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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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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

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 Univariate Time Series 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .12Autoregressive Unit Roots . . . . . . . . . . . 10. . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Stationarity and Ergodicity . . . . . . . . . .12 8. . . . . . . . . . . .2 GMM Estimator . . . . . . . . . . . . .5 Stationarity of AR(k) . . . . . . . . . . . . . . . . . . . . . . . .5 GMM: The General Case . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 Endogeneity 11. . . . . . . . . . . . . . . . . . . . .9 Trend Stationarity . . . . . . . . . .6 Over-Identiﬁcation Test . . . . . . . . . . . . . . . . .11Model Selection . . . . . . . . . Symmetric Two-Sided Tests . . . . . 9. . . . . . . . . . . . . . . . . iii . . . . . . . . . . . . . . . . . . 11. . . . . . . . 11. . . . . . . . . . . . . . . . . . . . . .4 Estimation of the Eﬃcient Weight Matrix . . . . . .8. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8 Exercises . . . . . . . . . . . . . . . . . . . . . .2 Asymptotic Distribution of EL Estimator 10. . . .3 Stationarity of AR(1) Process . . . . . . .10 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10. . . . . . . . . . . . . . . . . .5 Numerical Computation . . . . . . . . . . . . . . . . . . .13 One-Sided Tests . . . . . . . . . . . . . . . . . . . 12.8 Conditional Moment Restrictions . . 11. . . . . .5 Special Cases: IV and 2SLS 11. . . . . . . . . . . . . . . . . . . . . . . . . . .9 8. . . . . . . . . . . . . 12. . . . 11. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . . . . . . . .3 Overidentifying Restrictions . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . .8 Bootstrap for Autoregressions . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . 12. . . . . . . . 10 Empirical Likelihood 10. . . . . . . . . . .6 Estimation . . . . . .3 Identiﬁcation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 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. . . . . . . 9. . . . . . . . . . . . . . . . . . . . . . . .3 Distribution of GMM Estimator . . . . . .4 Testing . . . . . . . . . . . . . . . . . . . . . . . .1 Overidentiﬁed Linear Model . . 9. . . . . . . . . 12. . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . .6 Bekker Asymptotics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4 Lag Operator . . . 11. . . . . . . . . . .10Testing for Omitted Serial Correlation 12. . . . . . . . . . . . . . . . .10 8. . . . . . .7 Identiﬁcation Failure . . . . . . 11. . . . Bootstrap Methods for Regression Models Exercises . . . . . 9. . . . . . . . . . . . . . . . . . .7 Hypothesis Testing: The Distance Statistic 9. .7 Asymptotic Distribution . . . . .1 Non-Parametric Likelihood . . . . . . . . . . . . . . . . . . . . . . . 12. . . . .2 Reduced Form . . . . .9 Bootstrap GMM Inference . . . . . . . . . . . . . . . . . . . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . 10. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9. . . . . .4 Estimation . . . . . . . . . . . . Percentile Conﬁdence Intervals . . . . . . .2 Autoregressions . . . . . . . . . . . . . . . . . . . . .11 8. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Instrumental Variables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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

an experiment might randomly divide children into groups. We can measure the joint distribution of these variables. They are distinguished by the dependence structure across observations. Surveys are a typical source for cross-sectional data. Applied econometrics concerns the application of these tools to economic data.Chapter 1 Introduction Econometrics is the study of estimation and inference for economic models using economic data. as we are not able to manipulate one variable to see the direct eﬀect on the other. Another issue of interest is the earnings gap between men and women. 1. and assess the joint dependence. household or corporation) is surveyed on multiple occasions. Cross-sectional data sets are characterized by mutually independent observations.2 Observational Data A common econometric question is to quantify the impact of one set of variables on another variable. Panel data combines elements of cross-section and time-series. 1 . Ideally. mandate diﬀerent levels of education to the diﬀerent groups. These data sets consist surveys of a set of individuals. holding other variables constant. timeseries. a concern in labor economics is the returns to schooling — the change in earnings induced by increasing a worker’s education. To measure the returns to schooling. Each individual (person. we would use experimental data to answer these questions. But we cannot infer causality. or corporations. 1.1 Economic Data An econometric study requires data for analysis. households. There are three major types of economic data sets: cross-sectional. The individuals surveyed may be persons. The diﬀerences between the groups could be attributed to the diﬀerent levels of education. For example. Typical examples include macroeconomic aggregates. even immoral! Instead. However. The quality of the study will be largely determined by the data available. This type of data is characterized by serial dependence. experiments such as this are infeasible. To continue the above example. Time-series data is indexed by time. Econometric theory concerns the study and development of tools and methods for applied econometric applications. what we observe (through data collection) is the level of a person’s education and their wage. repeated over time. prices and interest rates. and then follow the children’s wage path as they mature and enter the labor force. and panel. most economic data is observational.

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

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

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

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

The columns of a k × r matrix A.3 Trace The trace of a k × k square matrix A is the sum of its diagonal elements tr (A) = k X i=1 aii Some straightforward properties for square matrices A and B are tr (cA) = c tr (A) ¡ ¢ tr A0 = tr (A) tr (Ik ) = k. r ≤ k.An alternative way to write the matrix product is ∙ ¸∙ A11 A12 B11 AB = A21 A22 B21 ∙ A11 B11 + A12 B21 = A21 B11 + A22 B21 and £ to use matrix partitions. are said to be orthogonal if A0 A = Ir . . . ⎥ . . . A square matrix A is called orthogonal if A0 A = Ik . . 0 0 ··· 1 2. 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 important diagonal matrix is the identity matrix. . which has ones on the diagonal. Also. then AIr = A and Ik A = A. A k × k identity matrix is denoted as ⎡ ⎤ 1 0 ··· 0 ⎢ 0 1 ··· 0 ⎥ ⎢ ⎥ Ik = ⎢ . . . ¸ B12 B22 ¸ A11 B12 + A12 B22 A21 B12 + A22 B22 ⎡ B1 B2 . We say that two vectors a and b are orthogonal if a0 b = 0. for k × r A and r × k B we have tr (AB) = tr (BA) tr (A + B) = tr (A) + tr (B) 6 . ⎦ ⎣ .

The Moore-Penrose generalized inverse A− satisﬁes (2. 7 Also. 2. . (2. .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 . For non-singular A and C. then # ¡ ¢−1 ¡ ¢−1 ∙ ¸−1 " A − BD−1 C A B − A − BD−1 C BD−1 ¡ ¡ ¢−1 ¢−1 = .2) C D D − CA−1 B − D − CA−1 B CA−1 (AC)−1 = C −1 A−1 ¡ ¢−1 −1 (A + C)−1 = A−1 A−1 + C −1 C ¡ −1 ¢ −1 −1 −1 −1 −1 A − (A + C) = A A +C A ¡ ¢ −1 (A + BCD) = A−1 − A−1 BC C + CDA−1 BC CDA−1 (2.3) The matrix A− is not necessarily unique. some properties include AA−1 = A−1 A = Ik ¡ ¢−1 ¡ −1 ¢0 = A0 A Even if a matrix A does not possess an inverse. if A is an orthogonal matrix. the Moore-Penrose generalized inverse A− exists and is unique. or is nonsingular. .4 Inverse A k × k matrix A has full rank. . then A−1 = A. In this case there exists a unique matrix B such that AB = BA = Ik .3) plus the following three conditions A− AA− = A− AA− is symmetric A− A is symmetric For any matrix A. If A − BD−1 C and D − CA−1 B are non-singular. (2. . a0 bk k ⎤ ⎥ ⎥ ⎥ ⎦ a0 bi i b0 ai i = = tr (BA) . . The following fact about inverting partitioned matrices is sometimes useful. we can still deﬁne a generalized inverse A− as a matrix which satisﬁes AA− A = A. This matrix is called the inverse of A and is denoted by A−1 .1) . 0b 0b ak 1 ak 2 · · · a0 bk 1 a0 bk 2 . if there is no c 6= 0 such that Ac = 0. .

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

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

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

The two density curves show the eﬀect of gender on the distribution of wages. education and experience. These are indicated in Figure 3. Figure 3.73. or the covariates. An important summary measure is the conditional mean Z ∞ yf (y | x) dy. the mean wage for men is $27. the conditioning variable. ⎠ ⎝ . it is useful to have numerical measures of the diﬀerence. holding the other variables constant.22. We call xi alternatively the regressor.1 by the arrows drawn to the x-axis.1) xi = ⎜ . Take a closer look at the density functions displayed in Figure 3. and exists so long as E |yi | < ∞. While it is easy to observe that the two densities are unequal. These are conditional density functions — the density of hourly wages conditional on race. In this context we partition the observations into the pair (yi . We call yi the dependent variable. gender. 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. xki 3. See Chapter 16. the mean is not necessarily a good summary of the central tendency. These are asymmetric (skewed) densities. from the population of white non-military wage earners with a college degree and 10-15 years of potential work experience. and that for women is $20.Chapter 3 Regression and Projection The most commonly applied econometric tool is regression. This is used when the goal is to quantify the impact of one set of variables on another variable. We list the elements of xi in the vector ⎞ ⎛ x1i ⎜ x2i ⎟ ⎟ ⎜ (3.1. . we can focus on f (y | x) .1 displays the density1 of hourly wages for men and women. the conditional density of yi given xi . ⎟ . To illustrate. In this context it is often convenient These are nonparametric density estimates using a Gaussian kernel with the bandwidth selected by crossvalidation. In the example presented in Figure 3. m(x) can take any form. which is a common feature of wage distributions. When a distribution is skewed. (3. The data are from the 2004 Current Population Survey 1 11 .2) m(x) = E (yi | xi = x) = −∞ In general.1. xi ) where yi is a scalar (real-valued) and xi is a vector.

Of particular interest to graduate students may be the observation that diﬀerence between a B. For this reason. When the distribution of the control variable is continuous.1: Wage Densities for White College Grads with 10-15 Years Work Experience to transform the data by taking the (natural) logarithm.2 shows the density of log hourly wages for the same population. To illustrate.3 displays a scatter plot2 of log wages against education levels.3 is how the conditional expectation describes an important feature of the conditional distribution.2) evaluated at the observed value of xi : ei = yi − m(xi ). 12 . This is a more robust measure of the typical wage gap between men and women than the diﬀerence in the untransformed wage means. with mean log hourly wages drawn in with the arrows. The diﬀerence in the log mean wage between men and women is 0. implying an average 36% diﬀerence in wage levels. then comparisons become more complicated.D. Assuming for simplicity that this is the true joint distribution. 3.36. the solid line displays the conditional expectation of log wages varying with education. Figure 3. The comparison in Figure 3. and a Ph. Figure 3. The main point to be learned from Figure 3. The conditional expectation function is close to linear.A.3) White non-military male wage earners with 10-15 years of potential work experience. wage regressions typically use log wages as a dependent variable rather than the level of wages.Figure 3.5.1 is facilitated by the fact that the control variable (gender) is discrete. this yields the formula yi = m(xi ) + ei . the dashed line is a linear projection approximation which will be discussed in the Section 3. which implies a 30% average wage diﬀerence for this population. By construction. 2 (3.30.2 Regression Equation The regression error ei is deﬁned to be the diﬀerence between yi and its conditional mean (3. degree in mean log hourly wages is 0.

Figure 3. E (ei | xi ) = 0. E (h(xi )ei ) = 0 for any function h (·) . It is important to understand that this is a framework. These equations hold true by deﬁnition. 4. 13 . A regression model imposes further restrictions on the joint distribution. by the deﬁnition of ei and the linearity of conditional expectations.1 Properties of the regression error ei 1. restrictions on the permissible class of regression functions m(x). E (ei | xi ) = E ((yi − m(xi )) | xi ) = m(xi ) − m(xi ) = E (yi | xi ) − E (m(xi ) | xi ) = 0. E(xi ei ) = 0. 3.2: Log Wage Densities Theorem 3. are often stated jointly as the regression framework. The remaining parts of the Theorem are left as an exercise. The equations yi = m(xi ) + ei E (ei | xi ) = 0. not a model. because no restrictions have been placed on the joint distribution of the data. 2. To show the ﬁrst statement. most typically. E(ei ) = 0.2.

A common measure of the dispersion is the conditional variance ¡ ¢ σ 2 (x) = V ar (yi | xi = x) = E e2 | xi = x . when σ 2 (x) is a constant so that ¢ ¡ (3. The right-hand-side is minimized by setting g(x) = m(x). i .3: Conditional Mean of Wages Given Education The conditional mean also has the property of being the the best predictor of yi . Given the random variable xi .4) E e2 | xi = σ 2 i 14 While the conditional mean is a good measure of the location of a conditional distribution.1. and can take any form.3 Conditional Variance Generally. 3. To see this. In contrast.2. σ 2 (x) is a non-trivial function of x.3. In the general case i where σ 2 (x) depends on x we say that the error ei is heteroskedastic. in the sense of achieving the lowest mean squared error. subject to the restriction p that it is non-negative. the conditional variance of yi is σ 2 = σ 2 (xi ).Figure 3. The expected squared error using this prediction function is E (yi − g(xi ))2 = E (ei + m(xi ) − g(xi ))2 = Ee2 + 2E (ei (m(xi ) − g(xi ))) + E (m(xi ) − g(xi ))2 i = Ee2 + E (m(xi ) − g(xi ))2 i ≥ Ee2 i where the second equality uses Theorem 3. let g(x) be an arbitrary predictor of yi given xi = x. Thus the mean squared error is minimized by the conditional mean. The conditional standard deviation is its square root σ(x) = σ 2 (x). it does not provide information about the spread of the distribution.

which we derive in this section. it is convenient to augment the regressor vector xi by listing the number “1” as an element. its functional form is typically unknown. ⎝ . Equation (3.1) has been redeﬁned as the k × 1 vector ⎛ ⎞ 1 ⎜ x2i ⎟ ⎜ ⎟ (3.1). The conditional standard deviation for men is 12. Notationally. i (3. Equivalently. βk ⎛ (3.6) as an approximation. Some textbooks inappropriately describe heteroskedasticity as the case where “the variance of ei varies across observation i”.3) can be writen as yi = x0 β + ei i E (ei | xi ) = 0. they are also somewhat more dispersed.8) (3. it is more realistic to view the linear speciﬁcation (3. This concept is less helpful than deﬁning heteroskedasticity as the dependence of the conditional variance on the observables xi .1. ⎠ . where x1i is the ﬁrst element of the vector xi deﬁned in (3.we say that the error ei is homoskedastic.6) (3.5) xi = ⎜ . ⎠ . So while men have higher average wages. Thus (3. We call this the “constant” or “intercept”.5. An important special case is homoskedastic linear regression model yi = x0 β + ei i E (ei | xi ) = 0 ¢ ¡ E e2 | xi = σ 2 .3) is when the conditional mean function m(x) is linear in x (or linear in functions of x). take the conditional wage densities displayed in Figure 3. we can write it as m(x) = x0 β = β 1 + x2i β 2 + · · · + xki β k where ⎞ β1 ⎜ . we assume that x1i = 1. ⎟ . 3.5 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 and that for women is 10. Instead.7) is a k × 1 parameter vector.9) 3. ⎟ β=⎝ .8) is called the linear regression model. As an example.4 Linear Regression An important special case of (3. In this case (3. and the linear assumption of the previous section is empirically unlikely to accurate. 15 . xki When m(x) is linear in x.

10) exists and is unique as long as the k ×k matrix E (xi x0 ) is invertible. this situation must be excluded. written E (xi x0 ) > 0.11) 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 .5. We now summarize the assumptions necessary for its derivation and list the implications in Theorem 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. α0 E (xi x0 ) α = E (α0 xi )2 ≥ 0 so the matrix E (xi x0 ) is by construction i i positive semi-deﬁnite. This occurs when redundant variables are included in xi . x0 β is the best linear predictor for yi . i i (3. Rewriting. there cannot i exist a non-zero vector α such that α0 xi = 0 identically. Equivalently. we obtain a decomposition of yi into linear predictor and error yi = x0 β + ei . The error is i ei = yi − x0 β. E (xi x0 ) is a mai E(x y trix and E (xi yi ) is a vector. Given the deﬁnition of β in (3. As before. The vector (3. The ﬁrst-order condition for minimization (from Section 2.7) is 0= Solving for β we ﬁnd ¡ ¢ ∂ S(β) = −2E (xi yi ) + 2E xi x0 β. i ∂β ¢¢−1 ¡ ¡ E (xi yi ) . i (3. i 4.12) This completes the derivation of the linear projection model.5.1 1. It is invertible if and only if it is positive deﬁnite. Assumption 3. In order for β to be uniquely deﬁned. by “best” we mean the predictor function with lowest mean squared error. For any β ∈ Rk a linear predictor for yi is x0 β with expected squared prediction i error ¢2 ¡ S(β) = E yi − x0 β i ¢ ¢ ¡ ¡ 2 = Eyi − 2E yi x0 β + β 0 E xi x0 β. 2 2. The best linear predictor is obtained by selecting β to minimize S(β). Therefore. E (x0 xi ) < ∞. 3. Observe i that for any non-zero α ∈ Rk . E (xi x0 ) is invertible. i (3.10). alternative expressions such as E xixi ) or E (xi yi ) (E (xi x0 ))−1 i ( i 0i ) are incoherent and incorrect. Eyi < ∞.which is quadratic in β. i which requires that for all non-zero α. 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 . otherwise they are distinct. xi contains an intercept.1. i 16 .

the converse is not true as the projection error does not necessarily satisfy E (ei | xi ) = 0.Theorem 3.14). Using the deﬁnitions (3. (3.12) and (3. The ﬁnite variance Assumptions 3.5.1. Then i i Exi e2 = Ex3 = 0 yet E (ei | xi ) = x2 6= 0.5. Figure 3.14) holds. For example. ¥ (3.5. This means that the equation (3. Assumption 3.1.1 is employed to guarantee that (3.5.14) Proof. i i i Since E (xi ei ) = 0 we say that xi and ei are orthogonal.14) follows from (3.5. 17 . (3.4 is required to ensure that β is uniquely deﬁned.11) are well deﬁned.5.3 are called regularity conditions. Since ei is mean zero by (3.11) and (3.5.2. E (xi ei ) = 0 and E (ei ) = 0.1.4: Hourly Wage as a Function of Experience The conditions listed in Assumption 3.4 we know that the regression error has the property E (xi ei ) = 0. Assumption 3. the orthogonality restriction (3.1.3 ensure that the moments in (3. However. Since from Theorem 3.2 and 3. Furthermore.1.1 Under Assumption 3.5.5.1 are weak.8)-(3.5.4 guarantees that the solution β exits.13) and Assumption 3.9).1. Let’s compare it with the linear regression model (3. Assumption 3.13) The two equations (3.1.1.2 and 3. x0 β is the i projection of yi on xi since the error ei is orthogonal with xi . it follows that linear regression is a special case of the projection model.10) and (3.13) implies that xi and ei are uncorrelated.10) are deﬁned.1.12) can be alternatively interpreted as a projection decomposition.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. Equation (3.5.1. By deﬁnition. Assumption 3.13) summarize the linear projection model. suppose that for xi ∈ R that Ex3 = 0 and ei = x2 .1.

we can augment the regressor vector xi to include both experience and experience2 . However.4 we display as well this quadratic projection. In Figure 1. Other than the redeﬁnition of the regressor vector. Returning to the joint distribution displayed in Figure 3. No additional assumptions are required.10).12) is deﬁned by projection and the associated coeﬃcient deﬁnition (3.1 may be false. for any pair (yi .3. xi ) we can deﬁne a linear projection equation (3.12) with the properties listed in Theorem 3. there are no changes in our methods or analysis. and the straight dashed line is the linear projection. and are discussed in Chapter 11.10) may not hold and the implications of Theorem 3. In this example it is a much better approximation to the conditional mean than the linear projection.We have shown that under mild regularity conditions. 18 . This defect in linear projection can be partially corrected through a careful selection of regressors. in many economic models the parameter β may be deﬁned within the model. These structural models require alternative estimation methods. In the example just presented.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. Figure 3.5. and under-predicts for the rest. In contrast.4 displays the relationship3 between mean log hourly wages and labor market experience. Figure 3. since the resulting function is quadratic in experience.5. It over-predicts wages for young and old workers. We illustrate the issue in Figure 3. the dashed line is the linear projection of log wages on eduction. In this example the linear projection is a close approximation to the conditional mean. In this case the linear projection is a poor approximation to the conditional mean. The linear equation (3. it misses the strong downturn in expected wages for those above 35 years work experience (equivalently.1. In this case (3. A projection of log wages on these two variables can be called a quadratic projection. it is important to not misinterpret the generality of this statement. The solid line is the conditional mean. In other cases the two may be quite diﬀerent. for those over 53 in age). Most importantly.5 for a 3 In the population of Caucasian non-military male wage earners with 12 years of education.

