ECONOMETRICS

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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. . . . . . . . . . 9. . .5 Stationarity of AR(k) . . . . . . . . . . . . . . . . . . . . . . . . . .8. . . . . . . . . . .6 Over-Identification Test . .1 Non-Parametric Likelihood . . . . . . . . . . . . . . . . . . . . . . . . . 11.6 Estimation . . 9. . . . . . . . . . . . . . . . . . . . .11 8. . 9. . . 11. . . . .10 8. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Instrumental Variables . . . . . . . . . . Bootstrap Methods for Regression Models Exercises . . . . . . . . . . . . . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . . . . . . . .7 Asymptotic Distribution . . . . . . . . . . .2 Asymptotic Distribution of EL Estimator 10. . . . . . . . . . . . . . . . . . . . . . . 9. . . . . . . . . . . . .12 8. . . . . . . . . . . . . . . .7 Identification Failure . .2 GMM Estimator . . . . . . . . . .13 One-Sided Tests . . . . . . . . .3 Overidentifying Restrictions .5 Special Cases: IV and 2SLS 11. . . . . . . . . . . . . iii . . . . . . . . . 11. Symmetric Two-Sided Tests . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10. . . . . . . . . . . . . . . . . . . . . . . . . . . .3 Stationarity of AR(1) Process . . . . . . . . 10. . . . . . . . . . . . . . . . .9 8. . . . . . . . . . . . . . . . . . . . .3 Distribution of GMM Estimator . . . . . . . . . 12. . . .10Testing for Omitted Serial Correlation 12. . . . . . . . . . . . . . 12. . . . . . . . . . . . . . . . .1 Overidentified Linear Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8 Exercises . . . . . . .1 Stationarity and Ergodicity . .2 Reduced Form . . . . . . . . .4 Lag Operator . . . . . . . . . . 11. . . . . . .7 Hypothesis Testing: The Distance Statistic 9. . . 10 Empirical Likelihood 10. . 11. . . . . .3 Identification . . . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . .2 Autoregressions . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . .10 Exercises . 9. . . . . . . . .4 Testing . . . . . . . . . . . . . . . . . .4 Estimation of the Efficient Weight Matrix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8 Bootstrap for Autoregressions . . . . . . . 12. . . . . . .9 Bootstrap GMM Inference . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5 Numerical Computation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5 GMM: The General Case . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10. . . . . . . . . . . . . . . . . . . . . . . . . . . . .8 Conditional Moment Restrictions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 Endogeneity 11. . . . . . . . . . . . . . . 12 Univariate Time Series 12. . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9. . . . . 9. . .9 Trend Stationarity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11. . . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 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. . . . . . . . . . . . . . . . . . . . .12Autoregressive Unit Roots . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4 Estimation . . . . . . . . . . . .6 Bekker Asymptotics . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . .11Model Selection . . . . . . . . . . . . . . . . . . . Percentile Confidence Intervals .

. . . . . . . . A.4 Sample Selection . . . . . . . . . . . . .5 Testing for Omitted Serial Correlation 13. . . . . . . . . . . . . . . . . B. . . . . . . . .3 Dynamic Panel Regression . . . . . . . . . . .7 Granger Causality . . . . . . . . . . . . . . . . . .6 Conditional Distributions and Expectation . . . . . . . . . . . . . . . . . . . . . . . . . . . B Numerical Optimization B. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8 Normal and Related Distributions . . .9 Maximum Likelihood . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165 165 167 168 169 171 173 175 175 178 183 183 184 185 . . . . . A.2 Estimation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . iv . . . . . . . . . . . . . . . . . . . . . . . . 14 Limited Dependent Variables 14. . . . . . 13. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162 A Probability A. . . . . .1 Vector Autoregressions (VARs) . . . . A. . . . . 145 145 146 146 147 147 148 148 149 149 151 151 153 153 154 . . .3 Censored Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2 Random Variables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4 Common Distributions . .8 Cointegration .3 Expectation . . 157 15. . . . . . . . . . . . . . . . . . .2 Asymptotic MSE for Kernel Estimates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A. . . . . 13. . . . . . . . . . . . . . . 14. . . . .1 Binary Choice . . . . . . . . . . . . . . . . . . . .5 Multivariate Random Variables . . . . . . . . 15 Panel Data 157 15. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13. . . .3 Restricted VARs . . . 157 15.2 Fixed Effects . . . . . . . . . . . . . .1 Individual-Effects Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4 Single Equation from a VAR . . . . . . . . . . A. . . . 14. . . . . . . . . .7 Transformations . . . . . . . . A. . . . . . . . . . . . . . . . . . . . . . . . . . . . .2 Gradient Methods . . . . . . . . . . . . . . . .1 Foundations . . . . . . . . . .3 Derivative-Free Methods . . . . B. . . . . . . . . . . .2 Count Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13. . . . . . . . . . . . .6 Selection of Lag Length in an VAR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Kernel Density Estimation . . . . . . . .1 Grid Search . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13. A. . . . . . 13.13 Multivariate Time Series 13. . . . . . . . . . . . . . . . . . . . . A. . . . . . . . . . . 160 16. . . . . . . . . . . . . . . . .9 Cointegrated VARs . . . . . . . . . . . . . . . . . . . . 13. . . . . . . . . . . . . . . . . . . . . . . . 159 16 Nonparametrics 160 16. . .

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

For example..bls. the development of the internet has provided a convenient forum for dissemination of economic data. 1.3 Random Sample Typically. an econometrician has data {(y1 . x1 ) ..edu/Data/index.gov/ Federal Reserve Bank of St. This is an alternative explanation for an observed positive correlation between educational levels and wages. This abstraction can a source of confusion as it does not correspond to a physical population in the real world. This “population” is infinitely large. and are typically called dummy variables.. and the goal of statistical inference is to learn about features of F from the sample.census. xi ) is independent of the pair (yj .. The fact that a person is highly educated suggests a high level of ability.. xj ) for i 6= j.4 Economic Data Fortunately for economists.federalreserve. Sometimes the independent part of the label iid is misconstrued.html.g. xi } ∈ R × Rk is an observation on an individual (e.org/ US Census: http://www.wustl. n} where each pair {yi .. An excellent starting point is the Resources for Economists Data Links. xi ) . available at http://rfe.. We call these observations the sample. xi ) : i = 1. If the data is cross-sectional (each observation is a different individual) it is often reasonable to assume they are mutually independent. Louis: http://research. In this case the data are independent and identically distributed. We will return to a discussion of some of these issues in Chapter 11.org/fred2/ Board of Governors of the Federal Reserve System: http://www. At this point in our analysis it is unimportant whether the observations yi and xi come from continuous or discrete distributions. These factors are likely to be affected by their personal abilities and attitudes towards work. . The random variables (yi .stlouisfed.gov/econ/www/ 2 . many regressors in econometric practice are binary. Some other excellent data sources are listed below.nber.. household or firm). xi ) have a distribution F which we call the population. and therefore choose to attain higher levels of education. . taking on only the values 0 and 1. Causal inference requires identification.. High ability individuals do better in school. The distribution F is unknown. The point is that multiple explanations are consistent with a positive correlation between schooling levels and education. . We call this a random sample. (y2 . a person’s level of education is (at least partially) determined by that person’s choices and their achievement in education. (yn . (yi . If the data is randomly gathered. This discussion means that causality cannot be infered from observational data alone. it is reasonable to model each observation as a random draw from the same probability distribution.gov/releases/ National Bureau of Economic Research: http://www. It is not a statement about the relationship between yi and xi . Rather it means that the pair (yi . and this is based on strong assumptions. Bureau of Labor Statistics: http://www. 1. xn )} = {(yi .. or iid. and their high ability is the fundamental reason for their high wages. Knowledge of the joint distibution cannot distinguish between these explanations. Many large-scale economic datasets are available without charge from governmental agencies. x2 ) . For example.

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

If r = 1 or k = 1 then A is a vector. typically arranged in a column. ⎥ = [aij ] . ⎦ . . ak . . A matrix A is a k × r rectangular array of numbers. . ⎦ ⎣ . If k = 1 then a is a scalar. That is. A vector a is a k × 1 list of numbers. written as ⎤ ⎡ a11 a12 · · · a1r ⎢ a21 a22 · · · a2r ⎥ ⎥ ⎢ A=⎢ . ⎟ ⎝ . If r = k = 1. 2.1 Terminology Equivalently. hence a ∈ Rk . . ⎥ ⎣ . . ⎡ 0 ⎤ α1 ⎢ α0 ⎥ ¤ ⎢ 2 ⎥ £ A = a1 a2 · · · ar = ⎢ . then A is a scalar. . . α0 k where ⎢ ⎢ ai = ⎢ ⎣ 4 ⎡ a1i a2i . A matrix can be written as a set of column vectors or as a set of row vectors. We write this as ⎞ ⎛ a1 ⎜ a2 ⎟ ⎟ ⎜ a=⎜ . ak1 ak2 · · · akr By convention aij refers to the i0 th row and j 0 th column of A. . aki ⎤ ⎥ ⎥ ⎥ ⎦ A scalar a is a single number.Chapter 2 Matrix Algebra This chapter reviews the essential components of matrix algebra. a vector a is an element of Euclidean k space. ⎠ .

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

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

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

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

For a general k × k matrix A = [aij ] . xk ) be k × 1 and g(x) = g(x1 . ∂ g(x) ∂xk ··· ∂ ∂xk g(x) ⎞ ³ ∂ g(x) = ∂x0 Some properties are now summarized.. and let επ = +1 if this count is even and επ = −1 if the count is odd. Additionally. .7 Matrix Calculus ⎛ ∂ ∂x1 g(x) Let x = (x1 .. .. we can define the determinant as follows. .. 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 .. • • • • ∂ ∂x ∂ ∂x0 ∂ ∂x ´ .By the uniqueness of the characteristic roots. (a0 x) = ∂ ∂x (x0 a) = a (Ax) = A (x0 Ax) = (A + A0 ) x (x0 Ax) = A + A0 ∂2 ∂x∂x0 2.8 Determinant The determinant is defined for square matrices. tr(A) = rank(A). we deduce that Λ2 = Λ and λ2 = λi for i = 1. It follows that the spectral decomposition of A takes the form ¸ ∙ In−k 0 (2.. jk ) denote a permutation of (1. .. k)). The vector derivative is ∂ ⎜ g(x) = ⎝ ∂x ∂ ∂x1 g(x) and ⎟ ..4) H0 M =H 0 0 with H 0 H = In . .. Let π = (j1 ... ⎠ . k) . . then its determinant is det A = a11 a22 − a12 a21 .. . 2. There are k! such permutations. There is a unique count of the number of inversions of the indices of such permutations (relative to the natural order (1. k. If A is 2 × 2.. i Hence they must equal either 0 or 1..... xk ) : Rk → R..

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

holding the other variables constant. This is used when the goal is to quantify the impact of one set of variables on another variable. ⎟ . from the population of white non-military wage earners with a college degree and 10-15 years of potential work experience. ⎠ ⎝ .2) m(x) = E (yi | xi = x) = −∞ In general. . and that for women is $20.1 Conditional Mean To study how the distribution of yi varies with the variables xi in the population. we can focus on f (y | x) . When a distribution is skewed. m(x) can take any form. An important summary measure is the conditional mean Z ∞ yf (y | x) dy. These are conditional density functions — the density of hourly wages conditional on race.1 displays the density1 of hourly wages for men and women.Chapter 3 Regression and Projection The most commonly applied econometric tool is regression. Take a closer look at the density functions displayed in Figure 3. the mean wage for men is $27. the mean is not necessarily a good summary of the central tendency.1. xi ) where yi is a scalar (real-valued) and xi is a vector. the conditioning variable. We list the elements of xi in the vector ⎞ ⎛ x1i ⎜ x2i ⎟ ⎟ ⎜ (3. In this context we partition the observations into the pair (yi . or the covariates. You can see that the right tail of then density is much thicker than the left tail. These are asymmetric (skewed) densities. and exists so long as E |yi | < ∞. To illustrate. The data are from the 2004 Current Population Survey 1 11 . xki 3.1) xi = ⎜ . (3.73. These are indicated in Figure 3. The two density curves show the effect of gender on the distribution of wages.1 by the arrows drawn to the x-axis.1. it is useful to have numerical measures of the difference. See Chapter 16. In this context it is often convenient These are nonparametric density estimates using a Gaussian kernel with the bandwidth selected by crossvalidation. In the example presented in Figure 3. We call yi the dependent variable. education and experience. While it is easy to observe that the two densities are unequal. gender. which is a common feature of wage distributions. the conditional density of yi given xi . Figure 3.22. We call xi alternatively the regressor.

For this reason.5. Assuming for simplicity that this is the true joint distribution. implying an average 36% difference in wage levels.2 Regression Equation The regression error ei is defined to be the difference between yi and its conditional mean (3.1: Wage Densities for White College Grads with 10-15 Years Work Experience to transform the data by taking the (natural) logarithm. Of particular interest to graduate students may be the observation that difference between a B. 3. then comparisons become more complicated.3 displays a scatter plot2 of log wages against education levels. The main point to be learned from Figure 3. 12 . which implies a 30% average wage difference for this population.30.3) White non-military male wage earners with 10-15 years of potential work experience. The conditional expectation function is close to linear. The difference in the log mean wage between men and women is 0. wage regressions typically use log wages as a dependent variable rather than the level of wages. This is a more robust measure of the typical wage gap between men and women than the difference in the untransformed wage means. this yields the formula yi = m(xi ) + ei . By construction. Figure 3. 2 (3.2) evaluated at the observed value of xi : ei = yi − m(xi ). When the distribution of the control variable is continuous. and a Ph. the dashed line is a linear projection approximation which will be discussed in the Section 3.Figure 3.1 is facilitated by the fact that the control variable (gender) is discrete. degree in mean log hourly wages is 0.D.A. The comparison in Figure 3.36. with mean log hourly wages drawn in with the arrows.3 is how the conditional expectation describes an important feature of the conditional distribution. the solid line displays the conditional expectation of log wages varying with education. Figure 3.2 shows the density of log hourly wages for the same population. To illustrate.

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

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

which we derive in this section. xki When m(x) is linear in x. Notationally.7) is a k × 1 parameter vector. and the linear assumption of the previous section is empirically unlikely to accurate. ⎟ . The conditional standard deviation for men is 12. So while men have higher average wages.3) is when the conditional mean function m(x) is linear in x (or linear in functions of x). In this case (3. i (3. ⎠ . they are also somewhat more dispersed. take the conditional wage densities displayed in Figure 3. An important special case is homoskedastic linear regression model yi = x0 β + ei i E (ei | xi ) = 0 ¢ ¡ E e2 | xi = σ 2 . ⎠ . 3.4 Linear Regression An important special case of (3. Equation (3. We call this the “constant” or “intercept”. it is convenient to augment the regressor vector xi by listing the number “1” as an element. we can write it as m(x) = x0 β = β 1 + x2i β 2 + · · · + xki β k where ⎞ β1 ⎜ . βk ⎛ (3.8) (3. we assume that x1i = 1. Some textbooks inappropriately describe heteroskedasticity as the case where “the variance of ei varies across observation i”. 15 . Thus (3. where x1i is the first element of the vector xi defined in (3. ⎝ . As an example.9) 3. its functional form is typically unknown. it is more realistic to view the linear specification (3.5.3) can be writen as yi = x0 β + ei i E (ei | xi ) = 0.1) has been redefined as the k × 1 vector ⎛ ⎞ 1 ⎜ x2i ⎟ ⎜ ⎟ (3. This concept is less helpful than defining heteroskedasticity as the dependence of the conditional variance on the observables xi .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 .6) (3.we say that the error ei is homoskedastic.6) as an approximation. ⎟ β=⎝ .1). Equivalently.8) is called the linear regression model.1 and that for women is 10.1. Instead.5) xi = ⎜ .

The vector (3. written E (xi x0 ) > 0. xi contains an intercept. i which requires that for all non-zero α. there cannot i exist a non-zero vector α such that α0 xi = 0 identically. this situation must be excluded. alternative expressions such as E xixi ) or E (xi yi ) (E (xi x0 ))−1 i ( i 0i ) are incoherent and incorrect.1 1. i 4. For any β ∈ Rk a linear predictor for yi is x0 β with expected squared prediction i error ¢2 ¡ S(β) = E yi − x0 β i ¢ ¢ ¡ ¡ 2 = Eyi − 2E yi x0 β + β 0 E xi x0 β. i (3. Eyi < ∞. α0 E (xi x0 ) α = E (α0 xi )2 > 0. E (xi x0 ) is a mai E(x y trix and E (xi yi ) is a vector.which is quadratic in β.10). This occurs when redundant variables are included in xi .10) exists and is unique as long as the k ×k matrix E (xi x0 ) is invertible. E (xi x0 ) is invertible. we obtain a decomposition of yi into linear predictor and error yi = x0 β + ei . Rewriting.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 . 2 2. i 16 . Observe i that for any non-zero α ∈ Rk . As before. Assumption 3. We now summarize the assumptions necessary for its derivation and list the implications in Theorem 3. The error is i ei = yi − x0 β. α0 E (xi x0 ) α = E (α0 xi )2 ≥ 0 so the matrix E (xi x0 ) is by construction i i positive semi-definite.1.12) This completes the derivation of the linear projection model. otherwise they are distinct. Equivalently. i (3. Given the definition of β in (3. 3.10) It is worth taking the time to understand the notation involved in this expression. 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. x0 β is the best linear predictor for yi . It is invertible if and only if it is positive definite. i ∂β ¢¢−1 ¡ ¡ E (xi yi ) . Therefore. The best linear predictor is obtained by selecting β to minimize S(β).5. The first-order condition for minimization (from Section 2. i i (3.7) is 0= Solving for β we find ¡ ¢ ∂ S(β) = −2E (xi yi ) + 2E xi x0 β. In order for β to be uniquely defined. E (x0 xi ) < ∞. by “best” we mean the predictor function with lowest mean squared error.

5. (3.2 and 3. Assumption 3. (3.1. For example. Using the definitions (3.5. 17 . Then i i Exi e2 = Ex3 = 0 yet E (ei | xi ) = x2 6= 0. the orthogonality restriction (3.11) are well defined.1. Assumption 3.1 Under Assumption 3.2. Assumption 3.14) Proof. Assumption 3. However.1.1.4 is required to ensure that β is uniquely defined.13) implies that xi and ei are uncorrelated. 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 3.2 and 3.10) and (3.5.10) are defined. suppose that for xi ∈ R that Ex3 = 0 and ei = x2 .13) and Assumption 3.5.Theorem 3.1.1.14) holds.4 we know that the regression error has the property E (xi ei ) = 0.5. Since ei is mean zero by (3. Equation (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 = 0.5.1 are weak.5.4 guarantees that the solution β exits.12) and (3.1. This means that the equation (3.1 is employed to guarantee that (3. Figure 3. ¥ (3.13) The two equations (3.1. E (xi ei ) = 0 and E (ei ) = 0.9).14) follows from (3. Since from Theorem 3. By definition. it follows that linear regression is a special case of the projection model.5. i i i Since E (xi ei ) = 0 we say that xi and ei are orthogonal.11) and (3.12) can be alternatively interpreted as a projection decomposition. Let’s compare it with the linear regression model (3.5. The finite variance Assumptions 3.5.3 ensure that the moments in (3.3 are called regularity conditions.13) summarize the linear projection model. Furthermore.8)-(3.5. x0 β is the i projection of yi on xi since the error ei is orthogonal with xi .1.1.14).

10). In the example just presented.5. The solid line is the conditional mean. Other than the redefinition of the regressor vector.5.5 for a 3 In the population of Caucasian non-military male wage earners with 12 years of education. 18 . and under-predicts for the rest. for any pair (yi . In Figure 1. In this case the linear projection is a poor approximation to the conditional mean. xi ) we can define a linear projection equation (3. In this case (3. it is important to not misinterpret the generality of this statement. for those over 53 in age). the dashed line is the linear projection of log wages on eduction. and the straight dashed line is the linear projection.4 we display as well this quadratic projection. A projection of log wages on these two variables can be called a quadratic projection. In contrast. No additional assumptions are required. We illustrate the issue in Figure 3. we can augment the regressor vector xi to include both experience and experience2 . In this example the linear projection is a close approximation to the conditional mean. This defect in linear projection can be partially corrected through a careful selection of regressors. The linear equation (3.1. Figure 3. in many economic models the parameter β may be defined within the model. It over-predicts wages for young and old workers.We have shown that under mild regularity conditions. since the resulting function is quadratic in experience. These structural models require alternative estimation methods. Most importantly.3. there are no changes in our methods or analysis. and are discussed in Chapter 11. In this example it is a much better approximation to the conditional mean than the linear projection.5: Conditional Mean and Two Linear Projections Another defect of linear projection is that it is sensitive to the marginal distribution of the regressors when the conditional mean is non-linear. it misses the strong downturn in expected wages for those above 35 years work experience (equivalently.12) is defined by projection and the associated coefficient definition (3.10) may not hold and the implications of Theorem 3.1 may be false.12) with the properties listed in Theorem 3. In other cases the two may be quite different. Figure 3. However.4 displays the relationship3 between mean log hourly wages and labor market experience. Returning to the joint distribution displayed in Figure 3.

