero α ∈ Rk . we obtain a decomposition of yi into linear predictor and error yi = x0 β + ei .12) This completes the derivation of the linear projection model.which is quadratic in β. Eyi < ∞. E (xi x0 ) is invertible. Therefore. This occurs when redundant variables are included in xi . i (3.10). In order for β to be uniquely deﬁned. Rewriting.1 1. x0 β is the best linear predictor for yi . i which requires that for all non-zero α. written E (xi x0 ) > 0. this situation must be excluded.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 . α0 E (xi x0 ) α = E (α0 xi )2 > 0. i i (3. For any β ∈ Rk a linear predictor for yi is x0 β with expected squared prediction i error ¢2 ¡ S(β) = E yi − x0 β i ¢ ¢ ¡ ¡ 2 = Eyi − 2E yi x0 β + β 0 E xi x0 β. i 16 . by “best” we mean the predictor function with lowest mean squared error. We now summarize the assumptions necessary for its derivation and list the implications in Theorem 3.5. alternative expressions such as E xixi ) or E (xi yi ) (E (xi x0 ))−1 i ( i 0i ) are incoherent and incorrect. Given the deﬁnition of β in (3. It is invertible if and only if it is positive deﬁnite.1. The error is i ei = yi − x0 β. i (3. The ﬁrst-order condition for minimization (from Section 2. As before. 2 2. i 4. Equivalently.

suppose that for xi ∈ R that Ex3 = 0 and ei = x2 .Theorem 3.4 guarantees that the solution β exits.5. the orthogonality restriction (3. i i i Since E (xi ei ) = 0 we say that xi and ei are orthogonal.2 and 3. (3.12) can be alternatively interpreted as a projection decomposition. Since from Theorem 3. Let’s compare it with the linear regression model (3.5.9).5.13) The two equations (3.14). The ﬁnite variance Assumptions 3. Assumption 3. 17 .13) summarize the linear projection model.8)-(3.5.4: Hourly Wage as a Function of Experience The conditions listed in Assumption 3.13) and Assumption 3.3 ensure that the moments in (3.2 and 3. Then i i Exi e2 = Ex3 = 0 yet E (ei | xi ) = x2 6= 0. it follows that linear regression is a special case of the projection model. Since ei is mean zero by (3. However.5.11) are well deﬁned.14) holds. This means that the equation (3.14) Proof. (3.1 are weak.1.10) are deﬁned. For example.4 we know that the regression error has the property E (xi ei ) = 0.1.1.1.11) and (3. x0 β is the i projection of yi on xi since the error ei is orthogonal with xi . the converse is not true as the projection error does not necessarily satisfy E (ei | xi ) = 0. E (xi ei ) = 0 and E (ei ) = 0.1.10) ¡ ¡ ¢¢ E (xi ei ) = E xi yi − x0 β i ¡ ¢¡ ¡ ¢¢−1 E (xi yi ) = E (xi yi ) − E xi x0 E xi x0 i i = 0.1 is employed to guarantee that (3.5.13) implies that xi and ei are uncorrelated. Using the deﬁnitions (3.1.1. Assumption 3.12) and (3.14) follows from (3.1. Assumption 3.1. Figure 3. By deﬁnition.10) and (3. Equation (3.5.5.5.5.1 Under Assumption 3.4 is required to ensure that β is uniquely deﬁned. Assumption 3.2. ¥ (3. Furthermore.5.3 are called regularity conditions.1.1.

A projection of log wages on these two variables can be called a quadratic projection. In the example just presented. since the resulting function is quadratic in experience. it is important to not misinterpret the generality of this statement. It over-predicts wages for young and old workers. We illustrate the issue in Figure 3.5. 18 . Other than the redeﬁnition of the regressor vector. and under-predicts for the rest. xi ) we can deﬁne a linear projection equation (3. In this case (3.We have shown that under mild regularity conditions. The solid line is the conditional mean.5: Conditional Mean and Two Linear Projections Another defect of linear projection is that it is sensitive to the marginal distribution of the regressors when the conditional mean is non-linear. This defect in linear projection can be partially corrected through a careful selection of regressors. No additional assumptions are required. the dashed line is the linear projection of log wages on eduction. for those over 53 in age). However.10).4 we display as well this quadratic projection. In this case the linear projection is a poor approximation to the conditional mean. In this example the linear projection is a close approximation to the conditional mean. Most importantly. for any pair (yi .3. In this example it is a much better approximation to the conditional mean than the linear projection. and the straight dashed line is the linear projection. it misses the strong downturn in expected wages for those above 35 years work experience (equivalently. In Figure 1.5 for a 3 In the population of Caucasian non-military male wage earners with 12 years of education.4 displays the relationship3 between mean log hourly wages and labor market experience.1. The linear equation (3. Figure 3. in many economic models the parameter β may be deﬁned within the model.5. there are no changes in our methods or analysis.1 may be false.12) is deﬁned by projection and the associated coeﬃcient deﬁnition (3. Returning to the joint distribution displayed in Figure 3. Figure 3. we can augment the regressor vector xi to include both experience and experience2 . and are discussed in Chapter 11. In other cases the two may be quite diﬀerent.12) with the properties listed in Theorem 3. In contrast. These structural models require alternative estimation methods.10) may not hold and the implications of Theorem 3.

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

s) = 0 if and only if m = µ and s = σ 2 . If yi = xi β + ei . then E(x2 ei ) = 0.6 Exercises 1. True or False.1 . If yi = x0 β + ei and E(xi ei ) = 0. x 6. 2. 3. y) = 3 x2 + y 2 on 0 ≤ x ≤ 1. 9. True or False. m. Let X be a random variable with µ = EX and σ 2 = V ar(X). σ = . Prove parts 2. σ 2 = V ar(xi ). Deﬁne µ ¶ ¢ ¡ x−µ 2 g x. Show that x y β 1 = σ xy /σ 2 and β 0 = µy − β 1 µx . and the conditional distribution of yi given xi is Poisson: P (yi = k | xi = x) = e−x β (x0 β)j . Take the bivariate linear projection model yi = β 0 + β 1 xi + ei E (ei ) = 0 E (xi ei ) = 0 Deﬁne µy = Eyi . 3 and 4 of Theorem 3. 1. and E(ei | xi ) = 0. Compute 2 the coeﬃcients of the linear projection yi = β 0 + β 1 xi + ei . E(Y 2 | X = x) and V ar(Y | X = x). xi ∈ R. 2. Suppose that Y and X only take the values 0 and 1. and have the following joint probability distribution X=0 X=1 Y =0 . µ. then E(x2 ei ) = 0. then E(ei | xi ) = 0. j! 0 j = 0. and E(xi ei ) = 0. then ei is i i independent of xi .4 . i 11. taking values only on the non-negative integers. If yi = x0 β + ei . If yi = x0 β + ei and E(ei | xi ) = 0. then ei is independent of xi .2. Are they diﬀerent? Hint: If P (Y = j) = 5.3.3 Find E(Y | X = x). True or False. If yi = xi β + ei . 20 . i 8. Compute the conditional mean m(x) = E (yi | xi = x) . Let xi and yi have the joint density f (x.. σ 2 = V ar(yi ) and σ xy = Cov(xi . (x − µ)2 − σ 2 Show that Eg (X. ¡ ¢ 4. i 7. Compute E(yi | xi = x) and V ar(yi | xi = x). E(ei | xi ) = 0.2 Y =1 . µx = Exi . Does this justify a linear regression model of the form yi = x0 β + εi ? i then EY = λ and V ar(Y ) = λ. yi ). i 10.1.. Suppose that yi is discrete-valued. . and E(e2 | xi ) = σ 2 . xi ∈ R. True or False. True or False. a constant. e−λ λj j! . 0 ≤ y ≤ 1.

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

117 1 14. excluding military. This sample has 988 observations.37 µ ¶ 1. 30 = . These are white male wage earners from the March 2004 Current Population Survey. consider the data used to generate Figure 3.83 ¶−1 µ ¶ .95 42.30 + 0.83 µ We often write the estimated equation using the format \ log(W agei ) = 1.170 37. 40 2. n X i=1 2 yi − 2β 0 n X i=1 xi yi + β 0 n X i=1 xi x0 β.14 205.5) = n n 1X 1X ˆ xi yi − xi x0 β i n n i=1 i=1 whose solution is (4.4).ˆ This is a set of k equations which are linear in β.14 205. 40 0. Deﬁne the sum-of-squared errors (SSE) function n X¡ ¢2 yi − x0 β Sn (β) = i i=1 = This is a quadratic function of β.40 n i=1 1 n Thus ˆ β = n X i=1 xi x0 i = µ 1 14.95 xi yi = 42.4). ¶ 2. Let yi be log wages and xi be an intercept and years of education. with 10-15 years of potential work experience.94 −2. The estimator β is the value which jointly sets these equations equal to zero: 0 = g (β) ˆ ˆ n ´ 1X ³ ˆ xi yi − x0 β = i n i=1 (4.2 Least Squares There is another classic motivation for the estimator (4.40 µ ¶µ ¶ 34.3. An interpretation of the estimated equation is that each year of education is associated with an 11. Then µ ¶ n 1X 2.117 Educationi . 0.14 14.7% increase in mean wages. 4. i 22 .71 = −2.14 14. To illustrate.

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

one implication is that n 1X ei = 0. It measures the variation in the i “unexplained” part of the regression.7.5) implies that 1X xi ei = 0. The error variance σ 2 = Ee2 is also a parameter of interest. These are algebraic results.2: Sum-of-Squared Error Function Contours Equation (4. 24 .7) A justiﬁcation for the latter choice will be provided in Section 4. ˆ n i=1 n Since xi contains a constant. Its method of moments estimator is the sample average 1X 2 ei . 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. ˆ n−k 2 i=1 (4.6) An alternative estimator uses the formula n 1 X 2 s = ei . and hold true for all linear regression estimates.Figure 4.

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

x0 n ⎞ ⎛ e1 e2 . n or equivalently Y = Xβ + e.8) . ⎟. one for each observation. n X i=1 Thus the estimator (4. . yn ⎟ ⎟ ⎟. 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. 4. Due to this equivalence. ˆi 2 ∂σ 2 2ˆ σ 2 σ ˆ i=1 ˆ ˆ Solving for σ 2 yields the method of moments estimator (4. . For example n X i=1 For many purposes. We can stack these n equations together as y1 = x0 β + e1 1 y2 = x0 β + e2 2 .12) is a system of n equations. = β+ XX 26 (4. We deﬁne ⎛ ⎞ ⎛ y1 ⎜ ⎜ y2 ⎟ ⎜ ⎟ ⎜ X=⎜ Y = ⎜ . σ 2 ) = − 2 + ¡ ¢2 e2 = 0. and sample error variance can be written as ¢−1 ¡ 0 ¢ ¡ ˆ β = X 0X XY ˆ e = Y − Xβ ˆ σ 2 = n−1 e0 e.4). σ 2 ) for the normal ˆ regression model are identical to the method of moment estimators. .4 Model in Matrix Notation convenient to write the model and statistics in x0 1 x0 2 . ⎠ . the ˆ OLS estimator β is frequently referred to as the Gaussian MLE. . and X is an n × k matrix.6).Maximization with respect to σ 2 yields the ﬁrst-order condition n X ∂ n 1 ˆ ˆ Ln (β. Thus the MLE (β. including computation. ⎠ xi x0 = X 0 X i xi yi = X 0 Y. yn = x0 β + en . The linear equation (3. ⎠ ⎜ ⎜ e=⎜ ⎝ ⎟ ⎟ ⎟. . residual vector. . ⎝ ⎝ . en ⎞ Observe that Y and e are n × 1 vectors. it is matrix notation. Sample sums can also be written in matrix notation.

4.5

Projection Matrices

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

Deﬁne the matrices and

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

and

PP

=

= M − MP = M

1

A matrix A is idempotent if AA = A.

27

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

r X j=1

(4.9) (4.10)

ajj

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

and

4.6

Residual Regression

X = [X1 X2 ] ¶ .

Partition and β= µ

β1 β2

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

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

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

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

It follows that

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

2

(4.15)

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

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

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

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

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

the FWL theorem can be used to speed computation. is the demeaning formula for regression. The FWL theorem says that β 2 is the OLS estimate from a regression of ˜ ˜ Y on X2 . and X2 is the vector of observed regressors.7 Bias and Variance In this and the following section we consider the special case of the linear regression model (3.14) or via the ˆ following algorithm: ˜ 1. 4. Partition X = [X1 X2 ] where X1 = ι is a vector of ones. .13). A common application of the FWL theorem. By the independence of the observations and (3. 30 . .18) E (e | X) = ⎜ E (ei | X) ⎟ = ⎜ E (ei | xi ) ⎟ = 0. . Regress X2 on X1 . ! Thus the OLS estimator for the slope coeﬃcients is a regression with demeaned data. ˆ which are “demeaned”. . Regress Y on X1 .9). . ⎟ ⎜ ⎟ ⎜ (4. Rather. ¡ ¢−1 0 ι. 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) . the OLS estimator of β 2 and the OLS residuals e may be equivalently computed by either the OLS regression (4. In some contexts. Regress Y on X2 . . which you may have seen in an introductory econometrics course. ⎠ ⎝ ⎠ ⎝ . In this case. observe that ⎞ ⎛ ⎞ ⎛ . the primary use is theoretical. . obtain residuals X2 . ˆ ˜ ˜ ˆ 3.8)(3. In this section we derive the small sample conditional mean and variance of the OLS estimator. . obtain OLS estimates β 2 and residuals e. but in most cases there is little computational advantage to using the two-step algorithm. In the model (4. 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. . obtain residuals Y . ˜ 2.Theorem 4.1 (Frisch-Waugh-Lovell).9).6. .

X 0 DX = X 0 Xσ 2 . ¡ X 0X ¢−1 ¡ ¢−1 X 0 DX X 0 X while the ij 0 th oﬀ-diagonal element of D is ¢ ¢ ¡ ¡ E e2 | X = E e2 | xi = σ 2 i i i E (ei ej | X) = E (ei | xi ) E (ej | xj ) = 0. σ 2 = σ 2 and we have the simplii ﬁcations D = In σ 2 . . Next. ⎝ .Using (4. under the of ˆ ¢ 2 | x = σ 2 . and ³ ´ ¡ ¢−1 2 ˆ σ . σ2 = ˆ ¢ 1 ¡ ¢ 1 0 1 1 1 ¡ e e = e0 M M e = e0 M e = tr e0 M e = tr M ee0 ˆˆ n n n n n 31 In the special case of the linear homoskedastic regression model.. . σ2 n ⎞ We now calculate the ﬁnite sample bias of the method ¡ moments estimator σ 2 for σ 2 . Then given (4. Thus D is a diagonal matrix with i’th diagonal element σ 2 : i ⎛ 2 σ1 0 · · · ⎜ 0 σ2 · · · 2 ⎜ D = diag{σ 2 . From (4. and the trace operator observe that.18)..8). for any random vector Z deﬁne the covariance materix V ar(Z) = E (Z − EZ) (Z − EZ)0 = EZZ 0 − (EZ) (EZ)0 . .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 . σ 2 } = ⎜ . . 1 n . the properties additional assumption of conditional homoskedasticity E ei i of projection matrices.12). and (4. the properties of conditional expectations. . V ar β | X = X 0 X ⎟ ⎟ ⎟..20) . .19) ˆ and thus the OLS estimator β is unbiased for β.. . ⎠ (4. We have shown that which implies ³ ´ ˆ E β|X =β ³ ´ ˆ E β =β (4. . we can calculate ³ ´ ³¡ ´ ¢−1 0 ˆ E β−β |X = E X 0X Xe|X ¢−1 0 ¡ X E (e | X) = X 0X = 0. 0 0 ··· 0 0 .

What is the best choice of A? The Gauss-Markov theorem. It is important to remember. As an alternative. 32 . the estimator ˆ 2 deﬁned (4.8)¢ ¡ (3. In the homoskedastic linear regression model.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 . however. It is not unbiased in the absence of homoskedasticity. By a calculation similar to those of the previous section. and thus can be written as ˜ β = A0 Y where A is an n × k function of X. which we now present. Theorem 4. The least-squares estimator is the special case obtained by setting A = X(X 0 X)−1 . 4.1 Gauss-Markov. ˜ β L = A0 Y = A (Xβ + e) = β + Ae.8. or in the projection model. known as the Gauss-Markov theorem.8 Gauss-Markov Theorem In this section we restrict attention to the homoskedastic linear regression model.10). is a famous statement of the solution. This is the justiﬁcation for the common s ˆ preference of s2 over σ 2 in empirical practice. Now consider the class of estimators of β which are linear functions of i the vector Y. In this case. as it yields the smallest variance among all unbiased linear estimators.9) plus E e2 | xi = σ 2 . Thus since V ar (e | X) = In σ 2 under homoskedasticity. ³ ´ ˜ E β | X = A0 Xβ. The following result. = σ2 n the ﬁnal equality by (4.7) is unbiased for σ 2 by this calculation. 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. ˜ so β is unbiased if (and only if) A0 X = Ik . which is (3. that this estimator is only unbiased in the special case of the homoskedastic linear regression model. ³ ´ ˜ V ar β | X = A0 V ar (e | X) A = A0 Aσ 2 . Thus σ 2 is biased towards zero. says that the least-squares estimator is the best choice. the best (minimumvariance) unbiased linear estimator is OLS.

