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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

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

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

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

Bureau of Labor Statistics: http://www. xn )} = {(yi . The fact that a person is highly educated suggests a high level of ability. 1.. If the data is randomly gathered. This abstraction can a source of confusion as it does not correspond to a physical population in the real world... In this case the data are independent and identically distributed.federalreserve. (yn .g.stlouisfed. and are typically called dummy variables.org/ US Census: http://www.For example. a person’s level of education is (at least partially) determined by that person’s choices and their achievement in education.org/fred2/ Board of Governors of the Federal Reserve System: http://www. The distribution F is unknown. Some other excellent data sources are listed below. High ability individuals do better in school. household or ﬁrm). Causal inference requires identiﬁcation. and the goal of statistical inference is to learn about features of F from the sample.. xi ) . This discussion means that causality cannot be infered from observational data alone. (y2 . taking on only the values 0 and 1. (yi .bls. Louis: http://research. n} where each pair {yi .. an econometrician has data {(y1 . For example. The point is that multiple explanations are consistent with a positive correlation between schooling levels and education. . xi ) is independent of the pair (yj . the development of the internet has provided a convenient forum for dissemination of economic data.nber. These factors are likely to be aﬀected by their personal abilities and attitudes towards work. Sometimes the independent part of the label iid is misconstrued. and their high ability is the fundamental reason for their high wages.3 Random Sample Typically.gov/ Federal Reserve Bank of St. An excellent starting point is the Resources for Economists Data Links. xj ) for i 6= j.gov/econ/www/ 2 .. xi } ∈ R × Rk is an observation on an individual (e. We call these observations the sample.census. and this is based on strong assumptions. Many large-scale economic datasets are available without charge from governmental agencies.gov/releases/ National Bureau of Economic Research: http://www. Knowledge of the joint distibution cannot distinguish between these explanations. available at http://rfe. This is an alternative explanation for an observed positive correlation between educational levels and wages... It is not a statement about the relationship between yi and xi . xi ) : i = 1. This “population” is inﬁnitely large. x1 ) . At this point in our analysis it is unimportant whether the observations yi and xi come from continuous or discrete distributions.html.wustl. many regressors in econometric practice are binary.. . The random variables (yi .. x2 ) . xi ) have a distribution F which we call the population. We call this a random sample. and therefore choose to attain higher levels of education. If the data is cross-sectional (each observation is a diﬀerent individual) it is often reasonable to assume they are mutually independent. it is reasonable to model each observation as a random draw from the same probability distribution. .edu/Data/index. Rather it means that the pair (yi . or iid. We will return to a discussion of some of these issues in Chapter 11. 1.4 Economic Data Fortunately for economists.

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

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

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

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

If A − BD−1 C and D − CA−1 B are non-singular. . some properties include AA−1 = A−1 A = Ik ¡ ¢−1 ¡ −1 ¢0 = A0 A Even if a matrix A does not possess an inverse. 7 Also. (2.3) plus the following three conditions A− AA− = A− AA− is symmetric A− A is symmetric For any matrix A. (2. . if there is no c 6= 0 such that Ac = 0. then # ¡ ¢−1 ¡ ¢−1 ∙ ¸−1 " A − BD−1 C A B − A − BD−1 C BD−1 ¡ ¡ ¢−1 ¢−1 = . In this case there exists a unique matrix B such that AB = BA = Ik . The Moore-Penrose generalized inverse A− satisﬁes (2. . if A is an orthogonal matrix. . The following fact about inverting partitioned matrices is sometimes useful. then A−1 = A. . .2) C D D − CA−1 B − D − CA−1 B CA−1 (AC)−1 = C −1 A−1 ¡ ¢−1 −1 (A + C)−1 = A−1 A−1 + C −1 C ¡ −1 ¢ −1 −1 −1 −1 −1 A − (A + C) = A A +C A ¡ ¢ −1 (A + BCD) = A−1 − A−1 BC C + CDA−1 BC CDA−1 (2.3) The matrix A− is not necessarily unique. 0b 0b ak 1 ak 2 · · · a0 bk 1 a0 bk 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 . we can still deﬁne a generalized inverse A− as a matrix which satisﬁes AA− A = A. For non-singular A and C. .4 Inverse A k × k matrix A has full rank. a0 bk k ⎤ ⎥ ⎥ ⎥ ⎦ a0 bi i b0 ai i = = tr (BA) . This matrix is called the inverse of A and is denoted by A−1 . or is nonsingular. 2.1) . the Moore-Penrose generalized inverse A− exists and is unique.

2. If λi is an eigenvalue of A.5 Eigenvalues det (A − λIk ) = 0. and then set B = HΛ1/2 . If A is symmetric.. and the characteristic roots are all real. We call B a matrix square root of A. We say that a square matrix A is positive semi-deﬁnite if for all non-zero c. • If A has distinct characteristic roots. In this case. If A > 0 we can ﬁnd a matrix B such that A = BB 0 . This is written as A ≥ 0. Let λi and hi . then A is non-singular and A−1 exists. λ−1 . This is written as A > 0. then A is positive semi-deﬁnite. Furthermore.. If A is also symmetric (most idempotent matrices are) then all its characteristic roots equal either zero or one. We say that X is n × k. k < n. c0 Ac > 0. Let Λ be a diagonal matrix with the characteristic roots in the diagonal.. One way to construct B is to use the spectral decomposition A = HΛH 0 where Λ is diagonal.6 Rank and Positive Deﬁniteness The rank of a square matrix is the number of its non-zero characteristic roots. which are not necessarily distinct and may be real or complex. Then A = AA = HΛH 0 HΛH 0 = HΛ2 H 0 . λ−1 .) If A is positive deﬁnite. 8 . . then A > 0 if and only if all its characteristic roots are positive. • The characteristic roots of A−1 are λ−1 . i = 1. (For any c 6= 0. A−1 > 0. We now state some useful properties. has full rank k if there is no non-zero c such that Xc = 0.2. k denote the k eigenvalues and eigenvectors of a square matrix A. 1 2 k The decomposition A = HΛH 0 is called the spectral decomposition of a matrix. 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 = HΛH 0 and H 0 AH = Λ. note that we can write A = HΛH 0 where H is orthogonal and Λ contains the (real) characteristic roots. Q • det(A) = k λi i=1 Pk • tr(A) = i=1 λi • A is non-singular if and only if all its characteristic roots are non-zero. .. They are called the latent roots or characteristic roots or eigenvalues of A. If A = G0 G. A square matrix A is idempotent if AA = A.. and let H = [h1 · · · hk ]. c0 Ac ≥ 0. c0 Ac = α0 a ≥ 0 where α = Gc. The characteristic equation of a square matrix A is The left side is a polynomial of degree k in λ so it has exactly k roots. To see this. there exists a nonsingular matrix P such that A = P −1 ΛP and P AP −1 = Λ. X 0 X is symmetric and positive deﬁnite. The matrix B need not be unique. We say that A is positive deﬁnite if for all non-zero c. • If A is symmetric..

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

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

In this context it is often convenient These are nonparametric density estimates using a Gaussian kernel with the bandwidth selected by crossvalidation. (3.73. When a distribution is skewed. from the population of white non-military wage earners with a college degree and 10-15 years of potential work experience. These are indicated in Figure 3. These are asymmetric (skewed) densities. xki 3. which is a common feature of wage distributions. In the example presented in Figure 3. In this context we partition the observations into the pair (yi . The two density curves show the eﬀect of gender on the distribution of wages.1 displays the density1 of hourly wages for men and women. We call yi the dependent variable. We call xi alternatively the regressor. . or the covariates. and that for women is $20. This is used when the goal is to quantify the impact of one set of variables on another variable. ⎠ ⎝ . and exists so long as E |yi | < ∞. We list the elements of xi in the vector ⎞ ⎛ x1i ⎜ x2i ⎟ ⎟ ⎜ (3.1 Conditional Mean To study how the distribution of yi varies with the variables xi in the population.1 by the arrows drawn to the x-axis. gender. we can focus on f (y | x) . the conditional density of yi given xi . the mean is not necessarily a good summary of the central tendency. While it is easy to observe that the two densities are unequal. You can see that the right tail of then density is much thicker than the left tail. the mean wage for men is $27. ⎟ . Take a closer look at the density functions displayed in Figure 3.22. See Chapter 16.1. Figure 3. the conditioning variable. To illustrate. m(x) can take any form.1) xi = ⎜ . it is useful to have numerical measures of the diﬀerence. holding the other variables constant. education and experience. These are conditional density functions — the density of hourly wages conditional on race. The data are from the 2004 Current Population Survey 1 11 . An important summary measure is the conditional mean Z ∞ yf (y | x) dy.Chapter 3 Regression and Projection The most commonly applied econometric tool is regression. xi ) where yi is a scalar (real-valued) and xi is a vector.1.2) m(x) = E (yi | xi = x) = −∞ In general.

The conditional expectation function is close to linear. The main point to be learned from Figure 3. the dashed line is a linear projection approximation which will be discussed in the Section 3. 3.Figure 3. 2 (3. For this reason.2 shows the density of log hourly wages for the same population.3) White non-military male wage earners with 10-15 years of potential work experience. implying an average 36% diﬀerence in wage levels. the solid line displays the conditional expectation of log wages varying with education.1: Wage Densities for White College Grads with 10-15 Years Work Experience to transform the data by taking the (natural) logarithm. and a Ph. Figure 3. 12 .30.2 Regression Equation The regression error ei is deﬁned to be the diﬀerence between yi and its conditional mean (3. then comparisons become more complicated.3 is how the conditional expectation describes an important feature of the conditional distribution. this yields the formula yi = m(xi ) + ei . which implies a 30% average wage diﬀerence for this population. When the distribution of the control variable is continuous. This is a more robust measure of the typical wage gap between men and women than the diﬀerence in the untransformed wage means.5. Figure 3.D. Assuming for simplicity that this is the true joint distribution. The diﬀerence in the log mean wage between men and women is 0.A. Of particular interest to graduate students may be the observation that diﬀerence between a B.1 is facilitated by the fact that the control variable (gender) is discrete. By construction. degree in mean log hourly wages is 0.2) evaluated at the observed value of xi : ei = yi − m(xi ). with mean log hourly wages drawn in with the arrows.3 displays a scatter plot2 of log wages against education levels. To illustrate.36. The comparison in Figure 3. wage regressions typically use log wages as a dependent variable rather than the level of wages.

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

3 Conditional Variance Generally. it does not provide information about the spread of the distribution. let g(x) be an arbitrary predictor of yi given xi = x. when σ 2 (x) is a constant so that ¢ ¡ (3. in the sense of achieving the lowest mean squared error. The right-hand-side is minimized by setting g(x) = m(x). 3. subject to the restriction p that it is non-negative. To see this.1. The conditional standard deviation is its square root σ(x) = σ 2 (x). i .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 3.3: Conditional Mean of Wages Given Education The conditional mean also has the property of being the the best predictor of yi . and can take any form.4) E e2 | xi = σ 2 i 14 While the conditional mean is a good measure of the location of a conditional distribution. A common measure of the dispersion is the conditional variance ¡ ¢ σ 2 (x) = V ar (yi | xi = x) = E e2 | xi = x .3. Thus the mean squared error is minimized by the conditional mean. σ 2 (x) is a non-trivial function of x. the conditional variance of yi is σ 2 = σ 2 (xi ). Given the random variable xi . In contrast.2. In the general case i where σ 2 (x) depends on x we say that the error ei is heteroskedastic.

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). This concept is less helpful than deﬁning heteroskedasticity as the dependence of the conditional variance on the observables xi . 3. its functional form is typically unknown. The conditional standard deviation for men is 12. which we derive in this section.1). ⎟ . So while men have higher average wages. and the linear assumption of the previous section is empirically unlikely to accurate. In this case (3. Some textbooks inappropriately describe heteroskedasticity as the case where “the variance of ei varies across observation i”. As an example. ⎠ .1) has been redeﬁned as the k × 1 vector ⎛ ⎞ 1 ⎜ x2i ⎟ ⎜ ⎟ (3. Instead.5) xi = ⎜ . we can write it as m(x) = x0 β = β 1 + x2i β 2 + · · · + xki β k where ⎞ β1 ⎜ .4 Linear Regression An important special case of (3. Thus (3.6) (3. Equivalently. ⎟ β=⎝ . 15 .6) as an approximation. Equation (3. ⎝ .7) is a k × 1 parameter vector. xki When m(x) is linear in x. it is more realistic to view the linear speciﬁcation (3. take the conditional wage densities displayed in Figure 3. where x1i is the ﬁrst element of the vector xi deﬁned in (3.3) can be writen as yi = x0 β + ei i E (ei | xi ) = 0.8) (3.we say that the error ei is homoskedastic. Notationally.5.8) is called the linear regression model. We call this the “constant” or “intercept”. they are also somewhat more dispersed.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 . we assume that x1i = 1. ⎠ .1 and that for women is 10. βk ⎛ (3. i (3. it is convenient to augment the regressor vector xi by listing the number “1” as an element.9) 3.1.

E (x0 xi ) < ∞. The ﬁrst-order condition for minimization (from Section 2. As before. 3. i 4. The vector (3.10) exists and is unique as long as the k ×k matrix E (xi x0 ) is invertible. there cannot i exist a non-zero vector α such that α0 xi = 0 identically.10) It is worth taking the time to understand the notation involved in this expression. The error is i ei = yi − x0 β. i ∂β ¢¢−1 ¡ ¡ E (xi yi ) .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 . 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 .5.1 1. E (xi x0 ) is invertible. The best linear predictor is obtained by selecting β to minimize S(β). i (3. i (3. Therefore. Eyi < ∞. we obtain a decomposition of yi into linear predictor and error yi = x0 β + ei . 2 2. Assumption 3. α0 E (xi x0 ) α = E (α0 xi )2 ≥ 0 so the matrix E (xi x0 ) is by construction i i positive semi-deﬁnite. Rewriting.7) is 0= Solving for β we ﬁnd ¡ ¢ ∂ S(β) = −2E (xi yi ) + 2E xi x0 β. 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. We now summarize the assumptions necessary for its derivation and list the implications in Theorem 3.which is quadratic in β. this situation must be excluded. i i (3. Observe i that for any non-zero α ∈ Rk . Given the deﬁnition of β in (3. α0 E (xi x0 ) α = E (α0 xi )2 > 0.10).5.12) This completes the derivation of the linear projection model. xi contains an intercept. In order for β to be uniquely deﬁned. x0 β is the best linear predictor for yi . written E (xi x0 ) > 0. by “best” we mean the predictor function with lowest mean squared error.1. alternative expressions such as E xixi ) or E (xi yi ) (E (xi x0 ))−1 i ( i 0i ) are incoherent and incorrect. i 16 . E (xi x0 ) is a mai E(x y trix and E (xi yi ) is a vector. Equivalently. otherwise they are distinct. This occurs when redundant variables are included in xi . It is invertible if and only if it is positive deﬁnite.

Using the deﬁnitions (3.2 and 3.11) are well deﬁned. Furthermore.4 is required to ensure that β is uniquely deﬁned. Let’s compare it with the linear regression model (3.11) and (3. Assumption 3.2. the converse is not true as the projection error does not necessarily satisfy E (ei | xi ) = 0.1.4: Hourly Wage as a Function of Experience The conditions listed in Assumption 3.1.13) The two equations (3. i i i Since E (xi ei ) = 0 we say that xi and ei are orthogonal. By deﬁnition. ¥ (3. (3.5. Assumption 3.10) ¡ ¡ ¢¢ E (xi ei ) = E xi yi − x0 β i ¡ ¢¡ ¡ ¢¢−1 E (xi yi ) = E (xi yi ) − E xi x0 E xi x0 i i = 0.12) can be alternatively interpreted as a projection decomposition.1. Since ei is mean zero by (3.8)-(3.1 is employed to guarantee that (3.13) summarize the linear projection model.14) Proof.5.1.Theorem 3.5.14) follows from (3. This means that the equation (3. 17 . it follows that linear regression is a special case of the projection model. Assumption 3.3 are called regularity conditions.5. Then i i Exi e2 = Ex3 = 0 yet E (ei | xi ) = x2 6= 0.12) and (3.9).4 we know that the regression error has the property E (xi ei ) = 0. However.1 Under Assumption 3. E (xi ei ) = 0 and E (ei ) = 0.1 are weak. (3.1.1.2 and 3. Equation (3.3 ensure that the moments in (3. x0 β is the i projection of yi on xi since the error ei is orthogonal with xi .1.4 guarantees that the solution β exits.5.5.5. The ﬁnite variance Assumptions 3.1.5.13) and Assumption 3. suppose that for xi ∈ R that Ex3 = 0 and ei = x2 . the orthogonality restriction (3. Figure 3.1.1.10) and (3. Assumption 3.1.5.10) are deﬁned. For example.14).14) holds.5.5. Since from Theorem 3.13) implies that xi and ei are uncorrelated.

However. In Figure 1. Figure 3. No additional assumptions are required. It over-predicts wages for young and old workers. for any pair (yi . and are discussed in Chapter 11. it is important to not misinterpret the generality of this statement. the dashed line is the linear projection of log wages on eduction. In this case (3.5 for a 3 In the population of Caucasian non-military male wage earners with 12 years of education.12) with the properties listed in Theorem 3.1 may be false. In the example just presented. and the straight dashed line is the linear projection. Other than the redeﬁnition of the regressor vector. since the resulting function is quadratic in experience. 18 . In this example the linear projection is a close approximation to the conditional mean.4 displays the relationship3 between mean log hourly wages and labor market experience. These structural models require alternative estimation methods. In contrast.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. In this case the linear projection is a poor approximation to the conditional mean. This defect in linear projection can be partially corrected through a careful selection of regressors.1.10) may not hold and the implications of Theorem 3. The linear equation (3. for those over 53 in age). Figure 3. in many economic models the parameter β may be deﬁned within the model. In other cases the two may be quite diﬀerent. A projection of log wages on these two variables can be called a quadratic projection.12) is deﬁned by projection and the associated coeﬃcient deﬁnition (3. xi ) we can deﬁne a linear projection equation (3.5.5. there are no changes in our methods or analysis.4 we display as well this quadratic projection. and under-predicts for the rest.10). it misses the strong downturn in expected wages for those above 35 years work experience (equivalently. we can augment the regressor vector xi to include both experience and experience2 . Returning to the joint distribution displayed in Figure 3. In this example it is a much better approximation to the conditional mean than the linear projection. We illustrate the issue in Figure 3. The solid line is the conditional mean.We have shown that under mild regularity conditions. Most importantly.3.

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

taking values only on the non-negative integers. xi ∈ R. and the conditional distribution of yi given xi is Poisson: P (yi = k | xi = x) = e−x β (x0 β)j . 20 . then E(x2 ei ) = 0. E(Y 2 | X = x) and V ar(Y | X = x). σ = .2.1 . 2. True or False. Does this justify a linear regression model of the form yi = x0 β + εi ? i then EY = λ and V ar(Y ) = λ. and E(e2 | xi ) = σ 2 . If yi = x0 β + ei . i 8.4 . Compute the conditional mean m(x) = E (yi | xi = x) . m. Let xi and yi have the joint density f (x. j! 0 j = 0. Compute 2 the coeﬃcients of the linear projection yi = β 0 + β 1 xi + ei . E(ei | xi ) = 0. s) = 0 if and only if m = µ and s = σ 2 . If yi = xi β + ei . 3 and 4 of Theorem 3. True or False. 9. ¡ ¢ 4. Deﬁne µ ¶ ¢ ¡ x−µ 2 g x.6 Exercises 1. then ei is independent of xi . a constant. 1. yi ). True or False. 0 ≤ y ≤ 1. If yi = x0 β + ei and E(ei | xi ) = 0. True or False. Suppose that yi is discrete-valued. σ 2 = V ar(yi ) and σ xy = Cov(xi . Let X be a random variable with µ = EX and σ 2 = V ar(X). and E(ei | xi ) = 0. µx = Exi . i 11. Show that x y β 1 = σ xy /σ 2 and β 0 = µy − β 1 µx . i 7. Prove parts 2.1.. If yi = x0 β + ei and E(xi ei ) = 0. e−λ λj j! .2 Y =1 . then E(ei | xi ) = 0. σ 2 = V ar(xi ).3 Find E(Y | X = x). then ei is i i independent of xi . µ. Take the bivariate linear projection model yi = β 0 + β 1 xi + ei E (ei ) = 0 E (xi ei ) = 0 Deﬁne µy = Eyi . x 6. i 10. and have the following joint probability distribution X=0 X=1 Y =0 . Suppose that Y and X only take the values 0 and 1. 2. 3. True or False. Compute E(yi | xi = x) and V ar(yi | xi = x). . If yi = xi β + ei . xi ∈ R. y) = 3 x2 + y 2 on 0 ≤ x ≤ 1. and E(xi ei ) = 0. then E(x2 ei ) = 0. (x − µ)2 − σ 2 Show that Eg (X.. Are they diﬀerent? Hint: If P (Y = j) = 5.3.