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

i 7. m. yi ). 2. 20 . then E(x2 ei ) = 0. Compute E(yi | xi = x) and V ar(yi | xi = x). If yi = xi β + ei . 3. 3 and 4 of Theorem 3.1.. Are they diﬀerent? Hint: If P (Y = j) = 5. taking values only on the non-negative integers. i 10. and E(ei | xi ) = 0. σ = . True or False.4 . i 8.. xi ∈ R.3. E(ei | xi ) = 0.1 . Does this justify a linear regression model of the form yi = x0 β + εi ? i then EY = λ and V ar(Y ) = λ. a constant. Deﬁne µ ¶ ¢ ¡ x−µ 2 g x. . e−λ λj j! . Compute 2 the coeﬃcients of the linear projection yi = β 0 + β 1 xi + ei . (x − µ)2 − σ 2 Show that Eg (X. Take the bivariate linear projection model yi = β 0 + β 1 xi + ei E (ei ) = 0 E (xi ei ) = 0 Deﬁne µy = Eyi . then E(ei | xi ) = 0. 9. 2. If yi = xi β + ei . and have the following joint probability distribution X=0 X=1 Y =0 . Compute the conditional mean m(x) = E (yi | xi = x) . If yi = x0 β + ei and E(xi ei ) = 0. Suppose that Y and X only take the values 0 and 1. E(Y 2 | X = x) and V ar(Y | X = x). σ 2 = V ar(yi ) and σ xy = Cov(xi . True or False. then ei is i i independent of xi . Show that x y β 1 = σ xy /σ 2 and β 0 = µy − β 1 µx . and E(xi ei ) = 0.6 Exercises 1.2. µx = Exi . If yi = x0 β + ei and E(ei | xi ) = 0. i 11. and the conditional distribution of yi given xi is Poisson: P (yi = k | xi = x) = e−x β (x0 β)j . x 6. then ei is independent of xi . and E(e2 | xi ) = σ 2 . y) = 3 x2 + y 2 on 0 ≤ x ≤ 1. xi ∈ R. True or False. 1. Prove parts 2. Suppose that yi is discrete-valued. If yi = x0 β + ei . then E(x2 ei ) = 0. True or False. j! 0 j = 0. True or False.3 Find E(Y | X = x). Let xi and yi have the joint density f (x. ¡ ¢ 4. Let X be a random variable with µ = EX and σ 2 = V ar(X). s) = 0 if and only if m = µ and s = σ 2 . σ 2 = V ar(xi ). 0 ≤ y ≤ 1.2 Y =1 . µ.

i It follows that the moment estimator of β replaces the population moments in (4. i n i=1 n 21 . 4.2) (4.3) In Sections 4. we narrow the focus to the linear regression model. 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 . Observe that (4.3) writes the projection coeﬃcient β as an explicit function of population moments E (xi yi ) and E (xi x0 ) .8.2) can be written in the parametric 0 β)) = 0. but for most of the chapter we retain the broader focus on the projection model.1) (4.7 and 4. (4.1 Estimation Equation (4.Chapter 4 Least Squares Estimation This chapter explores estimation and inference in the linear projection model yi = x0 β + ei i E (xi ei ) = 0 ¡ ¡ ¢¢−1 E (xi yi ) β = E xi x0 i (4. The function g(β) can be estimated by form g(β) = E (xi (yi − xi g (β) = ˆ ¢ 1X ¡ xi yi − x0 β .3) with the sample moments: ³ ¡ ¢´−1 ˆ ˆ ˆ β = E xi x0 E (xi yi ) i Ã n !−1 n 1X 1X 0 xi xi xi yi = n n i=1 i=1 Ã n !−1 n X X = xi x0 xi yi .4) i i=1 i=1 ˆ Another way to derive β is as follows.

This sample has 988 observations.117 Educationi .95 xi yi = 42. 0. These are white male wage earners from the March 2004 Current Population Survey. with 10-15 years of potential work experience.83 µ We often write the estimated equation using the format \ log(W agei ) = 1.170 37.3.4). consider the data used to generate Figure 3. ¶ 2. excluding military. n X i=1 2 yi − 2β 0 n X i=1 xi yi + β 0 n X i=1 xi x0 β. 4. 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 (4.37 µ ¶ 1.71 = −2. 40 2.14 14.4). Let yi be log wages and xi be an intercept and years of education.95 42.ˆ This is a set of k equations which are linear in β.30 + 0.117 1 14. 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.14 205.40 µ ¶µ ¶ 34.5) = n n 1X 1X ˆ xi yi − xi x0 β i n n i=1 i=1 whose solution is (4.14 14.7% increase in mean wages. Then µ ¶ n 1X 2.83 ¶−1 µ ¶ . i 22 . To illustrate.2 Least Squares There is another classic motivation for the estimator (4.14 205.40 n i=1 1 n Thus ˆ β = n X i=1 xi x0 i = µ 1 14. An interpretation of the estimated equation is that each year of education is associated with an 11. 30 = .94 −2.

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

ˆ n i=1 n Since xi contains a constant.6) An alternative estimator uses the formula n 1 X 2 s = ei . one implication is that n 1X ei = 0. 24 . 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. The error variance σ 2 = Ee2 is also a parameter of interest. It measures the variation in the i “unexplained” part of the regression. ˆ n−k 2 i=1 (4.7.2: Sum-of-Squared Error Function Contours Equation (4. ˆ σ = ˆ n 2 i=1 n (4.7) A justiﬁcation for the latter choice will be provided in Section 4. and hold true for all linear regression estimates. These are algebraic results.Figure 4.5) implies that 1X xi ei = 0. Its method of moments estimator is the sample average 1X 2 ei .

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 ). σ 2 ) = − log 2πσ 2 − 2 2 2σ i=1 25 . ˆ Plugging β into the log-likelihood we obtain n ¡ ¢ n 1 X 2 ˆ ei ˆ Ln (β. σ 2 ). This is the linear regression model with the additional assumption that the error ei is independent of xi and has the distribution N (0.where A measure of the explained variation relative to the total variation is the coeﬃcient of determination or R-squared. σ 2 ) is a function of β only through the sum of squared errors Sn (β). σ 2 ) maximize Ln (β. This is a parametric model. Instead. 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. σ ) = 2σ (2πσ 2 )1/2 i=1 ¡ ¢ n 1 = − log 2πσ 2 − 2 Sn (β) 2 2σ ˆ ˆ The MLE (β. and therefore is expected to be a better estimator of ρ2 than the unadjusted estimator R2 . 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. n−1 i=1 Theil’s estimator R is a ratio of adjusted variance estimators. Since Ln (β. testing. σ 2 ). Hence the MLE for β equals the OLS estimator. 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 . maximizing the likelihood is identical to minimizing Sn (β). It is an ˆ inappropriate label as the value of R2 does not help interpret the parameter estimates β or test statistics concerning β. and distribution theory. Pn y2 ˆ σ2 ˆ R2 = Pn i=1 i 2 = 1 − 2 σy ˆ i=1 (yi − y) σ2 = ˆy 1X (yi − y)2 n i=1 n is the sample variance of yi . where likelihood methods can be used for estimation. 4.

it is matrix notation. ⎝ ⎝ . = β+ XX 26 (4. For example n X i=1 For many purposes. We deﬁne ⎛ ⎞ ⎛ y1 ⎜ ⎜ y2 ⎟ ⎜ ⎟ ⎜ X=⎜ Y = ⎜ . . . yn ⎟ ⎟ ⎟. . ⎠ xi x0 = X 0 X i xi yi = X 0 Y. n or equivalently Y = Xβ + e. x0 n ⎞ ⎛ e1 e2 . Sample sums can also be written in matrix notation. yn = x0 β + en . ⎟. 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. en ⎞ Observe that Y and e are n × 1 vectors. . σ 2 ) for the normal ˆ regression model are identical to the method of moment estimators. ⎠ . ˆi 2 ∂σ 2 2ˆ σ 2 σ ˆ i=1 ˆ ˆ Solving for σ 2 yields the method of moments estimator (4. the ˆ OLS estimator β is frequently referred to as the Gaussian MLE.4 Model in Matrix Notation convenient to write the model and statistics in x0 1 x0 2 .Maximization with respect to σ 2 yields the ﬁrst-order condition n X ∂ n 1 ˆ ˆ Ln (β.8) . ⎠ ⎜ ⎜ e=⎜ ⎝ ⎟ ⎟ ⎟. We can stack these n equations together as y1 = x0 β + e1 1 y2 = x0 β + e2 2 . . n X i=1 Thus the estimator (4. Thus the MLE (β. Due to this equivalence. one for each observation. including computation. 4.6). and X is an n × k matrix. 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.12) is a system of n equations. . σ 2 ) = − 2 + ¡ ¢2 e2 = 0. residual vector. The linear equation (3.4).

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

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. . By the independence of the observations and (3. Rather. . . .9).9). In this case. obtain residuals X2 . In the model (4. Regress X2 on X1 . Regress Y on X2 .18) E (e | X) = ⎜ E (ei | X) ⎟ = ⎜ E (ei | xi ) ⎟ = 0. .14) or via the ˆ following algorithm: ˜ 1.7 Bias and Variance In this and the following section we consider the special case of the linear regression model (3.13). In this section we derive the small sample conditional mean and variance of the OLS estimator. A common application of the FWL theorem. Partition X = [X1 X2 ] where X1 = ι is a vector of ones. In some contexts. ˜ 2. which you may have seen in an introductory econometrics course. . ⎟ ⎜ ⎟ ⎜ (4. ! Thus the OLS estimator for the slope coeﬃcients is a regression with demeaned data. and X2 is the vector of observed regressors.6. The FWL theorem says that β 2 is the OLS estimate from a regression of ˜ ˜ Y on X2 . 4. obtain residuals Y .1 (Frisch-Waugh-Lovell). 30 . . the FWL theorem can be used to speed computation. the OLS estimator of β 2 and the OLS residuals e may be equivalently computed by either the OLS regression (4. 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) . ˆ ˜ ˜ ˆ 3. but in most cases there is little computational advantage to using the two-step algorithm. the primary use is theoretical. ˆ which are “demeaned”.8)(3. . is the demeaning formula for regression. obtain OLS estimates β 2 and residuals e. . ¡ ¢−1 0 ι. Regress Y on X1 . . ⎠ ⎝ ⎠ ⎝ .Theorem 4. observe that ⎞ ⎛ ⎞ ⎛ .

0 0 ··· 0 0 . X 0 DX = X 0 Xσ 2 . and ³ ´ ¡ ¢−1 2 ˆ σ .8). V ar β | X = X 0 X ⎟ ⎟ ⎟. under the of ˆ ¢ 2 | x = σ 2 . and the trace operator observe that. . ⎠ (4.Using (4. . . ¡ 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 ) = 0.12). ⎝ . We have shown that which implies ³ ´ ˆ E β|X =β ³ ´ ˆ E β =β (4.. σ2 n ⎞ We now calculate the ﬁnite sample bias of the method ¡ moments estimator σ 2 for σ 2 .. . From (4. σ2 = ˆ ¢ 1 ¡ ¢ 1 0 1 1 1 ¡ e e = e0 M M e = e0 M e = tr e0 M e = tr M ee0 ˆˆ n n n n n 31 In the special case of the linear homoskedastic regression model.19) ˆ and thus the OLS estimator β is unbiased for β. σ 2 } = ⎜ . . . for any random vector Z deﬁne the covariance materix V ar(Z) = E (Z − EZ) (Z − EZ)0 = EZZ 0 − (EZ) (EZ)0 ..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 . and (4.. σ 2 = σ 2 and we have the simplii ﬁcations D = In σ 2 . Thus D is a diagonal matrix with i’th diagonal element σ 2 : i ⎛ 2 σ1 0 · · · ⎜ 0 σ2 · · · 2 ⎜ D = diag{σ 2 . Then given (4. the properties additional assumption of conditional homoskedasticity E ei i of projection matrices. . the properties of conditional expectations.18). . 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. Next.20) . 1 n .

which we now present. which is (3. 4. As an alternative. that this estimator is only unbiased in the special case of the homoskedastic linear regression model. By a calculation similar to those of the previous section. the best (minimumvariance) unbiased linear estimator is OLS. It is important to remember.8. the estimator ˆ 2 deﬁned (4. says that the least-squares estimator is the best choice. ³ ´ ˜ E β | X = A0 Xβ. and thus can be written as ˜ β = A0 Y where A is an n × k function of X.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 . In this case.9) plus E e2 | xi = σ 2 . What is the best choice of A? The Gauss-Markov theorem. or in the projection model. as it yields the smallest variance among all unbiased linear estimators. ˜ β L = A0 Y = A (Xβ + e) = β + Ae. = σ2 n the ﬁnal equality by (4.1 Gauss-Markov. ³ ´ ˜ V ar β | X = A0 V ar (e | X) A = A0 Aσ 2 . The least-squares estimator is the special case obtained by setting A = X(X 0 X)−1 . In the homoskedastic linear regression model. is a famous statement of the solution. Now consider the class of estimators of β which are linear functions of i the vector Y. however.10). known as the Gauss-Markov theorem.7) is unbiased for σ 2 by this calculation. ˜ so β is unbiased if (and only if) A0 X = Ik .8 Gauss-Markov Theorem In this section we restrict attention to the homoskedastic linear regression model. Thus σ 2 is biased towards zero.8)¢ ¡ (3. The following result. This is the justiﬁcation for the common s ˆ preference of s2 over σ 2 in empirical practice. It is not unbiased in the absence of homoskedasticity. 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. Theorem 4. 32 . Thus since V ar (e | X) = In σ 2 under homoskedasticity.

π j is the percentage of the observations ˆ ˆ which fall in each category.5) as required. and π j . The variance of the least-squares estimator is (X 0 X)−1 σ 2 and that of A0 Y is A0 Aσ 2 . (We know the values yi and xi can take..9 Semiparametric Eﬃciency In the previous section we presented the Gauss-Markov theorem as a limited eﬃciency justiﬁcation for the least-squares estimator.. ¥ The Gauss-Markov theorem is an eﬃciency justiﬁcation for the least-squares estimator. the maximum likelihood estimator (MLE) is ¡ ¢ 1X 1 (yi = τ j ) 1 xi = ξ j πj = ˆ n i=1 n for j = 1. Not only has the class of models has been restricted to homoskedastic linear regressions..3) can be rewritten as ⎞−1 ⎛ ⎞ ⎛ r r X X β=⎝ πj ξ j ξ 0 ⎠ ⎝ πj ξ j τ j ⎠ (4. 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. and is a strong justiﬁcation for the least-squares estimator. Assume that the τ j and ξ j are known. That is. As the data are multinomial. . who established that in the projection model the OLS estimator has the smallest asymptotic meansquared error among feasible estimators. Suppose that the joint distribution of (yi . r for some constant vectors τ j . but it is quite limited in scope. The MLE β mle for β is then the analog of (4... xi = ξ j = π j . . where 1 (·) is the indicator function. We discuss the intuition behind his result in this section. Set C = A − X (X 0 X)−1 . j = 1. r.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 ⎠ . . but we don’t know the probabilities. It is suﬃcient to show that the diﬀerence A0 A − (X 0 X)−1 is positive semi-deﬁnite. the class of potential estimators has been restricted to linear unbiased estimators.. That is.. ξ j . This property is called semiparametric eﬃciency. ˆ β mle = ⎝ j j=1 j=1 33 . but the π j are unknown. Let A be any n×k function of X such that A0 X = Ik . 4. This latter restriction is particularly unsatisfactory.. the deﬁnition (4.21) j j=1 j=1 Thus β is a function of (π 1 . ¡ ¢ P yi = τ j .) In this discrete setting. A broader justiﬁcation is provided in Chamberlain (1987). xi ) is discrete.. Note that X 0 C = 0.Proof. for ﬁnite r. 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. π r ) .

Substituting in the expressions for π j .10) for the class of models satisfying Assumption 3. and thus so is the OLS estimator.5. Chamberlain (1987) extends this argument to the case of continuously-distributed data.10 Omitted Variables xi = µ x1i x2i ¶ .1. 1X xi x0 i n i=1 1X xi yi n i=1 n ˆ = β ols 4. and any continuous distribution can be arbitrarily well approximated by a multinomial distribution. He proves that generically the OLS estimator (4. 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 . (4.22) 34 . We can write the model as yi = x0 β 1 + x0 β 2 + ei 1i 2i E (xi ei ) = 0 where the parameter of interest is β 1 . if the data have a discrete distribution. the maximum likelihood estimator is identical to the OLS estimator. ˆ r X j=1 πj ξ j ξ 0 ˆ j r n X1X ¡ ¢ = 1 (yi = τ j ) 1 xi = ξ j ξ j ξ 0 j n j=1 = 1 n 1 n i=1 n X X r i=1 j=1 n X i=1 ¡ ¢ 1 (yi = τ j ) 1 xi = ξ j xi x0 i = and r X j=1 xi x0 i πj ξ j τ j ˆ r n X1X ¡ ¢ = 1 (yi = τ j ) 1 xi = ξ j ξ j τ j n j=1 i=1 = r n ¡ ¢ 1 XX 1 (yi = τ j ) 1 xi = ξ j xi yi n = Thus ˆ β mle = Ã 1 n n i=1 j=1 n X i=1 xi yi !−1 Ã ! In other words. He observes that the above argument holds for all multinomial distributions. Since this is a regular parametric model the MLE is asymptotically eﬃcient (see Appendix A.9).4) is an asymptotically eﬃcient estimator for the parameter β deﬁned in (3.

or second. To see this. 4. β 1 6= γ 1 . The diﬀerence Γβ 2 is known as omitted variable bias. 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 .11 Multicollinearity ˆ If rank(X 0 X) < k + 1.22) the long regression and (4. as many desired variables are not available in a given dataset.23) where is the coeﬃcient from a regression of x2i on x1i . we regress yi on x1i only. Most commonly. there is some α such that Xα = 0. and the error as ui rather than ei .22) by least-squares. For example. This is the situation when the X 0 X matrix is near singular. This happens when the columns of X are linearly dependent.Now suppose that instead of estimating equation (4. when the columns of X are close to linearly dependent.22) is zero. This is because the model being estimated is diﬀerent than (4. In this case. 35 .23) the short regression to emphasize the distinction. the general model will be free of the omitted variables problem. this is rarely a problem for applied econometric practice. then β is not deﬁned. By construction. except in special cases. Typically there are limits. Goldberger (1991) calls (4. This is called strict multicollinearity. the possibility of omitted variables bias should be acknowledged and discussed in the course of an empirical investigation.22). To avoid omitted variables bias the standard advice is to include potentially relevant variables in the estimated model. When this happens.23) is an estimate of γ 1 = β 1 + Γβ 2 rather than β 1 . the regression of x2i on x1i yields a set of zero coeﬃcients (they are uncorrelated). which is often called “multicollinearity” for brevity. 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. i. First.. Since the error is discovered quickly. It is the consequence of omission of a relevant correlated variable. Thus the short and long regressions have the same coeﬃcient on x1i only under one of two conditions. Observe that γ 1 6= β 1 unless Γ = 0 or β 2 = 0. because we have not said what it means for a matrix to be “near singular”. if X includes both the logs of two prices and the log of the relative prices. This is one diﬃculty with the deﬁnition and interpretation of multicollinearity. the coeﬃcient on x2i in (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.e. log(p2 ) and log(p1 /p2 ). this arises when sets of regressors are included which are identically related. Typically. least-squares estimation of (4. The more relevant issue is near multicollinearity. In general. log(p1 ).

