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

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Contents

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

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

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i

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

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

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

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

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ii

. . . . . . . . . . . . . . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . 12 Univariate Time Series 12. . . . . . . . . . . . . . . . . . . . . . . . . . .3 Stationarity of AR(1) Process . . . . . .5 Special Cases: IV and 2SLS 11. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11. . . . . 9. . . . . . . . . . 11. . . . . .8 Bootstrap for Autoregressions . . . . . .6 Over-Identiﬁcation Test . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9 8. . 12. . .9 Bootstrap GMM Inference . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Stationarity and Ergodicity . . . . . . . . . . . . . . . . . . .10Testing for Omitted Serial Correlation 12. . . . . . . . . . . . . .12 8. . . . . . . . . . . . . . . . . . . .1 Non-Parametric Likelihood . 10 Empirical Likelihood 10. . . . . . . . . . . . . . . . . . . . 12. .7 Asymptotic Distribution . . . . . . . . . . . 11. . . . . . . . . . . . . . . Percentile Conﬁdence Intervals . . .10 Exercises . . . . . . . .1 Overidentiﬁed Linear Model . . . . . . . 11. . . . . . . . . . . . . . . . . . .8 Conditional Moment Restrictions . . . . . . . . . . . . . . . . . . . . . . .3 Distribution of GMM Estimator . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . . . . . .6 Estimation . . . . . . . . . . . . .8 Exercises . . . . . . . . . . . . . .2 GMM Estimator . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2 Reduced Form . . . . . . . . . 9. 10. . . . . . . . . . . . .8. . . . . . . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . .9 Trend Stationarity . . . . . 100 101 102 103 104 106 106 107 107 108 109 110 111 112 113 114 117 117 119 120 121 121 124 125 126 127 127 128 129 130 133 135 135 137 137 138 138 139 140 140 141 142 142 143 9 Generalized Method of Moments 9. . . . . . . . 9. . . . . . . . . . . . . . . . . . 9. . . . . . . 12. . . . . . . . . . . . . . . . . . Bootstrap Methods for Regression Models Exercises . . . . . . . . . . . . . . . . . . . . . .3 Identiﬁcation . . . . . . . . . . . . . .7 Identiﬁcation Failure . . . . . . . . . . . . 12. . . . . . 10. . 10. . . . . . .10 8. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Instrumental Variables . . . . . . . . . . . . . . . . . . . .5 Numerical Computation . . . . . . . . . . . . . . . . . . . . . . . . . .2 Autoregressions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12.3 Overidentifying Restrictions . . . . . . . . . 11 Endogeneity 11. . . . . . . . . . . . . . . . . . . . 9. . . . . . .11Model Selection . . . . . . . . . . . . .4 Estimation . . . . . . . Symmetric Two-Sided Tests . . . . . . . . 12. . . . . . . . . . . . . . .13 One-Sided Tests .12Autoregressive Unit Roots .4 Lag Operator . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .6 Bekker Asymptotics . . . . . . . . . . 9. . . .2 Asymptotic Distribution of EL Estimator 10. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4 Estimation of the Eﬃcient Weight Matrix . . . . . . . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .7 Hypothesis Testing: The Distance Statistic 9. . . . . . . . . . . . . 12. . . .4 Testing . . .11 8. . . . . . . . . . .5 Stationarity of AR(k) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11. . . . iii . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5 GMM: The General Case . . . . . . . . . . . . . . . . . . . . . 11. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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

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

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

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

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

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

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

This matrix is called the inverse of A and is denoted by A−1 . The Moore-Penrose generalized inverse A− satisﬁes (2. or is nonsingular.1) . . . then A−1 = A. some properties include AA−1 = A−1 A = Ik ¡ ¢−1 ¡ −1 ¢0 = A0 A Even if a matrix A does not possess an inverse.4 Inverse A k × k matrix A has full rank.3) plus the following three conditions A− AA− = A− AA− is symmetric A− A is symmetric For any matrix A. If A − BD−1 C and D − CA−1 B are non-singular.The can be seen since ⎢ ⎢ tr (AB) = tr ⎢ ⎣ = k X i=1 k X i=1 ⎡ a0 b1 a0 b2 · · · 1 1 a0 b1 a0 b2 · · · 2 2 . . . (2. a0 bk k ⎤ ⎥ ⎥ ⎥ ⎦ a0 bi i b0 ai i = = tr (BA) . 0b 0b ak 1 ak 2 · · · a0 bk 1 a0 bk 2 . if A is an orthogonal matrix.3) The matrix A− is not necessarily unique. then # ¡ ¢−1 ¡ ¢−1 ∙ ¸−1 " A − BD−1 C A B − A − BD−1 C BD−1 ¡ ¡ ¢−1 ¢−1 = . . the Moore-Penrose generalized inverse A− exists and is unique.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. if there is no c 6= 0 such that Ac = 0. 7 Also. 2. For non-singular A and C. . (2. . The following fact about inverting partitioned matrices is sometimes useful. we can still deﬁne a generalized inverse A− as a matrix which satisﬁes AA− A = A. In this case there exists a unique matrix B such that AB = BA = Ik .

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. This is written as A ≥ 0. λ−1 . then A is positive semi-deﬁnite.. One way to construct B is to use the spectral decomposition A = HΛH 0 where Λ is diagonal. X 0 X is symmetric and positive deﬁnite.. This is written as A > 0. Let λi and hi . If A = G0 G. We say that X is n × k. We say that a square matrix A is positive semi-deﬁnite if for all non-zero c. and let H = [h1 · · · hk ]. If A is also symmetric (most idempotent matrices are) then all its characteristic roots equal either zero or one. Let Λ be a diagonal matrix with the characteristic roots in the diagonal. If λi is an eigenvalue of A. • If A has distinct characteristic roots. there exists a nonsingular matrix P such that A = P −1 ΛP and P AP −1 = Λ. c0 Ac ≥ 0.) If A is positive deﬁnite. 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 . c0 Ac = α0 a ≥ 0 where α = Gc. . • If A is symmetric. note that we can write A = HΛH 0 where H is orthogonal and Λ contains the (real) characteristic roots. They are called the latent roots or characteristic roots or eigenvalues of A. . A−1 > 0.5 Eigenvalues det (A − λIk ) = 0.. We call B a matrix square root of A.. The matrix B need not be unique. We say that A is positive deﬁnite if for all non-zero c. A square matrix A is idempotent if AA = A. 1 2 k The decomposition A = HΛH 0 is called the spectral decomposition of a matrix. then A > 0 if and only if all its characteristic roots are positive. 8 . (For any c 6= 0. then A is non-singular and A−1 exists.2. which are not necessarily distinct and may be real or complex. To see this. λ−1 . • The characteristic roots of A−1 are λ−1 .6 Rank and Positive Deﬁniteness The rank of a square matrix is the number of its non-zero characteristic roots. then A = HΛH 0 and H 0 AH = Λ. 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. In this case. and then set B = HΛ1/2 .. If A is symmetric. We now state some useful properties. k denote the k eigenvalues and eigenvectors of a square matrix A. Furthermore. 2. and the characteristic roots are all real. has full rank k if there is no non-zero c such that Xc = 0. k < n. c0 Ac > 0. i = 1. Then A = AA = HΛH 0 HΛH 0 = HΛ2 H 0 .. If A > 0 we can ﬁnd a matrix B such that A = BB 0 .

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

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

it is useful to have numerical measures of the diﬀerence. You can see that the right tail of then density is much thicker than the left tail. m(x) can take any form. The data are from the 2004 Current Population Survey 1 11 . holding the other variables constant. An important summary measure is the conditional mean Z ∞ yf (y | x) dy. or the covariates. While it is easy to observe that the two densities are unequal. xki 3. and that for women is $20. we can focus on f (y | x) . The two density curves show the eﬀect of gender on the distribution of wages. the conditional density of yi given xi . from the population of white non-military wage earners with a college degree and 10-15 years of potential work experience.Chapter 3 Regression and Projection The most commonly applied econometric tool is regression. the conditioning variable. which is a common feature of wage distributions. These are indicated in Figure 3. the mean wage for men is $27. In this context it is often convenient These are nonparametric density estimates using a Gaussian kernel with the bandwidth selected by crossvalidation. xi ) where yi is a scalar (real-valued) and xi is a vector. . In this context we partition the observations into the pair (yi .1. We call xi alternatively the regressor.2) m(x) = E (yi | xi = x) = −∞ In general. In the example presented in Figure 3. These are conditional density functions — the density of hourly wages conditional on race. We list the elements of xi in the vector ⎞ ⎛ x1i ⎜ x2i ⎟ ⎟ ⎜ (3. education and experience.22. ⎟ . See Chapter 16. Take a closer look at the density functions displayed in Figure 3. To illustrate. These are asymmetric (skewed) densities. Figure 3. This is used when the goal is to quantify the impact of one set of variables on another variable.1. and exists so long as E |yi | < ∞.1 Conditional Mean To study how the distribution of yi varies with the variables xi in the population. (3.1) xi = ⎜ . We call yi the dependent variable.73. ⎠ ⎝ . When a distribution is skewed.1 displays the density1 of hourly wages for men and women. gender.1 by the arrows drawn to the x-axis. the mean is not necessarily a good summary of the central tendency.

A. The conditional expectation function is close to linear. To illustrate.2) evaluated at the observed value of xi : ei = yi − m(xi ). 12 . When the distribution of the control variable is continuous. the dashed line is a linear projection approximation which will be discussed in the Section 3. and a Ph. Figure 3.1: Wage Densities for White College Grads with 10-15 Years Work Experience to transform the data by taking the (natural) logarithm.1 is facilitated by the fact that the control variable (gender) is discrete. For this reason. 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 .3 displays a scatter plot2 of log wages against education levels.D. 2 (3.2 Regression Equation The regression error ei is deﬁned to be the diﬀerence between yi and its conditional mean (3. with mean log hourly wages drawn in with the arrows. then comparisons become more complicated. wage regressions typically use log wages as a dependent variable rather than the level of wages.2 shows the density of log hourly wages for the same population. implying an average 36% diﬀerence in wage levels.Figure 3. By construction. Of particular interest to graduate students may be the observation that diﬀerence between a B. the solid line displays the conditional expectation of log wages varying with education. The main point to be learned from Figure 3.5. degree in mean log hourly wages is 0.36.3) White non-military male wage earners with 10-15 years of potential work experience. which implies a 30% average wage diﬀerence for this population. The comparison in Figure 3. Figure 3. The diﬀerence in the log mean wage between men and women is 0.30. Assuming for simplicity that this is the true joint distribution. 3.3 is how the conditional expectation describes an important feature of the conditional distribution.

by the deﬁnition of ei and the linearity of conditional expectations. 13 . E (h(xi )ei ) = 0 for any function h (·) . 3.1 Properties of the regression error ei 1. E (ei | xi ) = 0. are often stated jointly as the regression framework. because no restrictions have been placed on the joint distribution of the data. E(ei ) = 0. The remaining parts of the Theorem are left as an exercise. These equations hold true by deﬁnition. not a model.2. 4. restrictions on the permissible class of regression functions m(x).Figure 3. most typically. 2. A regression model imposes further restrictions on the joint distribution. To show the ﬁrst statement. It is important to understand that this is a framework.2: Log Wage Densities Theorem 3. The equations yi = m(xi ) + ei E (ei | xi ) = 0. E(xi ei ) = 0. E (ei | xi ) = E ((yi − m(xi )) | xi ) = m(xi ) − m(xi ) = E (yi | xi ) − E (m(xi ) | xi ) = 0.

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

In this case (3. ⎟ β=⎝ . where x1i is the ﬁrst element of the vector xi deﬁned in (3. i (3. Equation (3. The conditional standard deviation for men is 12. βk ⎛ (3. Instead.8) (3.7) is a k × 1 parameter vector.1). We call this the “constant” or “intercept”. it is more realistic to view the linear speciﬁcation (3.8) is called the linear regression model.5) xi = ⎜ . Notationally. ⎠ .3) can be writen as yi = x0 β + ei i E (ei | xi ) = 0. An important special case is homoskedastic linear regression model yi = x0 β + ei i E (ei | xi ) = 0 ¢ ¡ E e2 | xi = σ 2 . 15 . ⎝ . take the conditional wage densities displayed in Figure 3. which we derive in this section. This concept is less helpful than deﬁning heteroskedasticity as the dependence of the conditional variance on the observables xi . ⎟ .1 and that for women is 10.6) as an approximation. and the linear assumption of the previous section is empirically unlikely to accurate. As an example. So while men have higher average wages.1) has been redeﬁned as the k × 1 vector ⎛ ⎞ 1 ⎜ x2i ⎟ ⎜ ⎟ (3. Some textbooks inappropriately describe heteroskedasticity as the case where “the variance of ei varies across observation i”. 3.1.4 Linear Regression An important special case of (3.6) (3.9) 3.3) is when the conditional mean function m(x) is linear in x (or linear in functions of x).5. xki When m(x) is linear in x. they are also somewhat more dispersed. Thus (3. we can write it as m(x) = x0 β = β 1 + x2i β 2 + · · · + xki β k where ⎞ β1 ⎜ . its functional form is typically unknown.we say that the error ei is homoskedastic. it is convenient to augment the regressor vector xi by listing the number “1” as an element.5 Best Linear Predictor While the conditional mean m(x) = E (yi | xi = x) is the best predictor of yi among all functions of xi . ⎠ . we assume that x1i = 1. Equivalently.

E (xi x0 ) is invertible.7) is 0= Solving for β we ﬁnd ¡ ¢ ∂ S(β) = −2E (xi yi ) + 2E xi x0 β. Observe i that for any non-zero α ∈ Rk . We now summarize the assumptions necessary for its derivation and list the implications in Theorem 3. Rewriting. Therefore. i which requires that for all non-zero α.1 1.10) It is worth taking the time to understand the notation involved in this expression. Eyi < ∞. Given the deﬁnition of β in (3. otherwise they are distinct. The best linear predictor is obtained by selecting β to minimize S(β). Assumption 3. i 16 . E (xi x0 ) is a mai E(x y trix and E (xi yi ) is a vector. E (x0 xi ) < ∞. there cannot i exist a non-zero vector α such that α0 xi = 0 identically. As before. x0 β is the best linear predictor for yi . alternative expressions such as E xixi ) or E (xi yi ) (E (xi x0 ))−1 i ( i 0i ) are incoherent and incorrect. we obtain a decomposition of yi into linear predictor and error yi = x0 β + ei .12) This completes the derivation of the linear projection model.which is quadratic in β. Equivalently.10). In order for β to be uniquely deﬁned. i (3. this situation must be excluded. α0 E (xi x0 ) α = E (α0 xi )2 ≥ 0 so the matrix E (xi x0 ) is by construction i i positive semi-deﬁnite. written E (xi x0 ) > 0. 2 2. This occurs when redundant variables are included in xi . xi contains an intercept. i (3.11) 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 . The vector (3. The error is i ei = yi − x0 β. For any β ∈ Rk a linear predictor for yi is x0 β with expected squared prediction i error ¢2 ¡ S(β) = E yi − x0 β i ¢ ¢ ¡ ¡ 2 = Eyi − 2E yi x0 β + β 0 E xi x0 β. α0 E (xi x0 ) α = E (α0 xi )2 > 0. i i (3. It is invertible if and only if it is positive deﬁnite.10) exists and is unique as long as the k ×k matrix E (xi x0 ) is invertible. by “best” we mean the predictor function with lowest mean squared error. i ∂β ¢¢−1 ¡ ¡ E (xi yi ) .1. 3.5.5. 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 . The ﬁrst-order condition for minimization (from Section 2. i 4.

Theorem 3.1.12) and (3.14) Proof. Equation (3.1. the converse is not true as the projection error does not necessarily satisfy E (ei | xi ) = 0.5.5. Figure 3.8)-(3. Assumption 3.13) summarize the linear projection model. suppose that for xi ∈ R that Ex3 = 0 and ei = x2 .10) are deﬁned.1 are weak.2 and 3. The ﬁnite variance Assumptions 3. Then i i Exi e2 = Ex3 = 0 yet E (ei | xi ) = x2 6= 0.1.13) implies that xi and ei are uncorrelated.3 ensure that the moments in (3. E (xi ei ) = 0 and E (ei ) = 0.14). Since from Theorem 3.11) are well deﬁned. x0 β is the i projection of yi on xi since the error ei is orthogonal with xi . Assumption 3.4: Hourly Wage as a Function of Experience The conditions listed in Assumption 3.2. Assumption 3. it follows that linear regression is a special case of the projection model.1 is employed to guarantee that (3. the orthogonality restriction (3. This means that the equation (3. By deﬁnition.5.10) and (3.5.12) can be alternatively interpreted as a projection decomposition.4 is required to ensure that β is uniquely deﬁned.5.1. Assumption 3.14) follows from (3.5. For example.1.9).1 Under Assumption 3. However.1. ¥ (3. (3.14) holds.3 are called regularity conditions. Since ei is mean zero by (3.1.5.4 guarantees that the solution β exits.5. Furthermore. 17 .5.13) The two equations (3. (3. Let’s compare it with the linear regression model (3.1.1.1.2 and 3. i i i Since E (xi ei ) = 0 we say that xi and ei are orthogonal.13) and Assumption 3.4 we know that the regression error has the property E (xi ei ) = 0.5.1.11) and (3. Using the deﬁnitions (3.5.10) ¡ ¡ ¢¢ 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.

and under-predicts for the rest. we can augment the regressor vector xi to include both experience and experience2 . for those over 53 in age).5.10). it is important to not misinterpret the generality of this statement. the dashed line is the linear projection of log wages on eduction. These structural models require alternative estimation methods.5.1.We have shown that under mild regularity conditions. In this case the linear projection is a poor approximation to the conditional mean. Figure 3. The solid line is the conditional mean. for any pair (yi .4 displays the relationship3 between mean log hourly wages and labor market experience. In this case (3.3. Figure 3. and are discussed in Chapter 11. In Figure 1. it misses the strong downturn in expected wages for those above 35 years work experience (equivalently. 18 . In contrast. No additional assumptions are required.4 we display as well this quadratic projection. Returning to the joint distribution displayed in Figure 3. However.12) with the properties listed in Theorem 3. there are no changes in our methods or analysis. It over-predicts wages for young and old workers. A projection of log wages on these two variables can be called a quadratic projection. Most importantly. in many economic models the parameter β may be deﬁned within the model. In this example it is a much better approximation to the conditional mean than the linear projection. xi ) we can deﬁne a linear projection equation (3. In other cases the two may be quite diﬀerent.10) may not hold and the implications of Theorem 3. Other than the redeﬁnition of the regressor vector.1 may be false. In the example just presented.5 for a 3 In the population of Caucasian non-military male wage earners with 12 years of education.12) is deﬁned by projection and the associated coeﬃcient deﬁnition (3. The linear equation (3. and the straight dashed line is the linear projection. This defect in linear projection can be partially corrected through a careful selection of regressors. We illustrate the issue in Figure 3. since the resulting function is quadratic in experience.5: Conditional Mean and Two Linear Projections Another defect of linear projection is that it is sensitive to the marginal distribution of the regressors when the conditional mean is non-linear. In this example the linear projection is a close approximation to the conditional mean.