4.1) (4. i n i=1 n 21 .2) can be written in the parametric 0 β)) = 0.7 and 4. (4.3) with the sample moments: ³ ¡ ¢´−1 ˆ ˆ ˆ β = E xi x0 E (xi yi ) i Ã n !−1 n 1X 1X 0 xi xi xi yi = n n i=1 i=1 Ã n !−1 n X X = xi x0 xi yi .3) In Sections 4. Observe that (4.1 Estimation Equation (4. Their moment estimators are the sample moments i ˆ E (xi yi ) = ¢ ¡ ˆ E xi x0 = i 1X xi yi n 1 n i=1 n X i=1 n xi x0 .3) writes the projection coeﬃcient β as an explicit function of population moments E (xi yi ) and E (xi x0 ) .4) i i=1 i=1 ˆ Another way to derive β is as follows.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. i It follows that the moment estimator of β replaces the population moments in (4.8. we narrow the focus to the linear regression model. but for most of the chapter we retain the broader focus on the projection model. The function g(β) can be estimated by form g(β) = E (xi (yi − xi g (β) = ˆ ¢ 1X ¡ xi yi − x0 β .2) (4.

ˆ This is a set of k equations which are linear in β. 30 = .40 n i=1 1 n Thus ˆ β = n X i=1 xi x0 i = µ 1 14. Then µ ¶ n 1X 2.14 14. excluding military.14 205.83 µ We often write the estimated equation using the format \ log(W agei ) = 1.170 37.7% increase in mean wages. To illustrate.71 = −2.117 Educationi .94 −2.95 xi yi = 42. 40 2. These are white male wage earners from the March 2004 Current Population Survey. ¶ 2.4). with 10-15 years of potential work experience.14 14.40 µ ¶µ ¶ 34.5) = n n 1X 1X ˆ xi yi − xi x0 β i n n i=1 i=1 whose solution is (4.2 Least Squares There is another classic motivation for the estimator (4. Let yi be log wages and xi be an intercept and years of education. 4. i 22 .14 205. This sample has 988 observations.95 42.37 µ ¶ 1. n X i=1 2 yi − 2β 0 n X i=1 xi yi + β 0 n X i=1 xi x0 β.30 + 0.3. consider the data used to generate Figure 3.83 ¶−1 µ ¶ .117 1 14. Deﬁne the sum-of-squared errors (SSE) function n X¡ ¢2 yi − x0 β Sn (β) = i i=1 = This is a quadratic function of β. An interpretation of the estimated equation is that each year of education is associated with an 11.4). 0. 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. 40 0.

Since the function Sn (β) is a quadratic function of β.4). To visualize the sum-of-squared errors function.1: Sum-of-Squared Errors Function As a by-product of OLS estimation. Following convention we will call β the OLS estimator of β. we deﬁne the predicted value ˆ yi = x0 β ˆ i and the residual ˆ ei = yi − yi ˆ ˆ = yi − x0 β. 23 . Figure 4. which can cause confusion. Figure 4. Figure 4. i ˆ ˆ Note that yi = yi + ei . The error is unobservable. These two ˆ variables are frequently mislabeled.1 displays an example sum—of-squared errors function Sn (β) for the case k = 2. Matrix calculus (see Appendix 2. It is important to understand the distinction between the error ei and the residual ei . the contour lines are ellipses.The Ordinary Least Squares (OLS) estimator is the value of β which minimizes Sn (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 (4.2 displays the contour lines of the same function — horizontal slices at equally spaced heights. while the residual is a by-product of estimation.

24 .2: Sum-of-Squared Error Function Contours Equation (4. ˆ n i=1 Thus the residuals have a sample mean of zero and the sample correlation between the regressors and the residual is zero. It measures the variation in the i “unexplained” part of the regression. Its method of moments estimator is the sample average 1X 2 ei . These are algebraic results. ˆ σ = ˆ n 2 i=1 n (4. and hold true for all linear regression estimates.7.6) An alternative estimator uses the formula n 1 X 2 s = ei . ˆ n i=1 n Since xi contains a constant. ˆ n−k 2 i=1 (4. The error variance σ 2 = Ee2 is also a parameter of interest.5) implies that 1X xi ei = 0.7) A justiﬁcation for the latter choice will be provided in Section 4.Figure 4. one implication is that n 1X ei = 0.

σ 2 ) maximize Ln (β. An alternative estimator of ρ2 proposed by Theil called “R-bar-squared” is y R =1− where σ2 = ˜y 2 n 2 s2 σ2 ˜y 1 X (yi − y)2 . ˆ Plugging β into the log-likelihood we obtain n ¡ ¢ n 1 X 2 ˆ ei ˆ Ln (β. and distribution theory. σ 2 ). where likelihood methods can be used for estimation. testing. 4. σ ) = 2σ (2πσ 2 )1/2 i=1 ¡ ¢ n 1 = − log 2πσ 2 − 2 Sn (β) 2 2σ ˆ ˆ The MLE (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. This is a parametric model. σ 2 ) is a function of β only through the sum of squared errors Sn (β). maximizing the likelihood is identical to minimizing Sn (β).3 Normal Regression Model Another motivation for the least-squares estimator can be obtained from the normal regression model. 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 . Instead. 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. σ 2 ) = − log 2πσ 2 − 2 2 2σ i=1 25 .where A measure of the explained variation relative to the total variation is the coeﬃcient of determination or R-squared. 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 ). The R2 is frequently mislabeled as a measure of “ﬁt”. Since Ln (β. This is the linear regression model with the additional assumption that the error ei is independent of xi and has the distribution N (0. and therefore is expected to be a better estimator of ρ2 than the unadjusted estimator R2 . n−1 i=1 Theil’s estimator R is a ratio of adjusted variance estimators. Hence the MLE for β equals the OLS estimator.

yn ⎟ ⎟ ⎟. . Thus the MLE (β. = β+ XX 26 (4.12) is a system of n equations. . ⎟. For example n X i=1 For many purposes. residual vector. en ⎞ Observe that Y and e are n × 1 vectors. yn = x0 β + en . Due to this equivalence. 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. and sample error variance can be written as ¢−1 ¡ 0 ¢ ¡ ˆ β = X 0X XY ˆ e = Y − Xβ ˆ σ 2 = n−1 e0 e. n X i=1 Thus the estimator (4. ⎠ . Sample sums can also be written in matrix notation. The linear equation (3.8) .4). the ˆ OLS estimator β is frequently referred to as the Gaussian MLE. ⎠ ⎜ ⎜ e=⎜ ⎝ ⎟ ⎟ ⎟. one for each observation. σ 2 ) = − 2 + ¡ ¢2 e2 = 0. σ 2 ) for the normal ˆ regression model are identical to the method of moment estimators. . and X is an n × k matrix.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. We can stack these n equations together as y1 = x0 β + e1 1 y2 = x0 β + e2 2 .6). . ˆi 2 ∂σ 2 2ˆ σ 2 σ ˆ i=1 ˆ ˆ Solving for σ 2 yields the method of moments estimator (4. ⎝ ⎝ . . . We deﬁne ⎛ ⎞ ⎛ y1 ⎜ ⎜ y2 ⎟ ⎜ ⎟ ⎜ X=⎜ Y = ⎜ . 4. it is matrix notation. including computation. ⎠ xi x0 = X 0 X i xi yi = X 0 Y. x0 n ⎞ ⎛ e1 e2 . n or equivalently Y = Xβ + e.

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

observe that ⎞ ⎛ ⎞ ⎛ . is the demeaning formula for regression. . ¡ ¢−1 0 ι. but in most cases there is little computational advantage to using the two-step algorithm. . . ! Thus the OLS estimator for the slope coeﬃcients is a regression with demeaned data.8)(3. obtain residuals X2 . .Theorem 4. Rather. . In this section we derive the small sample conditional mean and variance of the OLS estimator. Regress X2 on X1 .18) E (e | X) = ⎜ E (ei | X) ⎟ = ⎜ E (ei | xi ) ⎟ = 0. In this case. In the model (4. .9). Regress Y on X1 .7 Bias and Variance In this and the following section we consider the special case of the linear regression model (3. ˜ 2. ⎠ ⎝ ⎠ ⎝ .6. the FWL theorem can be used to speed computation. A common application of the FWL theorem. 4. The FWL theorem says that β 2 is the OLS estimate from a regression of ˜ ˜ Y on X2 . . the primary use is theoretical. . ˆ ˜ ˜ ˆ 3.13). 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. which you may have seen in an introductory econometrics course.9). Partition X = [X1 X2 ] where X1 = ι is a vector of ones. In some contexts. and X2 is the vector of observed regressors. obtain residuals Y . ˆ which are “demeaned”. 30 . ⎟ ⎜ ⎟ ⎜ (4. By the independence of the observations and (3.14) or via the ˆ following algorithm: ˜ 1. . 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) . obtain OLS estimates β 2 and residuals e. the OLS estimator of β 2 and the OLS residuals e may be equivalently computed by either the OLS regression (4. .1 (Frisch-Waugh-Lovell). Regress Y on X2 .

From (4. V ar β | X = X 0 X ⎟ ⎟ ⎟. Next. . σ 2 } = ⎜ . .12). the properties of conditional expectations. 1 n . for any random vector Z deﬁne the covariance materix V ar(Z) = E (Z − EZ) (Z − EZ)0 = EZZ 0 − (EZ) (EZ)0 . and ³ ´ ¡ ¢−1 2 ˆ σ .Using (4.19) we see that ¶ µ³ ³ ´ ´³ ´0 ˆ ˆ ˆ V ar β | X = E β−β β−β |X = where The i’th diagonal element of D is ¡ ¢ D = E ee0 | X . σ2 n ⎞ We now calculate the ﬁnite sample bias of the method ¡ moments estimator σ 2 for 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 . . 0 0 ··· 0 0 . and (4. . .. ⎝ ..20) .. 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. and the trace operator observe that. X 0 DX = X 0 Xσ 2 . the properties additional assumption of conditional homoskedasticity E ei i of projection matrices. ⎠ (4. Then given (4..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. ¡ X 0X ¢−1 ¡ ¢−1 X 0 DX X 0 X while the ij 0 th oﬀ-diagonal element of D is ¢ ¢ ¡ ¡ E e2 | X = E e2 | xi = σ 2 i i i E (ei ej | X) = E (ei | xi ) E (ej | xj ) = 0. . σ 2 = σ 2 and we have the simplii ﬁcations D = In σ 2 . .19) ˆ and thus the OLS estimator β is unbiased for β. We have shown that which implies ³ ´ ˆ E β|X =β ³ ´ ˆ E β =β (4. under the of ˆ ¢ 2 | x = σ 2 . .8).

This is the justiﬁcation for the common s ˆ preference of s2 over σ 2 in empirical practice. ˜ β L = A0 Y = A (Xβ + e) = β + Ae. Thus σ 2 is biased towards zero. and thus can be written as ˜ β = A0 Y where A is an n × k function of X.1 Gauss-Markov. It is not unbiased in the absence of homoskedasticity. In this case. 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.9) plus E e2 | xi = σ 2 . ˜ so β is unbiased if (and only if) A0 X = Ik .10). known as the Gauss-Markov theorem. 32 . The following result. which is (3. It is important to remember. In the homoskedastic linear regression model. which we now present.8. 4.7) is unbiased for σ 2 by this calculation. the estimator ˆ 2 deﬁned (4. = σ2 n the ﬁnal equality by (4.8 Gauss-Markov Theorem In this section we restrict attention to the homoskedastic linear regression model. or in the projection model. By a calculation similar to those of the previous section. Thus since V ar (e | X) = In σ 2 under homoskedasticity.8)¢ ¡ (3. What is the best choice of A? The Gauss-Markov theorem. that this estimator is only unbiased in the special case of the homoskedastic linear regression model. is a famous statement of the solution. The least-squares estimator is the special case obtained by setting A = X(X 0 X)−1 . Now consider the class of estimators of β which are linear functions of i the vector Y. says that the least-squares estimator is the best choice. ³ ´ ˜ E β | X = A0 Xβ. as it yields the smallest variance among all unbiased linear estimators. As an alternative. however. ³ ´ ˜ V ar β | X = A0 V ar (e | X) A = A0 Aσ 2 .Then ¢ ¡ E σ2 | X = ˆ ¢¤ 1 £ ¡ tr E M ee0 | X n ¡ ¢¤ 1 £ = tr M E ee0 | X n ¤ 1 £ tr M σ 2 = n n−k . the best (minimumvariance) unbiased linear estimator is OLS. Theorem 4.

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

Chamberlain (1987) extends this argument to the case of continuously-distributed data. (4.5.Substituting in the expressions for π j . and any continuous distribution can be arbitrarily well approximated by a multinomial distribution. We can write the model as yi = x0 β 1 + x0 β 2 + ei 1i 2i E (xi ei ) = 0 where the parameter of interest is β 1 . if the data have a discrete distribution.22) 34 . the maximum likelihood estimator is identical to the OLS estimator. 1X xi x0 i n i=1 1X xi yi n i=1 n ˆ = β ols 4. Since this is a regular parametric model the MLE is asymptotically eﬃcient (see Appendix A. He observes that the above argument holds for all multinomial distributions.1.4) is an asymptotically eﬃcient estimator for the parameter β deﬁned in (3.9).10 Omitted Variables xi = µ x1i x2i ¶ . He proves that generically the OLS estimator (4. and thus so is the OLS estimator.10) for the class of models satisfying Assumption 3. ˆ r X j=1 πj ξ j ξ 0 ˆ j r n X1X ¡ ¢ = 1 (yi = τ j ) 1 xi = ξ j ξ j ξ 0 j n j=1 = 1 n 1 n i=1 n X X r i=1 j=1 n X i=1 ¡ ¢ 1 (yi = τ j ) 1 xi = ξ j xi x0 i = and r X j=1 xi x0 i πj ξ j τ j ˆ r n X1X ¡ ¢ = 1 (yi = τ j ) 1 xi = ξ j ξ j τ j n j=1 i=1 = r n ¡ ¢ 1 XX 1 (yi = τ j ) 1 xi = ξ j xi yi n = Thus ˆ β mle = Ã 1 n n i=1 j=1 n X i=1 xi yi !−1 Ã ! In other words. Let the regressors be partitioned as Suppose we are interested in the coeﬃcient on x1i alone in the regression of yi on the full set xi .

Most commonly. In general. the possibility of omitted variables bias should be acknowledged and discussed in the course of an empirical investigation. Typically. This is the situation when the X 0 X matrix is near singular. To see this. if X includes both the logs of two prices and the log of the relative prices.11 Multicollinearity ˆ If rank(X 0 X) < k + 1. log(p2 ) and log(p1 /p2 ). The diﬀerence Γβ 2 is known as omitted variable bias. or second. and the error as ui rather than ei . 35 .Now suppose that instead of estimating equation (4. 4. which is often called “multicollinearity” for brevity. the coeﬃcient on x2i in (4. because we have not said what it means for a matrix to be “near singular”. 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 . When this happens. we regress yi on x1i only. this arises when sets of regressors are included which are identically related. It is the consequence of omission of a relevant correlated variable. the regression of x2i on x1i yields a set of zero coeﬃcients (they are uncorrelated). Since the error is discovered quickly. β 1 6= γ 1 . Thus the short and long regressions have the same coeﬃcient on x1i only under one of two conditions. The more relevant issue is near multicollinearity.e. then β is not deﬁned. This is one diﬃculty with the deﬁnition and interpretation of multicollinearity. when the columns of X are close to linearly dependent. To avoid omitted variables bias the standard advice is to include potentially relevant variables in the estimated model. i. 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. First. This is called strict multicollinearity. as many desired variables are not available in a given dataset.23) where is the coeﬃcient from a regression of x2i on x1i . log(p1 ). For example. Goldberger (1991) calls (4. By construction. This is because the model being estimated is diﬀerent than (4. least-squares estimation of (4. This deﬁnition is not precise.22) is zero. the applied researcher quickly discovers the error as the statistical software will be unable to construct (X 0 X)−1 . except in special cases.23) is an estimate of γ 1 = β 1 + Γβ 2 rather than β 1 .22) by least-squares. In this case.23) the short regression to emphasize the distinction. there is some α such that Xα = 0. the general model will be free of the omitted variables problem.22) the long regression and (4. Typically there are limits.. this is rarely a problem for applied econometric practice. This happens when the columns of X are linearly dependent. Observe that γ 1 6= β 1 unless Γ = 0 or β 2 = 0.22).

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

The key is equation (2.4 which states that ¡ ¢ (A + BCD)−1 = A−1 − A−1 BC C + CDA−1 BC CDA−1 .27).25). ¢−1 ¡ 0 ¢−1 ¡ 0 ¢−1 ¡ 0 ¢−1 ¡ = XX + XX xi (1 − hi )−1 x0 X 0 X X X − xi x0 i i ¡ 0 ¢−1 ¡ 0 ¢ X X − xi x0 X Y − xi yi i ¢ ¡ ¡ ¢ ¡ ¢−1 ¡ 0 ¢−1 ¢−1 ¡ 0 X Y − xi yi + (1 − hi )−1 X 0 X X Y − xi yi = X 0X xi x0 X 0 X i ¢−1 ¡ ˆ xi ei .1) in Section 2. then this observation is a leverage point and has the potential to be an inﬂuential observation. which is considerably more informative than plots of the uncorrected residuals ei . ˆ = β − (1 − hi )−1 X 0 X and thus ˆ β (−i) = 37 . Investigations into the presence of inﬂuential observations can plot the values of (4. ˆ We now derive equation (4.This implies has a large value of hi .

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

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

P (g(X) > α) ≤ α−1 Eg(X). n→∞ lim P (|Zn − Z| > δ) = 0. tangent lines lie below it. ¥ 5. The WLLN shows that sample averages converge in probability to the population average. Let a + bx be the tangent line to g(x) at x = EX.4) Proof of Jensen’s Inequality.Markov’s Inequality. We say that Zn converges in probability to Z as n → ∞. This is a probabilistic way of generalizing the mathematical deﬁnition of a limit. as stated. Let U = |X|p /E |X|p and V = |Y |q /E |Y |q . Eg(X) ≥ a + bEX = g(EX). 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}. then as n → ∞ n 1X Xn = Xi →p E(X). if for all δ > 0.1 Weak Law of Large Numbers (WLLN). ¥ Proof of Holder’s Inequality. If Xi ∈ Rk is iid and E |Xi | < ∞. 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 ) = + . So for all x. (E |X|p )1/p (E |Y |q )1/q ¥ µ ¶ ´ ³ U V 1 1 1/p 1/q ≤E + = + = 1. For any strictly increasing function g(X) ≥ 0. Since g(x) is convex. Theorem 5. p p p q which is (5. Applying expectations. =E U V p q p q Proof of Markov’s Inequality.2 Weak Law of Large Numbers Let Zn ∈ Rk be a random vector. g(x) ≥ a + bx yet g(EX) = a + bEX since the curve is tangent at EX. denoted Zn →p Z as n → ∞. (5.2.3). Set Y = g(X) and let f denote the density function of Y. Note EU = EV = 1. n i=1 42 .

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

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

k ≤ m. Σ) = N 0. Recall that A ⊂ B implies P (A) ≤ P (B). √ Theorem 5. This is suﬃcient to establish the theorem.4 Asymptotic Transformations 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 (0.4.4. Stacking across elements of g. and g(θ) : Rm → Rk . ¥ 5. then g(Zn ) →p g(c) as n → ∞. gj (θn ) = gj (θ0 ) + gjθ (θ∗ ) (θn − θ0 ) jn where θnj lies on the line segment between θn and θ0 and therefore converges in probability to θ0 . we see that as n → ∞.1 Continuous Mapping Theorem 1 (CMT).2 Continuous Mapping Theorem 2.√ where λn → 0 lies on the line segment joining 0 and λ/ n. we ﬁnd jn ¢ ¡ √ √ 0 n (g (θn ) − g(θ0 )) = (gθ + an ) n (θn − θ0 ) →d gθ N (0. Since cλλ (λn ) → cλλ (0) = −Ik . then ¡ ¢ √ 0 n (g (θn ) − g(θ0 )) →d N 0. Σ) . where θ is m × 1 and Σ is m × m. It follows that ajn = gjθ (θ∗ ) − gjθ →p 0. Proof: Since g is continuous at c. for all ε > 0 we can ﬁnd a δ > 0 such that if |Zn − c| < δ then |g (Zn ) − g (c)| ≤ ε. If Zn →p c as n → ∞ and g (·) is continuous at c. Hence g(Zn ) →p g(c) as n → ∞. Theorem 5.3 Delta Method: If n (θn − θ0 ) →d N (0. for each element of g. Thus P (|g (Zn ) − g (c)| ≤ ε) ≥ P (|Zn − c| < δ) → 1 as n → ∞ by the assumption that Zn →p c. gθ Σgθ . Ik ) distribution.4. Proof : By a vector Taylor series expansion. then g(Zn ) →d g(Z) as n → ∞. If Zn →d Z as n → ∞ and g (·) is continuous. 45 .