27) (4. 1] and sum to k. the precision of individual estimates are reduced. To investigate the possibility of inﬂuential observations. it is statistically diﬃcult to disentangle the impact of β 1 from that of β 2 .One implication of near singularity of matrices is that the numerical reliability of the calculations is reduced. the worse the precision of the individual coeﬃcient estimates. We can also deﬁne the leave-one-out residual ˆ ˆ ei. ˆ i A simple comparison yields that ˆ ei − ei. the OLS estimator based on the sample excluding the i’th observation. 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 .−i = (1 − hi )−1 hi ei . that is.25) below. A convenient alternative expression is ¡ ¢−1 ˆ ˆ xi ei ˆ (4. deﬁne the leave-one-out least-squares estimator of β. The hi take values in [0. since as ρ approaches 1 the matrix becomes singular. ˆ ˆ (4. We can see the eﬀect of collinearity on precision by observing that the asymptotic variance of a coeﬃcient ¡ ¢−1 approaches inﬁnity as ρ approaches 1. We can see this most simply in a homoskedastic linear regression model with two regressors yi = x1i β 1 + x2i β 2 + ei .12 Inﬂuential Observations where X(−i) and Y(−i) are the data matrices omitting the i’th row.26) As we can see. A more relevant implication of near multicollinearity is that individual coeﬃcient estimates will be imprecise.24) β (−i) = X(−i) X(−i) is the i’th diagonal element of the projection matrix X (X 0 X)−1 X 0 . What is happening is that when the regressors are highly dependent. µ ¶−1 µ ¶ ³ ´ 2 σ2 1 ρ 1 −ρ ˆ|X = σ .−i = yi − x0 β (−i) = (1 − hi )−1 ei . This equals ´−1 ³ 0 ˆ X(−i) Y(−i) (4. = V ar β ρ 1 n n (1 − ρ2 ) −ρ 1 4. If the i’th observation 36 . We derive expression (4. and 1 0 XX= n µ 1 ρ ρ 1 ¶ In this case The correlation ρ indexes collinearity. Thus the more “collinear” are the estimate σ 2 1 − ρ2 regressors.25) β (−i) = β − (1 − hi )−1 X 0 X where ¢−1 ¡ xi hi = x0 X 0 X i The i’th observation is inﬂuential on the least-squares estimate if the deletion of the observation ˆ from the sample results in a meaningful change in β. As a consequence.

ˆ = β − (1 − hi )−1 X 0 X and thus ˆ β (−i) = 37 . ˆ We now derive equation (4.1) in Section 2. then this observation is a leverage point and has the potential to be an inﬂuential observation. The key is equation (2. which is considerably more informative than plots of the uncorrected residuals ei .27).This implies has a large value of hi . ¢−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).4 which states that ¡ ¢ (A + BCD)−1 = A−1 − A−1 BC C + CDA−1 BC CDA−1 .

4.13

Exercises

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

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

Pn

i=1 g

¡ ¢ Xi , µ, σ 2 .

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

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

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

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

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

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

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

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

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

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

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

39

(f) (g) (h)

Pn

Pn

ˆˆ i=1 yi ei ˆ2 i=1 ei R2

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

40

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

Applying expectations. Let a + bx be the tangent line to g(x) at x = EX.3). ¥ Proof of Holder’s Inequality. Eg(X) ≥ a + bEX = g(EX). We say that Zn converges in probability to Z as n → ∞. Let U = |X|p /E |X|p and V = |Y |q /E |Y |q . Since g(x) is convex. g(x) ≥ a + bx yet g(EX) = a + bEX since the curve is tangent at EX. =E U V p q p q Proof of Markov’s Inequality.4) Proof of Jensen’s Inequality. p p p q which is (5.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. 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}. tangent lines lie below it.1 Weak Law of Large Numbers (WLLN). as stated. Set Y = g(X) and let f denote the density function of Y. Note EU = EV = 1. Theorem 5.2. For any strictly increasing function g(X) ≥ 0. If Xi ∈ Rk is iid and E |Xi | < ∞. n i=1 42 . n→∞ lim P (|Zn − Z| > δ) = 0. then as n → ∞ n 1X Xn = Xi →p E(X). denoted Zn →p Z as n → ∞. (5.2 Weak Law of Large Numbers Let Zn ∈ Rk be a random vector. So for all x. This is a probabilistic way of generalizing the mathematical deﬁnition of a limit. if for all δ > 0. The WLLN shows that sample averages converge in probability to the population average. ¥ 5. Since 1 + 1 = 1 an application of Jensen’s inequality shows that p q U Then 1/p V 1/q 1 1 ln U + ln V = exp p q E |XY | ∙ ¸ ≤ 1 1 U V exp (ln U ) + exp (ln V ) = + . P (g(X) > α) ≤ α−1 Eg(X).

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

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

k ≤ m. 45 . Theorem 5. Proof: Since g is continuous at c.4 Asymptotic Transformations Theorem 5. then g(Zn ) →p g(c) as n → ∞.4.4. It follows that ajn = gjθ (θ∗ ) − gjθ →p 0. we ﬁnd jn ¢ ¡ √ √ 0 n (g (θn ) − g(θ0 )) = (gθ + an ) n (θn − θ0 ) →d gθ N (0. ¥ 5. then g(Zn ) →d g(Z) as n → ∞. This is suﬃcient to establish the theorem. then ¡ ¢ √ 0 n (g (θn ) − g(θ0 )) →d N 0. Since cλλ (λn ) → cλλ (0) = −Ik . Σ) = N 0. for all ε > 0 we can ﬁnd a δ > 0 such that if |Zn − c| < δ then |g (Zn ) − g (c)| ≤ ε. Hence g(Zn ) →p g(c) as n → ∞. Σ) . If Zn →d Z as n → ∞ and g (·) is continuous. Ik ) distribution. and g(θ) : Rm → Rk .3 Delta Method: If n (θn − θ0 ) →d N (0. for each element of g. Proof : By a vector Taylor series expansion.2 Continuous Mapping Theorem 2. Thus P (|g (Zn ) − g (c)| ≤ ε) ≥ P (|Zn − c| < δ) → 1 as n → ∞ by the assumption that Zn →p c.√ where λn → 0 lies on the line segment joining 0 and λ/ n. gj (θn ) = gj (θ0 ) + gjθ (θ∗ ) (θn − θ0 ) jn where θnj lies on the line segment between θn and θ0 and therefore converges in probability to θ0 . √ Theorem 5. gθ Σgθ where gθ (θ) = ∂ g(θ) ∂θ0 and gθ = gθ (θ0 ). µ ¶ 1 Cn (λ) → exp − λ0 λ 2 the characteristic function of the N (0. gθ Σgθ . Recall that A ⊂ B implies P (A) ≤ P (B).4. we see that as n → ∞. Stacking across elements of g. where θ is m × 1 and Σ is m × m.1 Continuous Mapping Theorem 1 (CMT). If Zn →p c as n → ∞ and g (·) is continuous at c.

1: Sampling Density of β 2 To illustrate the possibilities in one example. xi ) and the sample size n. y) = 2πxy 2 2 ˆ and let β 2 be the slope coeﬃcient estimate computed on observations from this joint density.1 for sample sizes of n = 25. since it is a function of the random data. In general. 46 . the density function of β 2 was computed and plotted in Figure 6.1 Sampling Distribution The least-squares estimator is a random vector. The verticle line marks the true value of the projection coeﬃcient. Using ˆ simulation methods. n = 100 and n = 800. its distribution is a complicated function of the joint distribution of (yi .Chapter 6 Inference 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. ˆ Figure 6. and therefore has a sampling distribution.

1 and the WLLN (Theorem 5. we will use the methods of asymptotic approximation. Equation (4. For a complete argument. 0) = Q−1 0 = 0 β−β =g n n i=1 i=1 ˆ which implies β →p β as stated. n i=1 (6. Ã n ! n X 1X 0 1 ˆ xi xi .1). (6. Assumption 3. To characterize the sampling distribution more fully.2. This is illustrated in Figure 6. Assumption 3. ¥ We can similarly show that the estimators σ 2 and s2 are consistent for σ 2 .1) and ˆ We now deduce the consistency of β. (6.5.4.2) i i n i=1 n From (6.4. Asymptotic (large sample) methods approximate sampling distributions based on the limiting experiment that the sample size n tends to inﬁnity. and the continuous mapping theorem (Theorem 5.1 Under Assumption 3.2). β →p β as n → ∞. xi ei →p g (Q. ·) is continuous at (Q.1).1) imply that n ¡ ¢ 1X xi x0 →p E xi x0 = Q (6.1.4 implies that Q−1 exists and thus g(·. As the sample size increases the density becomes more concentrated about the population coeﬃcient. using (6.2.5.5.8) implies that ˆ β−β = Ã n X i=1 xi x0 i !−1 n X i=1 xi ei . (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 . 0).1).3) Ã where g(A. Proof. 6.1. 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. b) = A−1 b is a continuous function of A and b at all values of the arguments such that A−1 exist. ˆ Theorem 6.2 Consistency ˆ As discussed in Section 6. Hence by the continuous mapping theorem (Theorem 5. xi ei = g i n n i=1 i=1 1X xi ei →p E (xi ei ) = 0.1).1 by the fact that the sampling densities become more concentrated as n gets larger. we can conclude ˆ that β →p β.3).1.From the ﬁgure we can see that the density functions are dispersed and highly non-normal. First. ˆ 47 . the OLS estimator β is has a statistical distribution which is unknown.

1).2). n 1 X √ xi ei →d N (0. it follows that s2 = ¥ n σ 2 →p σ 2 .5.4) 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. σ 2 →p σ 2 and s2 →p σ 2 as n → ∞. i i Assumption 6.5) Thus xi ei is iid with mean zero and has covariance matrix Ω.2.1 guarantees that the elements of Ω are ﬁnite.Theorem 6. since n/(n − k) → 1 as n → ∞. Assumption 6.3 Asymptotic Normality ˆ We now establish the asymptotic distribution of β after normalization. (6.3. by the Cauchy-Schwarz inequality (5.3. ˆ Proof. 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 .1 In addition to Assumption 3. (6. (6. To see this.5. E ¯ei ¯ E ¯e4 ¯ i i i i (6. ˆ n−k 6.2 Under Assumption 3.2). (6.2.6) n i=1 48 .3) and Theorem (6.3. ´1/2 ¡ ¯ ¯¢ ¯ ³ ¯ ¯2 ´1/2 ¡ ¯ 4 ¯¢1/2 ³ ¯ 1/2 E ¯xi x0 e2 ¯ ≤ E ¯xi x0 ¯ = E |xi |4 < ∞.1). Ee4 < ∞ and E |xi |4 < ∞. Ω) .1. We need a strengthening of the moment conditions. ˆ Finally.1. i Now deﬁne ¡ ¢ Ω = E xi x0 e2 . By the central limit theorem (Theorem 5. Thus σ 2 is consistent for σ 2 .

there is no simple answer to this reasonable question.7) is true or false.2). e2 ) = 0. For α 49 . for example.1 states that the sampling distribution of the least-squares estimator.7) the asymptotic variance formulas simplify as ¡ ¢ ¡ ¢ (6. and εi is independent of xi with the Double Pareto density f (ε) = α |ε|−α−1 . If α > 2 the 2 error εi has zero mean and variance α/(α − 2). (6.7) is true then V = V 0 . There is a special case where Ω and V simplify.1 Under Assumption 6. 1) asymptotic distibution.8) Ω = E xi x0 E e2 = Qσ 2 i i V = Q−1 ΩQ−1 = Q−1 σ 2 ≡ V 0 (6. 1). V ) where V = Q−1 ΩQ−1 . otherwise V 6= V 0 . 1 X √ xi ei n i=1 n ! the N (0. The approximation may be poor when n is small. When (6. when xi and ei are independent. We illustrate this problem using a simulation. The trouble is that no matter how large is the sample size.3. V is often referred to as ˆ the asymptotic covariance matrix of β. the normal approximation is arbitrarily poor for some data distribution satisfying the assumptions. i i Condition (6.2 we display the ﬁnite sample densities of the q ³ ˆ normalized estimator n α−2 β 2 − β 2 .3.6).7) Cov(xi x0 . The expression V = Q−1 ΩQ−1 is called a sandwich form. xi ) which satisfy the conditions of Assumption 6. However.1. but this is not a necessary condition.7) holds.3.3. We call V 0 the homoskedastic covariance matrix. and (6. In´Figure 6. as n → ∞ ´ √ ³ ˆ n β − β →d N (0.9) In (6.Then using (6. its variance diverges q ³ ´ ˆ to inﬁnity. is approximately normal when the sample size n is suﬃciently large. setting n = 100 and varying the parameter α.9) we deﬁne V 0 = Q−1 σ 2 whether (6. however. Q−1 ΩQ−1 . ´ √ ³ ˆ n β−β = Ã 1X xi x0 i n i=1 n !−1 Ã Theorem 6. In Figure 6.3. Under (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.1 is commonly used to approximate the ﬁnite of √ ³ˆ sample distribution of n β − β . |ε| ≥ 1. Ω) ¡ ¢ = N 0. The asymptotic distribution ´ Theorem 6. Theorem 6. In this context the normalized least-squares slope estimator n α−2 β 2 − β 2 has α →d Q−1 N (0.1). Let yi = β 0 + β 1 xi + εi where xi is N (0. after rescaling. We say that ei is a Homoskedastic Projection Error when (6. ´ √ ³ˆ As V is the variance of the asymptotic distribution of n β − β . As α approaches 2. This holds true for all joint distibutions of (yi .1. How large should n be in order for the approximation to be useful? Unfortunately. for any ˆ ﬁxed n the sampling distribution of β can be arbitrarily far from the normal distribution.

2: Density of Normalized OLS estimator α = 3. 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. we need an estimate of Ω = E xi x0 e2 . The estimator 2 2 in (6.0 the density is very close to the N (0.11) 50 .1) it is clear that V 0 →p V 0 . The MME estimator is i i 1X ˆ xi x0 e2 Ω= i ˆi n i=1 n (6. σ may also be substituted for s ˆ ¡ ¢ To estimate V = Q−1 ΩQ−1 . The lesson from Figures 6. The homoskedastic covariance matrix V 0 = Q−1 σ 2 is typically estimated by ˆ ˆ (6. 6 and 8. ˆ ˆ Since Q →p Q and s2 →p σ 2 (see (6. 1) asymptotic approximation is never guaranteed to be accurate. As α diminishes the density changes signiﬁcantly. concentrating most of the probability mass around zero.10) without changing this result.2.4 Let Covariance Matrix Estimation 1X ˆ xi x0 Q= i n i=1 n be the method of moments estimator for Q. the sampling distribution becomes highly skewed and non-normal. Another example is shown in Figure 6.10) V 0 = Q−1 s2 .Figure 6. As k increases.2) and Theorem 6.2 and 6. 6.3 is that the N (0.3. 4. 1) density. 1). for k = 1. We show the sampling distribution of n β 1 − β 1 setting n = 100.

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

35/988 = . (.30 + 0.14 205. but not under another set of assumptions.199 2.14 14.14 14. We calculate that s2 = 0. To illustrate. We can write the estimated equation with standards errors using the format \ log(W agei ) = 1.035 ¶ . the standard method to calculate the standard errors is to ˆ ﬁrst calculate n−1 V . by Holder’s inequality (5.14 205.493 −0. we return to the log wage regression of Section 4.6 Therefore the two covariance matrix estimates are µ ¶−1 µ ¶ 1 14.83 ¶−1 = µ 7. Using (6.14 6.020) 6. n n i=1 52 .5) and the WLLN (Theorem 5.20 −0.5 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.4) ˆ Ω = = n n n ³ ´0 ³ ´0 ³ ´ 1X 2X 1X 0 2 0 ˆ ˆ ˆ xi xi ei − xi xi β − β xi ei + xi x0 β − β xi x0 β − β .6 ¶µ 1 14.98 −0. The standard errors for β 0 are 7.used by an author when studying their work.085 p ˆ and that for β 1 is .14 205.493 0. just as any other estimator.80 2.085) (. First.2/988 = .039 and ˆ V = µ 1 14.480 .80 . (6.117 Educationi .80 40. (6.3) so by the WLLN ³ ´ ³ ´3/4 ¡ ¯ ¯¢ 1/4 E |xi |3 |ei | ≤ E |xi |4 < ∞.20 = V 14.1. From a computational standpoint.80 40. It is also important to understand that a particular standard error may be relevant under one set of model assumptions.480 ˆ0 = 0.1) show that n ¡ ¢ 1X xi x0 e2 →p E xi x0 e2 = Ω. then take the diagonal elements.20 and µ ¶ ˆ = 0.12) in turn.12) i i n n n i=1 i=1 We now examine each sum on the right-hand-side of (6. and then the square roots. p ˆ In this case the two estimates are quite similar. from which it follows that V →p V as n → ∞.83 ¶−1 µ .83 −0.2. i i i i n i=1 Second.020.199 2. Ω 2. E ¯e4 ¯ i ³ ´ 1X |xi |3 |ei | →p E |xi |3 |ei | .

25).¯ ¯ ¯ ¯ˆ and thus since ¯β − β ¯ →p 0.14) 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 . i=1 Third.13) Using formula (4. n i=1 n ˆ ˆ Theorem 6.6 Alternative Covariance Matrix Estimators ˆ MacKinnon and White (1985) suggested a small-sample corrected version of V based on the jackˆ knife principle.13) of Efron (1982). They also suggest that the scaling factor (n − 1)/n in (??) can be omitted. which. From equation (3. these establish consistency.−i = (1 − hi )−1 ei ˆ presented in (4. is deﬁned ˆ ˆ by replacing the OLS residual ei in (6. 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. 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. you can show that 1 Xˆ ¯ β= β (−i) . n i=1 n − 1 ˆ −1 ˆ ∗ ˆ −1 ˆ V∗ = Q Ω Q n where 1X ˆ (1 − hi )−2 xi x0 e2 − Ω∗ = i ˆi n i=1 n (6. Using this substitution. Ω →p Ω and V →p V. Andrews’ proposed estimator is ˆ ˆ ˆ ˆ V ∗∗ = Q−1 Ω∗∗ Q−1 53 . Andrews (1991) suggested an similar estimator based on cross-validation. Recall from Section 4. 6.26). MacKinnon and White (1985) present numerical (simulation) evidence i ˆ ˆ that V ∗ works better than V as an estimator of V . ¯ ¯ ¯ ¯ ¯n ¯ n i=1 i=1 1X |xi |4 →p E |xi |4 . ¯ n ¯ n ¯2 X ¯1 X ³ ´0 ³ ´¯ ¯ ¯ 0 ˆ ˆ ˆ − β ¯ ≤ ¯β − β ¯ 1 xi xi β − β xi xi β |xi |4 →p 0.1 As n → ∞. ¯ ¯n ¯ n i=1 so Together.11) with the leave-one-out estimator ei.5.12 the deﬁnition of β (−i) as the least-squares estimator with the i’th observation deleted.

. Hβ = ∂β In many cases. ˆ θ What is an appropriate standard error for ˆ Assume that h(β) is diﬀerentiable at the true θ? value of β. then the natural estimate for the variance of ˆ is θ ˆ0 ˆ ˆ ˆ Vθ = Hβ V Hβ where ∂ ˆ ˆ h(β). β k+1 ). so Vθ = R0 V R.15) where 0 Vθ = Hβ V Hβ . the function h(β) is linear: h(β) = R0 β ˆ ˆ ˆ for some k × q matrix R. Ω∗∗ = i ˆi n i=1 n 6.. 54 . 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. Let h : Rk → Rq denote this function and let θ = h(β) denote the parameter of interest. Vθ ). For example. ˆ ˆ If V is the estimated covariance matrix for β. V ) where ∂ h(β) ∂β (k + 1) × q.where ˆ It is similar to the MacKinnon-White estimator V ∗ . The estimate of θ is ˆ = h(β). 1X ˆ (1 − hi )−2 xi x0 e2 . In these cases we can write the parameter of interest as a function of β. . = N (0. we may be interested in a single coeﬃcient β j or a ratio β j /β l . Andrews ˆ ˆ (1991) argues that simulation evidence indicates that V ∗∗ is an improvement on V ∗ . but omits the mean correction. In this case. By a ﬁrst-order Taylor series approximation: ³ ´ 0 ˆ ˆ h(β) ' h(β) + Hβ β − β . Hβ = R and Hβ = R. (6.7 Functions of Parameters Sometimes we are interested in some lower-dimensional function of the parameter vector β = (β 1 ..