The data are divided in two — Group 1 and Group 2 — which have different marginal distributions for the regressor xi . combined with different marginal distributions for the conditioning variables. 1). 1) and those in Group 2 are N(4. 1) where m(x) = 2x − x2 /6. The solid line is the non-linear conditional mean of yi given xi . The xi in Group 1 are N(2. and Group 1 has a lower mean value of xi than Group 2. and the conditional distriubtion of yi given xi is N(m(xi ). 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. These two projections are distinct approximations to the conditional mean. This conclusion is incorrect because is fact there is no difference in the conditional mean between the two groups.constructed4 joint distribution of yi and xi . 4 19 . 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.

then ei is i i independent of xi . E(Y 2 | X = x) and V ar(Y | X = x). then E(x2 ei ) = 0.2 Y =1 .. y) = 3 x2 + y 2 on 0 ≤ x ≤ 1. i 8. taking values only on the non-negative integers. True or False. then ei is independent of xi . and E(ei | xi ) = 0. Take the bivariate linear projection model yi = β 0 + β 1 xi + ei E (ei ) = 0 E (xi ei ) = 0 Define µy = Eyi .1 . j! 0 j = 0. then E(x2 ei ) = 0. 2. E(ei | xi ) = 0. 3 and 4 of Theorem 3. m. i 7. 0 ≤ y ≤ 1. Prove parts 2. If yi = x0 β + ei . 1. Suppose that yi is discrete-valued. and have the following joint probability distribution X=0 X=1 Y =0 . . x 6. σ = . σ 2 = V ar(yi ) and σ xy = Cov(xi . yi ). i 10. True or False. and the conditional distribution of yi given xi is Poisson: P (yi = k | xi = x) = e−x β (x0 β)j .3. a constant. Let X be a random variable with µ = EX and σ 2 = V ar(X).1. Does this justify a linear regression model of the form yi = x0 β + εi ? i then EY = λ and V ar(Y ) = λ. True or False. Compute the conditional mean m(x) = E (yi | xi = x) . σ 2 = V ar(xi ). µ. 3. True or False. Compute 2 the coefficients of the linear projection yi = β 0 + β 1 xi + ei . xi ∈ R. Are they different? Hint: If P (Y = j) = 5.4 . Suppose that Y and X only take the values 0 and 1.3 Find E(Y | X = x). i 11. True or False. then E(ei | xi ) = 0. If yi = xi β + ei . (x − µ)2 − σ 2 Show that Eg (X. Show that x y β 1 = σ xy /σ 2 and β 0 = µy − β 1 µx . If yi = x0 β + ei and E(xi ei ) = 0. e−λ λj j! . 2. Compute E(yi | xi = x) and V ar(yi | xi = x). If yi = x0 β + ei and E(ei | xi ) = 0. µx = Exi .2. and E(xi ei ) = 0.6 Exercises 1. Define µ ¶ ¢ ¡ x−µ 2 g x. s) = 0 if and only if m = µ and s = σ 2 . 9. 20 . Let xi and yi have the joint density f (x. ¡ ¢ 4. and E(e2 | xi ) = σ 2 . If yi = xi β + ei . xi ∈ R..

2) (4. The function g(β) can be estimated by form g(β) = E (xi (yi − xi g (β) = ˆ ¢ 1X ¡ xi yi − x0 β . i It follows that the moment estimator of β replaces the population moments in (4. (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 .4) i i=1 i=1 ˆ Another way to derive β is as follows.8. we narrow the focus to the linear regression model.2) can be written in the parametric 0 β)) = 0.7 and 4.1 Estimation Equation (4.3) writes the projection coefficient β as an explicit function of population moments E (xi yi ) and E (xi x0 ) .1) (4. i n i=1 n 21 .3) with the sample moments: ³ ¡ ¢´−1 ˆ ˆ ˆ β = E xi x0 E (xi yi ) i à n !−1 n 1X 1X 0 xi xi xi yi = n n i=1 i=1 à n !−1 n X X = xi x0 xi yi .Chapter 4 Least Squares Estimation This chapter explores estimation and inference in the linear projection model yi = x0 β + ei i E (xi ei ) = 0 ¡ ¡ ¢¢−1 E (xi yi ) β = E xi x0 i (4. Observe that (4.3) In Sections 4. 4. but for most of the chapter we retain the broader focus on the projection model.

170 37.83 ¶−1 µ ¶ .ˆ This is a set of k equations which are linear in β.40 n i=1 1 n Thus ˆ β = n X i=1 xi x0 i = µ 1 14.5) = n n 1X 1X ˆ xi yi − xi x0 β i n n i=1 i=1 whose solution is (4. 0. These are white male wage earners from the March 2004 Current Population Survey.14 14. 40 2. To illustrate.30 + 0.95 42.14 205.95 xi yi = 42. Then µ ¶ n 1X 2.83 µ We often write the estimated equation using the format \ log(W agei ) = 1.40 µ ¶µ ¶ 34.7% increase in mean wages.94 −2.37 µ ¶ 1. ¶ 2. consider the data used to generate Figure 3.14 205. i 22 . excluding military.14 14. Define the sum-of-squared errors (SSE) function n X¡ ¢2 yi − x0 β Sn (β) = i i=1 = This is a quadratic function of β. 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 (4.71 = −2.117 Educationi . Let yi be log wages and xi be an intercept and years of education.3. This sample has 988 observations. An interpretation of the estimated equation is that each year of education is associated with an 11.4). 30 = . 4. n X i=1 2 yi − 2β 0 n X i=1 xi yi + β 0 n X i=1 xi x0 β.117 1 14. 40 0.2 Least Squares There is another classic motivation for the estimator (4. with 10-15 years of potential work experience.4).

i ˆ ˆ Note that yi = yi + ei . Following convention we will call β the OLS estimator of β. The error is unobservable. Figure 4. Matrix calculus (see Appendix 2. Since the function Sn (β) is a quadratic function 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. It is important to understand the distinction between the error ei and the residual ei . while the residual is a by-product of estimation. Figure 4.4). 23 .7) gives the first-order conditions for minimization: 0 = ∂ ˆ Sn (β) ∂β n n X X ˆ = −2 xi yi + 2 xi x0 β i i=1 i=1 ˆ whose solution is (4. Figure 4. These two ˆ variables are frequently mislabeled. To visualize the sum-of-squared errors function.1 displays an example sum—of-squared errors function Sn (β) for the case k = 2. the contour lines are ellipses. which can cause confusion.The Ordinary Least Squares (OLS) estimator is the value of β which minimizes Sn (β).2 displays the contour lines of the same function — horizontal slices at equally spaced heights.1: Sum-of-Squared Errors Function As a by-product of OLS estimation.

ˆ n−k 2 i=1 (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. 24 .5) implies that 1X xi ei = 0. The error variance σ 2 = Ee2 is also a parameter of interest.7. Its method of moments estimator is the sample average 1X 2 ei . and hold true for all linear regression estimates.6) An alternative estimator uses the formula n 1 X 2 s = ei .Figure 4. ˆ n i=1 n Since xi contains a constant. one implication is that n 1X ei = 0.7) A justification for the latter choice will be provided in Section 4. ˆ σ = ˆ n 2 i=1 n (4.2: Sum-of-Squared Error Function Contours Equation (4. These are algebraic results.

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

ˆi 2 ∂σ 2 2ˆ σ 2 σ ˆ i=1 ˆ ˆ Solving for σ 2 yields the method of moments estimator (4.8) . ˆ ˆˆ ˆ A useful result is obtained by inserting Y = Xβ + e into the formula for β to obtain ¢ ¡ 0 ¢−1 ¡ 0 ˆ X (Xβ + e) β = XX ¡ ¢−1 ¡ 0 ¢ ¡ 0 ¢−1 0 Xe X Xβ + X 0 X = XX ¡ 0 ¢−1 0 X e. .4 Model in Matrix Notation convenient to write the model and statistics in x0 1 x0 2 . . x0 n ⎞ ⎛ e1 e2 . and X is an n × k matrix. ⎝ ⎝ . one for each observation. For example n X i=1 For many purposes. the ˆ OLS estimator β is frequently referred to as the Gaussian MLE. σ 2 ) for the normal ˆ regression model are identical to the method of moment estimators. including computation. yn ⎟ ⎟ ⎟. n X i=1 Thus the estimator (4. ⎠ xi x0 = X 0 X i xi yi = X 0 Y. We define ⎛ ⎞ ⎛ y1 ⎜ ⎜ y2 ⎟ ⎜ ⎟ ⎜ X=⎜ Y = ⎜ . ⎟.6). σ 2 ) = − 2 + ¡ ¢2 e2 = 0.Maximization with respect to σ 2 yields the first-order condition n X ∂ n 1 ˆ ˆ Ln (β. 4. n or equivalently Y = Xβ + 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. . Sample sums can also be written in matrix notation. en ⎞ Observe that Y and e are n × 1 vectors. The linear equation (3. . = β+ XX 26 (4.4). Due to this equivalence. ⎠ ⎜ ⎜ e=⎜ ⎝ ⎟ ⎟ ⎟. residual vector. yn = x0 β + en . We can stack these n equations together as y1 = x0 β + e1 1 y2 = x0 β + e2 2 . . . Thus the MLE (β.12) is a system of n equations. it is matrix notation. ⎠ .

4.5

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

Define the matrices and

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

and

PP

=

= M − MP = M
1

A matrix A is idempotent if AA = A.

27

since M P = 0. Another useful property is that tr P tr M where the trace operator tr A = = k = n−k
r X j=1

(4.9) (4.10)

ajj

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

and

4.6

Residual Regression
X = [X1 X2 ] ¶ .

Partition and β= µ

β1 β2

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

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

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

It follows that

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

(4.15)

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

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

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

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

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

7 Bias and Variance In this and the following section we consider the special case of the linear regression model (3. . Regress X2 on X1 . is the demeaning formula for regression. Regress Y on X2 . ⎠ ⎝ ⎠ ⎝ .9).18) E (e | X) = ⎜ E (ei | X) ⎟ = ⎜ E (ei | xi ) ⎟ = 0. .9). . observe that ⎞ ⎛ ⎞ ⎛ . Partition X = [X1 X2 ] where X1 = ι is a vector of ones.14) or via the ˆ following algorithm: ˜ 1. ⎟ ⎜ ⎟ ⎜ (4.8)(3. obtain OLS estimates β 2 and residuals e. ˆ ˜ ˜ ˆ 3. In this case. Rather. ¡ ¢−1 0 ι. but in most cases there is little computational advantage to using the two-step algorithm. . By the independence of the observations and (3. ! Thus the OLS estimator for the slope coefficients is a regression with demeaned data. A common application of the FWL theorem. In some contexts. In this section we derive the small sample conditional mean and variance of the OLS estimator. ˆ which are “demeaned”. . and X2 is the vector of observed regressors. the OLS estimator of β 2 and the OLS residuals e may be equivalently computed by either the OLS regression (4.13). . obtain residuals Y .6. obtain residuals X2 . . ˜ 2. The FWL theorem says that β 2 is the OLS estimate from a regression of ˜ ˜ Y on X2 . 30 . the primary use is theoretical. In the model (4. M1 = I − ι ι0 ι Observe that ¡ ¢−1 0 ˜ ι X2 X2 = M1 X2 = X2 − ι ι0 ι = X2 − X 2 and ˜ Y ¡ ¢−1 0 = M1 Y = Y − ι ι0 ι ιY = Y −Y.1 (Frisch-Waugh-Lovell). which you may have seen in an introductory econometrics course. the FWL theorem can be used to speed computation. 4. or yi − y on x2i − x2 : ˆ β2 = Ã n X i=1 (x2i − x2 ) (x2i − x2 ) 0 !−1 Ã n X i=1 (x2i − x2 ) (yi − y) . Regress Y on X1 .Theorem 4. . . .

we can calculate ³ ´ ³¡ ´ ¢−1 0 ˆ E β−β |X = E X 0X Xe|X ¢−1 0 ¡ X E (e | X) = X 0X = 0.20) . Thus D is a diagonal matrix with i’th diagonal element σ 2 : i ⎛ 2 σ1 0 · · · ⎜ 0 σ2 · · · 2 ⎜ D = diag{σ 2 . ⎝ . .12). the properties of conditional expectations. . Then given (4. . for any random vector Z define the covariance materix V ar(Z) = E (Z − EZ) (Z − EZ)0 = EZZ 0 − (EZ) (EZ)0 .. We have shown that which implies ³ ´ ˆ E β|X =β ³ ´ ˆ E β =β (4. .. σ 2 } = ⎜ .Using (4. Next. ⎠ (4.8). V ar β | X = X 0 X ⎟ ⎟ ⎟. and (4. . 0 0 ··· 0 0 .18). . 1 n . ¡ 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 ) = 0.19) ˆ and thus the OLS estimator β is unbiased for β. 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. X 0 DX = X 0 Xσ 2 . σ2 n ⎞ We now calculate the finite sample bias of the method ¡ moments estimator σ 2 for σ 2 . .. From (4. the properties additional assumption of conditional homoskedasticity E ei i of projection matrices. and the trace operator observe that.. under the of ˆ ¢ 2 | x = σ 2 . and ³ ´ ¡ ¢−1 2 ˆ σ . σ 2 = σ 2 and we have the simplii fications D = In σ 2 . .19) we see that ¶ µ³ ³ ´ ´³ ´0 ˆ ˆ ˆ V ar β | X = E β−β β−β |X = where The i’th diagonal element of D is ¡ ¢ D = E ee0 | X .

the estimator ˆ 2 defined (4.8. ³ ´ ˜ E β | X = A0 Xβ. ˜ so β is unbiased if (and only if) A0 X = Ik . is a famous statement of the solution. 4. As an alternative. known as the Gauss-Markov theorem.1 Gauss-Markov. The least-squares estimator is the special case obtained by setting A = X(X 0 X)−1 . ³ ´ ˜ V ar β | X = A0 V ar (e | X) A = A0 Aσ 2 . = σ2 n the final equality by (4.10). the best (minimumvariance) unbiased linear estimator is OLS. or in the projection model. It is important to remember. 32 . It is not unbiased in the absence of homoskedasticity. which is (3.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 . as it yields the smallest variance among all unbiased linear estimators. What is the best choice of A? The Gauss-Markov theorem.7) is unbiased for σ 2 by this calculation. By a calculation similar to those of the previous section. Thus since V ar (e | X) = In σ 2 under homoskedasticity. In this case. however.8 Gauss-Markov Theorem In this section we restrict attention to the homoskedastic linear regression model. The following result. ˜ β L = A0 Y = A (Xβ + e) = β + Ae. which we now present. Theorem 4. we can write The “best” linear estimator is obtained by finding the matrix A for which this variance is the smallest in the positive definite sense. This is the justification for the common s ˆ preference of s2 over σ 2 in empirical practice. and thus can be written as ˜ β = A0 Y where A is an n × k function of X. In the homoskedastic linear regression model. Thus σ 2 is biased towards zero.9) plus E e2 | xi = σ 2 . says that the least-squares estimator is the best choice.8)¢ ¡ (3. Now consider the class of estimators of β which are linear functions of i the vector Y. that this estimator is only unbiased in the special case of the homoskedastic linear regression model.

As the data are multinomial.. 4. (We know the values yi and xi can take. 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.. j = 1.. but the π j are unknown. r for some constant vectors τ j . π j is the percentage of the observations ˆ ˆ which fall in each category. It is sufficient to show that the difference A0 A − (X 0 X)−1 is positive semi-definite. the class of potential estimators has been restricted to linear unbiased estimators.. That is.. Suppose that the joint distribution of (yi . Set C = A − X (X 0 X)−1 .. but we don’t know the probabilities. The variance of the least-squares estimator is (X 0 X)−1 σ 2 and that of A0 Y is A0 Aσ 2 . This property is called semiparametric efficiency. ˆ β mle = ⎝ j j=1 j=1 33 . That is. where 1 (·) is the indicator function. . and π j . π r ) . Assume that the τ j and ξ j are known. A broader justification is provided in Chamberlain (1987). Not only has the class of models has been restricted to homoskedastic linear regressions. r. the maximum likelihood estimator (MLE) is ¡ ¢ 1X 1 (yi = τ j ) 1 xi = ξ j πj = ˆ n i=1 n for j = 1.5) as required.) In this discrete setting. .. xi ) is discrete.21) j j=1 j=1 Thus β is a function of (π 1 . the definition (4. ¡ ¢ P yi = τ j . and is a strong justification for the least-squares estimator. as the theorem leaves open the possibility that a non-linear or biased estimator could have lower mean squared error than the least-squares estimator. but it is quite limited in scope. The MLE β mle for β is then the analog of (4.3) can be rewritten as ⎞−1 ⎛ ⎞ ⎛ r r X X β=⎝ πj ξ j ξ 0 ⎠ ⎝ πj ξ j τ j ⎠ (4. We discuss the intuition behind his result in this section. Let A be any n×k function of X such that A0 X = Ik . xi = ξ j = π j .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 ⎠ .9 Semiparametric Efficiency In the previous section we presented the Gauss-Markov theorem as a limited efficiency justification for the least-squares estimator. who established that in the projection model the OLS estimator has the smallest asymptotic meansquared error among feasible estimators. This latter restriction is particularly unsatisfactory.. for finite r. ¥ The Gauss-Markov theorem is an efficiency justification for the least-squares estimator.Proof. Note that X 0 C = 0.. . ξ j .

(4. and any continuous distribution can be arbitrarily well approximated by a multinomial distribution. Since this is a regular parametric model the MLE is asymptotically efficient (see Appendix A.1. He observes that the above argument holds for all multinomial distributions.22) 34 . Chamberlain (1987) extends this argument to the case of continuously-distributed data. if the data have a discrete distribution. 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 .5. He proves that generically the OLS estimator (4.Substituting in the expressions for π j .9). and thus so is the OLS estimator. We can write the model as yi = x0 β 1 + x0 β 2 + ei 1i 2i E (xi ei ) = 0 where the parameter of interest is β 1 .4) is an asymptotically efficient estimator for the parameter β defined in (3. 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 4.10) 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.10 Omitted Variables xi = µ x1i x2i ¶ .

4. This is one difficulty with the definition and interpretation of multicollinearity. which is often called “multicollinearity” for brevity. except in special cases. the possibility of omitted variables bias should be acknowledged and discussed in the course of an empirical investigation. Observe that γ 1 6= β 1 unless Γ = 0 or β 2 = 0. 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. the regression of x2i on x1i yields a set of zero coefficients (they are uncorrelated). This is called strict multicollinearity. Since the error is discovered quickly. because we have not said what it means for a matrix to be “near singular”. the general model will be free of the omitted variables problem.23) the short regression to emphasize the distinction. This is the situation when the X 0 X matrix is near singular.22) the long regression and (4. this is rarely a problem for applied econometric practice. This is because the model being estimated is different than (4. β 1 6= γ 1 . and the error as ui rather than ei . log(p1 ). This definition is not precise. least-squares estimation of (4. The difference Γβ 2 is known as omitted variable bias. we regress yi on x1i only. the applied researcher quickly discovers the error as the statistical software will be unable to construct (X 0 X)−1 . Most commonly. This happens when the columns of X are linearly dependent.22) by least-squares. For example. To see this. The more relevant issue is near multicollinearity. this arises when sets of regressors are included which are identically related. By construction. In general. First.e.Now suppose that instead of estimating equation (4. then β is not defined. Typically. as many desired variables are not available in a given dataset. Goldberger (1991) calls (4. there is some α such that Xα = 0.. if X includes both the logs of two prices and the log of the relative prices.22) is zero. When this happens. In this case.11 Multicollinearity ˆ If rank(X 0 X) < k + 1.23) is an estimate of γ 1 = β 1 + Γβ 2 rather than β 1 . or second. To avoid omitted variables bias the standard advice is to include potentially relevant variables in the estimated model. 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 . i. It is the consequence of omission of a relevant correlated variable. 35 .22). the coefficient on x2i in (4.23) where is the coefficient from a regression of x2i on x1i . when the columns of X are close to linearly dependent. Thus the short and long regressions have the same coefficient on x1i only under one of two conditions. log(p2 ) and log(p1 /p2 ). Typically there are limits.

If the i’th observation 36 . define the leave-one-out least-squares estimator of β. A more relevant implication of near multicollinearity is that individual coefficient estimates will be imprecise. 1] and sum to k.24) β (−i) = X(−i) X(−i) is the i’th diagonal element of the projection matrix X (X 0 X)−1 X 0 .26) As we can see. As a consequence.12 Influential Observations where X(−i) and Y(−i) are the data matrices omitting the i’th row. To investigate the possibility of influential observations. that is. In extreme cases it is possible that the reported calculations will be in error due to floating-point calculation difficulties. the precision of individual estimates are reduced. The hi take values in [0. A convenient alternative expression is ¡ ¢−1 ˆ ˆ xi ei ˆ (4.27) (4. We can see the effect of collinearity on precision by observing that the asymptotic variance of a coefficient ¡ ¢−1 approaches infinity as ρ approaches 1. the change in the coefficient estimate by deletion of the i’th observation depends critically on the magnitude of hi . the worse the precision of the individual coefficient estimates.−i = yi − x0 β (−i) = (1 − hi )−1 ei .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. We derive expression (4. and 1 0 XX= n µ 1 ρ ρ 1 ¶ In this case The correlation ρ indexes collinearity. ˆ ˆ (4.One implication of near singularity of matrices is that the numerical reliability of the calculations is reduced. Thus the more “collinear” are the estimate σ 2 1 − ρ2 regressors. We can see this most simply in a homoskedastic linear regression model with two regressors yi = x1i β 1 + x2i β 2 + ei . ˆ i A simple comparison yields that ˆ ei − ei. This equals ´−1 ³ 0 ˆ X(−i) Y(−i) (4.25) below. = V ar β ρ 1 n n (1 − ρ2 ) −ρ 1 4.−i = (1 − hi )−1 hi ei . What is happening is that when the regressors are highly dependent. µ ¶−1 µ ¶ ³ ´ 2 σ2 1 ρ 1 −ρ ˆ|X = σ . since as ρ approaches 1 the matrix becomes singular. We can also define the leave-one-out residual ˆ ˆ ei. the OLS estimator based on the sample excluding the i’th observation. it is statistically difficult to disentangle the impact of β 1 from that of β 2 .

then this observation is a leverage point and has the potential to be an influential observation.This implies has a large value of hi .4 which states that ¡ ¢ (A + BCD)−1 = A−1 − A−1 BC C + CDA−1 BC CDA−1 . ˆ We now derive equation (4.27).1) in Section 2. which is considerably more informative than plots of the uncorrected residuals ei . The key is equation (2. ˆ = β − (1 − hi )−1 X 0 X and thus ˆ β (−i) = 37 . ¢−1 ¡ 0 ¢−1 ¡ 0 ¢−1 ¡ 0 ¢−1 ¡ = XX + XX xi (1 − hi )−1 x0 X 0 X X X − xi x0 i i ¡ 0 ¢−1 ¡ 0 ¢ X X − xi x0 X Y − xi yi i ¢ ¡ ¡ ¢ ¡ ¢−1 ¡ 0 ¢−1 ¢−1 ¡ 0 X Y − xi yi + (1 − hi )−1 X 0 X X Y − xi yi = X 0X xi x0 X 0 X i ¢−1 ¡ ˆ xi ei . Investigations into the presence of influential observations can plot the values of (4.25).