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

He observes that the above argument holds for all multinomial distributions. Chamberlain (1987) extends this argument to the case of continuously-distributed data. 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 proves that generically the OLS estimator (4.9). 1X xi x0 i n i=1 1X xi yi n i=1 n ˆ = β ols 4.5. if the data have a discrete 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 . (4. and thus so is the OLS estimator. and any continuous distribution can be arbitrarily well approximated by a multinomial distribution. Since this is a regular parametric model the MLE is asymptotically eﬃcient (see Appendix A.4) is an asymptotically eﬃcient estimator for the parameter β deﬁned in (3.1. the maximum likelihood estimator is identical to the OLS estimator.22) 34 . Let the regressors be partitioned as Suppose we are interested in the coeﬃcient on x1i alone in the regression of yi on the full set xi .10) for the class of models satisfying Assumption 3.10 Omitted Variables xi = µ x1i x2i ¶ .

or second. 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. Goldberger (1991) calls (4.22) the long regression and (4. the general model will be free of the omitted variables problem. First. In general. To avoid omitted variables bias the standard advice is to include potentially relevant variables in the estimated model. log(p2 ) and log(p1 /p2 ). we regress yi on x1i only. This is the situation when the X 0 X matrix is near singular.22) is zero. log(p1 ). To see this.22) by least-squares. 35 . The more relevant issue is near multicollinearity. and the error as ui rather than ei . then β is not deﬁned. Typically.22). when the columns of X are close to linearly dependent.e. For example. except in special cases. least-squares estimation of (4. Observe that γ 1 6= β 1 unless Γ = 0 or β 2 = 0. Thus the short and long regressions have the same coeﬃcient on x1i only under one of two conditions. the regression of x2i on x1i yields a set of zero coeﬃcients (they are uncorrelated). This is one diﬃculty with the deﬁnition and interpretation of multicollinearity.23) is an estimate of γ 1 = β 1 + Γβ 2 rather than β 1 . This happens when the columns of X are linearly dependent. β 1 6= γ 1 . Typically there are limits. Most commonly. By construction. When this happens. because we have not said what it means for a matrix to be “near singular”. In this case.11 Multicollinearity ˆ If rank(X 0 X) < k + 1. this is rarely a problem for applied econometric practice. this arises when sets of regressors are included which are identically related. The diﬀerence Γβ 2 is known as omitted variable bias.23) the short regression to emphasize the distinction. Since the error is discovered quickly.. there is some α such that Xα = 0. the coeﬃcient on x2i in (4. It is the consequence of omission of a relevant correlated variable.Now suppose that instead of estimating equation (4. 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. i. This is called strict multicollinearity. as many desired variables are not available in a given dataset. which is often called “multicollinearity” for brevity. if X includes both the logs of two prices and the log of the relative prices. This is estimation of the equation yi = x0 γ 1 + ui 1i E (x1i ui ) = 0 Notice that we have written the coeﬃcient on x1i as γ 1 rather than β 1 .23) where is the coeﬃcient from a regression of x2i on x1i . the applied researcher quickly discovers the error as the statistical software will be unable to construct (X 0 X)−1 . This deﬁnition is not precise.

since as ρ approaches 1 the matrix becomes singular.25) below.24) β (−i) = X(−i) X(−i) is the i’th diagonal element of the projection matrix X (X 0 X)−1 X 0 . A more relevant implication of near multicollinearity is that individual coeﬃcient estimates will be imprecise. This equals ´−1 ³ 0 ˆ X(−i) Y(−i) (4.12 Inﬂuential Observations where X(−i) and Y(−i) are the data matrices omitting the i’th row. 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. As a consequence. = V ar β ρ 1 n n (1 − ρ2 ) −ρ 1 4. Thus the more “collinear” are the estimate σ 2 1 − ρ2 regressors.26) As we can see. If the i’th observation 36 . We can also deﬁne the leave-one-out residual ˆ ˆ ei. deﬁne the leave-one-out least-squares estimator of β. To investigate the possibility of inﬂuential observations. that is. We derive expression (4.27) (4. 1] and sum to k. the worse the precision of the individual coeﬃcient estimates.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.−i = (1 − hi )−1 hi ei . What is happening is that when the regressors are highly dependent. the precision of individual estimates are reduced. ˆ i A simple comparison yields that ˆ ei − ei. it is statistically diﬃcult to disentangle the impact of β 1 from that of β 2 . µ ¶−1 µ ¶ ³ ´ 2 σ2 1 ρ 1 −ρ ˆ|X = σ . We can see this most simply in a homoskedastic linear regression model with two regressors yi = x1i β 1 + x2i β 2 + ei .−i = yi − x0 β (−i) = (1 − hi )−1 ei . In extreme cases it is possible that the reported calculations will be in error due to ﬂoating-point calculation diﬃculties. the change in the coeﬃcient estimate by deletion of the i’th observation depends critically on the magnitude of hi . and 1 0 XX= n µ 1 ρ ρ 1 ¶ In this case The correlation ρ indexes collinearity. The hi take values in [0. ˆ ˆ (4. the OLS estimator based on the sample excluding the i’th observation.One implication of near singularity of matrices is that the numerical reliability of the calculations is reduced. A convenient alternative expression is ¡ ¢−1 ˆ ˆ xi ei ˆ (4.

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

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

If g(·) : R → R is convex. |a| = a a i i=1 If A is a m × n matrix.Chapter 5 Asymptotic Theory This chapter reviews the essential components of asymptotic theory. ij i=1 j=1 (5.3) E |XY | ≤ (E |X|p )1/p (E |Y |q )1/q . 5. The Euclidean norm of an m × 1 vector a is Ã m !1/2 X ¡ 0 ¢1/2 = a2 . then its Euclidean norm is The following are an important set of inequalities which are used in asymptotic distribution theory.2) + 1 q = 1. then (5.1) (5. Triangle inequality |X + Y | ≤ |X| + |Y | . If p > 1 and q > 1 and 1 p ⎞1/2 ⎛ m n XX ¡ 0 ¢1/2 |A| = tr A A =⎝ a2 ⎠ .1 Inequalities Asymptotic theory is based on a set of approximations. ´1/2 ³ ´1/2 ³ E |Y |2 E |XY | ≤ E |X|2 Holder’s Inequality. These approximations are bounded through the use of mathematical inequalities. 41 . Jensen’s Inequality. We list here some of the most critical deﬁnitions and inequalities. then g(E(X)) ≤ E(g(X)). Cauchy-Schwarz Inequality.

(5. tangent lines lie below it. Let a + bx be the tangent line to g(x) at x = EX. So for all x. For any strictly increasing function g(X) ≥ 0. 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}. Note EU = EV = 1. then as n → ∞ n 1X Xn = Xi →p E(X). denoted Zn →p Z as n → ∞.2. Since g(x) is convex.3). Eg(X) ≥ a + bEX = g(EX). ¥ Proof of Holder’s Inequality.2 Weak Law of Large Numbers Let Zn ∈ Rk be a random vector.Markov’s Inequality. If Xi ∈ Rk is iid and E |Xi | < ∞. =E U V p q p q Proof of Markov’s Inequality. (E |X|p )1/p (E |Y |q )1/q ¥ µ ¶ ´ ³ U V 1 1 1/p 1/q ≤E + = + = 1. n i=1 42 . p p p q which is (5. Set Y = g(X) and let f denote the density function of Y. Theorem 5.4) Proof of Jensen’s Inequality. The WLLN shows that sample averages converge in probability to the population average. P (g(X) > α) ≤ α−1 Eg(X). We say that Zn converges in probability to Z as n → ∞. 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 ) = + . ¥ 5. Let U = |X|p /E |X|p and V = |Y |q /E |Y |q . if for all δ > 0. n→∞ lim P (|Zn − Z| > δ) = 0.1 Weak Law of Large Numbers (WLLN). Applying expectations. g(x) ≥ a + bx yet g(EX) = a + bEX since the curve is tangent at EX. This is a probabilistic way of generalizing the mathematical deﬁnition of a limit. as stated.

where Z has distribution F (x) = P (Z ≤ x) . the fact that the Wi are iid and mean zero.5). by Markov’s inequality (5. ¯ ¯ ¯ ¯ ¯ ¯ ¢ E ¯X n ¯ ¡¯ ¯ E ¯W n ¯ + E ¯Z n ¯ 3ε ≤ ≤ = η.3 Convergence in Distribution Let Zn be a random variable with distribution Fn (x) = P (Zn ≤ x) . Set ε = δη/3. denoted Zn →d Z. V ) . 43 . the triangle inequality. Fix δ and η. We say that Zn converges in distribution to Z as n → ∞. ≤ 2E |Xi | 1 (|Xi | > C) Zi = Xi 1 (|Xi | > C) − E (Xi 1 (|Xi | > C)) . ≤ E |Xi | 1 (|Xi | > C) + |E (Xi 1 (|Xi | > C))| (5. ¯ ¯ E ¯Z n ¯ ≤ E |Zi | ≤ 2ε.4). we can set E(X) = 0 (by recentering Xi on its expectation). Jensen’s inequality (5. as needed. and the bound |Wi | ≤ 2C. the fact that X n = W n + Z n . 5.1) and (5.3.7). (5. Deﬁne the random vectors Wi = Xi 1 (|Xi | ≤ C) − E (Xi 1 (|Xi | ≤ C)) By the triangle inequality. if for all x at which F (x) is continuous. We have shown that for any δ > 0 and η > 0 then for all ¢ ¡¯ ¯ ¥ n ≥ 36C 2 /δ 2 η 2 .6) By Jensen’s inequality (5. Fn (x) → F (x) as n → ∞.1).6) and (5. ¯¢2 ¡ ¯ 2 ≤ EW n E ¯W n ¯ = EWi2 n 4C 2 ≤ n ≤ ε2 (5. Finally. Pick C < ∞ large enough so that E (|X| 1 (|X| > C)) ≤ ε (5.1 Central Limit Theorem (CLT).Proof: Without loss of generality. We need to ¢show that for all δ > 0 and η > 0 there is some N < ∞ so that for all n ≥ N.5) (where 1 (·) is the indicator function) which is possible since E |X| < ∞. Theorem 5. P ¯X n ¯ > δ ≤ η.7) the ﬁnal inequality holding for n ≥ 4C 2 /ε2 = 36C 2 /δ 2 η 2 . If Xi ∈ Rk is iid and E |Xi |2 < ∞. n i=1 0 where µ = EX and V = E (X − µ) (X − µ) . ¡¯ ¯ P ¯X n ¯ > δ ≤ η. P ¯X n ¯ > δ ≤ δ δ δ the equality by the deﬁnition of ε. then as n→∞ n ¢ √ ¡ 1 X n Xn − µ = √ (Xi − µ) →d N (0.

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

where θ is m × 1 and Σ is m × m. √ Theorem 5. gθ Σgθ where gθ (θ) = ∂ g(θ) ∂θ0 and gθ = gθ (θ0 ). k ≤ m. 45 .4. we see that as n → ∞. Theorem 5.2 Continuous Mapping Theorem 2. Σ) = N 0. ¥ 5. If Zn →d Z as n → ∞ and g (·) is continuous. then g(Zn ) →p g(c) as n → ∞. then ¡ ¢ √ 0 n (g (θn ) − g(θ0 )) →d N 0. µ ¶ 1 Cn (λ) → exp − λ0 λ 2 the characteristic function of the N (0. Proof: Since g is continuous at c.3 Delta Method: If n (θn − θ0 ) →d N (0.4. for all ε > 0 we can ﬁnd a δ > 0 such that if |Zn − c| < δ then |g (Zn ) − g (c)| ≤ ε. Ik ) distribution. If Zn →p c as n → ∞ and g (·) is continuous at c.√ where λn → 0 lies on the line segment joining 0 and λ/ n. gθ Σgθ . It follows that ajn = gjθ (θ∗ ) − gjθ →p 0. Thus P (|g (Zn ) − g (c)| ≤ ε) ≥ P (|Zn − c| < δ) → 1 as n → ∞ by the assumption that Zn →p c.1 Continuous Mapping Theorem 1 (CMT). Σ) . for each element of g. 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 . we ﬁnd jn ¢ ¡ √ √ 0 n (g (θn ) − g(θ0 )) = (gθ + an ) n (θn − θ0 ) →d gθ N (0. Stacking across elements of g.4. Proof : By a vector Taylor series expansion. Since cλλ (λn ) → cλλ (0) = −Ik . Hence g(Zn ) →p g(c) as n → ∞. and g(θ) : Rm → Rk . then g(Zn ) →d g(Z) as n → ∞. Recall that A ⊂ B implies P (A) ≤ P (B). This is suﬃcient to establish the theorem.4 Asymptotic Transformations Theorem 5.

and therefore has a sampling distribution.1 for sample sizes of n = 25.1 Sampling Distribution The least-squares estimator is a random vector. 46 . In general. xi ) and the sample size n. n = 100 and n = 800. ˆ Figure 6. let yi and xi be drawn from the joint density µ ¶ µ ¶ 1 1 1 2 2 exp − (ln y − ln x) exp − (ln x) f (x. since it is a function of the random data. y) = 2πxy 2 2 ˆ and let β 2 be the slope coeﬃcient estimate computed on observations from this joint density. Using ˆ simulation methods.1: Sampling Density of β 2 To illustrate the possibilities in one example. The verticle line marks the true value of the projection coeﬃcient. its distribution is a complicated function of the joint distribution of (yi . the density function of β 2 was computed and plotted in Figure 6.Chapter 6 Inference 6.

6. Hence by the continuous mapping theorem (Theorem 5.1 and the WLLN (Theorem 5.2) i i n i=1 n From (6.1 Under Assumption 3. 0). (6.3) Ã where g(A. ˆ 47 . n i=1 (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 . Assumption 3.4. Asymptotic (large sample) methods approximate sampling distributions based on the limiting experiment that the sample size n tends to inﬁnity.5.5. This is illustrated in Figure 6. (6. ˆ Theorem 6. (6. Assumption 3.1) and ˆ We now deduce the consistency of β.1).8) implies that ˆ β−β = Ã n X i=1 xi x0 i !−1 n X i=1 xi ei .2.1. using (6. ·) is continuous at (Q.2. and the continuous mapping theorem (Theorem 5.4. First. For a complete argument. Proof. we can conclude ˆ that β →p β. 0) = Q−1 0 = 0 β−β =g n n i=1 i=1 ˆ which implies β →p β as stated.1).1).5. To characterize the sampling distribution more fully.1. 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. ¥ We can similarly show that the estimators σ 2 and s2 are consistent for σ 2 .2 Consistency ˆ As discussed in Section 6.1 by the fact that the sampling densities become more concentrated as n gets larger.3).1). xi ei →p g (Q.1) imply that n ¡ ¢ 1X xi x0 →p E xi x0 = Q (6. the OLS estimator β is has a statistical distribution which is unknown. β →p β as n → ∞. we will use the methods of asymptotic approximation.1. Equation (4.From the ﬁgure we can see that the density functions are dispersed and highly non-normal. b) = A−1 b is a continuous function of A and b at all values of the arguments such that A−1 exist. xi ei = g i n n i=1 i=1 1X xi ei →p E (xi ei ) = 0.4 implies that Q−1 exists and thus g(·.2). Ã n ! n X 1X 0 1 ˆ xi xi . As the sample size increases the density becomes more concentrated about the population coeﬃcient.

1 guarantees that the elements of Ω are ﬁnite. By the central limit theorem (Theorem 5. Ee4 < ∞ and E |xi |4 < ∞. n 1 X √ xi ei →d N (0. E ¯ei ¯ E ¯e4 ¯ i i i i (6. Note that ˆ ei = yi − x0 β ˆ i i Thus and n ˆ = ei + x0 β − x0 β i i ³ ´ ˆ = ei − x0 β − β . ˆ Proof. We need a strengthening of the moment conditions. Thus σ 2 is consistent for σ 2 .1). To see this.5) Thus xi ei is iid with mean zero and has covariance matrix Ω. (6.2).Theorem 6. ´1/2 ¡ ¯ ¯¢ ¯ ³ ¯ ¯2 ´1/2 ¡ ¯ 4 ¯¢1/2 ³ ¯ 1/2 E ¯xi x0 e2 ¯ ≤ E ¯xi x0 ¯ = E |xi |4 < ∞. ˆ n−k 6.6) n i=1 48 . (6.2).4) ³ ´ ³ ´0 ³ ´ ˆ ˆ ˆ e2 = e2 − 2ei x0 β − β + β − β xi x0 β − β ˆi i i i σ2 = ˆ 1X 2 ei ˆ n i=1 i=1 →p σ 2 n 1X 2 = ei − 2 n Ã ! Ã n ! n ´ ³ ´0 1 X ³ ´ 1 X 0 ³ˆ 0 ˆ ˆ β−β + β−β β−β ei xi xi xi n n i=1 i=1 the last line using the WLLN. i Now deﬁne ¡ ¢ Ω = E xi x0 e2 . since n/(n − k) → 1 as n → ∞.1.3.1).3) and Theorem (6.2. Assumption 6. ˆ Finally.5.1.3. it follows that s2 = ¥ n σ 2 →p σ 2 . σ 2 →p σ 2 and s2 →p σ 2 as n → ∞.2 Under Assumption 3. by the Cauchy-Schwarz inequality (5. Ω) .3.5. i i Assumption 6. (6.3 Asymptotic Normality ˆ We now establish the asymptotic distribution of β after normalization. (6.2.1 In addition to Assumption 3.

2 we display the ﬁnite sample densities of the q ³ ˆ normalized estimator n α−2 β 2 − β 2 . ´ √ ³ˆ As V is the variance of the asymptotic distribution of n β − β . There is a special case where Ω and V simplify. setting n = 100 and varying the parameter α. Q−1 ΩQ−1 . but this is not a necessary condition. In´Figure 6. and εi is independent of xi with the Double Pareto density f (ε) = α |ε|−α−1 .7) is true then V = V 0 . 1 X √ xi ei n i=1 n ! the N (0.1 Under Assumption 6.Then using (6. The trouble is that no matter how large is the sample size. 1) asymptotic distibution. when xi and ei are independent. For α 49 .3. The asymptotic distribution ´ Theorem 6.9) In (6. We say that ei is a Homoskedastic Projection Error when (6.9) we deﬁne V 0 = Q−1 σ 2 whether (6. after rescaling.7) holds. however. In Figure 6. ´ √ ³ ˆ n β−β = Ã 1X xi x0 i n i=1 n !−1 Ã Theorem 6. The approximation may be poor when n is small.2). However.8) Ω = E xi x0 E e2 = Qσ 2 i i V = Q−1 ΩQ−1 = Q−1 σ 2 ≡ V 0 (6. the normal approximation is arbitrarily poor for some data distribution satisfying the assumptions.6).3. Theorem 6.3. How large should n be in order for the approximation to be useful? Unfortunately.1. We call V 0 the homoskedastic covariance matrix. V is often referred to as ˆ the asymptotic covariance matrix of β.1. If α > 2 the 2 error εi has zero mean and variance α/(α − 2).1). is approximately normal when the sample size n is suﬃciently large. i i Condition (6. Under (6. for any ˆ ﬁxed n the sampling distribution of β can be arbitrarily far from the normal distribution. |ε| ≥ 1. Let yi = β 0 + β 1 xi + εi where xi is N (0. otherwise V 6= V 0 . 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. Ω) ¡ ¢ = N 0. there is no simple answer to this reasonable question. This holds true for all joint distibutions of (yi . V ) where V = Q−1 ΩQ−1 . its variance diverges q ³ ´ ˆ to inﬁnity.1 is commonly used to approximate the ﬁnite of √ ³ˆ sample distribution of n β − β . e2 ) = 0. and (6.7) is true or false. xi ) which satisfy the conditions of Assumption 6.1 states that the sampling distribution of the least-squares estimator. We illustrate this problem using a simulation. 1).7) Cov(xi x0 . (6. as n → ∞ ´ √ ³ ˆ n β − β →d N (0.3. for example.7) the asymptotic variance formulas simplify as ¡ ¢ ¡ ¢ (6.1 we have already seen a simple example where the least-squares estimate is quite asymmetric and non-normal even for reasonably large sample sizes. When (6.3. As α approaches 2.