In general. The verticle line marks the true value of the projection coeﬃcient. y) = 2πxy 2 2 ˆ and let β 2 be the slope coeﬃcient estimate computed on observations from this joint density. the density function of β 2 was computed and plotted in Figure 6. xi ) and the sample size n. 46 . since it is a function of the random data. Using ˆ simulation methods.1 for sample sizes of n = 25. let yi and xi be drawn from the joint density µ ¶ µ ¶ 1 1 1 2 2 exp − (ln y − ln x) exp − (ln x) f (x. and therefore has a sampling distribution.1 Sampling Distribution The least-squares estimator is a random vector. n = 100 and n = 800.1: Sampling Density of β 2 To illustrate the possibilities in one example. ˆ Figure 6. its distribution is a complicated function of the joint distribution of (yi .Chapter 6 Inference 6.

1.5. For a complete argument. the OLS estimator β is has a statistical distribution which is unknown.1). First. Asymptotic (large sample) methods approximate sampling distributions based on the limiting experiment that the sample size n tends to inﬁnity.1) and ˆ We now deduce the consistency of β. we can conclude ˆ that β →p β. Assumption 3. Assumption 3. b) = A−1 b is a continuous function of A and b at all values of the arguments such that A−1 exist. As the sample size increases the density becomes more concentrated about the population coeﬃcient. ˆ Theorem 6.1 by the fact that the sampling densities become more concentrated as n gets larger.5.8) implies that ˆ β−β = Ã n X i=1 xi x0 i !−1 n X i=1 xi ei . (6.1). This is illustrated in Figure 6. Ã n ! n X 1X 0 1 ˆ xi xi . 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. ˆ 47 .1).2 Consistency ˆ As discussed in Section 6. (6.2. 0) = Q−1 0 = 0 β−β =g n n i=1 i=1 ˆ which implies β →p β as stated.3). using (6.4.3) Ã where g(A.1.From the ﬁgure we can see that the density functions are dispersed and highly non-normal. Hence by the continuous mapping theorem (Theorem 5. n i=1 (6.2) i i n i=1 n From (6. xi ei = g i n n i=1 i=1 1X xi ei →p E (xi ei ) = 0. xi ei →p g (Q. Equation (4.1. 0).5.1 Under Assumption 3. ·) is continuous at (Q. β →p β as n → ∞.4. ¥ We can similarly show that the estimators σ 2 and s2 are consistent for σ 2 . Proof.2.1) imply that n ¡ ¢ 1X xi x0 →p E xi x0 = Q (6. we will use the methods of asymptotic approximation. (6.2). 6. and the continuous mapping theorem (Theorem 5.1). To characterize the sampling distribution more fully. we can write !−1 Ã n ! n 1X 1X 0 ˆ β−β = xi xi xi ei n n i=1 i=1 Ã n ! n X X 1 1 xi x0 .1 and the WLLN (Theorem 5.4 implies that Q−1 exists and thus g(·.

1. ´1/2 ¡ ¯ ¯¢ ¯ ³ ¯ ¯2 ´1/2 ¡ ¯ 4 ¯¢1/2 ³ ¯ 1/2 E ¯xi x0 e2 ¯ ≤ E ¯xi x0 ¯ = E |xi |4 < ∞. By the central limit theorem (Theorem 5. 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). Thus σ 2 is consistent for σ 2 .1). σ 2 →p σ 2 and s2 →p σ 2 as n → ∞.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. by the Cauchy-Schwarz inequality (5. ˆ Proof.3.3.1 guarantees that the elements of Ω are ﬁnite. n 1 X √ xi ei →d N (0.6) n i=1 48 . (6. ˆ Finally. To see this. ˆ n−k 6.5.2). i Now deﬁne ¡ ¢ Ω = E xi x0 e2 .Theorem 6.1 In addition to Assumption 3. Assumption 6.3. Ee4 < ∞ and E |xi |4 < ∞. since n/(n − k) → 1 as n → ∞. (6.3) and Theorem (6.1. We need a strengthening of the moment conditions. E ¯ei ¯ E ¯e4 ¯ i i i i (6. i i Assumption 6. it follows that s2 = ¥ n σ 2 →p σ 2 . (6.2).5) Thus xi ei is iid with mean zero and has covariance matrix Ω. (6.2.5.2. Ω) .3 Asymptotic Normality ˆ We now establish the asymptotic distribution of β after normalization.2 Under Assumption 3.

7) Cov(xi x0 . We say that ei is a Homoskedastic Projection Error when (6. however. We illustrate this problem using a simulation. after rescaling. 1).3. When (6. (6. As α approaches 2. In Figure 6. Let yi = β 0 + β 1 xi + εi where xi is N (0.2). the normal approximation is arbitrarily poor for some data distribution satisfying the assumptions. How large should n be in order for the approximation to be useful? Unfortunately.1 states that the sampling distribution of the least-squares estimator. its variance diverges q ³ ´ ˆ to inﬁnity.1. V is often referred to as ˆ the asymptotic covariance matrix of β. For α 49 .6).1 is commonly used to approximate the ﬁnite of √ ³ˆ sample distribution of n β − β . There is a special case where Ω and V simplify.7) is true or false. ´ √ ³ˆ As V is the variance of the asymptotic distribution of n β − β . and εi is independent of xi with the Double Pareto density f (ε) = α |ε|−α−1 . and (6. Q−1 ΩQ−1 . We call V 0 the homoskedastic covariance matrix. This holds true for all joint distibutions of (yi .3.1 Under Assumption 6. The approximation may be poor when n is small.3. |ε| ≥ 1.1). However. Under (6. otherwise V 6= V 0 . there is no simple answer to this reasonable question.9) we deﬁne V 0 = Q−1 σ 2 whether (6. V ) where V = Q−1 ΩQ−1 . as n → ∞ ´ √ ³ ˆ n β − β →d N (0. for example. i i Condition (6. The trouble is that no matter how large is the sample size. In this context the normalized least-squares slope estimator n α−2 β 2 − β 2 has α →d Q−1 N (0. setting n = 100 and varying the parameter α. 1) asymptotic distibution. is approximately normal when the sample size n is suﬃciently large.Then using (6. Ω) ¡ ¢ = N 0.7) holds. Theorem 6. In´Figure 6.7) the asymptotic variance formulas simplify as ¡ ¢ ¡ ¢ (6. 1 X √ xi ei n i=1 n ! the N (0. when xi and ei are independent.9) In (6.3. for any ˆ ﬁxed n the sampling distribution of β can be arbitrarily far from the normal distribution.3. If α > 2 the 2 error εi has zero mean and variance α/(α − 2).7) is true then V = V 0 . The expression V = Q−1 ΩQ−1 is called a sandwich form.8) Ω = E xi x0 E e2 = Qσ 2 i i V = Q−1 ΩQ−1 = Q−1 σ 2 ≡ V 0 (6. e2 ) = 0. xi ) which satisfy the conditions of Assumption 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. ´ √ ³ ˆ n β−β = Ã 1X xi x0 i n i=1 n !−1 Ã Theorem 6.2 we display the ﬁnite sample densities of the q ³ ˆ normalized estimator n α−2 β 2 − β 2 .1. The asymptotic distribution ´ Theorem 6. but this is not a necessary condition.

2) and Theorem 6.2: Density of Normalized OLS estimator α = 3.2.3.0 the density is very close to the N (0. 6. ˆ ˆ Since Q →p Q and s2 →p σ 2 (see (6.10) without changing this result. 1) density. 4.1) it is clear that V 0 →p V 0 .4 Let Covariance Matrix Estimation 1X ˆ xi x0 Q= i n i=1 n be the method of moments estimator for Q. 1).3 is that the N (0. Here the model is yi = β 1 + εi where uk − Euk i i εi = ³ ¡ k ¢2 ´1/2 Eu2k − Eui i ´ √ ³ˆ and ui ∼ N (0. The homoskedastic covariance matrix V 0 = Q−1 σ 2 is typically estimated by ˆ ˆ (6.2 and 6. 1) asymptotic approximation is never guaranteed to be accurate. As k increases. 6 and 8. As α diminishes the density changes signiﬁcantly. we need an estimate of Ω = E xi x0 e2 . The estimator 2 2 in (6.Figure 6.11) 50 . σ may also be substituted for s ˆ ¡ ¢ To estimate V = Q−1 ΩQ−1 . The lesson from Figures 6. the sampling distribution becomes highly skewed and non-normal. concentrating most of the probability mass around zero. Another example is shown in Figure 6.10) V 0 = Q−1 s2 . The MME estimator is i i 1X ˆ xi x0 e2 Ω= i ˆi n i=1 n (6. We show the sampling distribution of n β 1 − β 1 setting n = 100. for k = 1.

Figure 6.. vis. these all mean the same thing. ˆ ˆ When V is used rather than the traditional choice V 0 . The methods switched during ˆ the late 1980s and early 1990s. ˆ The estimator V 0 was the dominate covariance estimator used before 1980. many authors will state that their “standard errors have been corrected for heteroskedasticity”. In most cases. as there may be more than one estimator of the variance of the estimator. It is therefore important to understand what formula and method is 51 .4. Generically. or that they use the “White formula”... ˆ ˆ Deﬁnition 6.1 A standard error s(β) for an estimator β is an estimate of the standard ˆ deviation of the distribution of β. When reading and reporting applied work. and was still the standard choice for much empirical work done in the early 1980s.3: Sampling distribution where ei are the OLS residuals. . Thus q ˆ ˆ s(β j ) = n−1/2 Vjj . k. and V is an estimator of the variance of n β − β . ˆ ˆ The variance estimator V is an estimate of the variance of the asymptotic distribution of β. it is important to pay ˆ ˆ attention to the distinction between V 0 and V . A more easily interpretable measure of spread is its square root — the standard deviation. the “Eicker-White formula”. the “Huber-White formula” or the “GMM covariance matrix”. we focus on individual elements of β one-at-a-time. or that they use a “heteroskedasticity-robust covariance matrix estimator”. we set s(β) = n−1/2 V . This motivates the deﬁnition of a standard error. 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). When β is a vector. the “Huber formula”. β j . as it is not always clear which has been computed. j = 0.. so that by the late 1990s White estimate V emerged as the standard covariance matrix estimator. 1. ´ p √ ³ˆ ˆ ˆ ˆ When β is scalar. standard errors are not unique.

98 −0.83 −0.20 and µ ¶ ˆ = 0.085) (. First. (6.14 205.30 + 0. Ω 2.35/988 = .3) so by the WLLN ³ ´ ³ ´3/4 ¡ ¯ ¯¢ 1/4 E |xi |3 |ei | ≤ E |xi |4 < ∞.5) and the WLLN (Theorem 5.14 205.480 .493 −0.1.12) i i n n n i=1 i=1 We now examine each sum on the right-hand-side of (6.20 = V 14. from which it follows that V →p V as n → ∞.4) ˆ Ω = = n n n ³ ´0 ³ ´0 ³ ´ 1X 2X 1X 0 2 0 ˆ ˆ ˆ xi xi ei − xi xi β − β xi ei + xi x0 β − β xi x0 β − β .80 40. the standard method to calculate the standard errors is to ˆ ﬁrst calculate n−1 V .480 ˆ0 = 0. i i i i n i=1 Second.5 Consistency of the White Covariance Matrix Estimate 1X xi x0 e2 i ˆi n i=1 i=1 n ˆ ˆ We now show Ω →p Ω.085 p ˆ and that for β 1 is .12) in turn. n n i=1 52 .used by an author when studying their work. we return to the log wage regression of Section 4.6 Therefore the two covariance matrix estimates are µ ¶−1 µ ¶ 1 14.020. (6.80 . (.14 205. and then the square roots.6 ¶µ 1 14.117 Educationi . From a computational standpoint. just as any other estimator.199 2. Using (6.83 ¶−1 = µ 7.14 6. E ¯e4 ¯ i ³ ´ 1X |xi |3 |ei | →p E |xi |3 |ei | .14 14.1) show that n ¡ ¢ 1X xi x0 e2 →p E xi x0 e2 = Ω. We calculate that s2 = 0.20 −0. It is also important to understand that a particular standard error may be relevant under one set of model assumptions.80 2.020) 6. p ˆ In this case the two estimates are quite similar. To illustrate. but not under another set of assumptions.2.493 0.039 and ˆ V = µ 1 14.199 2.14 14.83 ¶−1 µ .2/988 = . We can write the estimated equation with standards errors using the format \ log(W agei ) = 1. The standard errors for β 0 are 7. by Holder’s inequality (5.80 40.035 ¶ . then take the diagonal elements.

n i=1 n ˆ ˆ Theorem 6.11) with the leave-one-out estimator ei. They also suggest that the scaling factor (n − 1)/n in (??) can be omitted. ¯ ¯ ¯ ¯ ¯n ¯ n i=1 i=1 1X |xi |4 →p E |xi |4 . Recall from Section 4.5. Using this substitution.12 the deﬁnition of β (−i) as the least-squares estimator with the i’th observation deleted. which.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 .¯ ¯ ¯ ¯ˆ and thus since ¯β − β ¯ →p 0. Ω →p Ω and V →p V. 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 so Together. 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 0.6 Alternative Covariance Matrix Estimators ˆ MacKinnon and White (1985) suggested a small-sample corrected version of V based on the jackˆ knife principle.−i = (1 − hi )−1 ei ˆ presented in (4.13) of Efron (1982). i=1 Third. is deﬁned ˆ ˆ by replacing the OLS residual ei in (6. ¯ 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 0.25). 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 (6.1 As n → ∞. 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. 6. you can show that 1 Xˆ ¯ β= β (−i) .26). these establish consistency. Andrews (1991) suggested an similar estimator based on cross-validation.13) Using formula (4. From equation (3. Andrews’ proposed estimator is ˆ ˆ ˆ ˆ V ∗∗ = Q−1 Ω∗∗ Q−1 53 .

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

In general. In this case. A simple null and composite hypothesis takes the form H0 : θ = θ0 H1 : θ 6= θ0 where θ0 is some pre-speciﬁed value.1 tn (θ) →d N (0.8 t tests Let θ = h(β) : Rk → R be any parameter of interest. the statistic tn has an exact t distribution.16) ¥ Thus the asymptotic distribution of the t-ratio tn (θ) is the standard normal. pivotal statistics are unavailable and so we must rely on asymptotically pivotal statistics. 55 . s(ˆ = n−1/2 H 0 V Hβ . ˆ When q = 1q h(β) is real-valued). and θ = h(β) is some function of the parameter vector. the standard error for ˆ is the square root of n−1 Vθ . Vθ ) √ Vθ = N (0.8. we say that tn (θ) is asymptotically pivotal. By (6. θ could be a single element of β). we say that tn is an exactly pivotal statistic. ˆ its estimate and s(ˆ its asymptotic θ θ) standard error. (For example. however. 1) Proof.For example. Since the standard normal distribution does not depend on the parameters. see Section X). and is therefore exactly free of unknowns. µ I 0 ¶ ˆ the upper-left block of V . Consider the studentized statistic tn (θ) = Theorem 6. β 2 ). θ) β 6. In special cases (such as the normal regression model. 1) →d ˆ−θ θ . that (so θ ˆ ˆ ˆ is.15) tn (θ) = ˆ−θ θ s(ˆ θ) ´ √ ³ˆ n θ−θ q = ˆ Vθ N (0. then θ = R0 β = β 1 and ˆ Vθ = ¡ I 0 ¢ ˆ V µ I 0 ¶ ˆ = V11 . if R is a “selector matrix” R= so that if β = (β 1 . s(ˆ θ) (6.

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 is because ¡ ¢ P (reject H0 | H0 true) = P |tn | > zα/2 | θ = θ0 ¢ ¡ → P |Z| > zα/2 = α. P (1 − p(tn ) ≤ u) establishing that 1 − pn →d U [0. The p-value is more general. 1]. is to report an asymptotic p-value. under H0 . In a sense. and is a function of the data and hence is / random. regardless of the complication of the distribution of the original test statistic. To see this fact. note that the asymptotic distribution of |tn | is F (x) = 1 − p(x). 56 . 6. The asymptotic p-value for the above statistic is constructed as follows. The coverage probability is P (θ ∈ Cn ). That is. z. Otherwise the test does not reject.05 = 1. 1]. s(ˆ θ) Under H0 . Thus an equivalent statement of a Neyman-Pearson test is to reject at the α% level if and only if pn < α. For example. pn →d U [0.96 and z. if Z ∼ N (0. 1). 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 . Deﬁne the tail probability. associated with Fisher.025 = 1. then P (Z > zα/2 ) = α/2 and P (|Z| > zα/2 ) = α. That is. Another helpful observation is that the p-value function has simply made a unit-free transformation of the test statistic. An alternative approach. Either θ ∈ Cn or θ ∈ Cn . or asymptotic p-value function p(t) = P (|Z| > |t|) = 2 (1 − Φ(|t|)) . Let zα/2 is the upper α/2 quantile of the standard normal distribution. however.9 Conﬁdence Intervals A conﬁdence interval Cn is an interval estimate of θ. 1).The standard test for H0 against H1 is the t-statistic (or studentized statistic) tn = tn (θ0 ) = ˆ − θ0 θ . It is designed to cover θ with high probability. so the “unusualness” of the test statistic can be compared to the easy-to-understand uniform distribution.645. from which it follows that pn →d U [0. Thus P (1 − pn ≤ u) = = P (F (tn ) ≤ u) ¡ ¢ = P |tn | ≤ F −1 (u) ¡ ¢ → F F −1 (u) = u. or “accepts” H0 . The rejection/acceptance dichotomy is associated with the Neyman-Pearson approach to hypothesis testing. If the p-value pn is small (close to zero) then the evidence against H0 is strong. A test of asymptotic signiﬁcance α rejects H0 if |tn | > zα/2 .

= n h(β) − θ0 Hβ V Hβ 57 (6.10 Wald Tests Sometimes θ = h(β) is a q × 1 vector. The t-test of the previous setion rejects H0 : θ0 = θ if |tn (θ)| > zα/2 where tn (θ) is the t-statistic (6.05.16) and zα/2 is the upper α/2 quantile of the standard normal distribution. 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). Hβ = ∂β The Wald statistic for H0 against H1 is ´0 ³ ´ ³ ˆ θ θ Wn = n ˆ − θ0 Vθ−1 ˆ − θ0 ´0 ³ ´−1 ³ ´ ³ ˆ ˆ ˆ0 ˆ ˆ h(β) − θ0 . A good method for construction of a conﬁdence interval is the collection of parameter values which are not rejected by a statistical test. and values of θ outside two standard θ errors of the estimated ˆ are considered unlikely or unreasonable candidates for the true value. We say that Cn has asymptotic (1 − α)% coverage for θ if P (θ ∈ Cn ) → 1 − α as n → ∞. θ θ) (6. 6. We have the null and alternative H0 : θ = θ0 H1 : θ 6= θ0 . A conﬁdence interval is then constructed as the values of θ for which this test does not reject: © ª Cn = θ : |tn (θ)| ≤ zα/2 ( ) ˆ−θ θ = θ : −zα/2 ≤ ≤ zα/2 s(ˆ θ) i h θ). θ The interval has been constructed so that as n → ∞. or α = . In this case the t-statistic approach does not work. While there is no hard-and-fast guideline for choosing the coverage probability 1 − α. This corresponds to selecting the conﬁdence h i h ˆ ± 1.We typically cannot calculate the exact coverage probability P (θ ∈ Cn ). ˆ + zα/2 s(ˆ .96s(ˆ ≈ ˆ ± 2s(ˆ . Thus values of θ within two standard errors of the estimated interval θ θ) θ θ) ˆ are considered “reasonable” candidates for the true value θ.17) = ˆ − zα/2 s(ˆ θ and Cn is an asymptotic (1 − α)% conﬁdence interval. the most common professional choice isi95%.18) . ¢ ¡ ¢ ¡ P (θ ∈ Cn ) = P |tn (θ)| ≤ zα/2 → P |Z| ≤ zα/2 = 1 − α. and it is desired to test the joint restrictions simultaneously. However we often can calculate the asymptotic coverage probability limn→∞ P (θ ∈ Cn ).

