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

This manuscript may be printed and reproduced for individual or instructional use, but may not be printed for commercial purposes.

1

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

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

. . . . . . . . . . . . . .9 Cointegrated VARs . . . . . . . . . . . . . . . . iv . . . . .2 Fixed Eﬀects . . . . . . . . . . . . . . .1 Kernel Density Estimation . . 13. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . B. . . . . . . . 15 Panel Data 157 15. . . . 13. . . . . . . . . . 159 16 Nonparametrics 160 16.2 Estimation . . .4 Sample Selection . . . . . . . . . . . . . . . . . .2 Count Data . . . . . . . . . . . . . . . . . . . . . . . . .9 Maximum Likelihood . . . . . . . . . . . . . . . 145 145 146 146 147 147 148 148 149 149 151 151 153 153 154 . . . . . . . . A. . .3 Expectation . . . . . . . . . . . . . . . . . . . . . 14. . . . . . . . . . . . . . . . . . . . . . . .1 Foundations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Binary Choice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A. . . . 157 15. . . . . . .8 Cointegration . . . . . . . . . . . .3 Derivative-Free Methods . . . . . . . . . A. .13 Multivariate Time Series 13. 14. . . . . .8 Normal and Related Distributions . . . . . . . . . . . . . . . . . . . . . . . . A. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Grid Search . . . . . . . . . . . . . . .7 Transformations . . .2 Gradient Methods . . . . . . . . .2 Asymptotic MSE for Kernel Estimates . . . . . . . . . . . . . . . . . . . . . . 14 Limited Dependent Variables 14. . . . 165 165 167 168 169 171 173 175 175 178 183 183 184 185 . . . . . . . . . . . . . . . . . . . . . . . . . . . .6 Selection of Lag Length in an VAR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160 16. . . . . . . . . . .4 Common Distributions . . . . . . . . . . . . . . . . . . . . . . .2 Random Variables . B Numerical Optimization B. . . . . . .3 Restricted VARs .1 Vector Autoregressions (VARs) . 13. . . . . . . . . . . . . . . . . . . . A. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157 15. . . . .6 Conditional Distributions and Expectation . . . . . . . . 13. 162 A Probability A. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5 Testing for Omitted Serial Correlation 13. . . . . . . . . . . . . . . . . . A. . A. .1 Individual-Eﬀects Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13. . . . . . . . . A. . . . . . . . . . . . . . . . . . . .3 Censored Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .7 Granger Causality . . . . . . . . . . . . . . . . . . . . . . . . 14. .4 Single Equation from a VAR . . . . .5 Multivariate Random Variables . .3 Dynamic Panel Regression . . . . . 13. . . . . . . . B. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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

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

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

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

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

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

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

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

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

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

1 displays the density1 of hourly wages for men and women. These are asymmetric (skewed) densities. the mean is not necessarily a good summary of the central tendency. the conditioning variable. The data are from the 2004 Current Population Survey 1 11 .1) xi = ⎜ . ⎟ . This is used when the goal is to quantify the impact of one set of variables on another variable. (3.22. . and that for women is $20. In this context we partition the observations into the pair (yi . or the covariates. the conditional density of yi given xi . You can see that the right tail of then density is much thicker than the left tail. and exists so long as E |yi | < ∞. The two density curves show the eﬀect of gender on the distribution of wages. See Chapter 16. from the population of white non-military wage earners with a college degree and 10-15 years of potential work experience.2) m(x) = E (yi | xi = x) = −∞ In general. xki 3. These are indicated in Figure 3. An important summary measure is the conditional mean Z ∞ yf (y | x) dy. To illustrate. which is a common feature of wage distributions.1. Figure 3. In this context it is often convenient These are nonparametric density estimates using a Gaussian kernel with the bandwidth selected by crossvalidation. it is useful to have numerical measures of the diﬀerence.73.1 by the arrows drawn to the x-axis. When a distribution is skewed. While it is easy to observe that the two densities are unequal. m(x) can take any form.1. We call yi the dependent variable. holding the other variables constant. These are conditional density functions — the density of hourly wages conditional on race.Chapter 3 Regression and Projection The most commonly applied econometric tool is regression. We call xi alternatively the regressor. we can focus on f (y | x) . xi ) where yi is a scalar (real-valued) and xi is a vector. In the example presented in Figure 3. education and experience. ⎠ ⎝ . We list the elements of xi in the vector ⎞ ⎛ x1i ⎜ x2i ⎟ ⎟ ⎜ (3. gender. Take a closer look at the density functions displayed in Figure 3.1 Conditional Mean To study how the distribution of yi varies with the variables xi in the population. the mean wage for men is $27.