2.11) 50 .3 is that the N (0.10) without changing this result. we need an estimate of Ω = E xi x0 e2 .2: Density of Normalized OLS estimator α = 3.1) it is clear that V 0 →p V 0 .0 the density is very close to the N (0.4 Let Covariance Matrix Estimation 1X ˆ xi x0 Q= i n i=1 n be the method of moments estimator for Q. The homoskedastic covariance matrix V 0 = Q−1 σ 2 is typically estimated by ˆ ˆ (6.3. The lesson from Figures 6. The MME estimator is i i 1X ˆ xi x0 e2 Ω= i ˆi n i=1 n (6. concentrating most of the probability mass around zero. Here the model is yi = β 1 + εi where uk − Euk i i εi = ³ ¡ k ¢2 ´1/2 Eu2k − Eui i ´ √ ³ˆ and ui ∼ N (0. 4.2 and 6.2) and Theorem 6. the sampling distribution becomes highly skewed and non-normal. for k = 1. ˆ ˆ Since Q →p Q and s2 →p σ 2 (see (6. As k increases. The estimator 2 2 in (6. 1) density. 1). σ may also be substituted for s ˆ ¡ ¢ To estimate V = Q−1 ΩQ−1 . We show the sampling distribution of n β 1 − β 1 setting n = 100. 6 and 8.Figure 6. As α diminishes the density changes signiﬁcantly.10) V 0 = Q−1 s2 . 1) asymptotic approximation is never guaranteed to be accurate. 6. Another example is shown in Figure 6.

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

(.5 Consistency of the White Covariance Matrix Estimate 1X xi x0 e2 i ˆi n i=1 i=1 n ˆ ˆ We now show Ω →p Ω.085) (.493 0.3) so by the WLLN ³ ´ ³ ´3/4 ¡ ¯ ¯¢ 1/4 E |xi |3 |ei | ≤ E |xi |4 < ∞.83 ¶−1 µ .480 .20 −0.14 205. Using (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 .20 and µ ¶ ˆ = 0.14 14. The standard errors for β 0 are 7. To illustrate.480 ˆ0 = 0.6 ¶µ 1 14. n n i=1 52 . From a computational standpoint. (6. (6. p ˆ In this case the two estimates are quite similar.12) i i n n n i=1 i=1 We now examine each sum on the right-hand-side of (6.80 .020) 6.used by an author when studying their work.493 −0.117 Educationi . We calculate that s2 = 0.2.199 2.80 2.039 and ˆ V = µ 1 14.80 40.035 ¶ .14 205.14 205.83 ¶−1 = µ 7.5) and the WLLN (Theorem 5. from which it follows that V →p V as n → ∞.1.6 Therefore the two covariance matrix estimates are µ ¶−1 µ ¶ 1 14.30 + 0.1) show that n ¡ ¢ 1X xi x0 e2 →p E xi x0 e2 = Ω.14 6.20 = V 14. just as any other estimator.12) in turn. It is also important to understand that a particular standard error may be relevant under one set of model assumptions. then take the diagonal elements.020.085 p ˆ and that for β 1 is .2/988 = .80 40.83 −0. E ¯e4 ¯ i ³ ´ 1X |xi |3 |ei | →p E |xi |3 |ei | .35/988 = . the standard method to calculate the standard errors is to ˆ ﬁrst calculate n−1 V . we return to the log wage regression of Section 4.14 14. i i i i n i=1 Second. by Holder’s inequality (5. We can write the estimated equation with standards errors using the format \ log(W agei ) = 1. Ω 2. but not under another set of assumptions. First.199 2.98 −0. and then the square roots.

They also suggest that the scaling factor (n − 1)/n in (??) can be omitted.13) of Efron (1982).26).5. i=1 Third. 6. ¯ ¯ ¯ ¯ ¯n ¯ n i=1 i=1 1X |xi |4 →p E |xi |4 .−i = (1 − hi )−1 ei ˆ presented in (4. 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 (6.25). 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.¯ ¯ ¯ ¯ˆ and thus since ¯β − β ¯ →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 . Using this substitution. is deﬁned ˆ ˆ by replacing the OLS residual ei in (6.11) with the leave-one-out estimator ei. ¯ n ¯ n ¯2 X ¯1 X ³ ´0 ³ ´¯ ¯ ¯ 0 ˆ ˆ ˆ − β ¯ ≤ ¯β − β ¯ 1 xi xi β − β xi xi β |xi |4 →p 0. ¯ ¯n ¯ 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 .12 the deﬁnition of β (−i) as the least-squares estimator with the i’th observation deleted. 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. Andrews’ proposed estimator is ˆ ˆ ˆ ˆ V ∗∗ = Q−1 Ω∗∗ Q−1 53 . these establish consistency. Andrews (1991) suggested an similar estimator based on cross-validation.6 Alternative Covariance Matrix Estimators ˆ MacKinnon and White (1985) suggested a small-sample corrected version of V based on the jackˆ knife principle.13) Using formula (4. Recall from Section 4. From equation (3. which. n i=1 n ˆ ˆ Theorem 6. Ω →p Ω and V →p V.1 As n → ∞.

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

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

if Z ∼ N (0.The standard test for H0 against H1 is the t-statistic (or studentized statistic) tn = tn (θ0 ) = ˆ − θ0 θ . regardless of the complication of the distribution of the original test statistic. For example.645. tn →d N (0.05 = 1. in that the reader is allowed to pick the level of signiﬁcance α. Let zα/2 is the upper α/2 quantile of the standard normal distribution. To see this fact.025 = 1. 56 . Deﬁne the tail probability. or “accepts” H0 . Otherwise the test does not reject. is to report an asymptotic p-value. or asymptotic p-value function p(t) = P (|Z| > |t|) = 2 (1 − Φ(|t|)) . The asymptotic p-value for the above statistic is constructed as follows. 1]. P (1 − p(tn ) ≤ u) establishing that 1 − pn →d U [0. A test of asymptotic signiﬁcance α rejects H0 if |tn | > zα/2 . Then the asymptotic p-value of the statistic tn is pn = p(tn ). pn →d U [0. from which it follows that pn →d U [0. The coverage probability is P (θ ∈ Cn ). so the “unusualness” of the test statistic can be compared to the easy-to-understand uniform distribution. Thus P (1 − pn ≤ u) = = P (F (tn ) ≤ u) ¡ ¢ = P |tn | ≤ F −1 (u) ¡ ¢ → F F −1 (u) = u. and is a function of the data and hence is / random. however. 6. In a sense. p-values and hypothesis tests are equivalent since pn < α if and only if |tn | > zα/2 . Another helpful observation is that the p-value function has simply made a unit-free transformation of the test statistic. The rejection/acceptance dichotomy is associated with the Neyman-Pearson approach to hypothesis testing. in contrast to Neyman-Pearson rejection/acceptance reporting where the researcher picks the level. An alternative approach. It is designed to cover θ with high probability. That is. 1). then P (Z > zα/2 ) = α/2 and P (|Z| > zα/2 ) = α. This is because ¡ ¢ P (reject H0 | H0 true) = P |tn | > zα/2 | θ = θ0 ¢ ¡ → P |Z| > zα/2 = α. under H0 . 1]. If the p-value pn is small (close to zero) then the evidence against H0 is strong. 1). The p-value is more general. Thus an equivalent statement of a Neyman-Pearson test is to reject at the α% level if and only if pn < α. note that the asymptotic distribution of |tn | is F (x) = 1 − p(x). Either θ ∈ Cn or θ ∈ Cn . associated with Fisher.96 and z. s(ˆ θ) Under H0 . z. That is.9 Conﬁdence Intervals A conﬁdence interval Cn is an interval estimate of θ. 1].

ˆ + zα/2 s(ˆ . ¢ ¡ ¢ ¡ P (θ ∈ Cn ) = P |tn (θ)| ≤ zα/2 → P |Z| ≤ zα/2 = 1 − α. 6.05. 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 . While there is no hard-and-fast guideline for choosing the coverage probability 1 − α. 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%. A good method for construction of a conﬁdence interval is the collection of parameter values which are not rejected by a statistical test. The t-test of the previous setion rejects H0 : θ0 = θ if |tn (θ)| > zα/2 where tn (θ) is the t-statistic (6.10 Wald Tests Sometimes θ = h(β) is a q × 1 vector. θ The interval has been constructed so that as n → ∞. = n h(β) − θ0 Hβ V Hβ 57 (6. However we often can calculate the asymptotic coverage probability limn→∞ P (θ ∈ Cn ). We have the null and alternative H0 : θ = θ0 H1 : θ 6= θ0 . and it is desired to test the joint restrictions simultaneously. and values of θ outside two standard θ errors of the estimated ˆ are considered unlikely or unreasonable candidates for the true value. In this case the t-statistic approach does not work. θ θ) (6.We typically cannot calculate the exact coverage probability P (θ ∈ Cn ). We say that Cn has asymptotic (1 − α)% coverage for θ if P (θ ∈ Cn ) → 1 − α as n → ∞.18) . 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). 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). or α = . This corresponds to selecting the conﬁdence h i h ˆ ± 1.17) = ˆ − zα/2 s(ˆ θ and Cn is an asymptotic (1 − α)% conﬁdence interval.96s(ˆ ≈ ˆ ± 2s(ˆ .16) and zα/2 is the upper α/2 quantile of the standard normal distribution.

χ2 (.025 . As before.15) showed that n ˆ − θ →d Z ∼ N (0. We have established: ³ ´0 ³ ´ ˆ − θ0 V −1 ˆ − θ0 →d Z 0 V −1 Z = χ2 . In this case. the upper-α quantile q 2 of the χ2 distribution. and Theorem 6. Hence β β by Theorem A.8. a chiq square random variable with q degrees of freedom. The null hypothesis is H0 : β 2 = 0. ˜˜ n ˜ e = Y − X1 β 1 . An asymptotic Wald test rejects H0 in favor of H1 if Wn exceeds χ2 (α). Furthermore. the test rejects at the α% level iﬀ pn < α. Hβ (β) is a continuous function of β.5. q and pn is asymptotically U[0. ˆ Wn = n θ θ q θ θ Theorem 6. 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. so by the continuous mapping ˆ ˆ ˆ ˆ ˆ theorem. and there are q = k2 restrictions. θ = β 2 . where p(x) = P χ2 ≥ x is the tail q q probability function of the χ2 distribution. Wn = n R0 β − θ0 ´ √ ³ The delta method (6. 6. then the Wald statistic can be written in the form ¶ µ 2 ˆ σ − σ2 ˜ Wn = n (6.10. Vθ ).1. For example. then the Wald statistic takes the form ´0 ³ ´ ³ ´−1 ³ ˆ ˆ ˆ R0 V R R0 β − θ 0 .1 Under H0 and Assumption 6.1 showed θ ˆ that V →p V. The asymptotic p-value for Wn is pn = p(Wn ). The Wald test fails to reject if Wn is q 1 ¡ ¢ less than χ2 (α).When h is a linear function of β. Thus Vθ = H 0 V Hβ →p H 0 V Hβ = Vθ > 0 if Hβ has full rank q. 1] under H0 . then Wn →d χ2 .3. h(β) = R0 β. if rank(Hβ ) = q. = nβ 2 R0 V R R0 β is linear with R = µ 0 I ¶ ¢−1 ¡ ˆ ˆ ˆ . 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.84 = z.2. ˜ 58 ¡ 0 ¢−1 0 ˜ β 1 = X1 X1 X1 Y .19) σ2 ˆ where σ2 = ˜ 1 0 e e.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 . Also h(β) = a selector matrix. Hβ (β) →p Hβ .05) = 3.

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

when sample sizes were very small and researchers wanted to know if there was “any explanatory power” to their regression. σ 2 ) can be be used to calculate a set of exact distribution results. introduced in Section 4. these cases are atypical. Since uncorrelated normal variables are independent. 6. H 0 H) ∼ N (0. n−k 60 .12 Normal Regression Model As an alternative to asymptotic distribution theory. this implies that conditional on X µ ¶ µ ¶ µ µ 2 0 −1 ¶¶ ˆ β−β (X 0 X)−1 X 0 σ (X X) 0 = e ∼ N 0. there is an exact distribution theory available for the normal linear regression model. This is ¢ ¡ 2 ˆ σ y − σ 2 / (k − 1) ˜ F = . σ 2 /(n − k) ˆ σ2 = ˜y 1 (y − y)0 (y − y) n is the sample variance of yi .3. This was a popular statistic in the early days of econometric reporting. 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 . as sample sizes are typically suﬃciently large that this F statistic is highly “signiﬁcant”. While there are special cases where this F statistic is useful. equivalently the residual variance from an intercept-only model. an “F statistic” is reported. under the normality assumption the error vector e is independent of X and ¢ ¡ has distribution N 0. Let u = σ −1 H 0 e ∼ N (0. This is rarely an issue today. In ) . The modelling assumption that the error ei is independent of xi and N (0.4)) where H 0 H = In . In particular. it follows ˆ that β is independent of any function of the OLS residuals. including the estimated error variance 2. Since linear functions of normals are also normal. e ˆ M 0 σ2 M where M = I − X (X 0 X)−1 X 0 . when an OLS regression is reported. In σ 2 . This special F statistic is testing the hypothesis that all slope coeﬃcients (other than the intercept) are zero.where In many statistical packages. s The spectral decomposition of M yields ¸ ∙ In−k−1 0 H0 M =H 0 0 (see equation (2.

1 and Theorem 6. β 2 . and standard errors are calculated using the homoskedastic formula (6.1 we showed that in large samples.1 If ei is independent of xi and distributed N(0. β 2 .) Now let us partition β = (β 1 . β 2 ) and consider tests of the linear restriction H0 : β 2 = 0 H1 : β 2 6= 0 In the context of parametric models. σ2 ˆ 61 . which is twice the diﬀerence in the log-likelihood function evaluated under the null and alternative hypotheses. σ ˆ ˆ βj − βj βj − βj N (0. The critical values are quite close if n − k ≥ 30. As inference (conﬁdence intervals) are based on the t-ratio.1 shows that under the strong assumption of ˆ normality. β 2 .8.10) then ´ ³ ˆ • β ∼ N 0. β and t are approximately normally distributed. n−k • ∼ tn−k ˆ In Theorem 6.10) µ h i ¶ 2 (X 0 X)−1 N 0. The log-likelihood of this model is ¡ 2¢ n n n ˜ ˜ ˜ Ln (β 1 . The estimator under the alternative is the unrestricted estimator ˆ ˆ ˆ (β 1 . the notable distinction is between the N (0.3. σ 2 ) discussed above. 1) jj rh ∼ tn−k = rh i ∼q i = q χ2 ˆ s(β j ) n−k σ2 2 0 X)−1 0 X)−1 (X s (X n−k n−k χn−k jj jj a t distribution with n − k degrees of freedom. 0. σ 2 ). a good testing procedure is based on the likelihood ratio statistic. We summarize these ﬁndings Theorem 6. σ 2 (X 0 X)−1 • (n−k)s2 σ2 ˆ β j −β j ˆ s(β ) j ∼ χ2 . so as a practical matter it does not matter which distribution is used. with residual variance σ . σ 2 ) = − log 2πˆ 2 − 2 e0 e ˆˆ 2 2ˆ σ ¡ ¢ n n n = − log σ 2 − log (2π) − .12. (Unless the sample size is unreasonably small. 2 2 2 The LR statistic for H0 is ´ ³ ˆ ˆ ˆ ˜ ˜ LR = 2 Ln (β 1 . if standard errors are calculated using the homoskedastic formula (6. 0. 0.a chi-square distribution with n − k degrees of freedom. β has an exact normal distribution and t has an exact t distribution. 1) and tn−k distributions. Theorem 6. ˆ 2 2 2 ˜ ˜ The MLE of the model under the null hypothesis is (β 1 . σ 2 ) ¡ ¢¢ ¡ ¡ ¢ ˆ = n log σ 2 − log σ 2 ˜ µ 2¶ σ ˜ = n log . σ 2 ) where β 1 is the OLS estimate from ˜ 2 ˜ a regression of yi on x1i only. In contrast.12. Furthermore. The Gaussian log-likelihood at these estimates is ¡ ¢ n 1 ˆ ˆ ˆ σ Ln (β 1 . σ 2 ) − Ln (β 1 . σ 2 ) = − log σ − log (2π) − .