1. Thus Vθ = H 0 V Hβ →p H 0 V Hβ = Vθ > 0 if Hβ has full rank q.05) = 3. q and pn is asymptotically U[0. h(β) = R0 β. then the Wald statistic takes the form ´0 ³ ´ ³ ´−1 ³ ˆ ˆ ˆ R0 V R R0 β − θ 0 . and there are q = k2 restrictions. Hβ (β) →p Hβ . 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. 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 . Furthermore. For example. The Wald test fails to reject if Wn is q 1 ¡ ¢ less than χ2 (α).10.1 showed θ ˆ that V →p V. then Wn →d χ2 . so by the continuous mapping ˆ ˆ ˆ ˆ ˆ theorem. 1] under H0 .84 = z.When h is a linear function of β. An asymptotic Wald test rejects H0 in favor of H1 if Wn exceeds χ2 (α). ˜ 58 ¡ 0 ¢−1 0 ˜ β 1 = X1 X1 X1 Y . Hence β β by Theorem A. if rank(Hβ ) = q. ˆ Wn = n θ θ q θ θ Theorem 6. ˜˜ n ˜ e = Y − X1 β 1 . Also h(β) = a selector matrix.025 . a chiq square random variable with q degrees of freedom. The null hypothesis is H0 : β 2 = 0. Hβ (β) is a continuous function of β. χ2 (. the upper-α quantile q 2 of the χ2 distribution. As before.5. In this case. We know that the Wald statistic takes the form 0 Wn = nˆ Vθ−1 ˆ θ ˆ θ ³ ´−1 ˆ ˆ0 ˆ β 2.3. Wn = n R0 β − θ0 ´ √ ³ The delta method (6. then the Wald statistic can be written in the form ¶ µ 2 ˆ σ − σ2 ˜ Wn = n (6. and Theorem 6. θ = β 2 .2.8. = nβ 2 R0 V R R0 β is linear with R = µ 0 I ¶ ¢−1 ¡ ˆ ˆ ˆ . We have established: ³ ´0 ³ ´ ˆ − θ0 V −1 ˆ − θ0 →d Z 0 V −1 Z = χ2 . The asymptotic p-value for Wn is pn = p(Wn ). 6.19) σ2 ˆ where σ2 = ˜ 1 0 e e.1 Under H0 and Assumption 6.15) showed that n ˆ − θ →d Z ∼ N (0. where p(x) = P χ2 ≥ x is the tail q q probability function of the χ2 distribution. Vθ ).

19) only holds if V 0 = σ 2 n−1 X 0 X ˆ . ˜˜ ˆˆ ˆˆ σ 2 = n−1 e0 e ˆ we conclude that Wn = n as claimed.19). note that if we regress Y on X1 alone.19) is that it is directly computable from the standard output from two simple OLS regressions. as the sum of squared errors is a typical output from statistical packages. = F = n k2 σ 2 /(n − k) ˆ ¢−1 ¡ ˆ While it should be emphasized that equality (6. By the FWL theorem. 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. since ˆ0 0 ˆ β 2 X2 M1 X2 β 2 = e0 e − e0 e. µ e0 e − e0 e ˜˜ ˆˆ e0 e ˆˆ ¶ =n µ σ2 − σ2 ˜ ˆ 2 σ ˆ ¶ . This statistic is typically reported as an “F-statistic” which is deﬁned as ¡ 2 ¢ σ − σ 2 /k2 ˜ ˆ n − k Wn . 59 . 2 σ ˆ To simplify this expression further. and σ2 = ˆ 1 0 e e.are from OLS of Y on X1 . note that partitioned matrix inversion (2. Now consider the residual regression of e on X2 = M1 X2 . X2 ). We now derive expression (6. the residual is ˜ ˜ e = M1 Y. ˆ ¡ ¢−1 0 ˆ β = X 0X XY are from OLS of Y on X = (X1 . First. 2 2 2 or alternatively. still this formula often ﬁnds good use in reading applied papers. ˆˆ n ˆ e = Y − X β.19) the F form of the Wald statistic. Thus ¡ 0 ¢−1 R = X2 M1 X2 and ³ ¡ ´−1 ³ ¢−1 ´−1 ¡ 0 ¢ ˆ = σ −2 n−1 R0 X 0 X ˆ R = σ −2 n−1 X2 M1 X2 ˆ R0 V 0 R ³ ´−1 ˆ0 ˆ ˆ Wn = nβ 2 R0 V 0 R β2 = 0 ˆ ˆ0 β 2 (X2 M1 X2 ) β 2 . Also. Because of this connection we call (6. The elegant feature about (6. ˜ ˆ ˜ 2 β 2 + e and X 0 e = 0.2) ¢−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 .

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

β has an exact normal distribution and t has an exact t distribution. which is twice the diﬀerence in the log-likelihood function evaluated under the null and alternative hypotheses. if standard errors are calculated using the homoskedastic formula (6. The log-likelihood of this model is ¡ 2¢ n n n ˜ ˜ ˜ Ln (β 1 . 0. ˆ 2 2 2 ˜ ˜ The MLE of the model under the null hypothesis is (β 1 . σ2 ˆ 61 .10) then ´ ³ ˆ • β ∼ N 0. 2 2 2 The LR statistic for H0 is ´ ³ ˆ ˆ ˆ ˜ ˜ LR = 2 Ln (β 1 . 0. the notable distinction is between the N (0.1 If ei is independent of xi and distributed N(0. σ 2 (X 0 X)−1 • (n−k)s2 σ2 ˆ β j −β j ˆ s(β ) j ∼ χ2 . σ 2 ) where β 1 is the OLS estimate from ˜ 2 ˜ a regression of yi on x1i only. a good testing procedure is based on the likelihood ratio statistic.3. so as a practical matter it does not matter which distribution is used. β and t are approximately normally distributed. We summarize these ﬁndings Theorem 6. and standard errors are calculated using the homoskedastic formula (6. 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. In contrast. σ 2 ) = − log 2πˆ 2 − 2 e0 e ˆˆ 2 2ˆ σ ¡ ¢ n n n = − log σ 2 − log (2π) − . Furthermore. β 2 . σ 2 ) − Ln (β 1 .12.8. The estimator under the alternative is the unrestricted estimator ˆ ˆ ˆ (β 1 . σ 2 ) = − log σ − log (2π) − . β 2 ) and consider tests of the linear restriction H0 : β 2 = 0 H1 : β 2 6= 0 In the context of parametric models. (Unless the sample size is unreasonably small. with residual variance σ .1 shows that under the strong assumption of ˆ normality.1 and Theorem 6. σ ˆ ˆ βj − βj βj − βj N (0. β 2 . 1) and tn−k distributions.) Now let us partition β = (β 1 . σ 2 ). The critical values are quite close if n − k ≥ 30. σ 2 ) ¡ ¢¢ ¡ ¡ ¢ ˆ = n log σ 2 − log σ 2 ˜ µ 2¶ σ ˜ = n log . β 2 .1 we showed that in large samples. The Gaussian log-likelihood at these estimates is ¡ ¢ n 1 ˆ ˆ ˆ σ Ln (β 1 . n−k • ∼ tn−k ˆ In Theorem 6. σ 2 ) discussed above. Theorem 6. As inference (conﬁdence intervals) are based on the t-ratio.12.a chi-square distribution with n − k degrees of freedom.10) µ h i ¶ 2 (X 0 X)−1 N 0. 0.

This can be seen by a simple example introduced by Lafontaine and White (1986). while there are other values of s for which test test statistic is insigniﬁcant. features of this distribution can be calculated. ˆ Let β and σ 2 be the sample mean and variance of yi . Letting h(β) = β s . Through repetition. one feature of importance is the Type I error of the test using the asymptotic 5% critical value 3. σ 2 s2 β ˆ ˆ While the hypothesis β s = 1 is unaﬀected by the choice of s.7. σ2 ˆ Now notice that H0 is equivalent to the hypothesis H0 (s) : β s = 1 for any positive integer s. the statistic Wn (s) varies with s. It is easy to see that in each case there are values of s for which the line is for the case β test statistic is signiﬁcant relative to asymptotic critical values. To demonstrate this eﬀect. The increasing solid line is for the case β = 0. This produces random draws from the sampling distribution of interest. This is distressing since the choice of s seems arbitrary and irrelevant to the actual hypothesis. and noting Hβ = sβ s−1 . The method uses random simulation to create an artiﬁcial dataset to apply the statistical tools of interest. The decreasing dashed ˆ = 1. σ 2 ) and consider the hypothesis H0 : β = 1.13 Problems with Tests of NonLinear Hypotheses While the t and Wald tests work well when the hypothesis is a linear restriction on β.By a ﬁrst-order Taylor series approximation ¶ µ 2 ¶ µ σ ˜ σ2 ˜ − 1 = Wn .84 — the probability of a false rejection. as Wn (s) →d χ2 under H0 for 1 any s. we ﬁnd that the standard Wald test for H0 (s) is ´2 ³ s ˆ β −1 Wn (s) = n 2s−2 . 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. we have plotted in Figure 6. This is an unfortunate feature of the Wald statistic. Take the model yi = β + ei ei ∼ N (0.4 the Wald statistic Wn (s) as a function ˆ of s. setting n/σ 2 = 10. Then the standard Wald test for H0 is ˆ ³ ´2 ˆ β−1 Wn = n . 62 .8. LR = n log 1 + 2 − 1 ' n σ ˆ σ2 ˆ the F statistic. 6. they can work quite poorly when the restrictions are nonlinear. Our ﬁrst-order asymptotic theory is not useful to help pick s. In the present context of the Wald statistic.

Table 4. Rates above 20% are unexceptable. In each case. however. For this particular example.1 Type I error Probability of Asymptotic 5% Wn (s) Test 63 . which is not surprising given the dependence of Wn (s) on s as shown in Figure 6. 100 and 500. no magic choice of n for which all tests perform uniformly well. When comparing statistical procedures. Each row of the table corresponds to a diﬀerent value of s — and thus corresponds to a particular choice of test statistic.000 simulated Wald statistics Wn (s) which are larger than 3. The value of s is varied from 1 to 10.000 random samples. and rarely fall outside of the 3%-8% range. and σ 2 .1 you can also see the impact of variation in sample size. To interpret the table. These probabilities are calculated as the percentage of the 50. Table 4.05) with deviations indicating+ distortion. remember that the ideal Type I error probability is 5% (.4: Wald Statistic as a function of s P (Wn (s) > 3.4. and σ is varied among 1 and 3. we compare the rates row by row. In Table 4. n is varied among 20. Test performance deteriorates as s increases. The second through seventh columns contain the Type I error probabilities for diﬀerent combinations of n and σ. Typically. this probability depends only on s.84. There is. the Type I error probability improves towards 5% as the sample size n increases. Type I error rates between 3% and 8% are considered reasonable. Given the simplicity of the model. the only test which meets this criterion is the conventional Wn = Wn (1) test. n. In Table 2.Figure 6.1 reports the simulation estimate of the Type I error probability from 50. Any other choice of s leads to a test with unacceptable Type I error probabilities. The null hypothesis β s = 1 is true.1 we report the results of a Monte Carlo simulation where we vary these three parameters.84 | β = 1) . looking for tests for which rate rejection rates are close to 5%. Error rates avove 10% are considered excessive. so these probabilities are Type I error.

08 .15 .06 .25 .33 .31 .26 .19 .23 . An alternative statistic can be constructed through reformulating the null hypothesis as H0 : β 1 − rβ 2 = 0.30 .13 .22 .15 .08 .21 .15 . so the hypothesis can be stated as H0 : θ = r.24 .09 .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 .07 .05 .10 .17 . 64 .15 .07 .05 . This point can be illustrated through another example. deﬁne θ = β 1 /β 2 . While this is clear in this particular example.20) ³ ´1/2 ˆ0 ˆ ˆ so that the standard error for ˆ is s(ˆ = n−1 H1 V H1 θ θ) .06 .07 .18 .08 .14 .12 .20).05 .28 .07 .07 .10 .22 .05 .25 . Take the model yi = β 0 + x1i β 1 + x2i β 2 + ei E (xi ei ) = 0 and the hypothesis H0 : β1 =r β2 (6.16 Rejection frequencies from 50.14 .10 .06 .12 . let V be an estimate of the ˆ asymptotic variance matrix for β and set ˆ = β 1 /β 2 .08 . in other examples natural choices are not always obvious and the best choices may in fact appear counter-intuitive at ﬁrst.06 .05 .11 .34 .000 simulated random samples In this example it is not surprising that the choice s = 1 yields the best test statistic.08 .06 . β 2 ) be the least-squares estimates of (6. Equivalently.06 .05 .35 . ˆ ˆ ˆ ˆ ˆ Let β = (β 0 . Deﬁne θ ˆ ˆ ⎞ ⎛ 0 ⎟ ⎜ ⎟ ⎜ ⎜ 1 ⎟ ⎟ ⎜ ⎜ ˆ ⎟ ˆ H1 = ⎜ β 2 ⎟ ⎟ ⎜ ⎟ ⎜ ⎜ β ⎟ ˆ ⎠ ⎝ − 1 ˆ2 β2 ´ s(ˆ θ) −r .20 . In this case a t-statistic for H0 is t1n = ³ˆ β1 ˆ β2 where r is a known constant.06 .20 .13 . Other choices are arbitrary and would not be used in practice. β 1 .06 .13 .

00 .06 .05 .00 .06 .00 .645) P (tn > 1. The results are presented in Table 4. the entries in the table should be 0. the rejection rates for the t1n statistic diverge greatly from this value.645) are close to zero in most cases.02 . . and are close to the ideal 5% rate for both sample sizes.06 . The common message from both examples is that Wald statistics are sensitive to the algebraic formulation of the null hypothesis. 6.00 The one-sided Type I error probabilities P (tn < −1. σ 2 ) draw with σ = 3.00 .26 .15 .645) are calculated from 50. and 1.2.28 . then the “most linear” formulation should be selected.05 .00 .50. It is also prudent to consider alternative tests to the Wald statistic.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. 1) variables. Ideally.07 . and alternatives to asymptotic critical values should be considered.2 is that the two t-ratios have dramatically diﬀerent sampling behavior.000 simulated samples.75.05.05 . ei be an independent N (0.05 . especially for small values of β 2 . if the hypothesis can be expressed as a linear restriction on the model parameters.05 . Table 4.05 .05 . −r ⎛ t2n where To compare t1n and t2n we perform another simple Monte Carlo simulation.00 . such as the GMM distance statistic which will be presented in Section 9.645) and P (tn > 1.75 1. However. This leaves β 2 as a free parameter.645) P (tn < −1.0 and n among 100 and 500.06 . In contrast.05 .09 .645) P (tn > 1. the rejection rates for the linear t2n statistic are invariant to the value of β 2 . along with sample size n.06 .25.06 .1.10 .06 .06 .05 β2 . −1 H V H ˆ 2 n 2 ⎞ 0 H2 = ⎝ 1 ⎠ . The implication of Table 4. . We let x1i and x2i be mutually independent N (0. while the right tail probabilities P (t1n > 1.05 .A t-statistic based on this formulation of the hypothesis is ´2 ³ ˆ 1 − rβ 2 ˆ β =³ ´1/2 .7. In this section we describe the method in more detail. this formulation should be used. If no linear formulation is feasible. In all cases. and normalize β 0 = 0 and β 1 = 1.00 .47 .10 .15 .00 .10 . 65 .12 .00 .2 Type I error Probability of Asymptotic 5% t-tests n = 100 n = 500 P (tn < −1.25 . We vary β 2 among .06 .50 .06 .645) greatly exceed 5%. The left tail probabilities P (t1n < −1.645) t1n t2n t1n t2n t1n t2n t1n t2n . .

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

We now expand the sample all non-military wage earners. it is simple to make inferences about rejection probabilities from statistical tests. The typical purpose of a Monte Carlo simulation is to investigate the performance of a statistical procedure (estimator or test) in realistic settings. B b=1 (6.22/ B. the performance will depend on n and F. an estimator or test may perform wonderfully for some values. and our regressors include years of education. hispanic. Hence the ³ ´ ˆ standard errors for B = 100. experience squared. a larger B results in more precise estimates of the features of interest of Gn . excluding military. we included a dummy 67 . and poorly for others. For the dependent variable we use the natural log of wages.Suppose we are interested in the ¯Type I error associated with an asymptotic 5% two-sided ¯ ¯ ¯ θ) θ t-test. and estimate a multivariate regression. Then qα is the N ’th number in this ordered sequence. are. female. then we can set s P = (.96) . union member. Again our dependent variable is the natural log of wages. The α% sample quantile is a number qα such that α% of the sample are less than qα . Quite simply. As P is unknown. We separately estimate equations for white and non-whites. then B will have to be increased. Since the results of a Monte Carlo experiment are estimates computed from a random sample of size B. potential work experience.15 Estimating a Wage Equation We again return to our wage equation. A simple way to compute sample quantiles is to sort the sample {Tnb } from low to high. It is therefore useful to conduct a variety of experiments. The random variable 1 (Tnb ≥ 1. and . If the standard error is too large to make a reliable inference.007. immigrant.21) the percentage of the simulated t-ratios which exceed the asymptotic 5% critical value. respectively. such as the percentage estimate reported in (6. equalling 1 with probability P = E1 (Tnb ≥ 1. but requires more computational time. and 5000. For example. . s P = .96) . and hispanic. The average (6.21) is therefore an ³ ´ p ˆ unbiased estimator of P with standard error s P = P (1 − P ) /B. where N = (B +1)α. It is therefore convenient to pick B so that N is an integer. if we set B = 999.022.96) is iid Bernoulli. 1000. therefore. and dummy variable indicators for the following: married. Generally. the researcher must select the number of experiments. for a selection of choices of n and F. As discussed above.95) /B ' . 6. We us the sample of wage earners from the March 2004 Current Population Survey. Suppose we are interested in the 5% and 95% quantile of Tn = ˆ We then compute the 10% θ. the choice of B is often guided by the computational demands of the statistical procedure. immigrant. this may ˆ be approximated by replacing P with P or with an hypothesized value. For example. female. In practice. Furthermore.003. We would then set Tn = ¯ˆ − θ¯ /s(ˆ and calculate B X ˆ= 1 P 1 (Tnb ≥ 1. potential work experience. and non-white. experience squared. then the 5% sample quantile is 50’th sorted value and the 95% sample quantile is the 950’th sorted value. and 90% sample quantiles of the sample {Tnb }. B. and dummy variable indicators for the following: married. union member. so that coeﬃcients may be interpreted as semi-elasticities. For regressors we include years of education. Often this is called the number of replications.05) (. In particular.21). 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.

as the 1% critical value for the χ2 distribution is 76.variable for state of residence (including the District of Columbia.097 −.001 .49452 σ ˜ Notice that the two statistics are close. Wn = n 1 − 2 = 18.69.19) is ˜ µ ¶ µ ¶ σ2 ˆ . 808 1 − . but not equal. 50 Another interesting question which can be addressed from these estimates is the maximal impact of experience on mean wages.00057 . excluding the coeﬃcients on the state dummy variables. we ﬁnd Wn = 550.232 .1 we ﬁnd the point estimate ˆ ˆ = − β 2 = 28.033 −.34 ˆ s(β) .102 −. Table 4. reestimating the model with the 50 state dummies excluded. Computing the Wald statistic (6.027 . Alternatively.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.1 OLS Estimates of Linear Equation for Log(Wage) ˆ β 1. The F form of the Wald statistic (6.808 so the parameter estimates are quite precise and reported in Table 4.4945.008 .102 −. the restricted standard deviation estimate is σ = .070 . Using either statistic the hypothesis is easily rejected. Ignoring the other coeﬃcients.032 . 2β 3 68 . this adds 50 regressors).1. if β 2 > 0 and β 3 < 0 the solution is θ=− From Table 4.00002 .808 .101 . The available sample is 18.4877 18.014 .18) that the state coeﬃcients are jointly zero.007 .010 .002 .013 .121 −. θ ˆ 2β 3 β2 . 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.

implying a 95% conﬁdence θ) interval of [27. Instead. Our desired conﬁdence interval will be the set of parameter values θ which are not rejected by the hypothesis test. In the present context we are interested in forming a conﬁdence interval.5]. 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 ). 29. not testing a hypothesis.9.40. we can calculate a standard error of s(ˆ = . 29.96. as the coverage probability of this conﬁdence interval is one minus the Type I error of the hypothesis test based on the t-test. In the previous section we discovered that such t-tests had very poor Type I error rates.5].Using the Delta Method. there is not a simple expression for this set. we found better Type I error rates by reformulating the hypothesis as a linear restriction. but it can be found numerically quite easily. Notice that the upper end of the conﬁdence interval is the same as that from the delta method. Since tn (θ) is a non-linear function of θ. However. This set is [27. but the lower end is substantially lower. this is a poor choice. so we have to go one step further. 69 . This is the set of θ such that |tn (θ)| ≤ 1.0.

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

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

Let η i = e2 . Often the functional form is kept simple for parsimony. . Typically. where z1i is some q × 1 function of xi . σ1 We now discuss this estimation problem. we know that the least-squares estimator is semi-parametrically eﬃcient for the projection coeﬃcient.. z1i are squares (and perhaps levels) of some (or all) elements of xi . in the linear regression model yi = x0 β + ei i E (ei | xi ) = 0.1) XD Y β = X 0 D−1 X ¡ ¢ 2 .Chapter 7 Additional Regression Topics 7. A ˆ ˆn feasible GLS (FGLS) estimator replaces the unknown D with an estimate D = diag{ˆ 2 .. The error ξ i in this regression error ξ i is generally heteroskedastic and has the conditional variance ¡ ¢ V ar (ξ i | xi ) = V ar e2 | xi i ´ ³¡ ¢¢2 ¡ = E e2 − E e2 | xi | xi i i ¡ 4 ¢ ¡ ¡ 2 ¢¢2 = E ei | xi − E ei | xi . . The 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 ¢ ¡ ˜ (7.2) E (ξ i | xi ) = 0.. The GLS estimator is sometimes called where D = diag{σ 1 i i n i i the Aitken estimator. The GLS estimator (7.1 Generalized Least Squares In the projection model. σ 2 } and σ 2 = σ 2 (x ) = E e2 | x .. Suppose that we model the conditional variance using the parametric form 0 σ 2 = α0 + z1i α1 i = α0 zi .1) infeasible since the matrix D is unknown. the least-squares estimator is ineﬃcient.. 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. 74 .. However. σ 2 }.