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

E(ei | xi ) = 0. µ. taking values only on the non-negative integers. σ = .2. Let xi and yi have the joint density f (x. True or False. then E(x2 ei ) = 0. σ 2 = V ar(xi ). True or False.2 Y =1 . yi ). 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. then ei is i i independent of xi . e−λ λj j! . (x − µ)2 − σ 2 Show that Eg (X. If yi = x0 β + ei and E(ei | xi ) = 0. Suppose that Y and X only take the values 0 and 1. σ 2 = V ar(yi ) and σ xy = Cov(xi . Show that x y β 1 = σ xy /σ 2 and β 0 = µy − β 1 µx . i 7. i 10. then E(ei | xi ) = 0.1 . i 11. xi ∈ R. True or False. 9. Suppose that yi is discrete-valued. 0 ≤ y ≤ 1. then ei is independent of xi . Compute the conditional mean m(x) = E (yi | xi = x) . a constant. Prove parts 2. 1. and E(xi ei ) = 0. E(Y 2 | X = x) and V ar(Y | X = x).3 Find E(Y | X = x). and have the following joint probability distribution X=0 X=1 Y =0 . If yi = x0 β + ei . j! 0 j = 0. y) = 3 x2 + y 2 on 0 ≤ x ≤ 1. If yi = xi β + ei . Compute E(yi | xi = x) and V ar(yi | xi = x). s) = 0 if and only if m = µ and s = σ 2 . Take the bivariate linear projection model yi = β 0 + β 1 xi + ei E (ei ) = 0 E (xi ei ) = 0 Deﬁne µy = Eyi . Deﬁne µ ¶ ¢ ¡ x−µ 2 g x. 2. then E(x2 ei ) = 0. If yi = x0 β + ei and E(xi ei ) = 0. Compute 2 the coeﬃcients of the linear projection yi = β 0 + β 1 xi + ei . Let X be a random variable with µ = EX and σ 2 = V ar(X). 3 and 4 of Theorem 3.3.6 Exercises 1. If yi = xi β + ei . and E(ei | xi ) = 0. and the conditional distribution of yi given xi is Poisson: P (yi = k | xi = x) = e−x β (x0 β)j . ¡ ¢ 4. .. µx = Exi . xi ∈ R. m. True or False. 20 .. i 8.1. 2. Are they diﬀerent? Hint: If P (Y = j) = 5. 3.4 . x 6. and E(e2 | xi ) = σ 2 .

i n i=1 n 21 .3) writes the projection coeﬃcient β as an explicit function of population moments E (xi yi ) and E (xi x0 ) . i It follows that the moment estimator of β replaces the population moments in (4.2) (4.3) In Sections 4. (4.2) can be written in the parametric 0 β)) = 0. 4. The function g(β) can be estimated by form g(β) = E (xi (yi − xi g (β) = ˆ ¢ 1X ¡ xi yi − x0 β . Observe that (4.7 and 4. but for most of the chapter we retain the broader focus on the projection model.4) i i=1 i=1 ˆ Another way to derive β is as follows. Their moment estimators are the sample moments i ˆ E (xi yi ) = ¢ ¡ ˆ E xi x0 = i 1X xi yi n 1 n i=1 n X i=1 n xi x0 .Chapter 4 Least Squares Estimation This chapter explores estimation and inference in the linear projection model yi = x0 β + ei i E (xi ei ) = 0 ¡ ¡ ¢¢−1 E (xi yi ) β = E xi x0 i (4.3) with the sample moments: ³ ¡ ¢´−1 ˆ ˆ ˆ β = E xi x0 E (xi yi ) i Ã n !−1 n 1X 1X 0 xi xi xi yi = n n i=1 i=1 Ã n !−1 n X X = xi x0 xi yi .8.1) (4.1 Estimation Equation (4. we narrow the focus to the linear regression model.

30 = . 4.4).95 xi yi = 42.94 −2.ˆ This is a set of k equations which are linear in β. Let yi be log wages and xi be an intercept and years of education.14 14. 40 2. consider the data used to generate Figure 3. This sample has 988 observations. excluding military.2 Least Squares There is another classic motivation for the estimator (4. The estimator β is the value which jointly sets these equations equal to zero: 0 = g (β) ˆ ˆ n ´ 1X ³ ˆ xi yi − x0 β = i n i=1 (4.40 µ ¶µ ¶ 34. 0.117 1 14.3. 40 0.4).83 ¶−1 µ ¶ . Then µ ¶ n 1X 2. with 10-15 years of potential work experience.37 µ ¶ 1.83 µ We often write the estimated equation using the format \ log(W agei ) = 1.117 Educationi .5) = n n 1X 1X ˆ xi yi − xi x0 β i n n i=1 i=1 whose solution is (4.71 = −2.14 14. These are white male wage earners from the March 2004 Current Population Survey.7% increase in mean wages.170 37. To illustrate.14 205.40 n i=1 1 n Thus ˆ β = n X i=1 xi x0 i = µ 1 14. ¶ 2. Deﬁne the sum-of-squared errors (SSE) function n X¡ ¢2 yi − x0 β Sn (β) = i i=1 = This is a quadratic function of β. An interpretation of the estimated equation is that each year of education is associated with an 11.95 42. n X i=1 2 yi − 2β 0 n X i=1 xi yi + β 0 n X i=1 xi x0 β.14 205.30 + 0. i 22 .

1 displays an example sum—of-squared errors function Sn (β) for the case k = 2. the contour lines are ellipses.1: Sum-of-Squared Errors Function As a by-product of OLS estimation. we deﬁne the predicted value ˆ yi = x0 β ˆ i and the residual ˆ ei = yi − yi ˆ ˆ = yi − x0 β. These two ˆ variables are frequently mislabeled. Figure 4. i ˆ ˆ Note that yi = yi + ei . Matrix calculus (see Appendix 2.4).2 displays the contour lines of the same function — horizontal slices at equally spaced heights. 23 . which can cause confusion. Figure 4. Figure 4. Since the function Sn (β) is a quadratic function of β.7) gives the ﬁrst-order conditions for minimization: 0 = ∂ ˆ Sn (β) ∂β n n X X ˆ = −2 xi yi + 2 xi x0 β i i=1 i=1 ˆ whose solution is (4. while the residual is a by-product of estimation. The error is unobservable. It is important to understand the distinction between the error ei and the residual ei . Following convention we will call β the OLS estimator of β.The Ordinary Least Squares (OLS) estimator is the value of β which minimizes Sn (β). To visualize the sum-of-squared errors function.

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

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

For example n X i=1 For many purposes. n or equivalently Y = Xβ + e. ⎠ ⎜ ⎜ e=⎜ ⎝ ⎟ ⎟ ⎟. x0 n ⎞ ⎛ e1 e2 . = β+ XX 26 (4. Due to this equivalence. ˆi 2 ∂σ 2 2ˆ σ 2 σ ˆ i=1 ˆ ˆ Solving for σ 2 yields the method of moments estimator (4. and sample error variance can be written as ¢−1 ¡ 0 ¢ ¡ ˆ β = X 0X XY ˆ e = Y − Xβ ˆ σ 2 = n−1 e0 e.4). . yn ⎟ ⎟ ⎟. the ˆ OLS estimator β is frequently referred to as the Gaussian MLE. σ 2 ) = − 2 + ¡ ¢2 e2 = 0.4 Model in Matrix Notation convenient to write the model and statistics in x0 1 x0 2 . . . n X i=1 Thus the estimator (4. . . ⎟. including computation. ⎠ . We deﬁne ⎛ ⎞ ⎛ y1 ⎜ ⎜ y2 ⎟ ⎜ ⎟ ⎜ X=⎜ Y = ⎜ .12) is a system of n equations.8) . yn = x0 β + en . Sample sums can also be written in matrix notation. Thus the MLE (β. it is matrix notation. We can stack these n equations together as y1 = x0 β + e1 1 y2 = x0 β + e2 2 . The linear equation (3. and X is an n × k matrix. ⎠ xi x0 = X 0 X i xi yi = X 0 Y. . σ 2 ) for the normal ˆ regression model are identical to the method of moment estimators.Maximization with respect to σ 2 yields the ﬁrst-order condition n X ∂ n 1 ˆ ˆ Ln (β. 4. one for each observation. en ⎞ Observe that Y and e are n × 1 vectors.6). 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. residual vector. ⎝ ⎝ .

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. ⎠ ⎝ ⎠ ⎝ . .13). . In this case. By the independence of the observations and (3. and X2 is the vector of observed regressors. Regress X2 on X1 . Rather. observe that ⎞ ⎛ ⎞ ⎛ . Regress Y on X1 . obtain residuals X2 . ˆ ˜ ˜ ˆ 3. the OLS estimator of β 2 and the OLS residuals e may be equivalently computed by either the OLS regression (4. In some contexts.14) or via the ˆ following algorithm: ˜ 1. In this section we derive the small sample conditional mean and variance of the OLS estimator. A common application of the FWL theorem.6.Theorem 4.9). Partition X = [X1 X2 ] where X1 = ι is a vector of ones. . The FWL theorem says that β 2 is the OLS estimate from a regression of ˜ ˜ Y on X2 . ! Thus the OLS estimator for the slope coeﬃcients is a regression with demeaned data.8)(3. Regress Y on X2 . obtain residuals Y . M1 = I − ι ι0 ι Observe that ¡ ¢−1 0 ˜ ι X2 X2 = M1 X2 = X2 − ι ι0 ι = X2 − X 2 and ˜ Y ¡ ¢−1 0 = M1 Y = Y − ι ι0 ι ιY = Y −Y. but in most cases there is little computational advantage to using the two-step algorithm.1 (Frisch-Waugh-Lovell). ¡ ¢−1 0 ι. is the demeaning formula for regression. . . .18) E (e | X) = ⎜ E (ei | X) ⎟ = ⎜ E (ei | xi ) ⎟ = 0. 4. the primary use is theoretical. 30 . . .9). obtain OLS estimates β 2 and residuals e. ⎟ ⎜ ⎟ ⎜ (4. which you may have seen in an introductory econometrics course. ˆ which are “demeaned”. the FWL theorem can be used to speed computation. 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) . In the model (4. ˜ 2. .

. σ 2 = σ 2 and we have the simplii ﬁcations D = In σ 2 ..Using (4.12). for any random vector Z deﬁne the covariance materix V ar(Z) = E (Z − EZ) (Z − EZ)0 = EZZ 0 − (EZ) (EZ)0 . and (4. σ2 = ˆ ¢ 1 ¡ ¢ 1 0 1 1 1 ¡ e e = e0 M M e = e0 M e = tr e0 M e = tr M ee0 ˆˆ n n n n n 31 In the special case of the linear homoskedastic regression model. From (4. ⎠ (4. . . and ³ ´ ¡ ¢−1 2 ˆ σ . σ2 n ⎞ We now calculate the ﬁnite sample bias of the method ¡ moments estimator σ 2 for σ 2 . 0 0 ··· 0 0 . X 0 DX = X 0 Xσ 2 ... . Then given (4. . the properties additional assumption of conditional homoskedasticity E ei i of projection matrices.18).20) . .. ⎝ . . V ar β | X = X 0 X ⎟ ⎟ ⎟.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 . .19) ˆ and thus the OLS estimator β is unbiased for β. under the of ˆ ¢ 2 | x = σ 2 .8). Next. σ 2 } = ⎜ . We have shown that which implies ³ ´ ˆ E β|X =β ³ ´ ˆ E β =β (4. and the trace operator observe that. 1 n . 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. the properties of conditional expectations. Thus D is a diagonal matrix with i’th diagonal element σ 2 : i ⎛ 2 σ1 0 · · · ⎜ 0 σ2 · · · 2 ⎜ D = diag{σ 2 . ¡ X 0X ¢−1 ¡ ¢−1 X 0 DX X 0 X while the ij 0 th oﬀ-diagonal element of D is ¢ ¢ ¡ ¡ E e2 | X = E e2 | xi = σ 2 i i i E (ei ej | X) = E (ei | xi ) E (ej | xj ) = 0.

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

3) can be rewritten as ⎞−1 ⎛ ⎞ ⎛ r r X X β=⎝ πj ξ j ξ 0 ⎠ ⎝ πj ξ j τ j ⎠ (4.5) as required.9 Semiparametric Eﬃciency In the previous section we presented the Gauss-Markov theorem as a limited eﬃciency justiﬁcation for the least-squares estimator. Note that X 0 C = 0. The MLE β mle for β is then the analog of (4... This latter restriction is particularly unsatisfactory... ˆ β mle = ⎝ j j=1 j=1 33 . 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. This property is called semiparametric eﬃciency.. j = 1. It is suﬃcient to show that the diﬀerence A0 A − (X 0 X)−1 is positive semi-deﬁnite. who established that in the projection model the OLS estimator has the smallest asymptotic meansquared error among feasible estimators. . .. π j is the percentage of the observations ˆ ˆ which fall in each category. 4.. We discuss the intuition behind his result in this section. That is. the class of potential estimators has been restricted to linear unbiased estimators.21) j j=1 j=1 Thus β is a function of (π 1 . r for some constant vectors τ j . where 1 (·) is the indicator function.) In this discrete setting. Set C = A − X (X 0 X)−1 .Proof. for ﬁnite r. xi ) is discrete. As the data are multinomial. That is. but we don’t know the probabilities.. the maximum likelihood estimator (MLE) is ¡ ¢ 1X 1 (yi = τ j ) 1 xi = ξ j πj = ˆ n i=1 n for j = 1. but it is quite limited in scope. Not only has the class of models has been restricted to homoskedastic linear regressions. A broader justiﬁcation is provided in Chamberlain (1987).. π r ) . r. Let A be any n×k function of X such that A0 X = Ik . and is a strong justiﬁcation for the least-squares estimator. and π j . xi = ξ j = π j . ξ j . (We know the values yi and xi can take. the deﬁnition (4. 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. Suppose that the joint distribution of (yi . ¡ ¢ P yi = τ j . The variance of the least-squares estimator is (X 0 X)−1 σ 2 and that of A0 Y is A0 Aσ 2 .21) with the parameters ˆ π j replaced by the estimates π j : ⎞−1 ⎛ ⎞ ⎛ r r X X ˆ πj ξj ξ0 ⎠ ⎝ ˆ πj ξ j τ j ⎠ . . Assume that the τ j and ξ j are known. ¥ The Gauss-Markov theorem is an eﬃciency justiﬁcation for the least-squares estimator. but the π j are unknown.

10 Omitted Variables xi = µ x1i x2i ¶ . Chamberlain (1987) extends this argument to the case of continuously-distributed data. the maximum likelihood estimator is identical to the OLS estimator. Let the regressors be partitioned as Suppose we are interested in the coeﬃcient on x1i alone in the regression of yi on the full set xi . 1X xi x0 i n i=1 1X xi yi n i=1 n ˆ = β ols 4.5. (4. 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 .22) 34 . He observes that the above argument holds for all multinomial distributions. 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. and any continuous distribution can be arbitrarily well approximated by a multinomial distribution. He proves that generically the OLS estimator (4.4) is an asymptotically eﬃcient estimator for the parameter β deﬁned in (3.10) for the class of models satisfying Assumption 3. Since this is a regular parametric model the MLE is asymptotically eﬃcient (see Appendix A.Substituting in the expressions for π j . if the data have a discrete distribution.1. and thus so is the OLS estimator.9).

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

A more relevant implication of near multicollinearity is that individual coeﬃcient estimates will be imprecise. since as ρ approaches 1 the matrix becomes singular. deﬁne the leave-one-out least-squares estimator of β. We can also deﬁne the leave-one-out residual ˆ ˆ ei. What is happening is that when the regressors are highly dependent. the precision of individual estimates are reduced. ˆ ˆ (4. the OLS estimator based on the sample excluding the i’th observation. the worse the precision of the individual coeﬃcient estimates. the change in the coeﬃcient estimate by deletion of the i’th observation depends critically on the magnitude of hi . We can see this most simply in a homoskedastic linear regression model with two regressors yi = x1i β 1 + x2i β 2 + 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.25) below. A convenient alternative expression is ¡ ¢−1 ˆ ˆ xi ei ˆ (4.27) (4. and 1 0 XX= n µ 1 ρ ρ 1 ¶ In this case The correlation ρ indexes collinearity.One implication of near singularity of matrices is that the numerical reliability of the calculations is reduced. that is. it is statistically diﬃcult to disentangle the impact of β 1 from that of β 2 . ˆ i A simple comparison yields that ˆ ei − ei.12 Inﬂuential Observations where X(−i) and Y(−i) are the data matrices omitting the i’th row. We derive expression (4. = V ar β ρ 1 n n (1 − ρ2 ) −ρ 1 4. 1] and sum to k.−i = (1 − hi )−1 hi ei . This equals ´−1 ³ 0 ˆ X(−i) Y(−i) (4. To investigate the possibility of inﬂuential observations. Thus the more “collinear” are the estimate σ 2 1 − ρ2 regressors. µ ¶−1 µ ¶ ³ ´ 2 σ2 1 ρ 1 −ρ ˆ|X = σ .26) As we can see.24) β (−i) = X(−i) X(−i) is the i’th diagonal element of the projection matrix X (X 0 X)−1 X 0 . As a consequence.−i = yi − x0 β (−i) = (1 − hi )−1 ei . The hi take values in [0. We can see the eﬀect of collinearity on precision by observing that the asymptotic variance of a coeﬃcient ¡ ¢−1 approaches inﬁnity as ρ approaches 1. If the i’th observation 36 . In extreme cases it is possible that the reported calculations will be in error due to ﬂoating-point calculation diﬃculties.

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

then (5. |a| = a a i i=1 If A is a m × n matrix. We list here some of the most critical deﬁnitions and inequalities.1 Inequalities Asymptotic theory is based on a set of approximations.1) (5. Triangle inequality |X + Y | ≤ |X| + |Y | . ´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. These approximations are bounded through the use of mathematical inequalities. The Euclidean norm of an m × 1 vector a is Ã m !1/2 X ¡ 0 ¢1/2 = a2 . 5.2) + 1 q = 1. ij i=1 j=1 (5.Chapter 5 Asymptotic Theory This chapter reviews the essential components of asymptotic theory. If g(·) : R → R is convex. Jensen’s Inequality.3) E |XY | ≤ (E |X|p )1/p (E |Y |q )1/q . then g(E(X)) ≤ E(g(X)). If p > 1 and q > 1 and 1 p ⎞1/2 ⎛ m n XX ¡ 0 ¢1/2 |A| = tr A A =⎝ a2 ⎠ . 41 . Cauchy-Schwarz Inequality.

p p p q which is (5. ¥ Proof of Holder’s Inequality. Note EU = EV = 1. We say that Zn converges in probability to Z as n → ∞. as stated. n i=1 42 . P (g(X) > α) ≤ α−1 Eg(X). For any strictly increasing function g(X) ≥ 0. n→∞ lim P (|Zn − Z| > δ) = 0. So for all x.4) Proof of Jensen’s Inequality. tangent lines lie below it. This is a probabilistic way of generalizing the mathematical deﬁnition of a limit. g(x) ≥ a + bx yet g(EX) = a + bEX since the curve is tangent at EX. (E |X|p )1/p (E |Y |q )1/q ¥ µ ¶ ´ ³ U V 1 1 1/p 1/q ≤E + = + = 1. then as n → ∞ n 1X Xn = Xi →p E(X). if for all δ > 0. Let U = |X|p /E |X|p and V = |Y |q /E |Y |q .Markov’s Inequality. denoted Zn →p Z as n → ∞. If Xi ∈ Rk is iid and E |Xi | < ∞. The WLLN shows that sample averages converge in probability to the population average. Since g(x) is convex.2 Weak Law of Large Numbers Let Zn ∈ Rk be a random vector. Eg(X) ≥ a + bEX = g(EX). Let a + bx be the tangent line to g(x) at x = EX. Theorem 5. 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}. Set Y = g(X) and let f denote the density function of Y.3).2. =E U V p q p q Proof of Markov’s Inequality. ¥ 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 ) = + . (5.1 Weak Law of Large Numbers (WLLN). Applying expectations.