By a ﬁrst-order Taylor series approximation ¶ µ 2 ¶ µ σ ˜ σ2 ˜ − 1 = Wn . The increasing solid line is for the case β = 0. This can be seen by a simple example introduced by Lafontaine and White (1986). Through repetition. To demonstrate this eﬀect.8.84 — the probability of a false rejection. as Wn (s) →d χ2 under H0 for 1 any s. This produces random draws from the sampling distribution of interest.4 the Wald statistic Wn (s) as a function ˆ of s. one feature of importance is the Type I error of the test using the asymptotic 5% critical value 3.7. ˆ Let β and σ 2 be the sample mean and variance of yi . This is an unfortunate feature of the Wald statistic. In the present context of the Wald statistic. Letting h(β) = β s .13 Problems with Tests of NonLinear Hypotheses While the t and Wald tests work well when the hypothesis is a linear restriction on β. σ2 ˆ Now notice that H0 is equivalent to the hypothesis H0 (s) : β s = 1 for any positive integer s. Our ﬁrst-order asymptotic theory is not useful to help pick s. 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. we have plotted in Figure 6. and noting Hβ = sβ s−1 . while there are other values of s for which test test statistic is insigniﬁcant. 6. σ 2 s2 β ˆ ˆ While the hypothesis β s = 1 is unaﬀected by the choice of s. This is a context where Monte Carlo simulation can be quite useful as a tool to study and compare the exact distributions statistical procedures in ﬁnite samples. the statistic Wn (s) varies with s. The method uses random simulation to create an artiﬁcial dataset to apply the statistical tools of interest. they can work quite poorly when the restrictions are nonlinear. The decreasing dashed ˆ = 1. features of this distribution can be calculated. Take the model yi = β + ei ei ∼ N (0. setting n/σ 2 = 10. we ﬁnd that the standard Wald test for H0 (s) is ´2 ³ s ˆ β −1 Wn (s) = n 2s−2 . LR = n log 1 + 2 − 1 ' n σ ˆ σ2 ˆ the F statistic. Then the standard Wald test for H0 is ˆ ³ ´2 ˆ β−1 Wn = n . σ 2 ) and consider the hypothesis H0 : β = 1. 62 . This is distressing since the choice of s seems arbitrary and irrelevant to the actual hypothesis.

Typically. the Type I error probability improves towards 5% as the sample size n increases. For this particular example.84 | β = 1) . To interpret the table. Test performance deteriorates as s increases. Each row of the table corresponds to a diﬀerent value of s — and thus corresponds to a particular choice of test statistic. and σ 2 . In Table 2. There is. When comparing statistical procedures. the only test which meets this criterion is the conventional Wn = Wn (1) test.4.1 Type I error Probability of Asymptotic 5% Wn (s) Test 63 . and σ is varied among 1 and 3. looking for tests for which rate rejection rates are close to 5%. however. The null hypothesis β s = 1 is true.000 simulated Wald statistics Wn (s) which are larger than 3.1 you can also see the impact of variation in sample size. n. n is varied among 20. The second through seventh columns contain the Type I error probabilities for diﬀerent combinations of n and σ. and rarely fall outside of the 3%-8% range. no magic choice of n for which all tests perform uniformly well. Type I error rates between 3% and 8% are considered reasonable. we compare the rates row by row. remember that the ideal Type I error probability is 5% (. In Table 4.1 we report the results of a Monte Carlo simulation where we vary these three parameters.Figure 6.1 reports the simulation estimate of the Type I error probability from 50. so these probabilities are Type I error.000 random samples. this probability depends only on s. Error rates avove 10% are considered excessive. These probabilities are calculated as the percentage of the 50. In each case. 100 and 500. Table 4.4: Wald Statistic as a function of s P (Wn (s) > 3. which is not surprising given the dependence of Wn (s) on s as shown in Figure 6. Any other choice of s leads to a test with unacceptable Type I error probabilities. Table 4. Rates above 20% are unexceptable.84. The value of s is varied from 1 to 10.05) with deviations indicating+ distortion. Given the simplicity of the model.

let V be an estimate of the ˆ asymptotic variance matrix for β and set ˆ = β 1 /β 2 .05 .08 .13 .17 .12 . ˆ ˆ ˆ ˆ ˆ Let β = (β 0 .23 .07 . An alternative statistic can be constructed through reformulating the null hypothesis as H0 : β 1 − rβ 2 = 0.06 . Equivalently.20 .10 .13 .16 Rejection frequencies from 50.33 .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 .15 .20).08 .11 .08 .15 . This point can be illustrated through another example.06 .25 .12 .06 . While this is clear in this particular example.26 .05 .35 .22 .14 .31 .10 .000 simulated random samples In this example it is not surprising that the choice s = 1 yields the best test statistic.06 .14 .05 . In this case a t-statistic for H0 is t1n = ³ˆ β1 ˆ β2 where r is a known constant.21 . deﬁne θ = β 1 /β 2 .34 .07 . Deﬁne θ ˆ ˆ ⎞ ⎛ 0 ⎟ ⎜ ⎟ ⎜ ⎜ 1 ⎟ ⎟ ⎜ ⎜ ˆ ⎟ ˆ H1 = ⎜ β 2 ⎟ ⎟ ⎜ ⎟ ⎜ ⎜ β ⎟ ˆ ⎠ ⎝ − 1 ˆ2 β2 ´ s(ˆ θ) −r .25 . so the hypothesis can be stated as H0 : θ = r.07 .07 .08 . Take the model yi = β 0 + x1i β 1 + x2i β 2 + ei E (xi ei ) = 0 and the hypothesis H0 : β1 =r β2 (6.19 .22 .06 .06 .20) ³ ´1/2 ˆ0 ˆ ˆ so that the standard error for ˆ is s(ˆ = n−1 H1 V H1 θ θ) .18 . in other examples natural choices are not always obvious and the best choices may in fact appear counter-intuitive at ﬁrst. β 2 ) be the least-squares estimates of (6.06 . 64 .05 .24 .20 .28 .30 . Other choices are arbitrary and would not be used in practice.15 .09 .13 .05 .15 . β 1 .05 .10 .08 .07 .06 .

the entries in the table should be 0.05 β2 .10 . and alternatives to asymptotic critical values should be considered.645) P (tn > 1.06 . . We vary β 2 among .07 .645) t1n t2n t1n t2n t1n t2n t1n t2n .645) P (tn < −1.00 .05 . The common message from both examples is that Wald statistics are sensitive to the algebraic formulation of the null hypothesis.00 .15 .06 . The implication of Table 4.02 .09 . However. σ 2 ) draw with σ = 3.50. 1) variables.000 simulated samples. We let x1i and x2i be mutually independent N (0.00 .25 .06 .06 .25.05 .10 .05 . In contrast.00 .47 .2 is that the two t-ratios have dramatically diﬀerent sampling behavior.0 and n among 100 and 500.06 . along with sample size n.2.28 .00 .06 . this formulation should be used. 65 .05 .05 .15 .10 .645) are calculated from 50. and 1.645) and P (tn > 1.06 .645) greatly exceed 5%. If no linear formulation is feasible. . The left tail probabilities P (t1n < −1.1.645) P (tn > 1.00 .06 . In all cases. while the right tail probabilities P (t1n > 1. if the hypothesis can be expressed as a linear restriction on the model parameters. 6.75. then the “most linear” formulation should be selected.7. the rejection rates for the t1n statistic diverge greatly from this value.50 .A t-statistic based on this formulation of the hypothesis is ´2 ³ ˆ 1 − rβ 2 ˆ β =³ ´1/2 .05 .14 Monte Carlo Simulation In the previous section we introduced the method of Monte Carlo simulation to illustrate the small sample problems with tests of nonlinear hypotheses.00 The one-sided Type I error probabilities P (tn < −1. This leaves β 2 as a free parameter.00 . −1 H V H ˆ 2 n 2 ⎞ 0 H2 = ⎝ 1 ⎠ . especially for small values of β 2 . The results are presented in Table 4.05 .05 .00 .75 1. and are close to the ideal 5% rate for both sample sizes.26 . and normalize β 0 = 0 and β 1 = 1.06 .2 Type I error Probability of Asymptotic 5% t-tests n = 100 n = 500 P (tn < −1. Ideally.645) are close to zero in most cases. It is also prudent to consider alternative tests to the Wald statistic.05. . −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. In this section we describe the method in more detail.00 . the rejection rates for the linear t2n statistic are invariant to the value of β 2 . ei be an independent N (0.06 .12 . Table 4.05 .

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

We now expand the sample all non-military wage earners. then we can set s P = (. and therefore it is straightforward to calculate standard errors for any quantity of interest. Hence the ³ ´ ˆ standard errors for B = 100. potential work experience. . We separately estimate equations for white and non-whites. therefore. 6. for a selection of choices of n and F. and dummy variable indicators for the following: married. B b=1 (6. As discussed above. female. A simple way to compute sample quantiles is to sort the sample {Tnb } from low to high.95) /B ' .15 Estimating a Wage Equation We again return to our wage equation. and hispanic. If the standard error is too large to make a reliable inference. and dummy variable indicators for the following: married. if we set B = 999.21) is therefore an ³ ´ p ˆ unbiased estimator of P with standard error s P = P (1 − P ) /B. We us the sample of wage earners from the March 2004 Current Population Survey. and non-white. For example. respectively. immigrant. the performance will depend on n and F. Furthermore. if we are ³ ´ p √ ˆ assessing an asymptotic 5% test. For the dependent variable we use the natural log of wages.007. the researcher must select the number of experiments. Again our dependent variable is the natural log of wages. The random variable 1 (Tnb ≥ 1. experience squared. and poorly for others. and estimate a multivariate regression. Generally. In particular. In practice. s P = . B. an estimator or test may perform wonderfully for some values.Suppose we are interested in the ¯Type I error associated with an asymptotic 5% two-sided ¯ ¯ ¯ θ) θ t-test. excluding military. equalling 1 with probability P = E1 (Tnb ≥ 1. Quite simply. immigrant. it is simple to make inferences about rejection probabilities from statistical tests.21). In many cases. and 5000. Suppose we are interested in the 5% and 95% quantile of Tn = ˆ We then compute the 10% θ. so that coeﬃcients may be interpreted as semi-elasticities. such as the percentage estimate reported in (6. then B will have to be increased. potential work experience. Since the results of a Monte Carlo experiment are estimates computed from a random sample of size B.022. It is therefore convenient to pick B so that N is an integer. and .96) is iid Bernoulli. The average (6. are. union member. 1000.05) (. a larger B results in more precise estimates of the features of interest of Gn . then the 5% sample quantile is 50’th sorted value and the 95% sample quantile is the 950’th sorted value.21) the percentage of the simulated t-ratios which exceed the asymptotic 5% critical value. but requires more computational time. hispanic. where N = (B +1)α. and our regressors include years of education. The α% sample quantile is a number qα such that α% of the sample are less than qα .003. experience squared. this may ˆ be approximated by replacing P with P or with an hypothesized value. and 90% sample quantiles of the sample {Tnb }. the choice of B is often guided by the computational demands of the statistical procedure. We would then set Tn = ¯ˆ − θ¯ /s(ˆ and calculate B X ˆ= 1 P 1 (Tnb ≥ 1. we included a dummy 67 . For example. For regressors we include years of education. Then qα is the N ’th number in this ordered sequence.96) .22/ B.96) . female. As P is unknown. 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. It is therefore useful to conduct a variety of experiments. Often this is called the number of replications.

097 −.008 . Table 4. The F form of the Wald statistic (6. this adds 50 regressors).34 ˆ s(β) . 2β 3 68 .808 so the parameter estimates are quite precise and reported in Table 4. 808 1 − . θ ˆ 2β 3 β2 .101 . 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.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.232 .014 .808 .002 .102 −. the restricted standard deviation estimate is σ = .4877 18.007 .033 −.19) is ˜ µ ¶ µ ¶ σ2 ˆ . Wn = n 1 − 2 = 18. as the 1% critical value for the χ2 distribution is 76.00057 .1 OLS Estimates of Linear Equation for Log(Wage) ˆ β 1. excluding the coeﬃcients on the state dummy variables. Ignoring the other coeﬃcients.00002 . reestimating the model with the 50 state dummies excluded. Using either statistic the hypothesis is easily rejected.121 −.variable for state of residence (including the District of Columbia. Alternatively. we ﬁnd Wn = 550. if β 2 > 0 and β 3 < 0 the solution is θ=− From Table 4.18) that the state coeﬃcients are jointly zero.027 .1.001 . 50 Another interesting question which can be addressed from these estimates is the maximal impact of experience on mean wages.013 . Computing the Wald statistic (6. The available sample is 18.49452 σ ˜ Notice that the two statistics are close.4945.102 −.010 .032 . but not equal.1 we ﬁnd the point estimate ˆ ˆ = − β 2 = 28.070 .69.48772 = 515.

so we have to go one step further. not testing a hypothesis. as the coverage probability of this conﬁdence interval is one minus the Type I error of the hypothesis test based on the t-test. we found better Type I error rates by reformulating the hypothesis as a linear restriction. Since tn (θ) is a non-linear function of θ. but it can be found numerically quite easily. Instead. there is not a simple expression for this set.9.40.5].0.Using the Delta Method.5]. 29. 29. implying a 95% conﬁdence θ) interval of [27. Notice that the upper end of the conﬁdence interval is the same as that from the delta method. Our desired conﬁdence interval will be the set of parameter values θ which are not rejected by the hypothesis test. This is the set of θ such that |tn (θ)| ≤ 1. this is a poor choice. In the previous section we discovered that such t-tests had very poor Type I error rates.96. 69 . 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 ). In the present context we are interested in forming a conﬁdence interval. However. we can calculate a standard error of s(ˆ = . but the lower end is substantially lower. This set is [27.

In the model Y = X1 β 1 + X2 β 2 + e. and rank(R) = s. (c) Show that if R0 β = r is true. ˜ (e) Find an appropriate formula to calculate standard errors for the elements of β. In the model Y = X1 β 1 + X2 β 2 + e. 0 < s < k. 4. β 2 ). Explain why β solves the minimization of the Lagrangian ¢ ¡ 1 L(β. λ) = Sn (β) + λ0 R0 β − r 2 where λ is s × 1. subject to the constraint that β 1 = −β 2 . β − β = Ik − X 0 X 70 . the following deﬁnition is used. β minimizes the sum of squared errors Sn (β) over all β such that the restriction holds. r ˜ is a known s × 1 vector. (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. 2. ﬁnd the least-squares estimate of β = (β 1 . β 2 ) subject to the constraint that β 2 = 0 is the OLS regression of Y on X1 . ﬁnd the asymptotic distribution of √ ³˜ n β − β as n → ∞.6. (d) Under the ´ standard assumptions plus R0 β = r. ˜ (b) Verify that R0 β = r. show that the least-squares estimate of β = (β 1 . then ¶ µ ¡ ¢−1 h 0 ¡ 0 ¢−1 i−1 0 ¡ 0 ¢−1 0 ˜ XX R R XX R R X e. show that the least-squares estimate of β = (β 1 . 3. subject to the constraint that β 1 = c (where c is some given vector) is simply the OLS regression of Y − X1 c on X2 . In the model Y = X1 β 1 + X2 β 2 + e. In the model Y = Xβ + e. 1.16 Exercises For exercises 1-4. the least-squares estimate of β subject to the restriction h(β) = 0 is ˜ β = argmin Sn (β) h(β)=0 Sn (β) = (Y − Xβ)0 (Y − Xβ) . β 2 ). ˜ That is. Take the model Y = Xβ + e with the restriction R0 β = r where R is a known k × s matrix.

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

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

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

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

or equivalently that i H0 : α1 = 0 in the regression (7. we impose the stronger hypothesis and test the hypothesis that ei is independent of xi . In the linear regression model the conditional mean of yi given xi = x is 77 . White (1980) proposed that the test for heteroskedasticity be based on setting zi to equal all non-redundant elements of xi . on the other hand. Vα = E zi zi (7. Typically. 7. If i this simpliﬁcation is replaced by the standard formula (under independence of the error).7) Hence the standard test of H0 is a classic F (or Wald) test for exclusion of all regressors from the skedastic regression (7. and the cost is a reduction of robustness to misspeciﬁcatio 7. If the equation of interest is a linear projection.4) and constructing a Wald statistic. Third. the two tests coincide. σ 2 ). but also under the assumptions of linear projection. The main diﬀerences between popular “tests” is which transformations of xi enter zi . The point is that the eﬃciency gains from FGLS are built on the stronger assumption of a correct conditional mean. Second. the estimated conditional variances may contain more noise than information about the true conditional variances. Motivated by the form of the asymptotic variance ˆ of the OLS estimator β.2). q Most tests for heteroskedasticity take this basic form. however. The GLS and FGLS estimators. This introduces an element of arbitrariness which is unsettling to empirical researchers. OLS is a more robust estimator of the parameter vector.4). and this requires trimming to solve. then the OLS and FGLS estimators will converge in probability to diﬀerent limits. as they will be estimating two diﬀerent projections. but the only diﬀerence is that they a ¢ allowed for general choice of zi . The asymptotic distribution (7. its squares. In this case.5) and the asymptotic variance (7. We may therefore test this hypothesis by the estimation (7.3) for α simpliﬁes to ¡ ¡ 0 ¢¢−1 ¡ 2 ¢ E ξi . And the FGLS probability limit will depend on the particular function selected for the skedastic regression. BreuschPagan (1979) proposed what might appear to be ¡ distinct test. in which case ξ i is ˜ independent of xi and the asymptotic variance (7.2 Testing for Heteroskedasticity ¢ ¡ The hypothesis of homoskedasticity is that E e2 | xi = σ 2 . and not a conditional mean. and all cross-products. This hypothesis does not imply that ξ i is independent of xi .error.2.7) under independence show that this test has an asymptotic chi-square distribution. individual estimated conditional variances may be negative.1 Under H0 and ei independent of xi . and replaced E ξ 2 with 2σ 4 which holds when ei is N(0. the Wald test of H0 is asymptotically χ2 . require the assumption of a correct conditional mean. FGLS will do worse than OLS in practice. It is consistent not only in the regression model. Theorem 7.3 Forecast Intervals m(x) = E (yi | xi = x) = x0 β.