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

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

This corresponds to selecting the conﬁdence h i h ˆ ± 1.05. However we often can calculate the asymptotic coverage probability limn→∞ P (θ ∈ Cn ). The t-test of the previous setion rejects H0 : θ0 = θ if |tn (θ)| > zα/2 where tn (θ) is the t-statistic (6.16) and zα/2 is the upper α/2 quantile of the standard normal distribution. θ θ) (6. the most common professional choice isi95%. and it is desired to test the joint restrictions simultaneously. 6. While there is no hard-and-fast guideline for choosing the coverage probability 1 − α.10 Wald Tests Sometimes θ = h(β) is a q × 1 vector. 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. 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 .17) = ˆ − zα/2 s(ˆ θ and Cn is an asymptotic (1 − α)% conﬁdence interval. ¢ ¡ ¢ ¡ P (θ ∈ Cn ) = P |tn (θ)| ≤ zα/2 → P |Z| ≤ zα/2 = 1 − α. We say that Cn has asymptotic (1 − α)% coverage for θ if P (θ ∈ Cn ) → 1 − α as n → ∞. 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). 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 + zα/2 s(ˆ . θ The interval has been constructed so that as n → ∞. 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. We have the null and alternative H0 : θ = θ0 H1 : θ 6= θ0 .96s(ˆ ≈ ˆ ± 2s(ˆ .18) . or α = . = n h(β) − θ0 Hβ V Hβ 57 (6.We typically cannot calculate the exact coverage probability P (θ ∈ Cn ). A good method for construction of a conﬁdence interval is the collection of parameter values which are not rejected by a statistical test.

Furthermore. As before.19) σ2 ˆ where σ2 = ˜ 1 0 e e. Hβ (β) is a continuous function of β. if rank(Hβ ) = q. θ = β 2 . The asymptotic p-value for Wn is pn = p(Wn ).10. then the Wald statistic can be written in the form ¶ µ 2 ˆ σ − σ2 ˜ Wn = n (6. Wn = n R0 β − θ0 ´ √ ³ The delta method (6. and Theorem 6. then Wn →d χ2 . We have established: ³ ´0 ³ ´ ˆ − θ0 V −1 ˆ − θ0 →d Z 0 V −1 Z = χ2 .15) showed that n ˆ − θ →d Z ∼ N (0. ˜˜ n ˜ e = Y − X1 β 1 . In this case. so by the continuous mapping ˆ ˆ ˆ ˆ ˆ theorem. 1] under H0 . a chiq square random variable with q degrees of freedom.When h is a linear function of β.8. Also h(β) = a selector matrix. Thus Vθ = H 0 V Hβ →p H 0 V Hβ = Vθ > 0 if Hβ has full rank q.5. Vθ ). ˆ Wn = n θ θ q θ θ Theorem 6.3. the test rejects at the α% level iﬀ pn < α.11 F Tests Y = X1 β 1 + X2 β 2 + e Take the linear model where X1 is n × k1 and X2 is n × k2 and k + 1 = k1 + k2 . For example. the upper-α quantile q 2 of the χ2 distribution. q and pn is asymptotically U[0.1.05) = 3. χ2 (. Hence β β by Theorem A.1 showed θ ˆ that V →p V. = nβ 2 R0 V R R0 β is linear with R = µ 0 I ¶ ¢−1 ¡ ˆ ˆ ˆ . 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 2.2. where p(x) = P χ2 ≥ x is the tail q q probability function of the χ2 distribution. An asymptotic Wald test rejects H0 in favor of H1 if Wn exceeds χ2 (α). The null hypothesis is H0 : β 2 = 0. The Wald test fails to reject if Wn is q 1 ¡ ¢ less than χ2 (α).025 . and there are q = k2 restrictions. Hβ (β) →p Hβ . then the Wald statistic takes the form ´0 ³ ´ ³ ´−1 ³ ˆ ˆ ˆ R0 V R R0 β − θ 0 . h(β) = R0 β.1 Under H0 and Assumption 6. the covariance What we will show in this section is that if V is replaced with V 0 = σ 2 n−1 X 0 X matrix estimator valid under homoskedasticity. ˜ 58 ¡ 0 ¢−1 0 ˜ β 1 = X1 X1 X1 Y .84 = z.

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

6. s The spectral decomposition of M yields ¸ ∙ In−k−1 0 H0 M =H 0 0 (see equation (2. While there are special cases where this F statistic is useful. equivalently the residual variance from an intercept-only model. e ˆ M 0 σ2 M where M = I − X (X 0 X)−1 X 0 . This is rarely an issue today. H 0 H) ∼ N (0. 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. as sample sizes are typically suﬃciently large that this F statistic is highly “signiﬁcant”. σ 2 ) can be be used to calculate a set of exact distribution results. these cases are atypical. under the normality assumption the error vector e is independent of X and ¢ ¡ has distribution N 0. Since uncorrelated normal variables are independent. In σ 2 . This was a popular statistic in the early days of econometric reporting. Since linear functions of normals are also normal. 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 .12 Normal Regression Model As an alternative to asymptotic distribution theory. The modelling assumption that the error ei is independent of xi and N (0. σ 2 /(n − k) ˆ σ2 = ˜y 1 (y − y)0 (y − y) n is the sample variance of yi . This special F statistic is testing the hypothesis that all slope coeﬃcients (other than the intercept) are zero. an “F statistic” is reported. In particular. it follows ˆ that β is independent of any function of the OLS residuals.where In many statistical packages. This is ¢ ¡ 2 ˆ σ y − σ 2 / (k − 1) ˜ F = . when sample sizes were very small and researchers wanted to know if there was “any explanatory power” to their regression. In ) .4)) where H 0 H = In . introduced in Section 4.3. Let u = σ −1 H 0 e ∼ N (0. when an OLS regression is reported. including the estimated error variance 2. there is an exact distribution theory available for the normal linear regression model. n−k 60 .

The Gaussian log-likelihood at these estimates is ¡ ¢ n 1 ˆ ˆ ˆ σ Ln (β 1 . σ2 ˆ 61 .12. σ 2 ).1 If ei is independent of xi and distributed N(0. β 2 . As inference (conﬁdence intervals) are based on the t-ratio. σ 2 ) − Ln (β 1 . σ 2 (X 0 X)−1 • (n−k)s2 σ2 ˆ β j −β j ˆ s(β ) j ∼ χ2 . ˆ 2 2 2 ˜ ˜ The MLE of the model under the null hypothesis is (β 1 . σ 2 ) = − log σ − log (2π) − . so as a practical matter it does not matter which distribution is used.a chi-square distribution with n − k degrees of freedom. if standard errors are calculated using the homoskedastic formula (6. σ ˆ ˆ βj − βj βj − βj N (0. σ 2 ) = − log 2πˆ 2 − 2 e0 e ˆˆ 2 2ˆ σ ¡ ¢ n n n = − log σ 2 − log (2π) − . n−k • ∼ tn−k ˆ In Theorem 6.) Now let us partition β = (β 1 . 2 2 2 The LR statistic for H0 is ´ ³ ˆ ˆ ˆ ˜ ˜ LR = 2 Ln (β 1 . (Unless the sample size is unreasonably small.12. 0. The critical values are quite close if n − k ≥ 30.10) µ h i ¶ 2 (X 0 X)−1 N 0. Theorem 6.1 and Theorem 6. 0. and standard errors are calculated using the homoskedastic formula (6.3. with residual variance σ . β and t are approximately normally distributed. the notable distinction is between the N (0. 1) and tn−k distributions. β 2 . σ 2 ) where β 1 is the OLS estimate from ˜ 2 ˜ a regression of yi on x1i only. which is twice the diﬀerence in the log-likelihood function evaluated under the null and alternative hypotheses.1 we showed that in large samples. We summarize these ﬁndings Theorem 6. β has an exact normal distribution and t has an exact t distribution. 0.8. β 2 ) and consider tests of the linear restriction H0 : β 2 = 0 H1 : β 2 6= 0 In the context of parametric models.10) then ´ ³ ˆ • β ∼ N 0. σ 2 ) ¡ ¢¢ ¡ ¡ ¢ ˆ = n log σ 2 − log σ 2 ˜ µ 2¶ σ ˜ = n log . The estimator under the alternative is the unrestricted estimator ˆ ˆ ˆ (β 1 . β 2 . 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. Furthermore. The log-likelihood of this model is ¡ 2¢ n n n ˜ ˜ ˜ Ln (β 1 . In contrast.1 shows that under the strong assumption of ˆ normality. a good testing procedure is based on the likelihood ratio statistic.

It is easy to see that in each case there are values of s for which the line is for the case β test statistic is signiﬁcant relative to asymptotic critical values. setting n/σ 2 = 10. Our ﬁrst-order asymptotic theory is not useful to help pick s. This can be seen by a simple example introduced by Lafontaine and White (1986). σ2 ˆ Now notice that H0 is equivalent to the hypothesis H0 (s) : β s = 1 for any positive integer s.13 Problems with Tests of NonLinear Hypotheses While the t and Wald tests work well when the hypothesis is a linear restriction on β. 6. 62 . and noting Hβ = sβ s−1 . Then the standard Wald test for H0 is ˆ ³ ´2 ˆ β−1 Wn = n . Take the model yi = β + ei ei ∼ N (0. LR = n log 1 + 2 − 1 ' n σ ˆ σ2 ˆ the F statistic.84 — the probability of a false rejection. This is distressing since the choice of s seems arbitrary and irrelevant to the actual hypothesis. This is a context where Monte Carlo simulation can be quite useful as a tool to study and compare the exact distributions statistical procedures in ﬁnite samples. while there are other values of s for which test test statistic is insigniﬁcant. we ﬁnd that the standard Wald test for H0 (s) is ´2 ³ s ˆ β −1 Wn (s) = n 2s−2 . features of this distribution can be calculated. The method uses random simulation to create an artiﬁcial dataset to apply the statistical tools of interest. the statistic Wn (s) varies with s. To demonstrate this eﬀect.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. ˆ Let β and σ 2 be the sample mean and variance of yi . Letting h(β) = β s . σ 2 s2 β ˆ ˆ While the hypothesis β s = 1 is unaﬀected by the choice of s. The increasing solid line is for the case β = 0. we have plotted in Figure 6. as Wn (s) →d χ2 under H0 for 1 any s. Through repetition. σ 2 ) and consider the hypothesis H0 : β = 1. In the present context of the Wald statistic. This produces random draws from the sampling distribution of interest. This is an unfortunate feature of the Wald statistic. The decreasing dashed ˆ = 1. they can work quite poorly when the restrictions are nonlinear.7.8.By a ﬁrst-order Taylor series approximation ¶ µ 2 ¶ µ σ ˜ σ2 ˜ − 1 = Wn .

1 Type I error Probability of Asymptotic 5% Wn (s) Test 63 . Typically. Rates above 20% are unexceptable. which is not surprising given the dependence of Wn (s) on s as shown in Figure 6. however. There is. Test performance deteriorates as s increases. and σ is varied among 1 and 3. this probability depends only on s.84 | β = 1) . n. Given the simplicity of the model. Table 4. 100 and 500. To interpret the table. and rarely fall outside of the 3%-8% range. looking for tests for which rate rejection rates are close to 5%. The null hypothesis β s = 1 is true. In Table 2. Each row of the table corresponds to a diﬀerent value of s — and thus corresponds to a particular choice of test statistic.1 reports the simulation estimate of the Type I error probability from 50. The value of s is varied from 1 to 10. and σ 2 . Type I error rates between 3% and 8% are considered reasonable. we compare the rates row by row. Table 4. the only test which meets this criterion is the conventional Wn = Wn (1) test. so these probabilities are Type I error. In each case.000 simulated Wald statistics Wn (s) which are larger than 3.000 random samples.4. These probabilities are calculated as the percentage of the 50.1 you can also see the impact of variation in sample size.1 we report the results of a Monte Carlo simulation where we vary these three parameters. the Type I error probability improves towards 5% as the sample size n increases. n is varied among 20. Any other choice of s leads to a test with unacceptable Type I error probabilities. In Table 4. For this particular example.Figure 6. no magic choice of n for which all tests perform uniformly well.05) with deviations indicating+ distortion. remember that the ideal Type I error probability is 5% (. Error rates avove 10% are considered excessive. When comparing statistical procedures.84.4: Wald Statistic as a function of s P (Wn (s) > 3. The second through seventh columns contain the Type I error probabilities for diﬀerent combinations of n and σ.

05 .15 .09 .34 .26 .10 .18 .06 . deﬁne θ = β 1 /β 2 . 64 . Deﬁne θ ˆ ˆ ⎞ ⎛ 0 ⎟ ⎜ ⎟ ⎜ ⎜ 1 ⎟ ⎟ ⎜ ⎜ ˆ ⎟ ˆ H1 = ⎜ β 2 ⎟ ⎟ ⎜ ⎟ ⎜ ⎜ β ⎟ ˆ ⎠ ⎝ − 1 ˆ2 β2 ´ s(ˆ θ) −r .05 .07 .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 .08 .11 .07 . let V be an estimate of the ˆ asymptotic variance matrix for β and set ˆ = β 1 /β 2 .12 .25 .19 . This point can be illustrated through another example.14 . An alternative statistic can be constructed through reformulating the null hypothesis as H0 : β 1 − rβ 2 = 0.06 .05 .33 .13 .22 .17 .14 . ˆ ˆ ˆ ˆ ˆ Let β = (β 0 .05 .20) ³ ´1/2 ˆ0 ˆ ˆ so that the standard error for ˆ is s(ˆ = n−1 H1 V H1 θ θ) .13 .35 .06 .05 . Take the model yi = β 0 + x1i β 1 + x2i β 2 + ei E (xi ei ) = 0 and the hypothesis H0 : β1 =r β2 (6.25 .21 .31 .06 .16 Rejection frequencies from 50.000 simulated random samples In this example it is not surprising that the choice s = 1 yields the best test statistic.08 .06 .30 .08 .12 .20).22 .13 .07 .20 . so the hypothesis can be stated as H0 : θ = r.06 .15 .07 . β 2 ) be the least-squares estimates of (6. While this is clear in this particular example.08 .08 . In this case a t-statistic for H0 is t1n = ³ˆ β1 ˆ β2 where r is a known constant.15 . β 1 . Other choices are arbitrary and would not be used in practice.07 .06 . in other examples natural choices are not always obvious and the best choices may in fact appear counter-intuitive at ﬁrst.28 .10 .06 . Equivalently.05 .24 .23 .20 .10 .

The implication of Table 4.05 β2 .26 .A t-statistic based on this formulation of the hypothesis is ´2 ³ ˆ 1 − rβ 2 ˆ β =³ ´1/2 . If no linear formulation is feasible. 65 .07 .645) P (tn > 1.645) are calculated from 50. The left tail probabilities P (t1n < −1.06 .06 . if the hypothesis can be expressed as a linear restriction on the model parameters.05 . The common message from both examples is that Wald statistics are sensitive to the algebraic formulation of the null hypothesis.000 simulated samples.05 .05.14 Monte Carlo Simulation In the previous section we introduced the method of Monte Carlo simulation to illustrate the small sample problems with tests of nonlinear hypotheses.645) are close to zero in most cases.10 .05 .06 . The results are presented in Table 4. We vary β 2 among .2.06 .645) and P (tn > 1.00 .05 .75.06 . −r ⎛ t2n where To compare t1n and t2n we perform another simple Monte Carlo simulation.00 The one-sided Type I error probabilities P (tn < −1.15 .50 . In contrast.0 and n among 100 and 500.05 .645) greatly exceed 5%.645) P (tn < −1.10 . Table 4. the rejection rates for the t1n statistic diverge greatly from this value.06 .05 . However. and 1. Ideally. .05 . In this section we describe the method in more detail.00 .15 .00 . and normalize β 0 = 0 and β 1 = 1.645) P (tn > 1. and are close to the ideal 5% rate for both sample sizes. especially for small values of β 2 .09 .00 . and alternatives to asymptotic critical values should be considered.28 . In all cases.05 . while the right tail probabilities P (t1n > 1.10 .7.47 .00 .06 .12 . −1 H V H ˆ 2 n 2 ⎞ 0 H2 = ⎝ 1 ⎠ . σ 2 ) draw with σ = 3.50. the entries in the table should be 0. This leaves β 2 as a free parameter.05 . along with sample size n.02 .06 . the rejection rates for the linear t2n statistic are invariant to the value of β 2 .2 Type I error Probability of Asymptotic 5% t-tests n = 100 n = 500 P (tn < −1.25 . We let x1i and x2i be mutually independent N (0. 1) variables.25. ei be an independent N (0.1. It is also prudent to consider alternative tests to the Wald statistic.00 . . .75 1. then the “most linear” formulation should be selected. such as the GMM distance statistic which will be presented in Section 9.645) t1n t2n t1n t2n t1n t2n t1n t2n .06 .2 is that the two t-ratios have dramatically diﬀerent sampling behavior.06 .00 .00 . 6. this formulation should be used.00 .

B. are drawn from the distribution F using i the computer’s random number generator. and from these most random variables can be constructed. xn .. or equivalently the value θ is selected directly by the researcher. x1 . A “true” value of θ is implied by this choice. The researcher chooses F (the distribution of the data) and the sample size n. the exact (ﬁnite sample) distribution Gn is generally unknown. The above experiment creates one random draw from the distribution Gn (x. the distribution function Gn (x.. we can estimate any feature of interest using (typically) a method of moments estimator. we set B = 1000 or B = 5000. a chi-square can be generated by sums of squares of normals. F ) for selected choices of F. F ) can be calculated numerically through simulation. b = 1.. x∗ . While the asymptotic distribution of Tn might be known. The name Monte Carlo derives from the famous Mediterranean gambling resort. Clearly. We will discuss this choice later. This is useful to investigate the performance of the statistic Tn in reasonable situations and sample sizes. our data consist of observations (yi . xi ) which are random draws from a population distribution F. Let θ be a parameter and let Tn = Tn (y1 . i = 1. where B is a large number. ∗ ∗ • The statistic Tn = Tn (y1 . For example: Suppose we are interested in the bias. 1) random numbers. So the researcher repeats the experiment B times. .. n n For step 1. F ). n. The method of Monte Carlo is quite simple to describe. let the b0 th experiment result in the draw Tnb . θ) be a statistic of interest. run the above experiment. Typically. Notationally. Monte Carlo simulation uses numerical simulation to compute Gn (x. most computer packages have built-in procedures for generating U [0. They constitute a random sample of size B from the distribution of Gn (x... yn . 1] and N (0. This is one observation from an unknown distribution. θ) is calculated on this pseudo data.. for example an estimator ˆ or a t-statistic (ˆ − θ)/s(ˆ The exact distribution of Tn is θ θ θ). From a random sample. and calculate θ of θ \ ˆ Bias(θ) = B B 1 X 1 Xˆ Tnb = θb − θ B B b=1 b=1 B 1 X \θ) (Tnb )2 M SE(ˆ = B b=1 µ ¶2 \ = M SE(ˆ − Bias(ˆ \θ) \ ˆ V ar(θ) θ) 66 . We then set Tn = ˆ − θ. Gn (x. F ) = P (Tnb ≤ x) = P (Tn ≤ x | F ) . (For example. F ) = P (Tn ≤ x | F ) . where games of chance are played. The basic idea is that for any given F. from one observation very little can be said. or variance of the distribution ˆ − θ.. x∗ ) ... it is important that the statistic be evaluated at the “true” value of θ corresponding to the choice of F. These results are stored. which implies restrictions on F . . mean-squared error (MSE). yn .. Then the following experiment is conducted ∗ • n independent random pairs (yi .) For step 2.. x∗ .Recall.

and non-white. If the standard error is too large to make a reliable inference. it is simple to make inferences about rejection probabilities from statistical tests. 6. then B will have to be increased. B. As discussed above.007. The typical purpose of a Monte Carlo simulation is to investigate the performance of a statistical procedure (estimator or test) in realistic settings. A simple way to compute sample quantiles is to sort the sample {Tnb } from low to high. hispanic. Often this is called the number of replications.96) . It is therefore convenient to pick B so that N is an integer. the researcher must select the number of experiments. For the dependent variable we use the natural log of wages.96) . and hispanic. experience squared. the choice of B is often guided by the computational demands of the statistical procedure. equalling 1 with probability P = E1 (Tnb ≥ 1. The random variable 1 (Tnb ≥ 1.95) /B ' . and dummy variable indicators for the following: married. We would then set Tn = ¯ˆ − θ¯ /s(ˆ and calculate B X ˆ= 1 P 1 (Tnb ≥ 1. female. this may ˆ be approximated by replacing P with P or with an hypothesized value.15 Estimating a Wage Equation We again return to our wage equation. and dummy variable indicators for the following: married.21) is therefore an ³ ´ p ˆ unbiased estimator of P with standard error s P = P (1 − P ) /B. Again our dependent variable is the natural log of wages. Generally. immigrant. We separately estimate equations for white and non-whites. respectively. if we are ³ ´ p √ ˆ assessing an asymptotic 5% test. . In many cases. and therefore it is straightforward to calculate standard errors for any quantity of interest. In particular. for a selection of choices of n and F. 1000. and our regressors include years of education. potential work experience. Furthermore. then the 5% sample quantile is 50’th sorted value and the 95% sample quantile is the 950’th sorted value. Hence the ³ ´ ˆ standard errors for B = 100.22/ B. excluding military. Suppose we are interested in the 5% and 95% quantile of Tn = ˆ We then compute the 10% θ. In practice.003. s P = . are. and . We now expand the sample all non-military wage earners. and poorly for others. female. Since the results of a Monte Carlo experiment are estimates computed from a random sample of size B.96) is iid Bernoulli. Then qα is the N ’th number in this ordered sequence. union member. and 5000. B b=1 (6. For example. We us the sample of wage earners from the March 2004 Current Population Survey. if we set B = 999. union member. potential work experience. As P is unknown. an estimator or test may perform wonderfully for some values.022. then we can set s P = (. For example.05) (. immigrant. The average (6. and estimate a multivariate regression. and 90% sample quantiles of the sample {Tnb }. a larger B results in more precise estimates of the features of interest of Gn . For regressors we include years of education. we included a dummy 67 . but requires more computational time.21) the percentage of the simulated t-ratios which exceed the asymptotic 5% critical value.Suppose we are interested in the ¯Type I error associated with an asymptotic 5% two-sided ¯ ¯ ¯ θ) θ t-test. Quite simply. therefore.21). It is therefore useful to conduct a variety of experiments. the performance will depend on n and F. where N = (B +1)α. The α% sample quantile is a number qα such that α% of the sample are less than qα . experience squared. such as the percentage estimate reported in (6. so that coeﬃcients may be interpreted as semi-elasticities.