Finally. 5. Fn (x) → F (x) as n → ∞. by Markov’s inequality (5. we can set E(X) = 0 (by recentering Xi on its expectation). P ¯X n ¯ > δ ≤ η. ¯¢2 ¡ ¯ 2 ≤ EW n E ¯W n ¯ = EWi2 n 4C 2 ≤ n ≤ ε2 (5.4).6) By Jensen’s inequality (5.Proof: Without loss of generality. ≤ E |Xi | 1 (|Xi | > C) + |E (Xi 1 (|Xi | > C))| (5.1 Central Limit Theorem (CLT). Deﬁne the random vectors Wi = Xi 1 (|Xi | ≤ C) − E (Xi 1 (|Xi | ≤ C)) By the triangle inequality. We say that Zn converges in distribution to Z as n → ∞. n i=1 0 where µ = EX and V = E (X − µ) (X − µ) .3. ¯ ¯ ¯ ¯ ¯ ¯ ¢ E ¯X n ¯ ¡¯ ¯ E ¯W n ¯ + E ¯Z n ¯ 3ε ≤ ≤ = η.7) the ﬁnal inequality holding for n ≥ 4C 2 /ε2 = 36C 2 /δ 2 η 2 . the fact that X n = W n + Z n . ¡¯ ¯ P ¯X n ¯ > δ ≤ η. 43 . denoted Zn →d Z. If Xi ∈ Rk is iid and E |Xi |2 < ∞. where Z has distribution F (x) = P (Z ≤ x) .5). and the bound |Wi | ≤ 2C. Jensen’s inequality (5. ≤ 2E |Xi | 1 (|Xi | > C) Zi = Xi 1 (|Xi | > C) − E (Xi 1 (|Xi | > C)) . ¯ ¯ E ¯Z n ¯ ≤ E |Zi | ≤ 2ε. We need to ¢show that for all δ > 0 and η > 0 there is some N < ∞ so that for all n ≥ N. (5.7). Set ε = δη/3. Theorem 5. P ¯X n ¯ > δ ≤ δ δ δ the equality by the deﬁnition of ε.3 Convergence in Distribution Let Zn be a random variable with distribution Fn (x) = P (Zn ≤ x) .5) (where 1 (·) is the indicator function) which is possible since E |X| < ∞. the fact that the Wi are iid and mean zero. V ) . Fix δ and η.6) and (5. then as n→∞ n ¢ √ ¡ 1 X n Xn − µ = √ (Xi − µ) →d N (0. as needed.1) and (5.1). We have shown that for any δ > 0 and η > 0 then for all ¢ ¡¯ ¯ ¥ n ≥ 36C 2 /δ 2 η 2 . if for all x at which F (x) is continuous. the triangle inequality. Pick C < ∞ large enough so that E (|X| 1 (|X| > C)) ≤ ε (5.

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

Theorem 5. This is suﬃcient to establish the theorem. Proof : By a vector Taylor series expansion. Since cλλ (λn ) → cλλ (0) = −Ik . 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 .4.2 Continuous Mapping Theorem 2. gθ Σgθ where gθ (θ) = ∂ g(θ) ∂θ0 and gθ = gθ (θ0 ). then g(Zn ) →p g(c) as n → ∞. 45 .3 Delta Method: If n (θn − θ0 ) →d N (0. Recall that A ⊂ B implies P (A) ≤ P (B). Σ) . Thus P (|g (Zn ) − g (c)| ≤ ε) ≥ P (|Zn − c| < δ) → 1 as n → ∞ by the assumption that Zn →p c. ¥ 5. then g(Zn ) →d g(Z) as n → ∞. If Zn →p c as n → ∞ and g (·) is continuous at c. we ﬁnd jn ¢ ¡ √ √ 0 n (g (θn ) − g(θ0 )) = (gθ + an ) n (θn − θ0 ) →d gθ N (0.4.√ where λn → 0 lies on the line segment joining 0 and λ/ n. we see that as n → ∞. k ≤ m. where θ is m × 1 and Σ is m × m. gθ Σgθ . for each element of g. √ Theorem 5.4. Σ) = N 0. and g(θ) : Rm → Rk .1 Continuous Mapping Theorem 1 (CMT). Stacking across elements of g. Hence g(Zn ) →p g(c) as n → ∞. Ik ) distribution. 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 Asymptotic Transformations Theorem 5. for all ε > 0 we can ﬁnd a δ > 0 such that if |Zn − c| < δ then |g (Zn ) − g (c)| ≤ ε. then ¡ ¢ √ 0 n (g (θn ) − g(θ0 )) →d N 0. Proof: Since g is continuous at c. If Zn →d Z as n → ∞ and g (·) is continuous.

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

Ã n ! n X 1X 0 1 ˆ xi xi .1). Equation (4.1.2). First. using (6.2.5.2 Consistency ˆ As discussed in Section 6. ˆ Theorem 6. β →p β as n → ∞. ˆ 47 . (6.1).1 by the fact that the sampling densities become more concentrated as n gets larger.8) implies that ˆ β−β = Ã n X i=1 xi x0 i !−1 n X i=1 xi ei . we will use the methods of asymptotic approximation.5.4.3).1). Assumption 3. Assumption 3. Asymptotic (large sample) methods approximate sampling distributions based on the limiting experiment that the sample size n tends to inﬁnity. This is illustrated in Figure 6. For a complete argument. the OLS estimator β is has a statistical distribution which is unknown.1) imply that n ¡ ¢ 1X xi x0 →p E xi x0 = Q (6. ·) is continuous at (Q. ¥ We can similarly show that the estimators σ 2 and s2 are consistent for σ 2 .4. n i=1 (6.2. Proof.1. (6. 6. 0).1 Under Assumption 3. xi ei = g i n n i=1 i=1 1X xi ei →p E (xi ei ) = 0. Hence by the continuous mapping theorem (Theorem 5.1.1) and ˆ We now deduce the consistency of β. 0) = Q−1 0 = 0 β−β =g n n i=1 i=1 ˆ which implies β →p β as stated.4 implies that Q−1 exists and thus g(·. we can conclude ˆ that β →p β. b) = A−1 b is a continuous function of A and b at all values of the arguments such that A−1 exist. (6.5.1).From the ﬁgure we can see that the density functions are dispersed and highly non-normal.2) i i n i=1 n From (6.1 and the WLLN (Theorem 5. To characterize the sampling distribution more fully. and the continuous mapping theorem (Theorem 5. 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.3) Ã where g(A. 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 . As the sample size increases the density becomes more concentrated about the population coeﬃcient. xi ei →p g (Q.

ˆ Finally. by the Cauchy-Schwarz inequality (5.2.3. ˆ n−k 6. Note that ˆ ei = yi − x0 β ˆ i i Thus and n ˆ = ei + x0 β − x0 β i i ³ ´ ˆ = ei − x0 β − β .1 In addition to Assumption 3. (6. (6.4) ³ ´ ³ ´0 ³ ´ ˆ ˆ ˆ e2 = e2 − 2ei x0 β − β + β − β xi x0 β − β ˆi i i i σ2 = ˆ 1X 2 ei ˆ n i=1 i=1 →p σ 2 n 1X 2 = ei − 2 n Ã ! Ã n ! n ´ ³ ´0 1 X ³ ´ 1 X 0 ³ˆ 0 ˆ ˆ β−β + β−β β−β ei xi xi xi n n i=1 i=1 the last line using the WLLN.2 Under Assumption 3. since n/(n − k) → 1 as n → ∞. σ 2 →p σ 2 and s2 →p σ 2 as n → ∞. Ω) .1.2). Thus σ 2 is consistent for σ 2 .5.3) and Theorem (6. n 1 X √ xi ei →d N (0. We need a strengthening of the moment conditions.5.3.1).3 Asymptotic Normality ˆ We now establish the asymptotic distribution of β after normalization. ´1/2 ¡ ¯ ¯¢ ¯ ³ ¯ ¯2 ´1/2 ¡ ¯ 4 ¯¢1/2 ³ ¯ 1/2 E ¯xi x0 e2 ¯ ≤ E ¯xi x0 ¯ = E |xi |4 < ∞. Assumption 6.2. Ee4 < ∞ and E |xi |4 < ∞. ˆ Proof. To see this.Theorem 6.3.2). it follows that s2 = ¥ n σ 2 →p σ 2 . (6. E ¯ei ¯ E ¯e4 ¯ i i i i (6.1.1).6) n i=1 48 .5) Thus xi ei is iid with mean zero and has covariance matrix Ω. (6.1 guarantees that the elements of Ω are ﬁnite. i Now deﬁne ¡ ¢ Ω = E xi x0 e2 . i i Assumption 6. By the central limit theorem (Theorem 5.

(6.9) we deﬁne V 0 = Q−1 σ 2 whether (6. and (6. This holds true for all joint distibutions of (yi .3. setting n = 100 and varying the parameter α.1 states that the sampling distribution of the least-squares estimator. its variance diverges q ³ ´ ˆ to inﬁnity. V is often referred to as ˆ the asymptotic covariance matrix of β. and εi is independent of xi with the Double Pareto density f (ε) = α |ε|−α−1 . i i Condition (6.3. For α 49 .7) holds. In Figure 6.1 we have already seen a simple example where the least-squares estimate is quite asymmetric and non-normal even for reasonably large sample sizes. ´ √ ³ ˆ n β−β = Ã 1X xi x0 i n i=1 n !−1 Ã Theorem 6. 1). as n → ∞ ´ √ ³ ˆ n β − β →d N (0. 1) asymptotic distibution. The expression V = Q−1 ΩQ−1 is called a sandwich form. If α > 2 the 2 error εi has zero mean and variance α/(α − 2).9) In (6.7) is true then V = V 0 .1). Ω) ¡ ¢ = N 0.6).1 Under Assumption 6. V ) where V = Q−1 ΩQ−1 . there is no simple answer to this reasonable question.3. However. after rescaling.2 we display the ﬁnite sample densities of the q ³ ˆ normalized estimator n α−2 β 2 − β 2 .3.1.7) Cov(xi x0 . In´Figure 6. The asymptotic distribution ´ Theorem 6.7) is true or false. however.Then using (6. |ε| ≥ 1. when xi and ei are independent. ´ √ ³ˆ As V is the variance of the asymptotic distribution of n β − β . The trouble is that no matter how large is the sample size. otherwise V 6= V 0 . xi ) which satisfy the conditions of Assumption 6. Q−1 ΩQ−1 . In this context the normalized least-squares slope estimator n α−2 β 2 − β 2 has α →d Q−1 N (0. Under (6. for any ˆ ﬁxed n the sampling distribution of β can be arbitrarily far from the normal distribution. The approximation may be poor when n is small.1 is commonly used to approximate the ﬁnite of √ ³ˆ sample distribution of n β − β . the normal approximation is arbitrarily poor for some data distribution satisfying the assumptions.2). There is a special case where Ω and V simplify.3. 1 X √ xi ei n i=1 n ! the N (0. We say that ei is a Homoskedastic Projection Error when (6. Theorem 6.7) the asymptotic variance formulas simplify as ¡ ¢ ¡ ¢ (6. When (6. for example.8) Ω = E xi x0 E e2 = Qσ 2 i i V = Q−1 ΩQ−1 = Q−1 σ 2 ≡ V 0 (6. We illustrate this problem using a simulation.1. As α approaches 2. is approximately normal when the sample size n is suﬃciently large. but this is not a necessary condition. Let yi = β 0 + β 1 xi + εi where xi is N (0. We call V 0 the homoskedastic covariance matrix. How large should n be in order for the approximation to be useful? Unfortunately. e2 ) = 0.

we need an estimate of Ω = E xi x0 e2 . The estimator 2 2 in (6. concentrating most of the probability mass around zero.3 is that the N (0. The homoskedastic covariance matrix V 0 = Q−1 σ 2 is typically estimated by ˆ ˆ (6.11) 50 . σ may also be substituted for s ˆ ¡ ¢ To estimate V = Q−1 ΩQ−1 . 4. ˆ ˆ Since Q →p Q and s2 →p σ 2 (see (6. 6 and 8.3. for k = 1.10) V 0 = Q−1 s2 . The lesson from Figures 6. 1). The MME estimator is i i 1X ˆ xi x0 e2 Ω= i ˆi n i=1 n (6. As k increases.2: Density of Normalized OLS estimator α = 3. As α diminishes the density changes signiﬁcantly.1) it is clear that V 0 →p V 0 .0 the density is very close to the N (0. 1) asymptotic approximation is never guaranteed to be accurate. Another example is shown in Figure 6.4 Let Covariance Matrix Estimation 1X ˆ xi x0 Q= i n i=1 n be the method of moments estimator for Q. We show the sampling distribution of n β 1 − β 1 setting n = 100. Here the model is yi = β 1 + εi where uk − Euk i i εi = ³ ¡ k ¢2 ´1/2 Eu2k − Eui i ´ √ ³ˆ and ui ∼ N (0. the sampling distribution becomes highly skewed and non-normal. 6.2.10) without changing this result.Figure 6.2 and 6.2) and Theorem 6. 1) density.

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

From a computational standpoint.used by an author when studying their work.085 p ˆ and that for β 1 is .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 .5) and the WLLN (Theorem 5.117 Educationi . we return to the log wage regression of Section 4. p ˆ In this case the two estimates are quite similar.14 6.199 2.80 . n n i=1 52 .20 −0.2. To illustrate.14 205.14 14. The standard errors for β 0 are 7.20 = V 14. We calculate that s2 = 0. (6.199 2. i i i i n i=1 Second.3) so by the WLLN ³ ´ ³ ´3/4 ¡ ¯ ¯¢ 1/4 E |xi |3 |ei | ≤ E |xi |4 < ∞.493 0. then take the diagonal elements.1.2/988 = . but not under another set of assumptions.039 and ˆ V = µ 1 14. by Holder’s inequality (5.80 40. (6. First.20 and µ ¶ ˆ = 0.020) 6.480 . just as any other estimator.6 Therefore the two covariance matrix estimates are µ ¶−1 µ ¶ 1 14.30 + 0.035 ¶ .6 ¶µ 1 14.12) i i n n n i=1 i=1 We now examine each sum on the right-hand-side of (6.83 ¶−1 µ . We can write the estimated equation with standards errors using the format \ log(W agei ) = 1.020. and then the square roots.12) in turn. Ω 2.085) (. It is also important to understand that a particular standard error may be relevant under one set of model assumptions.35/988 = .14 205.83 −0. from which it follows that V →p V as n → ∞.80 2. E ¯e4 ¯ i ³ ´ 1X |xi |3 |ei | →p E |xi |3 |ei | .493 −0. Using (6. (.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.14 205.480 ˆ0 = 0.98 −0.83 ¶−1 = µ 7.14 14.1) show that n ¡ ¢ 1X xi x0 e2 →p E xi x0 e2 = Ω. the standard method to calculate the standard errors is to ˆ ﬁrst calculate n−1 V .80 40.

by the WLLN ¯ n ¯ Ã n ! ¯ 1X ¯1 X ¯ ¯ ³ ´0 ¯ ¯ ¯ ¯ˆ 3 0 ˆ xi xi β − β xi ei ¯ ≤ ¯β − β ¯ |xi | |ei | →p 0. Using this substitution. n i=1 n ˆ ˆ Theorem 6.¯ ¯ ¯ ¯ˆ and thus since ¯β − β ¯ →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. ¯ 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. Recall from Section 4. Andrews’ proposed estimator is ˆ ˆ ˆ ˆ V ∗∗ = Q−1 Ω∗∗ Q−1 53 .11) with the leave-one-out estimator ei. ¯ ¯ ¯ ¯ ¯n ¯ n i=1 i=1 1X |xi |4 →p E |xi |4 .26).1 As n → ∞.−i = (1 − hi )−1 ei ˆ presented in (4. n i=1 n − 1 ˆ −1 ˆ ∗ ˆ −1 ˆ V∗ = Q Ω Q n where 1X ˆ (1 − hi )−2 xi x0 e2 − Ω∗ = i ˆi n i=1 n (6.13) of Efron (1982). They also suggest that the scaling factor (n − 1)/n in (??) can be omitted. i=1 Third.12 the deﬁnition of β (−i) as the least-squares estimator with the i’th observation deleted.13) Using formula (4. ¯ ¯n ¯ n i=1 so Together. these establish consistency. is deﬁned ˆ ˆ by replacing the OLS residual ei in (6. which.5.14) Ã 1X (1 − hi )−1 xi ei ˆ n i=1 n !Ã 1X (1 − hi )−1 xi ei ˆ n i=1 n !0 and hi = x0 (X 0 X)−1 xi . you can show that 1 Xˆ ¯ β= β (−i) . Andrews (1991) suggested an similar estimator based on cross-validation. MacKinnon and White (1985) present numerical (simulation) evidence i ˆ ˆ that V ∗ works better than V as an estimator of V . From equation (3.6 Alternative Covariance Matrix Estimators ˆ MacKinnon and White (1985) suggested a small-sample corrected version of V based on the jackˆ knife principle.25). 6. Ω →p Ω and V →p V.

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

s(ˆ = n−1/2 H 0 V Hβ . Vθ ) √ Vθ = N (0.8.For example. that (so θ ˆ ˆ ˆ is. 55 .8 t tests Let θ = h(β) : Rk → R be any parameter of interest. and θ = h(β) is some function of the parameter vector. the statistic tn has an exact t distribution. Consider the studentized statistic tn (θ) = Theorem 6. if R is a “selector matrix” R= so that if β = (β 1 . see Section X). ˆ its estimate and s(ˆ its asymptotic θ θ) standard error. and is therefore exactly free of unknowns. Since the standard normal distribution does not depend on the parameters. the standard error for ˆ is the square root of n−1 Vθ . µ I 0 ¶ ˆ the upper-left block of V . we say that tn is an exactly pivotal statistic. ˆ When q = 1q h(β) is real-valued).1 tn (θ) →d N (0. however. 1) →d ˆ−θ θ . (For example. β 2 ).16) ¥ Thus the asymptotic distribution of the t-ratio tn (θ) is the standard normal. then θ = R0 β = β 1 and ˆ Vθ = ¡ I 0 ¢ ˆ V µ I 0 ¶ ˆ = V11 . A simple null and composite hypothesis takes the form H0 : θ = θ0 H1 : θ 6= θ0 where θ0 is some pre-speciﬁed value. In general. 1) Proof.15) tn (θ) = ˆ−θ θ s(ˆ θ) ´ √ ³ˆ n θ−θ q = ˆ Vθ N (0. By (6. In this case. s(ˆ θ) (6. θ) β 6. pivotal statistics are unavailable and so we must rely on asymptotically pivotal statistics. we say that tn (θ) is asymptotically pivotal. In special cases (such as the normal regression model. θ could be a single element of β).

The p-value is more general. under H0 . z. 1]. however. 1). or asymptotic p-value function p(t) = P (|Z| > |t|) = 2 (1 − Φ(|t|)) . The coverage probability is P (θ ∈ Cn ). In a sense. so the “unusualness” of the test statistic can be compared to the easy-to-understand uniform distribution. and is a function of the data and hence is / random. Thus an equivalent statement of a Neyman-Pearson test is to reject at the α% level if and only if pn < α. in contrast to Neyman-Pearson rejection/acceptance reporting where the researcher picks the level. A test of asymptotic signiﬁcance α rejects H0 if |tn | > zα/2 . from which it follows that pn →d U [0.05 = 1. 1]. note that the asymptotic distribution of |tn | is F (x) = 1 − p(x). Either θ ∈ Cn or θ ∈ Cn . Let zα/2 is the upper α/2 quantile of the standard normal distribution. The rejection/acceptance dichotomy is associated with the Neyman-Pearson approach to hypothesis testing. That is. If the p-value pn is small (close to zero) then the evidence against H0 is strong.The standard test for H0 against H1 is the t-statistic (or studentized statistic) tn = tn (θ0 ) = ˆ − θ0 θ . p-values and hypothesis tests are equivalent since pn < α if and only if |tn | > zα/2 . That is. 6. This is because ¡ ¢ P (reject H0 | H0 true) = P |tn | > zα/2 | θ = θ0 ¢ ¡ → P |Z| > zα/2 = α.9 Conﬁdence Intervals A conﬁdence interval Cn is an interval estimate of θ. then P (Z > zα/2 ) = α/2 and P (|Z| > zα/2 ) = α. The asymptotic p-value for the above statistic is constructed as follows. P (1 − p(tn ) ≤ u) establishing that 1 − pn →d U [0. is to report an asymptotic p-value. Otherwise the test does not reject. regardless of the complication of the distribution of the original test statistic. pn →d U [0. Another helpful observation is that the p-value function has simply made a unit-free transformation of the test statistic. 1]. 1). 56 . Deﬁne the tail probability. tn →d N (0.025 = 1. associated with Fisher. in that the reader is allowed to pick the level of signiﬁcance α. or “accepts” H0 . An alternative approach.96 and z. To see this fact. Thus P (1 − pn ≤ u) = = P (F (tn ) ≤ u) ¡ ¢ = P |tn | ≤ F −1 (u) ¡ ¢ → F F −1 (u) = u. For example.645. if Z ∼ N (0. It is designed to cover θ with high probability. s(ˆ θ) Under H0 . Then the asymptotic p-value of the statistic tn is pn = p(tn ).