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

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

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

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

The main diﬃculty is the estimation of f (0). we provide a sketch here for completeness. ∂β 0 so Third.Theorem 7. the height of the error density at its median.1 ´ √ ³ˆ n β − β 0 →d N (0. Computation of standard error for LAD estimates typically is based on equation (7. ¢¢−1 ¡ ¢¢−1 ¢¡ ¡ 1¡ ¡ 0 Exi x0 E xi x0 f (0 | xi ) E xi xi f (0 | xi ) i i 4 The variance of the asymptotic distribution inversely depends on f (0 | x) . by the central limit theorem (Theorm 5. then f (0 | x) = f (0) and the asymptotic variance simpliﬁes V = (Exi x0 )−1 i 4f (0)2 (7. We need where g n (β) = n i i=1 gi (β) and gi (β) = xi (1 − 2 · 1 (yi ≤ xi three preliminary result. See Chapter 16. In the special case where the error is independent of xi . where V = and f (e | x) is the conditional density of ei given xi = x.5.1) n X √ −1/2 n (g n (β 0 ) − g(β 0 )) = −n gi (β 0 ) →d N (0. Pn −1 0 β)) . While a complete proof of Theorem 7.10) is equivalent to g n (β) = 0. then there are many innovations near to the median.3. the conditional density of the error at its median. Exi x0 ) i i=1 since Egi (β 0 )gi (β 0 )0 = Exi x0 .11). Second using the law of iterated expectations and the chain rule of i diﬀerentiation. Let g(β) = Eg (β). ˆ Proof of Theorem 7. by a Taylor series expansion and the fact g(β 0 ) = 0 82 . This can be done with kernel estimation techniques. When f (0 | x) is large. First. ∂β ˆ g(β) ' ´ ³ ∂ ˆ g(β 0 ) β − β 0 .5.11) This simpliﬁcation is similar to the simpliﬁcation of the asymptotic covariance of the OLS estimator under homoskedasticity. and this improves estimation of the median. (7.1: Since sgn (a) = 1 − 2 · 1 (a ≤ 0) . ∂ g(β) = ∂β 0 ¡ ¡ ¢¢ ∂ 0 0 Exi 1 − 2 · 1 yi ≤ xi β ∂β £ ¡ ¡ ¢ ¢¤ ∂ = −2 0 E xi E 1 ei ≤ x0 β − x0 β 0 | xi i i ∂β " Z 0 # xi β−x0 β 0 i ∂ = −2 0 E xi f (e | xi ) de ∂β −∞ £ ¢¤ ¡ = −2E xi x0 f x0 β − x0 β 0 | xi i i i £ 0 ¤ ∂ 0 g(β 0 ) = −2E xi xi f (0 | xi ) .5.1 is advanced. V ).

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

Thus. then f (0 | xi ) = f (0) . One simple test for neglected nonlinearity is to add nonlinear functions of the regressors to ˆ ˆ the regression. and are widely available. ´ √ ³ˆ Theorem 7. the asymptotic variance depends on the conditional density of the quantile regression error. Fortunately. Furthermore. and test their signiﬁcance using a Wald test. Vτ ). 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 (7.1 n β τ − β τ →d N (0. n numerical methods are necessary for its minimization.1. otherwise its properties are unspeciﬁed without further restrictions. the τ ’th conditional quantile of ei is zero. 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. and we have the simpliﬁcation Vτ = τ (1 − τ ) ¡ ¡ 0 ¢¢−1 . it is useful to have a general test of the adequacy of the speciﬁcation. conventional Newton-type optimization methods are inappropriate. E xi xi f (0)2 A recent monograph on the details of quantile regression is Koenker (2005). 7. and form a Wald statistic i for γ = 0.13). if the model yi = x0 β + ei has i been ﬁt by OLS. the unconditional density of ei at 0. ˆ Given the representation (7.5. where and f (e | x) is the conditional density of ei given xi = x.6. fast linear programming methods have been developed for this problem. The null model is yi = x0 β + εi i 84 . When the error ei is independent of xi . i By construction. ¡ ¡ ¢¢−1 ¡ ¢¢−1 ¢¡ ¡ Exi x0 E xi x0 f (0 | xi ) Vτ = τ (1 − τ ) E xi x0 f (0 | xi ) i i i ¢ 1X ¡ ρτ yi − x0 β i n i=1 In general.where ei is the error deﬁned to be the diﬀerence between yi and its τ ’th conditional quantile x0 β τ . since it has discontinuous derivatives. Since the quanitle regression criterion function Lτ (β) does not have an algebraic solution.12).7 Testing for Omitted NonLinearity If the goal is to estimate the conditional expectation E (yi | xi ) . A asymptotic distribution theory for the quantile regression estimator can be derived using similar arguments as those for the LAD estimator in Theorem 7. Another popular approach is the RESET test proposed by Ramsey (1969).

since Q12 Q−1 Q21 > 0. note that (7. The comparison between the two estimators is straightforward when the error is conditionally ¢ ¡ homoskedastic E e2 | xi = σ 2 . Now let ˆ i ⎛ 2 ⎞ yi ˆ ⎜ . It is easy (although somewhat tedious) to show that under the null hypothesis. and n→∞ say. One estimator of β 1 is to regress 0 0 ˜ yi on x1i alone. ⎠ . β 2 ).14) by OLS. 7.8 Irrelevant Variables yi = x0 β 1 + x0 β 2 + ei 1i 2i E (xi ei ) = 0. Otherwise. Under which conditions is β 1 or β 1 superior? It is easy to see that both estimators are consistent for β 1 . 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 . yielding ˆ ˜ ˆ ˆ (β 1 . and form the Wald statistic Wn for γ = 0. or 4 seem to work best. However. yi ˆm (7. In this case i ¡ ¢−1 2 ˜ σ = Q−1 σ 2 . 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. Then run the auxiliary regression ˆ 0 ˜ yi = x0 β + zi γ + ei ˜ ˜ i ˆ which is estimated by OLS. 1i 2i 2i 1i 22 . To implement the test. lim nV ar( β 1 ) = Ex1i x0 1i 11 n→∞ say.be an (m − 1)-vector of powers of yi . and consequently 22 ¡ ¢−1 2 σ . 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. m must be selected in advance. Another is to regress yi on x1i and x2i jointly. Thus the null is rejected at the α% level if Wn m−1 exceeds the upper α% tail critical value of the χ2 m−1 distribution. and the two estimators have equal asymptotic eﬃciency. Wn →d χ2 . they will (typically) have diﬀerence asymptotic variances. then 22 Q11 > Q11 − Q12 Q−1 Q21 . ⎟ zi = ⎝ . 3. β 1 = (X1 X1 )−1 (X1 Y ) . If Q12 = 0 (so the variables are orthogonal) then these two variance matrices equal. In the model x2i is “irrelevant” if β 1 is the parameter of interest and β 2 = 0. small values such as m = 2. Typically. To see why this is the case.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.

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

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

β 2 = β 3 = · · · = β K = 0 M2 : β 1 6= 0. which can be a very large number. . and then selects the model with the lowest AIC (7. β K 6= 0. . 210 = 1024. The AIC selection criteria estimates the K models by OLS. there are 2K such models. . xKi }. E (εi | xi ) = 0 and the question is which subset of the coeﬃcients are non-zero (equivalently. In the latter case. which regressors enter the regression). We have discussed model selection between two models. The methods extend readily to the issue of selection among multiple regressors. log(n) µ LRn > k2 | M2 log(n) ¶ ´ ³ c P M = M2 | M2 = P → 1. In the ordered case. selecting based on (7. . a full-blown implementation of the BIC selection criterion would seem computationally prohibitive. . β 2 6= 0. β 3 = · · · = β K = 0 . one can show that thus LRn →p ∞. Also under M2 .17).15). a model consists of any possible subset of the regressors {x1i . 88 .. 576. the models are M1 : β 1 6= 0. which are nested.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. For example. . β 2 6= 0. In the unordered case. and 220 = 1. . The general problem is the model yi = β 1 x1i + β 2 x1i + · · · + β K xKi + εi . There are two leading cases: ordered regressors and unordered. Similarly for ˆ the BIC. However. MK : β 1 6= 0.. stores the residual variance σ 2 for each model. 048.. and the AIC or BIC in principle can be implemented by estimating all possible subset models.

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

add the variable (ln Qi )2 to the regression. The model is non-linear because of the parameter a7 . In addition. Find an asymptotic 95% conﬁdence interval for g(x). θ is the NLLS estimator. In Chapter 6. Assess the merits of this new speciﬁcation using (i) a hypothesis test. Consider model (7. (iii) BIC criterion. calculate zi and estimate the model by OLS. For values of ln Qi much below a7 .. a7 ). I recommend the concentration method: Pick 10 (or more or you like) values of a7 in this range. Consider the two estimators ˆ β = ˜ β = Pn i=1 x y Pn i 2 i i=1 xi n 1 X yi . 8. (d) Calculate standard errors for all the parameters (a1 . Do so. n xi i=1 (a) Under the stated assumptions. Exercise 13.18) plus the extra term a6 zi . The model works best when a7 is selected so that several values (in this example. the variable ln Qi has a regression slope of a2 . For each value of a7 .18) (a) Following Nerlove. For values much above a7 . (ii) AIC criterion. the regression slope is a2 + a6 . and the model imposes a smooth transition between these regimes.ˆ ˆ 7. Do you agree with this modiﬁcation? (b) Now try a non-linear speciﬁcation.. 90 . . You are interested in the conditional mean function E (yi | xi = x) = θ g(x) at some x. are both estimators consistent for β? (b) Are there conditions under which either estimator is eﬃcient? 9. and V is the = g(x estimate of V ar ˆ . you estimated a cost function on a cross-section of electric companies. Suppose that yi ³ ´ i .. and ﬁnd the value of a7 for which the sum of squared errors is minimized. (7. The model is yi = xi β + ei E (ei | xi ) = 0 where xi ∈ R. at least 10 to 15) of ln Qi are both below and above a7 . (c) Estimate the model by non-linear least squares. This model is called a smooth threshold model. impose the restriction a3 + a4 + a5 = 1. 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 . where zi = ln Qi (1 + exp (− (ln Qi − a7 )))−1 . Record the sum of squared errors. Examine the data and pick an appropriate range for a7 .

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

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

xi ). note that for any (y. x∗ ) with the i distribution Fn . x). √ n (Fn (y. but the approximation appears to improve for the large n. x) (1 − F (y. The random draws are from the N (0. i 93 . ∗ P (yi ≤ y.. x)) →d N (0. The EDF is a consistent estimator of the CDF. This is a population moment.. x))) . Fn is a nonparametric estimate of F. To see this. x) is called the empirical distribution function (EDF). x∗ ≤ x) = Fn (y. by the CLT (Theorem 5.1: Empirical Distribution Functions The EDF is a valid discrete probability distribution which puts probability mass 1/n at each ∗ pair (yi . I have plotted the EDF and true CDF for three random samples of size n = 25. 50. xi ≤ x) = E (1 (yi ≤ y) 1 (xi ≤ x)) .8. i = 1. it is helpful to think of a random pair (yi .2) Fn (y. Thus by the WLLN (Theorem 5.1). x) →p F (y. x) = P (yi ≤ y. Fn is by construction a step function. the EDF step function gets uniformly close to the true CDF. For n = 25.. Notationally. n. in the Figure below. Furthermore. Note that while F may be either discrete or continuous. . F (y.1). x) − F (y. (8. as the sample size gets larger.2 The Empirical Distribution Function Fn (y. To see the eﬀect of sample size on the EDF. That is. the EDF is only a crude approximation to the CDF. In general. 1) distribution. x). Fn (y. where 1(·) is the indicator function. x) . and 100. Recall that F (y. x).2.3. 1 (yi ≤ y) 1 (xi ≤ x) is an iid random variable with expectation F (y. The method of moments estimator is the corresponding sample moment: n 1X 1 (yi ≤ y) 1 (xi ≤ x) . x) = n i=1 Figure 8.

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

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

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

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

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

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

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

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

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

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

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

What is wrong with this procedure? Tn = θ/s(θ) n 6. (a) Report the 95% Efron Percentile interval for θ. ˆ = 1. 105 . θ respectively. ∗ ∗ where s(ˆ is the standard error in the original data.5% and 97.95) denote the 5% θ) ∗ and 95% quantiles of Tn .2. you generate bootstrap samples. The dataﬁle hprice1.5% quantiles of the ˆ are . size of house. ˆ − s(ˆ n (. can you report the 95% Percentile-t interval for θ? 7. Estimate a linear regression of price on the number of bedrooms. The test for H0 is to reject if Tn = ˆ ˆ > c where c is picked so that Type I error is α.dat contains data on house prices (sales). The ˆ are sorted.2 and s(ˆ = .Show that C exactly equals the Alternative percentile interval (not the percentile-t interval). Suppose that in an application.95).pdf. You replace c with qn (. Let qn (.95). and thus reject H0 if ˆ ˆ > q ∗ (. and the colonial dummy. Calculate 95% conﬁdence intervals for the regression coeﬃcients using both the asymptotic normal approximation and the percentile-t bootstrap. and the 2.3. θ θ) ∗ 1000 samples are generated from the bootstrap distribution. (b) Report the 95% Alternative Percentile interval for θ.95) denote the 95% quantile of Tn . θ θ)q ∗ θ θ)q ∗ θ/s(θ) 5. and ˆ is calculated on each θ ∗ ∗ θ sample. lot size. Using the non-parametric bootstrap. with variables listed in the ﬁle hprice1.05) and qn (. (c) With the given information.95). ∗ ∗ ∗ Let qn (. Using the non-parametric ∗ bootstrap.05) . You do this as follows. calculate the estimates ˆ on these samples and θ then calculate ∗ ∗ ∗ θ θ Tn = ˆ /s(ˆ ). and deﬁne the bootstrap conﬁdence interval h i C = ˆ − s(ˆ n (. You want to test H0 : θ = 0 against H1 : θ > 0.75 and 1.

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

let Jn (β) = n · g n (β)0 Wn g n (β). ˆ Deﬁnition 9. The ﬁrst order conditions for the GMM estimator are 0 = ∂ ˆ Jn (β) ∂β ∂ ˆ ˆ = 2 g n (β)0 Wn g n (β) ∂β ´ 1 1 ³ ˆ = −2 Z 0 XWn X 0 Y − Z β n n so which establishes the following. The GMM estimator minimizes Jn (β). For example. if Wn = I. Proposition 9. but this is generally not possible when > k. β ˆ Note that if k = . β GMM = Z 0 XWn X 0 Z 9.1 β GMM = argmin Jn (β).2) g n (β) = (9. This is a non-negative measure of the “length” of the vector g n (β). Let and where gi = xi ei . gi (β) = xi yi − zi β = n n n i=1 i=1 Deﬁne the sample analog of (9. Jn (β) = n · g n (β)0 g n (β) = n · |g n (β)|2 . 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 . for if Wn is replaced ˆ by cWn for some c > 0. The idea of the generalized method of moments (GMM) is to deﬁne an estimator which sets g n (β) “close” to zero. the square of the Euclidean length.2 GMM Estimator n n ¢ 1¡ 0 ¢ 1X 1X ¡ 0 X Y − X 0 Zβ . For some × weight matrix Wn > 0. the dependence is only up to scale.9.3 Distribution of GMM Estimator ¡ 0¢ Q = E xi zi Assume that Wn →p W > 0. then. and the GMM estimator is the MME. β GMM does not change.2. then g n (β) = 0.3) The method of moments estimator for β is deﬁned as the parameter value which sets g n (β) = 0.1 ˆ 2Z 0 XWn X 0 Z β = 2Z 0 XWn X 0 Y While the estimator depends on Wn . ¡ ¢−1 0 ˆ Z XWn X 0 Y. i i .2.

9. W0 = Ω−1 is not known in practice. The proof is left as an exercise. V ) . it turns out that the GMM estimator is semiparametrically eﬃcient. Given any such ﬁrst0ˆ ˆ ˆ ˆ step estimator. n β − β →d N 0. the GMM estimator β is consistent yet ineﬃcient.2 For the eﬃcient GMM estimator. ˆ Construct n 1X ˆ g n = g n (β) = gi . Q0 Ω−1 Q ¢−1 ¡ 0 ¢¡ ¢−1 ¡ . This turns out to be W0 = Ω−1 . The optimal weight matrix W0 is one which minimizes V. ˆ n i=1 gi = gi − g n . Since the GMM estimator has this can have a smaller asymptotic variance than G0 Ω−1 G asymptotic variance. this is a semi-parametric problem. Chamberlain showed that in this context. However. as we are only considering alternative weight matrices Wn . it is semiparametrically eﬃcient. ˆ∗ ˆ 108 . and this is all that is known. This results shows that in the linear model. where In general. No estimator can do better (in this ﬁrst-order asymptotic sense). β). without imposing additional assumptions. 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 . This yields the eﬃcient GMM estimator: ¢−1 0 ¡ ˆ Z XΩ−1 X 0 Y. we can deﬁne the residuals ei = yi −zi β and moment equations gi = xi ei = g(wi . For example. GMM estimators are asymptotically normal with “sandwich form” asymptotic variances. If it is known that E (gi (β)) = 0. no estimator has greater asymptotic eﬃciency than the eﬃcient linear GMM estimator.4 Estimation of the Eﬃcient Weight Matrix ˆ Given any weight matrix Wn > 0.3. we can set Wn = I . Q W ΩW Q Q0 W Q V = Q0 W Q Thus we have Theorem 9. as shown by Gary Chamberlain (1987). n n We conclude: Theorem 9. but it can be estimated consistently. This is a weak concept of optimality. as the distribution of the data is unknown. as it has the same asymptotic distribution.and µ µ ¶ ¶ 1 0 1 0 Z X Wn X e →d Q0 W N (0. β = Z 0 XΩ−1 X 0 Z ´ ³ ¡ ¢−1 ´ √ ³ˆ .1 ´ √ ³ˆ n β − β →d N (0. a better choice is Wn = (X 0 X)−1 . In the linear model.3. ˆ We have described the estimator β as “eﬃcient GMM” if the optimal (variance minimizing) weight matrix is selected. Ω) . ˆ we still call β the eﬃcient GMM estimator. no semiparametric estimator (one which is consistent globally for the class of models considered) ¢−1 ¡ .