4.13

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

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

(5. Since 1 + 1 = 1 an application of Jensen’s inequality shows that p q U Then 1/p V 1/q 1 1 ln U + ln V = exp p q E |XY | ∙ ¸ ≤ 1 1 U V exp (ln U ) + exp (ln V ) = + . Note EU = EV = 1. n→∞ lim P (|Zn − Z| > δ) = 0. then as n → ∞ n 1X Xn = Xi →p E(X).1 Weak Law of Large Numbers (WLLN). If Xi ∈ Rk is iid and E |Xi | < ∞. Let a + bx be the tangent line to g(x) at x = EX. Eg(X) ≥ a + bEX = g(EX). if for all δ > 0. ¥ Proof of Holder’s Inequality. The WLLN shows that sample averages converge in probability to the population average. So for all x. Let U = |X|p /E |X|p and V = |Y |q /E |Y |q . Applying expectations.4) Proof of Jensen’s Inequality. ¥ 5. This is a probabilistic way of generalizing the mathematical definition of a limit.2 Weak Law of Large Numbers Let Zn ∈ Rk be a random vector. Since g(x) is convex. =E U V p q p q Proof of Markov’s Inequality. We say that Zn converges in probability to Z as n → ∞. tangent lines lie below it. denoted Zn →p Z as n → ∞. 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}.3). p p p q which is (5. Theorem 5.2. Set Y = g(X) and let f denote the density function of Y. (E |X|p )1/p (E |Y |q )1/q ¥ µ ¶ ´ ³ U V 1 1 1/p 1/q ≤E + = + = 1. as stated. g(x) ≥ a + bx yet g(EX) = a + bEX since the curve is tangent at EX. For any strictly increasing function g(X) ≥ 0. n i=1 42 . P (g(X) > α) ≤ α−1 Eg(X).Markov’s Inequality.

where Z has distribution F (x) = P (Z ≤ x) .Proof: Without loss of generality. Jensen’s inequality (5. Fn (x) → F (x) as n → ∞. (5. We say that Zn converges in distribution to Z as n → ∞. the fact that X n = W n + Z n . ¯¢2 ¡ ¯ 2 ≤ EW n E ¯W n ¯ = EWi2 n 4C 2 ≤ n ≤ ε2 (5. Pick C < ∞ large enough so that E (|X| 1 (|X| > C)) ≤ ε (5. n i=1 0 where µ = EX and V = E (X − µ) (X − µ) .3 Convergence in Distribution Let Zn be a random variable with distribution Fn (x) = P (Zn ≤ x) . ¯ ¯ E ¯Z n ¯ ≤ E |Zi | ≤ 2ε. Theorem 5. Fix δ and η. the fact that the Wi are iid and mean zero. and the bound |Wi | ≤ 2C. we can set E(X) = 0 (by recentering Xi on its expectation). denoted Zn →d Z. P ¯X n ¯ > δ ≤ η. ≤ 2E |Xi | 1 (|Xi | > C) Zi = Xi 1 (|Xi | > C) − E (Xi 1 (|Xi | > C)) . Define the random vectors Wi = Xi 1 (|Xi | ≤ C) − E (Xi 1 (|Xi | ≤ C)) By the triangle inequality. 43 . ¯ ¯ ¯ ¯ ¯ ¯ ¢ E ¯X n ¯ ¡¯ ¯ E ¯W n ¯ + E ¯Z n ¯ 3ε ≤ ≤ = η. by Markov’s inequality (5. Set ε = δη/3.3. If Xi ∈ Rk is iid and E |Xi |2 < ∞.1).6) and (5.5) (where 1 (·) is the indicator function) which is possible since E |X| < ∞. if for all x at which F (x) is continuous.1) and (5. We need to ¢show that for all δ > 0 and η > 0 there is some N < ∞ so that for all n ≥ N. ¡¯ ¯ P ¯X n ¯ > δ ≤ η. 5.1 Central Limit Theorem (CLT). then as n→∞ n ¢ √ ¡ 1 X n Xn − µ = √ (Xi − µ) →d N (0. the triangle inequality.6) By Jensen’s inequality (5. We have shown that for any δ > 0 and η > 0 then for all ¢ ¡¯ ¯ ¥ n ≥ 36C 2 /δ 2 η 2 .4).7).5).7) the final inequality holding for n ≥ 4C 2 /ε2 = 36C 2 /δ 2 η 2 . ≤ E |Xi | 1 (|Xi | > C) + |E (Xi 1 (|Xi | > C))| (5. P ¯X n ¯ > δ ≤ δ δ δ the equality by the definition of ε. Finally. as needed. V ) .

let C(λ) = E exp iλ0 X denote the characteristic function of X and set c(λ) = ln C(λ). so when evaluated at λ = 0 c(0) = 0 cλ (0) = 0 cλλ (0) = −Ik . 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 . 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.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 . the definition of c(λ) and (5. By a second-order Taylor series expansion of c(λ) about λ = 0. ∂λ∂λ cλ (λ) = cλλ (λ) = ∂ ∂ c(λ) = C(λ)−1 C(λ) ∂λ ∂λ ∂ ∂2 ∂2 −2 ∂ C(λ) 0 C(λ) c(λ) = C(λ)−1 0 0 C(λ) − C(λ) ∂λ ∂λ∂λ ∂λ∂λ ∂λ so when evaluated at λ = 0 Furthermore. 1 1 c(λ) = c(0) + cλ (0)0 λ + λ0 cλλ (λ∗ )λ = λ0 cλλ (λ∗ )λ 2 2 (5. For ¡ ¢ λ ∈ Rk . the independence of the Xi .Proof: Without loss of generality.8) where λ∗ lies on the line segment joining 0 and λ.

Proof: Since g is continuous at c. Hence g(Zn ) →p g(c) as n → ∞. Stacking across elements of g. and g(θ) : Rm → Rk . Σ) = N 0. then g(Zn ) →d g(Z) as n → ∞. ¥ 5. we see that as n → ∞. for each element of g.1 Continuous Mapping Theorem 1 (CMT).4. Ik ) distribution. Thus P (|g (Zn ) − g (c)| ≤ ε) ≥ P (|Zn − c| < δ) → 1 as n → ∞ by the assumption that Zn →p c.4 Asymptotic Transformations Theorem 5. we find jn ¢ ¡ √ √ 0 n (g (θn ) − g(θ0 )) = (gθ + an ) n (θn − θ0 ) →d gθ N (0. then g(Zn ) →p g(c) as n → ∞. Σ) . k ≤ m. √ Theorem 5. This is sufficient to establish the theorem. If Zn →p c as n → ∞ and g (·) is continuous at c. If Zn →d Z as n → ∞ and g (·) is continuous. Proof : By a vector Taylor series expansion. Since cλλ (λn ) → cλλ (0) = −Ik . 45 . Recall that A ⊂ B implies P (A) ≤ P (B). Theorem 5.3 Delta Method: If n (θn − θ0 ) →d N (0. gθ Σgθ where gθ (θ) = ∂ g(θ) ∂θ0 and gθ = gθ (θ0 ).4. gθ Σgθ .√ where λn → 0 lies on the line segment joining 0 and λ/ n. It follows that ajn = gjθ (θ∗ ) − gjθ →p 0. µ ¶ 1 Cn (λ) → exp − λ0 λ 2 the characteristic function of the N (0.4. then ¡ ¢ √ 0 n (g (θn ) − g(θ0 )) →d N 0. 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 . where θ is m × 1 and Σ is m × m. for all ε > 0 we can find a δ > 0 such that if |Zn − c| < δ then |g (Zn ) − g (c)| ≤ ε.2 Continuous Mapping Theorem 2.

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

1). b) = A−1 b is a continuous function of A and b at all values of the arguments such that A−1 exist.1.8) implies that ˆ β−β = Ã n X i=1 xi x0 i !−1 n X i=1 xi ei . Ã n ! n X 1X 0 1 ˆ xi xi . Asymptotic (large sample) methods approximate sampling distributions based on the limiting experiment that the sample size n tends to infinity.1. and the continuous mapping theorem (Theorem 5. 6.2.5. ˆ 47 . As the sample size increases the density becomes more concentrated about the population coefficient.4 implies that Q−1 exists and thus g(·. Hence by the continuous mapping theorem (Theorem 5. Proof.1) imply that n ¡ ¢ 1X xi x0 →p E xi x0 = Q (6.2. ·) is continuous at (Q. (6. 0) = Q−1 0 = 0 β−β =g n n i=1 i=1 ˆ which implies β →p β as stated.From the figure we can see that the density functions are dispersed and highly non-normal. For a complete argument.1 and the WLLN (Theorem 5. we can conclude ˆ that β →p β.1) and ˆ We now deduce the consistency of β.2).2 Consistency ˆ As discussed in Section 6.5.1. 0).5.1).1 Under Assumption 3. xi ei = g i n n i=1 i=1 1X xi ei →p E (xi ei ) = 0. we will use the methods of asymptotic approximation. β →p β as n → ∞.2) i i n i=1 n From (6. xi ei →p g (Q. (6. ¥ We can similarly show that the estimators σ 2 and s2 are consistent for σ 2 .1 by the fact that the sampling densities become more concentrated as n gets larger. n i=1 (6. A preliminary step in this approach is the demonstration that estimators are consistent — that they converge in probability to the true parameters as the sample size gets large. First. This is illustrated in Figure 6.4. using (6. the OLS estimator β is has a statistical distribution which is unknown. To characterize the sampling distribution more fully. ˆ Theorem 6. (6.4. Equation (4. 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).3).3) Ã where g(A.1). Assumption 3. Assumption 3.

Note that ˆ ei = yi − x0 β ˆ i i Thus and n ˆ = ei + x0 β − x0 β i i ³ ´ ˆ = ei − x0 β − β . ˆ Proof. by the Cauchy-Schwarz inequality (5. ˆ n−k 6. Ee4 < ∞ and E |xi |4 < ∞. E ¯ei ¯ E ¯e4 ¯ i i i i (6.1.1 guarantees that the elements of Ω are finite. ˆ Finally. ´1/2 ¡ ¯ ¯¢ ¯ ³ ¯ ¯2 ´1/2 ¡ ¯ 4 ¯¢1/2 ³ ¯ 1/2 E ¯xi x0 e2 ¯ ≤ E ¯xi x0 ¯ = E |xi |4 < ∞. it follows that s2 = ¥ n σ 2 →p σ 2 .6) n i=1 48 . since n/(n − k) → 1 as n → ∞.1.3. (6.5) Thus xi ei is iid with mean zero and has covariance matrix Ω. To see this.1).1).2.5. By the central limit theorem (Theorem 5.2). n 1 X √ xi ei →d N (0. i Now define ¡ ¢ Ω = E xi x0 e2 .Theorem 6. (6. (6. i i Assumption 6.4) ³ ´ ³ ´0 ³ ´ ˆ ˆ ˆ e2 = e2 − 2ei x0 β − β + β − β xi x0 β − β ˆi i i i σ2 = ˆ 1X 2 ei ˆ n i=1 i=1 →p σ 2 n 1X 2 = ei − 2 n à ! à 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.2 Under Assumption 3. σ 2 →p σ 2 and s2 →p σ 2 as n → ∞. Thus σ 2 is consistent for σ 2 . We need a strengthening of the moment conditions.2). (6.2. Ω) .5.3 Asymptotic Normality ˆ We now establish the asymptotic distribution of β after normalization.3.3.3) and Theorem (6.1 In addition to Assumption 3. Assumption 6.

The asymptotic distribution ´ Theorem 6. Theorem 6. i i Condition (6.6). and εi is independent of xi with the Double Pareto density f (ε) = α |ε|−α−1 . 1).2). 1 X √ xi ei n i=1 n ! the N (0. Q−1 ΩQ−1 . when xi and ei are independent. V ) where V = Q−1 ΩQ−1 . as n → ∞ ´ √ ³ ˆ n β − β →d N (0. For α 49 . there is no simple answer to this reasonable question.1 states that the sampling distribution of the least-squares estimator. but this is not a necessary condition.2 we display the finite sample densities of the q ³ ˆ normalized estimator n α−2 β 2 − β 2 . If α > 2 the 2 error εi has zero mean and variance α/(α − 2). Ω) ¡ ¢ = N 0. Under (6.3. As α approaches 2. ´ √ ³ ˆ n β−β = à 1X xi x0 i n i=1 n !−1 à Theorem 6. In´Figure 6. for example.1. This holds true for all joint distibutions of (yi . The approximation may be poor when n is small. otherwise V 6= V 0 .9) In (6.1 we have already seen a simple example where the least-squares estimate is quite asymmetric and non-normal even for reasonably large sample sizes.1. ´ √ ³ˆ As V is the variance of the asymptotic distribution of n β − β . Let yi = β 0 + β 1 xi + εi where xi is N (0. We call V 0 the homoskedastic covariance matrix.Then using (6.3. We illustrate this problem using a simulation. is approximately normal when the sample size n is sufficiently large.1). We say that ei is a Homoskedastic Projection Error when (6.7) is true then V = V 0 . 1) asymptotic distibution.8) Ω = E xi x0 E e2 = Qσ 2 i i V = Q−1 ΩQ−1 = Q−1 σ 2 ≡ V 0 (6. xi ) which satisfy the conditions of Assumption 6. The trouble is that no matter how large is the sample size.9) we define V 0 = Q−1 σ 2 whether (6. There is a special case where Ω and V simplify. When (6. |ε| ≥ 1. The expression V = Q−1 ΩQ−1 is called a sandwich form.7) the asymptotic variance formulas simplify as ¡ ¢ ¡ ¢ (6. In Figure 6. its variance diverges q ³ ´ ˆ to infinity. the normal approximation is arbitrarily poor for some data distribution satisfying the assumptions.7) holds.3. for any ˆ fixed n the sampling distribution of β can be arbitrarily far from the normal distribution. How large should n be in order for the approximation to be useful? Unfortunately.7) Cov(xi x0 . setting n = 100 and varying the parameter α. (6.7) is true or false. and (6. In this context the normalized least-squares slope estimator n α−2 β 2 − β 2 has α →d Q−1 N (0. e2 ) = 0.1 is commonly used to approximate the finite of √ ³ˆ sample distribution of n β − β . However.3.3. V is often referred to as ˆ the asymptotic covariance matrix of β.1 Under Assumption 6. after rescaling. however.

for k = 1. 6.2) and Theorem 6. Another example is shown in Figure 6.2: Density of Normalized OLS estimator α = 3. We show the sampling distribution of n β 1 − β 1 setting n = 100.4 Let Covariance Matrix Estimation 1X ˆ xi x0 Q= i n i=1 n be the method of moments estimator for Q. ˆ ˆ Since Q →p Q and s2 →p σ 2 (see (6. The homoskedastic covariance matrix V 0 = Q−1 σ 2 is typically estimated by ˆ ˆ (6. 4. 1). concentrating most of the probability mass around zero.Figure 6. we need an estimate of Ω = E xi x0 e2 . 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 (0.2. The lesson from Figures 6. 1) density.1) it is clear that V 0 →p V 0 . σ may also be substituted for s ˆ ¡ ¢ To estimate V = Q−1 ΩQ−1 .2 and 6.3. 1) asymptotic approximation is never guaranteed to be accurate.10) without changing this result. The estimator 2 2 in (6. As k increases.11) 50 .10) V 0 = Q−1 s2 . As α diminishes the density changes significantly. 6 and 8. the sampling distribution becomes highly skewed and non-normal. The MME estimator is i i 1X ˆ xi x0 e2 Ω= i ˆi n i=1 n (6.3 is that the N (0.0 the density is very close to the N (0.

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

(.14 14.14 205. Using (6. from which it follows that V →p V as n → ∞.12) i i n n n i=1 i=1 We now examine each sum on the right-hand-side of (6.1. and then the square roots.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.199 2.020) 6.493 0. It is also important to understand that a particular standard error may be relevant under one set of model assumptions. we return to the log wage regression of Section 4.80 2.1) show that n ¡ ¢ 1X xi x0 e2 →p E xi x0 e2 = Ω.83 −0. Ω 2. The standard errors for β 0 are 7.12) in turn.6 Therefore the two covariance matrix estimates are µ ¶−1 µ ¶ 1 14.14 205.5) and the WLLN (Theorem 5. (6.493 −0.20 −0.039 and ˆ V = µ 1 14. We can write the estimated equation with standards errors using the format \ log(W agei ) = 1. the standard method to calculate the standard errors is to ˆ first calculate n−1 V .98 −0. but not under another set of assumptions. p ˆ In this case the two estimates are quite similar. just as any other estimator.2/988 = .80 40.30 + 0. then take the diagonal elements. First.085) (.3) so by the WLLN ³ ´ ³ ´3/4 ¡ ¯ ¯¢ 1/4 E |xi |3 |ei | ≤ E |xi |4 < ∞.14 205.035 ¶ . We calculate that s2 = 0. by Holder’s inequality (5.6 ¶µ 1 14. i i i i n i=1 Second.used by an author when studying their work. n n i=1 52 .20 and µ ¶ ˆ = 0.83 ¶−1 µ .480 ˆ0 = 0.4) 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 . From a computational standpoint.80 40.14 14.020.085 p ˆ and that for β 1 is .83 ¶−1 = µ 7. (6.80 . To illustrate. E ¯e4 ¯ i ³ ´ 1X |xi |3 |ei | →p E |xi |3 |ei | .480 .20 = V 14.117 Educationi .199 2.14 6.35/988 = .2.

n i=1 n ˆ ˆ Theorem 6. which. From equation (3. Andrews’ proposed estimator is ˆ ˆ ˆ ˆ V ∗∗ = Q−1 Ω∗∗ Q−1 53 .6 Alternative Covariance Matrix Estimators ˆ MacKinnon and White (1985) suggested a small-sample corrected version of V based on the jackˆ knife principle. Using this substitution. ¯ ¯ ¯ ¯ ¯n ¯ n i=1 i=1 1X |xi |4 →p E |xi |4 . They also suggest that the scaling factor (n − 1)/n in (??) can be omitted. you can show that 1 Xˆ ¯ β= β (−i) .13) of Efron (1982).1 As n → ∞.26). by the WLLN ¯ n ¯ à n ! ¯ 1X ¯1 X ¯ ¯ ³ ´0 ¯ ¯ ¯ ¯ˆ 3 0 ˆ xi xi β − β xi ei ¯ ≤ ¯β − β ¯ |xi | |ei | →p 0. the jackknife estimator of the ˆ variance matrix for β is ˆ V ∗ = (n − 1) where n X³ ˆ β i=1 ¯ (−i) − β n ´³ ˆ β ¯ (−i) − β ´0 (6. Ω →p Ω and V →p V.¯ ¯ ¯ ¯ˆ and thus since ¯β − β ¯ →p 0.25).5.14) à 1X (1 − hi )−1 xi ei ˆ n i=1 n !à 1X (1 − hi )−1 xi ei ˆ n i=1 n !0 and hi = x0 (X 0 X)−1 xi . MacKinnon and White (1985) present numerical (simulation) evidence i ˆ ˆ that V ∗ works better than V as an estimator of V . these establish consistency. i=1 Third. 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 (6.13) Using formula (4. 6.−i = (1 − hi )−1 ei ˆ presented in (4.12 the definition of β (−i) as the least-squares estimator with the i’th observation deleted. Recall from Section 4.11) with the leave-one-out estimator ei. ¯ n ¯ n ¯2 X ¯1 X ³ ´0 ³ ´¯ ¯ ¯ 0 ˆ ˆ ˆ − β ¯ ≤ ¯β − β ¯ 1 xi xi β − β xi xi β |xi |4 →p 0. ¯ ¯n ¯ n i=1 so Together. is defined ˆ ˆ by replacing the OLS residual ei in (6. Andrews (1991) suggested an similar estimator based on cross-validation.