We have the null and alternative H0 : θ = θ0 H1 : θ 6= θ0 . = n h(β) − θ0 Hβ V Hβ 57 (6. ¢ ¡ ¢ ¡ P (θ ∈ Cn ) = P |tn (θ)| ≤ zα/2 → P |Z| ≤ zα/2 = 1 − α.16) and zα/2 is the upper α/2 quantile of the standard normal distribution. 6. and values of θ outside two standard θ errors of the estimated ˆ are considered unlikely or unreasonable candidates for the true value. A good method for construction of a conﬁdence interval is the collection of parameter values which are not rejected by a statistical test.18) .We typically cannot calculate the exact coverage probability P (θ ∈ Cn ).05.96s(ˆ ≈ ˆ ± 2s(ˆ . 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). and it is desired to test the joint restrictions simultaneously. However we often can calculate the asymptotic coverage probability limn→∞ P (θ ∈ Cn ).17) = ˆ − zα/2 s(ˆ θ and Cn is an asymptotic (1 − α)% conﬁdence interval. θ The interval has been constructed so that as n → ∞. ˆ The natural estimate of θ is ˆ = h(β) and has asymptotic covariance matrix estimate θ ˆ0 ˆ ˆ ˆ Vθ = Hβ V Hβ where ∂ ˆ ˆ h(β). θ θ) (6.10 Wald Tests Sometimes θ = h(β) is a q × 1 vector. We say that Cn has asymptotic (1 − α)% coverage for θ if P (θ ∈ Cn ) → 1 − α as n → ∞. 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 . In this case the t-statistic approach does not work. Thus values of θ within two standard errors of the estimated interval θ θ) θ θ) ˆ are considered “reasonable” candidates for the true value θ. the most common professional choice isi95%. This corresponds to selecting the conﬁdence h i h ˆ ± 1. The t-test of the previous setion rejects H0 : θ0 = θ if |tn (θ)| > zα/2 where tn (θ) is the t-statistic (6. ˆ + zα/2 s(ˆ . While there is no hard-and-fast guideline for choosing the coverage probability 1 − α. or α = .

h(β) = R0 β. then Wn →d χ2 .84 = z.1. if rank(Hβ ) = q. An asymptotic Wald test rejects H0 in favor of H1 if Wn exceeds χ2 (α). and Theorem 6. The asymptotic p-value for Wn is pn = p(Wn ). χ2 (. Thus Vθ = H 0 V Hβ →p H 0 V Hβ = Vθ > 0 if Hβ has full rank q. 6.8. = nβ 2 R0 V R R0 β is linear with R = µ 0 I ¶ ¢−1 ¡ ˆ ˆ ˆ . The null hypothesis is H0 : β 2 = 0.025 . The Wald test fails to reject if Wn is q 1 ¡ ¢ less than χ2 (α). We have established: ³ ´0 ³ ´ ˆ − θ0 V −1 ˆ − θ0 →d Z 0 V −1 Z = χ2 . As before.1 showed θ ˆ that V →p V. q and pn is asymptotically U[0. In this case. the upper-α quantile q 2 of the χ2 distribution.5. 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. Hβ (β) →p Hβ . Vθ ). Hβ (β) is a continuous function of β. Also h(β) = a selector matrix. then the Wald statistic takes the form ´0 ³ ´ ³ ´−1 ³ ˆ ˆ ˆ R0 V R R0 β − θ 0 .2. a chiq square random variable with q degrees of freedom.19) σ2 ˆ where σ2 = ˜ 1 0 e e. 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. ˜ 58 ¡ 0 ¢−1 0 ˜ β 1 = X1 X1 X1 Y .1 Under H0 and Assumption 6.05) = 3.10. Furthermore. ˆ Wn = n θ θ q θ θ Theorem 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 . Hence β β by Theorem A. then the Wald statistic can be written in the form ¶ µ 2 ˆ σ − σ2 ˜ Wn = n (6. ˜˜ n ˜ e = Y − X1 β 1 . For example. θ = β 2 . 1] under H0 . so by the continuous mapping ˆ ˆ ˆ ˆ ˆ theorem.When h is a linear function of β. the test rejects at the α% level iﬀ pn < α. Wn = n R0 β − θ0 ´ √ ³ The delta method (6.3. 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. and there are q = k2 restrictions.

µ e0 e − e0 e ˜˜ ˆˆ e0 e ˆˆ ¶ =n µ σ2 − σ2 ˜ ˆ 2 σ ˆ ¶ .19) only holds if V 0 = σ 2 n−1 X 0 X ˆ . as the sum of squared errors is a typical output from statistical packages.19) is that it is directly computable from the standard output from two simple OLS regressions. ˆ ¡ ¢−1 0 ˆ β = X 0X XY are from OLS of Y on X = (X1 . We now derive expression (6. 2 2 2 or alternatively. 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. ˆˆ n ˆ e = Y − X β. the residual is ˜ ˜ e = M1 Y. = F = n k2 σ 2 /(n − k) ˆ ¢−1 ¡ ˆ While it should be emphasized that equality (6. and σ2 = ˆ 1 0 e e. ˜˜ ˆˆ ˆˆ σ 2 = n−1 e0 e ˆ we conclude that Wn = n as claimed. note that partitioned matrix inversion (2.19) the F form of the Wald statistic. note that if we regress Y on X1 alone. By the FWL theorem. First. 2 σ ˆ To simplify this expression further.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 . ˜ ˆ ˜ 2 β 2 + e and X 0 e = 0. Now consider the residual regression of e on X2 = M1 X2 . Also. The elegant feature about (6. This statistic is typically reported as an “F-statistic” which is deﬁned as ¡ 2 ¢ σ − σ 2 /k2 ˜ ˆ n − k Wn . X2 ). Because of this connection we call (6.are from OLS of Y on X1 . 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 . still this formula often ﬁnds good use in reading applied papers. 59 . since ˆ0 0 ˆ β 2 X2 M1 X2 β 2 = e0 e − e0 e.19).

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 . In particular. introduced in Section 4. this implies that conditional on X µ ¶ µ ¶ µ µ 2 0 −1 ¶¶ ˆ β−β (X 0 X)−1 X 0 σ (X X) 0 = e ∼ N 0. σ 2 /(n − k) ˆ σ2 = ˜y 1 (y − y)0 (y − y) n is the sample variance of yi . equivalently the residual variance from an intercept-only model. While there are special cases where this F statistic is useful. when an OLS regression is reported. This was a popular statistic in the early days of econometric reporting. it follows ˆ that β is independent of any function of the OLS residuals. n−k 60 . The modelling assumption that the error ei is independent of xi and N (0. In ) . as sample sizes are typically suﬃciently large that this F statistic is highly “signiﬁcant”. 6.12 Normal Regression Model As an alternative to asymptotic distribution theory. Let u = σ −1 H 0 e ∼ N (0. including the estimated error variance 2. Since linear functions of normals are also normal. This is ¢ ¡ 2 ˆ σ y − σ 2 / (k − 1) ˜ F = .where In many statistical packages.4)) where H 0 H = In .3. This is rarely an issue today. In σ 2 . e ˆ M 0 σ2 M where M = I − X (X 0 X)−1 X 0 . s The spectral decomposition of M yields ¸ ∙ In−k−1 0 H0 M =H 0 0 (see equation (2. σ 2 ) can be be used to calculate a set of exact distribution results. Since uncorrelated normal variables are independent. an “F statistic” is reported. there is an exact distribution theory available for the normal linear regression model. these cases are atypical. when sample sizes were very small and researchers wanted to know if there was “any explanatory power” to their regression. H 0 H) ∼ N (0. under the normality assumption the error vector e is independent of X and ¢ ¡ has distribution N 0. This special F statistic is testing the hypothesis that all slope coeﬃcients (other than the intercept) are zero.

σ2 ˆ 61 . β 2 . σ ˆ ˆ βj − βj βj − βj N (0.1 we showed that in large samples. β 2 ) and consider tests of the linear restriction H0 : β 2 = 0 H1 : β 2 6= 0 In the context of parametric models. σ 2 ) = − log 2πˆ 2 − 2 e0 e ˆˆ 2 2ˆ σ ¡ ¢ n n n = − log σ 2 − log (2π) − .12. and standard errors are calculated using the homoskedastic formula (6. β 2 . if standard errors are calculated using the homoskedastic formula (6.8. 1) and tn−k distributions.) Now let us partition β = (β 1 .1 and Theorem 6.12. The log-likelihood of this model is ¡ 2¢ n n n ˜ ˜ ˜ Ln (β 1 . σ 2 ) − Ln (β 1 . σ 2 ) = − log σ − log (2π) − . 1) jj rh ∼ tn−k = rh i ∼q i = q χ2 ˆ s(β j ) n−k σ2 2 0 X)−1 0 X)−1 (X s (X n−k n−k χn−k jj jj a t distribution with n − k degrees of freedom. Theorem 6. σ 2 ) discussed above. (Unless the sample size is unreasonably small. σ 2 ) where β 1 is the OLS estimate from ˜ 2 ˜ a regression of yi on x1i only. We summarize these ﬁndings Theorem 6. The Gaussian log-likelihood at these estimates is ¡ ¢ n 1 ˆ ˆ ˆ σ Ln (β 1 . which is twice the diﬀerence in the log-likelihood function evaluated under the null and alternative hypotheses. so as a practical matter it does not matter which distribution is used. As inference (conﬁdence intervals) are based on the t-ratio.1 If ei is independent of xi and distributed N(0. The estimator under the alternative is the unrestricted estimator ˆ ˆ ˆ (β 1 . β and t are approximately normally distributed.10) then ´ ³ ˆ • β ∼ N 0. 0. 0.10) µ h i ¶ 2 (X 0 X)−1 N 0.3. 0. n−k • ∼ tn−k ˆ In Theorem 6. β 2 . 2 2 2 The LR statistic for H0 is ´ ³ ˆ ˆ ˆ ˜ ˜ LR = 2 Ln (β 1 . 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 . The critical values are quite close if n − k ≥ 30. the notable distinction is between the N (0. a good testing procedure is based on the likelihood ratio statistic. ˆ 2 2 2 ˜ ˜ The MLE of the model under the null hypothesis is (β 1 . Furthermore.a chi-square distribution with n − k degrees of freedom. In contrast. with residual variance σ .1 shows that under the strong assumption of ˆ normality. β has an exact normal distribution and t has an exact t distribution. σ 2 ).

we ﬁnd that the standard Wald test for H0 (s) is ´2 ³ s ˆ β −1 Wn (s) = n 2s−2 . ˆ Let β and σ 2 be the sample mean and variance of yi . This is distressing since the choice of s seems arbitrary and irrelevant to the actual hypothesis. as Wn (s) →d χ2 under H0 for 1 any s. features of this distribution can be calculated. setting n/σ 2 = 10. This can be seen by a simple example introduced by Lafontaine and White (1986). This produces random draws from the sampling distribution of interest. To demonstrate this eﬀect.By a ﬁrst-order Taylor series approximation ¶ µ 2 ¶ µ σ ˜ σ2 ˜ − 1 = Wn . σ 2 ) and consider the hypothesis H0 : β = 1. 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. σ 2 s2 β ˆ ˆ While the hypothesis β s = 1 is unaﬀected by the choice of s.4 the Wald statistic Wn (s) as a function ˆ of s. and noting Hβ = sβ s−1 . 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. Letting h(β) = β s . This is an unfortunate feature of the Wald statistic. while there are other values of s for which test test statistic is insigniﬁcant. In the present context of the Wald statistic.13 Problems with Tests of NonLinear Hypotheses While the t and Wald tests work well when the hypothesis is a linear restriction on β. one feature of importance is the Type I error of the test using the asymptotic 5% critical value 3. 6.84 — the probability of a false rejection. σ2 ˆ Now notice that H0 is equivalent to the hypothesis H0 (s) : β s = 1 for any positive integer s. Through repetition. the statistic Wn (s) varies with s. The decreasing dashed ˆ = 1. Then the standard Wald test for H0 is ˆ ³ ´2 ˆ β−1 Wn = n . Our ﬁrst-order asymptotic theory is not useful to help pick s. LR = n log 1 + 2 − 1 ' n σ ˆ σ2 ˆ the F statistic. Take the model yi = β + ei ei ∼ N (0.8. they can work quite poorly when the restrictions are nonlinear. 62 .7. The increasing solid line is for the case β = 0. we have plotted in Figure 6. The method uses random simulation to create an artiﬁcial dataset to apply the statistical tools of interest.

n.4.Figure 6. When comparing statistical procedures. the only test which meets this criterion is the conventional Wn = Wn (1) test.84.1 Type I error Probability of Asymptotic 5% Wn (s) Test 63 . The second through seventh columns contain the Type I error probabilities for diﬀerent combinations of n and σ. Table 4. and σ 2 .000 random samples. In Table 4. Test performance deteriorates as s increases. Given the simplicity of the model. To interpret the table. The value of s is varied from 1 to 10. we compare the rates row by row.1 reports the simulation estimate of the Type I error probability from 50.1 you can also see the impact of variation in sample size.1 we report the results of a Monte Carlo simulation where we vary these three parameters. and σ is varied among 1 and 3.05) with deviations indicating+ distortion. Error rates avove 10% are considered excessive. 100 and 500. Table 4.84 | β = 1) . There is. however. These probabilities are calculated as the percentage of the 50.000 simulated Wald statistics Wn (s) which are larger than 3. no magic choice of n for which all tests perform uniformly well. remember that the ideal Type I error probability is 5% (. the Type I error probability improves towards 5% as the sample size n increases. In Table 2. Each row of the table corresponds to a diﬀerent value of s — and thus corresponds to a particular choice of test statistic. this probability depends only on s. and rarely fall outside of the 3%-8% range. which is not surprising given the dependence of Wn (s) on s as shown in Figure 6. Type I error rates between 3% and 8% are considered reasonable. For this particular example. Rates above 20% are unexceptable. n is varied among 20. Typically. In each case. so these probabilities are Type I error. The null hypothesis β s = 1 is true.4: Wald Statistic as a function of s P (Wn (s) > 3. Any other choice of s leads to a test with unacceptable Type I error probabilities. looking for tests for which rate rejection rates are close to 5%.

05 . β 2 ) be the least-squares estimates of (6.15 .23 .05 . This point can be illustrated through another example.26 .10 .06 . Other choices are arbitrary and would not be used in practice.35 .34 .10 . An alternative statistic can be constructed through reformulating the null hypothesis as H0 : β 1 − rβ 2 = 0.15 .17 .06 .05 . Take the model yi = β 0 + x1i β 1 + x2i β 2 + ei E (xi ei ) = 0 and the hypothesis H0 : β1 =r β2 (6.12 .14 .08 . so the hypothesis can be stated as H0 : θ = r.28 .13 .18 .06 .20).05 .15 .14 .20 .000 simulated random samples In this example it is not surprising that the choice s = 1 yields the best test statistic. 64 . β 1 . let V be an estimate of the ˆ asymptotic variance matrix for β and set ˆ = β 1 /β 2 . ˆ ˆ ˆ ˆ ˆ Let β = (β 0 .31 . In this case a t-statistic for H0 is t1n = ³ˆ β1 ˆ β2 where r is a known constant.07 .07 .07 .22 .09 .05 .13 .25 . Equivalently.08 .08 .10 .19 .07 .06 .22 .08 .06 .25 .33 .13 .16 Rejection frequencies from 50.07 .06 .20 . While this is clear in this particular example.05 . deﬁne θ = β 1 /β 2 .11 .24 . Deﬁne θ ˆ ˆ ⎞ ⎛ 0 ⎟ ⎜ ⎟ ⎜ ⎜ 1 ⎟ ⎟ ⎜ ⎜ ˆ ⎟ ˆ H1 = ⎜ β 2 ⎟ ⎟ ⎜ ⎟ ⎜ ⎜ β ⎟ ˆ ⎠ ⎝ − 1 ˆ2 β2 ´ s(ˆ θ) −r .15 .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) .21 . in other examples natural choices are not always obvious and the best choices may in fact appear counter-intuitive at ﬁrst.08 .06 .30 .12 .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 .

25.00 . while the right tail probabilities P (t1n > 1.645) are close to zero in most cases.645) t1n t2n t1n t2n t1n t2n t1n t2n .645) P (tn > 1.05 β2 .05 .06 .00 .00 .06 .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. then the “most linear” formulation should be selected. this formulation should be used. It is also prudent to consider alternative tests to the Wald statistic. along with sample size n. ei be an independent N (0.12 . and alternatives to asymptotic critical values should be considered. −r ⎛ t2n where To compare t1n and t2n we perform another simple Monte Carlo simulation.00 .06 .645) P (tn < −1. Ideally. This leaves β 2 as a free parameter. Table 4. the rejection rates for the t1n statistic diverge greatly from this value. The implication of Table 4.05.A t-statistic based on this formulation of the hypothesis is ´2 ³ ˆ 1 − rβ 2 ˆ β =³ ´1/2 .00 .47 .28 .15 . We let x1i and x2i be mutually independent N (0. The left tail probabilities P (t1n < −1.07 . and are close to the ideal 5% rate for both sample sizes.06 . The results are presented in Table 4.2.50 .05 . If no linear formulation is feasible.09 . σ 2 ) draw with σ = 3.25 .06 .645) and P (tn > 1. However. .05 .00 .75.15 .06 . .00 . and normalize β 0 = 0 and β 1 = 1. We vary β 2 among .0 and n among 100 and 500. 65 .645) P (tn > 1.00 The one-sided Type I error probabilities P (tn < −1.05 . In this section we describe the method in more detail.26 . the entries in the table should be 0. such as the GMM distance statistic which will be presented in Section 9.06 .05 . −1 H V H ˆ 2 n 2 ⎞ 0 H2 = ⎝ 1 ⎠ .2 is that the two t-ratios have dramatically diﬀerent sampling behavior.05 . 6.06 .00 .06 . .7.645) greatly exceed 5%.02 .00 .2 Type I error Probability of Asymptotic 5% t-tests n = 100 n = 500 P (tn < −1. In all cases.1.10 . In contrast.06 . The common message from both examples is that Wald statistics are sensitive to the algebraic formulation of the null hypothesis.05 .000 simulated samples.645) are calculated from 50. 1) variables.75 1.05 .50.10 . especially for small values of β 2 . and 1.05 .10 . if the hypothesis can be expressed as a linear restriction on the model parameters. the rejection rates for the linear t2n statistic are invariant to the value of β 2 .