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. 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. then the FGLS ˜i estimator is not well deﬁned.. If σ 2 < 0 for some i. ˜i Suppose that σ 2 > 0 for all i. Furthermore. σ 2 } σ1 ˜n and ³ ´−1 ˜ ˜ ˜ β = X 0 D−1 X X 0 D−1 Y. We have shown that α is consistently estimated by a simple procedure. then the FGLS estimator will force ˜i the regression equation through the point (yi . Vα ) (7. ³ ´ ˆ ˆ ˆ = −2ei x0 β − β + (β − β)0 xi x0 (β − β) i i say. One typical problem with implementation of FGLS estimation is that in a linear regression ˜i speciﬁcation. as it is estimating the conditional variance of the regression of yi on xi . Note that n n n ´ 1X √ ³ √ −2 X 1 X ˆ ˆ ˆ √ zi φi = zi ei x0 n β − β + zi (β − β)0 xi x0 (β − β) n i i n n n i=1 i=1 i=1 →p 0 Let be from OLS regression of η i on zi . Then set ˜i ˜ D = diag{˜ 2 .4) the skedastic regression. and hence we can estimate 0 σ 2 = zi α by i ˜ (7. Vα ) α ¡ ¡ 0 ¢¢−1 ¡ 0 2 ¢ ¡ ¡ 0 ¢¢−1 E zi zi ξ i E zi zi . estimator of β. This suggests 75 .6) σ 2 = α0 zi . Since there is not a unique speciﬁcation for the conditional variance the FGLS estimator is not unique. This is the feasible GLS.. xi ). we have the OLS residual ei = yi − x0 β = ei − x0 (β − β).5) ˆ Thus the fact that η i is replaced with η i is asymptotically irrelevant. We may call (7.3) ˆ ˆ While ei is not observed. Vα = E zi zi (7. there is no guarantee that σ 2 > 0 for all i. Thus ˆ i i η − η i = e2 − e2 ˆ ˆi i = φi . Then ˆ ¢−1 0 ¡ Zη ˆ α = Z 0Z ˜ (7. and will depend on the model (and estimation method) for the skedastic regression.. which is typically undesirable. . or FGLS.

1. σ 2 ] σi i for some σ 2 > 0. then FGLS is asymptotically equivalent to GLS. β should perhaps be i i called a quasi-FGLS estimator of β. 1992). FGLS is asymptotically superior to OLS. . Its asymptotic variance is not that given in Theorem 7. and was proposed by Cragg (Journal of Econometrics. Why then do we not exclusively estimate regression models by FGLS? This is a good question.. ¢¢−1 ¡ ¡ . Theorem 7.2) is correctly speciﬁed. and it may be estimated with considerable 76 V takes a sandwich form√. There are three reasons. e2 }.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 ˜ = . Unless σ 2 = α0 zi .that there is a need to bound the estimated variances away from zero. V = E σ −2 xi x0 i i ˆ where D = diag{ˆ2 . We just state the result without proof. It may be the case that α0 zi is only an approximation to the true conditional variance σ 2 = i ˜ E(e2 | xi ).1. i ˜ 0 is inconsistent for V . This is an estimator which is robust to misspeciﬁcation of the condie1 ˆn tional variance.1.1 If the skedastic regression is correctly speciﬁed. In the linear regression model. First. 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 → ∞. This estimator V 0 is appropriate when the skedastic regression (7. FGLS estimation depends on speciﬁcation and estimation of the skedastic regression. ´ √ ³ ˜ ˜ n β GLS − β F GLS →p 0. V ). V ˜ An appropriate solution is to use a White-type estimator in place of V 0 . Instead. Since the form of the skedastic regression is unknown.. and thus where ´ √ ³ ˜ n β F GLS − β →d N (0. It is possible to show that if the skedastic regression is correctly speciﬁed. ´´−1 ³ ³¡ ´´−1 ³ ³¡ ¢−1 ¢−2 2 0 ´´ ³ ³¡ 0 ¢−1 E α0 zi E α zi xi x0 σ i xi xi xi x0 . V = E α0 zi i i Examining the asymptotic distribution of Theorem 7. In this case we interpret α0 zi as a linear projection of e2 on zi .. similar to the covariance matrix of the OLS estimator.1. A trimming rule might make sense: σ 2 = max[˜ 2 . V n n i=1 . but the proof of this can be tricky.

its squares.3) for α simpliﬁes to ¡ ¡ 0 ¢¢−1 ¡ 2 ¢ E ξi . we impose the stronger hypothesis and test the hypothesis that ei is independent of xi . This hypothesis does not imply that ξ i is independent of xi . then the OLS and FGLS estimators will converge in probability to diﬀerent limits. The point is that the eﬃciency gains from FGLS are built on the stronger assumption of a correct conditional mean. require the assumption of a correct conditional mean.1 Under H0 and ei independent of xi .4) and constructing a Wald statistic.2.4). Typically. It is consistent not only in the regression model.5) and the asymptotic variance (7. Theorem 7. Third.7) under independence show that this test has an asymptotic chi-square distribution. and not a conditional mean. and the cost is a reduction of robustness to misspeciﬁcatio 7. Motivated by the form of the asymptotic variance ˆ of the OLS estimator β. however.2). In the linear regression model the conditional mean of yi given xi = x is 77 . This introduces an element of arbitrariness which is unsettling to empirical researchers. q Most tests for heteroskedasticity take this basic form. And the FGLS probability limit will depend on the particular function selected for the skedastic regression.7) Hence the standard test of H0 is a classic F (or Wald) test for exclusion of all regressors from the skedastic regression (7. 7. as they will be estimating two diﬀerent projections. White (1980) proposed that the test for heteroskedasticity be based on setting zi to equal all non-redundant elements of xi . We may therefore test this hypothesis by the estimation (7. and replaced E ξ 2 with 2σ 4 which holds when ei is N(0. In this case. and all cross-products. If the equation of interest is a linear projection. but the only diﬀerence is that they a ¢ allowed for general choice of zi . the two tests coincide. Vα = E zi zi (7. but also under the assumptions of linear projection. The GLS and FGLS estimators. FGLS will do worse than OLS in practice. BreuschPagan (1979) proposed what might appear to be ¡ distinct test. the estimated conditional variances may contain more noise than information about the true conditional variances. σ 2 ).2 Testing for Heteroskedasticity ¢ ¡ The hypothesis of homoskedasticity is that E e2 | xi = σ 2 . OLS is a more robust estimator of the parameter vector. or equivalently that i H0 : α1 = 0 in the regression (7. the Wald test of H0 is asymptotically χ2 . The asymptotic distribution (7.error.3 Forecast Intervals m(x) = E (yi | xi = x) = x0 β. If i this simpliﬁcation is replaced by the standard formula (under independence of the error). in which case ξ i is ˜ independent of xi and the asymptotic variance (7. Second. The main diﬀerences between popular “tests” is which transformations of xi enter zi . on the other hand. individual estimated conditional variances may be negative. and this requires trimming to solve.

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

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

4. θ) ' (ei + m(xi . and this is often a useful hypothesis (sub-model) to consider.5 Least Absolute Deviations We stated that a conventional goal in econometrics is estimation of impact of variation in xi on the central tendency of yi . under H0 . 80 . In particular. θ0 ) + m0 (θ − θ0 ) . θ0 )) − m(xi . θ which is that stated in the theorem. the model is yi = β 0 zi + εi 1 and both β 2 and γ have dropped out. tests of H0 do not have asymptotic normal or chi-square distributions. γ is not identiﬁed. but these are not the only measures of central tendency. Identiﬁcation is often tricky in nonlinear regression models. Hansen shows how to use simulation (similar to the bootstrap) to construct the asymptotic critical values (or p-values) in a given application. 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 . the parameter estimates are not asymptotically normally distributed. ¥ Based on Theorem 7. θ0 ) + m0 (θ − θ0 ) θi = ei − m0 (θ − θ0 ) θi 0 = yi − m0 θ.1. θ) ' m(xi . An alternative good measure is the conditional median. 7. The asymptotic theory of such tests have been worked out by Andrews and Ploberger (1994) and B. 1 2 The model is linear when β 2 = 0. m(xi . Thus when the truth is that β 2 = 0. However. We have discussed projections and conditional means. Furthermore. ˆ ˆ θ) ˆ θ). ˆ and ei = yi − m(xi . by a ﬁrst-order Taylor series approximation. θ) = β 0 zi + β 0 xi (γ). This means that under H0 . Hansen (1996). Thus the NLLS 0 estimator ˆ has the same asymptotic distribution as the (infeasible) OLS regression of yi on mθi . θi Hence the sum of squared errors function is Sn (θ) = n X i=1 (yi − m(xi . an estimate of the asymptotic variance V is ˆ V = Ã 1X mθi m0 ˆ ˆ θi n i=1 n !−1 Ã 1X mθi m0 e2 ˆ ˆ θi ˆi n i=1 n !Ã 1X mθi m0 ˆ ˆ θi n i=1 n !−1 where mθi = mθ (xi . θi Thus ¡ ¢ yi − m(xi . Thus we want to test H0 : β 2 = 0. Suppose that m(xi . This renders the distribution theory presented in the previous section invalid.For θ close to the true value θ0 .

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

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

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

E xi xi f (0)2 A recent monograph on the details of quantile regression is Koenker (2005). 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 (7.6. 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.7 Testing for Omitted NonLinearity If the goal is to estimate the conditional expectation E (yi | xi ) . Another popular approach is the RESET test proposed by Ramsey (1969). and are widely available. conventional Newton-type optimization methods are inappropriate.where ei is the error deﬁned to be the diﬀerence between yi and its τ ’th conditional quantile x0 β τ . Furthermore. then f (0 | xi ) = f (0) . since it has discontinuous derivatives. Fortunately. the unconditional density of ei at 0. and test their signiﬁcance using a Wald test. where and f (e | x) is the conditional density of ei given xi = x. n numerical methods are necessary for its minimization. ´ √ ³ˆ Theorem 7. Since the quanitle regression criterion function Lτ (β) does not have an algebraic solution. ¡ ¡ ¢¢−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. the asymptotic variance depends on the conditional density of the quantile regression error. A asymptotic distribution theory for the quantile regression estimator can be derived using similar arguments as those for the LAD estimator in Theorem 7. if the model yi = x0 β + ei has i been ﬁt by OLS.5. Thus. When the error ei is independent of xi . The null model is yi = x0 β + εi i 84 . fast linear programming methods have been developed for this problem. ˆ Given the representation (7. 7.1 n β τ − β τ →d N (0.1.12). and we have the simpliﬁcation Vτ = τ (1 − τ ) ¡ ¡ 0 ¢¢−1 . the τ ’th conditional quantile of ei is zero. and form a Wald statistic i for γ = 0. i By construction. otherwise its properties are unspeciﬁed without further restrictions. it is useful to have a general test of the adequacy of the speciﬁcation.13). One simple test for neglected nonlinearity is to add nonlinear functions of the regressors to ˆ ˆ the regression. Vτ ).

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

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

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

The general problem is the model yi = β 1 x1i + β 2 x1i + · · · + β K xKi + εi . 88 . 576.17). there are 2K such models. one can show that thus LRn →p ∞.so ´ ³ c P M = M1 | M1 = = P (BIC1 < BIC2 | M1 ) P (LRn < log(n)k2 | M1 ) µ ¶ LRn = P < k2 | M1 log(n) → P (0 < k2 ) = 1. However. β 2 6= 0. E (εi | xi ) = 0 and the question is which subset of the coeﬃcients are non-zero (equivalently. β K 6= 0. . Also under M2 . β 3 = · · · = β K = 0 . which are nested. and the AIC or BIC in principle can be implemented by estimating all possible subset models. In the latter case. and then selects the model with the lowest AIC (7. Similarly for ˆ the BIC. In the unordered case. β 2 6= 0. . 210 = 1024. In the ordered case.. xKi }. a full-blown implementation of the BIC selection criterion would seem computationally prohibitive. log(n) µ LRn > k2 | M2 log(n) ¶ ´ ³ c P M = M2 | M2 = P → 1. the models are M1 : β 1 6= 0. which regressors enter the regression). .. The methods extend readily to the issue of selection among multiple regressors. a model consists of any possible subset of the regressors {x1i . The AIC selection criteria estimates the K models by OLS. . MK : β 1 6= 0. For example. There are two leading cases: ordered regressors and unordered. selecting based on (7. β 2 = β 3 = · · · = β K = 0 M2 : β 1 6= 0.15). We have discussed model selection between two models. .. stores the residual variance σ 2 for each model. which can be a very large number. . and 220 = 1. 048. .

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

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

(e) Test whether the error variance is diﬀerent for whites and nonwhites. (d) Test whether the error variance is diﬀerent for men and women.dat contains 550 observations on 20 variables taken from the May 1978 current population survey. (i) Compare the estimated standard errors. (h) Do the OLS and FGLS estimates diﬀer greatly? Note any interesting diﬀerences. (g) Using this model for the conditional variance. Note any interesting diﬀerences. re-estimate the model from part (c) using FGLS. 91 . (b) Consider augmenting the model by squares and/or cross-products of the conditioning variables. The goal of the exercise is to estimate a model for the log of earnings (variable LNWAGE) as a function of the conditioning variables. 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. (a) Start by an OLS regression of LNWAGE on the other variables.10. Report the results. Variables are listed in the ﬁle cps78. test for general heteroskedasticity and report the results. (f) Construct a model for the conditional variance.pdf. The data ﬁle cps78. if desired. Interpret. Estimate your selected model and report the results. Report coeﬃcient estimates and standard errors. Interpret.

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

n... In general. i 93 . by the CLT (Theorem 5. and 100. x). x))) . x) − F (y. the EDF step function gets uniformly close to the true CDF. . x∗ ≤ x) = Fn (y. note that for any (y. 1) distribution. This is a population moment. That is. ∗ P (yi ≤ y. x∗ ) with the i distribution Fn . x) is called the empirical distribution function (EDF).1). The method of moments estimator is the corresponding sample moment: n 1X 1 (yi ≤ y) 1 (xi ≤ x) . x)) →d N (0. Notationally.8. xi ≤ x) = E (1 (yi ≤ y) 1 (xi ≤ x)) . Furthermore. √ n (Fn (y. x). x) = P (yi ≤ y. To see the eﬀect of sample size on the EDF. but the approximation appears to improve for the large n. xi ). To see this. 1 (yi ≤ y) 1 (xi ≤ x) is an iid random variable with expectation F (y.2) Fn (y. Recall that F (y. x) . The EDF is a consistent estimator of the CDF. it is helpful to think of a random pair (yi . Thus by the WLLN (Theorem 5. Fn is a nonparametric estimate of F. 50.2. the EDF is only a crude approximation to the CDF. F (y. x) →p F (y. (8. The random draws are from the N (0. Note that while F may be either discrete or continuous..1). I have plotted the EDF and true CDF for three random samples of size n = 25. as the sample size gets larger. For n = 25. x). in the Figure below. Fn (y.3. x) (1 − F (y. x) = n i=1 Figure 8. where 1(·) is the indicator function.2 The Empirical Distribution Function Fn (y. Fn is by construction a step function. i = 1.1: Empirical Distribution Functions The EDF is a valid discrete probability distribution which puts probability mass 1/n at each ∗ pair (yi .

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

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

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

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

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

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. F ) = Φ + o (1) . Equivalently. The following notation will be helpful. The ideal test rejects if Wn ≥ qn (α). we would use a Wald statistic ³ ´ ³ ´0 ˆ θ Wn (θ) = n ˆ − θ Vθ−1 ˆ − θ θ or some other asymptotically chi-square statistic. Deﬁnition 8. F ) then ³x´ . Let an be a sequence.1 an = o(1) if an → 0 as n → ∞ Deﬁnition 8.4) v ¡ ¢ While (8.3 an = o(n−r ) if nr |an | → 0 as n → ∞. θ θ θ ˆ θ ∗ ∗ Computationally. We say that a function g(x) is even if g(−x) = g(x). where qn (α) is the (1 − α)% quantile of the distribution of Wn .8.8.3) ´ √ ³ˆ If Tn = n θ − θ0 then v = V while if Tn is a t-ratio then v = 1. lim Gn (x. θ [This is a typical mistake made by practitioners. then to test H0 : θ = θ0 against H1 : θ 6= θ0 at size α. not ˆ − θ0 . (8. and vice-versa. the critical value qn (α) is found as the quantile from simulated values of W´ . 99 . n ´ ³ ∗ ³ ∗ θ θ Note in the simulation that the Wald statistic is a quadratic form in ˆ − ˆ .2 an = O(1) if |an | is uniformly bounded.∗ 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). The derivative of an even function is odd. where qn (α) is the (1 − α)% quantile of the distribution of ³ ∗ ³ ∗ ´0 ´ ∗ Wn = n ˆ − ˆ Vθ∗−1 ˆ − ˆ . Thus here Tn (θ) = Wn (θ). Deﬁnition 8. A better asymptotic approximation may be obtained through an asymptotic expansion. about the rate v of convergence. v 2 ). If θ is a vector. an = O(n−r ) if it declines to zero like n−r . Let Tn be a statistic such that (8.] 8.4) says that Gn converges to Φ x as n → ∞. Basically. or the size of the divergence for any particular sample size n. F ) = Φ n→∞ v or ³x´ Gn (x.8 Asymptotic Expansions Tn →d N (0. C4 is called the symmetric percentile-t interval. The bootstrap test ∗ ∗ rejects if Wn ≥ qn (α).8. however. it says nothing. writing Tn ∼ Gn (x.

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

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

which is not pivotal.1 shows that a ﬁrst-order approximation ³x´ + O(n−1/2 ). we ﬁnd Gn (x) = Gn (x. Theorem 8. A reader might get confused between the two simultaneous eﬀects. F0 ) = ∗ 2 (g2 (x. Two-sided tests have better rates of convergence than the one-sided tests. similar to a one-sided test. the asymptotic two-sided test has a better coverage rate than the asymptotic one-sided test. 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 . as it depends on the unknown V. F0 )) + O(n−3/2 ) n = O(n−3/2 ). Twosided tests will have more accurate size (Reported Type I error). This is because the ﬁrst term in the asymptotic expansion. Fn ) = Φ n v ˆ ˆ where V = V (Fn ) is the bootstrap estimate of V.8. meaning that the errors in the two directions exactly cancel out. but one-sided tests might have more power against alternatives of interest. is an even function. 8. Thus a two-sided bootstrap test also achieves an asymptotic reﬁnement. 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 g2 is continuous in F. and for the bootstrap ³x´ + O(n−1/2 ). We know that θ Tn →d N (0.5) to the bootstrap distribution. set Tn = n ˆ − θ0 . This is in contrast to the use of the asymptotic distribution. Fn ) − g2 (x. whose error is O(n−1 ). F ) = Φ v √ where v = V . and bootstrap tests have better rates of convergence than asymptotic tests. √ the last equality because Fn converges to F0 at rate n. the choice between symmetric and equal-tailed conﬁdence intervals is unclear. V ). The diﬀerence is ³x´ ³x´ −Φ + O(n−1/2 ) G∗ (x) − Gn (x. n Thus the diﬀerence between the bootstrap and exact distributions is Gn (x) − Gn (x. Fn ) + O(n−3/2 ). Applying (8.11 Percentile Conﬁdence Intervals ´ √ ³ To evaluate the coverage rate of the percentile interval. Gn (x. Fn ) = Φ(x) + ∗ 2 g2 (x. Therefore. The analysis shows that there may be a trade-oﬀ between one-sided and two-sided tests.Interestingly. g1 . 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 ). G∗ (x) = Gn (x. and needs to be determined on a case-by-case basis.