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

For example. By (6. A simple null and composite hypothesis takes the form H0 : θ = θ0 H1 : θ 6= θ0 where θ0 is some pre-specified value. if R is a “selector matrix” R= so that if β = (β 1 . (For example.1 tn (θ) →d N (0. ˆ its estimate and s(ˆ its asymptotic θ θ) standard error. and θ = h(β) is some function of the parameter vector. 55 .8 t tests Let θ = h(β) : Rk → R be any parameter of interest. we say that tn is an exactly pivotal statistic.16) ¥ Thus the asymptotic distribution of the t-ratio tn (θ) is the standard normal. Consider the studentized statistic tn (θ) = Theorem 6. µ I 0 ¶ ˆ the upper-left block of V . Since the standard normal distribution does not depend on the parameters. that (so θ ˆ ˆ ˆ is. ˆ When q = 1q h(β) is real-valued). see Section X). however. θ could be a single element of β). 1) Proof. In general. Vθ ) √ Vθ = N (0. In special cases (such as the normal regression model.8. then θ = R0 β = β 1 and ˆ Vθ = ¡ I 0 ¢ ˆ V µ I 0 ¶ ˆ = V11 . the statistic tn has an exact t distribution. β 2 ). pivotal statistics are unavailable and so we must rely on asymptotically pivotal statistics. the standard error for ˆ is the square root of n−1 Vθ . we say that tn (θ) is asymptotically pivotal. θ) β 6.15) tn (θ) = ˆ−θ θ s(ˆ θ) ´ √ ³ˆ n θ−θ q = ˆ Vθ N (0. s(ˆ = n−1/2 H 0 V Hβ . and is therefore exactly free of unknowns. s(ˆ θ) (6. 1) →d ˆ−θ θ . In this case.

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

96s(ˆ ≈ ˆ ± 2s(ˆ .05. or α = . Thus values of θ within two standard errors of the estimated interval θ θ) θ θ) ˆ are considered “reasonable” candidates for the true value θ. While there is no hard-and-fast guideline for choosing the coverage probability 1 − α.10 Wald Tests Sometimes θ = h(β) is a q × 1 vector. 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). The t-test of the previous setion rejects H0 : θ0 = θ if |tn (θ)| > zα/2 where tn (θ) is the t-statistic (6. ¢ ¡ ¢ ¡ P (θ ∈ Cn ) = P |tn (θ)| ≤ zα/2 → P |Z| ≤ zα/2 = 1 − α. However we often can calculate the asymptotic coverage probability limn→∞ P (θ ∈ Cn ). θ The interval has been constructed so that as n → ∞. and values of θ outside two standard θ errors of the estimated ˆ are considered unlikely or unreasonable candidates for the true value. 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 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).We typically cannot calculate the exact coverage probability P (θ ∈ Cn ). the most common professional choice isi95%. and it is desired to test the joint restrictions simultaneously. We have the null and alternative H0 : θ = θ0 H1 : θ 6= θ0 . We say that Cn has asymptotic (1 − α)% coverage for θ if P (θ ∈ Cn ) → 1 − α as n → ∞. This corresponds to selecting the confidence h i h ˆ ± 1.16) and zα/2 is the upper α/2 quantile of the standard normal distribution. ˆ + zα/2 s(ˆ . In this case the t-statistic approach does not work. = n h(β) − θ0 Hβ V Hβ 57 (6. θ θ) (6.18) . 6. A good method for construction of a confidence interval is the collection of parameter values which are not rejected by a statistical test.17) = ˆ − zα/2 s(ˆ θ and Cn is an asymptotic (1 − α)% confidence interval.

and there are q = k2 restrictions. the test rejects at the α% level iff pn < α.When h is a linear function of β. a chiq square random variable with q degrees of freedom. Also h(β) = a selector matrix. 1] under H0 . χ2 (. so by the continuous mapping ˆ ˆ ˆ ˆ ˆ theorem.19) σ2 ˆ where σ2 = ˜ 1 0 e e. The null hypothesis is H0 : β 2 = 0. An asymptotic Wald test rejects H0 in favor of H1 if Wn exceeds χ2 (α). Vθ ).5.05) = 3. where p(x) = P χ2 ≥ x is the tail q q probability function of the χ2 distribution.15) showed that n ˆ − θ →d Z ∼ N (0. h(β) = R0 β.1 Under H0 and Assumption 6.11 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 . and Theorem 6.1 showed θ ˆ that V →p V. 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. the upper-α quantile q 2 of the χ2 distribution. The asymptotic p-value for Wn is pn = p(Wn ). For example.025 . θ = β 2 .10. The Wald test fails to reject if Wn is q 1 ¡ ¢ less than χ2 (α). 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. then the Wald statistic can be written in the form ¶ µ 2 ˆ σ − σ2 ˜ Wn = n (6. Furthermore. Wn = n R0 β − θ0 ´ √ ³ The delta method (6. then the Wald statistic takes the form ´0 ³ ´ ³ ´−1 ³ ˆ ˆ ˆ R0 V R R0 β − θ 0 . Hβ (β) →p Hβ . We have established: ³ ´0 ³ ´ ˆ − θ0 V −1 ˆ − θ0 →d Z 0 V −1 Z = χ2 . As before. ˜˜ n ˜ e = Y − X1 β 1 . = nβ 2 R0 V R R0 β is linear with R = µ 0 I ¶ ¢−1 ¡ ˆ ˆ ˆ .2. In this case.84 = z. Hence β β by Theorem A. q and pn is asymptotically U[0. Hβ (β) is a continuous function of β.1. ˆ Wn = n θ θ q θ θ Theorem 6. Thus Vθ = H 0 V Hβ →p H 0 V Hβ = Vθ > 0 if Hβ has full rank q. ˜ 58 ¡ 0 ¢−1 0 ˜ β 1 = X1 X1 X1 Y .8. then Wn →d χ2 . 6. if rank(Hβ ) = q.

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

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

with residual variance σ . The critical values are quite close if n − k ≥ 30. σ 2 ) discussed above. 1) and tn−k distributions. σ 2 ) where β 1 is the OLS estimate from ˜ 2 ˜ a regression of yi on x1i only.12. As inference (confidence intervals) are based on the t-ratio.1 we showed that in large samples. Furthermore.10) then ´ ³ ˆ • β ∼ N 0. a good testing procedure is based on the likelihood ratio statistic.12. β 2 ) and consider tests of the linear restriction H0 : β 2 = 0 H1 : β 2 6= 0 In the context of parametric models. σ 2 (X 0 X)−1 • (n−k)s2 σ2 ˆ β j −β j ˆ s(β ) j ∼ χ2 . σ 2 ) ¡ ¢¢ ¡ ¡ ¢ ˆ = n log σ 2 − log σ 2 ˜ µ 2¶ σ ˜ = n log .1 If ei is independent of xi and distributed N(0.3. β has an exact normal distribution and t has an exact t distribution.a chi-square distribution with n − k degrees of freedom. so as a practical matter it does not matter which distribution is used.1 and Theorem 6. n−k • ∼ tn−k ˆ In Theorem 6. σ 2 ) = − log σ − log (2π) − . β 2 . In contrast. σ ˆ ˆ βj − βj βj − βj N (0. (Unless the sample size is unreasonably small.8. β and t are approximately normally distributed. which is twice the difference in the log-likelihood function evaluated under the null and alternative hypotheses. the notable distinction is between the N (0. σ 2 ). σ 2 ) = − log 2πˆ 2 − 2 e0 e ˆˆ 2 2ˆ σ ¡ ¢ n n n = − log σ 2 − log (2π) − . β 2 . ˆ 2 2 2 ˜ ˜ The MLE of the model under the null hypothesis is (β 1 . σ2 ˆ 61 . We summarize these findings Theorem 6. if standard errors are calculated using the homoskedastic formula (6. σ 2 ) − Ln (β 1 . β 2 . 0. The log-likelihood of this model is ¡ 2¢ n n n ˜ ˜ ˜ Ln (β 1 .) Now let us partition β = (β 1 . The Gaussian log-likelihood at these estimates is ¡ ¢ n 1 ˆ ˆ ˆ σ Ln (β 1 .10) µ h i ¶ 2 (X 0 X)−1 N 0. The estimator under the alternative is the unrestricted estimator ˆ ˆ ˆ (β 1 . Theorem 6. 0. 0.1 shows that under the strong assumption of ˆ normality. 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. 2 2 2 The LR statistic for H0 is ´ ³ ˆ ˆ ˆ ˜ ˜ LR = 2 Ln (β 1 . and standard errors are calculated using the homoskedastic formula (6.

Through repetition. ˆ Let β and σ 2 be the sample mean and variance of yi . the statistic Wn (s) varies with s. we find that the standard Wald test for H0 (s) is ´2 ³ s ˆ β −1 Wn (s) = n 2s−2 . setting n/σ 2 = 10. Letting h(β) = β s . while there are other values of s for which test test statistic is insignificant.4 the Wald statistic Wn (s) as a function ˆ of s. This can be seen by a simple example introduced by Lafontaine and White (1986). In the present context of the Wald statistic. This is an unfortunate feature of the Wald statistic. they can work quite poorly when the restrictions are nonlinear. and noting Hβ = sβ s−1 . σ2 ˆ Now notice that H0 is equivalent to the hypothesis H0 (s) : β s = 1 for any positive integer s. Take the model yi = β + ei ei ∼ N (0. 6.By a first-order Taylor series approximation ¶ µ 2 ¶ µ σ ˜ σ2 ˜ − 1 = Wn .8. The method uses random simulation to create an artificial dataset to apply the statistical tools of interest. The decreasing dashed ˆ = 1. features of this distribution can be calculated. σ 2 ) and consider the hypothesis H0 : β = 1.84 — the probability of a false rejection. This is a context where Monte Carlo simulation can be quite useful as a tool to study and compare the exact distributions statistical procedures in finite samples. The increasing solid line is for the case β = 0.7. as Wn (s) →d χ2 under H0 for 1 any s. LR = n log 1 + 2 − 1 ' n σ ˆ σ2 ˆ the F statistic. we have plotted in Figure 6. Then the standard Wald test for H0 is ˆ ³ ´2 ˆ β−1 Wn = n . σ 2 s2 β ˆ ˆ While the hypothesis β s = 1 is unaffected by the choice of s. This is distressing since the choice of s seems arbitrary and irrelevant to the actual hypothesis. one feature of importance is the Type I error of the test using the asymptotic 5% critical value 3. 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. 62 . Our first-order asymptotic theory is not useful to help pick s. To demonstrate this effect.13 Problems with Tests of NonLinear Hypotheses While the t and Wald tests work well when the hypothesis is a linear restriction on β. This produces random draws from the sampling distribution of interest.

Given the simplicity of the model. For this particular example. so these probabilities are Type I error.000 random samples.1 we report the results of a Monte Carlo simulation where we vary these three parameters.Figure 6. Rates above 20% are unexceptable. The value of s is varied from 1 to 10. and σ 2 . Type I error rates between 3% and 8% are considered reasonable. which is not surprising given the dependence of Wn (s) on s as shown in Figure 6. When comparing statistical procedures. These probabilities are calculated as the percentage of the 50. this probability depends only on s. no magic choice of n for which all tests perform uniformly well. the Type I error probability improves towards 5% as the sample size n increases. looking for tests for which rate rejection rates are close to 5%. In each case. and σ is varied among 1 and 3. There is. Test performance deteriorates as s increases.1 you can also see the impact of variation in sample size. Error rates avove 10% are considered excessive. 100 and 500.4: Wald Statistic as a function of s P (Wn (s) > 3.84. n. remember that the ideal Type I error probability is 5% (. The null hypothesis β s = 1 is true. Table 4. Each row of the table corresponds to a different value of s — and thus corresponds to a particular choice of test statistic.84 | β = 1) .000 simulated Wald statistics Wn (s) which are larger than 3.4. n is varied among 20.1 Type I error Probability of Asymptotic 5% Wn (s) Test 63 . Typically. however. the only test which meets this criterion is the conventional Wn = Wn (1) test.05) with deviations indicating+ distortion. In Table 4. In Table 2. Any other choice of s leads to a test with unacceptable Type I error probabilities. The second through seventh columns contain the Type I error probabilities for different combinations of n and σ. To interpret the table. Table 4.1 reports the simulation estimate of the Type I error probability from 50. and rarely fall outside of the 3%-8% range. we compare the rates row by row.

An alternative statistic can be constructed through reformulating the null hypothesis as H0 : β 1 − rβ 2 = 0.24 . β 1 . so the hypothesis can be stated as H0 : θ = r. Other choices are arbitrary and would not be used in practice.26 . define θ = β 1 /β 2 .11 . β 2 ) be the least-squares estimates of (6.12 .07 .25 .28 .12 . ˆ ˆ ˆ ˆ ˆ Let β = (β 0 .14 .09 .20).22 . 64 .06 .20 .08 . Equivalently.05 .06 .31 .05 .35 . Take the model yi = β 0 + x1i β 1 + x2i β 2 + ei E (xi ei ) = 0 and the hypothesis H0 : β1 =r β2 (6.15 .15 . let V be an estimate of the ˆ asymptotic variance matrix for β and set ˆ = β 1 /β 2 .07 .16 Rejection frequencies from 50. This point can be illustrated through another example.10 .07 .06 .20) ³ ´1/2 ˆ0 ˆ ˆ so that the standard error for ˆ is s(ˆ = n−1 H1 V H1 θ θ) .08 .05 .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 .000 simulated random samples In this example it is not surprising that the choice s = 1 yields the best test statistic.06 .05 .08 .08 .17 .05 .14 .08 .15 . In this case a t-statistic for H0 is t1n = ³ˆ β1 ˆ β2 where r is a known constant.15 .10 .10 .05 .13 . While this is clear in this particular example.34 .13 .33 .30 .19 .18 .23 .20 .13 .22 .06 .06 .06 .25 .06 .07 .07 . Define θ ˆ ˆ ⎞ ⎛ 0 ⎟ ⎜ ⎟ ⎜ ⎜ 1 ⎟ ⎟ ⎜ ⎜ ˆ ⎟ ˆ H1 = ⎜ β 2 ⎟ ⎟ ⎜ ⎟ ⎜ ⎜ β ⎟ ˆ ⎠ ⎝ − 1 ˆ2 β2 ´ s(ˆ θ) −r . in other examples natural choices are not always obvious and the best choices may in fact appear counter-intuitive at first.21 .

50 .06 .00 . then the “most linear” formulation should be selected.75 1. and are close to the ideal 5% rate for both sample sizes. this formulation should be used.06 .05 .00 .06 . This leaves β 2 as a free parameter.47 . σ 2 ) draw with σ = 3.06 .000 simulated samples.07 .645) t1n t2n t1n t2n t1n t2n t1n t2n .05 . 65 .645) greatly exceed 5%. ei be an independent N (0.645) P (tn > 1.26 .10 .05 .645) are close to zero in most cases.06 . The common message from both examples is that Wald statistics are sensitive to the algebraic formulation of the null hypothesis. −1 H V H ˆ 2 n 2 ⎞ 0 H2 = ⎝ 1 ⎠ .645) and P (tn > 1. while the right tail probabilities P (t1n > 1.25.10 . It is also prudent to consider alternative tests to the Wald statistic.1.05 .05 .2 Type I error Probability of Asymptotic 5% t-tests n = 100 n = 500 P (tn < −1. We let x1i and x2i be mutually independent N (0.2. In this section we describe the method in more detail. especially for small values of β 2 . In all cases.00 . the rejection rates for the linear t2n statistic are invariant to the value of β 2 . The implication of Table 4. .00 .15 . and 1.12 .645) P (tn < −1. . In contrast.0 and n among 100 and 500. and alternatives to asymptotic critical values should be considered.05 .00 . and normalize β 0 = 0 and β 1 = 1.09 .02 . If no linear formulation is feasible.00 The one-sided Type I error probabilities P (tn < −1.50. However.15 .06 . The results are presented in Table 4.05 . . the rejection rates for the t1n statistic diverge greatly from this value.05 .7. if the hypothesis can be expressed as a linear restriction on the model parameters.10 .00 .00 . Table 4.05.05 .06 . Ideally. We vary β 2 among . 1) variables. −r ⎛ t2n where To compare t1n and t2n we perform another simple Monte Carlo simulation.00 .A t-statistic based on this formulation of the hypothesis is ´2 ³ ˆ 1 − rβ 2 ˆ β =³ ´1/2 .06 .25 .05 β2 . The left tail probabilities P (t1n < −1.14 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.06 . the entries in the table should be 0. 6.06 .28 . such as the GMM distance statistic which will be presented in Section 9.2 is that the two t-ratios have dramatically different sampling behavior. along with sample size n.75.645) are calculated from 50.645) P (tn > 1.00 .

yn . The researcher chooses F (the distribution of the data) and the sample size n. We then set Tn = ˆ − θ. the distribution function Gn (x. The name Monte Carlo derives from the famous Mediterranean gambling resort. A “true” value of θ is implied by this choice.. From a random sample. B.. most computer packages have built-in procedures for generating U [0.. or equivalently the value θ is selected directly by the researcher. The basic idea is that for any given F. The above experiment creates one random draw from the distribution Gn (x. we set B = 1000 or B = 5000. we can estimate any feature of interest using (typically) a method of moments estimator. x∗ ) . or variance of the distribution ˆ − θ. We will discuss this choice later... These results are stored.) For step 2. b = 1. .. n n For step 1.. Typically... Notationally. The method of Monte Carlo is quite simple to describe. θ) is calculated on this pseudo data. yn . i = 1. run the above experiment. xn . (For example. 1] and N (0.. Gn (x. For example: Suppose we are interested in the bias. They constitute a random sample of size B from the distribution of Gn (x.. where games of chance are played. θ) be a statistic of interest. ∗ ∗ • The statistic Tn = Tn (y1 . 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. from one observation very little can be said. So the researcher repeats the experiment B times. x∗ .. Monte Carlo simulation uses numerical simulation to compute Gn (x. where B is a large number. let the b0 th experiment result in the draw Tnb . x∗ . F ) can be calculated numerically through simulation. F ) = P (Tn ≤ x | F ) . This is one observation from an unknown distribution. which implies restrictions on F . the exact (finite sample) distribution Gn is generally unknown. This is useful to investigate the performance of the statistic Tn in reasonable situations and sample sizes. F ) = P (Tnb ≤ x) = P (Tn ≤ x | F ) . xi ) which are random draws from a population distribution F. mean-squared error (MSE). . F ). Then the following experiment is conducted ∗ • n independent random pairs (yi . and from these most random variables can be constructed. 1) random numbers. Clearly. are drawn from the distribution F using i the computer’s random number generator. While the asymptotic distribution of Tn might be known. our data consist of observations (yi . Let θ be a parameter and let Tn = Tn (y1 .Recall. n. x1 . 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 . it is important that the statistic be evaluated at the “true” value of θ corresponding to the choice of F. a chi-square can be generated by sums of squares of normals.

the performance will depend on n and F. and non-white. We us the sample of wage earners from the March 2004 Current Population Survey. the choice of B is often guided by the computational demands of the statistical procedure. immigrant. such as the percentage estimate reported in (6. Quite simply. Suppose we are interested in the 5% and 95% quantile of Tn = ˆ We then compute the 10% θ.05) (. we included a dummy 67 . if we are ³ ´ p √ ˆ assessing an asymptotic 5% test. union member. and our regressors include years of education.15 Estimating a Wage Equation We again return to our wage equation. Furthermore. Often this is called the number of replications. Generally.21) the percentage of the simulated t-ratios which exceed the asymptotic 5% critical value. union member.96) is iid Bernoulli. then the 5% sample quantile is 50’th sorted value and the 95% sample quantile is the 950’th sorted value. A simple way to compute sample quantiles is to sort the sample {Tnb } from low to high.96) . In practice. excluding military.21). We would then set Tn = ¯ˆ − θ¯ /s(ˆ and calculate B X ˆ= 1 P 1 (Tnb ≥ 1. As discussed above. It is therefore convenient to pick B so that N is an integer. s P = . and .022. B. . For regressors we include years of education. and 90% sample quantiles of the sample {Tnb }. In particular. B b=1 (6. then we can set s P = (. We now expand the sample all non-military wage earners. Again our dependent variable is the natural log of wages. equalling 1 with probability P = E1 (Tnb ≥ 1. therefore. and dummy variable indicators for the following: married. We separately estimate equations for white and non-whites. Hence the ³ ´ ˆ standard errors for B = 100. Since the results of a Monte Carlo experiment are estimates computed from a random sample of size B.96) . but requires more computational time. immigrant. then B will have to be increased. respectively. If the standard error is too large to make a reliable inference. The random variable 1 (Tnb ≥ 1. if we set B = 999. and 5000. potential work experience. and therefore it is straightforward to calculate standard errors for any quantity of interest. are.22/ B. and hispanic. experience squared. this may ˆ be approximated by replacing P with P or with an hypothesized value. For example. where N = (B +1)α.21) is therefore an ³ ´ p ˆ unbiased estimator of P with standard error s P = P (1 − P ) /B. it is simple to make inferences about rejection probabilities from statistical tests. female. the researcher must select the number of experiments. female. experience squared. For example. for a selection of choices of n and F. In many cases. Then qα is the N ’th number in this ordered sequence. The average (6. and dummy variable indicators for the following: married. so that coefficients may be interpreted as semi-elasticities. It is therefore useful to conduct a variety of experiments.007. potential work experience. As P is unknown.003. 1000. 6.Suppose we are interested in the ¯Type I error associated with an asymptotic 5% two-sided ¯ ¯ ¯ θ) θ t-test. and poorly for others. The typical purpose of a Monte Carlo simulation is to investigate the performance of a statistical procedure (estimator or test) in realistic settings. and estimate a multivariate regression. For the dependent variable we use the natural log of wages.95) /B ' . hispanic. a larger B results in more precise estimates of the features of interest of Gn . The α% sample quantile is a number qα such that α% of the sample are less than qα . an estimator or test may perform wonderfully for some values.