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

The α% sample quantile is a number qα such that α% of the sample are less than qα .022.22/ B. then B will have to be increased. so that coeﬃcients may be interpreted as semi-elasticities. In many cases. then we can set s P = (. We separately estimate equations for white and non-whites. The typical purpose of a Monte Carlo simulation is to investigate the performance of a statistical procedure (estimator or test) in realistic settings. but requires more computational time.007. and 5000. are. As P is unknown. and therefore it is straightforward to calculate standard errors for any quantity of interest. experience squared. The random variable 1 (Tnb ≥ 1. As discussed above. B. B b=1 (6. immigrant. experience squared. Furthermore. the performance will depend on n and F.96) . For the dependent variable we use the natural log of wages. where N = (B +1)α. therefore. and poorly for others. A simple way to compute sample quantiles is to sort the sample {Tnb } from low to high. then the 5% sample quantile is 50’th sorted value and the 95% sample quantile is the 950’th sorted value. union member. Generally.15 Estimating a Wage Equation We again return to our wage equation.95) /B ' . the choice of B is often guided by the computational demands of the statistical procedure. and dummy variable indicators for the following: married. we included a dummy 67 . it is simple to make inferences about rejection probabilities from statistical tests. We would then set Tn = ¯ˆ − θ¯ /s(ˆ and calculate B X ˆ= 1 P 1 (Tnb ≥ 1. For regressors we include years of education. and hispanic.96) is iid Bernoulli. female. excluding military. equalling 1 with probability P = E1 (Tnb ≥ 1. It is therefore useful to conduct a variety of experiments. Often this is called the number of replications. potential work experience. For example.Suppose we are interested in the ¯Type I error associated with an asymptotic 5% two-sided ¯ ¯ ¯ θ) θ t-test.96) . Suppose we are interested in the 5% and 95% quantile of Tn = ˆ We then compute the 10% θ. union member. Since the results of a Monte Carlo experiment are estimates computed from a random sample of size B. respectively. hispanic. The average (6. Hence the ³ ´ ˆ standard errors for B = 100.21) the percentage of the simulated t-ratios which exceed the asymptotic 5% critical value. In particular. In practice. an estimator or test may perform wonderfully for some values. immigrant.21) is therefore an ³ ´ p ˆ unbiased estimator of P with standard error s P = P (1 − P ) /B. the researcher must select the number of experiments.003. potential work experience. if we set B = 999. and 90% sample quantiles of the sample {Tnb }. female. If the standard error is too large to make a reliable inference. We us the sample of wage earners from the March 2004 Current Population Survey. if we are ³ ´ p √ ˆ assessing an asymptotic 5% test. 6. for a selection of choices of n and F. We now expand the sample all non-military wage earners. and . 1000. such as the percentage estimate reported in (6. . Quite simply. s P = . and dummy variable indicators for the following: married. and non-white. and estimate a multivariate regression. this may ˆ be approximated by replacing P with P or with an hypothesized value.05) (.21). It is therefore convenient to pick B so that N is an integer. and our regressors include years of education. Then qα is the N ’th number in this ordered sequence. Again our dependent variable is the natural log of wages. a larger B results in more precise estimates of the features of interest of Gn . For example.

232 . 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.002 .19) is ˜ µ ¶ µ ¶ σ2 ˆ .1 OLS Estimates of Linear Equation for Log(Wage) ˆ β 1.010 .014 .variable for state of residence (including the District of Columbia.070 .121 −. Wn = n 1 − 2 = 18. but not equal.007 .48772 = 515.1. we ﬁnd Wn = 550. Using either statistic the hypothesis is easily rejected. Ignoring the other coeﬃcients.097 −.4877 18.49452 σ ˜ Notice that the two statistics are close.033 −. Table 4. reestimating the model with the 50 state dummies excluded. excluding the coeﬃcients on the state dummy variables.69. as the 1% critical value for the χ2 distribution is 76.00057 .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. θ ˆ 2β 3 β2 . the restricted standard deviation estimate is σ = .4945.102 −. 808 1 − .18) that the state coeﬃcients are jointly zero.00002 .027 . 2β 3 68 . if β 2 > 0 and β 3 < 0 the solution is θ=− From Table 4.34 ˆ s(β) . Computing the Wald statistic (6.1 we ﬁnd the point estimate ˆ ˆ = − β 2 = 28.808 .032 . Alternatively. The F form of the Wald statistic (6.808 so the parameter estimates are quite precise and reported in Table 4.013 . The available sample is 18.101 .102 −. 50 Another interesting question which can be addressed from these estimates is the maximal impact of experience on mean wages.001 .

Our desired conﬁdence interval will be the set of parameter values θ which are not rejected by the hypothesis test. 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 ). This is the set of θ such that |tn (θ)| ≤ 1.96.5].Using the Delta Method. 29. but the lower end is substantially lower. In the present context we are interested in forming a conﬁdence interval.40. this is a poor choice. Since tn (θ) is a non-linear function of θ. 29. This set is [27. we found better Type I error rates by reformulating the hypothesis as a linear restriction. there is not a simple expression for this set. 69 . Instead. Notice that the upper end of the conﬁdence interval is the same as that from the delta method.9.5]. so we have to go one step further. as the coverage probability of this conﬁdence interval is one minus the Type I error of the hypothesis test based on the t-test. but it can be found numerically quite easily.0. In the previous section we discovered that such t-tests had very poor Type I error rates. However. not testing a hypothesis. we can calculate a standard error of s(ˆ = . implying a 95% conﬁdence θ) interval of [27.

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

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

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

2

is the homoskedasticity-formula standard error.

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

i=1 i=1

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

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

E (xi ei ) = 0

∗ yi = yi + ui

71

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

∗ E (yi ui ) = 0

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

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

• Qi • Di • Ci

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

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

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

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

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

73

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

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

. This estimator V 0 is appropriate when the skedastic regression (7. ´´−1 ³ ³¡ ´´−1 ³ ³¡ ¢−1 ¢−2 2 0 ´´ ³ ³¡ 0 ¢−1 E α0 zi E α zi xi x0 σ i xi xi xi x0 . V = E α0 zi i i Examining the asymptotic distribution of Theorem 7. e2 }. σ 2 ] σi i for some σ 2 > 0.1. In the linear regression model. V ˜ An appropriate solution is to use a White-type estimator in place of V 0 . . V n n i=1 . V ). There are three reasons. This is an estimator which is robust to misspeciﬁcation of the condie1 ˆn tional variance. ´ √ ³ ˜ ˜ n β GLS − β F GLS →p 0. Its asymptotic variance is not that given in Theorem 7. It may be the case that α0 zi is only an approximation to the true conditional variance σ 2 = i ˜ E(e2 | xi ). 1992). and thus where ´ √ ³ ˜ n β F GLS − β →d N (0.. FGLS estimation depends on speciﬁcation and estimation of the skedastic regression. and was proposed by Cragg (Journal of Econometrics. A trimming rule might make sense: σ 2 = max[˜ 2 . β should perhaps be i i called a quasi-FGLS estimator of β. FGLS is asymptotically superior to OLS. It is possible to show that if the skedastic regression is correctly speciﬁed.1. and it may be estimated with considerable 76 V takes a sandwich form√. the natural estimator of the asympˆ totic variance of β is Ã n !−1 µ ¶−1 1 X −2 0 1 0 ˜ −1 ˜0 = XD X σ i xi xi ˜ = . then FGLS is asymptotically equivalent to GLS. This may be written as !−1 Ã n !Ã n !−1 Ã n 1 X −4 2 0 1 X −2 0 1 X −2 0 ˜ σ i xi xi ˜ σ i ei xi xi ˜ ˆ σ i xi xi ˜ V = n n n i=1 i=1 i=1 ³ ´−1 ³ ´³ ´−1 ˜ ˜ ˆ˜ ˜ X 0 D−1 DD−1 X X 0 D−1 X = n X 0 D−1 X ˜ which is consistent for V as n → ∞.that there is a need to bound the estimated variances away from zero. We just state the result without proof.1 If the skedastic regression is correctly speciﬁed. Theorem 7. V = E σ −2 xi x0 i i ˆ where D = diag{ˆ2 . i ˜ 0 is inconsistent for V . ¢¢−1 ¡ ¡ . similar to the covariance matrix of the OLS estimator. Unless σ 2 = α0 zi . but the proof of this can be tricky. Why then do we not exclusively estimate regression models by FGLS? This is a good question. First.1. Instead.2) is correctly speciﬁed. Since the form of the skedastic regression is unknown.1.1. In this case we interpret α0 zi as a linear projection of e2 on zi ..

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

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

θ0 ). When the regression function is nonlinear. ˆ ei . In other cases. m(x. See Appendix E. When m(x. ˆ must be found by numerical θ methods. mθ (x. θ)ˆ (7. then the FOC for minimization are 0= n X i=1 mθ (xi . ¢¢−1 ¡ ¡ ¢¢ ¡ ¡ ¢¢−1 ¡ ¡ E mθi m0 e2 E mθi m0 V = E mθi m0 θi θi i θi Sketch of Proof. When it exists. so the minimization of Sn (θ) only needs to be examined for θ close to θ0 . θ))2 Since sum-of-squared-errors function Sn (θ) is not quadratic. θ) = (θ1 + θ2 x1 ) 1 (x2 < θ3 ) + (θ4 + θ5 x1 ) 1 (x2 > θ3 ) In the ﬁrst ﬁve examples. θ) = θ1 + θ2 m(x.Examples of nonlinear regression functions include x 1 + θ3 x m(x. θ) = θ1 + θ2 exp(θ3 x) m(x. θ))2 . but we won’t cover that argument here. θ) is diﬀerentiable. Since ˆ →p θ0 . θ) = θ1 + θ2 x + θ4 (x − θ3 ) 1 (x > θ3 ) µ ¶ m(x. ´ √ ³ n ˆ − θ0 →d N (0.8) Theorem 7. θ) is suggested by an economic model. This can be done using arguments θ for optimization estimators. In the ﬁnal two examples. θ) = G(x0 θ). θ) = θ1 + θ2 xθ3 m(x. θ) = ∂θ Nonlinear regression is frequently adopted because the functional form m(x. θi 79 . Let 0 yi = ei + m0 θ0 . it must be shown that ˆ →p θ0 . θ) is diﬀerentiable with respect to θ. ˆ ˆ One motivation for the choice of NLLS as the estimation method is that the parameter θ is the solution to the population problem minθ E (yi − m(xi . estimator. θ) is (generically) diﬀerentiable in the parameters θ. θ) = θ1 + θ2 x1 + (θ3 + θ4 x1 ) Φ θ6 m(x. let ∂ m(x.1 If the model is identiﬁed and m(x. The least squares estimator ˆ minimizes the sum-of-squared-errors θ Sn (θ) = n X i=1 (yi − m(xi . we call this the nonlinear least squares (NLLS) θ). ˆ is close to θ θ θ0 for n large. m is not diﬀerentiable with respect to θ3 . which alters some of the analysis. it is adopted as a ﬂexible approximation to an unknown regression function.4. θ). V ) θ where mθi = mθ (xi . First. G known x2 − θ5 m(x. The NLLS residuals are ei = yi − m(xi .

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

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

This can be done with kernel estimation techniques.Theorem 7.5.10) is equivalent to g n (β) = 0. ∂β ˆ g(β) ' ´ ³ ∂ ˆ g(β 0 ) β − β 0 .11). and this improves estimation of the median. When f (0 | x) is large. ∂β 0 so Third. First. See Chapter 16.1 ´ √ ³ˆ n β − β 0 →d N (0. The main diﬃculty is the estimation of f (0). In the special case where the error is independent of xi . then f (0 | x) = f (0) and the asymptotic variance simpliﬁes V = (Exi x0 )−1 i 4f (0)2 (7. We need where g n (β) = n i i=1 gi (β) and gi (β) = xi (1 − 2 · 1 (yi ≤ xi three preliminary result. where V = and f (e | x) is the conditional density of ei given xi = x. Second using the law of iterated expectations and the chain rule of i diﬀerentiation.3. Computation of standard error for LAD estimates typically is based on equation (7. by the central limit theorem (Theorm 5. (7.11) This simpliﬁcation is similar to the simpliﬁcation of the asymptotic covariance of the OLS estimator under homoskedasticity.5. ∂ g(β) = ∂β 0 ¡ ¡ ¢¢ ∂ 0 0 Exi 1 − 2 · 1 yi ≤ xi β ∂β £ ¡ ¡ ¢ ¢¤ ∂ = −2 0 E xi E 1 ei ≤ x0 β − x0 β 0 | xi i i ∂β " Z 0 # xi β−x0 β 0 i ∂ = −2 0 E xi f (e | xi ) de ∂β −∞ £ ¢¤ ¡ = −2E xi x0 f x0 β − x0 β 0 | xi i i i £ 0 ¤ ∂ 0 g(β 0 ) = −2E xi xi f (0 | xi ) . ˆ Proof of Theorem 7.1) n X √ −1/2 n (g n (β 0 ) − g(β 0 )) = −n gi (β 0 ) →d N (0.5.1: Since sgn (a) = 1 − 2 · 1 (a ≤ 0) . ¢¢−1 ¡ ¢¢−1 ¢¡ ¡ 1¡ ¡ 0 Exi x0 E xi x0 f (0 | xi ) E xi xi f (0 | xi ) i i 4 The variance of the asymptotic distribution inversely depends on f (0 | x) . we provide a sketch here for completeness. the height of the error density at its median. Let g(β) = Eg (β). the conditional density of the error at its median. V ). by a Taylor series expansion and the fact g(β 0 ) = 0 82 . While a complete proof of Theorem 7. Pn −1 0 β)) . then there are many innovations near to the median.1 is advanced. Exi x0 ) i i=1 since Egi (β 0 )gi (β 0 )0 = Exi x0 .

9) for the median to all quantiles. V ). 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)) . Again. Exi x0 ) →d i 2 = N (0. The quantile Qτ is the value such that τ (percent) of the mass of the distribution is less than Qτ . For the random variables (yi . so you can think of the quantile as the inverse of the distribution function. However for computational convenience it is typical to assume that they are (approximately) linear in x (after suitable transformations). ¥ 7. The median is the special case τ = . As functions of x. The third line follows from an asymptotic empirical process argument.Together ´ √ ³ ˆ n β − β0 ' ' ¶−1 √ ∂ ˆ ng(β) 0 g(β 0 ) ∂β ´ ¡ £ ¤¢−1 √ ³ ˆ ˆ = −2E xi x0 f (0 | xi ) n g(β) − g n (β) i µ ¤¢−1 √ 1¡ £ 0 n (g n (β 0 ) − g(β 0 )) E xi xi f (0 | xi ) 2 ¤¢−1 1¡ £ 0 E xi xi f (0 | xi ) N (0. The following alternative representation is useful.12) Qτ = argmin Eρτ (U − θ) . If the random variable U has τ ’th quantile Qτ . then (7. the quantile regression function qτ (x) describes how the τ ’th quantile of the conditional distribution varies with the regressors. xi ) with conditional distribution function F (y | x) the conditional quantile function qτ (x) is Qτ (x) = inf {y : F (y | x) ≥ τ } . the quantile regression functions can take any shape.6 Quantile Regression The method of quantile regression has become quite popular in recent econometric practice. For τ ∈ [0. This linear speciﬁcation assumes that Qτ (x) = β 0 x where the coeﬃcients β τ τ vary across the quantiles τ . 1] the τ ’th quantile Qτ of a random variable with distribution function F (u) is deﬁned as Qτ = inf {u : F (u) ≥ τ } When F (u) is continuous and strictly monotonic. We then have the linear quantile regression model yi = x0 β τ + ei i 83 .5. when F (y | x) is continuous and strictly monotonic in y. then F (Qτ ) = τ . (7.13) This generalizes representation (7. For ﬁxed τ . then F (Qτ (x) | x) = τ .

and we have the simpliﬁcation Vτ = τ (1 − τ ) ¡ ¡ 0 ¢¢−1 . the quantile regression estimator β τ for β τ solves the minimization problem ˆ β τ = argmin Lτ (β) n β∈Rk n where Lτ (β) = n and ρτ (q) is deﬁned in (7. conventional Newton-type optimization methods are inappropriate. Furthermore.1.6. where and f (e | x) is the conditional density of ei given xi = x.where ei is the error deﬁned to be the diﬀerence between yi and its τ ’th conditional quantile x0 β τ .1 n β τ − β τ →d N (0. 7. then f (0 | xi ) = f (0) . Vτ ). One simple test for neglected nonlinearity is to add nonlinear functions of the regressors to ˆ ˆ the regression. fast linear programming methods have been developed for this problem. ˆ Given the representation (7. and form a Wald statistic i for γ = 0. it is useful to have a general test of the adequacy of the speciﬁcation. the τ ’th conditional quantile of ei is zero. i By construction.13). Fortunately. ´ √ ³ˆ Theorem 7. and are widely available. n numerical methods are necessary for its minimization. ¡ ¡ ¢¢−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. Thus.12). let zi = h(xi ) denote functions of xi which are not linear functions of xi (perhaps 0˜ ˜ ˜ squares of non-binary regressors) and then ﬁt yi = x0 β +zi γ + ei by OLS. and test their signiﬁcance using a Wald test. since it has discontinuous derivatives. E xi xi f (0)2 A recent monograph on the details of quantile regression is Koenker (2005). When the error ei is independent of xi . Another popular approach is the RESET test proposed by Ramsey (1969). otherwise its properties are unspeciﬁed without further restrictions. the unconditional density of ei at 0. A asymptotic distribution theory for the quantile regression estimator can be derived using similar arguments as those for the LAD estimator in Theorem 7. Since the quanitle regression criterion function Lτ (β) does not have an algebraic solution. if the model yi = x0 β + ei has i been ﬁt by OLS.5. the asymptotic variance depends on the conditional density of the quantile regression error.7 Testing for Omitted NonLinearity If the goal is to estimate the conditional expectation E (yi | xi ) . The null model is yi = x0 β + εi i 84 .

3. It is easy (although somewhat tedious) to show that under the null hypothesis. In this case i ¡ ¢−1 2 ˜ σ = Q−1 σ 2 . yi ˆm (7.14) by OLS. Now let ˆ i ⎛ 2 ⎞ yi ˆ ⎜ . Wn →d χ2 . and consequently 22 ¡ ¢−1 2 σ . ⎠ . ⎟ zi = ⎝ . Otherwise. To see why this is the case.be an (m − 1)-vector of powers of yi . and form the Wald statistic Wn for γ = 0. they will (typically) have diﬀerence asymptotic variances. since Q12 Q−1 Q21 > 0. small values such as m = 2. m must be selected in advance. If Q12 = 0 (so the variables are orthogonal) then these two variance matrices equal. and n→∞ say. β 2 ). In the model x2i is “irrelevant” if β 1 is the parameter of interest and β 2 = 0. However. 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. then 22 Q11 > Q11 − Q12 Q−1 Q21 . Typically. Then run the auxiliary regression ˆ 0 ˜ yi = x0 β + zi γ + ei ˜ ˜ i ˆ which is estimated by OLS. β 1 = (X1 X1 )−1 (X1 Y ) .8 Irrelevant Variables yi = x0 β 1 + x0 β 2 + ei 1i 2i E (xi ei ) = 0. 7. note that (7. yielding ˆ ˜ ˆ ˆ (β 1 . Another is to regress yi on x1i and x2i jointly. The comparison between the two estimators is straightforward when the error is conditionally ¢ ¡ homoskedastic E e2 | xi = σ 2 . and the two estimators have equal asymptotic eﬃciency. 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. To implement the test.14) may be written as ³ ´3 ³ ´m ³ ´2 ˜ ˆ ˜ ˆ ˜ ˆ yi = x0 β + x0 β γ 1 + x0 β γ 2 + · · · x0 β γ m−1 + ei ˜ ˜ i i i i which has essentially approximated G(·) by a m’th order polynomial. Under which conditions is β 1 or β 1 superior? It is easy to see that both estimators are consistent for β 1 . 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 . One estimator of β 1 is to regress 0 0 ˜ yi on x1i alone. 1i 2i 2i 1i 22 . The RESET test appears to work well as a test of functional form against a wide range of smooth alternatives. lim nV ar( β 1 ) = Ex1i x0 1i 11 n→∞ say. yielding predicted values yi = x0 β. or 4 seem to work best.