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

4. The methods discussed above are unattractive for most applications in econometrics because they impose the stringent assumption that xi and εi are independent. F0 (x) (1 − F0 (x))) . Show that this bootstrap procedure is (numerically) identical to the non-parametric bootstrap. Let β denote the ˆ the OLS residuals.. Typically what is desirable is to impose only the regression condition E (εi | xi ) = 0. 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 . yielding OLS estimates β and any other statistic of interest. ei ) : i = 1. e∗ ) from the pair {(xi . ˆ 3. The idea is to construct a conditional distribution for ε∗ so that i E (ε∗ | xi ) = 0 i ¡ ∗2 ¢ E εi | xi = e2 ˆi ¡ ∗3 ¢ E εi | xi = e3 . . n].. 2. Find the bootstrap moments ETn and V ar(Tn ). Let ∗ ∗ ∗ {y1 ..13 Exercises 1. Set y∗ = x∗0 β + e∗ . Let the statistic of interest be the sample mean Tn = y n . OLS estimator from the regression of Y on X. n} . you sample ε∗ using this two-point distribution. One proposal which imposes the regression condition without independence is the Wild Bootstrap. Let Fn (x) denote the EDF of a random sample. generate ∗ bootstrap samples. and set x∗ = xi0 and e∗ = ei0 . That is. Show that √ n (Fn (x) − F0 (x)) →d N (0. yn } be a random sample from the empirical distribution function and let Tn = y ∗ be n ∗ ∗ its sample mean. Take a random sample {y1 . Consider the following bootstrap procedure... creating a random bootstrap data set (Y ∗ . which is a valid statistical approach. Find the population moments ETn and V ar(Tn ).. ˆ Draw (with replacement) n such vectors. draw a ˆ ˆ random integer i0 from [1.. however. yn } with µ = Eyi and σ 2 = V ar(yi ). Unfortunately this is a harder problem.observed values of the regressors.. calculate the estimate ˆ on these samples and then calculate θ ∗ ∗ θ θ)/s(ˆ θ). . It does not really matter. ˆ∗ (b) Regress Y ∗ on X ∗ . 2. i 8.. X ∗ ).. . Consider the following bootstrap procedure for a regression of yi on xi . Using the non-parametric bootstrap. ... and e = Y − X β ˆ (a) Draw a random vector (x∗ . ˆi A conditional distribution with these features will preserve the main important features of the data. Tn = (ˆ − ˆ 104 . whether or not the xi are really “ﬁxed” or random.

5% and 97.95). The ˆ are sorted. with variables listed in the ﬁle hprice1. Let qn (.Show that C exactly equals the Alternative percentile interval (not the percentile-t interval). Using the non-parametric ∗ bootstrap. and ˆ is calculated on each θ ∗ ∗ θ sample. calculate the estimates ˆ on these samples and θ then calculate ∗ ∗ ∗ θ θ Tn = ˆ /s(ˆ ). Calculate 95% conﬁdence intervals for the regression coeﬃcients using both the asymptotic normal approximation and the percentile-t bootstrap. You do this as follows. Estimate a linear regression of price on the number of bedrooms. You want to test H0 : θ = 0 against H1 : θ > 0.95). θ θ) ∗ 1000 samples are generated from the bootstrap distribution. What is wrong with this procedure? Tn = θ/s(θ) n 6.75 and 1. θ respectively. (c) With the given information.05) . You replace c with qn (. Using the non-parametric bootstrap. and the colonial dummy. θ θ)q ∗ θ θ)q ∗ θ/s(θ) 5. ˆ = 1. you generate bootstrap samples.2.95). lot size. ∗ ∗ where s(ˆ is the standard error in the original data. 105 . size of house.dat contains data on house prices (sales).95) denote the 95% quantile of Tn . The test for H0 is to reject if Tn = ˆ ˆ > c where c is picked so that Type I error is α. and the 2. The dataﬁle hprice1. (b) Report the 95% Alternative Percentile interval for θ.05) and qn (. ˆ − s(ˆ n (.2 and s(ˆ = .3. Suppose that in an application. can you report the 95% Percentile-t interval for θ? 7. and deﬁne the bootstrap conﬁdence interval h i C = ˆ − s(ˆ n (. (a) Report the 95% Efron Percentile interval for θ.pdf. ∗ ∗ ∗ Let qn (. and thus reject H0 if ˆ ˆ > q ∗ (.95) denote the 5% θ) ∗ and 95% quantiles of Tn .5% quantiles of the ˆ are .

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

2 GMM Estimator n n ¢ 1¡ 0 ¢ 1X 1X ¡ 0 X Y − X 0 Zβ . the dependence is only up to scale. β GMM does not change.2) g n (β) = (9. Jn (β) = n · g n (β)0 g n (β) = n · |g n (β)|2 .3) The method of moments estimator for β is deﬁned as the parameter value which sets g n (β) = 0. The GMM estimator minimizes Jn (β). This is a non-negative measure of the “length” of the vector g n (β). i i . the square of the Euclidean length. Let and where gi = xi ei .9. β GMM = Z 0 XWn X 0 Z 9. Proposition 9.1 ˆ 2Z 0 XWn X 0 Z β = 2Z 0 XWn X 0 Y While the estimator depends on Wn . For example. let Jn (β) = n · g n (β)0 Wn g n (β). and the GMM estimator is the MME.2. then g n (β) = 0. The idea of the generalized method of moments (GMM) is to deﬁne an estimator which sets g n (β) “close” to zero. gi (β) = xi yi − zi β = n n n i=1 i=1 Deﬁne the sample analog of (9. but this is generally not possible when > k. for if Wn is replaced ˆ by cWn for some c > 0.3 Distribution of GMM Estimator ¡ 0¢ Q = E xi zi Assume that Wn →p W > 0. β ˆ Note that if k = . ˆ Deﬁnition 9.1 β GMM = argmin Jn (β). if Wn = I. ¡ ¢−1 0 ˆ Z XWn X 0 Y. For some × weight matrix Wn > 0.2. then. Then µ ¶ ¶ µ 1 0 1 0 Z X Wn X Z →p Q0 W Q n n 107 ¡ ¢ ¡ 0¢ Ω = E xi x0 e2 = E gi gi . The 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.

GMM estimators are asymptotically normal with “sandwich form” asymptotic variances. In the linear model. ˆ n i=1 gi = gi − g n . a better choice is Wn = (X 0 X)−1 . n n We conclude: Theorem 9. as it has the same asymptotic distribution. Q W ΩW Q Q0 W Q V = Q0 W Q Thus we have Theorem 9. This is a weak concept of optimality. ˆ∗ ˆ 108 . If it is known that E (gi (β)) = 0. as shown by Gary Chamberlain (1987). ˆ we still call β the eﬃcient GMM estimator. This yields the eﬃcient GMM estimator: ¢−1 0 ¡ ˆ Z XΩ−1 X 0 Y. ˆ We have described the estimator β as “eﬃcient GMM” if the optimal (variance minimizing) weight matrix is selected. but it can be estimated consistently. However. V ) . and this is all that is known. This turns out to be W0 = Ω−1 . β). Chamberlain showed that in this context. The proof is left as an exercise. n β − β →d N 0. we can set Wn = I .3.3. no semiparametric estimator (one which is consistent globally for the class of models considered) ¢−1 ¡ . it is semiparametrically eﬃcient. we can deﬁne the residuals ei = yi −zi β and moment equations gi = xi ei = g(wi . this is a semi-parametric problem. This results shows that in the linear model. it turns out that the GMM estimator is semiparametrically eﬃcient. β = Z 0 XΩ−1 X 0 Z ´ ³ ¡ ¢−1 ´ √ ³ˆ . 9. Given any such ﬁrst0ˆ ˆ ˆ ˆ step estimator. as we are only considering alternative weight matrices Wn . Since the GMM estimator has this can have a smaller asymptotic variance than G0 Ω−1 G asymptotic variance. the GMM estimator β is consistent yet ineﬃcient. as the distribution of the data is unknown. W0 = Ω−1 is not known in practice.1 ´ √ ³ˆ n β − β →d N (0.4 Estimation of the Eﬃcient Weight Matrix ˆ Given any weight matrix Wn > 0. where In general. No estimator can do better (in this ﬁrst-order asymptotic sense). ˆ Construct n 1X ˆ g n = g n (β) = gi . This estimator is eﬃcient only in the sense that it is the best (asymptotically) in the class of GMM estimators with this set of moment conditions. For example.and µ µ ¶ ¶ 1 0 1 0 Z X Wn X e →d Q0 W N (0. without imposing additional assumptions. no estimator has greater asymptotic eﬃciency than the eﬃcient linear GMM estimator. For any Wn →p W0 .2 For the eﬃcient GMM estimator. Ω) . Q0 Ω−1 Q ¢−1 ¡ 0 ¢¡ ¢−1 ¡ . The optimal weight matrix W0 is one which minimizes V.

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

1 (Sargan-Hansen). 9. take the linear model yi = β 0 x1i + β 0 x2i + ei with E (x1i ei ) = 0 and E (x2i ei ) = 0. and thus g n can be used to assess whether or not the hypothesis that Egi = 0 is true or not. Note that g n →p Egi . G0 Ω−1 G . n β − β →d N 0. The variance of β may be estimated by G0 Ω−1 G where P ∗ ∗0 P ∂ ˆ ˆ ˆ g g and G = n−1 ˆ ˆ Ω = n−1 0 gi (β). and then β recomputed. this is all that is known.Often. Theorem 9. perhaps obtained by ﬁrst ˆ setting Wn = I. ˆˆ n is a quadratic form in g n . where ³ ´−1 ∂ 0 ˆ ˆ ˆ ˆ Ω = (E (gi gi ))−1 and G = E ∂β 0 gi (β). Identiﬁcation requires l ≥ k = dim(β). For example. The general theory of GMM estimation and testing was exposited by L. β) = 0 holds. so that the linear equation may be written as yi = β 0 x1i + ei . and is thus a natural test statistic for H0 : Egi = 0.5. In this sense an 1i 1i exclusion restriction can be seen as an overidentifying restriction. However. Under the hypothesis of correct speciﬁcation. and if the weight matrix is asymptotically eﬃcient. 1 it is possible that β 2 6= 0.1 Under general regularity conditions.6. i i i i ∂β 1X 0 gi gi − g n g 0 ˆˆ n n i=1 n !−1 . ˆ J = J(β) →d χ2−k . This estimator can be iterated if needed. 110 . 1 2 It is possible that β 2 = 0. Hansen (1982). 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. ´ ³ ¡ ¢−1 ´ √ ³ˆ Theorem 9. 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 . The GMM estimator minimizes J(β) = n · g n (β)0 Wn g n (β) where g n (β) = and Wn = Ã 1X gi (β) n i=1 n ˜ ˜ with gi = gi (β) constructed using a preliminary consistent estimator β.6 Over-Identiﬁcation Test Overidentiﬁed models ( > k) are special in the sense that there may not be a parameter value β such that the moment condition Eg(wi . often the weight ˆ matrix Wn is updated. Thus the model — the overidentifying restrictions — are testable. Since the GMM estimator depends upon the ﬁrst-stage estimator.

however. it is unclear what is wrong.The proof of the theorem is left as an exercise. In contrast.7. The idea was ﬁrst put forward by Newey and West (1987).7 Hypothesis Testing: The Distance Statistic We described before how to construct estimates of the asymptotic covariance matrix of the GMM estimates. 1. If h is non-linear. If the hypothesis is non-linear. but it is typically cause for concern. then D equals the Wald statistic. we can reject the model. the GMM criterion function is J(β) = n · g n (β)0 Wn g n (β) For h : Rk → Rr . The GMM distance statistic is the diﬀerence ˜ ˆ D = J(β) − J(β). the Wald statistic can work quite poorly. D ≥ 0 2.1 If the same weight matrix Wn is used for both null and alternative. When over-identiﬁed models are estimated by GMM. and it is advisable to report the statistic J whenever GMM is the estimation method. and sometimes called a LR-like statistic (the LR is for likelihood-ratio). For a given weight matrix Wn . If the statistic J exceeds the chi-square critical value. The estimates under H1 are ˆ β = argmin J(β) β and those under H0 are ˜ β = argmin J(β). If h is linear in β. and is the preferred test statistic. Proposition 9. h(β)=0 ˆ ˜ The two minimizing criterion functions are J(β) and J(β). This test shares the useful feature of LR tests in that it is a natural by-product of the computation of alternative models. The GMM overidentiﬁcation test is a very useful by-product of the GMM methodology. a better approach is to directly use the GMM criterion function. This result was established by Sargan (1958) for a specialized case. 9. and by L. 111 . current evidence suggests that the D statistic appears to have quite good sampling properties. Based on this information alone. the hypothesis is H0 : h(β) = 0. and some current research suggests that this restriction is not necessary for good performance of the test. Newey and West (1987) suggested to use the same weight matrix Wn for both null and alternative. This is sometimes called the GMM Distance statistic. Hansen (1982) for the general case. 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. This reasoning is not compelling. as this ensures that D ≥ 0. The degrees of freedom of the asymptotic distribution are the number of overidentifying restrictions. D →d χ2 r 3.

In practice. 0 In the linear model ei (β) = yi − zi β. ei (β) = yi − x0 β. but its form does help us think about construction of optimal instruments. 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. ei (β. Given a conditional moment restriction. β). so is just-identiﬁed) yields the best GMM estimator possible.. Which should be selected? This is equivalent to the problem of selection of the best instruments. than the unconditional moment restriction discussed above. x2 . 0 Our linear model yi = zi β + ei with instruments xi falls into this class under the stronger 0 assumption E (ei | xi ) = 0. and then use the ﬁrst k instruments. A recent study of this problem is Donald and Newey (2001).. Which should be used? i i One solution is to construct an inﬁnite list of potent instruments. we can set gi (β) = φ(xi . the model implies more than an unconditional moment restriction of the form Egi (β) = 0. The obvious problem is that the class of functions φ is inﬁnite. an unconditional moment restriction can always be constructed. Setting gi (β) to be this choice (which is k × 1. . β).8 Conditional Moment Restrictions In many contexts. In a joint model of the conditional mean and variance ⎧ yi − x0 β ⎨ i . then xi . It turns out that this conditional moment restriction is much more powerful. while in a nonlinear i regression model ei (β) = yi − g(xi . For example. etc. That is for any × 1 function φ(xi . Another approach is to construct the optimal instrument. i Ai = −σ −2 Ri i . Take the case s = 1. The form was uncovered by Chamberlain (1987). note that Ri = −E (zi | xi ) 112 ¡ ¢ σ 2 = E ei (β)2 | xi . and restrictive. In many cases.. except that in this case zi = xi . It is also helpful to realize that conventional regression models also fall into this class. 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. Let ¶ µ ∂ ei (β) | xi Ri = E ∂β and Then the “optimal instrument” is so the optimal moment is gi (β) = Ai ei (β). are all valid instruments. Then ei (β) = yi − zi β. x3 . in linear regression. γ) = ⎩ 0 β)2 − f (x )0 γ (yi − xi i Here s = 2.9.. β)ei (β) which satisﬁes Egi (β) = 0 and hence deﬁnes a GMM estimator. Ai is unknown. s = 1.

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

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

VR ) where ¡ ¢−1 0 R V. 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. Vn = X X i=1 ˜ and hence R0 β = r. xi . 115 . is deﬁned as Jn (β) = ˜ β = argmin Jn (β).6) (a) Show that you can rewrite Jn (β) in (9. VR = V − V R R0 V R (d) Show that in this setting. The equation of interest is yi = g(xi . The GMM estimator of β. λ) = 1 Jn (β) + λ0 (R0 β − r) where λ is 2 s × 1. subject ˆ i ˆi i=1 to the restriction h(β) = 0. In the linear model Y = Xβ + e with E(xi ei ) = 0. Deﬁne the Lagrangian L(β. Show that the minimizer is ³ ´−1 ³ ´ ˆ ˜ ˆ ˆ ˆ R0 β − r β = β − Vn R R0 Vn R ´ ´−1 ³ ³ ˆ ˆ ˆ R0 β − r . Show how to construct an eﬃcient GMM estimator for β. The observed data is (yi .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. 6.5) n 1 P ˆ where ei are the OLS residuals and Ωn = n n xi x0 e2 . β) + ei E (zi ei ) = 0. zi ). Thus ˜ β = argmin Jn (β) R0 β−r Ã n ! ¡ 0 ¢−1 ¡ 0 ¢−1 X 0 2 ˆ XX xi xi ei ˆ . the distance statistic D in (9. zi is l × 1 and β is k × 1.6) equals the Wald statistic. λ = R0 Vn R (c) Show that if R0 β = r then ´ √ ³˜ n β − β →d N (0. l ≥ k. h(β)=0 (9.5. h(β)=0 The GMM test statistic (the distance statistic) of the hypothesis h(β) = 0 is ˜ D = Jn (β) = min Jn (β).

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

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

2) subject to the restrictions (10. probabilities 1 ³ ´´ . p (10. but must be obtained numerically (see section 6. Ln (β) = Rn (β.3). λ.. λ) is a convex function of λ. pi = ¡ n 1 + λ0 gi (β) Substituting into L∗ we ﬁnd n Rn (β. pn .7) 118 . The solution (when it exists) is well deﬁned since Rn (β. Multiplying the ﬁrst equation by pi .where λ and µ are Lagrange multipliers. we ﬁnd µ = n and 1 ¢. 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. λ) : λ(β) = argmin Rn (β. p1 .5) This minimization problem is the dual of the constrained maximization problem. and using the second and third equations. µ. pi = ³ ˆ ˆ ˆ0 n 1 + λ gi β ˆ Ln = n X i=1 ln (ˆi ) .. (10. µ) = n i=1 i=1 i=1 L∗ n with respect to pi . the Lagrange multiplier λ(β) minimizes Rn (β. λ).1) and (10. (see section 6.5). or equivalently minimizes its negative ˆ (10. This yields the (proﬁle) empirical log-likelihood function for β. . λ(β)) = −n ln (n) − n X i=1 ˆ The EL estimate β is the value which maximizes Ln (β). λ) = −n ln (n) − n X i=1 For given β.5) ˆ ˆ As a by-product of estimation. pi gi (β) = 0.. we also obtain the Lagrange multiplier λ = λ(β). The solution cannot be obtained explicitly.4) (10. 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.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. summing over i. λ ¡ ¢ ln 1 + λ0 gi (β) .

13) Premultiplying by G0 Ω−1 and using (10. λ) = − (10. and Ω = E xi x0 e2 .14) ³ ´ ˆ ˆ 0 ' −G0 Ω−1 g n − G0 Ω−1 Gn β − β 0 + G0 Ω−1 Ωn λ n n n n n n ³ ´ ˆ = −G0 Ω−1 g n − G0 Ω−1 Gn β − β 0 n n n n 119 . λ) jointly solve ³ ´ ˆ n gi β X ∂ ³ ³ ´´ Rn (β. G = −E (xi zi ).13) yields n n Expanding (10.8) and ¢ 0 0 For example.9) and (10. n (10. Gi (.12) ∂β ˆ ˆ0 i=1 1 + λ gi β 1 P 1 P 1 P Let Gn = n n Gi (β 0 ) . ´ √ ³ ˆ n β − β 0 →d √ ˆ nλ →d N (0. ˆ ˆ Proof.12) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ 0 ' G0 λ − λ0 . β λ ∂ ³ ´. ˆ The asymptotic variance V for β is the same as for eﬃcient GMM.2.1 Under regularity conditions. λ) = − (10.10.10).11) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ ˆ 0 ' −g n − Gn β − β 0 + Ωn λ (10. in the linear model.2 Deﬁne Asymptotic Distribution of EL Estimator Gi (β) = ∂ gi (β) ∂β 0 (10. Vλ ) ´ √ ˆ √ ³ˆ where V and Vλ are deﬁned in (10. 0 = Rn (β. Thus the EL estimator is asymptotically eﬃcient.9) (10.10) ¡ Ω−1 N (0. g n = n n gi (β 0 ) and Ωn = n n g (β 0 ) gi (β 0 )0 . (β. 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. and n β − β 0 and nλ are asymptotically independent.11) 0 = ∂λ ˆ0 ˆ i=1 1 + λ gi β ³ ´0 ˆ n X Gi . β) = −xi zi . i=1 i=1 i=1i Expanding (10.

10. LRn = i=1 Theorem 10. The same statistic can be constructed for empirical likelihood.3.16). Since the EL estimator achieves this bound.16) ´ √ ˆ √ ³ˆ n β − β 0 and nλ are asymptotically uncorrelated and hence independent. and (10.15) yields ³ ¡ ¢−1 0 −1 ´ √ √ ˆ nλ ' Ω−1 I − Gn G0 Ω−1 Gn Gn Ωn ng n n n n ³ ¡ 0 −1 ¢−1 0 −1 ´ N (0.1 If Eg(wi . ¥ Chamberlain (1987) showed that V is the semiparametric eﬃciency bound for β in the overidentiﬁed moment condition model. Ω) →d Ω−1 I − G G Ω G GΩ = Ω−1 N (0.7) is n ³ ´´ ³ X ˆ ˆ0 (10. They are asymptotically ﬁrst-order equivalent. by a Taylor expansion. Twice the diﬀerence between the unrestricted empirical likelihood −n log (n) and the maximized empirical likelihood for the model (10.15) (10. V ) ˆ Solving (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. it is an asymptotically eﬃcient estimator for β. n ³ ´´ ´ √ ³ 1 X ³ ˆ ˆ √ g wi .17) 2 ln 1 + λ gi β . This means that no consistent estimator for this class of models can have a lower asymptotic variance than V .15). Vλ ) Furthermore. Proof. 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. tests are based on the diﬀerence in the log likelihood functions.14) for λ and using (10. Ω) GΩ G →d = N (0. and it is advisable to report the statistic LRn whenever EL is the estimation method. 120 . and have the same interpretation. The EL overidentiﬁcation test is similar to the GMM overidentiﬁcation test. since ³ ¡ ¢−1 0 ´ G0 I − Ω−1 G G0 Ω−1 G G =0 (10. (10.3 Overidentifying Restrictions In a parametric likelihood context. First. The overidentiﬁcation test is a very useful by-product of EL estimation.