Computing the Wald statistic (6.007 .010 .008 . this adds 50 regressors).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. but not equal.097 −.232 . 808 1 − . Using either statistic the hypothesis is easily rejected. the restricted standard deviation estimate is σ = .102 −.070 .48772 = 515.34 ˆ s(β) .121 −.1.69.4945. we find Wn = 550.00057 . θ ˆ 2β 3 β2 .4877 18.014 .032 .002 .027 . if β 2 > 0 and β 3 < 0 the solution is θ=− From Table 4.033 −. The F form of the Wald statistic (6. The available sample is 18. Table 4. 2β 3 68 . as the 1% critical value for the χ2 distribution is 76. 50 Another interesting question which can be addressed from these estimates is the maximal impact of experience on mean wages.19) is ˜ µ ¶ µ ¶ σ2 ˆ .49452 σ ˜ Notice that the two statistics are close.101 . we can write this effect as log(W age) = β 2 Experience + β 3 Experience2 + · · · Our question is: At which level of experience θ do workers achieve the highest wage? In this quadratic model. excluding the coefficients on the state dummy variables.1 we find the point estimate ˆ ˆ = − β 2 = 28.808 so the parameter estimates are quite precise and reported in Table 4.102 −.808 .1 OLS Estimates of Linear Equation for Log(Wage) ˆ β 1.00002 . Ignoring the other coefficients.013 .variable for state of residence (including the District of Columbia. Wn = n 1 − 2 = 18.18) that the state coefficients are jointly zero. Alternatively. reestimating the model with the 50 state dummies excluded.001 .

However. implying a 95% confidence θ) interval of [27. Since tn (θ) is a non-linear function of θ. but it can be found numerically quite easily.40. This is the set of θ such that |tn (θ)| ≤ 1. Notice that the upper end of the confidence interval is the same as that from the delta method. Our desired confidence interval will be the set of parameter values θ which are not rejected by the hypothesis test. 29.96. In the present context we are interested in forming a confidence interval. so we have to go one step further. 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. This set is [27. there is not a simple expression for this set. but the lower end is substantially lower. this is a poor choice. 69 . Instead. as the coverage probability of this confidence interval is one minus the Type I error of the hypothesis test based on the t-test.9.5].5]. In the previous section we discovered that such t-tests had very poor Type I error rates.0. not testing a hypothesis.Using the Delta Method. we found better Type I error rates by reformulating the hypothesis as a linear restriction. we can calculate a standard error of s(ˆ = .

In the model Y = Xβ + e. ˜ (b) Verify that R0 β = r. In the model Y = X1 β 1 + X2 β 2 + e. (d) Under the ´ standard assumptions plus R0 β = r. In the model Y = X1 β 1 + X2 β 2 + e. In the model Y = X1 β 1 + X2 β 2 + e. 1.6. (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. Explain why β solves the minimization of the Lagrangian ¢ ¡ 1 L(β. β minimizes the sum of squared errors Sn (β) over all β such that the restriction holds. β 2 ). λ) = Sn (β) + λ0 R0 β − r 2 where λ is s × 1. find the least-squares estimate of β = (β 1 . the least-squares estimate of β subject to the restriction h(β) = 0 is ˜ β = argmin Sn (β) h(β)=0 Sn (β) = (Y − Xβ)0 (Y − Xβ) . show that the least-squares estimate of β = (β 1 . then ¶ µ ¡ ¢−1 h 0 ¡ 0 ¢−1 i−1 0 ¡ 0 ¢−1 0 ˜ XX R R XX R R X e. β − β = Ik − X 0 X 70 . ˜ (e) Find an appropriate formula to calculate standard errors for the elements of β. find the asymptotic distribution of √ ³˜ n β − β as n → ∞. 0 < s < k.16 Exercises For exercises 1-4. (c) Show that if R0 β = r is true. 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 . 2. subject to the constraint that β 1 = −β 2 . β 2 ). 4. and rank(R) = s. ˜ That is. β 2 ) subject to the constraint that β 2 = 0 is the OLS regression of Y on X1 . show that the least-squares estimate of β = (β 1 . 3. r ˜ is a known s × 1 vector. the following definition is used.

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 à n !−1 à 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

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

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

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

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

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

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

1. This means that under H0 . θ) ' m(xi . ˆ ˆ θ) ˆ θ).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 . We have discussed projections and conditional means. 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 . Thus when the truth is that β 2 = 0.4. θ) = β 0 zi + β 0 xi (γ). γ is not identified. In particular. the model is yi = β 0 zi + εi 1 and both β 2 and γ have dropped out. and this is often a useful hypothesis (sub-model) to consider. under H0 .For θ close to the true value θ0 . Thus the NLLS 0 estimator ˆ has the same asymptotic distribution as the (infeasible) OLS regression of yi on mθi . θ0 )) − m(xi . An alternative good measure is the conditional median. but these are not the only measures of central tendency. m(xi . θ0 ) + m0 (θ − θ0 ) . ˆ and ei = yi − m(xi . Thus we want to test H0 : β 2 = 0. θi Thus ¡ ¢ yi − m(xi . Hansen (1996). θ) ' (ei + m(xi . 80 . However. by a first-order Taylor series approximation. tests of H0 do not have asymptotic normal or chi-square distributions. 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 . The asymptotic theory of such tests have been worked out by Andrews and Ploberger (1994) and B. θ which is that stated in the theorem. This renders the distribution theory presented in the previous section invalid. Suppose that m(xi . the parameter estimates are not asymptotically normally distributed. ¥ Based on Theorem 7. Hansen shows how to use simulation (similar to the bootstrap) to construct the asymptotic critical values (or p-values) in a given application. θ0 ) + m0 (θ − θ0 ) θi = ei − m0 (θ − θ0 ) θi 0 = yi − m0 θ. Identification is often tricky in nonlinear regression models. 1 2 The model is linear when β 2 = 0. θi Hence the sum of squared errors function is Sn (θ) = n X i=1 (yi − m(xi . Furthermore. 7.

as i=1 these estimators are indeed identical. let Y be a continuous random variable. Now let’s consider the conditional median of Y given a random variable X. however. it is a solution to the moment condition ³ ´ 1X ˆ xi sgn yi − x0 β = 0. Two useful facts about the median are that (7. the linear function M ed (yi | xi = x) = x0 β is the conditional median function. The first definition is the 50th empirical 1 P quantile. and let M ed (Y | X) = m(X) be this function evaluated at the random variable X.5 • E (sgn (ei ) | xi ) = 0 • E (xi sgn (ei )) = 0 • β 0 = minβ E |yi − x0 β| i These facts motivate the following estimator. and the substantive assumption is that the median function is linear in x.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. Let ¯ 1 X¯ ¯yi − x0 β ¯ Ln (β) = i n i=1 n be the average of absolute deviations. The second is the value which minimizes n n |yi − θ| . These distinctions are illusory. The median θ0 = M ed(Y ) is the value such that P (Y ≤ θ0 ) = P (Y ≥ θ0 ) = . and the third definition is the i=1 1 P solution to the moment equation n n sgn (yi − θ) . Let m(x) = M ed (Y | X = x) denote the conditional median of Y given X = x. Conditional analogs of the facts about the median are • P (yi ≤ x0 β 0 | xi = x) = P (yi > x0 β | xi = x) = . The linear median regression model takes the form yi = x0 β + ei i M ed (ei | xi ) = 0 In this model. i n n i=1 (7.10) The LAD estimator has the asymptotic distribution 81 .5. The least absolute deviations (LAD) estimator of β minimizes this function ˆ β = argmin Ln (β) β Equivalently. These facts definitions motivate three estimators of θ.To recall the definition and properties of the median.

ˆ Proof of Theorem 7. (7.11) This simplification is similar to the simplification of the asymptotic covariance of the OLS estimator under homoskedasticity. by a Taylor series expansion and the fact g(β 0 ) = 0 82 .1: Since sgn (a) = 1 − 2 · 1 (a ≤ 0) . by the central limit theorem (Theorm 5. ∂β ˆ g(β) ' ´ ³ ∂ ˆ g(β 0 ) β − β 0 . the conditional density of the error at its median. In the special case where the error is independent of xi . ∂ 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 ) . ∂β 0 so Third. Second using the law of iterated expectations and the chain rule of i differentiation. then there are many innovations near to the median. the height of the error density at its median. This can be done with kernel estimation techniques. Exi x0 ) i i=1 since Egi (β 0 )gi (β 0 )0 = Exi x0 . When f (0 | x) is large.10) is equivalent to g n (β) = 0. The main difficulty is the estimation of f (0).1) n X √ −1/2 n (g n (β 0 ) − g(β 0 )) = −n gi (β 0 ) →d N (0. See Chapter 16. and this improves estimation of the median. While a complete proof of Theorem 7.5.Theorem 7.11). where V = and f (e | x) is the conditional density of ei given xi = x. we provide a sketch here for completeness. Computation of standard error for LAD estimates typically is based on equation (7. Pn −1 0 β)) . then f (0 | x) = f (0) and the asymptotic variance simplifies V = (Exi x0 )−1 i 4f (0)2 (7.5.5. 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. Let g(β) = Eg (β). V ).1 ´ √ ³ˆ n β − β 0 →d N (0. First. ¢¢−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) .3.

9) for the median to all quantiles. then F (Qτ ) = τ . θ where ρτ (q) is the piecewise linear function ½ −q (1 − τ ) q<0 ρτ (q) = qτ q≥0 = q (τ − 1 (q < 0)) . The median is the special case τ = .12) Qτ = argmin Eρτ (U − θ) . then (7. 1] the τ ’th quantile Qτ of a random variable with distribution function F (u) is defined as Qτ = inf {u : F (u) ≥ τ } When F (u) is continuous and strictly monotonic. The third line follows from an asymptotic empirical process argument. If the random variable U has τ ’th quantile Qτ . This linear specification assumes that Qτ (x) = β 0 x where the coefficients β τ τ vary across the quantiles τ .13) This generalizes representation (7.5. xi ) with conditional distribution function F (y | x) the conditional quantile function qτ (x) is Qτ (x) = inf {y : F (y | x) ≥ τ } . (7. We then have the linear quantile regression model yi = x0 β τ + ei i 83 . Exi x0 ) →d i 2 = N (0. However for computational convenience it is typical to assume that they are (approximately) linear in x (after suitable transformations). the quantile regression function qτ (x) describes how the τ ’th quantile of the conditional distribution varies with the regressors. For the random variables (yi . V ). For τ ∈ [0.6 Quantile Regression The method of quantile regression has become quite popular in recent econometric practice. then F (Qτ (x) | x) = τ . ¥ 7. The following alternative representation is useful. so you can think of the quantile as the inverse of the distribution function. Again. For fixed τ . the quantile regression functions can take any shape. The quantile Qτ is the value such that τ (percent) of the mass of the distribution is less than Qτ . when F (y | x) is continuous and strictly monotonic in y. As functions of x.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.

fast linear programming methods have been developed for this problem. ˆ Given the representation (7.7 Testing for Omitted NonLinearity If the goal is to estimate the conditional expectation E (yi | xi ) .5. One simple test for neglected nonlinearity is to add nonlinear functions of the regressors to ˆ ˆ the regression. otherwise its properties are unspecified without further restrictions. ´ √ ³ˆ Theorem 7. ¡ ¡ ¢¢−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. Another popular approach is the RESET test proposed by Ramsey (1969). then f (0 | xi ) = f (0) .12). Thus. since it has discontinuous derivatives. and we have the simplification Vτ = τ (1 − τ ) ¡ ¡ 0 ¢¢−1 . if the model yi = x0 β + ei has i been fit by OLS. and form a Wald statistic i for γ = 0. i By construction. where and f (e | x) is the conditional density of ei given xi = x.1. Fortunately. and test their significance using a Wald test.13). and are widely available. A asymptotic distribution theory for the quantile regression estimator can be derived using similar arguments as those for the LAD estimator in Theorem 7. When the error ei is independent of xi . Furthermore. the unconditional density of ei at 0. 7. The null model is yi = x0 β + εi i 84 . Since the quanitle regression criterion function Lτ (β) does not have an algebraic solution.6. it is useful to have a general test of the adequacy of the specification. E xi xi f (0)2 A recent monograph on the details of quantile regression is Koenker (2005). Vτ ). n numerical methods are necessary for its minimization. the τ ’th conditional quantile of ei is zero. the quantile regression estimator β τ for β τ solves the minimization problem ˆ β τ = argmin Lτ (β) n β∈Rk n where Lτ (β) = n and ρτ (q) is defined in (7. the asymptotic variance depends on the conditional density of the quantile regression error.where ei is the error defined to be the difference between yi and its τ ’th conditional quantile x0 β τ . conventional Newton-type optimization methods are inappropriate.1 n β τ − β τ →d N (0. let zi = h(xi ) denote functions of xi which are not linear functions of xi (perhaps 0˜ ˜ ˜ squares of non-binary regressors) and then fit yi = x0 β +zi γ + ei by OLS.

Now let ˆ i ⎛ 2 ⎞ yi ˆ ⎜ . 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 . they will (typically) have difference asymptotic variances. The comparison between the two estimators is straightforward when the error is conditionally ¢ ¡ homoskedastic E e2 | xi = σ 2 . or 4 seem to work best. yielding predicted values yi = x0 β. Typically. since Q12 Q−1 Q21 > 0. To see why this is the case. The RESET test appears to work well as a test of functional form against a wide range of smooth alternatives. If Q12 = 0 (so the variables are orthogonal) then these two variance matrices equal. and form the Wald statistic Wn for γ = 0. Another is to regress yi on x1i and x2i jointly. In the model x2i is “irrelevant” if β 1 is the parameter of interest and β 2 = 0. yielding ˆ ˜ ˆ ˆ (β 1 . small values such as m = 2. It is particularly powerful at detecting single-index models of the form yi = G(x0 β) + εi i where G(·) is a smooth “link” function. β 1 = (X1 X1 )−1 (X1 Y ) . Under which conditions is β 1 or β 1 superior? It is easy to see that both estimators are consistent for β 1 . then 22 Q11 > Q11 − Q12 Q−1 Q21 . 1i 2i 2i 1i 22 . and consequently 22 ¡ ¢−1 2 σ . and the two estimators have equal asymptotic efficiency. Then run the auxiliary regression ˆ 0 ˜ yi = x0 β + zi γ + ei ˜ ˜ i ˆ which is estimated by OLS. 7. 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. ⎠ .8 Irrelevant Variables yi = x0 β 1 + x0 β 2 + ei 1i 2i E (xi ei ) = 0. Otherwise. However. One estimator of β 1 is to regress 0 0 ˜ yi on x1i alone. lim nV ar( β 1 ) = Ex1i x0 1i 11 n→∞ say. note that (7.14) by OLS.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. β 2 ). ⎟ zi = ⎝ .be an (m − 1)-vector of powers of yi . yi ˆm (7. To implement the test. 3. Wn →d χ2 . and n→∞ say. It is easy (although somewhat tedious) to show that under the null hypothesis. In this case i ¡ ¢−1 2 ˜ σ = Q−1 σ 2 . m must be selected in advance.

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

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

which regressors enter the regression). and the AIC or BIC in principle can be implemented by estimating all possible subset models. which are nested. . there are 2K such models. Also under M2 .15). a model consists of any possible subset of the regressors {x1i . xKi }. 88 . stores the residual variance σ 2 for each model. . the models are M1 : β 1 6= 0. ... and then selects the model with the lowest AIC (7. In the ordered case. MK : β 1 6= 0. Similarly for ˆ the BIC. β 2 = β 3 = · · · = β K = 0 M2 : β 1 6= 0. However.17). 210 = 1024. The methods extend readily to the issue of selection among multiple regressors. 048. log(n) µ LRn > k2 | M2 log(n) ¶ ´ ³ c P M = M2 | M2 = P → 1. In the unordered case. a full-blown implementation of the BIC selection criterion would seem computationally prohibitive. which can be a very large number. and 220 = 1. The AIC selection criteria estimates the K models by OLS. For example.so ´ ³ c P M = M1 | M1 = = P (BIC1 < BIC2 | M1 ) P (LRn < log(n)k2 | M1 ) µ ¶ LRn = P < k2 | M1 log(n) → P (0 < k2 ) = 1.. In the latter case. one can show that thus LRn →p ∞. β 2 6= 0. We have discussed model selection between two models. selecting based on (7. β 2 6= 0. 576. The general problem is the model yi = β 1 x1i + β 2 x1i + · · · + β K xKi + εi . . β K 6= 0. β 3 = · · · = β K = 0 . . E (εi | xi ) = 0 and the question is which subset of the coefficients are non-zero (equivalently. . There are two leading cases: ordered regressors and unordered. .

Let (yi . Define g(u) = τ − 1 (u < 0) where 1 (·) is the indicator function (takes the value 1 if the argument is true. You wish to forecast an out-of-sample value of y given that ˆ ˆ ˆ ˆ X = x. ˜ the residual vector is e = Y − X β..12). Show that the function g(x) which minimizes the MAE is the conditional median M (x). i ˆ ˆ suppose β is the OLS estimate of β with covariance matrix V . E(e | X) = 0. 5. . and the out-of-sample value of the regressors. 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 . V . x. For any predictor g(xi ) for y. Verify equation (7. xi ) be a random sample with E(Y | X) = Xβ.. . Is θ a quantile of the distribution of Yi ? 3. 2. In the homoskedastic regression model Y = Xβ + e with E(ei | xi ) = 0 and E(e2 | xi ) = σ 2 . and an estimate of σ 2 is ˆ s2 = 1 e0 Ω−1 e. σ 2 ). the estimates (β. 4. the mean absolute error (MAE) is E |yi − g(xi )| . Consider the Weighted Least Squares (WLS) estimator of β ¢−1 ¡ 0 ¢ ¡ ˜ X WY β = X 0W X where W = diag(w1 . based on a sample of size n. Let θ satisfy Eg(Yi − θ) = 0. Thus the available information is the sample (Y. else equals zero). the residuals e.. the GLS estimator is ¡ ¢−1 ¡ 0 −1 ¢ ˜ β = X 0 Ω−1 X XΩ Y . ˆ ˆ n−k 6. Let σ 2 be the estimate of σ 2 . 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 . X). (b) Find an estimate of the variance of this forecast. where xji is one of the xi . (b) Prove that e = M1 e. V ar(e | X) = σ 2 Ω with Ω known. ji ˜ (a) In which contexts would β be a good estimator? ˜ (b) Using your intuition. In a linear model Y = Xβ + e.10 Exercises 1.7. wn ) and wi = x−2 . ˆ (a) Find a point forecast of y.

The model works best when a7 is selected so that several values (in this example. . Record the sum of squared errors. Assess the merits of this new specification using (i) a hypothesis test... Do so. The model is non-linear because of the parameter a7 . The equation you estimated was ln T Ci = β 1 + β 2 ln Qi + β 3 ln P Li + β 4 ln P Ki + β 5 ln P Fi + ei . 90 . (d) Calculate standard errors for all the parameters (a1 . the regression slope is a2 + a6 . Do you agree with this modification? (b) Now try a non-linear specification. calculate zi and estimate the model by OLS. θ) + ei with E (ei | xi ) = 0. This model is called a smooth threshold model. and the model imposes a smooth transition between these regimes. 8.. For each value of a7 . you estimated a cost function on a cross-section of electric companies.18) plus the extra term a6 zi . I recommend the concentration method: Pick 10 (or more or you like) values of a7 in this range. θ is the NLLS estimator. and V is the = g(x estimate of V ar ˆ .18) (a) Following Nerlove. impose the restriction a3 + a4 + a5 = 1. at least 10 to 15) of ln Qi are both below and above a7 . For values much above a7 . n xi i=1 (a) Under the stated assumptions. (ii) AIC criterion. (c) Estimate the model by non-linear least squares. (7. You are interested in the conditional mean function E (yi | xi = x) = θ g(x) at some x. Suppose that yi ³ ´ i . In addition. (iii) BIC criterion. are both estimators consistent for β? (b) Are there conditions under which either estimator is efficient? 9. Find an asymptotic 95% confidence interval for g(x). The model is yi = xi β + ei E (ei | xi ) = 0 where xi ∈ R. For values of ln Qi much below a7 . a7 ). In Chapter 6.ˆ ˆ 7. and find the value of a7 for which the sum of squared errors is minimized. Examine the data and pick an appropriate range for a7 . Consider model (7. Consider the two estimators ˆ β = ˜ β = Pn i=1 x y Pn i 2 i i=1 xi n 1 X yi . Exercise 13. add the variable (ln Qi )2 to the regression. the variable ln Qi has a regression slope of a2 . where zi = ln Qi (1 + exp (− (ln Qi − a7 )))−1 .

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

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

The EDF is a consistent estimator of the CDF. where 1(·) is the indicator function.2. x) is called the empirical distribution function (EDF). xi ≤ x) = E (1 (yi ≤ y) 1 (xi ≤ x)) . I have plotted the EDF and true CDF for three random samples of size n = 25. and 100. Fn (y. by the CLT (Theorem 5. 50. ∗ P (yi ≤ y. i 93 . For n = 25. 1) distribution. Fn is by construction a step function. x) . Furthermore. Recall that F (y. note that for any (y. x). x∗ ) with the i distribution Fn . it is helpful to think of a random pair (yi . x) (1 − F (y. the EDF step function gets uniformly close to the true CDF. The random draws are from the N (0. The method of moments estimator is the corresponding sample moment: n 1X 1 (yi ≤ y) 1 (xi ≤ x) . x)) →d N (0.1). i = 1.2 The Empirical Distribution Function Fn (y.2) Fn (y. but the approximation appears to improve for the large n.8. in the Figure below.1).3. 1 (yi ≤ y) 1 (xi ≤ x) is an iid random variable with expectation F (y. x) − F (y. √ n (Fn (y. as the sample size gets larger. Thus by the WLLN (Theorem 5. n. To see the effect of sample size on the EDF. . In general.. x). F (y..1: Empirical Distribution Functions The EDF is a valid discrete probability distribution which puts probability mass 1/n at each ∗ pair (yi . x). x) = P (yi ≤ y. This is a population moment. x))) . Fn is a nonparametric estimate of F. xi ).. the EDF is only a crude approximation to the CDF. That is. x∗ ≤ x) = Fn (y. (8. Notationally. Note that while F may be either discrete or continuous. x) = n i=1 Figure 8. To see this. x) →p F (y.