To ﬁx notation. E (ε | X1 .. xKi = xK )?” is well posed. when economic theory does not provide complete guidance? This is the question of model selection. .9 Model Selection In earlier sections we discussed the costs and beneﬁts of inclusion/exclusion of variables. There are many possible desirable properties for a model selection procedure.. etc. One useful property is consistency. estimated ˆ ˆ ˆ2 the variances σ 2 and σ 2 . models 1 and 2 are estimated by OLS.. This is equivalent to the comparison of the two models M1 : M2 : Y = X1 β 1 + ε. the question. We thus consider the question of the inclusion of X2 in the linear regression Y = X1 β 1 + X2 β 2 + ε. In the absence of the homoskedasticity assumption. where X1 is n × k1 and X2 is n × k2 . that it selects the true model with probability one if the sample is suﬃciently large.).. respectively. Let Exi = µ. We c can write this as M. this result can be reversed when the error is conditionally heteroskedastic. We conclude that the inclusion of irrelevant variable reduces estimation eﬃciency if these variables are correlated with the relevant variables. X2 ) = 0. Let β 1 be the ˜ be the estimate under the constraint β = 0. as the larger problem can be written as a sequence of such comparisons. σ2 ˜ lim nV ar( β 1 ) = 2 n→∞ σ x + µ2 while σ2 ˆ lim nV ar( β 1 )−1 = 2 .. and E (xi − µ)2 = σ 2 . the question: “What is the right model for y?” is not well posed. To simplify some of ¢ statistical discussion. In contrast. It is important that the model selection question be well-posed. we see that β 1 has a lower asymptotic variance. However. take the model yi = β 0 + β 1 xi + ei and suppose that β 0 = 0.7). x Then under (6. i A model selection procedure is a data-dependent rule which selects one of the two models. ˆ For example. xK ) enters the regression function E(yi | x1i = x1 . and β 1 0 (The least-squares estimate with the intercept omitted. because it does not make clear the conditioning set. “Which subset of (x1 . there is no clear ranking of the eﬃciency of the ˜ restricted estimator β 1 versus the unrestricted estimator.. E (ε | X1 . . How does a researcher go about selecting an econometric speciﬁcation. estimate of β 1 from the unconstrained model. To be concrete.. x2i = σ 2 . n→∞ σx ˜ When µ 6= 0. X2 ) = 0 Note that M1 ⊂ M2 . Y = X1 β 1 + X2 β 2 + ε. A model selection procedure is consistent if ´ ³ c → 1 P M = M1 | M1 ³ ´ c P M = M2 | M2 → 1 86 .˜ ˆ This means that β 1 has a lower asymptotic variance matrix than β 1 . For example. In many cases the problem of model selection can be reduced to the comparison of two nested models. we say that M2 is true if β 2 6= 0. we will on ˆ1 ¡ occasion use the homoskedasticity assumption E e2 | x1i . 7. with residual vectors e1 and e2 .

In contrast to the AIC. Another common approach to model selection is to to a selection criterion. let cα satisfy ¢ ¡ P χ22 > cα . If the truth is inﬁnite dimensional. based on Bayesian arguments. depending on the sample size. 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. else select M2 . the BIC places a larger penalty than the AIC on the number of estimated parameters and is more parsimonious. known as the BIC. That is.16) LRn = n log σ 2 − log σ 2 ' Wn →d χ22 . Then select M1 if Wn ≤ cα .17) Since log(n) > 2 (if n > 8). LRn →p 0. this rule only makes sense when the true model is ﬁnite dimensional. One popular choice is the Akaike Information Criterion (AIC). k A major problem with this approach is that the critical level α is indeterminate. M)) between the true density and the model density.However. Another problem is that if α is held ﬁxed. 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. log(n) 87 . For some critical level α. A common approach to model selection is to base the decision on a statistical test such as the Wald Wn . Indeed. k = While many modiﬁcations of the AIC have been proposed. then P M ´ ³ c 1 − α but P M = M2 | M2 could vary dramatically. if α is set to be a small number. Indeed. then this model selection procedure is inconsistent. BIC model selection is consistent. and km is the number of coeﬃcients in the model.16) holds under M1 . else select M2 . since under M1 . is ¡ ¢ km ˆm BICm = log σ 2 + log(n) . as ³ ´ c P M = M1 | M1 → 1 − α < 1. n (7. since (7. The model selection rule is as follows. The rule is to select M1 if AIC1 < AIC2 . as the rule tends to overﬁt. The AIC for model m is ¡ ¢ km ˆm AICm = log σ 2 + 2 . ¢ ¡ ˆ1 ˆ2 (7.15) then where σ 2 is the variance estimate for model m. His criterion. AIC selection is inconsistent. n (7. etc. the most popular to be one proposed by Schwarz. it is more appropriate to view model selection as determining the best ﬁnite sample approximation. 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.

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

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

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

if desired. (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. Estimate your selected model and report the results. (i) Compare the estimated standard errors. Interpret. Estimate such a model. Variables are listed in the ﬁle cps78. The data ﬁle cps78. (c) Are there any variables which seem to be unimportant as a determinant of wages? You may re-estimate the model without these variables. The goal of the exercise is to estimate a model for the log of earnings (variable LNWAGE) as a function of the conditioning variables. (d) Test whether the error variance is diﬀerent for men and women. (g) Using this model for the conditional variance. Report the results. re-estimate the model from part (c) using FGLS. (f) Construct a model for the conditional variance. Interpret. test for general heteroskedasticity and report the results.pdf. (e) Test whether the error variance is diﬀerent for whites and nonwhites.10. 91 . Report coeﬃcient estimates and standard errors. (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. Note any interesting diﬀerences.

The unknown F is replaced by a consistent estimate Fn (one choice is discussed in the next section). xi ) . In the next sections we describe computation of the bootstrap distribution. Efron (1979) proposed the bootstrap. for example an estimator ˆ or a t-statistic ˆ − θ /s(ˆ Note that we θ θ θ). write Tn as possibly a function of F . we say that Tn is asymptotically pivotal and use the distribution function G(x) for inferential purposes. P (T ∗ ≤ x) = G∗ (x). as it depends on the sample through the estimator Fn . F ) = G(x) does not depend on F. A random sample from this i ∗ ∗ ∗ distribution is call the bootstrap data. In a seminal contribution. x∗ ) denote random variables with the distribution Fn . .1 Deﬁnition of the Bootstrap Let F denote a distribution function for the population of observations (yi . This is generally impossible since F is unknown.. n (8. F ) with G(x. F ) we obtain G∗ (x) = Gn (x. F ).Chapter 8 The Bootstrap 8.1) We call G∗ the bootstrap distribution. The exact CDF of Tn when the data are sampled from the distribution F is Gn (x. For example. Asymptotic inference is based on approximating Gn (x. Gn (x. ∗ . meaning that G changes as F changes. Let Tn = Tn (y1 . x∗ . F ) = P (Tn ≤ x | F ) In general. xn . F ) ³ ´ be a statistic of interest.. When G(x. F ) = limn→∞ Gn (x.. yn . The bootstrap distribution is itself random. which makes a diﬀerent approximation. F ) depends on F.. Ideally. The statistic Tn = Tn (y1 . F ). the t-statistic is a function of the parameter θ which itself is a function of F... 92 . n n ∗ Let (yi . yn . x∗ . Fn ) constructed on n 1. Bootstrap inference is based on G∗ (x). inference would be based on Gn (x. The distribution of Tn is identical to that of Tn when the true CDF of Fn rather than F. x1. We call T ∗ this sample is a random variable with distribution Gn n n n ∗ the bootstrap statistic. Fn ). That is. Plugged into Gn (x.

3. it is helpful to think of a random pair (yi .. Note that while F may be either discrete or continuous. 1) distribution. √ n (Fn (y. The random draws are from the N (0. x) .. xi ≤ x) = E (1 (yi ≤ y) 1 (xi ≤ x)) . note that for any (y. 50. as the sample size gets larger. by the CLT (Theorem 5. x) = P (yi ≤ y. xi ). and 100. The method of moments estimator is the corresponding sample moment: n 1X 1 (yi ≤ y) 1 (xi ≤ x) . Fn is a nonparametric estimate of F. To see the eﬀect of sample size on the EDF. To see this. Furthermore.1). the EDF is only a crude approximation to the CDF. x) = n i=1 Figure 8.2 The Empirical Distribution Function Fn (y. x) is called the empirical distribution function (EDF). This is a population moment. in the Figure below.. Thus by the WLLN (Theorem 5. i = 1.8. x). but the approximation appears to improve for the large n. ∗ P (yi ≤ y. x). That is. the EDF step function gets uniformly close to the true CDF. where 1(·) is the indicator function.2. x∗ ≤ x) = Fn (y.1: Empirical Distribution Functions The EDF is a valid discrete probability distribution which puts probability mass 1/n at each ∗ pair (yi . I have plotted the EDF and true CDF for three random samples of size n = 25. x). Fn (y. 1 (yi ≤ y) 1 (xi ≤ x) is an iid random variable with expectation F (y. For n = 25. x) →p F (y. n. x))) . x)) →d N (0. . x∗ ) with the i distribution Fn . Notationally. Fn is by construction a step function.1). x) − F (y. i 93 . In general. The EDF is a consistent estimator of the CDF.2) Fn (y. F (y. x) (1 − F (y. (8. Recall that F (y.

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

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

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

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

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

Basically. F ) = Φ + o (1) . then to test H0 : θ = θ0 against H1 : θ 6= θ0 at size α. we would use a Wald statistic ³ ´ ³ ´0 ˆ θ Wn (θ) = n ˆ − θ Vθ−1 ˆ − θ θ or some other asymptotically chi-square statistic. Thus here Tn (θ) = Wn (θ).8.8 Asymptotic Expansions Tn →d N (0. F ) then ³x´ . If θ is a vector. an = O(n−r ) if it declines to zero like n−r . Let Tn be a statistic such that (8. the critical value qn (α) is found as the quantile from simulated values of W´ . and a function h(x) is odd if h(−x) = −h(x). and vice-versa. lim Gn (x. θ [This is a typical mistake made by practitioners.∗ where qn (α) is the bootstrap critical value for a two-sided hypothesis test. n ´ ³ ∗ ³ ∗ θ θ Note in the simulation that the Wald statistic is a quadratic form in ˆ − ˆ .1 an = o(1) if an → 0 as n → ∞ Deﬁnition 8. where qn (α) is the (1 − α)% quantile of the distribution of Wn . about the rate v of convergence. where qn (α) is the (1 − α)% quantile of the distribution of ³ ∗ ³ ∗ ´0 ´ ∗ Wn = n ˆ − ˆ Vθ∗−1 ˆ − ˆ . F ) = Φ n→∞ v or ³x´ Gn (x. The derivative of an even function is odd.4) v ¡ ¢ While (8.2 an = O(1) if |an | is uniformly bounded. It is designed to work well since ³ ´ P (θ0 ∈ C4 ) = P ˆ − s(ˆ n (α) ≤ θ0 ≤ ˆ + s(ˆ n (α) θ θ)q ∗ θ θ)q ∗ ∗ = P (|Tn (θ0 )| < qn (α)) ' P (|Tn (θ0 )| < qn (α)) = 1 − α.3 an = o(n−r ) if nr |an | → 0 as n → ∞. We say that a function g(x) is even if g(−x) = g(x). θ θ θ ˆ θ ∗ ∗ Computationally. it says nothing. not ˆ − θ0 .4) says that Gn converges to Φ x as n → ∞. A better asymptotic approximation may be obtained through an asymptotic expansion. v 2 ). The ideal test rejects if Wn ≥ qn (α). Let an be a sequence. (8. The bootstrap test ∗ ∗ rejects if Wn ≥ qn (α). writing Tn ∼ Gn (x.8. 99 . or the size of the divergence for any particular sample size n. Equivalently.8. however.3) ´ √ ³ˆ If Tn = n θ − θ0 then v = V while if Tn is a t-ratio then v = 1. C4 is called the symmetric percentile-t interval. The following notation will be helpful.] 8. Deﬁnition 8. Deﬁnition 8.

³x´ Gn (x. F0 )) + O(n−1 ). Fn ) − g1 (x. F ) + n−1 g2 (x. and g2 is an odd function of x. adding leptokurtosis). the density function is skewed. F0 ) + O(n−1 ) 1/2 1 n = O(n−1/2 ). F0 ) (Fn − F0 ) ∂F = O(n−1/2 ). g1 and g2 are diﬀerentiable functions of x and continuous in F relative to the supremum norm on the space of distribution functions. where g1 is an even function of x. Fn ) − g1 (x. the diﬀerence between the bootstrap distribution and the true distribution is G∗ (x) − Gn (x.8. The diﬀerence is Φ(x) − Gn (x. ³x´ Gn (x. 100 . F0 ) + O(n−1 ) 1/2 1 n 1 g (x. F0 )) converges to 0 at rate n. To the second order. F ) ≈ Φ + n−1/2 g1 (x. g1 (x. √ Since Fn converges to F at rate n. F ) + g2 (x. A bootstrap test is based on G∗ (x).1 has the expansion n G∗ (x) = Gn (x.8. F ) = Φ v n n 8.uniformly over x. F ) ≈ Φ + n−1/2 g1 (x. Moreover. 1/2 1 n Because Φ(x) appears in both expansions.8. Gn (x. We can interpret Theorem 8.1. we can assess the accuracy of one-sided hypothesis tests and conﬁdence regions based on an asymptotically normal t-ratio Tn .1 Under regularity conditions and (8.8. and g1 is continuous with respect to F. Fn ) + O(n−1 ). which from Theorem 8.3). so the order of the error is O(n−1/2 ). F0 ) = Φ(x) + since v = 1. To a third order of approximation. ³x´ 1 1 + 1/2 g1 (x. F ). Theorem 8. F ) + O(n−3/2 ) Gn (x.9 One-Sided Tests Using the expansion of Theorem 8. Fn ) − g1 (x. F0 ) ≈ ∂ g1 (x. To a second order of approximation. F0 ) = n 1 n1/2 (g1 (x. An asymptotic test is based on Φ(x). F0 ) = 1 g (x.1 as follows. Fn ) = Φ(x) + n 1 g (x. F ) v which adds a symmetric non-normal component to the approximate density (for example. the exact distribution is P (Tn < x) = Gn (x. v Since the derivative of g1 is odd. Heuristically. First. F ) converges to the normal limit at rate n1/2 . the diﬀerence √ (g1 (x.

F0 ) distribution. = P (X ≤ x) − P (X ≤ −x) For example. F0 ) + O(n−3/2 ) = O(n−1 ).The “derivative” ∂ ∂F g1 (x. F ) = Gn (x. F ) = Gn (x. F ) ¶ µ 1 1 = Φ(x) + 1/2 g1 (x. F ) + O(n−3/2 ) n n 2 = Φ(x) + g2 (x. F ).10 Symmetric Two-Sided Tests If a random variable X has distribution function H(x) = P (X ≤ x). 8. which is an improved rate of convergence over the asymptotic test (which converged at rate O(n−1/2 )).1.5) where the simpliﬁcations are because g1 is even and g2 is odd. A two-sided hypothesis test rejects H0 for large values of |Tn | . if Z ∼ N (0. Hence the diﬀerence between the asymptotic distribution and the exact distribution is Φ(x) − Gn (x. n . n or ∗ P (Tn ≤ x) = P (Tn ≤ x) + O(n−1 ). Similarly. F ) n n µ ¶ 1 1 − Φ(−x) + 1/2 g1 (−x. F ) + g2 (x. n (8. Thus asymptotic critical values are taken from the Φ distribution. 1). F ) − Gn (−x. 101 2 g2 (x. we can calculate that Gn (x. F ) is only heuristic. then |Z| has distribution function Φ(x) = Φ(x) − Φ(−x) = 2Φ(x) − 1. F0 ) = The order of the error is O(n−1 ). and exact critical values are taken from the Gn (x. if Tn has exact distribution Gn (x. then |Tn | →d |Z| ∼ Φ. F ) + g2 (−x. Since Tn →d Z. F0 ) = O(n−1 ). We conclude that G∗ (x) − 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). From Theorem 8. as F is a function. then |Tn | has the distribution function Gn (x. F ) + O(n−3/2 ). F ) − Gn (−x.8. 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 ).

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

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

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

You do this as follows. 105 . The dataﬁle hprice1.95).05) and qn (. (a) Report the 95% Efron Percentile interval for θ. θ θ) ∗ 1000 samples are generated from the bootstrap distribution. ∗ ∗ ∗ Let qn (.dat contains data on house prices (sales). Using the non-parametric ∗ bootstrap. size of house. you generate bootstrap samples. calculate the estimates ˆ on these samples and θ then calculate ∗ ∗ ∗ θ θ Tn = ˆ /s(ˆ ).95) denote the 5% θ) ∗ and 95% quantiles of Tn . and thus reject H0 if ˆ ˆ > q ∗ (.05) . What is wrong with this procedure? Tn = θ/s(θ) n 6. ˆ = 1. (b) Report the 95% Alternative Percentile interval for θ. with variables listed in the ﬁle hprice1. lot size.75 and 1. and ˆ is calculated on each θ ∗ ∗ θ sample.5% quantiles of the ˆ are . and the 2.3. Calculate 95% conﬁdence intervals for the regression coeﬃcients using both the asymptotic normal approximation and the percentile-t bootstrap. The ˆ are sorted. You replace c with qn (.95).95). can you report the 95% Percentile-t interval for θ? 7. and deﬁne the bootstrap conﬁdence interval h i C = ˆ − s(ˆ n (. ˆ − s(ˆ n (. ∗ ∗ where s(ˆ is the standard error in the original data. (c) With the given information.pdf. θ respectively. Let qn (.2 and s(ˆ = .5% and 97. Using the non-parametric bootstrap. θ θ)q ∗ θ θ)q ∗ θ/s(θ) 5. Estimate a linear regression of price on the number of bedrooms. and the colonial dummy. You want to test H0 : θ = 0 against H1 : θ > 0. The test for H0 is to reject if Tn = ˆ ˆ > c where c is picked so that Type I error is α.Show that C exactly equals the Alternative percentile interval (not the percentile-t interval).2.95) denote the 95% quantile of Tn . Suppose that in an application.

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

For example. if Wn = I.2. ¡ ¢−1 0 ˆ Z XWn X 0 Y. This is a non-negative measure of the “length” of the vector g n (β). the square of the Euclidean length. then.9. gi (β) = xi yi − zi β = n n n i=1 i=1 Deﬁne the sample analog of (9. for if Wn is replaced ˆ by cWn for some c > 0. For some × weight matrix Wn > 0.1 β GMM = argmin Jn (β). β ˆ Note that if k = . i i .1 ˆ 2Z 0 XWn X 0 Z β = 2Z 0 XWn X 0 Y While the estimator depends on Wn . ˆ Deﬁnition 9.2 GMM Estimator n n ¢ 1¡ 0 ¢ 1X 1X ¡ 0 X Y − X 0 Zβ . let Jn (β) = n · g n (β)0 Wn g n (β). then g n (β) = 0. Jn (β) = n · g n (β)0 g n (β) = n · |g n (β)|2 . Let and where gi = xi ei . the dependence is only up to scale. β GMM = Z 0 XWn X 0 Z 9.2) g n (β) = (9. The GMM estimator minimizes Jn (β). Proposition 9. but this is generally not possible when > k. β GMM does not change.3) The method of moments estimator for β is deﬁned as the parameter value which sets g n (β) = 0. 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.3 Distribution of GMM Estimator ¡ 0¢ Q = E xi zi Assume that Wn →p W > 0. Then µ ¶ ¶ µ 1 0 1 0 Z X Wn X Z →p Q0 W Q n n 107 ¡ ¢ ¡ 0¢ Ω = E xi x0 e2 = E gi gi . The idea of the generalized method of moments (GMM) is to deﬁne an estimator which sets g n (β) “close” to zero.2. and the GMM estimator is the MME.

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

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

9. For example. 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 . Note that g n →p Egi . The criterion function at the parameter estimates is J = n g 0 Wn g n n ¡ ¢−1 2 0 = n g n g 0 g − ng n g 0 gn .1 (Sargan-Hansen). perhaps obtained by ﬁrst ˆ setting Wn = I.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 . 1 2 It is possible that β 2 = 0. where ³ ´−1 ∂ 0 ˆ ˆ ˆ ˆ Ω = (E (gi gi ))−1 and G = E ∂β 0 gi (β). The GMM estimator minimizes J(β) = n · g n (β)0 Wn g n (β) where g n (β) = and Wn = Ã 1X gi (β) n i=1 n ˜ ˜ with gi = gi (β) constructed using a preliminary consistent estimator β. β) = 0 holds. ´ ³ ¡ ¢−1 ´ √ ³ˆ Theorem 9. 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. Since the GMM estimator depends upon the ﬁrst-stage estimator. and then β recomputed. 110 . and is thus a natural test statistic for H0 : Egi = 0. Identiﬁcation requires l ≥ k = dim(β). this is all that is known. often the weight ˆ matrix Wn is updated. Hansen (1982). However. 1 it is possible that β 2 6= 0.6. n β − β →d N 0. Thus the model — the overidentifying restrictions — are testable. and thus g n can be used to assess whether or not the hypothesis that Egi = 0 is true or not. Theorem 9. 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). The general theory of GMM estimation and testing was exposited by L. take the linear model yi = β 0 x1i + β 0 x2i + ei with E (x1i ei ) = 0 and E (x2i ei ) = 0.Often. In this sense an 1i 1i exclusion restriction can be seen as an overidentifying restriction. and if the weight matrix is asymptotically eﬃcient. G0 Ω−1 G .5. Under the hypothesis of correct speciﬁcation. so that the linear equation may be written as yi = β 0 x1i + ei .1 Under general regularity conditions. This estimator can be iterated if needed. ˆ J = J(β) →d χ2−k .