101 . 2β 3 68 .121 −. 808 1 − .007 .variable for state of residence (including the District of Columbia.002 .00002 . The F form of the Wald statistic (6.232 .1 OLS Estimates of Linear Equation for Log(Wage) ˆ β 1. Ignoring the other coeﬃcients. reestimating the model with the 50 state dummies excluded.001 . 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.48772 = 515.014 .102 −. as the 1% critical value for the χ2 distribution is 76. Alternatively. if β 2 > 0 and β 3 < 0 the solution is θ=− From Table 4. this adds 50 regressors).1 we ﬁnd the point estimate ˆ ˆ = − β 2 = 28.34 ˆ s(β) .013 .69.027 .4945. Table 4. but not equal. the restricted standard deviation estimate is σ = . θ ˆ 2β 3 β2 .49452 σ ˜ Notice that the two statistics are close.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.808 so the parameter estimates are quite precise and reported in Table 4.010 . Wn = n 1 − 2 = 18.033 −.032 . Computing the Wald statistic (6.18) that the state coeﬃcients are jointly zero. Using either statistic the hypothesis is easily rejected. The available sample is 18.070 .1. 50 Another interesting question which can be addressed from these estimates is the maximal impact of experience on mean wages.4877 18. excluding the coeﬃcients on the state dummy variables.808 .097 −.19) is ˜ µ ¶ µ ¶ σ2 ˆ .00057 . we ﬁnd Wn = 550.008 .102 −.

In the present context we are interested in forming a conﬁdence interval.Using the Delta Method. Our desired conﬁdence interval will be the set of parameter values θ which are not rejected by the hypothesis test. 29.5].40. However. In the previous section we discovered that such t-tests had very poor Type I error rates. as the coverage probability of this conﬁdence interval is one minus the Type I error of the hypothesis test based on the t-test. Since tn (θ) is a non-linear function of θ.5]. 29. This set is [27. Instead. This is the set of θ such that |tn (θ)| ≤ 1. 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 ). 69 .9. we found better Type I error rates by reformulating the hypothesis as a linear restriction. so we have to go one step further. this is a poor choice. there is not a simple expression for this set.96. we can calculate a standard error of s(ˆ = . not testing a hypothesis. Notice that the upper end of the conﬁdence interval is the same as that from the delta method.0. but the lower end is substantially lower. implying a 95% conﬁdence θ) interval of [27. but it can be found numerically quite easily.

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

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

σ 2 } σ1 ˜n and ³ ´−1 ˜ ˜ ˜ β = X 0 D−1 X X 0 D−1 Y. This suggests 75 . Thus ˆ i i η − η i = e2 − e2 ˆ ˆi i = φi . Vα = E zi zi (7. . Since there is not a unique speciﬁcation for the conditional variance the FGLS estimator is not unique. and hence we can estimate 0 σ 2 = zi α by i ˜ (7. there is no guarantee that σ 2 > 0 for all i.6) σ 2 = α0 zi .5) ˆ Thus the fact that η i is replaced with η i is asymptotically irrelevant. Then set ˜i ˜ D = diag{˜ 2 . we have the OLS residual ei = yi − x0 β = ei − x0 (β − β)..Suppose ei (and thus η i ) were observed. if σ 2 ≈ 0 for some i.4) ¡ ¢−1 −1/2 0 √ √ n (˜ − α) = n (ˆ − α) + n−1 Z 0 Z α α n Zφ →d N (0.. xi ). We have shown that α is consistently estimated by a simple procedure. ˜i Suppose that σ 2 > 0 for all i. Then we could estimate α by OLS: ¢−1 0 ¡ Z η →p α α = Z 0Z ˆ and where √ n (ˆ − α) →d N (0.4) the skedastic regression. estimator of β. This is the feasible GLS. or FGLS.3) ˆ ˆ While ei is not observed. Vα ) (7. then the FGLS ˜i estimator is not well deﬁned. 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 the FGLS estimator will force ˜i the regression equation through the point (yi . One typical problem with implementation of FGLS estimation is that in a linear regression ˜i speciﬁcation. Furthermore. Then ˆ ¢−1 0 ¡ Zη ˆ α = Z 0Z ˜ (7. Vα ) α ¡ ¡ 0 ¢¢−1 ¡ 0 2 ¢ ¡ ¡ 0 ¢¢−1 E zi zi ξ i E zi zi . and will depend on the model (and estimation method) for the skedastic regression. If σ 2 < 0 for some i. which is typically undesirable. as it is estimating the conditional variance of the regression of yi on xi . We may call (7. ³ ´ ˆ ˆ ˆ = −2ei x0 β − β + (β − β)0 xi x0 (β − β) i i say..

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

and not a conditional mean.4). Third. If i this simpliﬁcation is replaced by the standard formula (under independence of the error). and replaced E ξ 2 with 2σ 4 which holds when ei is N(0. The asymptotic distribution (7. we impose the stronger hypothesis and test the hypothesis that ei is independent of xi . but the only diﬀerence is that they a ¢ allowed for general choice of zi . require the assumption of a correct conditional mean. σ 2 ). It is consistent not only in the regression model. 7.5) and the asymptotic variance (7. If the equation of interest is a linear projection. This hypothesis does not imply that ξ i is independent of xi . the estimated conditional variances may contain more noise than information about the true conditional variances. its squares. but also under the assumptions of linear projection. BreuschPagan (1979) proposed what might appear to be ¡ distinct test. then the OLS and FGLS estimators will converge in probability to diﬀerent limits. Typically. and the cost is a reduction of robustness to misspeciﬁcatio 7.3) for α simpliﬁes to ¡ ¡ 0 ¢¢−1 ¡ 2 ¢ E ξi . This introduces an element of arbitrariness which is unsettling to empirical researchers.2). however. in which case ξ i is ˜ independent of xi and the asymptotic variance (7. as they will be estimating two diﬀerent projections. q Most tests for heteroskedasticity take this basic form. on the other hand.3 Forecast Intervals m(x) = E (yi | xi = x) = x0 β. the two tests coincide. In the linear regression model the conditional mean of yi given xi = x is 77 . OLS is a more robust estimator of the parameter vector. Motivated by the form of the asymptotic variance ˆ of the OLS estimator β.2 Testing for Heteroskedasticity ¢ ¡ The hypothesis of homoskedasticity is that E e2 | xi = σ 2 . The point is that the eﬃciency gains from FGLS are built on the stronger assumption of a correct conditional mean. and all cross-products. individual estimated conditional variances may be negative.2. And the FGLS probability limit will depend on the particular function selected for the skedastic regression. Vα = E zi zi (7. White (1980) proposed that the test for heteroskedasticity be based on setting zi to equal all non-redundant elements of xi . In this case. or equivalently that i H0 : α1 = 0 in the regression (7. and this requires trimming to solve.error.7) under independence show that this test has an asymptotic chi-square distribution.7) Hence the standard test of H0 is a classic F (or Wald) test for exclusion of all regressors from the skedastic regression (7. The main diﬀerences between popular “tests” is which transformations of xi enter zi . The GLS and FGLS estimators.4) and constructing a Wald statistic. the Wald test of H0 is asymptotically χ2 . We may therefore test this hypothesis by the estimation (7. Second.1 Under H0 and ei independent of xi . Theorem 7. FGLS will do worse than OLS in practice.

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

θ) is suggested by an economic model. V ) θ where mθi = mθ (xi . In the ﬁnal two examples. See Appendix E. θ) is (generically) diﬀerentiable in the parameters θ. When it exists. so the minimization of Sn (θ) only needs to be examined for θ close to θ0 . When the regression function is nonlinear.1 If the model is identiﬁed and m(x. G known x2 − θ5 m(x. we call this the nonlinear least squares (NLLS) θ). ˆ ˆ One motivation for the choice of NLLS as the estimation method is that the parameter θ is the solution to the population problem minθ E (yi − m(xi . estimator. let ∂ m(x. θ))2 . ¢¢−1 ¡ ¡ ¢¢ ¡ ¡ ¢¢−1 ¡ ¡ E mθi m0 e2 E mθi m0 V = E mθi m0 θi θi i θi Sketch of Proof. m is not diﬀerentiable with respect to θ3 . The NLLS residuals are ei = yi − m(xi . θ) is diﬀerentiable with respect to θ. When m(x. which alters some of the analysis. θ))2 Since sum-of-squared-errors function Sn (θ) is not quadratic. The least squares estimator ˆ minimizes the sum-of-squared-errors θ Sn (θ) = n X i=1 (yi − m(xi . θ) = G(x0 θ). it is adopted as a ﬂexible approximation to an unknown regression function. it must be shown that ˆ →p θ0 . θ)ˆ (7.4. then the FOC for minimization are 0= n X i=1 mθ (xi . ´ √ ³ n ˆ − θ0 →d N (0. First. This can be done using arguments θ for optimization estimators. θ) = ∂θ Nonlinear regression is frequently adopted because the functional form m(x. θ). mθ (x. In other cases. m(x. θ) = θ1 + θ2 x + θ4 (x − θ3 ) 1 (x > θ3 ) µ ¶ m(x. θ) = θ1 + θ2 m(x. ˆ is close to θ θ θ0 for n large. Since ˆ →p θ0 . θ) = θ1 + θ2 exp(θ3 x) m(x. ˆ must be found by numerical θ methods. θ0 ). θi 79 . θ) is diﬀerentiable.Examples of nonlinear regression functions include x 1 + θ3 x m(x.8) Theorem 7. θ) = (θ1 + θ2 x1 ) 1 (x2 < θ3 ) + (θ4 + θ5 x1 ) 1 (x2 > θ3 ) In the ﬁrst ﬁve examples. ˆ ei . Let 0 yi = ei + m0 θ0 . θ) = θ1 + θ2 xθ3 m(x. θ) = θ1 + θ2 x1 + (θ3 + θ4 x1 ) Φ θ6 m(x. but we won’t cover that argument here.

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 . Hansen (1996). 1 2 The model is linear when β 2 = 0. the model is yi = β 0 zi + εi 1 and both β 2 and γ have dropped out. Identiﬁcation is often tricky in nonlinear regression models. and this is often a useful hypothesis (sub-model) to consider. 80 . Hansen shows how to use simulation (similar to the bootstrap) to construct the asymptotic critical values (or p-values) in a given application. θ0 )) − m(xi . ˆ ˆ θ) ˆ θ). ˆ and ei = yi − m(xi . θ) ' (ei + m(xi . under H0 . tests of H0 do not have asymptotic normal or chi-square distributions. the parameter estimates are not asymptotically normally distributed. θi Thus ¡ ¢ yi − m(xi . However. m(xi .1. γ is not identiﬁed. We have discussed projections and conditional means. Suppose that m(xi . Thus the NLLS 0 estimator ˆ has the same asymptotic distribution as the (infeasible) OLS regression of yi on mθi . ¥ Based on Theorem 7.For θ close to the true value θ0 . Thus we want to test H0 : β 2 = 0. In particular. An alternative good measure is the conditional median. 7. 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 . θ0 ) + m0 (θ − θ0 ) θi = ei − m0 (θ − θ0 ) θi 0 = yi − m0 θ. θ which is that stated in the theorem. The asymptotic theory of such tests have been worked out by Andrews and Ploberger (1994) and B. θ) = β 0 zi + β 0 xi (γ). This means that under H0 . but these are not the only measures of central tendency. θi Hence the sum of squared errors function is Sn (θ) = n X i=1 (yi − m(xi . This renders the distribution theory presented in the previous section invalid. an estimate of the asymptotic variance V is ˆ V = Ã 1X mθi m0 ˆ ˆ θi n i=1 n !−1 Ã 1X mθi m0 e2 ˆ ˆ θi ˆi n i=1 n !Ã 1X mθi m0 ˆ ˆ θi n i=1 n !−1 where mθi = mθ (xi . θ) ' m(xi . by a ﬁrst-order Taylor series approximation. Thus when the truth is that β 2 = 0. Furthermore.4.

The second is the value which minimizes n n |yi − θ| . and the third deﬁnition is the i=1 1 P solution to the moment equation n n sgn (yi − θ) .5.10) The LAD estimator has the asymptotic distribution 81 . These distinctions are illusory. Two useful facts about the median are that (7. Now let’s consider the conditional median of Y given a random variable X. Let m(x) = M ed (Y | X = x) denote the conditional median of Y given X = x.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. and the substantive assumption is that the median function is linear in x. The linear median regression model takes the form yi = x0 β + ei i M ed (ei | xi ) = 0 In this model. and let M ed (Y | X) = m(X) be this function evaluated at the random variable X. i n n i=1 (7. Let ¯ 1 X¯ ¯yi − x0 β ¯ Ln (β) = i n i=1 n be the average of absolute deviations. the linear function M ed (yi | xi = x) = x0 β is the conditional median function. as i=1 these estimators are indeed identical. The ﬁrst deﬁnition is the 50th empirical 1 P quantile. The least absolute deviations (LAD) estimator of β minimizes this function ˆ β = argmin Ln (β) β Equivalently. however. These facts deﬁnitions motivate three estimators of θ. let Y be a continuous random variable.9) θ0 = argmin E |Y − θ| θ and E sgn (Y − θ0 ) = 0 where sgn (u) = ½ 1 −1 if u ≥ 0 if u < 0 is the sign function. The median θ0 = M ed(Y ) is the value such that P (Y ≤ θ0 ) = P (Y ≥ θ0 ) = . 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. Conditional analogs of the facts about the median are • P (yi ≤ x0 β 0 | xi = x) = P (yi > x0 β | xi = x) = .

5. Exi x0 ) i i=1 since Egi (β 0 )gi (β 0 )0 = Exi x0 . Pn −1 0 β)) . the conditional density of the error at its median.5. This can be done with kernel estimation techniques. then there are many innovations near to the median. the height of the error density at its median.3. ˆ Proof of Theorem 7.10) is equivalent to g n (β) = 0. ∂β ˆ g(β) ' ´ ³ ∂ ˆ g(β 0 ) β − β 0 . Let g(β) = Eg (β). ¢¢−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) . Computation of standard error for LAD estimates typically is based on equation (7. by the central limit theorem (Theorm 5. The main diﬃculty is the estimation of f (0). V ).1: Since sgn (a) = 1 − 2 · 1 (a ≤ 0) . In the special case where the error is independent of xi . See Chapter 16. by a Taylor series expansion and the fact g(β 0 ) = 0 82 .1 ´ √ ³ˆ n β − β 0 →d N (0.1 is advanced. (7. ∂ g(β) = ∂β 0 ¡ ¡ ¢¢ ∂ 0 0 Exi 1 − 2 · 1 yi ≤ xi β ∂β £ ¡ ¡ ¢ ¢¤ ∂ = −2 0 E xi E 1 ei ≤ x0 β − x0 β 0 | xi i i ∂β " Z 0 # xi β−x0 β 0 i ∂ = −2 0 E xi f (e | xi ) de ∂β −∞ £ ¢¤ ¡ = −2E xi x0 f x0 β − x0 β 0 | xi i i i £ 0 ¤ ∂ 0 g(β 0 ) = −2E xi xi f (0 | xi ) . We need where g n (β) = n i i=1 gi (β) and gi (β) = xi (1 − 2 · 1 (yi ≤ xi three preliminary result.5. ∂β 0 so Third.1) n X √ −1/2 n (g n (β 0 ) − g(β 0 )) = −n gi (β 0 ) →d N (0.11) This simpliﬁcation is similar to the simpliﬁcation of the asymptotic covariance of the OLS estimator under homoskedasticity.11). we provide a sketch here for completeness.Theorem 7. When f (0 | x) is large. First. and this improves estimation of the median. then f (0 | x) = f (0) and the asymptotic variance simpliﬁes V = (Exi x0 )−1 i 4f (0)2 (7. Second using the law of iterated expectations and the chain rule of i diﬀerentiation. While a complete proof of Theorem 7. where V = and f (e | x) is the conditional density of ei given xi = x.

12) Qτ = argmin Eρτ (U − θ) . so you can think of the quantile as the inverse of the distribution function. when F (y | x) is continuous and strictly monotonic in y. (7. The quantile Qτ is the value such that τ (percent) of the mass of the distribution is less than Qτ . then F (Qτ (x) | x) = τ . This linear speciﬁcation assumes that Qτ (x) = β 0 x where the coeﬃcients β τ τ vary across the quantiles τ . For τ ∈ [0. V ). As functions of x. 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. However for computational convenience it is typical to assume that they are (approximately) linear in x (after suitable transformations). The third line follows from an asymptotic empirical process argument.13) This generalizes representation (7. the quantile regression function qτ (x) describes how the τ ’th quantile of the conditional distribution varies with the regressors.Together ´ √ ³ ˆ n β − β0 ' ' ¶−1 √ ∂ ˆ ng(β) 0 g(β 0 ) ∂β ´ ¡ £ ¤¢−1 √ ³ ˆ ˆ = −2E xi x0 f (0 | xi ) n g(β) − g n (β) i µ ¤¢−1 √ 1¡ £ 0 n (g n (β 0 ) − g(β 0 )) E xi xi f (0 | xi ) 2 ¤¢−1 1¡ £ 0 E xi xi f (0 | xi ) N (0. For the random variables (yi . ¥ 7. θ where ρτ (q) is the piecewise linear function ½ −q (1 − τ ) q<0 ρτ (q) = qτ q≥0 = q (τ − 1 (q < 0)) . If the random variable U has τ ’th quantile Qτ . then F (Qτ ) = τ . then (7. The median is the special case 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 following alternative representation is useful. Again.5. We then have the linear quantile regression model yi = x0 β τ + ei i 83 . the quantile regression functions can take any shape.6 Quantile Regression The method of quantile regression has become quite popular in recent econometric practice.9) for the median to all quantiles. For ﬁxed τ . Exi x0 ) →d i 2 = N (0.