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

β) = 0 holds.1 (Sargan-Hansen).6. 9.5. Thus the model — the overidentifying restrictions — are testable. n β − β →d N 0. ´ ³ ¡ ¢−1 ´ √ ³ˆ Theorem 9. Identiﬁcation requires l ≥ k = dim(β).1 Under general regularity conditions. This estimator can be iterated if needed. this is all that is known.Often. 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 . 1 2 It is possible that β 2 = 0. perhaps obtained by ﬁrst ˆ setting Wn = I. ˆ J = J(β) →d χ2−k . Since the GMM estimator depends upon the ﬁrst-stage estimator. 110 . Hansen (1982). and thus g n can be used to assess whether or not the hypothesis that Egi = 0 is true or not. 1 it is possible that β 2 6= 0. take the linear model yi = β 0 x1i + β 0 x2i + ei with E (x1i ei ) = 0 and E (x2i ei ) = 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). i i i i ∂β 1X 0 gi gi − g n g 0 ˆˆ n n i=1 n !−1 . However. 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. G0 Ω−1 G .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 . Note that g n →p Egi . where ³ ´−1 ∂ 0 ˆ ˆ ˆ ˆ Ω = (E (gi gi ))−1 and G = E ∂β 0 gi (β). and in this case it would be impossible to ﬁnd a value of β 1 so that both E (x1i (yi − x0 β 1 )) = 0 and E (x2i (yi − x0 β 1 )) = 0 hold simultaneously. For example. ˆˆ n is a quadratic form in g n . Theorem 9. and is thus a natural test statistic for H0 : Egi = 0. so that the linear equation may be written as yi = β 0 x1i + ei . In this sense an 1i 1i exclusion restriction can be seen as an overidentifying restriction. The general theory of GMM estimation and testing was exposited by L. Under the hypothesis of correct speciﬁcation. often the weight ˆ matrix Wn is updated. and if the weight matrix is asymptotically eﬃcient. and then β recomputed.

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

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

A straightforward application of the nonparametric bootstrap works in the sense of consistently achieving the ﬁrst-order asymptotic distribution. namely that improved eﬃciency can be obtained if the observations are weighted inversely to the conditional variance of the errors. To date. ˆ where g n (β) is from the in-sample data. i i 9. not just an arbitrary linear projection. ˆ Brown and Newey (2002) have an alternative solution. In the linear model. wn } with the empirical likelihood probabilities {ˆi } described in Chapter X. this sampling scheme preserves the moment conditions of the model. 1 ´ Pn ˆ = 0. identically as in the regression model. In other words. Thus according to ∗ . we need the best conditional mean model for zi given xi .and so In the case of linear regression. They note that we can sample from the p observations {w³. Given the bootstrap sample (Y ∗ . caution should be applied when interpreting such results. However. The bootstrap J statistic is J ∗ (β ). and deﬁne all statistics and tests accordingly. zi ). 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. 113 . zi = xi . A correction suggested by Hall and Horowitz (1996) can solve the problem. as this is a very new area of research. to get the best instrument for zi . Furthermore. β is the “true” value and yet g n (β) 6= 0. and construct conﬁdence intervals for β. 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. not from the bootstrap data. ∗ ˆ Let β minimize J ∗ (β). x∗ . ˆ ˆ The problem is that in the sample. xi . so ˆ Since i=1 pi gi β no recentering or adjustments are needed. . random variables (yi i i n ³ ³ ´´ ˆ ˆ E gi β = g n (β) 6= 0.9 Bootstrap GMM Inference ˆ Let β be the 2SLS or GMM estimator of β.. Z ∗ ). we can apply the ˆ bootstrap methods discussed in Chapter 8 to compute estimates of the bias and variance of β.. as we i discussed earlier in the course. X ∗ . Hence eﬃcient GMM is GLS. the bootstrap applied J test will yield the wrong answer. This has been shown by Hahn (1996). Brown and Newey argue that this bootstrap procedure will be more eﬃcient than the Hall-Horowitz GMM bootstrap. this implies that the bootstrap estimator is ¢−1 ¡ ∗0 ∗ ∗ ¡ ∗0 ∗ ¡ ¢¢ ˆ∗ Z X W X Y − X 0e . there are very few empirical applications of bootstrap GMM. note that the eﬃcient instrument Ai involves the estimation of the conditional mean of zi given xi . In the case of endogenous variables. Using the EDF of (yi . jeopardizing the theoretical justiﬁcation for percentile-t methods. it fails to achieve an asymptotic reﬁnement when the model is over-identiﬁed. i ¡ ¢ σ 2 = E e2 | xi . so Ai = σ −2 xi . Ai = σ −2 E (zi | xi ) .. z ∗ ) drawn from the EDF F . However. The eﬃcient instrument is also inversely proportional to the conditional variance of ei . This is the same as the GLS estimator.

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

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

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

3) i=1 117 .. 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. xi . (10.Chapter 10 Empirical Likelihood 10. . xi . zi . pn ) = i=1 An alternative to GMM is empirical likelihood.. 2001) and has been extended to moment condition models by Qin and Lawless (1994). β).. Combined with i the constraint (10. these probabilities must satisfy the requirements that pi ≥ 0 and n X pi = 1. pn ) which places probability pi at each observation. ..1 Non-Parametric Likelihood Since each observation is observed once in the sample.. In this case the moment condition places no additional restrictions on the multinomial distribution. (10.. The multinomial distribution which places probability pi at each observation (yi . pn ) are those which maximize the log-likelihood subject to the constraint (10.. zi ) will satisfy this condition if and only if n X pi gi (β) = 0 (10. . It is a non-parametric analog of likelihood estimation. the log-likelihood function for this multinomial distribution is n X ln(pi ). 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 . To be a valid multinomial distribution. The maximum likelihood estimator of the probabilities (p1 .. The n ﬁrst order conditions are 0 = p−1 − µ. The idea is to construct a multinomial distribution F (p1 . The idea is due to Art Owen (1988.1)..1) i=1 First let us consider a just-identiﬁed model.2) Ln (p1 .1) we ﬁnd that the MLE is pi = n−1 yielding the log-likelihood −n log(n).

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

10. Vλ ) ´ √ ˆ √ ³ˆ where V and Vλ are deﬁned in (10. Thus the EL estimator is asymptotically eﬃcient. i=1 i=1 i=1i Expanding (10. (β. λ) jointly solve ³ ´ ˆ n gi β X ∂ ³ ³ ´´ Rn (β. i i Theorem 10. 0 = Rn (β.9) and (10.10). ˆ The asymptotic variance V for β is the same as for eﬃcient GMM. Gi (. in the linear model. ´ √ ³ ˆ n β − β 0 →d √ ˆ nλ →d N (0. β λ ∂ ³ ´. g n = n n gi (β 0 ) and Ωn = n n g (β 0 ) gi (β 0 )0 . G = −E (xi zi ). and n β − β 0 and nλ are asymptotically independent. λ) = − (10.13) yields n n Expanding (10.8) and ¢ 0 0 For example.13) Premultiplying by G0 Ω−1 and using (10. n (10.2. λ) = − (10.12) ∂β ˆ ˆ0 i=1 1 + λ gi β 1 P 1 P 1 P Let Gn = n n Gi (β 0 ) .10) ¡ Ω−1 N (0.9) (10.14) ³ ´ ˆ ˆ 0 ' −G0 Ω−1 g n − G0 Ω−1 Gn β − β 0 + G0 Ω−1 Ωn λ n n n n n n ³ ´ ˆ = −G0 Ω−1 g n − G0 Ω−1 Gn β − β 0 n n n n 119 .12) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ 0 ' G0 λ − λ0 . and Ω = E xi x0 e2 .11) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ ˆ 0 ' −g n − Gn β − β 0 + Ωn λ (10.1 Under regularity conditions. 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. ˆ ˆ Proof.2 Deﬁne Asymptotic Distribution of EL Estimator Gi (β) = ∂ gi (β) ∂β 0 (10. β) = −xi zi .11) 0 = ∂λ ˆ0 ˆ i=1 1 + λ gi β ³ ´0 ˆ n X Gi .

β 0 ) = 0 then LRn →d χ2−k . The same statistic can be constructed for empirical likelihood. Since the EL estimator achieves this bound. They are asymptotically ﬁrst-order equivalent. (10.15). This means that no consistent estimator for this class of models can have a lower asymptotic variance than V . V ) ˆ Solving (10. ¥ Chamberlain (1987) showed that V is the semiparametric eﬃciency bound for β in the overidentiﬁed moment condition model.3. Ω) GΩ G →d = N (0. it is an asymptotically eﬃcient estimator for β. and (10. Twice the diﬀerence between the unrestricted empirical likelihood −n log (n) and the maximized empirical likelihood for the model (10. 10.17) 2 ln 1 + λ gi β . Vλ ) Furthermore.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. tests are based on the diﬀerence in the log likelihood functions.1 If Eg(wi . 120 . First.16) ´ √ ˆ √ ³ˆ n β − β 0 and nλ are asymptotically uncorrelated and hence independent. and have the same interpretation.16). 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. and it is advisable to report the statistic LRn whenever EL is the estimation method.14) for λ and using (10. Ω) →d Ω−1 I − G G Ω G GΩ = Ω−1 N (0. The EL overidentiﬁcation test is similar to the GMM overidentiﬁcation test. n ³ ´´ ´ √ ³ 1 X ³ ˆ ˆ √ g wi . The overidentiﬁcation test is a very useful by-product of EL estimation.3 Overidentifying Restrictions In a parametric likelihood context.7) is n ³ ´´ ³ X ˆ ˆ0 (10. by a Taylor expansion. since ³ ¡ ¢−1 0 ´ G0 I − Ω−1 G G0 Ω−1 G G =0 (10. Proof.ˆ Solving for β and using the WLLN and CLT yields ´ ¢−1 0 −1 √ ¡ √ ³ ˆ ' − G0 Ω−1 Gn n β − β0 Gn Ωn ng n n n ¡ 0 −1 ¢−1 0 −1 G Ω N (0.15) (10. LRn = i=1 Theorem 10.

so there is no fundamental change in the distribution theory for β relative to β. a The proof of this result is more challenging and is omitted.prc 121 .17) is not appropriate.Second. This test statistic is a natural analog of the GMM distance statistic. The hypothesis of interest is h(β) = 0.18) and H0 : h(β) = 0. Theorem 10.18) Let the maintained model be where g is × 1 and β is k × 1. h(β)=0 ˜ Fundamentally. Instead we use the diﬀerence in log-likelihoods: ³ ´ ˆ ˜ LRn = 2 Ln − Ln . Vλ ) ¥ where the proof of the ﬁnal equality is left as an exercise.4. where h : Rk → Ra . By “maintained” we mean that the overidentfying restrictions contained in (10. since ln(1 + x) ' x − x2 /2 for x small. Vλ )0 Ω−1 N (0. The restricted EL estimator and likelihood are the values which solve ˜ β = argmax Ln (β) h(β)=0 ˜ ˜ Ln = Ln (β) = max Ln (β).wisc. LRn →d χ2 .18).ssc. 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 (0.1 Under (10. 10.4 Testing Egi (β) = 0 (10. To test the hypothesis h(β) while maintaining (10. the restricted EL estimator β is simply an EL estimator with − k + a overidenti˜ ˆ fying restrictions.5 Numerical Computation Gauss code which implements the methods discussed below can be found at http://www. the simple overidentifying restrictions test (10.edu/~bhansen/progs/elike.18) are assumed to hold and are not being challenged (at least for the test discussed in this section). 10.

i Rββ = Inner Loop The so-called “inner loop” solves (10. λ)0 0 Rn (β.Derivatives The numerical calculations depend on derivatives of the dual likelihood function (10. λ) gi (β. Deﬁne ∗ gi (β.19) X ∂2 ∗ ∗ gi (β. λ) G∗ (β. The value of δ which minimizes this quadratic is ˆ = R2 + 3R0 − 4R1 . A complication is that λ must be constrained so that 0 ≤ pi ≤ 1 which holds if ¢ ¡ n 1 + λ0 gi (β) ≥ 1 122 (10.4) are Rλ = Rβ = The second derivatives are Rλλ = Rλβ = ¡ Gi (β)0 λ 1 + λ0 gi (β) gi (β) ¢ 1 + λ0 gi (β) X ∂ ∗ Rn (β. λ) ∂λ i=1 n ∂ Rn (β. The modiﬁed Newton method takes a quadratic approximation to Rn (β. λ) . λ) = i ∂λ∂β 0 1 + λ0 gi (β) i=1 ⎞ ⎛ ¡ 0 ¢ ∂2 n 2 X 0 gi (β) λ ∂ ⎠ ⎝G∗ (β. λ) yielding the iteration rule λj+1 = λj − δ (Rλλ (β. λp ) A quadratic function can be ﬁt exactly through these three points. λ)0 − ∂β∂β Rn (β.19). λ) = i i ∂β∂β 0 1 + λ0 gi (β) i=1 n where δ > 0 is a scalar steplength (to be discussed next). λj )) Rp = Rn (β. The iteration (10. set 2 λp = λj − δ p (Rλλ (β.5) for given β.20) . λ) = − gi (β. λj ) is smaller than some prespeciﬁed tolerance. One method uses the following quadratic approximation. 2. λ) = ∂λ∂λ i=1 ¶ n 2 Xµ ∂ Gi (β) ∗ gi (β. λ) = i The ﬁrst derivatives of (10. λ) = G∗ (β. δ 1 = 1 and δ 2 = 1. (10. Eﬃcient convergence requires a good choice of steplength δ. λ)0 − Rn (β.4). The starting value λ1 can be set to the zero vector. δ 4R2 + 4R0 − 8R1 yielding the steplength to be plugged into (10. λj ) . λ) G∗ (β. 1.19) is continued until the gradient Rλ (β. Set δ 0 = 0. For p = 0.. λj ))−1 Rλ (β. λ) = − ∂β n X i=1 G∗ (β. λj ))−1 Rλ (β.

123 . It is not guaranteed that Lββ > 0. the stepsize δ needs to be decreased. If not. λ(β)) + λ0 Rλ (β. λ(β)) = 0. Outer Loop The outer loop is the minimization (10. The Hessian for (10.20) fails.6).for all i. λ) = Rβ + λ0 Rλ = Rβ β ∂β ∂β since Rλ (β. This can be done by the modiﬁed Newton method described in the previous section. and the rule is iterated until convergence.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. λ) = 0 at λ = λ(β). λ(β)) + Rλβ λβ + λ0 Rλβ + λ0 Rλλ λβ β β −1 0 = Rλβ Rλλ Rλβ − Rββ . where λβ = ∂ −1 λ(β) = −Rλλ Rλβ . the eigenvalues of Lββ should be adjusted so that all are positive. λ(β)) β ∂β ¡ ¢ 0 = − Rββ (β.6) is Lβ = ∂ ∂ Ln (β) = Rn (β. If (10. ∂β 0 the second equality following from the implicit function theorem applied to Rλ (β. The gradient for (10.

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

some regressors in zi will be uncorrelated with ei (for example. 11.1) the structural equation. at least the intercept). In matrix notation.4) xi = x2i 2 where z1i = x1i are the included exogenous variables.1) if E (xi ei ) = 0. (11. This is called simultaneous equations bias. z1i is an instrumental variable for (11.1 The × 1 random vector xi is an instrumental variable for (11. That is x2i are variables which could be included in the equation for yi (in the sense 125 . and x2i are the excluded exogenous variables. So we have the partition µ ¶ z1i k1 (11. We call z1i exogenous and z2i endogenous.1.1 Instrumental Variables 0 yi = zi β + ei Let the equation of interest be (11. By the above deﬁnition. this can be written as Y = Zβ + e. We call (11. which does not equal either β 1 or β 2 . Deﬁnition 11.2) Any solution to the problem of endogeneity requires additional information which we call instruments.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) where zi is k × 1. β →p β ∗ . and assume that E(zi ei ) 6= 0 so there is endogeneity. In a typical set-up. ¶ µ ∙ β2 β1 1 −1 β 2 e1i + β 1 e2i (e1i − e2i ) ¸µ e1i e2i ¶ ˆ Hence if it is estimated by OLS. Thus we make the partition ¶ µ k1 z1i (11. so should be included in xi .1).3) zi = z2i k2 where E(z1i ei ) = 0 yet E(z2i ei ) 6= 0.

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

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

This is particularly nasty.15) is unaﬀected. Suppose this condition fails. We see that β is identiﬁed if and only if Γ22 = γ 6= 0. In addition. This can be handled in an asymptotic analysis by modeling it as local-to-zero. the instrument xi is weak for zi if γ = n−1/2 c. Suppose that identiﬁcation does not complete fail.Take the simplest case where k = l = 1 (so there is no X1 ). Qc + N2 ˆ As in the case of complete identiﬁcation failure. so E (zi xi ) = 0. but is weak. This occurs when Γ22 is full rank. Thus identiﬁcation hinges on the existence of correlation between the excluded exogenous variable and the included endogenous variable. standard test statistics have non-standard asymptotic distribution of β distributions. Then by the CLT ¡ ¡ ¢¢ 1 X √ xi ei →d N1 ∼ N 0. E x2 u2 i i n n i=1 i=1 n n (11.15) therefore ¢¢ ¡ ¡ 1 X 1 X √ xi zi = √ xi ui →d N2 ∼ N 0. To see the consequences.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 . where C is a full rank matrix. but (11. Then the model may be written as yi = zi β + ei zi = xi γ + ui and Γ22 = γ = E (xi zi ) /Ex2 . as the Cauchy distribution does not have a ﬁnite mean. and was examined by Phillips (1989) and Choi and Phillips (1992). meaning that inferences about parameters of interest can be misleading.16) ˆ β−β = 1 √ n 1 √ n Pn Pn i=1 xi ei i=1 xi zi →d N1 ∼ Cauchy. E x2 e2 i i n i=1 n (11. but small. Here. once again take the simple case k = l = 1. viz Γ22 = n−1/2 C. 131 . N2 since the ratio of two normals is Cauchy. The n−1/2 is picked because it provides just the right balancing to allow a rich distribution theory. we ﬁnd that β is inconsistent for β and the ˆ is non-normal. Then (11. This result carries over to more general settings. which occurs i when E (zi xi ) 6= 0.

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

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

Estimate the model by 2SLS. 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. listed in card. (d) Re-estimate the model by eﬃcient GMM. (c) Re-estimate by 2SLS (report estimates and standard errors) adding three additional instruments: near2 (a dummy indicating that the observation lives near a 2-year college). (e) Calculate and report the J statistic for overidentiﬁcation. of the mother). (f) Discuss your ﬁndings. f atheduc (the education. and the remaining variables as exogenous. are the parameters identiﬁed? 8.. in years. 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. using zi as an instrument for xi . using the instrument near4. (b) Now treat Education as endogenous.pdf. of the father) and motheduc (the education. Report estimates and standard errors. a dummy indicating that the observation lives near a 4-year college. 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. Report estimates and standard errors. and South and Black are regional and racial dummy variables. I suggest that you use the 2SLS estimates as the ﬁrst-step to get the weight matrix. In this model. and then calculate the GMM estimator from this weight matrix without further iteration.(b) Deﬁne the 2SLS estimator of β. Does this diﬀer from 2SLS and/or OLS? 7. 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 the estimates and standard errors. There are 2215 observations with 19 variables. (a) Estimate the model by OLS. in years. 134 .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).