This result was established by Sargan (1958) for a specialized case. The GMM overidentiﬁcation test is a very useful by-product of the GMM methodology. Proposition 9. When over-identiﬁed models are estimated by GMM. 1. These may be used to construct Wald tests of statistical hypotheses. and sometimes called a LR-like statistic (the LR is for likelihood-ratio). For a given weight matrix Wn . but it is typically cause for concern. D ≥ 0 2. Based on this information alone. The estimates under H1 are ˆ β = argmin J(β) β and those under H0 are ˜ β = argmin J(β). 9. Newey and West (1987) suggested to use the same weight matrix Wn for both null and alternative. and by L. If h is non-linear. If the hypothesis is non-linear. The GMM distance statistic is the diﬀerence ˜ ˆ D = J(β) − J(β). the Wald statistic can work quite poorly. a better approach is to directly use the GMM criterion function.7.7 Hypothesis Testing: The Distance Statistic We described before how to construct estimates of the asymptotic covariance matrix of the GMM estimates. If h is linear in β. the GMM criterion function is J(β) = n · g n (β)0 Wn g n (β) For h : Rk → Rr . the hypothesis is H0 : h(β) = 0. In contrast. it is customary to report the J statistic as a general test of model adequacy. and it is advisable to report the statistic J whenever GMM is the estimation method. as this ensures that D ≥ 0.The proof of the theorem is left as an exercise. Hansen (1982) for the general case. The degrees of freedom of the asymptotic distribution are the number of overidentifying restrictions. D →d χ2 r 3.1 If the same weight matrix Wn is used for both null and alternative. h(β)=0 ˆ ˜ The two minimizing criterion functions are J(β) and J(β). This reasoning is not compelling. current evidence suggests that the D statistic appears to have quite good sampling properties. it is unclear what is wrong. This test shares the useful feature of LR tests in that it is a natural by-product of the computation of alternative models. and is the preferred test statistic. we can reject the model. then D equals the Wald statistic. The idea was ﬁrst put forward by Newey and West (1987). 111 . however. This is sometimes called the GMM Distance statistic. and some current research suggests that this restriction is not necessary for good performance of the test. If the statistic J exceeds the chi-square critical value.

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

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

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

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

we can write Ω−1 = CC 0 and Ω = C 0−1 C −1 ³ ´0 ³ ´−1 ˆ ˆ ˆ C 0 ΩC (b) Jn = n C 0 g n (β) C 0 g n (β) ˆ (c) C 0 g n (β) = Dn C 0 g n (β 0 ) (d) Dn →p Il − R (R0 R)−1 R0 (e) n1/2 C 0 g n (β 0 ) →d N ∼ N (0. 116 . Let ˆ ˆ ˆ Jn = ng n (β)0 Ω−1 g n (β) denote the test of overidentifying restrictions. ˆ and consider the GMM estimator β of β. 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 . l−k Hint: Il − R (R0 R)−1 R0 is a projection matrix..7. 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.

1). (10. In this case the moment condition places no additional restrictions on the multinomial distribution. pn ) are those which maximize the log-likelihood subject to the constraint (10.. zi . the log-likelihood function for this multinomial distribution is n X ln(pi ). The maximum likelihood estimator of the probabilities (p1 . xi . Now consider the case of an overidentiﬁed model with moment condition Egi (β 0 ) = 0 where g is × 1 and β is k × 1 and for simplicity we write gi (β) = g(yi .. these probabilities must satisfy the requirements that pi ≥ 0 and n X pi = 1. zi ) will satisfy this condition if and only if n X pi gi (β) = 0 (10. xi .3) i=1 117 .2) Ln (p1 . This is equivalent to maximizing Ã n ! n X X log(pi ) − µ pi − 1 i=1 i=1 where µ is a Lagrange multiplier. Combined with i the constraint (10. ...Chapter 10 Empirical Likelihood 10. It is a non-parametric analog of likelihood estimation.. β).. The idea is due to Art Owen (1988.1 Non-Parametric Likelihood Since each observation is observed once in the sample. The n ﬁrst order conditions are 0 = p−1 − µ... .1) i=1 First let us consider a just-identiﬁed model. To be a valid multinomial distribution.. pn ) which places probability pi at each observation. . The idea is to construct a multinomial distribution F (p1 . 2001) and has been extended to moment condition models by Qin and Lawless (1994). pn ) = i=1 An alternative to GMM is empirical likelihood. The multinomial distribution which places probability pi at each observation (yi . (10.1) we ﬁnd that the MLE is pi = n−1 yielding the log-likelihood −n log(n).

The solution cannot be obtained explicitly. The Lagrangian for this maximization problem is Ã n ! n n X X X ln(pi ) − µ pi − 1 − nλ0 pi gi (β) L∗ (β. λ).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.. the Lagrange multiplier λ(β) minimizes Rn (β. or equivalently minimizes its negative ˆ (10.5).3). p1 . we ﬁnd µ = n and 1 ¢. but must be obtained numerically (see section 6.2) subject to the restrictions (10. The ﬁrst-order-conditions of and λ are 1 = µ + nλ0 gi (β) pi n X pi = 1 i=1 n X i=1 The empirical likelihood estimator is the value of β which maximizes the multinomial loglikelihood (10. pn . and using the second and third equations. pi = ¡ n 1 + λ0 gi (β) Substituting into L∗ we ﬁnd n Rn (β. λ) is a convex function of λ. Multiplying the ﬁrst equation by pi . This yields the (proﬁle) empirical log-likelihood function for β.4) (10.1) and (10. (10. pi gi (β) = 0. pi = ³ ˆ ˆ ˆ0 n 1 + λ gi β ˆ Ln = n X i=1 ln (ˆi ) . λ(β)) = −n ln (n) − n X i=1 ˆ The EL estimate β is the value which maximizes Ln (β).. λ. µ. p (10.where λ and µ are Lagrange multipliers. µ) = n i=1 i=1 i=1 L∗ n with respect to pi . λ) : λ(β) = argmin Rn (β. The solution (when it exists) is well deﬁned since Rn (β. λ ¡ ¢ ln 1 + λ0 gi (β) .7) 118 . we also obtain the Lagrange multiplier λ = λ(β). summing over i. Ln (β) = Rn (β. (see section 6.. . λ) = −n ln (n) − n X i=1 For given β.5) This minimization problem is the dual of the constrained maximization problem.5) ˆ ˆ As a by-product of estimation. probabilities 1 ³ ´´ .

and Ω = E xi x0 e2 . 0 = Rn (β.9) and (10. V ) ¢−1 ¡ V = G0 Ω−1 G ¡ ¢−1 0 Vλ = Ω − G G0 Ω−1 G G G = EGi (β 0 ) ¡ ¢ Ω = E gi (β 0 ) gi (β 0 )0 (10. i=1 i=1 i=1i Expanding (10. Gi (.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 .8) and ¢ 0 0 For example.11) 0 = ∂λ ˆ0 ˆ i=1 1 + λ gi β ³ ´0 ˆ n X Gi . ˆ The asymptotic variance V for β is the same as for eﬃcient GMM. g n = n n gi (β 0 ) and Ωn = n n g (β 0 ) gi (β 0 )0 . ´ √ ³ ˆ n β − β 0 →d √ ˆ nλ →d N (0. λ) = − (10.9) (10.11) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ ˆ 0 ' −g n − Gn β − β 0 + Ωn λ (10.1 Under regularity conditions.2. (β. ˆ ˆ Proof.10. Thus the EL estimator is asymptotically eﬃcient.12) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ 0 ' G0 λ − λ0 . n (10. in the linear model.13) yields n n Expanding (10. β λ ∂ ³ ´. λ) jointly solve ³ ´ ˆ n gi β X ∂ ³ ³ ´´ Rn (β.2 Deﬁne Asymptotic Distribution of EL Estimator Gi (β) = ∂ gi (β) ∂β 0 (10. and n β − β 0 and nλ are asymptotically independent. G = −E (xi zi ).10). λ) = − (10.13) Premultiplying by G0 Ω−1 and using (10.12) ∂β ˆ ˆ0 i=1 1 + λ gi β 1 P 1 P 1 P Let Gn = n n Gi (β 0 ) . Vλ ) ´ √ ˆ √ ³ˆ where V and Vλ are deﬁned in (10.10) ¡ Ω−1 N (0. i i Theorem 10. β) = −xi zi .

since ³ ¡ ¢−1 0 ´ G0 I − Ω−1 G G0 Ω−1 G G =0 (10.3.1 If Eg(wi . First. n ³ ´´ ´ √ ³ 1 X ³ ˆ ˆ √ g wi . Since the EL estimator achieves this bound.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. Vλ ) Furthermore. The overidentiﬁcation test is a very useful by-product of EL estimation. by a Taylor expansion. 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 . The EL overidentiﬁcation test is similar to the GMM overidentiﬁcation test. Twice the diﬀerence between the unrestricted empirical likelihood −n log (n) and the maximized empirical likelihood for the model (10. β ' n g n + Gn β − β 0 n i=1 ³ ¡ ¢−1 0 −1 ´ √ Gn Ωn ng n ' I − Gn G0 Ω−1 Gn n n √ ˆ ' Ωn nλ. (10.14) for λ and using (10. 10. it is an asymptotically eﬃcient estimator for β.3 Overidentifying Restrictions In a parametric likelihood context. Ω) GΩ G →d = N (0.7) is n ³ ´´ ³ X ˆ ˆ0 (10. LRn = i=1 Theorem 10. The same statistic can be constructed for empirical likelihood. 120 .15) (10.16). β 0 ) = 0 then LRn →d χ2−k .17) 2 ln 1 + λ gi β . and it is advisable to report the statistic LRn whenever EL is the estimation method. Proof.15). ¥ Chamberlain (1987) showed that V is the semiparametric eﬃciency bound for β in the overidentiﬁed moment condition model. and (10. V ) ˆ Solving (10. tests are based on the diﬀerence in the log likelihood functions. Ω) →d Ω−1 I − G G Ω G GΩ = Ω−1 N (0. and have the same interpretation.16) ´ √ ˆ √ ³ˆ n β − β 0 and nλ are asymptotically uncorrelated and hence independent.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.

edu/~bhansen/progs/elike.4 Testing Egi (β) = 0 (10. 10. h(β)=0 ˜ Fundamentally.4.1 Under (10.18) Let the maintained model be where g is × 1 and β is k × 1. The restricted EL estimator and likelihood are the values which solve ˜ β = argmax Ln (β) h(β)=0 ˜ ˜ Ln = Ln (β) = max Ln (β). so there is no fundamental change in the distribution theory for β relative to β. This test statistic is a natural analog of the GMM distance statistic. Theorem 10.Second. By “maintained” we mean that the overidentfying restrictions contained in (10. LRn = n X i=1 ˆ0 ' 2λ →d ˆ0 ˆ ' nλ Ωn λ = χ2−k n X i=1 ³ ´´ ³ ˆ ˆ0 2 ln 1 + λ gi β i=1 n ³ ´ X ³ ´ ³ ´0 ˆ − λ0 ˆ ˆ ˆ ˆ gi β gi β gi β λ N (0.18). where h : Rk → Ra . a The proof of this result is more challenging and is omitted. LRn →d χ2 .wisc. The hypothesis of interest is h(β) = 0. Vλ ) ¥ where the proof of the ﬁnal equality is left as an exercise. 10. To test the hypothesis h(β) while maintaining (10. the simple overidentifying restrictions test (10. Vλ )0 Ω−1 N (0.17) is not appropriate.5 Numerical Computation Gauss code which implements the methods discussed below can be found at http://www.prc 121 . the restricted EL estimator β is simply an EL estimator with − k + a overidenti˜ ˆ fying restrictions.18) and H0 : h(β) = 0. Instead we use the diﬀerence in log-likelihoods: ³ ´ ˆ ˜ LRn = 2 Ln − Ln .ssc. 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).

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

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

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

So we have the partition µ ¶ z1i k1 (11. That is x2i are variables which could be included in the equation for yi (in the sense 125 . z1i is an instrumental variable for (11.1 Instrumental Variables 0 yi = zi β + ei Let the equation of interest be (11.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 ¶ . 11.1).3) zi = z2i k2 where E(z1i ei ) = 0 yet E(z2i ei ) 6= 0.1 The × 1 random vector xi is an instrumental variable for (11. Deﬁnition 11.2) Any solution to the problem of endogeneity requires additional information which we call instruments. In matrix notation. β →p β ∗ . We call z1i exogenous and z2i endogenous. at least the intercept). ¶ µ ∙ β2 β1 1 −1 β 2 e1i + β 1 e2i (e1i − e2i ) ¸µ e1i e2i ¶ ˆ Hence if it is estimated by OLS.1) where zi is k × 1.1) if E (xi ei ) = 0.1. This is called simultaneous equations bias.4) xi = x2i 2 where z1i = x1i are the included exogenous variables. We call (11. In a typical set-up. this can be written as Y = Zβ + e. Thus we make the partition ¶ µ k1 z1i (11. so should be included in xi . (11.1) the structural equation. and assume that E(zi ei ) 6= 0 so there is endogeneity. By the above deﬁnition. which does not equal either β 1 or β 2 . and x2i are the excluded exogenous variables. some regressors in zi will be uncorrelated with ei (for example.

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

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

13).14) In general this is non-zero.14) approaches that in (11. the expression in (11. It is also close to zero when α = 0.14) is the probability limit of β 2SLS − β 11. the bias in the 2SLS estimator will be large. 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 .12) and this result. By the spectral decomposition of an idempotent matrix. 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. Let q = H 0 ξS −1/2 which satisﬁes Eqq 0 = In and partition q = (q1 q2 ) where q1 is l × 1. 0).7 Identiﬁcation Failure Recall the reduced form equation Z2 = X1 Γ12 + X2 Γ22 + u2 . The parameter β fails to be identiﬁed if Γ22 has deﬁcient rank. n and (11. 130 .Let PX = X (X 0 X)−1 X 0 . ¢ 1 ¡ ¢ 1 ¡ ¢ 1 ¡ 0 E Z PX e = E Γ0 X 0 e + E u0 PX e = αS21 . Bekker (1994) pointed out that it also has the reverse implication — that when α = l/n is large. The consequences of identiﬁcation failure for inference are quite severe. 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 . 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. l . Hence µ ¶ 1 0 1 1/20 ¡ 0 ¢ 1/2 ξ PX ξ S E q Λq S E = n n µ ¶ 1 0 1 1/20 S E q q1 S 1/2 = n n 1 l 1/20 1/2 S S = n = αS where α= Using (11. Indeed as α → 1. except when S21 = 0 (when Z is exogenous).

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

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

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

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

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

γ (0) ˆ Theorem 12. the sequence Yt Yt−k is strictly stationary and ergodic. then as T → ∞. T 1X Xt →p E(Xt ). T t=1 This allows us to consistently estimate parameters using time-series moments: The sample mean: T 1X µ= ˆ Yt T t=1 The sample autocovariance T 1X (Yt − µ) (Yt−k − µ) .2 (Ergodic Theorem). ˆ ˆ T t=1 γ (k) = ˆ The sample autocorrelation ρ(k) = ˆ γ (k) ˆ .1 above. ˆ ˆ γ ¥ 136 . and it has a ﬁnite mean by the assumption that EYt2 < ∞. ρ(k) →p ρ(k).1. µ →p E(Yt ). 1.3 If Yt is strictly stationary and ergodic and EYt2 < ∞.1. then as T → ∞. For Part (2). Thus an application of the Ergodic Theorem yields T 1X Yt Yt−k →p E(Yt Yt−k ). ˆ Part (3) follows by the continuous mapping theorem: ρ(k) = γ (k)/ˆ (0) →p γ(k)/γ(0) = ρ(k).1. γ (k) →p γ(k). ˆ 2. If Xt is strictly stationary and ergodic and E |Xt | < ∞. note that γ (k) = ˆ T 1X (Yt − µ) (Yt−k − µ) ˆ ˆ T t=1 = T T T 1X 1X 1X Yt Yt−k − Yt µ − ˆ Yt−k µ + µ2 . ˆ ˆ T t=1 T t=1 T t=1 By Theorem 12. ˆ 3. Part (1) is a direct consequence of the Ergodic theorem. T t=1 Thus γ (k) →p E(Yt Yt−k ) − µ2 − µ2 + µ2 = E(Yt Yt−k ) − µ2 = γ(k). ˆ Proof.Theorem 12.

∞ X = ρk et−k .. we ﬁnd Yt = et + ρet−1 + ρ2 et−2 + .. it is even more important in the time-series context. . Yt−k ) . or consumption growth rates. A useful property of a MDS is that et is uncorrelated with any function of the lagged information It−1 . the series {. 12. should be a MDS.. t By back-substitution. as it is diﬃcult to derive distribution theories without this property.. Deﬁnition 12.. A mean-zero AR(1) is Assume that et is iid..2. this series converges if the sequence ρk et−k gets small as k → ∞. Y2 .2 Autoregressions In time-series. .. k=0 Loosely speaking. E(Yt−k et ) = 0. Some time-series processes may be a MDS as a consequence of optimizing behavior. In fact. Regression errors are naturally a MDS.} are jointly random.. YT . 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. 137 . The last property deﬁnes a special time-series process.. then we have the autoregressive model Yt = α + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et E (et | It−1 ) = 0... E(et ) = 0 and Ee2 = σ 2 < ∞. . Most asset pricing models imply that asset returns should be the sum of a constant plus a MDS. Thus for k > 0.1 et is a martingale diﬀerence sequence (MDS) if E (et | It−1 ) = 0. . 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 . We consider the conditional expectation E (Yt | It−1 ) where It−1 = {Yt−1 . Letting et = Yt − E (Yt | It−1 ) ..3 Stationarity of AR(1) Process Yt = ρYt−1 + et . Yt−2 ... This occurs when |ρ| < 1. For example. An autoregressive (AR) model speciﬁes that only a ﬁnite number of past lags matter: E (Yt | It−1 ) = E (Yt | Yt−1 . Y1 .} is the past history of the series.12.. some versions of the life-cycle hypothesis imply that either changes in consumption.

the above results are unchanged. We can compute the moments of Yt using the inﬁnite sum: EYt = ∞ X k=0 ρk E (et−k ) = 0 σ2 . 138 . 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). or ρ(L)Yt = et where ρ(L) = 1 − ρ1 L − ρ2 L2 − · · · − ρk Lk . Deﬁning L2 = LL. 12. Deﬁnition 12. In general.1. ∞ X k=0 ρ2k V ar (et−k ) = 12. we see that L2 Yt = LYt−1 = Yt−2 .1 The lag operator L satisﬁes LYt = Yt−1 . We say that the root of the polynomial is 1/ρ. since ρ(z) = 0 when z = 1/ρ.5 Stationarity of AR(k) Yt = ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et . The AR(k) model is Using the lag operator.Theorem 12. The operator ρ(L) = (1 − ρL) is a polynomial in the operator L. 1 − ρ2 V ar(Yt ) = If the equation for Yt has an intercept. From Theorem 12. Lk Yt = Yt−k . an AR(1) is stationary iﬀ |ρ| < 1. and solving for EYt = EYt−1 we ﬁnd EYt = α/(1 − ρ).4 Lag Operator An algebraic construct which is useful for the analysis of autoregressive models is the lag operator.4.3. The AR(1) model can be written in the format Yt − ρYt−1 + et or (1 − ρL) Yt−1 = et . We call ρ(L) the autoregressive polynomial of Yt . except that the mean of Yt can be computed from the relationship EYt = α + ρEYt−1 . We call ρ(L) the autoregressive polynomial of Yt .3.1 If |ρ| < 1 then Yt is strictly stationary and ergodic. Yt − ρ1 LYt − ρ2 L2 Yt − · · · − ρk Lk Yt = et .