One simple test for neglected nonlinearity is to add nonlinear functions of the regressors to ˆ ˆ the regression. Vτ ). ˆ Given the representation (7. The null model is yi = x0 β + εi i 84 . Fortunately. the τ ’th conditional quantile of ei is zero. fast linear programming methods have been developed for this problem. i By construction.13). Another popular approach is the RESET test proposed by Ramsey (1969). it is useful to have a general test of the adequacy of the speciﬁcation.1 n β τ − β τ →d N (0. n numerical methods are necessary for its minimization. and test their signiﬁcance using a Wald test. the asymptotic variance depends on the conditional density of the quantile regression error. E xi xi f (0)2 A recent monograph on the details of quantile regression is Koenker (2005).1. the unconditional density of ei at 0. where and f (e | x) is the conditional density of ei given xi = x. and we have the simpliﬁcation Vτ = τ (1 − τ ) ¡ ¡ 0 ¢¢−1 .where ei is the error deﬁned to be the diﬀerence between yi and its τ ’th conditional quantile x0 β τ . and form a Wald statistic i for γ = 0.7 Testing for Omitted NonLinearity If the goal is to estimate the conditional expectation E (yi | xi ) . if the model yi = x0 β + ei has i been ﬁt by OLS. 7. Thus.5. and are widely available. Furthermore. ¡ ¡ ¢¢−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. When the error ei is independent of xi .12). then f (0 | xi ) = f (0) . otherwise its properties are unspeciﬁed without further restrictions. ´ √ ³ˆ Theorem 7. the quantile regression estimator β τ for β τ solves the minimization problem ˆ β τ = argmin Lτ (β) n β∈Rk n where Lτ (β) = n and ρτ (q) is deﬁned in (7. conventional Newton-type optimization methods are inappropriate. 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. since it has discontinuous derivatives. A asymptotic distribution theory for the quantile regression estimator can be derived using similar arguments as those for the LAD estimator in Theorem 7. Since the quanitle regression criterion function Lτ (β) does not have an algebraic solution.6.

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

with residual vectors e1 and e2 . We thus consider the question of the inclusion of X2 in the linear regression Y = X1 β 1 + X2 β 2 + ε. In contrast. n→∞ σx ˜ When µ 6= 0. One useful property is consistency.. there is no clear ranking of the eﬃciency of the ˜ restricted estimator β 1 versus the unrestricted estimator. when economic theory does not provide complete guidance? This is the question of model selection. as the larger problem can be written as a sequence of such comparisons. models 1 and 2 are estimated by OLS. . X2 ) = 0. In the absence of the homoskedasticity assumption. In many cases the problem of model selection can be reduced to the comparison of two nested models. estimated ˆ ˆ ˆ2 the variances σ 2 and σ 2 . Let β 1 be the ˜ be the estimate under the constraint β = 0. we see that β 1 has a lower asymptotic variance. A model selection procedure is consistent if ´ ³ c → 1 P M = M1 | M1 ³ ´ c P M = M2 | M2 → 1 86 . i A model selection procedure is a data-dependent rule which selects one of the two models. we say that M2 is true if β 2 6= 0. the question. “Which subset of (x1 . that it selects the true model with probability one if the sample is suﬃciently large. We conclude that the inclusion of irrelevant variable reduces estimation eﬃciency if these variables are correlated with the relevant variables. For example. Let Exi = µ. x2i = σ 2 . E (ε | X1 .˜ ˆ This means that β 1 has a lower asymptotic variance matrix than β 1 . This is equivalent to the comparison of the two models M1 : M2 : Y = X1 β 1 + ε. However.. and β 1 0 (The least-squares estimate with the intercept omitted. we will on ˆ1 ¡ occasion use the homoskedasticity assumption E e2 | x1i . where X1 is n × k1 and X2 is n × k2 . this result can be reversed when the error is conditionally heteroskedastic. To simplify some of ¢ statistical discussion. ˆ For example. 7. the question: “What is the right model for y?” is not well posed. xKi = xK )?” is well posed. X2 ) = 0 Note that M1 ⊂ M2 ..7).. Y = X1 β 1 + X2 β 2 + ε. There are many possible desirable properties for a model selection procedure. respectively. We c can write this as M. etc. because it does not make clear the conditioning set.). x Then under (6.. How does a researcher go about selecting an econometric speciﬁcation.. E (ε | X1 . σ2 ˜ lim nV ar( β 1 ) = 2 n→∞ σ x + µ2 while σ2 ˆ lim nV ar( β 1 )−1 = 2 . and E (xi − µ)2 = σ 2 . xK ) enters the regression function E(yi | x1i = x1 . To be concrete. It is important that the model selection question be well-posed. To ﬁx notation. . take the model yi = β 0 + β 1 xi + ei and suppose that β 0 = 0.9 Model Selection In earlier sections we discussed the costs and beneﬁts of inclusion/exclusion of variables. estimate of β 1 from the unconstrained model..

the BIC places a larger penalty than the AIC on the number of estimated parameters and is more parsimonious. as the rule tends to overﬁt.17) Since log(n) > 2 (if n > 8). M)) between the true density and the model density. if α is set to be a small number.However. else select M2 . The model selection rule is as follows. BIC model selection is consistent.16) LRn = n log σ 2 − log σ 2 ' Wn →d χ22 . If the truth is inﬁnite dimensional. Another problem is that if α is held ﬁxed. is ¡ ¢ km ˆm BICm = log σ 2 + log(n) . depending on the sample size. n (7. since (7. Indeed.16) holds under M1 . His criterion. 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. let cα satisfy ¢ ¡ P χ22 > cα . One popular choice is the Akaike Information Criterion (AIC). else select M2 . this rule only makes sense when the true model is ﬁnite dimensional. and km is the number of coeﬃcients in the model. In contrast to the AIC. since under M1 . as ³ ´ c P M = M1 | M1 → 1 − α < 1.15) then where σ 2 is the variance estimate for model m. etc. known as the BIC. Another common approach to model selection is to to a selection criterion. k A major problem with this approach is that the critical level α is indeterminate. log(n) 87 . based on Bayesian arguments. then P M ´ ³ c 1 − α but P M = M2 | M2 could vary dramatically. k = While many modiﬁcations of the AIC have been proposed. That is. it is more appropriate to view model selection as determining the best ﬁnite sample approximation. The rule is to select M1 if AIC1 < AIC2 . AIC selection is inconsistent. the most popular to be one proposed by Schwarz. Indeed. 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. ¢ ¡ ˆ1 ˆ2 (7. 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. The AIC for model m is ¡ ¢ km ˆm AICm = log σ 2 + 2 . For some critical level α. n (7. then this model selection procedure is inconsistent. LRn →p 0. A common approach to model selection is to base the decision on a statistical test such as the Wald Wn . Then select M1 if Wn ≤ cα .

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

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

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

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

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

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

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

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

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

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

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

Deﬁnition 8. 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. and vice-versa. or the size of the divergence for any particular sample size n. θ θ θ ˆ θ ∗ ∗ Computationally. If θ is a vector. where qn (α) is the (1 − α)% quantile of the distribution of Wn . 99 .3 an = o(n−r ) if nr |an | → 0 as n → ∞. an = O(n−r ) if it declines to zero like n−r . C4 is called the symmetric percentile-t interval. θ [This is a typical mistake made by practitioners. Let Tn be a statistic such that (8.1 an = o(1) if an → 0 as n → ∞ Deﬁnition 8. not ˆ − θ0 . Thus here Tn (θ) = Wn (θ). it says nothing. v 2 ).∗ where qn (α) is the bootstrap critical value for a two-sided hypothesis test. and a function h(x) is odd if h(−x) = −h(x).4) says that Gn converges to Φ x as n → ∞. The derivative of an even function is odd. (8. We say that a function g(x) is even if g(−x) = g(x). about the rate v of convergence.8 Asymptotic Expansions Tn →d N (0. the critical value qn (α) is found as the quantile from simulated values of W´ . writing Tn ∼ Gn (x.] 8. Basically. then to test H0 : θ = θ0 against H1 : θ 6= θ0 at size α. Deﬁnition 8. Equivalently.8. It is designed to work well since ³ ´ P (θ0 ∈ C4 ) = P ˆ − s(ˆ n (α) ≤ θ0 ≤ ˆ + s(ˆ n (α) θ θ)q ∗ θ θ)q ∗ ∗ = P (|Tn (θ0 )| < qn (α)) ' P (|Tn (θ0 )| < qn (α)) = 1 − α.3) ´ √ ³ˆ If Tn = n θ − θ0 then v = V while if Tn is a t-ratio then v = 1.8.8. F ) = Φ n→∞ v or ³x´ Gn (x. where qn (α) is the (1 − α)% quantile of the distribution of ³ ∗ ³ ∗ ´0 ´ ∗ Wn = n ˆ − ˆ Vθ∗−1 ˆ − ˆ . A better asymptotic approximation may be obtained through an asymptotic expansion. F ) = Φ + o (1) . The ideal test rejects if Wn ≥ qn (α). F ) then ³x´ . lim Gn (x. n ´ ³ ∗ ³ ∗ θ θ Note in the simulation that the Wald statistic is a quadratic form in ˆ − ˆ . Let an be a sequence. The bootstrap test ∗ ∗ rejects if Wn ≥ qn (α). The following notation will be helpful. however.2 an = O(1) if |an | is uniformly bounded.4) v ¡ ¢ While (8.

which from Theorem 8. v Since the derivative of g1 is odd. To a third order of approximation. the diﬀerence √ (g1 (x.1 Under regularity conditions and (8. Moreover. F0 )) + O(n−1 ). the diﬀerence between the bootstrap distribution and the true distribution is G∗ (x) − Gn (x. Theorem 8. Fn ) − g1 (x. the density function is skewed. An asymptotic test is based on Φ(x). ³x´ Gn (x.8. F ) + O(n−3/2 ) Gn (x. F ). F0 ) ≈ ∂ g1 (x. we can assess the accuracy of one-sided hypothesis tests and conﬁdence regions based on an asymptotically normal t-ratio Tn . F ) v which adds a symmetric non-normal component to the approximate density (for example. F0 ) = n 1 n1/2 (g1 (x. ³x´ 1 1 + 1/2 g1 (x.3). Fn ) + O(n−1 ). F0 ) = 1 g (x. where g1 is an even function of x. g1 (x. Fn ) − g1 (x. The diﬀerence is Φ(x) − Gn (x. F ) ≈ Φ + n−1/2 g1 (x. F0 ) = Φ(x) + since v = 1. F0 ) + O(n−1 ) 1/2 1 n 1 g (x. F ) ≈ Φ + n−1/2 g1 (x. Fn ) = Φ(x) + n 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.8.uniformly over x. First.1 has the expansion n G∗ (x) = Gn (x. F0 )) converges to 0 at rate n. 1/2 1 n Because Φ(x) appears in both expansions. and g1 is continuous with respect to F. so the order of the error is O(n−1/2 ). F0 ) (Fn − F0 ) ∂F = O(n−1/2 ). the exact distribution is P (Tn < x) = Gn (x. √ Since Fn converges to F at rate n. and g2 is an odd function of x. F ) converges to the normal limit at rate n1/2 . ³x´ Gn (x. Fn ) − g1 (x.1 as follows. Heuristically. 100 . adding leptokurtosis). F ) + g2 (x. We can interpret Theorem 8. To the second order. F ) + n−1 g2 (x. A bootstrap test is based on G∗ (x).9 One-Sided Tests Using the expansion of Theorem 8. F0 ) + O(n−1 ) 1/2 1 n = O(n−1/2 ). Gn (x. To a second order of approximation.8. F ) = Φ v n n 8.8.1.

= P (X ≤ x) − P (X ≤ −x) For example. F0 ) = The order of the error is O(n−1 ). 8. if Z ∼ N (0.5) where the simpliﬁcations are because g1 is even and g2 is odd. Thus asymptotic critical values are taken from the Φ distribution. F ) = Gn (x. F ) n n µ ¶ 1 1 − Φ(−x) + 1/2 g1 (−x. We conclude that G∗ (x) − Gn (x. F ) ¶ µ 1 1 = Φ(x) + 1/2 g1 (x. n or ∗ P (Tn ≤ x) = P (Tn ≤ x) + O(n−1 ).8. 101 2 g2 (x. we can calculate that Gn (x. then the random variable |X| has distribution function H(x) = H(x) − H(−x) since P (|X| ≤ x) = P (−x ≤ X ≤ x) = H(x) − H(−x).The “derivative” ∂ ∂F g1 (x. A two-sided hypothesis test rejects H0 for large values of |Tn | . 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. F ) + O(n−3/2 ) n n 2 = Φ(x) + g2 (x. Hence the diﬀerence between the asymptotic distribution and the exact distribution is Φ(x) − Gn (x. F ). F ) + O(n−3/2 ). which is an improved rate of convergence over the asymptotic test (which converged at rate O(n−1/2 )). F ) is only heuristic. F ) − Gn (−x. Similarly. n (8. F ) = Gn (x. then |Tn | →d |Z| ∼ Φ. then |Z| has distribution function Φ(x) = Φ(x) − Φ(−x) = 2Φ(x) − 1. From Theorem 8. F0 ) = O(n−1 ). n . F0 ) distribution. 1). F ) − Gn (−x. if Tn has exact distribution Gn (x. F ). F0 ) + O(n−3/2 ) = O(n−1 ). F ) + g2 (−x. as F is a function. and exact critical values are taken from the Gn (x. Since Tn →d Z.1. then |Tn | has the distribution function Gn (x.10 Symmetric Two-Sided Tests If a random variable X has distribution function H(x) = P (X ≤ x).

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

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

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

and ˆ is calculated on each θ ∗ ∗ θ sample.5% and 97.05) and qn (. θ respectively.pdf.2. You do this as follows.Show that C exactly equals the Alternative percentile interval (not the percentile-t interval). 105 .3. ˆ = 1. (c) With the given information. (b) Report the 95% Alternative Percentile interval for θ. Let qn (. size of house. You want to test H0 : θ = 0 against H1 : θ > 0. ∗ ∗ ∗ Let qn (. The test for H0 is to reject if Tn = ˆ ˆ > c where c is picked so that Type I error is α. and deﬁne the bootstrap conﬁdence interval h i C = ˆ − s(ˆ n (.2 and s(ˆ = . You replace c with qn (. Using the non-parametric bootstrap. can you report the 95% Percentile-t interval for θ? 7. The ˆ are sorted. (a) Report the 95% Efron Percentile interval for θ.95).dat contains data on house prices (sales).05) . and thus reject H0 if ˆ ˆ > q ∗ (. calculate the estimates ˆ on these samples and θ then calculate ∗ ∗ ∗ θ θ Tn = ˆ /s(ˆ ). and the colonial dummy. Using the non-parametric ∗ bootstrap. with variables listed in the ﬁle hprice1. Estimate a linear regression of price on the number of bedrooms. lot size.95) denote the 5% θ) ∗ and 95% quantiles of Tn . Suppose that in an application.95) denote the 95% quantile of Tn . ∗ ∗ where s(ˆ is the standard error in the original data. What is wrong with this procedure? Tn = θ/s(θ) n 6. Calculate 95% conﬁdence intervals for the regression coeﬃcients using both the asymptotic normal approximation and the percentile-t bootstrap. θ θ)q ∗ θ θ)q ∗ θ/s(θ) 5. and the 2. θ θ) ∗ 1000 samples are generated from the bootstrap distribution.75 and 1. ˆ − s(ˆ n (. you generate bootstrap samples.95). The dataﬁle hprice1.5% quantiles of the ˆ are .95).

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

Jn (β) = n · g n (β)0 g n (β) = n · |g n (β)|2 . gi (β) = xi yi − zi β = n n n i=1 i=1 Deﬁne the sample analog of (9. then. β GMM does not change.1 ˆ 2Z 0 XWn X 0 Z β = 2Z 0 XWn X 0 Y While the estimator depends on Wn .2.9. The GMM estimator minimizes Jn (β). Let and where gi = xi ei .1 β GMM = argmin Jn (β).3) The method of moments estimator for β is deﬁned as the parameter value which sets g n (β) = 0. i i .2. β GMM = Z 0 XWn X 0 Z 9. For example.3 Distribution of GMM Estimator ¡ 0¢ Q = E xi zi Assume that Wn →p W > 0. the square of the Euclidean length. 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 idea of the generalized method of moments (GMM) is to deﬁne an estimator which sets g n (β) “close” to zero. if Wn = I. but this is generally not possible when > k. for if Wn is replaced ˆ by cWn for some c > 0.2) g n (β) = (9. then g n (β) = 0. β ˆ Note that if k = .2 GMM Estimator n n ¢ 1¡ 0 ¢ 1X 1X ¡ 0 X Y − X 0 Zβ . let Jn (β) = n · g n (β)0 Wn g n (β). Proposition 9. Then µ ¶ ¶ µ 1 0 1 0 Z X Wn X Z →p Q0 W Q n n 107 ¡ ¢ ¡ 0¢ Ω = E xi x0 e2 = E gi gi . ¡ ¢−1 0 ˆ Z XWn X 0 Y. the dependence is only up to scale. ˆ Deﬁnition 9. For some × weight matrix Wn > 0. and the GMM estimator is the MME. This is a non-negative measure of the “length” of the vector g n (β).

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

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

1 Under general regularity conditions.6. n β − β →d N 0. For example. 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). Under the hypothesis of correct speciﬁcation. Theorem 9. Note that g n →p Egi . 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. This estimator can be iterated if needed. and if the weight matrix is asymptotically eﬃcient. perhaps obtained by ﬁrst ˆ setting Wn = I. β) = 0 holds.5. 110 .Often. Identiﬁcation requires l ≥ k = dim(β). ˆ J = J(β) →d χ2−k . G0 Ω−1 G . 9. ´ ³ ¡ ¢−1 ´ √ ³ˆ Theorem 9. In this sense an 1i 1i exclusion restriction can be seen as an overidentifying restriction. 1 it is possible that β 2 6= 0. i i i i ∂β 1X 0 gi gi − g n g 0 ˆˆ n n i=1 n !−1 . often the weight ˆ matrix Wn is updated. and thus g n can be used to assess whether or not the hypothesis that Egi = 0 is true or not. and is thus a natural test statistic for H0 : Egi = 0. Thus the model — the overidentifying restrictions — are testable. where ³ ´−1 ∂ 0 ˆ ˆ ˆ ˆ Ω = (E (gi gi ))−1 and G = E ∂β 0 gi (β). 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. and then β recomputed. Hansen (1982). The general theory of GMM estimation and testing was exposited by L. 1 2 It is possible that β 2 = 0. ˆˆ n is a quadratic form in g n . Since the GMM estimator depends upon the ﬁrst-stage estimator.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 . this is all that is known. take the linear model yi = β 0 x1i + β 0 x2i + ei with E (x1i ei ) = 0 and E (x2i ei ) = 0.1 (Sargan-Hansen). 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 . so that the linear equation may be written as yi = β 0 x1i + ei . However.