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

3 If Yt is strictly stationary and ergodic and EYt2 < ∞. ˆ 3.1. T t=1 Thus γ (k) →p E(Yt Yt−k ) − µ2 − µ2 + µ2 = E(Yt Yt−k ) − µ2 = γ(k). T 1X Xt →p E(Xt ). γ (k) →p γ(k).1.1 above. For Part (2). µ →p E(Yt ). then as T → ∞. ˆ ˆ T t=1 γ (k) = ˆ The sample autocorrelation ρ(k) = ˆ γ (k) ˆ . ˆ 2. Thus an application of the Ergodic Theorem yields T 1X Yt Yt−k →p E(Yt Yt−k ). γ (0) ˆ Theorem 12. ρ(k) →p ρ(k).Theorem 12. and it has a ﬁnite mean by the assumption that EYt2 < ∞. ˆ ˆ T t=1 T t=1 T t=1 By Theorem 12. T t=1 This allows us to consistently estimate parameters using time-series moments: The sample mean: T 1X µ= ˆ Yt T t=1 The sample autocovariance T 1X (Yt − µ) (Yt−k − µ) .1.2 (Ergodic Theorem). the sequence Yt Yt−k is strictly stationary and ergodic. 1. then as T → ∞. ˆ Part (3) follows by the continuous mapping theorem: ρ(k) = γ (k)/ˆ (0) →p γ(k)/γ(0) = ρ(k). Part (1) is a direct consequence of the Ergodic theorem. note that γ (k) = ˆ T 1X (Yt − µ) (Yt−k − µ) ˆ ˆ T t=1 = T T T 1X 1X 1X Yt Yt−k − Yt µ − ˆ Yt−k µ + µ2 . ˆ Proof. If Xt is strictly stationary and ergodic and E |Xt | < ∞. ˆ ˆ γ ¥ 136 .

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

1 If |ρ| < 1 then Yt is strictly stationary and ergodic.Theorem 12. Lk Yt = Yt−k .1. From Theorem 12. Yt − ρ1 LYt − ρ2 L2 Yt − · · · − ρk Lk Yt = et . Deﬁnition 12. The operator ρ(L) = (1 − ρL) is a polynomial in the operator L. The AR(1) model can be written in the format Yt − ρYt−1 + et or (1 − ρL) Yt−1 = et .3.3. since ρ(z) = 0 when z = 1/ρ. 1 − ρ2 V ar(Yt ) = If the equation for Yt has an intercept. and solving for EYt = EYt−1 we ﬁnd EYt = α/(1 − ρ).5 Stationarity of AR(k) Yt = ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et .4. We can compute the moments of Yt using the inﬁnite sum: EYt = ∞ X k=0 ρk E (et−k ) = 0 σ2 . Deﬁning L2 = LL. ∞ X k=0 ρ2k V ar (et−k ) = 12. except that the mean of Yt can be computed from the relationship EYt = α + ρEYt−1 . an AR(1) is stationary iﬀ |ρ| < 1. 12. or ρ(L)Yt = et where ρ(L) = 1 − ρ1 L − ρ2 L2 − · · · − ρk Lk . the above results are unchanged.1 The lag operator L satisﬁes LYt = Yt−1 . The AR(k) model is Using the lag operator. We call ρ(L) the autoregressive polynomial of Yt . 138 . We call ρ(L) the autoregressive polynomial of Yt .4 Lag Operator An algebraic construct which is useful for the analysis of autoregressive models is the lag operator. We say that the root of the polynomial is 1/ρ. 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). In general.

1. The vector xt is strictly stationary and ergodic. T ¢ ¡ 1X xt x0 →p E xt x0 = Q. we say that ρ(L). Theorem 12.. it is also strictly stationary and ergodic. . T t=1 T t=1 ¢−1 0 ¡ ˆ X Y. so is xt x0 .1) Theorem 12. ¢0 Then the model can be written as The OLS estimator is ¡ ˆ To study β. and hence Yt . and by Theorem 12. t t T t=1 ¥ Combined with (12.1.6. 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.1. Proof. This is a special case of non-stationarity. t T t=1 T t=1 139 ..5. β = X 0X (12.6 Let Estimation xt = β = ¡ 1 Yt−1 Yt−2 · · · α ρ1 ρ2 · · · yt = x0 β + et . For an AR(k).1 The AR(k) is strictly stationary and ergodic if and only if |λj | > 1 for all j. which satisfy ρ(λj ) = 0.” If one of the roots equals 1.1 If the AR(k) process Yt is strictly stationary and ergodic and EYt2 < ∞. 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 12.1. t Yt−k ¢0 ρk .where the λ1 . we see that Ã !−1 Ã ! T T 1X 1X ˆ β=β+ xt x0 xt et →p Q−1 0 = 0. One way of stating this is that “All roots lie outside the unit circle.. By Theorem 12. λk are the complex roots of ρ(z). Thus t by the Ergodic Theorem. Note that ut is a MDS. “has a unit root”. then ˆ β →p β as T → ∞. Let |λ| denote the modulus of a complex number λ. Thus T T 1X 1X xt et = ut →p E (ut ) = 0. and is of great interest in applied time series. it is helpful to deﬁne the process ut = xt et . We know that an AR(1) is stationary iﬀ the absolute value of the root of its autoregressive polynomial is larger than one.1) and the continuous mapping theorem.

the asymptotic covariance matrix is estimated just as in the cross-section case. . If ut is a strictly stationary and ergodic MDS and E(ut u0 ) = Ω < ∞.7. Fix an initial condition (Y−k+1 . this cannot work in a time-series application.7. ˆ 1. Method 1: Model-Based (Parametric) Bootstrap. as this imposes inappropriate independence. Ω) . In particular. . This is identical in form to the asymptotic distribution of OLS in cross-section regression.. ´ √ ³ ¡ ¢ ˆ T β − β →d N 0. t then as T → ∞. 140 . Brieﬂy. Y0 ). we constructed the bootstrap sample by randomly resampling from the data values {yt . T 1 X √ ut →d N (0. Divide the sample into T /m blocks of length m.1 to see that T 1 X √ xt et →d N (0.. there are two popular methods to implement bootstrap resampling for time-series data. Estimate β and residuals et . 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∗ .7. i 4. Ω) . we can apply Theorem 12. T t=1 where Ω = E(xt x0 e2 ).1 MDS CLT.. This creates an iid bootstrap sample. ˆ 2. t t Theorem 12.2 If the AR(k) process Yt is strictly stationary and ergodic and EYt4 < ∞.8 Bootstrap for Autoregressions In the non-parametric bootstrap. Y−k+2 . Q−1 ΩQ−1 . t This construction imposes homoskedasticity on the errors e∗ . then as T → ∞. Method 2: Block Resampling 1. T t=1 Since xt et is a MDS. Clearly. eT }.7 Asymptotic Distribution Theorem 12.12. 12. It also presumes that the AR(k) structure is the truth. The implication is that asymptotic inference is the same.. xt }. Simulate iid draws e∗ from the empirical distribution of the residuals {ˆ1 .. e ˆ 3.. which may be diﬀerent than the i properties of the actual ei .

12. This presumes that “seasonality” does not change over the sample.3) replacing St with St .. The series ∆s Yt is clearly free of seasonality. . 5. The seasonal factor is typically estimated by a two-sided weighted average of the data for that season in neighboring years. If s is the number of seasons (typically s = 4 or s = 12).3) or Yt = α0 + α1 t + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et . Paste the blocks together to create the bootstrap time-series Yt∗ . ﬁrst estimate (12. or the season-to-season change. 4. and the way that the data are partitioned into blocks. The reason why these two procedures are (essentially) the same is the Frisch-Waugh-Lovell theorem. 6. • You can estimate (12.4) There are two essentially equivalent ways to estimate the autoregressive parameters (ρ1 .3) sequentially by OLS. heteroskedasticity. draw T /m blocks. May not work well in small samples. • You can estimate (12. and then perform regression (12. (12. This allows for arbitrary stationary serial correlation. This procedure is sometimes called Detrending. however. (12.9 Trend Stationarity Yt = µ0 + µ1 t + St St = ρ1 St−1 + ρ2 St−2 + · · · + ρk St−l + et .2). 141 . 3. • First apply a seasonal diﬀerencing operator. Resample complete blocks.4) by OLS. get the ˆ ˆ residual St . and perhaps this was of relevance. Seasonal Eﬀects There are three popular methods to deal with seasonal data. • Use “seasonally adjusted” data. and for modelmisspeciﬁcation. The results may be sensitive to the block length. For each simulated sample.2)-(12. But the long-run trend is also eliminated. ρk ).2) (12.. This is a ﬂexible approach which can extract a wide range of seasonal factors. also alters the time-series correlations of the data..2. ∆s Yt = Yt − Yt−s . • Include dummy variables for each season. The seasonal adjustment. That is. Thus the seasonally adjusted data is a “ﬁltered” series.

Yt is an AR(1). An appropriate test is the Wald test of this restriction. or Yt = α(1 − θ) + (ρ + θ) Yt−1 − θρYt−2 + et = AR(2). if the null hypothesis is that Yt is an AR(k).5) We are interested in the question if the error ut is serially correlated. .12.) This can induce strange behavior in the AIC.. Thus under H0 . To combine (12. 142 .6) 12.g. We model this as an AR(1): ut = θut−1 + et with et a MDS. (12. to ﬁnd Yt − θYt−1 = α − θα + ρYt−1 − θρYt−1 + ut − θut−1 . In general. we take (12. We then multiply this by θ and subtract from (12. One approach to model selection is to choose k based on a Wald tests. this is the same as saying that under the alternative Yt is an AR(k+m). and this is equivalent to the restriction that the coeﬃcients on Yt−k−1 . e. (12. and the alternative is that the error is an AR(m).11 Model Selection What is the appropriate choice of k in practice? This is a problem of model selection. H0 may be expressed as the restriction that the coeﬃcient on Yt−2 is zero. and then estimate the models AR(1). and under H1 it is an AR(2). 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.10 Testing for Omitted Serial Correlation For simplicity. Another is to minimize the AIC or BIC information criterion. you need more initial conditions. AIC(k) = log σ 2 (k) + ˆ 2k . . (A simple exclusion test). The best remedy is to ﬁx a upper value k. AR(2).5) and (12. and then reserve the ﬁrst k as initial conditions.. AR(k) on this (uniﬁed) sample. let the null hypothesis be an AR(1): Yt = α + ρYt−1 + ut . (If you increase k.. Yt−k−m are jointly zero..5) and lag the equation once: Yt−1 = α + ρYt−2 + ut−1 . An appropriate test of H0 against H1 is therefore a Wald test that the coeﬃcient on Yt−2 is zero. The hypothesis of no omitted serial correlation is H0 : θ = 0 H1 : θ 6= 0.5).. We want to test H0 against H1 .6)..

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

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

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

146 . . either as a regression. or across equations. This (system) estimator is known as the SUR (Seemingly Unrelated Regressions) estimator. j Unrestricted VARs were introduced to econometrics by Sims (1980).2 Estimation E (xt ejt ) = 0. Consider the moment conditions j = 1. The GMM estimator corresponding to these moment conditions is equation-by-equation OLS aj = (X 0 X)−1 X 0 Yj . each with the same set of regressors. Note that a0 = Yj0 X(X 0 X)−1 . ˆ An alternative way to compute this is as follows. or as a linear projection. Restrictions may be imposed on individual equations. m. 13. A restricted VAR imposes restrictions on the system. and was originally derived by Zellner (1962) ¢ 13.2 ⎟ X(X 0 X)−1 A ⎜ . The GMM framework gives a convenient method to impose such restrictions on estimation. ˆj ˆ And if we stack these to create the estimate A.3 Restricted VARs The unrestricted VAR is a system of m equations.. The VAR model is a system of m equations. One way to write this is to let a0 be the jth row j of A. some regressors may be excluded from some of the equations. we ﬁnd ⎞ ⎛ Y10 ⎜ Y0 ⎟ ˆ = ⎜ .. ¡ Y1 Y2 · · · where Y = Ym 0 the T × m matrix of the stacked yt .then Yt = Axt + et . For example. ⎟ ⎝ . ⎠ 0 Ym+1 = Y 0 X(X 0 X)−1 .. These are implied by the VAR model. Then the VAR system can be written as the equations Yjt = a0 xt + ejt .

This can be done by a Wald test. which is called a common factor restriction.4 Single Equation from a VAR Yjt = a0 xt + et . t t−1 (13. h¡ 1 Yt−1 · · · 0 Yt−k Zt−1 · · · 0 Zt−k ¢0 i . This restriction. In this case.2) is a special case of (13. under the restriction γ = −βθ. the model (13. we are only interested in a single equation out of a VAR system. with time series data. Let yt = Yjt . t or yt = θyt−1 + x0 β + x0 γ + ut . it is convenient to re-deﬁne the variables. and Zt be the other variables. If valid. j Often.3). and subtract oﬀ the equation once lagged multiplied by θ. Otherwise it is invalid. Suppose that et is an AR(1).) Since the common factor restriction appears arbitrary. This takes the form 0 and xt consists of lagged values of Yjt and the other Ylt s.5 Testing for Omitted Serial Correlation Consider the problem of testing for omitted serial correlation in equation (13. t and xt = This is just a conventional regression.13. Then the null and alternative are H0 : θ = 0 H1 : θ 6= 0. may be tested if desired. t and et is iid N (0. and is typically rejected empirically. and simple way to test for omitted serial correlation is to test the signiﬁcance of extra lagged values of the dependent variable and regressors. 13. to get t ¡ ¢ ¡ ¢ yt − θyt−1 = x0 β + et − θ x0 β + et−1 t t−1 = x0 β − θxt−1 β + et − θet−1 . The DW test is appropriate only when regression yt = x0 β + et is not dynamic (has no lagged values on the RHS). and is still routinely reported by conventional regression packages. Another interesting fact is that (13. Then the single equation takes the form (13. xt−1 ) to the regression. 1). Then yt = x0 β + et t et = θet−1 + ut E (ut | It−1 ) = 0.2) may be estimated by iterated GLS. general. You may have heard of the Durbin-Watson test for omitted serial correlation. Let et = ejt and β = aj . 147 .3) which is a valid regression model.1). direct estimation of (13. We see that an appropriate.2) Take the equation yt = x0 β + et . (13. which once was very popular. (A simple version of this estimator is called Cochrane-Orcutt. So testing H0 versus H1 is equivalent to testing for the signiﬁcance of adding (yt−1 .1) yt = x0 β + et .2) is uncommon in recent applications.

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

Thus H0 can be tested using a univariate ADF test on zt . We are often interested in testing the hypothesis of no cointegration: H0 : r = 0 H1 : r > 0. m × r. it may be believed that β is known a priori. the asymptotic distribution of the test is aﬀected by the presence of the time trend. but it is useful in the construction of alternative estimators and tests. and was articulated in detail by Engle and Granger (1987).1 The m × 1 series Yt is cointegrated if Yt is I(1) yet there exists β.13. The r vectors in β are called the cointegrating vectors. Then under H0 zt is I(1). Yt is I(1) and cointegrated. Furthermore ˆ this estimation is super-consistent: T (β 2 − β 2 ) →d Limit. If Yt is cointegrated with a single cointegrating vector (r = 1). Hansen (1992). yet under H1 zt is I(0). from OLS of Y1t on Y2t .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 . as ﬁrst shown by Stock (1987). For 0 < r < m. then Yt is I(0). so zt = β 0 Yt is known. so the ADF critical values are not appropriate. In other cases. Y2t ) and β = (β 1 β 2 ) and normalize β 1 = 1. When β is unknown. For example. If Y = (log(Consumption) log(Income))0 . Often. such that zt = β 0 Yt is I(0). Under H0 . 13. in general. Whether or not the time trend is included. of rank r. If the series Yt is not cointegrated. Engle and Granger (1987) suggested using an ADF test on the estimated ˆ0 ˆ residual zt = β Yt . Thus Yt = ˆ (Y1t . β is not consistent. however. This is not. if Yt is a pair of interest rates. β may not be known. The asymptotic distribution was worked out in B. then it turns out that β can be consistently estimated by an OLS regression of one component of Yt on the others. In some cases. If r = m. β = (1 − 1)0 . then β = (1 − 1)0 speciﬁes that log(Consumption/Income) is stationary. The asymptotic distribution was worked out by Phillips and Ouliaris (1990).8. 149 . a good method to estimate β. When the data have time trends. Suppose that β is known. then r = 0.8 Cointegration The idea of cointegration is due to Granger (1981). Deﬁnition 13. Their justiﬁcation was Stock’s result that β is superˆ ˆ consistent under H1 . 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 . then β = (1 − 1)0 speciﬁes that the spread (the diﬀerence in returns) is stationary.

Theorem 13. Yt is cointegrated with m × r β if and only if rank(Π) = r and Π = αβ 0 where α is m × r. this does not work. Thus cointegration imposes a restriction upon the parameters of a VAR. These tests are constructed as likelihood ratio (LR) tests. One diﬃculty is that β is not identiﬁed without normalization. When r > 1. this is the MLE of the restricted parameters under the assumption that et is iid N (0. and diﬀerent authors have adopted diﬀerent identiﬁcation schemes. they are typically called the “Johansen Max and Trace” tests. then estimation is done by “reduced rank regression”. Equivalently. 1991. If β is known. rank(α) = r. it is simple to test for cointegration by testing the rank of Π. Ω). and are similar to the Dickey-Fuller distributions. 150 .1 (Granger Representation Theorem). this can be estimated by OLS of ∆Yt on zt−1 and the lags of ∆Yt . As they were discovered by Johansen (1988. Their asymptotic distributions are non-standard. which is least-squares subject to the stated restriction. we typically just normalize one element to equal unity. In the context of a cointegrated VAR estimated by reduced rank regression. If β is unknown. 1995). When r = 1.9. 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 .