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

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

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

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

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

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

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

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

and g2 is continuous in F. and for the bootstrap ³x´ + O(n−1/2 ). the asymptotic two-sided test has a better coverage rate than the asymptotic one-sided test. Thus a two-sided bootstrap test also achieves an asymptotic refinement. is an even function. We know that θ Tn →d N (0. Therefore. This is because the first term in the asymptotic expansion. F0 )) + O(n−3/2 ) n = O(n−3/2 ).Interestingly. we find Gn (x) = Gn (x. The analysis shows that there may be a trade-off between one-sided and two-sided tests.11 Percentile Confidence Intervals ´ √ ³ To evaluate the coverage rate of the percentile interval. as it depends on the unknown V. Two-sided tests have better rates of convergence than the one-sided tests. 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 ). meaning that the errors in the two directions exactly cancel out. F ) = Φ v √ where v = V . The difference is ³x´ ³x´ −Φ + O(n−1/2 ) G∗ (x) − Gn (x. Confidence intervals based on the bootstrap can be asymmetric if based on one-sided tests (equal-tailed intervals) and can therefore be more informative and have smaller length than symmetric intervals. Fn ) − g2 (x. Fn ) = Φ n v ˆ ˆ where V = V (Fn ) is the bootstrap estimate of V. Applying (8. This is in contrast to the use of the asymptotic distribution. V ). but one-sided tests might have more power against alternatives of interest. A reader might get confused between the two simultaneous effects. which is not pivotal. √ the last equality because Fn converges to F0 at rate n. set Tn = n ˆ − θ0 . Fn ) + O(n−3/2 ). 8. g1 . G∗ (x) = Gn (x. Fn ) = Φ(x) + ∗ 2 g2 (x. similar to a one-sided test. and bootstrap tests have better rates of convergence than asymptotic tests. 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 . Gn (x. Twosided tests will have more accurate size (Reported Type I error).8. whose error is O(n−1 ). F0 ) = ∗ 2 (g2 (x.5) to the bootstrap distribution. Theorem 8.1 shows that a first-order approximation ³x´ + O(n−1/2 ). and needs to be determined on a case-by-case basis. the choice between symmetric and equal-tailed confidence intervals is unclear. n Thus the difference between the bootstrap and exact distributions is Gn (x) − Gn (x.

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

Let the statistic of interest be the sample mean Tn = y n . Typically what is desirable is to impose only the regression condition E (εi | xi ) = 0. and set x∗ = xi0 and e∗ = ei0 .. Let β denote the ˆ the OLS residuals... calculate the estimate ˆ on these samples and then calculate θ ∗ ∗ θ θ)/s(ˆ θ). yn } be a random sample from the empirical distribution function and let Tn = y ∗ be n ∗ ∗ its sample mean. Unfortunately this is a harder problem. generate ∗ bootstrap samples. X ∗ ). Let Fn (x) denote the EDF of a random sample. . i 8. Show that this bootstrap procedure is (numerically) identical to the non-parametric bootstrap. Consider the following bootstrap procedure. Consider the following bootstrap procedure for a regression of yi on xi .... This can be achieved using a two-point distribution of the form à à √ ! ! √ 1+ 5 5−1 ∗ √ ei ˆ = P εi = 2 2 5 à à √ ! ! √ 1− 5 5+1 ∗ √ P εi = = ei ˆ 2 2 5 For each xi . draw a ˆ ˆ random integer i0 from [1. 4. yielding OLS estimates β and any other statistic of interest. whether or not the xi are really “fixed” or random. It does not really matter. . 2. ei ) : i = 1. however. and e = Y − X β ˆ (a) Draw a random vector (x∗ . Show that √ n (Fn (x) − F0 (x)) →d N (0.. n]. Let ∗ ∗ ∗ {y1 .. .. ˆ Draw (with replacement) n such vectors. That is. you sample ε∗ using this two-point distribution. The methods discussed above are unattractive for most applications in econometrics because they impose the stringent assumption that xi and εi are independent. creating a random bootstrap data set (Y ∗ .13 Exercises 1. 2. Take a random sample {y1 . Find the bootstrap moments ETn and V ar(Tn ).. Set y∗ = x∗0 β + e∗ .. F0 (x) (1 − F0 (x))) . n} . which is a valid statistical approach. Find the population moments ETn and V ar(Tn ). yn } with µ = Eyi and σ 2 = V ar(yi ).. OLS estimator from the regression of Y on X. ˆ 3. ˆ∗ (b) Regress Y ∗ on X ∗ . e∗ ) from the pair {(xi . The idea is to construct a conditional distribution for ε∗ so that i E (ε∗ | xi ) = 0 i ¡ ∗2 ¢ E εi | xi = e2 ˆi ¡ ∗3 ¢ E εi | xi = e3 . Tn = (ˆ − ˆ 104 . ˆi A conditional distribution with these features will preserve the main important features of the data. .observed values of the regressors. One proposal which imposes the regression condition without independence is the Wild Bootstrap. Using the non-parametric bootstrap.

95).95) denote the 95% quantile of Tn . Calculate 95% confidence intervals for the regression coefficients using both the asymptotic normal approximation and the percentile-t bootstrap. θ respectively.5% and 97.75 and 1. You replace c with qn (. calculate the estimates ˆ on these samples and θ then calculate ∗ ∗ ∗ θ θ Tn = ˆ /s(ˆ ). You want to test H0 : θ = 0 against H1 : θ > 0. θ θ)q ∗ θ θ)q ∗ θ/s(θ) 5. What is wrong with this procedure? Tn = θ/s(θ) n 6. Using the non-parametric bootstrap.dat contains data on house prices (sales). size of house. and define the bootstrap confidence interval h i C = ˆ − s(ˆ n (.Show that C exactly equals the Alternative percentile interval (not the percentile-t interval).95). and the colonial dummy. 105 . θ θ) ∗ 1000 samples are generated from the bootstrap distribution. (c) With the given information. (b) Report the 95% Alternative Percentile interval for θ. The test for H0 is to reject if Tn = ˆ ˆ > c where c is picked so that Type I error is α.95).05) and qn (. with variables listed in the file hprice1.2. ˆ = 1. Using the non-parametric ∗ bootstrap. and the 2.05) . can you report the 95% Percentile-t interval for θ? 7. ∗ ∗ where s(ˆ is the standard error in the original data.3.5% quantiles of the ˆ are . and ˆ is calculated on each θ ∗ ∗ θ sample. lot size. and thus reject H0 if ˆ ˆ > q ∗ (. ˆ − s(ˆ n (.pdf. Let qn (. Suppose that in an application. ∗ ∗ ∗ Let qn (. you generate bootstrap samples. The ˆ are sorted.95) denote the 5% θ) ∗ and 95% quantiles of Tn . You do this as follows. The datafile hprice1.2 and s(ˆ = . (a) Report the 95% Efron Percentile interval for θ. Estimate a linear regression of price on the number of bedrooms.

In the statistics literature. an asymptotically efficient estimator of β is the OLS estimator. Now we can write the model as yi = x0 β 1 + ei 1i E (xi ei ) = 0. is not necessarily efficient. Let g(y. We call r the number of overidentifying restrictions. while β 1 is of dimension k < . however. There are − k = r more moment restrictions than free parameters. The variables zi may be components and functions of xi . g(y. If k = the model is just identified. β) = x(y − x0 β). how should β 1 be estimated? One method is OLS regression of yi on x1i alone.Chapter 9 Generalized Method of Moments 9. This is a special case of a more general class of moment condition models. In our previous example.2) . z. Now suppose that we are given the information that β 2 = 0. β) be an × 1 function of a k × 1 parameter β with ≥ k such that Eg(yi . these are known as estimating equations. As an important special case we will devote special attention to linear moment condition models. In this case.1 Overidentified Linear Model yi = x0 β + ei i = x0 β 1 + x0 β 2 + ei 1i 2i E (xi ei ) = 0 where x1i is k × 1 and x2 is r × 1 with = k + r. which can be written as 0 yi = zi β + ei Consider the linear model E (xi ei ) = 0.1) where β 0 is the true value of β. where the dimensions of zi and xi are k × 1 and × 1 . z. but this is not required. with ≥ k. x. In econometrics. otherwise it is overidentified. This model falls in the class (9. This situation is called overidentified. β 0 ) = x(y − z 0 β) 106 (9. as their are restrictions in E (xi ei ) = 0. x. We know that without further restrictions. zi . β 0 ) = 0 (9. 1 this class of models are called moment condition models.1) by setting g(y. x. This method. xi .

1 β GMM = argmin Jn (β).1 ˆ 2Z 0 XWn X 0 Z β = 2Z 0 XWn X 0 Y While the estimator depends on Wn . The GMM estimator minimizes Jn (β). the square of the Euclidean length. β ˆ Note that if k = . i i . ˆ Definition 9. Then µ ¶ ¶ µ 1 0 1 0 Z X Wn X Z →p Q0 W Q n n 107 ¡ ¢ ¡ 0¢ Ω = E xi x0 e2 = E gi gi .2. β GMM does not change. let Jn (β) = n · g n (β)0 Wn g n (β). β GMM = Z 0 XWn X 0 Z 9. The idea of the generalized method of moments (GMM) is to define an estimator which sets g n (β) “close” to zero. but this is generally not possible when > k. For example. if Wn = I.2) g n (β) = (9.3) The method of moments estimator for β is defined as the parameter value which sets g n (β) = 0. then g n (β) = 0. and the GMM estimator is the MME.9. ¡ ¢−1 0 ˆ Z XWn X 0 Y. Let and where gi = xi ei . gi (β) = xi yi − zi β = n n n i=1 i=1 Define the sample analog of (9. Proposition 9. for if Wn is replaced ˆ by cWn for some c > 0. the dependence is only up to scale. then.2.3 Distribution of GMM Estimator ¡ 0¢ Q = E xi zi Assume that Wn →p W > 0.2 GMM Estimator n n ¢ 1¡ 0 ¢ 1X 1X ¡ 0 X Y − X 0 Zβ . For some × weight matrix Wn > 0. This is a non-negative measure of the “length” of the vector g n (β). Jn (β) = n · g n (β)0 g n (β) = n · |g n (β)|2 . The first order conditions for the GMM estimator are 0 = ∂ ˆ Jn (β) ∂β ∂ ˆ ˆ = 2 g n (β)0 Wn g n (β) ∂β ´ 1 1 ³ ˆ = −2 Z 0 XWn X 0 Y − Z β n n so which establishes the following.

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

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

5. Since the GMM estimator depends upon the first-stage estimator. The GMM estimator minimizes J(β) = n · g n (β)0 Wn g n (β) where g n (β) = and Wn = à 1X gi (β) n i=1 n ˜ ˜ with gi = gi (β) constructed using a preliminary consistent estimator β. so that the linear equation may be written as yi = β 0 x1i + ei . Identification requires l ≥ k = dim(β).1 (Sargan-Hansen). Note that g n →p Egi .Often. and is thus a natural test statistic for H0 : Egi = 0. this is all that is known. where ³ ´−1 ∂ 0 ˆ ˆ ˆ ˆ Ω = (E (gi gi ))−1 and G = E ∂β 0 gi (β). In this sense an 1i 1i exclusion restriction can be seen as an overidentifying restriction. 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). Thus the model — the overidentifying restrictions — are testable.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 . 9.1 Under general regularity conditions. and in this case it would be impossible to find a value of β 1 so that both E (x1i (yi − x0 β 1 )) = 0 and E (x2i (yi − x0 β 1 )) = 0 hold simultaneously. 1 2 It is possible that β 2 = 0. take the linear model yi = β 0 x1i + β 0 x2i + ei with E (x1i ei ) = 0 and E (x2i ei ) = 0. For example. G0 Ω−1 G . 110 . perhaps obtained by first ˆ setting Wn = I. and thus g n can be used to assess whether or not the hypothesis that Egi = 0 is true or not. Hansen (1982). ˆ J = J(β) →d χ2−k . and then β recomputed. 1 it is possible that β 2 6= 0. i i i i ∂β 1X 0 gi gi − g n g 0 ˆˆ n n i=1 n !−1 . ˆˆ n is a quadratic form in g n . 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 . Under the hypothesis of correct specification. often the weight ˆ matrix Wn is updated. However. n β − β →d N 0. β) = 0 holds. Theorem 9. and if the weight matrix is asymptotically efficient. ´ ³ ¡ ¢−1 ´ √ ³ˆ Theorem 9. This estimator can be iterated if needed. The general theory of GMM estimation and testing was exposited by L.6.

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

then xi . . It is also helpful to realize that conventional regression models also fall into this class. β). 0 In the linear model ei (β) = yi − zi β. are all valid instruments. It turns out that this conditional moment restriction is much more powerful. while in a nonlinear i regression model ei (β) = yi − g(xi . Which should be selected? This is equivalent to the problem of selection of the best instruments. the model implies more than an unconditional moment restriction of the form Egi (β) = 0. note that Ri = −E (zi | xi ) 112 ¡ ¢ σ 2 = E ei (β)2 | xi . an unconditional moment restriction can always be constructed. Then ei (β) = yi − zi β. Let ¶ µ ∂ ei (β) | xi Ri = E ∂β and Then the “optimal instrument” is so the optimal moment is gi (β) = Ai ei (β). Take the case s = 1. The form was uncovered by Chamberlain (1987). x2 . but its form does help us think about construction of optimal instruments. i Ai = −σ −2 Ri i .. except that in this case zi = xi . etc. 0 Our linear model yi = zi β + ei with instruments xi falls into this class under the stronger 0 assumption E (ei | xi ) = 0.8 Conditional Moment Restrictions In many contexts. ei (β. β)ei (β) which satisfies Egi (β) = 0 and hence defines a GMM estimator. Ai is unknown. In practice. ei (β) = yi − x0 β. The obvious problem is that the class of functions φ is infinite. and then use the first k instruments. If xi is a valid instrument satisfying E (ei | xi ) = 0. than the unconditional moment restriction discussed above..9.. In a joint model of the conditional mean and variance ⎧ yi − x0 β ⎨ i . 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. β). Another approach is to construct the optimal instrument. Given a conditional moment restriction. In many cases. so is just-identified) yields the best GMM estimator possible.. x3 . we can set gi (β) = φ(xi . Which should be used? i i One solution is to construct an infinite list of potent instruments. That is for any × 1 function φ(xi . Setting gi (β) to be this choice (which is k × 1. How is k to be determined? This is an area of theory still under development. and restrictive. in linear regression. For example. A recent study of this problem is Donald and Newey (2001). γ) = ⎩ 0 β)2 − f (x )0 γ (yi − xi i Here s = 2. s = 1.

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

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

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

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. Take the linear model 0 yi = zi β + ei E (xi ei ) = 0. Let ˆ ˆ ˆ Jn = ng n (β)0 Ω−1 g n (β) denote the test of overidentifying restrictions. l−k Hint: Il − R (R0 R)−1 R0 is a projection matrix.. 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. ˆ and consider the GMM estimator β of β. Il ) ³ ´ (f) Jn →d N 0 Il − R (R0 R)−1 R0 N ³ ´ (g) N 0 Il − R (R0 R)−1 R0 N ∼ χ2 .7. 116 .

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

the Lagrange multiplier λ(β) minimizes Rn (β. pi = ¡ n 1 + λ0 gi (β) Substituting into L∗ we find n Rn (β. p (10. pi = ³ ˆ ˆ ˆ0 n 1 + λ gi β ˆ Ln = n X i=1 ln (ˆi ) ..1) and (10.5). probabilities 1 ³ ´´ . . µ. Multiplying the first equation by pi . λ(β)) = −n ln (n) − n X i=1 ˆ The EL estimate β is the value which maximizes Ln (β). Ln (β) = Rn (β. but must be obtained numerically (see section 6. (see section 6. λ) is a convex function of λ.where λ and µ are Lagrange multipliers. and using the second and third equations. 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 (10.2) subject to the restrictions (10..5) ˆ ˆ As a by-product of estimation.3).5) This minimization problem is the dual of the constrained maximization problem. The solution (when it exists) is well defined since Rn (β.. or equivalently minimizes its negative ˆ (10. λ) : λ(β) = argmin Rn (β. p1 . The solution cannot be obtained explicitly. pi gi (β) = 0. λ ¡ ¢ ln 1 + λ0 gi (β) . (10. µ) = n i=1 i=1 i=1 L∗ n with respect to pi .7) 118 .4) (10. pn . λ. λ).6) β = argmin [−Ln (β)] β ¡ ¢ ln 1 + λ(β)0 gi (β) and maximized empirical likelihood ˆ Numerical methods are required for calculation of β. λ) = −n ln (n) − n X i=1 For given β. This yields the (profile) empirical log-likelihood function for β. summing over i. The Lagrangian for this maximization problem is à n ! n n X X X ln(pi ) − µ pi − 1 − nλ0 pi gi (β) L∗ (β. we find µ = n and 1 ¢. we also obtain the Lagrange multiplier λ = λ(β).

´ √ ³ ˆ n β − β 0 →d √ ˆ nλ →d N (0. λ) jointly solve ³ ´ ˆ n gi β X ∂ ³ ³ ´´ Rn (β. Gi (. ˆ The asymptotic variance V for β is the same as for efficient GMM. Thus the EL estimator is asymptotically efficient. β) = −xi zi . i=1 i=1 i=1i Expanding (10. and Ω = E xi x0 e2 .13) Premultiplying by G0 Ω−1 and using (10.9) (10. g n = n n gi (β 0 ) and Ωn = n n g (β 0 ) gi (β 0 )0 . λ) = − (10.1 Under regularity conditions.10) ¡ Ω−1 N (0. (β.12) ∂β ˆ ˆ0 i=1 1 + λ gi β 1 P 1 P 1 P Let Gn = n n Gi (β 0 ) .13) yields n n Expanding (10. i i Theorem 10. 0 = Rn (β.10).2 Define Asymptotic Distribution of EL Estimator Gi (β) = ∂ gi (β) ∂β 0 (10.11) 0 = ∂λ ˆ0 ˆ i=1 1 + λ gi β ³ ´0 ˆ n X Gi . G = −E (xi zi ). and n β − β 0 and nλ are asymptotically independent. ˆ ˆ Proof.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 .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. V ) ¢−1 ¡ V = G0 Ω−1 G ¡ ¢−1 0 Vλ = Ω − G G0 Ω−1 G G G = EGi (β 0 ) ¡ ¢ Ω = E gi (β 0 ) gi (β 0 )0 (10.2. n (10.12) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ 0 ' G0 λ − λ0 .9) and (10.8) and ¢ 0 0 For example. λ) = − (10. β λ ∂ ³ ´.10. Vλ ) ´ √ ˆ √ ³ˆ where V and Vλ are defined in (10.

1 If Eg(wi . LRn = i=1 Theorem 10.3. Ω) →d Ω−1 I − G G Ω G GΩ = Ω−1 N (0. n ³ ´´ ´ √ ³ 1 X ³ ˆ ˆ √ g wi . The same statistic can be constructed for empirical likelihood. by a Taylor expansion. (10. The EL overidentification test is similar to the GMM overidentification test.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 (0.3 Overidentifying Restrictions In a parametric likelihood context. First. Twice the difference between the unrestricted empirical likelihood −n log (n) and the maximized empirical likelihood for the model (10. ¥ Chamberlain (1987) showed that V is the semiparametric efficiency bound for β in the overidentified moment condition model.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. and (10. and have the same interpretation. Ω) GΩ G →d = N (0.16) ´ √ ˆ √ ³ˆ n β − β 0 and nλ are asymptotically uncorrelated and hence independent. V ) ˆ Solving (10.15) (10. 10. The overidentification test is a very useful by-product of EL estimation.16).14) for λ and using (10. Since the EL estimator achieves this bound. Proof. tests are based on the difference in the log likelihood functions.15). 120 .7) is n ³ ´´ ³ X ˆ ˆ0 (10. Vλ ) Furthermore. it is an asymptotically efficient estimator for β.17) 2 ln 1 + λ gi β . and it is advisable to report the statistic LRn whenever EL is the estimation method. 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. They are asymptotically first-order equivalent. This means that no consistent estimator for this class of models can have a lower asymptotic variance than V . since ³ ¡ ¢−1 0 ´ G0 I − Ω−1 G G0 Ω−1 G G =0 (10. β 0 ) = 0 then LRn →d χ2−k .