If the statistic J exceeds the chi-square critical value. and sometimes called a LR-like statistic (the LR is for likelihood-ratio). If h is linear in β. as this ensures that D ≥ 0. These may be used to construct Wald tests of statistical hypotheses. it is customary to report the J statistic as a general test of model adequacy. The estimates under H1 are ˆ β = argmin J(β) β and those under H0 are ˜ β = argmin J(β). If the hypothesis is non-linear. The GMM overidentiﬁcation test is a very useful by-product of the GMM methodology. The idea was ﬁrst put forward by Newey and West (1987). 9. Hansen (1982) for the general case. D →d χ2 r 3. For a given weight matrix Wn . h(β)=0 ˆ ˜ The two minimizing criterion functions are J(β) and J(β). the GMM criterion function is J(β) = n · g n (β)0 Wn g n (β) For h : Rk → Rr . we can reject the model. The degrees of freedom of the asymptotic distribution are the number of overidentifying restrictions. and is the preferred test statistic. When over-identiﬁed models are estimated by GMM. Newey and West (1987) suggested to use the same weight matrix Wn for both null and alternative. the Wald statistic can work quite poorly. the hypothesis is H0 : h(β) = 0. and by L. Proposition 9. This test shares the useful feature of LR tests in that it is a natural by-product of the computation of alternative models. however. This is sometimes called the GMM Distance statistic.7.7 Hypothesis Testing: The Distance Statistic We described before how to construct estimates of the asymptotic covariance matrix of the GMM estimates. 111 . current evidence suggests that the D statistic appears to have quite good sampling properties. it is unclear what is wrong. The GMM distance statistic is the diﬀerence ˜ ˆ D = J(β) − J(β).1 If the same weight matrix Wn is used for both null and alternative. a better approach is to directly use the GMM criterion function. This result was established by Sargan (1958) for a specialized case. then D equals the Wald statistic. This reasoning is not compelling. and it is advisable to report the statistic J whenever GMM is the estimation method. but it is typically cause for concern. If h is non-linear. and some current research suggests that this restriction is not necessary for good performance of the test. 1. D ≥ 0 2. Based on this information alone.The proof of the theorem is left as an exercise. In contrast.

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

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

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

h(β)=0 The GMM test statistic (the distance statistic) of the hypothesis h(β) = 0 is ˜ D = Jn (β) = min Jn (β). VR ) where ¡ ¢−1 0 R V. The observed data is (yi . λ = R0 Vn R (c) Show that if R0 β = r then ´ √ ³˜ n β − β →d N (0. Thus ˜ β = argmin Jn (β) R0 β−r Ã n ! ¡ 0 ¢−1 ¡ 0 ¢−1 X 0 2 ˆ XX xi xi ei ˆ . subject ˆ i ˆi i=1 to the restriction h(β) = 0. h(β)=0 (9. zi is l × 1 and β is k × 1. The GMM estimator of β. The equation of interest is yi = g(xi . 115 . β) + ei E (zi ei ) = 0. Show how to construct an eﬃcient GMM estimator for β. Show that the minimizer is ³ ´−1 ³ ´ ˆ ˜ ˆ ˆ ˆ R0 β − r β = β − Vn R R0 Vn R ´ ´−1 ³ ³ ˆ ˆ ˆ R0 β − r . 6. zi ).6) (a) Show that you can rewrite Jn (β) in (9.5.6) equals the Wald statistic. 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. xi .5) as ³ ´ ³ ´0 ˆ ˆ ˆ −1 β − β Jn (β) = β − β Vn where (b) Now focus on linear restrictions: h(β) = R0 β − r. VR = V − V R R0 V R (d) Show that in this setting. Deﬁne the Lagrangian L(β. l ≥ k. Vn = X X i=1 ˜ and hence R0 β = r. is deﬁned as Jn (β) = ˜ β = argmin Jn (β).5) n 1 P ˆ where ei are the OLS residuals and Ωn = n n xi x0 e2 . In the linear model Y = Xβ + e with E(xi ei ) = 0. the distance statistic D in (9. λ) = 1 Jn (β) + λ0 (R0 β − r) where λ is 2 s × 1.

we can write Ω−1 = CC 0 and Ω = C 0−1 C −1 ³ ´0 ³ ´−1 ˆ ˆ ˆ C 0 ΩC (b) Jn = n C 0 g n (β) C 0 g n (β) ˆ (c) C 0 g n (β) = Dn C 0 g n (β 0 ) (d) Dn →p Il − R (R0 R)−1 R0 (e) n1/2 C 0 g n (β 0 ) →d N ∼ N (0.7. l−k Hint: Il − R (R0 R)−1 R0 is a projection matrix. Let ˆ ˆ ˆ Jn = ng n (β)0 Ω−1 g n (β) denote the test of overidentifying restrictions. Deﬁne ¶µ ¶−1 µ 1 0 ˆ −1 1 0 1 0 ˆ −1 0−1 0 1 0 XZ Z XΩ XZ Z XΩ C Dn = Il − C n n n n 1 0 Xe g n (β 0 ) = n ¡ ¢ 0 R = C 0 E xi zi Show that Jn →d χ2 as n → ∞ by demonstrating each of the following: l−k (a) Since Ω > 0. 116 . ˆ and consider the GMM estimator β of β. Il ) ³ ´ (f) Jn →d N 0 Il − R (R0 R)−1 R0 N ³ ´ (g) N 0 Il − R (R0 R)−1 R0 N ∼ χ2 . Take the linear model 0 yi = zi β + ei E (xi ei ) = 0..

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

or equivalently minimizes its negative ˆ (10. This yields the (proﬁle) empirical log-likelihood function for β.4) (10. λ(β)) = −n ln (n) − n X i=1 ˆ The EL estimate β is the value which maximizes Ln (β).6) β = argmin [−Ln (β)] β ¡ ¢ ln 1 + λ(β)0 gi (β) and maximized empirical likelihood ˆ Numerical methods are required for calculation of β. (10.5) ˆ ˆ As a by-product of estimation. but must be obtained numerically (see section 6. (see section 6. Ln (β) = Rn (β.3). and using the second and third equations. The solution (when it exists) is well deﬁned since Rn (β. Multiplying the ﬁrst equation by pi . pi = ³ ˆ ˆ ˆ0 n 1 + λ gi β ˆ Ln = n X i=1 ln (ˆi ) .2) subject to the restrictions (10. λ). λ.1) and (10.7) 118 . λ) is a convex function of λ. p (10. The solution cannot be obtained explicitly.where λ and µ are Lagrange multipliers. λ ¡ ¢ ln 1 + λ0 gi (β) . we ﬁnd µ = n and 1 ¢. the Lagrange multiplier λ(β) minimizes Rn (β. p1 . pn . pi = ¡ n 1 + λ0 gi (β) Substituting into L∗ we ﬁnd n Rn (β. . 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.. we also obtain the Lagrange multiplier λ = λ(β).5) This minimization problem is the dual of the constrained maximization problem. µ) = n i=1 i=1 i=1 L∗ n with respect to pi . probabilities 1 ³ ´´ .. The Lagrangian for this maximization problem is Ã n ! n n X X X ln(pi ) − µ pi − 1 − nλ0 pi gi (β) L∗ (β. λ) = −n ln (n) − n X i=1 For given β. pi gi (β) = 0. summing over i.. µ. λ) : λ(β) = argmin Rn (β.5).

2 Deﬁne Asymptotic Distribution of EL Estimator Gi (β) = ∂ gi (β) ∂β 0 (10.10.13) yields n n Expanding (10. λ) jointly solve ³ ´ ˆ n gi β X ∂ ³ ³ ´´ Rn (β.11) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ ˆ 0 ' −g n − Gn β − β 0 + Ωn λ (10.9) and (10. and Ω = E xi x0 e2 . λ) = − (10. ˆ The asymptotic variance V for β is the same as for eﬃcient GMM.1 Under regularity conditions. n (10. 0 = Rn (β.10). Gi (. β λ ∂ ³ ´. g n = n n gi (β 0 ) and Ωn = n n g (β 0 ) gi (β 0 )0 . and n β − β 0 and nλ are asymptotically independent.2. ´ √ ³ ˆ n β − β 0 →d √ ˆ nλ →d N (0. V ) ¢−1 ¡ V = G0 Ω−1 G ¡ ¢−1 0 Vλ = Ω − G G0 Ω−1 G G G = EGi (β 0 ) ¡ ¢ Ω = E gi (β 0 ) gi (β 0 )0 (10. i i Theorem 10. G = −E (xi zi ). λ) = − (10. ˆ ˆ Proof. (β. Vλ ) ´ √ ˆ √ ³ˆ where V and Vλ are deﬁned in (10.9) (10.13) Premultiplying by G0 Ω−1 and using (10.12) ∂β ˆ ˆ0 i=1 1 + λ gi β 1 P 1 P 1 P Let Gn = n n Gi (β 0 ) .8) and ¢ 0 0 For example. β) = −xi zi .12) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ 0 ' G0 λ − λ0 . Thus the EL estimator is asymptotically eﬃcient.10) ¡ Ω−1 N (0.11) 0 = ∂λ ˆ0 ˆ i=1 1 + λ gi β ³ ´0 ˆ n X Gi . i=1 i=1 i=1i Expanding (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 . in the linear model.

The overidentiﬁcation test is a very useful by-product of EL estimation.15) (10.15). The EL overidentiﬁcation test is similar to the GMM overidentiﬁcation test. Since the EL estimator achieves this bound. 120 . Twice the diﬀerence between the unrestricted empirical likelihood −n log (n) and the maximized empirical likelihood for the model (10. and it is advisable to report the statistic LRn whenever EL is the estimation method. and (10. it is an asymptotically eﬃcient estimator for β. LRn = i=1 Theorem 10.16) ´ √ ˆ √ ³ˆ n β − β 0 and nλ are asymptotically uncorrelated and hence independent.3 Overidentifying Restrictions In a parametric likelihood context.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. β 0 ) = 0 then LRn →d χ2−k .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. ¥ Chamberlain (1987) showed that V is the semiparametric eﬃciency bound for β in the overidentiﬁed moment condition model. since ³ ¡ ¢−1 0 ´ G0 I − Ω−1 G G0 Ω−1 G G =0 (10. They are asymptotically ﬁrst-order equivalent. First. (10. β ' n g n + Gn β − β 0 n i=1 ³ ¡ ¢−1 0 −1 ´ √ Gn Ωn ng n ' I − Gn G0 Ω−1 Gn n n √ ˆ ' Ωn nλ.3. V ) ˆ Solving (10. and have the same interpretation. This means that no consistent estimator for this class of models can have a lower asymptotic variance than V .17) 2 ln 1 + λ gi β .7) is n ³ ´´ ³ X ˆ ˆ0 (10. The same statistic can be constructed for empirical likelihood.1 If Eg(wi .14) for λ and using (10. Vλ ) Furthermore. Ω) →d Ω−1 I − G G Ω G GΩ = Ω−1 N (0.16). Proof. n ³ ´´ ´ √ ³ 1 X ³ ˆ ˆ √ g wi . tests are based on the diﬀerence in the log likelihood functions. Ω) GΩ G →d = N (0. by a Taylor expansion. 10.

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

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

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

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

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

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

11.2

Reduced Form

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

Substituting (11.6) into (11.2), we ﬁnd

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

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

11.3

Identiﬁcation

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

11.4

Estimation

0 yi = zi β + ei

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

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

11.5

Special Cases: IV and 2SLS

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

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

which again is the IV estimator.

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

then

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

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

13) which is zero only when S21 = 0 (when Z is exogenous).12) Z = XΓ + u ξ = (e.12). In our notation. X2 ].11). ¡ ¢−1 ¡ 0 ¢ ˆ β 2SLS = Z 0 PX Z Z PX Y . the model is Y = Zβ + e (11.11) (11. ¶ 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 ) . let’s analyze the approximate bias of OLS applied to (11. 129 . Z2 . Here we present a simpliﬁed version of one of his results. u) E (ξ | X) = 0 ¢ ¡ E ξξ 0 | X = S As before. Using (11. We now derive a similar result for the 2SLS estimator. Thus in the second stage. X is n × l so there are l instruments. First. Z2 = [PX Z1 . So only the endogenous variables Z2 are replaced by their ﬁtted values: ˆ ˆ ˆ Z2 = X1 Γ12 + X2 Γ22 . PX Z2 ] = [Z1 . ˆ since Z1 lies in the span of X. Recall. 11. PX Z2 ] h i ˆ = Z1 .ˆ It is useful to scrutinize the projection Z. Then i h ˆ ˆ ˆ Z = Z1 . Z2 ] and X = [Z1 . 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. Z = [Z1 . we regress Y on Z1 and Z2 .6 Bekker Asymptotics Bekker (1994) used an alternative asymptotic framework to analyze the ﬁnite-sample bias in the 2SLS estimator.

By the spectral decomposition of an idempotent matrix. 0). l . 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. indicating that the bias in 2SLS approaches that of OLS as the number of instruments increases. ¢ 1 ¡ ¢ 1 ¡ ¢ 1 ¡ 0 E Z PX e = E Γ0 X 0 e + E u0 PX e = αS21 . 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 .14) approaches that in (11. except when S21 = 0 (when Z is exogenous). Hence µ ¶ 1 0 1 1/20 ¡ 0 ¢ 1/2 ξ PX ξ S E q Λq S E = n n µ ¶ 1 0 1 1/20 S E q q1 S 1/2 = n n 1 l 1/20 1/2 S S = n = αS where α= Using (11.12) and this result.14) is the probability limit of β 2SLS − β 11. The consequences of identiﬁcation failure for inference are quite severe. n and (11. Together µ µ ¶¶−1 µ ¶ ³ ´ 1 0 1 0 ˆ 2SLS − β E β Z PX Z Z PX e ≈ E E n n ¡ ¢−1 = α Γ0 QΓ + αS22 S21 . Let q = H 0 ξS −1/2 which satisﬁes Eqq 0 = In and partition q = (q1 q2 ) where q1 is l × 1. Bekker (1994) pointed out that it also has the reverse implication — that when α = l/n is large. 130 .7 Identiﬁcation Failure Recall the reduced form equation Z2 = X1 Γ12 + X2 Γ22 + u2 . the bias in the 2SLS estimator will be large.Let PX = X (X 0 X)−1 X 0 . It is also close to zero when α = 0. the expression in (11.14) In general this is non-zero. Indeed as α → 1. The parameter β fails to be identiﬁed if Γ22 has deﬁcient rank. P = HΛH 0 0 0 where Λ = diag(Il .13).

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

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

where xi and β are 1 × 1. xi is l × 1.8 Exercises yi = zi β + ei . Show that the GLS estimator of β can be written as an i IV estimator using some instrument xi . Explain why this is true. l ≥ k. ˆ ˆ Let the OLS estimator for β be β and the OLS residual be e = Y − Z β. Z is n × k. 1. 5. 6. show that if rank(Γ) < k then β cannot be identiﬁed.11. Consider the single equation model ˆ where yi and zi are both real-valued (1 × 1). 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 sense that e ˜ ˜ least in large samples? 4. 2. we claim that β is identiﬁed (can be recovered from the reduced form) if rank(Γ) = k. will IV “ﬁt” better than OLS. X is n × l.) 3. u is n × k. and Γ is l × k. at ˆˆ If X is indeed endogeneous. In the structural model Y = Zβ + e Z = XΓ + u with Γ l × k. 133 . In the linear model 0 yi = zi β + ei E (ei | zi ) = 0 ¡ 2 ¢ suppose σ 2 = E ei | zi is known. 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. (Find an expression for xi . ˆ ˜ ˜ Let the IV estimator for β using some instrument X be β and the IV residual be e = Y − Z β. That is. Take the linear model yi = xi β + ei E (ei | xi ) = 0. ˜ 0 e < e0 e. Take the linear model Y = Zβ + e. Find a simple expression for the IV estimator in this context. The parameter Γ is deﬁned by the population moment condition ¡ ¢ E xi u0 = 0 i ˆ Show that the method of moments estimator for Γ is Γ = (X 0 X)−1 (X 0 Z) .

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

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

ˆ Proof. ˆ 2. If Xt is strictly stationary and ergodic and E |Xt | < ∞. and it has a ﬁnite mean by the assumption that EYt2 < ∞. 1.1. then as T → ∞. ˆ ˆ γ ¥ 136 .1 above.Theorem 12.2 (Ergodic Theorem). ˆ ˆ T t=1 T t=1 T t=1 By Theorem 12. note that γ (k) = ˆ T 1X (Yt − µ) (Yt−k − µ) ˆ ˆ T t=1 = T T T 1X 1X 1X Yt Yt−k − Yt µ − ˆ Yt−k µ + µ2 . the sequence Yt Yt−k is strictly stationary and ergodic. Part (1) is a direct consequence of the Ergodic theorem. ˆ 3.1.1. then as T → ∞. T t=1 Thus γ (k) →p E(Yt Yt−k ) − µ2 − µ2 + µ2 = E(Yt Yt−k ) − µ2 = γ(k). ρ(k) →p ρ(k).3 If Yt is strictly stationary and ergodic and EYt2 < ∞. Thus an application of the Ergodic Theorem yields T 1X Yt Yt−k →p E(Yt Yt−k ). µ →p E(Yt ). γ (0) ˆ Theorem 12. γ (k) →p γ(k). T 1X Xt →p E(Xt ). T t=1 This allows us to consistently estimate parameters using time-series moments: The sample mean: T 1X µ= ˆ Yt T t=1 The sample autocovariance T 1X (Yt − µ) (Yt−k − µ) . ˆ Part (3) follows by the continuous mapping theorem: ρ(k) = γ (k)/ˆ (0) →p γ(k)/γ(0) = ρ(k). For Part (2). ˆ ˆ T t=1 γ (k) = ˆ The sample autocorrelation ρ(k) = ˆ γ (k) ˆ .

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

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

where the λ1 . By Theorem 12. and is of great interest in applied time series.1. λk are the complex roots of ρ(z). β = X 0X (12.5. One way of stating this is that “All roots lie outside the unit circle.1 If the AR(k) process Yt is strictly stationary and ergodic and EYt2 < ∞.. T ¢ ¡ 1X xt x0 →p E xt x0 = Q. Proof. Let |λ| denote the modulus of a complex number λ. ..” If one of the roots equals 1.1) Theorem 12. we see that Ã !−1 Ã ! T T 1X 1X ˆ β=β+ xt x0 xt et →p Q−1 0 = 0. it is also strictly stationary and ergodic.1. so is xt x0 . and hence Yt . t Yt−k ¢0 ρk .1. This is a special case of non-stationarity.6 Let Estimation xt = β = ¡ 1 Yt−1 Yt−2 · · · α ρ1 ρ2 · · · yt = x0 β + et . T t=1 T t=1 ¢−1 0 ¡ ˆ X Y. t T t=1 T t=1 139 .1 The AR(k) is strictly stationary and ergodic if and only if |λj | > 1 for all j. t t T t=1 ¥ Combined with (12. The Fundamental Theorem of Algebra says that any polynomial can be factored as ¢¡ ¢ ¡ ¢ ¡ ρ(z) = 1 − λ−1 z 1 − λ−1 z · · · 1 − λ−1 z 1 2 k 12. Note that ut is a MDS. the requirement is that all roots are larger than one. Thus T T 1X 1X xt et = ut →p E (ut ) = 0.1) and the continuous mapping theorem. which satisfy ρ(λj ) = 0. and by Theorem 12. The vector xt is strictly stationary and ergodic.1. “has a unit root”. since E (ut | It−1 ) = E (xt et | It−1 ) = xt E (et | It−1 ) = 0.6. it is helpful to deﬁne the process ut = xt et . we say that ρ(L). Theorem 12. Thus t by the Ergodic Theorem. then ˆ β →p β as T → ∞.. ¢0 Then the model can be written as The OLS estimator is ¡ ˆ To study β. For an AR(k). We know that an AR(1) is stationary iﬀ the absolute value of the root of its autoregressive polynomial is larger than one.

this cannot work in a time-series application..1 to see that T 1 X √ xt et →d N (0. Ω) .7. The implication is that asymptotic inference is the same. Divide the sample into T /m blocks of length m. 140 .7. e ˆ 3.. Fix an initial condition (Y−k+1 . Simulate iid draws e∗ from the empirical distribution of the residuals {ˆ1 .. . as this imposes inappropriate independence. T 1 X √ ut →d N (0. there are two popular methods to implement bootstrap resampling for time-series data.. T t=1 Since xt et is a MDS. t This construction imposes homoskedasticity on the errors e∗ . Brieﬂy. we constructed the bootstrap sample by randomly resampling from the data values {yt . If ut is a strictly stationary and ergodic MDS and E(ut u0 ) = Ω < ∞. It also presumes that the AR(k) structure is the truth. ˆ 1. Y−k+2 . 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∗ . In particular. ´ √ ³ ¡ ¢ ˆ T β − β →d N 0.12.7 Asymptotic Distribution Theorem 12. Method 1: Model-Based (Parametric) Bootstrap.. This is identical in form to the asymptotic distribution of OLS in cross-section regression. t t Theorem 12. . the asymptotic covariance matrix is estimated just as in the cross-section case. This creates an iid bootstrap sample. i 4.2 If the AR(k) process Yt is strictly stationary and ergodic and EYt4 < ∞. xt }. Ω) . which may be diﬀerent than the i properties of the actual ei . Q−1 ΩQ−1 . Y0 ). eT }. Clearly. then as T → ∞. ˆ 2. 12. Method 2: Block Resampling 1.. T t=1 where Ω = E(xt x0 e2 ). t then as T → ∞. we can apply Theorem 12.8 Bootstrap for Autoregressions In the non-parametric bootstrap.7.1 MDS CLT. Estimate β and residuals et .