Second.18) Let the maintained model be where g is × 1 and β is k × 1. 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. a The proof of this result is more challenging and is omitted. Vλ )0 Ω−1 N (0.5 Numerical Computation Gauss code which implements the methods discussed below can be found at http://www.1 Under (10.edu/~bhansen/progs/elike. This test statistic is a natural analog of the GMM distance statistic. Theorem 10. where h : Rk → Ra . LRn →d χ2 . By “maintained” we mean that the overidentfying restrictions contained in (10. 10.18). since ln(1 + x) ' x − x2 /2 for x small. the simple overidentifying restrictions test (10. To test the hypothesis h(β) while maintaining (10.4 Testing Egi (β) = 0 (10.ssc. h(β)=0 ˜ Fundamentally. Instead we use the diﬀerence in log-likelihoods: ³ ´ ˆ ˜ LRn = 2 Ln − Ln .18) are assumed to hold and are not being challenged (at least for the test discussed in this section).prc 121 . The hypothesis of interest is h(β) = 0.17) is not appropriate. 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). Vλ ) ¥ where the proof of the ﬁnal equality is left as an exercise. the restricted EL estimator β is simply an EL estimator with − k + a overidenti˜ ˆ fying restrictions.18) and H0 : h(β) = 0.4.wisc. so there is no fundamental change in the distribution theory for β relative to β.

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

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

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

(11. In matrix notation.1 The × 1 random vector xi is an instrumental variable for (11.4) xi = x2i 2 where z1i = x1i are the included exogenous variables. That is x2i are variables which could be included in the equation for yi (in the sense 125 .3) zi = z2i k2 where E(z1i ei ) = 0 yet E(z2i ei ) 6= 0. Thus we make the partition ¶ µ k1 z1i (11. and assume that E(zi ei ) 6= 0 so there is endogeneity.1 Instrumental Variables 0 yi = zi β + ei Let the equation of interest be (11. β →p β ∗ .1).1) where zi is k × 1.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 ¶ . z1i is an instrumental variable for (11. ¶ µ ∙ β2 β1 1 −1 β 2 e1i + β 1 e2i (e1i − e2i ) ¸µ e1i e2i ¶ ˆ Hence if it is estimated by OLS. So we have the partition µ ¶ z1i k1 (11. 11. We call z1i exogenous and z2i endogenous.1) the structural equation. We call (11.1. In a typical set-up. This is called simultaneous equations bias. this can be written as Y = Zβ + e. at least the intercept). Deﬁnition 11.2) Any solution to the problem of endogeneity requires additional information which we call instruments. so should be included in xi . some regressors in zi will be uncorrelated with ei (for example. By the above deﬁnition.1) if E (xi ei ) = 0. which does not equal either β 1 or β 2 . and x2i are the excluded exogenous variables.

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

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

P = HΛH 0 0 0 where Λ = diag(Il .14) is the probability limit of β 2SLS − β 11. Bekker (1994) pointed out that it also has the reverse implication — that when α = l/n is large. n and (11. ¢ 1 ¡ ¢ 1 ¡ ¢ 1 ¡ 0 E Z PX e = E Γ0 X 0 e + E u0 PX e = αS21 .13).12) and this result. Let q = H 0 ξS −1/2 which satisﬁes Eqq 0 = In and partition q = (q1 q2 ) where q1 is l × 1.Let PX = X (X 0 X)−1 X 0 . 130 . 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 (11.14) In general this is non-zero. except when S21 = 0 (when Z is exogenous). 0). indicating that the bias in 2SLS approaches that of OLS as the number of instruments increases. the bias in the 2SLS estimator will be large. It is also close to zero when α = 0. 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. The consequences of identiﬁcation failure for inference are quite severe.7 Identiﬁcation Failure Recall the reduced form equation Z2 = X1 Γ12 + X2 Γ22 + u2 . By the spectral decomposition of an idempotent matrix. 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 . 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. Indeed as α → 1. l . The parameter β fails to be identiﬁed if Γ22 has deﬁcient rank. the expression in (11.

The n−1/2 is picked because it provides just the right balancing to allow a rich distribution theory. and was examined by Phillips (1989) and Choi and Phillips (1992). 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. N2 since the ratio of two normals is Cauchy.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 . Here. Qc + N2 ˆ As in the case of complete identiﬁcation failure. viz Γ22 = n−1/2 C. but is weak. We see that β is identiﬁed if and only if Γ22 = γ 6= 0. This occurs when Γ22 is full rank. Suppose this condition fails.15) is unaﬀected. standard test statistics have non-standard asymptotic distribution of β distributions.16) ˆ β−β = 1 √ n 1 √ n Pn Pn i=1 xi ei i=1 xi zi →d N1 ∼ Cauchy. the instrument xi is weak for zi if γ = n−1/2 c. E x2 e2 i i n i=1 n (11. meaning that inferences about parameters of interest can be misleading. so E (zi xi ) = 0. This is particularly nasty. Then (11. but (11. as the Cauchy distribution does not have a ﬁnite mean. Suppose that identiﬁcation does not complete fail. Then the model may be written as yi = zi β + ei zi = xi γ + ui and Γ22 = γ = E (xi zi ) /Ex2 . but small. To see the consequences. which occurs i when E (zi xi ) 6= 0. E x2 u2 i i n n i=1 i=1 n n (11. This result carries over to more general settings. In addition. Then by the CLT ¡ ¡ ¢¢ 1 X √ xi ei →d N1 ∼ N 0.15) therefore ¢¢ ¡ ¡ 1 X 1 X √ xi zi = √ xi ui →d N2 ∼ N 0. we ﬁnd that β is inconsistent for β and the ˆ is non-normal.Take the simplest case where k = l = 1 (so there is no X1 ). once again take the simple case k = l = 1. where C is a full rank matrix. 131 .

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

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

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

we expect that Yt and Yt−1 are not independent. To indicate the dependence on time. γ(k) is called the autocovariance function. There proofs are rather diﬃcult.1. . Yt−k ) is independent of t for all k. . Deﬁnition 12. and T to denote the number of observations. Yt−k ) is the autocorrelation function.1 {Yt } is covariance (weakly) stationary if E(Yt ) = µ is independent of t. Deﬁnition 12. we adopt new notation.4 (loose). . Yt−1 ..2 {Yt } is strictly stationary if the joint distribution of (Yt .1. The primary model for multivariate time series is vector autoregressions (VARs). and multivariate (yt ∈ Rm is vector-valued). and Cov (Yt . 12.. Because of the sequential nature of time series..1. however. The primary model for univariate time series is autoregressions (ARs).. We can separate time series into two categories: univariate (yt ∈ R is scalar). so classical assumptions are not valid.1. and use the subscript t to denote the individual observation... T .. The following two theorems are essential to the analysis of stationary time series. Deﬁnition 12. Yt−k ) = γ(k) is independent of t for all k. Theorem 12. 135 .Chapter 12 Univariate Time Series A time series yt is a process observed in sequence over time. t = 1. then Xt is strictly stationary and ergodic.1 Stationarity and Ergodicity Deﬁnition 12.1.3 ρ(k) = γ(k)/γ(0) = Corr(Yt . A stationary time series is ergodic if γ(k) → 0 as k → ∞.) is a random variable..1 If Yt is strictly stationary and ergodic and Xt = f (Yt .

then as T → ∞.3 If Yt is strictly stationary and ergodic and EYt2 < ∞. For Part (2). ˆ ˆ T t=1 γ (k) = ˆ The sample autocorrelation ρ(k) = ˆ γ (k) ˆ .1.2 (Ergodic Theorem). ˆ ˆ T t=1 T t=1 T t=1 By Theorem 12. then as T → ∞. γ (0) ˆ Theorem 12. µ →p E(Yt ). ˆ Part (3) follows by the continuous mapping theorem: ρ(k) = γ (k)/ˆ (0) →p γ(k)/γ(0) = ρ(k). Thus an application of the Ergodic Theorem yields T 1X Yt Yt−k →p E(Yt Yt−k ). ˆ 2. If Xt is strictly stationary and ergodic and E |Xt | < ∞.1 above. ρ(k) →p ρ(k). 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) . T t=1 Thus γ (k) →p E(Yt Yt−k ) − µ2 − µ2 + µ2 = E(Yt Yt−k ) − µ2 = γ(k). ˆ ˆ γ ¥ 136 . and it has a ﬁnite mean by the assumption that EYt2 < ∞.1. ˆ 3.Theorem 12.1. note that γ (k) = ˆ T 1X (Yt − µ) (Yt−k − µ) ˆ ˆ T t=1 = T T T 1X 1X 1X Yt Yt−k − Yt µ − ˆ Yt−k µ + µ2 . γ (k) →p γ(k). 1. Part (1) is a direct consequence of the Ergodic theorem. ˆ Proof. the sequence Yt Yt−k is strictly stationary and ergodic. T 1X Xt →p E(Xt ).

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 ..2. Thus for k > 0.2 Autoregressions In time-series. some versions of the life-cycle hypothesis imply that either changes in consumption. Deﬁnition 12.. A mean-zero AR(1) is Assume that et is iid. 12. 137 . Y1 . Y2 . as it is diﬃcult to derive distribution theories without this property..... . A useful property of a MDS is that et is uncorrelated with any function of the lagged information It−1 . 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. ∞ X = ρk et−k . Regression errors are naturally a MDS.. it is even more important in the time-series context. In fact. ... Letting et = Yt − E (Yt | It−1 ) .} is the past history of the series.. then we have the autoregressive model Yt = α + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et E (et | It−1 ) = 0. We consider the conditional expectation E (Yt | It−1 ) where It−1 = {Yt−1 . Yt−k ) . YT ..1 et is a martingale diﬀerence sequence (MDS) if E (et | It−1 ) = 0. E(Yt−k et ) = 0. k=0 Loosely speaking.12. this series converges if the sequence ρk et−k gets small as k → ∞. or consumption growth rates. should be a MDS. E(et ) = 0 and Ee2 = σ 2 < ∞. Most asset pricing models imply that asset returns should be the sum of a constant plus a MDS. An autoregressive (AR) model speciﬁes that only a ﬁnite number of past lags matter: E (Yt | It−1 ) = E (Yt | Yt−1 ..} are jointly random.3 Stationarity of AR(1) Process Yt = ρYt−1 + et . This occurs when |ρ| < 1. Yt−2 . we ﬁnd Yt = et + ρet−1 + ρ2 et−2 + .. The last property deﬁnes a special time-series process. . . For example. Some time-series processes may be a MDS as a consequence of optimizing behavior. t By back-substitution... the series {.

From Theorem 12.1 If |ρ| < 1 then Yt is strictly stationary and ergodic.4. Note that an equivalent way to say this is that an AR(1) is stationary iﬀ the root of the autoregressive polynomial is larger than one (in absolute value). In general. an AR(1) is stationary iﬀ |ρ| < 1. except that the mean of Yt can be computed from the relationship EYt = α + ρEYt−1 . The AR(k) model is Using the lag operator. ∞ X k=0 ρ2k V ar (et−k ) = 12. or ρ(L)Yt = et where ρ(L) = 1 − ρ1 L − ρ2 L2 − · · · − ρk Lk . Deﬁnition 12. We say that the root of the polynomial is 1/ρ.4 Lag Operator An algebraic construct which is useful for the analysis of autoregressive models is the lag operator.5 Stationarity of AR(k) Yt = ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et . We call ρ(L) the autoregressive polynomial of Yt .1. The operator ρ(L) = (1 − ρL) is a polynomial in the operator L. Lk Yt = Yt−k . we see that L2 Yt = LYt−1 = Yt−2 . Deﬁning L2 = LL. 138 . The AR(1) model can be written in the format Yt − ρYt−1 + et or (1 − ρL) Yt−1 = et .Theorem 12.3. We can compute the moments of Yt using the inﬁnite sum: EYt = ∞ X k=0 ρk E (et−k ) = 0 σ2 . 12. Yt − ρ1 LYt − ρ2 L2 Yt − · · · − ρk Lk Yt = et . the above results are unchanged. We call ρ(L) the autoregressive polynomial of Yt .3. since ρ(z) = 0 when z = 1/ρ. 1 − ρ2 V ar(Yt ) = If the equation for Yt has an intercept. and solving for EYt = EYt−1 we ﬁnd EYt = α/(1 − ρ).1 The lag operator L satisﬁes LYt = Yt−1 .

For an AR(k). This is a special case of non-stationarity. so is xt x0 .6 Let Estimation xt = β = ¡ 1 Yt−1 Yt−2 · · · α ρ1 ρ2 · · · yt = x0 β + et . t Yt−k ¢0 ρk .” If one of the roots equals 1. and is of great interest in applied time series. Let |λ| denote the modulus of a complex number λ. Thus t by the Ergodic Theorem. The Fundamental Theorem of Algebra says that any polynomial can be factored as ¢¡ ¢ ¡ ¢ ¡ ρ(z) = 1 − λ−1 z 1 − λ−1 z · · · 1 − λ−1 z 1 2 k 12.1. we say that ρ(L). we see that Ã !−1 Ã ! T T 1X 1X ˆ β=β+ xt x0 xt et →p Q−1 0 = 0. Note that ut is a MDS.1 The AR(k) is strictly stationary and ergodic if and only if |λj | > 1 for all j. which satisfy ρ(λj ) = 0. The vector xt is strictly stationary and ergodic. it is helpful to deﬁne the process ut = xt et . and by Theorem 12.1. the requirement is that all roots are larger than one. Theorem 12. “has a unit root”. t t T t=1 ¥ Combined with (12. ¢0 Then the model can be written as The OLS estimator is ¡ ˆ To study β.where the λ1 . λk are the complex roots of ρ(z).1) Theorem 12. T t=1 T t=1 ¢−1 0 ¡ ˆ X Y.6. then ˆ β →p β as T → ∞. it is also strictly stationary and ergodic. Thus T T 1X 1X xt et = ut →p E (ut ) = 0.1) and the continuous mapping theorem. β = X 0X (12...1 If the AR(k) process Yt is strictly stationary and ergodic and EYt2 < ∞. and hence Yt . We know that an AR(1) is stationary iﬀ the absolute value of the root of its autoregressive polynomial is larger than one.1.1. By Theorem 12. . Proof.5. One way of stating this is that “All roots lie outside the unit circle. since E (ut | It−1 ) = E (xt et | It−1 ) = xt E (et | It−1 ) = 0. t T t=1 T t=1 139 .. T ¢ ¡ 1X xt x0 →p E xt x0 = Q.

. Divide the sample into T /m blocks of length m.7.. we can apply Theorem 12. as this imposes inappropriate independence. This creates an iid bootstrap sample. Y−k+2 .7. Ω) .. Brieﬂy. . ´ √ ³ ¡ ¢ ˆ T β − β →d N 0.. In particular. Clearly. this cannot work in a time-series application.7 Asymptotic Distribution Theorem 12. t This construction imposes homoskedasticity on the errors e∗ .1 to see that T 1 X √ xt et →d N (0. Fix an initial condition (Y−k+1 . the asymptotic covariance matrix is estimated just as in the cross-section case. we constructed the bootstrap sample by randomly resampling from the data values {yt .7. Method 2: Block Resampling 1. Create the bootstrap series Yt∗ by the recursive formula ˆ ˆ ∗ ˆ ∗ ˆ ∗ Yt∗ = α + ρ1 Yt−1 + ρ2 Yt−2 + · · · + ρk Yt−k + e∗ . This is identical in form to the asymptotic distribution of OLS in cross-section regression. Q−1 ΩQ−1 .8 Bootstrap for Autoregressions In the non-parametric bootstrap. Ω) .12. Simulate iid draws e∗ from the empirical distribution of the residuals {ˆ1 . T t=1 Since xt et is a MDS. Method 1: Model-Based (Parametric) Bootstrap.1 MDS CLT... eT }. t t Theorem 12. i 4.. t then as T → ∞. then as T → ∞. If ut is a strictly stationary and ergodic MDS and E(ut u0 ) = Ω < ∞. which may be diﬀerent than the i properties of the actual ei . Y0 ). 140 . Estimate β and residuals et . there are two popular methods to implement bootstrap resampling for time-series data. xt }. It also presumes that the AR(k) structure is the truth. The implication is that asymptotic inference is the same. ˆ 2. 12. ˆ 1. T t=1 where Ω = E(xt x0 e2 ). e ˆ 3. T 1 X √ ut →d N (0.2 If the AR(k) process Yt is strictly stationary and ergodic and EYt4 < ∞.

(12. The reason why these two procedures are (essentially) the same is the Frisch-Waugh-Lovell theorem. and then perform regression (12. 4.2)-(12. This is a ﬂexible approach which can extract a wide range of seasonal factors.3) or Yt = α0 + α1 t + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et .3) replacing St with St . This presumes that “seasonality” does not change over the sample. ρk ). 3. The seasonal factor is typically estimated by a two-sided weighted average of the data for that season in neighboring years. • You can estimate (12..2. The series ∆s Yt is clearly free of seasonality. ∆s Yt = Yt − Yt−s .. This allows for arbitrary stationary serial correlation. get the ˆ ˆ residual St . This procedure is sometimes called Detrending. That is. • First apply a seasonal diﬀerencing operator.2) (12. • Include dummy variables for each season. and perhaps this was of relevance. Paste the blocks together to create the bootstrap time-series Yt∗ .2).4) There are two essentially equivalent ways to estimate the autoregressive parameters (ρ1 .3) sequentially by OLS. ﬁrst estimate (12. however. 6. and for modelmisspeciﬁcation.4) by OLS. The seasonal adjustment.9 Trend Stationarity Yt = µ0 + µ1 t + St St = ρ1 St−1 + ρ2 St−2 + · · · + ρk St−l + et . draw T /m blocks. Resample complete blocks. The results may be sensitive to the block length. Thus the seasonally adjusted data is a “ﬁltered” series. If s is the number of seasons (typically s = 4 or s = 12). May not work well in small samples. (12. Seasonal Eﬀects There are three popular methods to deal with seasonal data. also alters the time-series correlations of the data.. or the season-to-season change. and the way that the data are partitioned into blocks. • You can estimate (12. 12. 5. 141 . • Use “seasonally adjusted” data. heteroskedasticity. But the long-run trend is also eliminated. . For each simulated sample.

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

Thus ρ(1) = (1 − 1) − α0 − (1 − 1) − · · · − (1 − 1) = −α0 .7) These models are equivalent linear transformations of one another. Since α0 is the parameter of a linear regression. Yt is non-stationary. under H0 . this is the most popular unit root test. It would seem natural to assess the signiﬁcance of the ADF statistic using the normal table. An alternative asymptotic framework has been developed to deal with non-stationary data. However. then Yt is “integrated of order d”. As we discussed before. Thus a time series with unit root is I(1). Hence. The DF parameterization is convenient because the parameter α0 summarizes the information about the unit root. or I(d). So the natural alternative is H1 : α0 < 0. observe that the lag polynomial for the Yt computed from (12. so conventional normal asymptotics are invalid. and test statistics are asymptotically non-normal.7). since ρ(1) = −α0 . we say that if Yt is non-stationary but ∆d Yt is stationary. We do not have the time to develop this theory in detail. Because of this property. Thus if Yt has a (single) unit root. and is called the Augmented Dickey-Fuller (ADF) test for a unit root. (12. Note that the model is stationary if α0 < 0.12 Autoregressive Unit Roots The AR(k) model is ρ(L)Yt = µ + et ρ(L) = 1 − ρ1 L − · · · − ρk Lk . then ∆Yt is a stationary AR process. To see this. Indeed. the natural test statistic is the t-statistic for H0 from OLS estimation of (12. as the models are equivalent.7) is (1 − L) − α0 L − α1 (L − L2 ) − · · · − αk−1 (Lk−1 − Lk ) But this must equal ρ(L). Under H0 . 143 . Yt is non-stationary. but simply assert the main results. 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 . In this case. which is an AR(k-1) in the ﬁrst-diﬀerence ∆Yt . or ρ1 + ρ2 + · · · + ρk = 1.12. the hypothesis of a unit root in Yt can be stated as H0 : α0 = 0. The ergodic theorem and MDS CLT do not apply. Yt has a unit root when ρ(1) = 0. the model for Yt is ∆Yt = µ + α1 ∆Yt−1 + · · · + αk−1 ∆Yt−(k−1) + et .