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

The iteration (10. λ) = i The first derivatives of (10. λ) G∗ (β. One method uses the following quadratic approximation. λ) ∂λ i=1 n ∂ Rn (β. λ)0 − Rn (β. λj ) is smaller than some prespecified tolerance. λj ))−1 Rλ (β. For p = 0. λj )) Rp = Rn (β. λj ) . The value of δ which minimizes this quadratic is ˆ = R2 + 3R0 − 4R1 .Derivatives The numerical calculations depend on derivatives of the dual likelihood function (10.5) for given β. 1. Efficient convergence requires a good choice of steplength δ. i Rββ = Inner Loop The so-called “inner loop” solves (10. λ)0 0 Rn (β.19) is continued until the gradient Rλ (β. λ) = i ∂λ∂β 0 1 + λ0 gi (β) i=1 ⎞ ⎛ ¡ 0 ¢ ∂2 n 2 X 0 gi (β) λ ∂ ⎠ ⎝G∗ (β.4). 2. λp ) A quadratic function can be fit exactly through these three points. set 2 λp = λj − δ p (Rλλ (β. λ) = ∂λ∂λ i=1 ¶ n 2 Xµ ∂ Gi (β) ∗ gi (β. Define ∗ gi (β.19). (10. λj ))−1 Rλ (β. λ)0 − ∂β∂β 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) = − gi (β. Set δ 0 = 0. λ) .20) .19) X ∂2 ∗ ∗ gi (β. λ) = − ∂β n X i=1 G∗ (β. λ) gi (β. λ) = i i ∂β∂β 0 1 + λ0 gi (β) i=1 n where δ > 0 is a scalar steplength (to be discussed next).. λ) yielding the iteration rule λj+1 = λj − δ (Rλλ (β. δ 4R2 + 4R0 − 8R1 yielding the steplength to be plugged into (10. The modified Newton method takes a quadratic approximation to Rn (β. The starting value λ1 can be set to the zero vector. δ 1 = 1 and δ 2 = 1. 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. λ) G∗ (β.

λ(β)) + λ0 Rλ (β. If (10. λ(β)) β ∂β ¡ ¢ 0 = − Rββ (β.for all i. The gradient for (10. The Hessian for (10.6) is Lββ = − ∂ Ln (β) ∂β∂β 0 ¤ ∂ £ = − 0 Rβ (β. Outer Loop The outer loop is the minimization (10. and the rule is iterated until convergence. ∂β 0 the second equality following from the implicit function theorem applied to Rλ (β. The Newton iteration rule is β j+1 = β j − δL−1 Lβ ββ where δ is a scalar stepsize.20) fails. 123 . λ(β)) + Rλβ λβ + λ0 Rλβ + λ0 Rλλ λβ β β −1 0 = Rλβ Rλλ Rλβ − Rββ . If not. λ(β)) = 0. the stepsize δ needs to be decreased. It is not guaranteed that Lββ > 0.6) is Lβ = ∂ ∂ Ln (β) = Rn (β. λ) = 0 at λ = λ(β). where λβ = ∂ −1 λ(β) = −Rλλ Rλβ . the eigenvalues of Lββ should be adjusted so that all are positive. This can be done by the modified Newton method described in the previous section. λ) = Rβ + λ0 Rλ = Rβ β ∂β ∂β since Rλ (β.6).

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

which does not equal either β 1 or β 2 . so should be included in xi . By the above definition. β →p β ∗ . We call (11.1 Instrumental Variables 0 yi = zi β + ei Let the equation of interest be (11. at least the intercept). Definition 11.1 The × 1 random vector xi is an instrumental variable for (11.2) Any solution to the problem of endogeneity requires additional information which we call instruments.1).1) the structural equation. We call z1i exogenous and z2i endogenous.1. this can be written as Y = Zβ + e. (11.3) zi = z2i k2 where E(z1i ei ) = 0 yet E(z2i ei ) 6= 0. So we have the partition µ ¶ z1i k1 (11. This is called simultaneous equations bias.so µ qi pi ¶ = = = The projection of qi on pi yields qi = β ∗ pi + εi E (pi εi ) = 0 where β∗ = β − β1 E (pi qi ) ¡ 2¢ = 2 2 E pi ∙ 1 β1 1 −β 2 ¸−1 µ e1i e2i ¶ . z1i is an instrumental variable for (11. 11. some regressors in zi will be uncorrelated with ei (for example.1) where zi is k × 1. Thus we make the partition ¶ µ k1 z1i (11. and x2i are the excluded exogenous variables.4) xi = x2i 2 where z1i = x1i are the included exogenous variables. ¶ µ ∙ β2 β1 1 −1 β 2 e1i + β 1 e2i (e1i − e2i ) ¸µ e1i e2i ¶ ˆ Hence if it is estimated by OLS. In a typical set-up. That is x2i are variables which could be included in the equation for yi (in the sense 125 . and assume that E(zi ei ) 6= 0 so there is endogeneity. In matrix notation.1) if E (xi ei ) = 0.

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

11.2

Reduced Form

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

Substituting (11.6) into (11.2), we find

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

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

11.3

Identification

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

11.4

Estimation
0 yi = zi β + ei

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

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

11.5

Special Cases: IV and 2SLS

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

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

which again is the IV estimator.

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

then

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

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

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

l . 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 .13).14) is the probability limit of β 2SLS − β 11. Bekker (1994) showed further that under the alternative asymptotic approximation that α is fixed as n → ∞ (so that the number of instruments goes to infinity proportionately with sample ˆ size) then the expression in (11. 0). The parameter β fails to be identified if Γ22 has deficient rank.Let PX = X (X 0 X)−1 X 0 .14) In general this is non-zero. Indeed as α → 1. the expression in (11.7 Identification Failure Recall the reduced form equation Z2 = X1 Γ12 + X2 Γ22 + u2 . except when S21 = 0 (when Z is exogenous). the bias in the 2SLS estimator will be large. n and (11. 130 . ¢ 1 ¡ ¢ 1 ¡ ¢ 1 ¡ 0 E Z PX e = E Γ0 X 0 e + E u0 PX e = αS21 . Let q = H 0 ξS −1/2 which satisfies Eqq 0 = In and partition q = (q1 q2 ) where q1 is l × 1. By the spectral decomposition of an idempotent matrix.12) and this result. Together µ µ ¶¶−1 µ ¶ ³ ´ 1 0 1 0 ˆ 2SLS − β E β Z PX Z Z PX e ≈ E E n n ¡ ¢−1 = α Γ0 QΓ + αS22 S21 .14) approaches that in (11. P = HΛH 0 0 0 where Λ = diag(Il . indicating that the bias in 2SLS approaches that of OLS as the number of instruments increases. The consequences of identification failure for inference are quite severe. Hence µ ¶ 1 0 1 1/20 ¡ 0 ¢ 1/2 ξ PX ξ S E q Λq S E = n n µ ¶ 1 0 1 1/20 S E q q1 S 1/2 = n n 1 l 1/20 1/2 S S = n = αS where α= Using (11. Bekker (1994) pointed out that it also has the reverse implication — that when α = l/n is large. It is also close to zero when α = 0.

Suppose that identification does not complete fail. Then (11. standard test statistics have non-standard asymptotic distribution of β distributions. To see the consequences. N2 since the ratio of two normals is Cauchy. but small. Then by the CLT ¡ ¡ ¢¢ 1 X √ xi ei →d N1 ∼ N 0. and was examined by Phillips (1989) and Choi and Phillips (1992). This occurs when Γ22 is full rank. but is weak. In addition. We see that β is identified if and only if Γ22 = γ 6= 0. Qc + N2 ˆ As in the case of complete identification failure. once again take the simple case k = l = 1. This is particularly nasty. Then the model may be written as yi = zi β + ei zi = xi γ + ui and Γ22 = γ = E (xi zi ) /Ex2 . This result carries over to more general settings. the instrument xi is weak for zi if γ = n−1/2 c. as the Cauchy distribution does not have a finite mean. E x2 e2 i i n i=1 n (11. where C is a full rank matrix.16) ˆ β−β = 1 √ n 1 √ n Pn Pn i=1 xi ei i=1 xi zi →d N1 ∼ Cauchy. Suppose this condition fails. meaning that inferences about parameters of interest can be misleading. which occurs i when E (zi xi ) 6= 0. E x2 u2 i i n n i=1 i=1 n n (11. so E (zi xi ) = 0.15) is unaffected. The n−1/2 is picked because it provides just the right balancing to allow a rich distribution theory. we find that β is inconsistent for β and the ˆ is non-normal. 131 . Thus identification hinges on the existence of correlation between the excluded exogenous variable and the included endogenous variable.15) therefore ¢¢ ¡ ¡ 1 X 1 X √ xi zi = √ xi ui →d N2 ∼ N 0.16) 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 .Take the simplest case where k = l = 1 (so there is no X1 ). Here. This can be handled in an asymptotic analysis by modeling it as local-to-zero. viz Γ22 = n−1/2 C. but (11.

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

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

There are 2215 observations with 19 variables. 134 . Report the estimates and standard errors. The data file card. 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). Does this differ from 2SLS and/or OLS? 7. in years. and then calculate the GMM estimator from this weight matrix without further iteration. In this model. Report estimates and standard errors. (d) Re-estimate the model by efficient GMM. 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. (a) Estimate the model by OLS. a dummy indicating that the observation lives near a 4-year college. (b) Now treat Education as endogenous. of the mother).. Estimate the model by 2SLS. using the instrument near4. (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). using zi as an instrument for xi .dat is taken from David Card “Using Geographic Variation in College Proximity to Estimate the Return to Schooling” in Aspects of Labour Market Behavior (1995). listed in card. (f) Discuss your findings. Report estimates and standard errors. I suggest that you use the 2SLS estimates as the first-step to get the weight matrix. of the father) and motheduc (the education. are the parameters identified? 8. (e) Calculate and report the J statistic for overidentification. in years. and the remaining variables as exogenous. Is zi = (xi i for estimation of β? x2 ) a valid instrumental variable i where income (Y ) and wage (W ) are determined outside the market. and South and Black are regional and racial dummy variables. 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.(b) Define the 2SLS estimator of β.pdf. f atheduc (the education.

then Xt is strictly stationary and ergodic.1 If Yt is strictly stationary and ergodic and Xt = f (Yt . Theorem 12. Definition 12. and Cov (Yt . Yt−1 . so classical assumptions are not valid. . and T to denote the number of observations. We can separate time series into two categories: univariate (yt ∈ R is scalar)..1 Stationarity and Ergodicity Definition 12.. The primary model for univariate time series is autoregressions (ARs). Definition 12. .. The following two theorems are essential to the analysis of stationary time series.. 135 . A stationary time series is ergodic if γ(k) → 0 as k → ∞. we adopt new notation. t = 1. Yt−k ) is the autocorrelation function. Yt−k ) = γ(k) is independent of t for all k. To indicate the dependence on time.2 {Yt } is strictly stationary if the joint distribution of (Yt . Yt−k ) is independent of t for all k.1.) is a random variable.Chapter 12 Univariate Time Series A time series yt is a process observed in sequence over time.1.3 ρ(k) = γ(k)/γ(0) = Corr(Yt . .4 (loose).. and multivariate (yt ∈ Rm is vector-valued).1. The primary model for multivariate time series is vector autoregressions (VARs). Definition 12. γ(k) is called the autocovariance function. and use the subscript t to denote the individual observation.1. however.1. Because of the sequential nature of time series.1 {Yt } is covariance (weakly) stationary if E(Yt ) = µ is independent of t.. T . 12.. There proofs are rather difficult.. we expect that Yt and Yt−1 are not independent.

2 (Ergodic Theorem). Part (1) is a direct consequence of the Ergodic theorem. 1. the sequence Yt Yt−k is strictly stationary and ergodic. ˆ 3. ρ(k) →p ρ(k). Thus an application of the Ergodic Theorem yields T 1X Yt Yt−k →p E(Yt Yt−k ). ˆ ˆ γ ¥ 136 . note that γ (k) = ˆ T 1X (Yt − µ) (Yt−k − µ) ˆ ˆ T t=1 = T T T 1X 1X 1X Yt Yt−k − Yt µ − ˆ Yt−k µ + µ2 .Theorem 12. then as T → ∞. 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) .3 If Yt is strictly stationary and ergodic and EYt2 < ∞. T t=1 Thus γ (k) →p E(Yt Yt−k ) − µ2 − µ2 + µ2 = E(Yt Yt−k ) − µ2 = γ(k). ˆ Part (3) follows by the continuous mapping theorem: ρ(k) = γ (k)/ˆ (0) →p γ(k)/γ(0) = ρ(k). If Xt is strictly stationary and ergodic and E |Xt | < ∞.1. ˆ 2. For Part (2).1. ˆ Proof.1. ˆ ˆ T t=1 γ (k) = ˆ The sample autocorrelation ρ(k) = ˆ γ (k) ˆ . then as T → ∞. µ →p E(Yt ). γ (0) ˆ Theorem 12.1 above. ˆ ˆ T t=1 T t=1 T t=1 By Theorem 12. and it has a finite mean by the assumption that EYt2 < ∞. γ (k) →p γ(k). 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 . Y1 . 137 . Regression errors are naturally a MDS. Most asset pricing models imply that asset returns should be the sum of a constant plus a MDS.. this series converges if the sequence ρk et−k gets small as k → ∞. A useful property of a MDS is that et is uncorrelated with any function of the lagged information It−1 . Yt−k ) .. Yt−2 . .1 et is a martingale difference sequence (MDS) if E (et | It−1 ) = 0.. Letting et = Yt − E (Yt | It−1 ) . E(et ) = 0 and Ee2 = σ 2 < ∞.. E(Yt−k et ) = 0. then we have the autoregressive model Yt = α + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et E (et | It−1 ) = 0.} is the past history of the series. the series {.. should be a MDS. Some time-series processes may be a MDS as a consequence of optimizing behavior.} are jointly random.. YT ..2.2 Autoregressions In time-series. it is even more important in the time-series context. as it is difficult to derive distribution theories without this property. An autoregressive (AR) model specifies that only a finite number of past lags matter: E (Yt | It−1 ) = E (Yt | Yt−1 .. . or consumption growth rates.. t By back-substitution. k=0 Loosely speaking. The last property defines a special time-series process. ∞ X = ρk et−k . . A mean-zero AR(1) is Assume that et is iid.. we find Yt = et + ρet−1 + ρ2 et−2 + . Definition 12. Y2 . some versions of the life-cycle hypothesis imply that either changes in consumption.. 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. . In fact. Thus for k > 0..12.3 Stationarity of AR(1) Process Yt = ρYt−1 + et . This occurs when |ρ| < 1.. We consider the conditional expectation E (Yt | It−1 ) where It−1 = {Yt−1 ... For example. 12.

The AR(k) model is Using the lag operator. the above results are unchanged. an AR(1) is stationary iff |ρ| < 1.Theorem 12.3.4 Lag Operator An algebraic construct which is useful for the analysis of autoregressive models is the lag operator. The operator ρ(L) = (1 − ρL) is a polynomial in the operator L. since ρ(z) = 0 when z = 1/ρ. In general. Defining L2 = LL. Lk Yt = Yt−k . We can compute the moments of Yt using the infinite sum: EYt = ∞ X k=0 ρk E (et−k ) = 0 σ2 .3. 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). except that the mean of Yt can be computed from the relationship EYt = α + ρEYt−1 .1. Definition 12. 1 − ρ2 V ar(Yt ) = If the equation for Yt has an intercept. Yt − ρ1 LYt − ρ2 L2 Yt − · · · − ρk Lk Yt = et .5 Stationarity of AR(k) Yt = ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et . From Theorem 12.4. 12.1 If |ρ| < 1 then Yt is strictly stationary and ergodic. or ρ(L)Yt = et where ρ(L) = 1 − ρ1 L − ρ2 L2 − · · · − ρk Lk .1 The lag operator L satisfies LYt = Yt−1 . We call ρ(L) the autoregressive polynomial of Yt . ∞ X k=0 ρ2k V ar (et−k ) = 12. and solving for EYt = EYt−1 we find EYt = α/(1 − ρ). We call ρ(L) the autoregressive polynomial of Yt . We say that the root of the polynomial is 1/ρ. The AR(1) model can be written in the format Yt − ρYt−1 + et or (1 − ρL) Yt−1 = et . 138 . we see that L2 Yt = LYt−1 = Yt−2 .

where the λ1 . This is a special case of non-stationarity. t t T t=1 ¥ Combined with (12. and by Theorem 12.1 If the AR(k) process Yt is strictly stationary and ergodic and EYt2 < ∞. and is of great interest in applied time series.1 The AR(k) is strictly stationary and ergodic if and only if |λj | > 1 for all j. we see that à !−1 à ! T T 1X 1X ˆ β=β+ xt x0 xt et →p Q−1 0 = 0. T ¢ ¡ 1X xt x0 →p E xt x0 = Q. which satisfy ρ(λj ) = 0.” If one of the roots equals 1.5. 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. . By Theorem 12. t T t=1 T t=1 139 . so is xt x0 . The vector xt is strictly stationary and ergodic. Proof. and hence Yt .1. One way of stating this is that “All roots lie outside the unit circle.1) and the continuous mapping theorem. Note that ut is a MDS. then ˆ β →p β as T → ∞. “has a unit root”. λk are the complex roots of ρ(z). it is also strictly stationary and ergodic. Thus t by the Ergodic Theorem.1. we say that ρ(L). We know that an AR(1) is stationary iff the absolute value of the root of its autoregressive polynomial is larger than one.1. since E (ut | It−1 ) = E (xt et | It−1 ) = xt E (et | It−1 ) = 0. For an AR(k). Theorem 12..6.1) Theorem 12. Let |λ| denote the modulus of a complex number λ.. it is helpful to define the process ut = xt et . T t=1 T t=1 ¢−1 0 ¡ ˆ X Y. β = X 0X (12. Thus T T 1X 1X xt et = ut →p E (ut ) = 0.6 Let Estimation xt = β = ¡ 1 Yt−1 Yt−2 · · · α ρ1 ρ2 · · · yt = x0 β + et .1. the requirement is that all roots are larger than one.. ¢0 Then the model can be written as The OLS estimator is ¡ ˆ To study β. t Yt−k ¢0 ρk .

If ut is a strictly stationary and ergodic MDS and E(ut u0 ) = Ω < ∞. e ˆ 3. which may be different than the i properties of the actual ei . t t Theorem 12.7. ˆ 2. This creates an iid bootstrap sample. In particular.. Y−k+2 .7. T t=1 where Ω = E(xt x0 e2 ). Q−1 ΩQ−1 . T 1 X √ ut →d N (0. . This is identical in form to the asymptotic distribution of OLS in cross-section regression. 140 . Fix an initial condition (Y−k+1 . Method 2: Block Resampling 1.. Ω) . i 4. Ω) . Simulate iid draws e∗ from the empirical distribution of the residuals {ˆ1 .2 If the AR(k) process Yt is strictly stationary and ergodic and EYt4 < ∞.1 MDS CLT. t This construction imposes homoskedasticity on the errors e∗ .12..7 Asymptotic Distribution Theorem 12. we can apply Theorem 12. 12.7.1 to see that T 1 X √ xt et →d N (0. T t=1 Since xt et is a MDS. It also presumes that the AR(k) structure is the truth.. t then as T → ∞. ´ √ ³ ¡ ¢ ˆ T β − β →d N 0.. . the asymptotic covariance matrix is estimated just as in the cross-section case. Y0 ). Method 1: Model-Based (Parametric) Bootstrap. Briefly. The implication is that asymptotic inference is the same. as this imposes inappropriate independence.8 Bootstrap for Autoregressions In the non-parametric bootstrap. Estimate β and residuals et . we constructed the bootstrap sample by randomly resampling from the data values {yt .. 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∗ . then as T → ∞. eT }. xt }. this cannot work in a time-series application. ˆ 1. Clearly. Divide the sample into T /m blocks of length m. there are two popular methods to implement bootstrap resampling for time-series data.

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

In general. An appropriate test of H0 against H1 is therefore a Wald test that the coefficient on Yt−2 is zero. (A simple exclusion test). 142 . An appropriate test is the Wald test of this restriction. Yt is an AR(1).5) and (12. We want to test H0 against H1 . you need more initial conditions.. we take (12.5) We are interested in the question if the error ut is serially correlated. or Yt = α(1 − θ) + (ρ + θ) Yt−1 − θρYt−2 + et = AR(2). We model this as an AR(1): ut = θut−1 + et with et a MDS..5) and lag the equation once: Yt−1 = α + ρYt−2 + ut−1 . if the null hypothesis is that Yt is an AR(k).. this is the same as saying that under the alternative Yt is an AR(k+m). and then reserve the first k as initial conditions. and the alternative is that the error is an AR(m). Thus under H0 . let the null hypothesis be an AR(1): Yt = α + ρYt−1 + ut .) This can induce strange behavior in the AIC. e.10 Testing for Omitted Serial Correlation For simplicity.11 Model Selection What is the appropriate choice of k in practice? This is a problem of model selection. The best remedy is to fix a upper value k.6) 12.. and this is equivalent to the restriction that the coefficients on Yt−k−1 . H0 may be expressed as the restriction that the coefficient on Yt−2 is zero.12. . (12. Another is to minimize the AIC or BIC information criterion. .g. (12. and under H1 it is an AR(2). We then multiply this by θ and subtract from (12.6). To combine (12.5). AR(k) on this (unified) sample. to find Yt − θYt−1 = α − θα + ρYt−1 − θρYt−1 + ut − θut−1 . One approach to model selection is to choose k based on a Wald tests... The hypothesis of no omitted serial correlation is H0 : θ = 0 H1 : θ 6= 0. Yt−k−m are jointly zero. and then estimate the models AR(1). AR(2). AIC(k) = log σ 2 (k) + ˆ 2k . T where σ 2 (k) is the estimated residual variance from an AR(k) ˆ One ambiguity in defining the AIC criterion is that the sample available for estimation changes as k changes. (If you increase k.