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

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

The ﬁrst censored regression model was developed by Tobin (1958) to explain consumption of durable goods. the consumption level (purchases) in a particular period was zero.1) yi = ∗ <0 .. 2. this motivates the label Poisson “regression. Since E (Yi | xi ) = λi = exp(x0 β) i is the conditional mean. This model (now called the Tobit) speciﬁes that the latent (or ideal) value of consumption may be negative (the household 153 .}. Censored models are typically applied when the data set has a meaningful proportion (say 5% or higher) of data at the boundary of the sample support. ... .” Also observe that the model implies that V ar (Yi | xi ) = λi = exp(x0 β). i so the model imposes the restriction that the conditional mean and variance of Yi are the same.2 Count Data exp (−λi ) λk i . k! = exp(x0 β). Tobin observed that for many households. but we observe only ½ ∗ ∗ yi if yi ≥ 0 (14. i i i=1 ˆ The MLE is the value β which maximizes ln (β). 2. incomes above a threshold are typically reported at the threshold. In surveys. This may be considered restrictive. The censoring process may be explicit in data collection.14. He proposed the latent variable model ∗ yi = x0 β + ei i ei ∼ iid N (0. a typical approach is to employ Poisson regression.3 Censored Data The idea of “censoring” is that some data above or below a threshold are mis-reported at the ∗ threshold. Thus the model is that there is some latent process yi with unbounded support. 0 if yi (This is written for the case of the threshold being zero. 1. This model speciﬁes that P (Yi = k | xi ) = λi k = 0. any known value can substitute.. A generalization is the negative binomial. The conditional density is the Poisson with parameter λi . 14. An example of a data collection censoring is top-coding of income. σ 2 ) with the observed variable yi generated by the censoring equation (14.1). or it may be a by-product of economic constraints. 1.) The observed data yi therefore come from a mixed continuous/discrete distribution. i If Y = {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 !) .

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

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

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

The goal is to eliminate ui from the estimator.1) fails if the individual-speciﬁc unobserved eﬀect ui is correlated with the observed explanatory variables xit . that eit is iid across individuals and time. and the t subscript denotes time. A panel may be balanced : {yit . xit } : For i = 1. however. ti . It is consistent if E (xit ui ) = 0 (15. 15. n. collected over time. and most applied researchers try to avoid its use...2 Fixed Eﬀects This is the most common technique for estimation of non-dynamic linear panel regressions. The motivation is to allow ui to be arbitrary. An observation is the pair {yit .. OLS can be improved upon via a GLS technique. xit }. t = ti .1) is called the random eﬀects hypothesis. T . and thus achieve invariance. OLS of yit on xit is called pooled estimation.... . or unbalanced : {yit . and have arbitrary correlated with xi . If (15. (15. xit } : t = 1.1) is true. it The typical maintained assumptions are that the individuals i are mutually independent. There are several derivations of the estimator. and that eit is uncorrelated with xit .. . It is a strong assumption.. then OLS is inconsistent. . In either event....1) If this condition fails.. i = 1. This is often believed to be plausible if ui is an omitted variable. 157 . Condition (15. . OLS appears a poor estimation choice. where the i subscript denotes the individual. that ui and eit are independent. 15.Chapter 15 Panel Data A panel is a set of observations on individuals. n.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 .

un ui = d0 u. Conventional inference applies. Y ∗ = Y − D(D0 D)−1 D0 Y where X ∗ = X − D(D0 D)−1 D0 X. so the intercept is typically omitted from xit . ˆ ˆ OLS on (15.2) ⎞ di1 ⎜ . with di as a regressor along with xi . you do not want to actually implement conventional OLS estimation. else Then note that and an n × 1 dummy vector with a “1” in the i0 th place. then by the FWL theorem.First. • There are n + k regression parameters. u). which is quite large as typically n is very large. • Any regressor in xit which is constant over time for all individuals (e. di ) = 0. ˆ β = ¢−1 ¡ 0 ¢ ¡ 0 X (1 − PD ) Y X (1 − PD ) X ¡ ¢−1 ¡ ∗0 ∗ ¢ = X ∗0 X ∗ X Y . 158 . Computationally. . din Observe that E (eit | xit . so will have to be omitted.2) is a valid regression. it i (15. . Observe that • This is generally consistent. ⎟ u = ⎝ .g. Let ⎛ ⎞ u1 ⎜ . ⎠.. • If xit contains an intercept. let dij = and ⎧ ⎨ 1 ⎩ 0 ⎛ if i = j . OLS estimation of β proceeds by the FWL theorem. so (15.2) yields estimator (β. i yit = x0 β + d0 u + eit . Stacking the observations together: Y = Xβ + Du + e. ⎟ di = ⎝ . as the parameter space is too large. ⎠ . it will be collinear with di . their gender) will be collinear with di .

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

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

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

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

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

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

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

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

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

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

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

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

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

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

y) fX (x + ε) ∂2 ∂x∂y F (x. y) fX (x) The conditional density of Y given X = x is deﬁned as fY |X (y | x) = if fX (x) > 0.6 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 .. Xk )0 is a function from S to Rk ..A k × 1 random vector X = (X1 ... y) ∂ lim ∂y ε→0 FX (x + ε) − FX (x) ∂ lim ∂y ε→0 ∂ ∂x F (x + ε. then Σ is a diagonal matrix and Ã k ! k X X V ar Xi = V ar (Xi ) i=1 i=1 A.. y) . . One way to derive this expression from the deﬁnition of conditional probability is fY |X (y | x) = = = = = = ∂ lim P (Y ≤ y | x ≤ X ≤ x + ε) ∂y ε→0 ∂ P ({Y ≤ y} ∩ {x ≤ X ≤ x + ε}) lim ∂y ε→0 P (x ≤ X ≤ x + ε) F (x + ε. y) − F (x. it has the distribution and density functions F (x) = P (X ≤ x) ∂k f (x) = F (x).. xk )0 . 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. fX (x) 173 . . ∂x1 · · · ∂xk For a measurable function g : Rk → Rs . Letting x = (x1 . y) fX (x) f (x. In particular.

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

g(x) = − ln(x) and h(y) = exp(−y) so the Jacobian is J(y) = − exp(y). 1] and Y = − ln(X). so FY (y) = P (g(X) ≤ y) = 1 − P (X ≥ h(Y )) = 1 − FX (h(Y )) and the density of Y is fY (y) = −fX (h(Y )) We can write these two cases jointly as fY (y) = fX (h(Y )) |J(y)| . As one example. As the range of X is [0.8 Normal and Related Distributions µ 2¶ 1 x . . dy This is known as the change-of-variables formula. then g(X) ≤ Y if and only if X ≥ h(Y ). dy dy If g(x) is a decreasing function.A.10) holds for k > 1. J(y) = det ∂y 0 Consider the univariate case k = 1. but its justiﬁcation requires deeper results from analysis. Let Y = g(X) where g(x) : Rk → Rk is one-to-one. This same formula (A.7 Transformations Suppose that X ∈ Rk with continuous distribution function FX (x) and density fX (x). Here. diﬀerentiable. φ(x) = √ exp − 2 2π 175 The standard normal density is −∞ < x < ∞. that for Y is [0. an exponential density. take the case X ∼ U [0. then g(X) ≤ Y if and only if X ≤ h(Y ). A. The Jacobian is ¶ µ ∂ h(y) . Since fX (x) = 1 for 0 ≤ x ≤ 1 (A. 0 ≤ y ≤ ∞. Let h(y) denote the inverse of g(x). If g(x) is an increasing function. 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).10) d h(y). and invertible. 1].∞).10) shows that fY (y) = exp(−y). (A.

then Z 0 A−1 Z ∼ χ2 . X has density Ã ! (x − µ)2 1 exp − . 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 . Theorem A. exp − f (x) = k/2 1/2 2 (2π) det (Σ) The mean and covariance matrix of the distribution are µ and Σ. Since it is symmetric about zero all odd moments are zero. q × q. Σ) and Y = a + BX with B an invertible matrix. The mean and variance of the distribution are µ and σ 2 . the multivariate normal density is ¶ µ (x − µ)0 Σ−1 (x − µ) 1 . For x ∈ Rk . The latter has no closed-form solution. and it is conventional to write X ∼ N (µ.This density has all moments ﬁnite. 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. It is conventional to write X ∼ N (0. where we used the fact that det (BΣB 0 )1/2 = det (Σ)1/2 det (B) . respectively. ¢ ¡ It useful to observe ¢ that the MGF and CF of the multivariate normal are exp λ0 µ + λ0 Σλ/2 ¡ 0 and exp iλ µ − λ0 Σλ/2 . This shows that if X is multivariate normal with uncorrelated elements. y ≥ 0. Σ). x ∈ Rk . Its mean and r variance are µ = r and σ 2 = 2r.8. By iterated integration by parts. Q has the density f (y) = Γ 1 ¡r¢ 2 2r/2 yr/2−1 exp (−y/2) . Ir ) and set Q = X 0 X. 1). A) with A > 0. f (x) = √ 2σ 2 2πσ which is the univariate normal density. (A. Another useful fact is that if X ∼ N (µ. k/2 1/2 2 (2π) det (ΣY ) where µY = a+Bµ and ΣY = BΣB 0 . q 176 . then using the change-of-variables formula. σ 2 ). and to denote the standard normal density function by φ(x) and its distribution function by Φ(x). If Z is standard normal and X = µ + σZ. −∞ < x < ∞. then by the change-of-variables formula.11) and is known as the chi-square density with r degrees of freedom. then they are mutually independent. we can also show that EX 2 = 1 and EX 4 = 3. If X ∈ Rk is multivariate normal and the elements of X are mutually uncorrelated.2 If Z ∼ N(0. x ∈ Rk . then Σ = diag{σ 2 } is a diagonal matrix.1 Let X ∼ N (0.8. Theorem A. and it is conventional to write X ∼ N(µ.

For Z ∼ N(0.8.6) can be used to show that the MGF j=1 ¥ Proof of Theorem A. q Proof of Theorem 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 . which can be found by applying change-of-variables to the gamma function. Set r Z . The MGF for the density (A.3 Let Z ∼ N (0. which we showed in (A. tr has distribution 177 . C −1 AC −10 ) = N (0. The fact that A > 0 means that we can write A = CC 0 where C is non-singular.13) is the MGF of the density (A.13) = (1 − 2t)−r/2 R∞ where the second equality uses the fact that 0 y a−1 exp (−by) dy = b−a Γ(a). C −1 CC 0 C −10 ) = N (0. Proof of Theorem A. From (A.Theorem A. Then A−1 = C −10 C −1 and C −1 Z ∼ N (0.3. Iq ). (A.11) 2 with r = 1.8. we see that the MGF of Z 2 is (1 − 2t)−1/2 . 1). Thus ¥ ¡ ¢0 ¡ ¢ Z 0 A−1 Z = Z 0 C −10 C −1 Z = C −1 Z C −1 Z ∼ χ2 .13).8. tr = p Q/r The density of tr is and is known as the student’s t distribution with r degrees of freedom.12) E exp (tQ) = 0 Γ (A. 1) and Q ∼ χ2 be independent.11) is Z ∞ ¢ ¡ Γ r+1 2 f (x) = ´ r+1 ¡r¢ ³ √ 2 2 πrΓ 2 1 + x r (A. Since we can write Q = P 2 X 0 X = r Zj where the Zj are independent N(0. Thus the density of Z 2 is (A.2.1.8.11). Using the simple law of iterated expectations. ¡ ¢ √ using the change—of-variables s = x2 and the fact Γ 1 = π.

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

9. we can ﬁnd an explicit expression for θ as a function of the data. θ Theorem A. n n i=1 n As the MLE ˆ maximizes the left-hand-side. θ) →p E ln f (Yi .16). the restriction to unbiased estimators means that the theorem has little direct relevance for ﬁnite sample eﬃciency. In fact.1 ¯ ¯ ∂ E ln f (Yi . ˆ →p θ0 as n → ∞. Theorem A. θ) ≡ L(θ). cases are rare.9. the MLE θ Why do we believe that the MLE ˆ is estimating the parameter θ? Observe that when stanθ dardized.17) The matrix I0 is called the information. then θ V ar(˜ ≥ (nI0 )−1 . but these ˆ must be found by numerical methods.Deﬁne the Hessian H = −E and the outer product matrix Ω=E µ ∂2 ln f (Yi . θ θ∈Θ ˆ In some simple cases.14) ¶ ∂ ∂ 0 ln f (Yi . 179 . I0 . θ) ∂θ ∂θ which holds at θ = θ0 by (A.3 Under regularity conditions.16) (A. the log-likelihood is a sample average 1X 1 Ln (θ) = ln f (Yi . we can see that it is an estimator of the maximizer θ of the right-hand-side. We can write this as ˆ = argmax Ln (θ).17) is often called the information matrix equality. ˆ is consistent θ for this value. θ)¯ =0 ¯ ∂θ θ=θ0 H = Ω ≡ I0 (A. which maximizes the log-likelihood). ∂θ ∂θ (A. If ˜ is an unbiased estimator of θ ∈ R.2 Cramer-Rao Lower Bound. and the equality (A. More typically. The ﬁrst-order condition for the latter problem is 0= ∂ ∂ L(θ) = E ln f (Yi . θ) The Cramer-Rao Theorem gives a lower bound for estimation. The maximum likelihood estimator or MLE ˆ is the parameter value which maximizes θ the likelihood (equivalently. ´ ¡ −1 ¢ √ ³ˆ n θ − θ0 →d N 0.9. under conventional regularity conditions. θ0 ) ∂θ∂θ 0 (A. θ0 ) ln f (Yi .15) Two important features of the likelihood are Theorem A. However. θ0 ) .

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

θ) d˜ = ˜ y ) ∂ ln f (˜. θ0 ) ¯ ∂ f (y. Diﬀerentiating with respect to θ and evaluating at θ0 yields ˜ Z Z ³ ´ ˜ y ) ∂ f (˜.9. V ar (S) nH so ¥ 181 . Since θ Z ˜ = ˜ y)f (˜. θ0 ) ∂θ ∂θ n i=1 which by Theorem (A. θ0 ) ∂θ f (Yi . θ) dy ¯ ∂θ f (y. ∂2 ln f (Yi .9. θ) ¯θ=θ0 ¯ Z ¯ ∂ f (y.16). θ0 )2 (Yi . θ0 = ln f (Yi . y y θ(˜ y y y θS 1 = θ(˜ ∂θ ∂θ By the Cauchy-Schwarz inequality ¯ ³ ´¯2 ³ ´ ¯ ¯ θS θ 1 = ¯E ˜ ¯ ≤ V ar (S) V ar ˜ ³ ´ V ar ˜ ≥ θ 1 1 = . θ0 ) = ∂θ∂θ0 = Taking expectations yields (A. yn ). θ0 ) d˜ = E ˜ . f (Yi .17).Proof of Theorem A. . Proof of Theorem A. To see (A. θ) f (˜. θ0 )0 . Write the estimator ˜ = ˜ Y ) as a θ θ( ˜ ˜ is unbiased for any θ. S= ∂2 f ∂θ∂θ0 ∂2 f ∂θ∂θ0 ∂ ∂θ Z Ã ∂2 f ∂θ∂θ0 ¯ ¯ ln f (y. θ0 ) (Yi . ¯ ¯ ∂ E ln f (Yi .9. θ0 )0 f (Yi . θ) d˜ θ = Eθ θ(˜ y y where y = (y1 . θ) dy ¯ ¯ ∂θ θ=θ0 ¯ ∂ ¯ 1¯ = 0. θ0 ) ∂θ ∂θ ¥ ³ ´ X ∂ ∂ ˜ ln fn Y . (Yi . θ0 ) dy ¯ ¯ ¯ θ=θ0 f (y.2.1) has mean zero and variance nH. θ0 ) ∂ ∂θ f ∂ (Yi .. θ0 ) f (Yi .. θ0 ) − f (Yi . θ) f (y. we can show that E By direction computation. ∂θ ¯θ=θ0 Z ! = 0..1. θ0 ) ln f (Yi . θ0 ) ∂ ∂ − ln f (Yi . function of the data. θ)¯ = ¯ ∂θ θ=θ0 = = = Similarly.

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

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

B. Then for ε small gj (θ) ' Similarly. To pick λi write the criterion function as a function of λ Q(λ) = Q(θi + Di gi λ) 184 . Most gradient methods are a variant of Newton’s method which is based on a quadratic approximation. and all require the computation θ.2) θi+1 = θi − Di gi λi Q(θ + δ j ε) − Q(θ) . however. they can be calculated numerically. ε where gi = g(θi ) and Di = H(θi )−1 for Newton’s method and Di = (H(θi ) + αi Im )−1 for quadratic hill-climbing.. . θ 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. numerical derivatives can be quite unstable. By a Taylor’s expansion for θ close to ˆ θ ³ ´ 0 = g(ˆ ' g(θ) + H(θ) ˆ − θ θ) θ gjk (θ) ' which implies ˆ = θ − H(θ)−1 g(θ). Allowing the steplength to be a free parameter allows for a line search. of the gradient of Q(θ) ∂ Q(θ) g(θ) = ∂θ and some require the Hessian ∂2 H(θ) = Q(θ). One modiﬁcation to prevent this possibility is quadratic hill-climbing which sets ˆi+1 = θi − (H(θi ) + αi Im )−1 g(θi ). Another productive modiﬁcation is to add a scalar steplength λi . In some cases. Take the j 0 th element of g(θ). a one-dimensional optimization. Q(θ + δ j ε + δ k ε) − Q(θ + δ k ε) − Q(θ + δ j ε) + Q(θ) ε2 In many cases. θ This suggests the iteration rule ˆi+1 = θi − H(θi )−1 g(θi ). Let δ j be the j 0 th unit vector (zeros everywhere except for a one in the j 0 th row). ∂θ∂θ 0 If the functions g(θ) and H(θ) are not analytically available. θ where αi is set just above the smallest eigenvalue of H(θi ) if H(θ) is not positive deﬁnite. numerical derivatives can work well but can be computationally costly relative to analytic derivatives.2 Gradient Methods Gradient Methods are iterative methods which produce a sequence θi : i = 1. which are designed to converge to ˆ All require the choice of a starting value θ1 . 2. In this case the iteration rule takes the form (B..

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

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