For this reason. When the distribution of the control variable is continuous.36. 2 (3.30.2 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. implying an average 36% diﬀerence in wage levels.1: Wage Densities for White College Grads with 10-15 Years Work Experience to transform the data by taking the (natural) logarithm. The conditional expectation function is close to linear. 3. Of particular interest to graduate students may be the observation that diﬀerence between a B. Figure 3.A.2) evaluated at the observed value of xi : ei = yi − m(xi ). To illustrate. wage regressions typically use log wages as a dependent variable rather than the level of wages. 12 .3 is how the conditional expectation describes an important feature of the conditional distribution. this yields the formula yi = m(xi ) + ei . the dashed line is a linear projection approximation which will be discussed in the Section 3. By construction. The comparison in Figure 3. Assuming for simplicity that this is the true joint distribution. Figure 3. the solid line displays the conditional expectation of log wages varying with education. The diﬀerence in the log mean wage between men and women is 0. The main point to be learned from Figure 3. degree in mean log hourly wages is 0. and a Ph. which implies a 30% average wage diﬀerence for this population.2 shows the density of log hourly wages for the same population.D.Figure 3.3 displays a scatter plot2 of log wages against education levels.5.3) White non-military male wage earners with 10-15 years of potential work experience. then comparisons become more complicated. This is a more robust measure of the typical wage gap between men and women than the diﬀerence in the untransformed wage means.1 is facilitated by the fact that the control variable (gender) is discrete.

3. by the deﬁnition of ei and the linearity of conditional expectations. A regression model imposes further restrictions on the joint distribution. E (h(xi )ei ) = 0 for any function h (·) . most typically. E (ei | xi ) = E ((yi − m(xi )) | xi ) = m(xi ) − m(xi ) = E (yi | xi ) − E (m(xi ) | xi ) = 0. restrictions on the permissible class of regression functions m(x). 13 .2: Log Wage Densities Theorem 3. E (ei | xi ) = 0. The remaining parts of the Theorem are left as an exercise. To show the ﬁrst statement. are often stated jointly as the regression framework. These equations hold true by deﬁnition. 2. 4. The equations yi = m(xi ) + ei E (ei | xi ) = 0.2. It is important to understand that this is a framework. not a model. because no restrictions have been placed on the joint distribution of the data. E(xi ei ) = 0.1 Properties of the regression error ei 1.Figure 3. E(ei ) = 0.

The expected squared error using this prediction function is E (yi − g(xi ))2 = E (ei + m(xi ) − g(xi ))2 = Ee2 + 2E (ei (m(xi ) − g(xi ))) + E (m(xi ) − g(xi ))2 i = Ee2 + E (m(xi ) − g(xi ))2 i ≥ Ee2 i where the second equality uses Theorem 3. when σ 2 (x) is a constant so that ¢ ¡ (3.4) 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 . subject to the restriction p that it is non-negative. 3. Given the random variable xi . The right-hand-side is minimized by setting g(x) = m(x). i . the conditional variance of yi is σ 2 = σ 2 (xi ). σ 2 (x) is a non-trivial function of x. In contrast.3. let g(x) be an arbitrary predictor of yi given xi = x. it does not provide information about the spread of the distribution. in the sense of achieving the lowest mean squared error. To see this. and can take any form.3 Conditional Variance Generally.1.Figure 3. The conditional standard deviation is its square root σ(x) = σ 2 (x). A common measure of the dispersion is the conditional variance ¡ ¢ σ 2 (x) = V ar (yi | xi = x) = E e2 | xi = x . In the general case i where σ 2 (x) depends on x we say that the error ei is heteroskedastic. Thus the mean squared error is minimized by the conditional mean.2.