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

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

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

The GMM framework gives a convenient method to impose such restrictions on estimation. some regressors may be excluded from some of the equations. For example.. This (system) estimator is known as the SUR (Seemingly Unrelated Regressions) estimator.. or across equations. 146 . and was originally derived by Zellner (1962) ¢ 13.3 Restricted VARs The unrestricted VAR is a system of m equations. j Unrestricted VARs were introduced to econometrics by Sims (1980). ˆj ˆ And if we stack these to create the estimate A. ⎠ 0 Ym+1 = Y 0 X(X 0 X)−1 .2 Estimation E (xt ejt ) = 0. ˆ An alternative way to compute this is as follows. ⎟ ⎝ . each with the same set of regressors. Then the VAR system can be written as the equations Yjt = a0 xt + ejt . Consider the moment conditions j = 1. we find ⎞ ⎛ Y10 ⎜ Y0 ⎟ ˆ = ⎜ . or as a linear projection.2 ⎟ X(X 0 X)−1 A ⎜ . 13. A restricted VAR imposes restrictions on the system. The VAR model is a system of m equations. Restrictions may be imposed on individual equations.then Yt = Axt + et . either as a regression. ¡ Y1 Y2 · · · where Y = Ym 0 the T × m matrix of the stacked yt . Note that a0 = Yj0 X(X 0 X)−1 . These are implied by the VAR model. One way to write this is to let a0 be the jth row j of A. .. m. The GMM estimator corresponding to these moment conditions is equation-by-equation OLS aj = (X 0 X)−1 X 0 Yj .

Let et = ejt and β = aj . We see that an appropriate. direct estimation of (13.5 Testing for Omitted Serial Correlation Consider the problem of testing for omitted serial correlation in equation (13. (A simple version of this estimator is called Cochrane-Orcutt. 13. and is typically rejected empirically. to get t ¡ ¢ ¡ ¢ yt − θyt−1 = x0 β + et − θ x0 β + et−1 t t−1 = x0 β − θxt−1 β + et − θet−1 . Let yt = Yjt . and is still routinely reported by conventional regression packages. You may have heard of the Durbin-Watson test for omitted serial correlation.3) which is a valid regression model.2) may be estimated by iterated GLS.2) is a special case of (13. t t−1 (13.2) Take the equation yt = x0 β + et . it is convenient to re-define the variables. t and et is iid N (0. t or yt = θyt−1 + x0 β + x0 γ + ut . with time series data.1). h¡ 1 Yt−1 · · · 0 Yt−k Zt−1 · · · 0 Zt−k ¢0 i . may be tested if desired. and simple way to test for omitted serial correlation is to test the significance of extra lagged values of the dependent variable and regressors. In this case. we are only interested in a single equation out of a VAR system. Suppose that et is an AR(1).3). Another interesting fact is that (13. which once was very popular.) Since the common factor restriction appears arbitrary. and subtract off the equation once lagged multiplied by θ. and Zt be the other variables. (13. If valid. This restriction.1) yt = x0 β + et . which is called a common factor restriction. Then the single equation takes the form (13. So testing H0 versus H1 is equivalent to testing for the significance of adding (yt−1 . xt−1 ) to the regression. Then yt = x0 β + et t et = θet−1 + ut E (ut | It−1 ) = 0. the model (13. general. 147 . under the restriction γ = −βθ.2) is uncommon in recent applications. Then the null and alternative are H0 : θ = 0 H1 : θ 6= 0. This takes the form 0 and xt consists of lagged values of Yjt and the other Ylt s. t and xt = This is just a conventional regression. This can be done by a Wald test. Otherwise it is invalid.4 Single Equation from a VAR Yjt = a0 xt + et . 1).13. The DW test is appropriate only when regression yt = x0 β + et is not dynamic (has no lagged values on the RHS). j Often.

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

The r vectors in β are called the cointegrating vectors. Their justification was Stock’s result that β is superˆ ˆ consistent under H1 .13. if Yt is a pair of interest rates. Often. β is not consistent. Hansen (1992). Y2t ) and β = (β 1 β 2 ) and normalize β 1 = 1. Then β 2 = (Y20 Y2 )−1 Y2 Y1 →p β 2 . β = (1 − 1)0 . 13. The asymptotic distribution was worked out by Phillips and Ouliaris (1990). such that zt = β 0 Yt is I(0). however. m × r. When the data have time trends. We are often interested in testing the hypothesis of no cointegration: H0 : r = 0 H1 : r > 0. Under H0 . a good method to estimate β. of rank r. Thus H0 can be tested using a univariate ADF test on zt . 149 . If Yt is cointegrated with a single cointegrating vector (r = 1). but it is useful in the construction of alternative estimators and tests. Engle and Granger (1987) suggested using an ADF test on the estimated ˆ0 ˆ residual zt = β Yt . If r = m.8 Cointegration The idea of cointegration is due to Granger (1981). In other cases. then r = 0.9 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 . For example. so zt = β 0 Yt is known. then it turns out that β can be consistently estimated by an OLS regression of one component of Yt on the others. Yt is I(1) and cointegrated. it may be believed that β is known a priori. Furthermore ˆ this estimation is super-consistent: T (β 2 − β 2 ) →d Limit. then β = (1 − 1)0 specifies that log(Consumption/Income) is stationary. Definition 13.8. then Yt is I(0). as first shown by Stock (1987). Thus Yt = ˆ (Y1t . If the series Yt is not cointegrated. so the ADF critical values are not appropriate. yet under H1 zt is I(0). Suppose that β is known. The asymptotic distribution was worked out in B. β may not be known. the asymptotic distribution of the test is affected by the presence of the time trend. In some cases. When β is unknown.1 The m × 1 series Yt is cointegrated if Yt is I(1) yet there exists β. If Y = (log(Consumption) log(Income))0 . For 0 < r < m. in general. then β = (1 − 1)0 specifies that the spread (the difference in returns) is stationary. Whether or not the time trend is included. This is not. and was articulated in detail by Engle and Granger (1987). from OLS of Y1t on Y2t . it may be necessary to include a time trend in the estimated cointegrating regression. Then under H0 zt is I(1).

9. 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. it is simple to test for cointegration by testing the rank of Π. and different authors have adopted different identification schemes. they are typically called the “Johansen Max and Trace” tests. Their asymptotic distributions are non-standard. Ω). rank(α) = r.1 (Granger Representation Theorem). In the context of a cointegrated VAR estimated by reduced rank regression. When r > 1. this can be estimated by OLS of ∆Yt on zt−1 and the lags of ∆Yt . These tests are constructed as likelihood ratio (LR) tests. If β is unknown. Equivalently. we typically just normalize one element to equal unity. 1991. The restricted model can be written as ∆Yt = αβ 0 Yt−1 + D(L)∆Yt−1 + et ∆Yt = αzt−1 + D(L)∆Yt−1 + et . and are similar to the Dickey-Fuller distributions. If β is known. When r = 1.Theorem 13. then estimation is done by “reduced rank regression”. As they were discovered by Johansen (1988. Thus cointegration imposes a restriction upon the parameters of a VAR. 150 . which is least-squares subject to the stated restriction. this does not work. 1995). Yt is cointegrated with m × r β if and only if rank(Π) = r and Π = αβ 0 where α is m × r.

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

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

σ 2 ) with the observed variable yi generated by the censoring equation (14. k! = exp(x0 β). but we observe only ½ ∗ ∗ yi if yi ≥ 0 (14. This may be considered restrictive.) The observed data yi therefore come from a mixed continuous/discrete distribution. The conditional density is the Poisson with parameter λi . i If Y = {0. This model specifies that P (Yi = k | xi ) = λi k = 0. i i i=1 ˆ The MLE is the value β which maximizes ln (β). .}. 2... the consumption level (purchases) in a particular period was zero. Since E (Yi | xi ) = λi = exp(x0 β) i is the conditional mean. 1. A generalization is the negative binomial. The censoring process may be explicit in data collection.1) yi = ∗ <0 .3 Censored Data The idea of “censoring” is that some data above or below a threshold are mis-reported at the ∗ threshold. An example of a data collection censoring is top-coding of income. Thus the model is that there is some latent process yi with unbounded support. 2. 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. 0 if yi (This is written for the case of the threshold being zero. this motivates the label Poisson “regression. This model (now called the Tobit) specifies that the latent (or ideal) value of consumption may be negative (the household 153 . incomes above a threshold are typically reported at the threshold. He proposed the latent variable model ∗ yi = x0 β + ei i ei ∼ iid N (0.2 Count Data exp (−λi ) λk i . 1. 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.1). The log-likelihood function is ln (β) = n X i=1 log f (yi | xi ) = n X¡ ¢ − exp(x0 β) + yi x0 β − log(yi !) . The functional form for λi has been picked to ensure that λi > 0.. any known value can substitute.. a typical approach is to employ Poisson regression. In surveys. 14. .” Also observe that the model implies that V ar (Yi | xi ) = λi = exp(x0 β). Tobin observed that for many households.14. The first censored regression model was developed by Tobin (1958) to explain consumption of durable goods.

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

Thus E (ui | Ti = 1. . However. but also can be consistently estimated by a Probit model for selection. Zi ) = 0. which can be observed only if a person is employed. The “Heckit” estimator is thus calculated as follows • Estimate γ from a Probit. yi could be a wage. as this is a two-step estimator. if γ were known. 1). zi . The binary dependent variable is Ti . The naive estimator of β is OLS regression of yi on xi for those observations for which yi is available. Zi + E vi | {e0i > −zi γ}. ˆ ³ ´ ˆ ˆ ˆ • Estimate β. It is unknown. Else it is unobserved. For example. Ti } for all observations. using regressors zi . e1i = ρe0i + vi . Or. 155 . Heckman (1979) observed that we could consistently estimate β and ρ from this equation. The dependent variable yi is observed if (and only if) Ti = 1. Zi ) = E e1i | {e0i > −zi γ}. Zi ¢ ¡ ¢ ¡ 0 0 = ρE e0i | {e0i > −zi γ}. The model is often completed by specifying that the errors are jointly normal ¶ µ µ ¶¶ µ 1 ρ e0i ∼ N 0.2) is a valid regression equation for the observations for which Ti = 1. ¡ ¢ 0 E (e1i | Ti = 1. The problem is that this is equivalent to conditioning on the event {Ti = 1}. ρ from OLS of yi on xi and λ(z 0 γ ). e1i ρ σ2 It is presumed that we observe {xi . which is non-zero. alternatively. where Hence ¡ 0 ¢ e1i = ρλ zi γ + ui . E (e0i | e0i > −x) = λ(x) = Φ(x) and the function λ(x) is called the inverse Mills ratio. ¡ 0 ¢ yi = x0 β + ρλ zi γ + ui i (14. i • The OLS standard errors will be incorrect. They can be corrected using a more complicated formula. Zi ¡ 0 ¢ = ρλ zi γ . where vi is independent of e0i ∼ N (0. Under the normality assumption. by viewing the Probit/OLS estimation equations as a large joint GMM problem. The equation for Ti is an equation specifying the probability that the person is employed.A simple sample selection model can be written as the latent model yi = x0 β + e1i i ¡ 0 ¢ Ti = 1 zi γ + e0i > 0 where 1 (·) is the indicator function. A useful fact about the standard normal distribution is that φ(x) .

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

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

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

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

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

ˆ(x) is small. 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. It follows that the variance of the density f (x) is à 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. f (x) ≥ 0 for all 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. If a large number of the observations Xi are near ˆ x. where the second-to-last equality used the change-of-variables u = (Xi − x)/h which has Jacobian h.This estimator is the average of a set of weights. 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. Conversely. f (x) is a valid density. That is. ˆ We can also calculate the moments of the density f (x). 161 . The bandwidth h controls the meaning of “near”. then the weights are small and f ˆ ˆ Interestingly. then the weights are relatively large and f (x) is larger.

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

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

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

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

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

(A.. This induces a new sample space — the real line — and a new probability function on the real line. and use lower case letters such as x for potential values and realized values. Pr where 0 ≤ π j ≤ 1 and j=1 π j = 1. . While there are examples of continuous random variables which do not possess a PDF. A function F (x) is a CDF if and only if the following three properties hold: 1. 167 . Instead. then for each i = 1.3) P (X = τ j ) = π j . For any set B and any partition A1 .. F (x) is right-continuous We say that the random variable X is discrete if F (x) is a step function.2 Random Variables A random variable X is a function from a sample space S into the real line. we denote random variables by uppercase letters such as X. of the sample space. In the latter case. 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. ∞ A function f (x) is a PDF if and only if f (x) ≥ 0 for all x ∈ R and −∞ f (x)dx.Theorem 2 (Bayes’ Rule). Typically.3) is unavailable.. F (x) is nondecreasing in x 3. these cases are unusualRand are typically ignored. a These expressions only make sense if F (x) is differentiable. . P (B | Ai ) P (Ai ) P (Ai | B) = P∞ j=1 P (B | Aj ) P (Aj ) A.2) Sometimes we write this as FX (x) to denote that it is the CDF of X. τ r ... We say that the random variable X is continuous if F (x) is continuous in x. ... The probability function for X takes the form j = 1. 2. ... In this case P (X = τ ) = 0 for all τ ∈ R so the representation (A. A2 . limx→−∞ F (x) = 0 and limx→∞ F (x) = 1 2.. For a random variable X we define its cumulative distribution function (CDF) as F (x) = P (X ≤ x) . r (A. the range of X consists of a countable set of real numbers τ 1 .

m C(λ)¯ dλ λ=0 The Lp norm. The MGF does not necessarily exist.A. The moment generating function (MGF) of X is M (λ) = E exp (λX) . √ where i = −1 is the imaginary unit. r X g(τ j )π j . However. More generally. If X is discrete. the characteristic function (CF) of X is C(λ) = E exp (iλX) . of the random variable X is kXkp = (E |X|p )1/p .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) = ∞. Two special moments are the mean µ = EX and variance σ 2 = E (X − µ)2 = EX 2 − µ2 . The CF always exists. p ≥ 1. we define the mean or expectation Eg(X) as follows. we say that expectation is a linear operator. We √ call σ = σ 2 the standard deviation of X. For example. Eg(X) = j=1 and if X is continuous Eg(X) = The latter is well defined and finite if Z If (A.4) does not hold. (A. we define the m0 th moment of X as EX m and the m0 th central moment as E (X − EX)m . −∞ ∞ −∞ |g(x)| f (x)dx < ∞. and when E |X|m < ∞ ¯ ¯ dm ¯ = im E (X m ) . 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. evaluate I1 = Z Z ∞ g(x)f (x)dx. 168 . For m > 0.3 Expectation For any measurable real function g. If both I1 = ∞ and I2 = ∞ then Eg(X) is undefined. this allows the convenient expression V ar(a + bX) = b2 V ar(X). If I1 < ∞ and I2 = ∞ then we define Eg(X) = −∞. Since E (a + bX) = a + bEX. We can also write σ 2 = V ar(X).

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

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

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

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

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

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

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

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

1).3 Let Z ∼ N (0. For Z ∼ N(0. Thus ¥ ¡ ¢0 ¡ ¢ Z 0 A−1 Z = Z 0 C −10 C −1 Z = C −1 Z C −1 Z ∼ χ2 .Theorem A. Iq ). 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 . 1) and Q ∼ χ2 be independent.11). The MGF for the density (A. From (A. Thus the density of Z 2 is (A. (A.2. Using the simple law of iterated expectations.3.6) can be used to show that the MGF j=1 ¥ Proof of Theorem A. ¡ ¢ √ using the change—of-variables s = x2 and the fact Γ 1 = π. Since we can write Q = P 2 X 0 X = r Zj where the Zj are independent N(0. which we showed in (A.8.13) = (1 − 2t)−r/2 R∞ where the second equality uses the fact that 0 y a−1 exp (−by) dy = b−a Γ(a).12) E exp (tQ) = 0 Γ (A.8.8.11) is Z ∞ ¢ ¡ Γ r+1 2 f (x) = ´ r+1 ¡r¢ ³ √ 2 2 πrΓ 2 1 + x r (A. Proof of Theorem A.13) is the MGF of the density (A.13).1.8. C −1 AC −10 ) = N (0. which can be found by applying change-of-variables to the gamma function. tr = p Q/r The density of tr is and is known as the student’s t distribution with r degrees of freedom. C −1 CC 0 C −10 ) = N (0. we see that the MGF of Z 2 is (1 − 2t)−1/2 . Set r Z .11) 2 with r = 1. The fact that A > 0 means that we can write A = CC 0 where C is non-singular. q Proof of Theorem A. Then A−1 = C −10 C −1 and C −1 Z ∼ N (0. tr has distribution 177 .

θ) where F is a known distribution function and θ ∈ Θ is an unknown m × 1 vector. 178 . In this setting the method of maximum likelihood is the appropriate technique for estimation and inference on θ. θ) .θ = fn Y f (Yi . Yn ) is n ³ ´ Y ˜. i=1 The likelihood of the sample is this joint density evaluated at the observed sample values. If the distribution F is continuous then the density of Yi can be written as f (y. The log-likelihood function is its natural log Ln (θ) = n X i=1 ln f (Yi . . viewed as a function of θ. θ) . we say that the distribution is parametric and that θ is the parameter of the distribution F.. θ) and the joint ˜ density of a random sample Y = (Y1 . θ) = P (Y = y. the likelihood and log-likelihood are constructed by setting f (y.. The space Θ is the set of permissible value for θ.. If the distribution F is discrete.9 Maximum Likelihood If the distribution of Yi is F (y.function F (x) = = = = Thus its density is f (x) = = = à r ! Q d E Φ x dx r à à r !r ! Q Q E φ x r r ! µ ¶¶ r à Z ∞µ qx2 1 q 1 r/2−1 ¡r¢ √ exp − q exp (−q/2) dq 2r r Γ 2 2r/2 2π 0 ¢ µ ¡ ¶− r+1 Γ r+1 x2 ( 2 ) 2¡ ¢ . θ) . 1+ √ r r rπΓ 2 ! Z P p ≤x Q/r ( r ) Q E Z≤x r !# " à r Q |Q E P Z≤x r à r ! Q EΦ x r à = ¥ A.

3 Under regularity conditions. θ0 ) .Define the Hessian H = −E and the outer product matrix Ω=E µ ∂2 ln f (Yi .9.17) is often called the information matrix equality.9. In fact. θ) ∂θ ∂θ which holds at θ = θ0 by (A. ˆ is consistent θ for this value. θ θ∈Θ ˆ In some simple cases. the log-likelihood is a sample average 1X 1 Ln (θ) = ln f (Yi . I0 .16) (A. However. ∂θ ∂θ (A. n n i=1 n As the MLE ˆ maximizes the left-hand-side. we can see that it is an estimator of the maximizer θ of the right-hand-side. 179 . More typically. Theorem A. θ Theorem A. The maximum likelihood estimator or MLE ˆ is the parameter value which maximizes θ the likelihood (equivalently. the restriction to unbiased estimators means that the theorem has little direct relevance for finite sample efficiency. θ) ≡ L(θ). the MLE θ Why do we believe that the MLE ˆ is estimating the parameter θ? Observe that when stanθ dardized. The first-order condition for the latter problem is 0= ∂ ∂ L(θ) = E ln f (Yi .1 ¯ ¯ ∂ E ln f (Yi . under conventional regularity conditions. and the equality (A. θ0 ) ln f (Yi . θ) →p E ln f (Yi . θ) The Cramer-Rao Theorem gives a lower bound for estimation. θ)¯ =0 ¯ ∂θ θ=θ0 H = Ω ≡ I0 (A. ´ ¡ −1 ¢ √ ³ˆ n θ − θ0 →d N 0.9. which maximizes the log-likelihood).14) ¶ ∂ ∂ 0 ln f (Yi .17) The matrix I0 is called the information. ˆ →p θ0 as n → ∞. then θ V ar(˜ ≥ (nI0 )−1 . cases are rare. we can find an explicit expression for θ as a function of the data.15) Two important features of the likelihood are Theorem A. but these ˆ must be found by numerical methods.2 Cramer-Rao Lower Bound.16). We can write this as ˆ = argmax Ln (θ). θ0 ) ∂θ∂θ 0 (A. If ˜ is an unbiased estimator of θ ∈ R.

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

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

θn ) − H(θn ) + H(θn ) − n n ∂θ∂θ0 ∂θ∂θ0 i=1 i=1 →p H by an application of a uniform WLLN. θn ) ∂θ ∂θ∂θ0 i=1 i=1 ln f (Yi .Proof of Theorem A. an application of the CLT yields 1 X ∂ √ ln f (Yi . the specific value of θn varies by row in this expansion. ´ ¡ ¢ ¡ ¢ √ ³ˆ n θ − θ0 →d H −1 N (0.3 Taking the first-order condition for maximization of Ln (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 . θ n ) θ − θ 0 .1 . and making a first-order Taylor series expansion. the final equality using Theorem A. ˆ = θ ∂θ i=1 n n ´ ³ X ∂ X ∂2 ˆ ln f (Yi . θ0 ) →d N (0. − ln f (Yi . ∂θ n i=1 n The analysis of the sample Hessian is somewhat more complicated due to the presence of θn .9. Let ∂2 H(θ) = − ∂θ∂θ0 ln f (Yi . Ω) = N 0. θ0 ) + ' 0 ln f (Yi . Ω) . θ) . H −1 ΩH −1 = N 0. we find ´ ³ ˆ − θ0 = θ Since ∂ ∂θ à !−1 à n ! n X ∂2 X ∂ ln f (Yi . (Technically. θ0 ) .) Rewriting this equation.9. ∂θ ∂θ∂θ i=1 i=1 θ where θn lies on a line segment joining ˆ and θ0 . ¯ ¯ ∂ Ln (θ)¯ 0 = ¯ ˆ ∂θ θ=θ n ³ ´ X ∂ ln f Yi . H −1 . ¥ 182 . Together. θn ) = ln f (Yi . If it is continuous in θ. θ0 ) is mean-zero with covariance matrix Ω.

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

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

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

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