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

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

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

h¡ 1 Yt−1 · · · 0 Yt−k Zt−1 · · · 0 Zt−k ¢0 i . it is convenient to re-deﬁne the variables.3) which is a valid regression model.1).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. under the restriction γ = −βθ. 147 . xt−1 ) to the regression. (A simple version of this estimator is called Cochrane-Orcutt. If valid. which once was very popular. (13. and subtract oﬀ the equation once lagged multiplied by θ. t and et is iid N (0.2) is uncommon in recent applications. t t−1 (13. Let et = ejt and β = aj .2) is a special case of (13. and simple way to test for omitted serial correlation is to test the signiﬁcance of extra lagged values of the dependent variable and regressors. direct estimation of (13. 13. t and xt = This is just a conventional regression. the model (13.13. to get t ¡ ¢ ¡ ¢ yt − θyt−1 = x0 β + et − θ x0 β + et−1 t t−1 = x0 β − θxt−1 β + et − θet−1 .3). 1).2) Take the equation yt = x0 β + et . Let yt = Yjt . t or yt = θyt−1 + x0 β + x0 γ + ut . which is called a common factor restriction. we are only interested in a single equation out of a VAR system. We see that an appropriate. Then the null and alternative are H0 : θ = 0 H1 : θ 6= 0. Then yt = x0 β + et t et = θet−1 + ut E (ut | It−1 ) = 0. j Often. and is still routinely reported by conventional regression packages. So testing H0 versus H1 is equivalent to testing for the signiﬁcance of adding (yt−1 . The DW test is appropriate only when regression yt = x0 β + et is not dynamic (has no lagged values on the RHS).4 Single Equation from a VAR Yjt = a0 xt + et . Then the single equation takes the form (13. This can be done by a Wald test. In this case. Otherwise it is invalid. with time series data. Another interesting fact is that (13. You may have heard of the Durbin-Watson test for omitted serial correlation. This restriction.1) yt = x0 β + et . general.) Since the common factor restriction appears arbitrary. Suppose that et is an AR(1). may be tested if desired.5 Testing for Omitted Serial Correlation Consider the problem of testing for omitted serial correlation in equation (13. and is typically rejected empirically. and Zt be the other variables.

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

The r vectors in β are called the cointegrating vectors. from OLS of Y1t on Y2t .9 Cointegrated VARs A(L)Yt = et A(L) = I − A1 L − A2 L2 − · · · − Ak Lk We can write a VAR as or alternatively as ∆Yt = ΠYt−1 + D(L)∆Yt−1 + et where Π = −A(1) = −I + A1 + A2 + · · · + Ak . Suppose that β is known. so zt = β 0 Yt is known.1 The m × 1 series Yt is cointegrated if Yt is I(1) yet there exists β. and was articulated in detail by Engle and Granger (1987). but it is useful in the construction of alternative estimators and tests. it may be believed that β is known a priori. Hansen (1992). Engle and Granger (1987) suggested using an ADF test on the estimated ˆ0 ˆ residual zt = β Yt . of rank r. then it turns out that β can be consistently estimated by an OLS regression of one component of Yt on the others. When the data have time trends. then β = (1 − 1)0 speciﬁes that log(Consumption/Income) is stationary. Often. Deﬁnition 13. then β = (1 − 1)0 speciﬁes that the spread (the diﬀerence in returns) is stationary. In other cases. 149 . the asymptotic distribution of the test is aﬀected by the presence of the time trend. then r = 0. For example. In some cases. β may not be known.8 Cointegration The idea of cointegration is due to Granger (1981). We are often interested in testing the hypothesis of no cointegration: H0 : r = 0 H1 : r > 0. For 0 < r < m. If Y = (log(Consumption) log(Income))0 . This is not. yet under H1 zt is I(0). β = (1 − 1)0 . Whether or not the time trend is included. in general. Under H0 . 13. When β is unknown.8. If the series Yt is not cointegrated. then Yt is I(0). m × r. Then under H0 zt is I(1).13. Then β 2 = (Y20 Y2 )−1 Y2 Y1 →p β 2 . Furthermore ˆ this estimation is super-consistent: T (β 2 − β 2 ) →d Limit. so the ADF critical values are not appropriate. such that zt = β 0 Yt is I(0). The asymptotic distribution was worked out by Phillips and Ouliaris (1990). Yt is I(1) and cointegrated. if Yt is a pair of interest rates. Y2t ) and β = (β 1 β 2 ) and normalize β 1 = 1. β is not consistent. a good method to estimate β. Thus H0 can be tested using a univariate ADF test on zt . The asymptotic distribution was worked out in B. Their justiﬁcation was Stock’s result that β is superˆ ˆ consistent under H1 . however. If Yt is cointegrated with a single cointegrating vector (r = 1). Thus Yt = ˆ (Y1t . it may be necessary to include a time trend in the estimated cointegrating regression. If r = m. as ﬁrst shown by Stock (1987).

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

14. 1}. so that F (z) = 1 − F (−z).. Even so estimation of a linear probability model is a useful starting point for subsequent analysis. this yields the regression: Yi = x0 β + ei which can be estimated by i OLS. 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.. . however. They still constitute the majority of LDV applications.} • Censored: Y = {x : x ≥ 0} The traditional approach to the estimation of limited dependent variable (LDV) models is parametric maximum likelihood. A major practical issue is construction of the likelihood function. 1} • Multinomial: Y = {0. the linear probability model does not impose the restriction that 0 ≤ P (Yi | xi ) ≤ 1. However. A parametric model is constructed. as this is the full conditional distribution... 1. The most common cases are • Binary: Y = {0.1 Binary Choice The dependent variable Yi = {0. If. you were to write a thesis involving LDV estimation. the goal is to describe P (Yi = 1 | xi ) . allowing the construction of the likelihood function. Given some regressors xi . We will discuss only the ﬁrst (parametric) approach. k} • Integer: Y = {0. The linear probability model speciﬁes that P (Yi = 1 | xi ) = x0 β. For the parametric approach. A more modern approach is semi-parametric. The two standard choices for F are 151 . due to time constraints.Chapter 14 Limited Dependent Variables A “limited dependent variable” Y is one which takes a “limited” set of values. you would be advised to consider employing a semi-parametric estimation approach.. This represents a Yes/No outcome. i As P (Yi = 1 | xi ) = E (Yi | xi ) . estimation is by MLE. 1. typically assumed to be symmetric about zero. 2. eliminating the dependence on a parametric distributional assumption. . 2.

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

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

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

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

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

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

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

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

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

161 . ˆ We can also calculate the moments of the density f (x).This estimator is the average of a set of weights. The bandwidth h controls the meaning of “near”. ˆ(x) is small. Conversely. 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. f (x) is a valid density. That is. 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. If a large number of the observations Xi are near ˆ x. 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 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 . if only a few Xi are near x. then the weights are small and f ˆ ˆ Interestingly. 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. f (x) ≥ 0 for all x.

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

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

which are known as smoothed cross-validation which is a close cousin of the bootstrap. The plug-in approach is to estimate R(f 00 ) in a ﬁrst step. They are also quite ill-behaved when the data has some discretization (as is common in economics).Epanechnikov Kernel: hrule = 2. There are other approaches. This is more treacherous than may ﬁrst appear. as the optimal h for estimation of the roughness R(f 00 ) is quite diﬀerent than the optimal h for estimation of f (x). and then plug this estimate into the formula (16.34n−1/5 Biweight (Quartic) Kernel: hrule = 2.2). 164 . Another popular choice for selection of h is cross-validation. 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. perhaps adjusted by visual inspection of the resulting estimate ˆ f (x). Fortunately there are remedies. There are some desirable properties of cross-validation bandwidths. there are modern versions of this estimator work well. However. but they are also known to converge very slowly to the optimal values. This works by constructing an estimate of the MISE using leave-one-out estimators. I now discuss some of these choices. but implementation can be delicate. in particular the iterative method of Sheather and Jones (1991).

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

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

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

of the random variable X is kXkp = (E |X|p )1/p . The moment generating function (MGF) of X is M (λ) = E exp (λX) . p ≥ 1.3 Expectation For any measurable real function g. The CF always exists. −∞ ∞ −∞ |g(x)| f (x)dx < ∞. More generally. If both I1 = ∞ and I2 = ∞ then Eg(X) is undeﬁned. Eg(X) = j=1 and if X is continuous Eg(X) = The latter is well deﬁned and ﬁnite if Z If (A. If X is discrete. evaluate I1 = Z Z ∞ g(x)f (x)dx. the characteristic function (CF) of X is C(λ) = E exp (iλX) . For m > 0. m C(λ)¯ dλ λ=0 The Lp norm. we deﬁne the mean or expectation Eg(X) as follows. 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. For example. we deﬁne the m0 th moment of X as EX m and the m0 th central moment as E (X − EX)m . (A.A. and when E |X|m < ∞ ¯ ¯ dm ¯ = im E (X m ) . 168 . Two special moments are the mean µ = EX and variance σ 2 = E (X − µ)2 = EX 2 − µ2 .4) does not hold.4) g(x)f (x)dx Z g(x)f (x)dx g(x)>0 I2 = − g(x)<0 If I1 = ∞ and I2 < ∞ then we deﬁne Eg(X) = ∞. We √ call σ = σ 2 the standard deviation of X. this allows the convenient expression V ar(a + bX) = b2 V ar(X). The MGF does not necessarily exist. we say that expectation is a linear operator. Since E (a + bX) = a + bEX. If I1 < ∞ and I2 = ∞ then we deﬁne Eg(X) = −∞. However. √ where i = −1 is the imaginary unit. r X g(τ j )π j . We can also write σ 2 = V ar(X).

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

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

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

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

In particular. y) . Letting x = (x1 . y) fX (x) The conditional density of Y given X = x is deﬁned as fY |X (y | x) = if fX (x) > 0.. we have the k × 1 multivariate mean µ = EX and k × k covariance matrix ¡ ¢ Σ = E (X − µ) (X − µ)0 = EXX 0 − µµ0 If the elements of X are mutually independent.. then Σ is a diagonal matrix and Ã k ! k X X V ar Xi = V ar (Xi ) i=1 i=1 A. . 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) fX (x + ε) ∂2 ∂x∂y F (x. .A k × 1 random vector X = (X1 . ∂x1 · · · ∂xk For a measurable function g : Rk → Rs . y) − F (x. fX (x) 173 .. xk )0 .6 Conditional Distributions and Expectation f (x.. it has the distribution and density functions F (x) = P (X ≤ x) ∂k f (x) = F (x).. y) fX (x) f (x. we deﬁne the expectation Z g(x)f (x)dx Eg(X) = Rk where the symbol dx denotes dx1 · · · dxk . Xk )0 is a function from S to Rk . y) ∂ lim ∂y ε→0 FX (x + ε) − FX (x) ∂ lim ∂y ε→0 ∂ ∂x F (x + ε.

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

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

the density of Y is Ã ! (y − µY )0 Σ−1 (y − µY ) 1 Y exp − f (y) = . where we used the fact that det (BΣB 0 )1/2 = det (Σ)1/2 det (B) . (A. By iterated integration by parts. σ 2 ). For x ∈ Rk . q 176 . The mean and variance of the distribution are µ and σ 2 . This shows that if X is multivariate normal with uncorrelated elements. If X ∈ Rk is multivariate normal and the elements of X are mutually uncorrelated. This shows that linear transformations of normals are also normal. respectively.11) and is known as the chi-square density with r degrees of freedom. If Z is standard normal and X = µ + σZ. q × q. the multivariate normal density is ¶ µ (x − µ)0 Σ−1 (x − µ) 1 .1 Let X ∼ N (0.2 If Z ∼ N(0. x ∈ Rk . then using the change-of-variables formula.8.8. x ∈ Rk . Σ). The latter has no closed-form solution. Since it is symmetric about zero all odd moments are zero. ¢ ¡ 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 . Its mean and r variance are µ = r and σ 2 = 2r. then by the change-of-variables formula. 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 . exp − f (x) = k/2 1/2 2 (2π) det (Σ) The mean and covariance matrix of the distribution are µ and Σ. Σ) and Y = a + BX with B an invertible matrix. A) with A > 0. It is conventional to write X ∼ N (0. 1). y ≥ 0. then they are mutually independent. Theorem A. f (x) = √ 2σ 2 2πσ which is the univariate normal density. Theorem A. Another useful fact is that if X ∼ N (µ. Ir ) and set Q = X 0 X. X has density Ã ! (x − µ)2 1 exp − . −∞ < x < ∞. and to denote the standard normal density function by φ(x) and its distribution function by Φ(x). then Z 0 A−1 Z ∼ χ2 .This density has all moments ﬁnite. and it is conventional to write X ∼ N(µ. and it is conventional to write X ∼ N (µ. Q has the density f (y) = Γ 1 ¡r¢ 2 2r/2 yr/2−1 exp (−y/2) . 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. denoted χ2 . then Σ = diag{σ 2 } is a diagonal matrix.

From (A. For Z ∼ N(0. Thus the density of Z 2 is (A. we see that the MGF of Z 2 is (1 − 2t)−1/2 . Iq ).13) is the MGF of the density (A. C −1 AC −10 ) = N (0. ¡ ¢ √ using the change—of-variables s = x2 and the fact Γ 1 = π. Set r Z . Since we can write Q = P 2 X 0 X = r Zj where the Zj are independent N(0.13). q Proof of Theorem A.3 Let Z ∼ N (0.8.3. Then A−1 = C −10 C −1 and C −1 Z ∼ N (0. 1). 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 . Using the simple law of iterated expectations. The MGF for the density (A.Theorem A. 1) and Q ∼ χ2 be independent.12) E exp (tQ) = 0 Γ (A. tr has distribution 177 . (A.11) 2 with r = 1. which we showed in (A. Thus ¥ ¡ ¢0 ¡ ¢ Z 0 A−1 Z = Z 0 C −10 C −1 Z = C −1 Z C −1 Z ∼ χ2 .2. Proof of Theorem A.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).8. The fact that A > 0 means that we can write A = CC 0 where C is non-singular.11). tr = p Q/r The density of tr is and is known as the student’s t distribution with r degrees of freedom.1. 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. which can be found by applying change-of-variables to the gamma function.8.8.

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

θ) →p E ln f (Yi . θ0 ) ∂θ∂θ 0 (A.14) ¶ ∂ ∂ 0 ln f (Yi . ´ ¡ −1 ¢ √ ³ˆ n θ − θ0 →d N 0.16) (A. 179 . ˆ →p θ0 as n → ∞. θ Theorem A.2 Cramer-Rao Lower Bound. θ) ≡ L(θ). under conventional regularity conditions. cases are rare. we can see that it is an estimator of the maximizer θ of the right-hand-side. θ θ∈Θ ˆ In some simple cases. θ) The Cramer-Rao Theorem gives a lower bound for estimation. the log-likelihood is a sample average 1X 1 Ln (θ) = ln f (Yi . the restriction to unbiased estimators means that the theorem has little direct relevance for ﬁnite sample eﬃciency. the MLE θ Why do we believe that the MLE ˆ is estimating the parameter θ? Observe that when stanθ dardized.17) The matrix I0 is called the information.Deﬁne the Hessian H = −E and the outer product matrix Ω=E µ ∂2 ln f (Yi .9. n n i=1 n As the MLE ˆ maximizes the left-hand-side.16). which maximizes the log-likelihood).3 Under regularity conditions. The ﬁrst-order condition for the latter problem is 0= ∂ ∂ L(θ) = E ln f (Yi . In fact. Theorem A.9. However. I0 . The maximum likelihood estimator or MLE ˆ is the parameter value which maximizes θ the likelihood (equivalently.1 ¯ ¯ ∂ E ln f (Yi . θ) ∂θ ∂θ which holds at θ = θ0 by (A. θ0 ) ln f (Yi . and the equality (A. ∂θ ∂θ (A.9. but these ˆ must be found by numerical methods. θ)¯ =0 ¯ ∂θ θ=θ0 H = Ω ≡ I0 (A. If ˜ is an unbiased estimator of θ ∈ R. We can write this as ˆ = argmax Ln (θ). ˆ is consistent θ for this value.17) is often called the information matrix equality. then θ V ar(˜ ≥ (nI0 )−1 .15) Two important features of the likelihood are Theorem A. we can ﬁnd an explicit expression for θ as a function of the data. More typically. θ0 ) .

17) does not hold.14) n ³ ´ 1 X ∂2 ˆ ˆ ln f Yi . since the information matrix equality (A. Thus the QMLE θ0 is the value which makes the parametric density “closest” to the true value according to this measure of distance.18) H =− n ∂θ∂θ0 i=1 the Kullback-Leibler information distance between the true density f (y) and the parametric density f (y. θ) θ In this case.ˆ ˆ−1 θ We then set I0 = H −1 . θ θ Ω= n ∂θ ∂θ n i=1 ˆ ˆ ˆˆ V = H −1 ΩH −1 Asymptotic standard errors (sometimes called qmle standard errors) are then the square roots of ˆ the diagonal elements of n−1 V . ˆ . θ) ¶ dy Thus in large samples. The QMLE is consistent for the pseudo-true value.9.3) yields the asymptotic distribution of the QMLE: ´ √ ³ n ˆ − θ0 →d N (0. Typically. θ (A. Instead we deﬁne the pseudo-true value θ0 as the maximizer of Z E ln f (Yi . In this case there is not a “true” value of the parameter θ. ˆ elements of n 0 Sometimes a parametric density function f (y.18) and ³ ³ ´ ∂ ´0 1X ∂ ˆ ln f Yi . Asymptotic standard errors for ˆ are then the square roots of the diagonal −1 I −1 . we refer to Ln (ˆ as a quasi-likelihood and the its maximizer ˆ as a quasi-mle or QMLE. to estimate the asymptotic variance of the MLE we use an estimate based on the Hessian formula (A. the approximate variance of the MLE is (nI0 )−1 which is the CramerRao lower bound. 180 . but it is not literally believed that the model f (y. Therefore the MLE is called asymptotically eﬃcient. Thus in large samples the MLE has approximately the best possible variance. θ). θ) is used to approximate the true unknown density f (y). ˆ ln f Yi . θ) = f (y) ln f (y. θ) is necessarily the true density. θ) dy which is the same as the minimizer of KLIC = Z f (y) ln µ f (y) f (y. θ V = H −1 ΩH −1 The moment estimator for V is ˆ where H is given in (A. A minor adjustment to Theorem (A. V ) . but has a diﬀerent covariance matrix than in the pure MLE case.

θ) dy ¯ ¯ ∂θ θ=θ0 ¯ ∂ ¯ 1¯ = 0. To see (A. θ0 )2 (Yi . y y θ(˜ y y y θS 1 = θ(˜ ∂θ ∂θ By the Cauchy-Schwarz inequality ¯ ³ ´¯2 ³ ´ ¯ ¯ θS θ 1 = ¯E ˜ ¯ ≤ V ar (S) V ar ˜ ³ ´ V ar ˜ ≥ θ 1 1 = . f (Yi . function of the data. θ0 = ln f (Yi . yn ). θ0 ) (Yi . Proof of Theorem A. θ0 ) ∂θ f (Yi . θ0 ) ∂ ∂ − ln f (Yi . ¯ ¯ ∂ E ln f (Yi .9.16). θ)¯ = ¯ ∂θ θ=θ0 = = = Similarly. θ0 )0 f (Yi . . Diﬀerentiating with respect to θ and evaluating at θ0 yields ˜ Z Z ³ ´ ˜ y ) ∂ f (˜. Since θ Z ˜ = ˜ y)f (˜. (Yi . θ0 ) ∂θ ∂θ ¥ ³ ´ X ∂ ∂ ˜ ln fn Y . Write the estimator ˜ = ˜ Y ) as a θ θ( ˜ ˜ is unbiased for any θ. θ) d˜ θ = Eθ θ(˜ y y where y = (y1 . θ) f (y. θ0 ) ∂ ∂θ f ∂ (Yi .1) has mean zero and variance nH. θ0 ) d˜ = E ˜ . V ar (S) nH so ¥ 181 . θ) dy ¯ ∂θ f (y. S= ∂2 f ∂θ∂θ0 ∂2 f ∂θ∂θ0 ∂ ∂θ Z Ã ∂2 f ∂θ∂θ0 ¯ ¯ ln f (y.Proof of Theorem A.9. ∂θ ¯θ=θ0 Z ! = 0. θ) f (˜. θ0 ) = ∂θ∂θ0 = Taking expectations yields (A. θ0 ) − f (Yi .17)..1. θ0 ) ¯ ∂ f (y. θ) d˜ = ˜ y ) ∂ ln f (˜.2. θ0 ) dy ¯ ¯ ¯ θ=θ0 f (y. θ0 ) f (Yi . ∂2 ln f (Yi . we can show that E By direction computation. θ) ¯θ=θ0 ¯ Z ¯ ∂ f (y. θ0 )0 .. θ0 ) ∂θ ∂θ n i=1 which by Theorem (A..9. θ0 ) ln f (Yi .

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

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

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

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

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