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

.5) We are interested in the question if the error ut is serially correlated.10 Testing for Omitted Serial Correlation For simplicity. and the alternative is that the error is an AR(m). H0 may be expressed as the restriction that the coeﬃcient on Yt−2 is zero. 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. let the null hypothesis be an AR(1): Yt = α + ρYt−1 + ut .. (12. and then reserve the ﬁrst k as initial conditions. this is the same as saying that under the alternative Yt is an AR(k+m).g. Yt−k−m are jointly zero. Thus under H0 .6). We then multiply this by θ and subtract from (12.11 Model Selection What is the appropriate choice of k in practice? This is a problem of model selection. An appropriate test is the Wald test of this restriction. we take (12.. e.12.6) 12. . (12. We want to test H0 against H1 . Another is to minimize the AIC or BIC information criterion. (If you increase k. In general. AIC(k) = log σ 2 (k) + ˆ 2k . Yt is an AR(1).. The best remedy is to ﬁx a upper value k. and then estimate the models AR(1).5) and (12. We model this as an AR(1): ut = θut−1 + et with et a MDS. . An appropriate test of H0 against H1 is therefore a Wald test that the coeﬃcient on Yt−2 is zero. AR(k) on this (uniﬁed) sample. One approach to model selection is to choose k based on a Wald tests. and under H1 it is an AR(2).5) and lag the equation once: Yt−1 = α + ρYt−2 + ut−1 . and this is equivalent to the restriction that the coeﬃcients on Yt−k−1 .5). 142 . or Yt = α(1 − θ) + (ρ + θ) Yt−1 − θρYt−2 + et = AR(2)..) This can induce strange behavior in the AIC.. (A simple exclusion test). if the null hypothesis is that Yt is an AR(k). To combine (12. you need more initial conditions. The hypothesis of no omitted serial correlation is H0 : θ = 0 H1 : θ 6= 0. AR(2). to ﬁnd Yt − θYt−1 = α − θα + ρYt−1 − θρYt−1 + ut − θut−1 .

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

a common conclusion is that the data suggests that Yt is non-stationary. this means that the evidence points to Yt being stationary. but diﬀerent critical values are required. This is called a “super-consistent” rate of convergence.1 (Dickey-Fuller Theorem). If the test rejects H0 . They are skewed to the left. Thus the Dickey-Fuller test is robust to heteroskedasticity. however.g. This distribution has been extensively α tabulated.8) This is natural when the alternative hypothesis is that the series is stationary about a linear time trend. This model is ∆Yt = µ1 + µ2 t + α0 Yt−1 + α1 ∆Yt−1 + · · · + αk−1 ∆Yt−(k−1) + et . The ADF test has a diﬀerent distribution when the time trend has been included. When conducting the ADF test. as the AR model cannot conceivably describe this data. then the series itself is nonstationary. In this context. These are included for completeness (from a pedagogical perspective) but have no relevance for empirical practice where intercepts are always included. s(ˆ 0 ) α The limit distributions DFα and DFt are non-normal. and a diﬀerent table should be consulted. this means that it is computed as the t-ratio for α0 from OLS estimation of (12.12. But the theorem does not require an assumption of homoskedasticity.8). If a time trend is included. Most texts include as well the critical values for the extreme polar case where the intercept has been omitted from the model. where c is the critical value from the ADF table. but does not depend on the parameters α. the test procedure is the same. the ADF test rejects H0 in favor of H1 when ADF < c. conventional rate of T The second result states that the t-statistic for α0 converges to a limit distribution which is ˆ non-normal. The ﬁrst result states that α0 converges to its true value (of zero) at rate T. We have described the test for the setting of with an intercept.Theorem 12. Since the alternative hypothesis is one-sided. If the test does not reject H0 . All we can say is that there is insuﬃcient evidence to conclude whether the data are stationary or not. (12. The natural solution is to include a time trend in the ﬁtted OLS equation. rather than the ˆ 1/2 . Stock Prices). T α0 →d (1 − α1 − α2 − · · · − αk−1 ) DFα ˆ ADF = α0 ˆ → DFt . and have negative means. This is not really a correct conclusion. and may be used for testing the hypothesis H0 . If the series has a linear trend (e. it is a silly waste of time to ﬁt an AR model to the level of the series without a time trend. As T → ∞. Another popular setting includes as well a linear time trend. Assume α0 = 0. Note: The standard error s(ˆ 0 ) is the conventional (“homoskedastic”) standard error. 144 . GDP. but it may be stationary around the linear time trend.

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

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

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

That is.) I2t = (Yt . then we deduce that our time-series model of E (Yt | It−1 ) does not require the use of Zt . . The latter has more information. and the information set I2t is generated by both Yt and Zt .. Zt ).. . This may be tested using an exclusion (Wald) test. 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. Zt does not Granger-cause Yt if and only if H0 : γ 1 = γ 2 = · · · = γ k = 0. Yt−2 . The reason why we call this “Granger Causality” rather than “causality” is because this is not a physical or structure deﬁnition of causality. such as a futures price. that Zt may still be useful to explain other features of Yt . The hypothesis can be tested by using the appropriate multivariate Wald test. The log determinant is the criterion from the multivariate normal likelihood.. the equation for Yt is 0 0 Yt = α + ρ1 Yt−1 + · · · + ρk Yt−k + Zt−1 γ 1 + · · · + Zt−k γ k + et . This idea can be applied to blocks of variables. you may either use a testingbased approach (using. for example. Note. Zt−2 . 148 . or an information criterion approach. In this equation.6 Selection of Lag Length in an VAR If you want a data-dependent rule to pick the lag length k in a VAR.) The information set I1t is generated only by the history of Yt .t−1 ) = E (Yt | I2. . Yt−2 . 13.7 Granger Causality Partition the data vector into (Yt . lagged Zt does not help to forecast Yt . conditional on information in lagged Yt . such as the conditional variance. Deﬁne the two information sets I1t = (Yt . In a linear VAR.13. the Wald statistic). then we say that Zt Granger-causes Yt . Yt−1 . however. This deﬁnition of causality was developed by Granger (1969) and Sims (1972). and et (k) is the OLS residual vector from the ˆ model with k lags. Yt−1 . Zt . If it is found that Zt does not Granger-cause Yt . We say that Zt does not Granger-cause Yt if E (Yt | I1. Yt and/or Zt can be vectors.. then Zt may help to forecast Yt even though it does not “cause” Yt .t−1 ) . That is. If this condition does not hold. Zt−1 . If Zt is some sort of forecast of the future.

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

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

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

In the Binary choice model. Details of such calculations are left to more advanced courses. otherwise Estimation is by maximum likelihood. i | Hence the log-likelihood function is ln (β) = = = = n X i=1 n X i=1 n X i=1 log f (yi | xi ) ¡ ¡ ¢y ¡ ¢ ¢ log F x0 β i (1 − F x0 β )1−yi i i yi =1 X £ ¡ ¢ ¡ ¢¤ yi log F x0 β + (1 − yi ) log(1 − F x0 β ) i i ¡ ¢ X ¡ ¢ log F x0 β + log(1 − F x0 β ). we call this the logit model. If F is logistic. This model is identical to the latent variable model Yi∗ = x0 β + ei i ei ∼ F (·) ½ 1 Yi = 0 For then P (Yi = 1 | xi ) = P (Yi∗ > 0 | xi ) ¡ ¢ = P x0 β + ei > 0 | xi i ¢ ¡ = P ei > −x0 β | xi i ¢ ¡ = 1 − F −x0 β i ¡ ¢ = F x0 β . i 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). we need the conditional distribution of an individual observation. 152 . 1. such that P (Y = 1) = p and P (Y = 0) = 1 − p. Thus i the conditional density is f (yi xi ) = pyi (1 − pi )1−yi i ¡ 0 ¢yi ¡ ¢ = F xi β (1 − F x0 β )1−yi . −1 . Recall that if Y is Bernoulli. To construct the likelihood. 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 . y = 0. Yi is conditionally Bernoulli with P (Yi = 1 | xi ) = pi = F (x0 β) .• Logistic: F (u) = (1 + e−u ) • Normal: F (u) = Φ(u). and if F is normal.

) The observed data yi therefore come from a mixed continuous/discrete distribution.. The log-likelihood function is ln (β) = n X i=1 log f (yi | xi ) = n X¡ ¢ − exp(x0 β) + yi x0 β − log(yi !) . . This model speciﬁes that P (Yi = k | xi ) = λi k = 0.3 Censored Data The idea of “censoring” is that some data above or below a threshold are mis-reported at the ∗ threshold. i If Y = {0. The ﬁrst censored regression model was developed by Tobin (1958) to explain consumption of durable goods.” Also observe that the model implies that V ar (Yi | xi ) = λi = exp(x0 β). 1. k! = exp(x0 β). this motivates the label Poisson “regression. 14. A generalization is the negative binomial... Tobin observed that for many households. 1. 2. The functional form for λi has been picked to ensure that λi > 0. He proposed the latent variable model ∗ yi = x0 β + ei i ei ∼ iid N (0. An example of a data collection censoring is top-coding of income. 0 if yi (This is written for the case of the threshold being zero.14. In surveys.1) yi = ∗ <0 . 2. i i i=1 ˆ The MLE is the value β which maximizes ln (β). but we observe only ½ ∗ ∗ yi if yi ≥ 0 (14. any known value can substitute. or it may be a by-product of economic constraints. σ 2 ) with the observed variable yi generated by the censoring equation (14.. This model (now called the Tobit) speciﬁes that the latent (or ideal) value of consumption may be negative (the household 153 . incomes above a threshold are typically reported at the threshold. Thus the model is that there is some latent process yi with unbounded support.}. 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. a typical approach is to employ Poisson regression.1). The conditional density is the Poisson with parameter λi . The censoring process may be explicit in data collection.2 Count Data exp (−λi ) λk i . Since E (Yi | xi ) = λi = exp(x0 β) i is the conditional mean. This may be considered restrictive. the consumption level (purchases) in a particular period was zero. . i so the model imposes the restriction that the conditional mean and variance of Yi are the same.

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

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

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

15. Condition (15. i = 1. n. then OLS is inconsistent. xit } : t = 1... or unbalanced : {yit . .. where the i subscript denotes the individual. collected over time. A panel may be balanced : {yit . xit }. . n.1) is true. It is consistent if E (xit ui ) = 0 (15. and that eit is uncorrelated with xit ... The motivation is to allow ui to be arbitrary.. that ui and eit are independent. ti . In either event.. and thus achieve invariance. There are several derivations of the estimator. . xit } : For i = 1. T .. OLS of yit on xit is called pooled estimation.. (15. This is often believed to be plausible if ui is an omitted variable. The goal is to eliminate ui from the estimator.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 . and have arbitrary correlated with xi ...1) If this condition fails. OLS can be improved upon via a GLS technique.Chapter 15 Panel Data A panel is a set of observations on individuals. 15.1) is called the random eﬀects hypothesis. 157 . and most applied researchers try to avoid its use. however.2 Fixed Eﬀects This is the most common technique for estimation of non-dynamic linear panel regressions. It is a strong assumption. and the t subscript denotes time. If (15. that eit is iid across individuals and time.1) fails if the individual-speciﬁc unobserved eﬀect ui is correlated with the observed explanatory variables xit . An observation is the pair {yit . t = ti . .. OLS appears a poor estimation choice. it The typical maintained assumptions are that the individuals i are mutually independent.

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

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

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

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

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

(16. Together with the above table. where φ is the N (0. Gaussian Kernel: hrule = 1. we need h → 0 but nh → ∞. We can calculate that √ R(φ00 ) = 3/ (8 π) . we ﬁnd the reference rules for the three kernel functions introduced earlier. Note that this h declines to zero. (16.2) This solution takes the form h0 = cn−1/5 where c is a function of K and f.1) is an asymptotic approximation to the MSE. the rule-of-thumb h can be quite ineﬃcient. The asymptotically optimal choice given in (16. Equation (16. 1) distribution and σ 2 is an estimate of σ 2 = V ar(X).Together.06n−1/5 163 . That is. Their K values for the three functions introduced in the previous section are given here. 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) . σ 2 . h must tend to zero.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 . That is. 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 + . and R(f 00 ). and gives a nearly optimal rule when f (x) is close to normal. 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.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 ). We deﬁne the asymptotically optimal bandwidth h0 as the value which minimizes this approximate MSE.2) depends on R(K). The downside is that if the density is very far from normal. but not of n. ˆ It uses formula (16. Thus for the AMISE to decline with n. This choice for h gives an optimal rule when f (x) is ˆ normal. h0 = argmin AM ISEh h It can be found by solving the ﬁrst order condition d R(K) AM ISEh = h3 σ 4 R(f 00 ) − =0 K dh nh2 yielding h0 = µ R(K) 4 R(f 00 ) σK ¶1/5 n−1/2 . but at a very slow rate. how should the bandwidth be selected? This is a diﬃcult problem. Notice that the ﬁrst term (the squared bias) is increasing in h and the second term (the variance) is decreasing in nh. and there is a large and continuing literature on the subject. A classic simple solution proposed by Silverman (1986)has come to be known as the reference bandwidth or Silverman’s Rule-of-Thumb. The ﬁrst two are determined by the kernel function. but at a slower rate than n−1 . In practice.

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

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

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

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

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

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

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

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

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

. . y) fX (x) The conditional density of Y given X = x is deﬁned as fY |X (y | x) = if fX (x) > 0. Xk )0 is a function from S to Rk . Letting x = (x1 ... we have the k × 1 multivariate mean µ = EX and k × k covariance matrix ¡ ¢ Σ = E (X − µ) (X − µ)0 = EXX 0 − µµ0 If the elements of X are mutually independent.A k × 1 random vector X = (X1 . xk )0 . ∂x1 · · · ∂xk For a measurable function g : Rk → Rs .. fX (x) 173 . then Σ is a diagonal matrix and Ã k ! k X X V ar Xi = V ar (Xi ) i=1 i=1 A.. y) fX (x) f (x. . it has the distribution and density functions F (x) = P (X ≤ x) ∂k f (x) = F (x).. y) fX (x + ε) ∂2 ∂x∂y F (x. 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) ∂ lim ∂y ε→0 FX (x + ε) − FX (x) ∂ lim ∂y ε→0 ∂ ∂x F (x + ε. y) − F (x. In particular. y) .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 .

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

dy dy If g(x) is a decreasing function. J(y) = det ∂y 0 Consider the univariate case k = 1. 1] and Y = − ln(X). but its justiﬁcation requires deeper results from analysis. then g(X) ≤ Y if and only if X ≥ h(Y ).10) d h(y). As one example. so the distribution function of Y is FY (y) = P (g(X) ≤ y) = FX (h(Y )) = P (X ≤ h(Y )) so the density of Y is fY (y) = d d FY (y) = fX (h(Y )) h(y). that for Y is [0.A. 0 ≤ y ≤ ∞.∞). Let Y = g(X) where g(x) : Rk → Rk is one-to-one. Let h(y) denote the inverse of g(x). Since fX (x) = 1 for 0 ≤ x ≤ 1 (A.10) shows that fY (y) = exp(−y).10) holds for k > 1. Here. As the range of X is [0.7 Transformations Suppose that X ∈ Rk with continuous distribution function FX (x) and density fX (x). . an exponential density. This same formula (A. A. φ(x) = √ exp − 2 2π 175 The standard normal density is −∞ < x < ∞. (A. The Jacobian is ¶ µ ∂ h(y) . g(x) = − ln(x) and h(y) = exp(−y) so the Jacobian is J(y) = − exp(y). diﬀerentiable. take the case X ∼ U [0. 1]. then g(X) ≤ Y if and only if X ≤ h(Y ).8 Normal and Related Distributions µ 2¶ 1 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)| . If g(x) is an increasing function. and invertible. dy This is known as the change-of-variables formula.

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

8.3. tr = p Q/r The density of tr is and is known as the student’s t distribution with r degrees of freedom. Proof of Theorem A.13). (A.11) 2 with r = 1. 1). For Z ∼ N(0. q Proof of Theorem A. Since we can write Q = P 2 X 0 X = r Zj where the Zj are independent N(0. ¡ ¢ √ using the change—of-variables s = x2 and the fact Γ 1 = π.8. The fact that A > 0 means that we can write A = CC 0 where C is non-singular. 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 . Iq ). tr has distribution 177 . Thus ¥ ¡ ¢0 ¡ ¢ Z 0 A−1 Z = Z 0 C −10 C −1 Z = C −1 Z C −1 Z ∼ χ2 . The MGF for the density (A.13) is the MGF of the density (A. C −1 CC 0 C −10 ) = N (0.11) is Z ∞ ¢ ¡ Γ r+1 2 f (x) = ´ r+1 ¡r¢ ³ √ 2 2 πrΓ 2 1 + x r (A.Theorem A.12) E exp (tQ) = 0 Γ (A. From (A. which we showed in (A.1.2. Set r Z . Using the simple law of iterated expectations. 1) and Q ∼ χ2 be independent.3 Let Z ∼ N (0. C −1 AC −10 ) = N (0.8.8.11). which can be found by applying change-of-variables to the gamma function. Thus the density of Z 2 is (A. Then A−1 = C −10 C −1 and C −1 Z ∼ N (0.6) can be used to show that the MGF j=1 ¥ Proof of Theorem A.13) = (1 − 2t)−r/2 R∞ where the second equality uses the fact that 0 y a−1 exp (−by) dy = b−a Γ(a). we see that the MGF of Z 2 is (1 − 2t)−1/2 .

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

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

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

θ0 ) dy ¯ ¯ ¯ θ=θ0 f (y.1) has mean zero and variance nH.2. θ0 ) ¯ ∂ f (y. ∂2 ln f (Yi .16). . θ0 ) ∂ ∂θ f ∂ (Yi .9. function of the data. θ0 ) ∂θ ∂θ n i=1 which by Theorem (A.1.17). θ0 ) ln f (Yi . θ0 ) = ∂θ∂θ0 = Taking expectations yields (A.. θ0 ) − f (Yi . S= ∂2 f ∂θ∂θ0 ∂2 f ∂θ∂θ0 ∂ ∂θ Z Ã ∂2 f ∂θ∂θ0 ¯ ¯ ln f (y. yn ).. θ) d˜ θ = Eθ θ(˜ y y where y = (y1 . we can show that E By direction computation.9. V ar (S) nH so ¥ 181 . (Yi .9. Write the estimator ˜ = ˜ Y ) as a θ θ( ˜ ˜ is unbiased for any θ. θ) f (˜. θ0 ) d˜ = E ˜ . 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 = .Proof of Theorem A. θ) ¯θ=θ0 ¯ Z ¯ ∂ f (y. θ0 ) ∂ ∂ − ln f (Yi . Since θ Z ˜ = ˜ y)f (˜. f (Yi . θ0 )0 . θ) f (y. θ0 ) ∂θ f (Yi . θ) d˜ = ˜ y ) ∂ ln f (˜. θ) dy ¯ ¯ ∂θ θ=θ0 ¯ ∂ ¯ 1¯ = 0. θ0 = ln f (Yi . Proof of Theorem A. To see (A. θ0 ) ∂θ ∂θ ¥ ³ ´ X ∂ ∂ ˜ ln fn Y .. θ0 ) (Yi . θ) dy ¯ ∂θ f (y. Diﬀerentiating with respect to θ and evaluating at θ0 yields ˜ Z Z ³ ´ ˜ y ) ∂ f (˜. θ)¯ = ¯ ∂θ θ=θ0 = = = Similarly. θ0 )0 f (Yi . ∂θ ¯θ=θ0 Z ! = 0. ¯ ¯ ∂ E ln f (Yi . θ0 )2 (Yi . θ0 ) f (Yi .

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

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

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

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

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