5.1 The AR(k) is strictly stationary and ergodic if and only if |λj | > 1 for all j. ¢0 Then the model can be written as The OLS estimator is ¡ ˆ To study β. .1. t T t=1 T t=1 139 . it is also strictly stationary and ergodic. The vector xt is strictly stationary and ergodic.” If one of the roots equals 1. so is xt x0 . λk are the complex roots of ρ(z).1 If the AR(k) process Yt is strictly stationary and ergodic and EYt2 < ∞. Theorem 12. since E (ut | It−1 ) = E (xt et | It−1 ) = xt E (et | It−1 ) = 0.. 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. Proof.6 Let Estimation xt = β = ¡ 1 Yt−1 Yt−2 · · · α ρ1 ρ2 · · · yt = x0 β + et . We know that an AR(1) is stationary iﬀ the absolute value of the root of its autoregressive polynomial is larger than one. we say that ρ(L). T t=1 T t=1 ¢−1 0 ¡ ˆ X Y. it is helpful to deﬁne the process ut = xt et . and hence Yt . then ˆ β →p β as T → ∞. and by Theorem 12. t t T t=1 ¥ Combined with (12. we see that Ã !−1 Ã ! T T 1X 1X ˆ β=β+ xt x0 xt et →p Q−1 0 = 0. which satisfy ρ(λj ) = 0. By Theorem 12.1) Theorem 12. One way of stating this is that “All roots lie outside the unit circle. the requirement is that all roots are larger than one.1.. β = X 0X (12.6. t Yt−k ¢0 ρk . Thus t by the Ergodic Theorem.1.1) and the continuous mapping theorem. Let |λ| denote the modulus of a complex number λ. Thus T T 1X 1X xt et = ut →p E (ut ) = 0. Note that ut is a MDS. This is a special case of non-stationarity. T ¢ ¡ 1X xt x0 →p E xt x0 = Q. and is of great interest in applied time series. For an AR(k).. “has a unit root”.where the λ1 .1.

.. ˆ 2. Y0 ). It also presumes that the AR(k) structure is the truth. Method 2: Block Resampling 1. Estimate β and residuals et . which may be diﬀerent than the i properties of the actual ei .1 to see that T 1 X √ xt et →d N (0.8 Bootstrap for Autoregressions In the non-parametric bootstrap.. there are two popular methods to implement bootstrap resampling for time-series data. T t=1 where Ω = E(xt x0 e2 ). In particular. t t Theorem 12. If ut is a strictly stationary and ergodic MDS and E(ut u0 ) = Ω < ∞. Divide the sample into T /m blocks of length m.1 MDS CLT. Fix an initial condition (Y−k+1 . T t=1 Since xt et is a MDS.. then as T → ∞. eT }. Method 1: Model-Based (Parametric) Bootstrap. This is identical in form to the asymptotic distribution of OLS in cross-section regression. t This construction imposes homoskedasticity on the errors e∗ . Clearly.. Q−1 ΩQ−1 . ..2 If the AR(k) process Yt is strictly stationary and ergodic and EYt4 < ∞.7 Asymptotic Distribution Theorem 12. t then as T → ∞. Ω) . Ω) . as this imposes inappropriate independence.7. this cannot work in a time-series application. 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∗ . ´ √ ³ ¡ ¢ ˆ T β − β →d N 0.12. Brieﬂy.. 12. The implication is that asymptotic inference is the same. This creates an iid bootstrap sample.7. e ˆ 3. 140 . the asymptotic covariance matrix is estimated just as in the cross-section case. Simulate iid draws e∗ from the empirical distribution of the residuals {ˆ1 . Y−k+2 . i 4. we constructed the bootstrap sample by randomly resampling from the data values {yt . T 1 X √ ut →d N (0. xt }.7. ˆ 1. we can apply Theorem 12.

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

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

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

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

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

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

we are only interested in a single equation out of a VAR system. with time series data. t or yt = θyt−1 + x0 β + x0 γ + ut .2) is a special case of (13. it is convenient to re-deﬁne the variables.13. If valid. Suppose that et is an AR(1). This takes the form 0 and xt consists of lagged values of Yjt and the other Ylt s.) Since the common factor restriction appears arbitrary. This can be done by a Wald test.3) which is a valid regression model. which is called a common factor restriction. under the restriction γ = −βθ. t and et is iid N (0.3). Let et = ejt and β = aj . Then the null and alternative are H0 : θ = 0 H1 : θ 6= 0. (A simple version of this estimator is called Cochrane-Orcutt. direct estimation of (13. and simple way to test for omitted serial correlation is to test the signiﬁcance of extra lagged values of the dependent variable and regressors. 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 . j Often. In this case. and is still routinely reported by conventional regression packages.2) Take the equation yt = x0 β + et .2) is uncommon in recent applications. 147 . 13. t t−1 (13. t and xt = This is just a conventional regression. 1).2) may be estimated by iterated GLS. general. and Zt be the other variables. Otherwise it is invalid. Let yt = Yjt . So testing H0 versus H1 is equivalent to testing for the signiﬁcance of adding (yt−1 . h¡ 1 Yt−1 · · · 0 Yt−k Zt−1 · · · 0 Zt−k ¢0 i . We see that an appropriate. and is typically rejected empirically. xt−1 ) to the regression.1) yt = x0 β + et . the model (13. The DW test is appropriate only when regression yt = x0 β + et is not dynamic (has no lagged values on the RHS). This restriction. Another interesting fact is that (13. which once was very popular. You may have heard of the Durbin-Watson test for omitted serial correlation. Then yt = x0 β + et t et = θet−1 + ut E (ut | It−1 ) = 0. may be tested if desired. Then the single equation takes the form (13. (13.5 Testing for Omitted Serial Correlation Consider the problem of testing for omitted serial correlation in equation (13.1). and subtract oﬀ the equation once lagged multiplied by θ.4 Single Equation from a VAR Yjt = a0 xt + et .

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

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

and diﬀerent authors have adopted diﬀerent identiﬁcation schemes. As they were discovered by Johansen (1988. Ω). it is simple to test for cointegration by testing the rank of Π. One diﬃculty is that β is not identiﬁed without normalization. which is least-squares subject to the stated restriction. we typically just normalize one element to equal unity. 1995). Thus cointegration imposes a restriction upon the parameters of a VAR. If β is unknown. Yt is cointegrated with m × r β if and only if rank(Π) = r and Π = αβ 0 where α is m × r. 150 . In the context of a cointegrated VAR estimated by reduced rank regression. then estimation is done by “reduced rank regression”. When r = 1. 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 . These tests are constructed as likelihood ratio (LR) tests. they are typically called the “Johansen Max and Trace” tests. this can be estimated by OLS of ∆Yt on zt−1 and the lags of ∆Yt . and are similar to the Dickey-Fuller distributions. rank(α) = r. When r > 1. If β is known. Their asymptotic distributions are non-standard. this does not work. this is the MLE of the restricted parameters under the assumption that et is iid N (0.Theorem 13.9.1 (Granger Representation Theorem). Equivalently.

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

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

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

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

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

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

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

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

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

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

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

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

1) distribution and σ 2 is an estimate of σ 2 = V ar(X). Note that this h declines to zero. and there is a large and continuing literature on the subject. Thus for the AMISE to decline with n. we ﬁnd the reference rules for the three kernel functions introduced earlier. Equation (16.1) is an asymptotic approximation to the MSE. but at a very slow rate. how should the bandwidth be selected? This is a diﬃcult problem. 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 rule-of-thumb h can be quite ineﬃcient. the asymptotic mean-squared error (AMSE) for ﬁxed x is the sum of the approximate squared bias and approximate variance 1 f (x) R(K) . (16. 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. The downside is that if the density is very far from normal. h0 = argmin AM ISEh h It can be found by solving the ﬁrst order condition d R(K) AM ISEh = h3 σ 4 R(f 00 ) − =0 K dh nh2 yielding h0 = µ R(K) 4 R(f 00 ) σK ¶1/5 n−1/2 . Notice that the ﬁrst term (the squared bias) is increasing in h and the second term (the variance) is decreasing in nh. In practice. The ﬁrst two are determined by the kernel function. That is.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 . We deﬁne the asymptotically optimal bandwidth h0 as the value which minimizes this approximate MSE. The asymptotically optimal choice given in (16. A classic simple solution proposed by Silverman (1986)has come to be known as the reference bandwidth or Silverman’s Rule-of-Thumb. Gaussian Kernel: hrule = 1. h must tend to zero. σ 2 .2) depends on R(K). This choice for h gives an optimal rule when f (x) is ˆ normal. and R(f 00 ). and gives a nearly optimal rule when f (x) is close to normal. (16. we need h → 0 but nh → ∞. We thus say that the optimal bandwidth is of order O(n−1/5 ).Together.2) This solution takes the form h0 = cn−1/5 where c is a function of K and f. but not of n. where φ is the N (0. ˆ It uses formula (16. We can calculate that √ R(φ00 ) = 3/ (8 π) . but at a slower rate than n−1 . That is.2) but replaces R(f 00 ) with σ −5 R(φ00 ).06n−1/5 163 . Together with the above table. Their K values for the three functions introduced in the previous section are given here.

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

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

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

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

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

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

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

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

Another implication of (A. y) = fX (x)fY (y). X and Y are independent if and only if there exist functions g(x) and h(y) such that f (x.Similarly. if EX = 0 and EX 3 = 0. If X and Y are independent. 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 ) . The covariance between X and Y is Cov(X. then V ar (X + Y ) = V ar(X) + V ar(Y ). then σ XY = 0 and ρXY = 0.5) is that if X and Y are independent and Z = X + Y. The reverse. σxσY (A. The correlation between X and Y is Corr(X. For example. A useful fact is that V ar (X + Y ) = V ar(X) + V ar(Y ) + 2Cov(X. Y ) = σ XY = E ((X − EX) (Y − EY )) = EXY − EXEY. −∞ The random variables X and Y are deﬁned to be independent if f (x. then Z Z E (g(X)h(Y )) = g(x)h(y)f (y. (A. y)dx. if X and Y are independent then E(XY ) = EXEY. 172 .6) The Cauchy-Schwarz Inequality implies that |ρXY | ≤ 1. Y ) = ρXY = σ XY . An implication is that if X and Y are independent. the variance of the sum is the sum of the variances. For example. X 2 ) = 0. however. free of units of measurement. If X and Y are independent. Furthermore. Y ). the marginal density of Y is fY (y) = Z ∞ f (x. then Cov(X.5) if the expectations exist. 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 correlation is a measure of linear dependence. y) = g(x)h(y). is not true.

. y) − F (x. 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. y) ..A k × 1 random vector X = (X1 . fX (x) 173 . we deﬁne the expectation Z g(x)f (x)dx Eg(X) = Rk where the symbol dx denotes dx1 · · · dxk . it has the distribution and density functions F (x) = P (X ≤ x) ∂k f (x) = F (x). y) ∂ lim ∂y ε→0 FX (x + ε) − FX (x) ∂ lim ∂y ε→0 ∂ ∂x F (x + ε.6 Conditional Distributions and Expectation f (x. Xk )0 is a function from S to Rk . y) fX (x) The conditional density of Y given X = x is deﬁned as fY |X (y | x) = if fX (x) > 0. One way to derive this expression from the deﬁnition of conditional probability is fY |X (y | x) = = = = = = ∂ lim P (Y ≤ y | x ≤ X ≤ x + ε) ∂y ε→0 ∂ P ({Y ≤ y} ∩ {x ≤ X ≤ x + ε}) lim ∂y ε→0 P (x ≤ X ≤ x + ε) F (x + ε. y) fX (x) f (x. In particular. . then Σ is a diagonal matrix and Ã k ! k X X V ar Xi = V ar (Xi ) i=1 i=1 A. ∂x1 · · · ∂xk For a measurable function g : Rk → Rs . Letting x = (x1 .. y) fX (x + ε) ∂2 ∂x∂y F (x.. . xk )0 ...

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

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

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

13) is the MGF of the density (A. For Z ∼ N(0. 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 . we see that the MGF of Z 2 is (1 − 2t)−1/2 .11) is Z ∞ ¢ ¡ Γ r+1 2 f (x) = ´ r+1 ¡r¢ ³ √ 2 2 πrΓ 2 1 + x r (A. which can be found by applying change-of-variables to the gamma function.8.12) E exp (tQ) = 0 Γ (A. Using the simple law of iterated expectations. The MGF for the density (A. From (A. tr has distribution 177 .6) can be used to show that the MGF j=1 ¥ Proof of Theorem A. 1) and Q ∼ χ2 be independent. q Proof of Theorem A. Since we can write Q = P 2 X 0 X = r Zj where the Zj are independent N(0.3 Let Z ∼ N (0. ¡ ¢ √ using the change—of-variables s = x2 and the fact Γ 1 = π. Proof of Theorem A. (A. C −1 CC 0 C −10 ) = N (0. Thus the density of Z 2 is (A. C −1 AC −10 ) = N (0.1.8. Set r Z . 1). Thus ¥ ¡ ¢0 ¡ ¢ Z 0 A−1 Z = Z 0 C −10 C −1 Z = C −1 Z C −1 Z ∼ χ2 . tr = p Q/r The density of tr is and is known as the student’s t distribution with r degrees of freedom. Then A−1 = C −10 C −1 and C −1 Z ∼ N (0. The fact that A > 0 means that we can write A = CC 0 where C is non-singular.8.2.11).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). which we showed in (A.13).3.8.Theorem A. Iq ).11) 2 with r = 1.

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

θ) ∂θ ∂θ which holds at θ = θ0 by (A. we can see that it is an estimator of the maximizer θ of the right-hand-side. ∂θ ∂θ (A. θ)¯ =0 ¯ ∂θ θ=θ0 H = Ω ≡ I0 (A. However. the MLE θ Why do we believe that the MLE ˆ is estimating the parameter θ? Observe that when stanθ dardized. ˆ is consistent θ for this value. n n i=1 n As the MLE ˆ maximizes the left-hand-side. θ Theorem A.Deﬁne the Hessian H = −E and the outer product matrix Ω=E µ ∂2 ln f (Yi . Theorem A. ˆ →p θ0 as n → ∞.16) (A. θ θ∈Θ ˆ In some simple cases. but these ˆ must be found by numerical methods. then θ V ar(˜ ≥ (nI0 )−1 . the restriction to unbiased estimators means that the theorem has little direct relevance for ﬁnite sample eﬃciency. under conventional regularity conditions.9. More typically.1 ¯ ¯ ∂ E ln f (Yi . θ0 ) ∂θ∂θ 0 (A. The maximum likelihood estimator or MLE ˆ is the parameter value which maximizes θ the likelihood (equivalently.2 Cramer-Rao Lower Bound. If ˜ is an unbiased estimator of θ ∈ R.14) ¶ ∂ ∂ 0 ln f (Yi .3 Under regularity conditions. the log-likelihood is a sample average 1X 1 Ln (θ) = ln f (Yi . and the equality (A. cases are rare.17) The matrix I0 is called the information.9. We can write this as ˆ = argmax Ln (θ). ´ ¡ −1 ¢ √ ³ˆ n θ − θ0 →d N 0. we can ﬁnd an explicit expression for θ as a function of the data.17) is often called the information matrix equality. 179 . θ0 ) .16). In fact. θ) ≡ L(θ). θ) →p E ln f (Yi . which maximizes the log-likelihood). The ﬁrst-order condition for the latter problem is 0= ∂ ∂ L(θ) = E ln f (Yi . I0 . θ0 ) ln f (Yi . θ) The Cramer-Rao Theorem gives a lower bound for estimation.9.15) Two important features of the likelihood are Theorem A.

Typically. 180 . In this case there is not a “true” value of the parameter θ. θ) dy which is the same as the minimizer of KLIC = Z f (y) ln µ f (y) f (y.17) does not hold.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. θ) = f (y) ln f (y. The QMLE is consistent for the pseudo-true value.9. θ) is used to approximate the true unknown density f (y). V ) . ˆ elements of n 0 Sometimes a parametric density function f (y. Thus the QMLE θ0 is the value which makes the parametric density “closest” to the true value according to this measure of distance. ˆ . θ) is necessarily the true density. ˆ ln f Yi . but it is not literally believed that the model f (y. but has a diﬀerent covariance matrix than in the pure MLE case. A minor adjustment to Theorem (A. to estimate the asymptotic variance of the MLE we use an estimate based on the Hessian formula (A. since the information matrix equality (A. Thus in large samples the MLE has approximately the best possible variance. θ V = H −1 ΩH −1 The moment estimator for V is ˆ where H is given in (A. Therefore the MLE is called asymptotically eﬃcient. θ (A.3) yields the asymptotic distribution of the QMLE: ´ √ ³ n ˆ − θ0 →d N (0.18) H =− n ∂θ∂θ0 i=1 the Kullback-Leibler information distance between the true density f (y) and the parametric density f (y. Instead we deﬁne the pseudo-true value θ0 as the maximizer of Z E ln f (Yi .ˆ ˆ−1 θ We then set I0 = H −1 . the approximate variance of the MLE is (nI0 )−1 which is the CramerRao lower bound.14) n ³ ´ 1 X ∂2 ˆ ˆ ln f Yi . Asymptotic standard errors for ˆ are then the square roots of the diagonal −1 I −1 . θ) ¶ dy Thus in large samples. θ θ Ω= n ∂θ ∂θ n i=1 ˆ ˆ ˆˆ V = H −1 ΩH −1 Asymptotic standard errors (sometimes called qmle standard errors) are then the square roots of ˆ the diagonal elements of n−1 V . θ) θ In this case. θ).

function of the data. θ0 = ln f (Yi . θ0 )2 (Yi . Proof of Theorem A. ∂θ ¯θ=θ0 Z ! = 0..9. θ) d˜ θ = Eθ θ(˜ y y where y = (y1 . (Yi .1. θ0 ) ∂ ∂ − ln f (Yi . θ) d˜ = ˜ y ) ∂ ln f (˜. θ0 ) ∂θ f (Yi . To see (A. θ0 )0 f (Yi .16). f (Yi . θ0 ) − f (Yi .17). θ0 ) dy ¯ ¯ ¯ θ=θ0 f (y. θ) dy ¯ ¯ ∂θ θ=θ0 ¯ ∂ ¯ 1¯ = 0. θ0 ) ∂θ ∂θ n i=1 which by Theorem (A.. θ0 ) f (Yi .. θ0 ) ∂θ ∂θ ¥ ³ ´ X ∂ ∂ ˜ ln fn Y . . θ) f (˜. θ0 ) ∂ ∂θ f ∂ (Yi . Write the estimator ˜ = ˜ Y ) as a θ θ( ˜ ˜ is unbiased for any θ. θ0 )0 .Proof of Theorem A.9.2. S= ∂2 f ∂θ∂θ0 ∂2 f ∂θ∂θ0 ∂ ∂θ Z Ã ∂2 f ∂θ∂θ0 ¯ ¯ ln f (y. θ0 ) ¯ ∂ f (y. V ar (S) nH so ¥ 181 . Diﬀerentiating with respect to θ and evaluating at θ0 yields ˜ Z Z ³ ´ ˜ y ) ∂ f (˜.9. θ0 ) (Yi .1) has mean zero and variance nH. we can show that E By direction computation. θ) ¯θ=θ0 ¯ Z ¯ ∂ f (y. ∂2 ln f (Yi . θ) f (y. θ0 ) ln f (Yi . θ)¯ = ¯ ∂θ θ=θ0 = = = Similarly. 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 f (y. ¯ ¯ ∂ E ln f (Yi . Since θ Z ˜ = ˜ y)f (˜. θ0 ) = ∂θ∂θ0 = Taking expectations yields (A. yn ). θ0 ) d˜ = E ˜ .

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

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

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

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

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