⎟ β=⎝ . The conditional standard deviation for men is 12.5 Best Linear Predictor While the conditional mean m(x) = E (yi | xi = x) is the best predictor of yi among all functions of xi .5) xi = ⎜ . So while men have higher average wages.3) can be writen as yi = x0 β + ei i E (ei | xi ) = 0. it is convenient to augment the regressor vector xi by listing the number “1” as an element. and the linear assumption of the previous section is empirically unlikely to accurate. Thus (3.1) has been redeﬁned as the k × 1 vector ⎛ ⎞ 1 ⎜ x2i ⎟ ⎜ ⎟ (3. xki When m(x) is linear in x. Instead.6) as an approximation. i (3. take the conditional wage densities displayed in Figure 3. which we derive in this section. 3.1). An important special case is homoskedastic linear regression model yi = x0 β + ei i E (ei | xi ) = 0 ¢ ¡ E e2 | xi = σ 2 . ⎠ . its functional form is typically unknown.1. This concept is less helpful than deﬁning heteroskedasticity as the dependence of the conditional variance on the observables xi . it is more realistic to view the linear speciﬁcation (3. we can write it as m(x) = x0 β = β 1 + x2i β 2 + · · · + xki β k where ⎞ β1 ⎜ . βk ⎛ (3. we assume that x1i = 1. they are also somewhat more dispersed.6) (3. ⎠ . Some textbooks inappropriately describe heteroskedasticity as the case where “the variance of ei varies across observation i”.7) is a k × 1 parameter vector.3) is when the conditional mean function m(x) is linear in x (or linear in functions of x). In this case (3. As an example.1 and that for women is 10. 15 .8) is called the linear regression model.9) 3. We call this the “constant” or “intercept”. Equivalently. Notationally.8) (3. ⎟ . ⎝ .5. where x1i is the ﬁrst element of the vector xi deﬁned in (3.4 Linear Regression An important special case of (3. Equation (3.we say that the error ei is homoskedastic.

alternative expressions such as E xixi ) or E (xi yi ) (E (xi x0 ))−1 i ( i 0i ) are incoherent and incorrect. E (xi x0 ) is a mai E(x y trix and E (xi yi ) is a vector. The vector (3. i 4.1. i i (3. In order for β to be uniquely deﬁned. Assumption 3.5.11) 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 .10) It is worth taking the time to understand the notation involved in this expression. The error is i ei = yi − x0 β. E (x0 xi ) < ∞. i which requires that for all non-zero α. Rewriting. E (xi x0 ) is invertible. We now summarize the assumptions necessary for its derivation and list the implications in Theorem 3. Eyi < ∞. It is invertible if and only if it is positive deﬁnite.which is quadratic in β.10) exists and is unique as long as the k ×k matrix E (xi x0 ) is invertible. we obtain a decomposition of yi into linear predictor and error yi = x0 β + ei . otherwise they are distinct. The ﬁrst-order condition for minimization (from Section 2. 3.1 1.5. The best linear predictor is obtained by selecting β to minimize S(β). i (3. i (3. α0 E (xi x0 ) α = E (α0 xi )2 > 0. Equivalently. i 16 . Observe i that for any non-zero α ∈ Rk . there cannot i exist a non-zero vector α such that α0 xi = 0 identically. i ∂β ¢¢−1 ¡ ¡ E (xi yi ) . 2 2. As before. Therefore. 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.7) is 0= Solving for β we ﬁnd ¡ ¢ ∂ S(β) = −2E (xi yi ) + 2E xi x0 β. by “best” we mean the predictor function with lowest mean squared error. xi contains an intercept. Given the deﬁnition of β in (3.12) This completes the derivation of the linear projection model. 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 . this situation must be excluded. x0 β is the best linear predictor for yi . 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. This occurs when redundant variables are included in xi .10).

5.4 is required to ensure that β is uniquely deﬁned.2 and 3. For example.1 are weak. Since from Theorem 3. Furthermore.1.1. suppose that for xi ∈ R that Ex3 = 0 and ei = x2 . i i i Since E (xi ei ) = 0 we say that xi and ei are orthogonal.5.1.5.1.2 and 3. ¥ (3. Assumption 3.13) The two equations (3. x0 β is the i projection of yi on xi since the error ei is orthogonal with xi .4: Hourly Wage as a Function of Experience The conditions listed in Assumption 3.4 we know that the regression error has the property E (xi ei ) = 0. By deﬁnition.10) and (3. it follows that linear regression is a special case of the projection model.4 guarantees that the solution β exits.Theorem 3. 17 .8)-(3.13) and Assumption 3. Then i i Exi e2 = Ex3 = 0 yet E (ei | xi ) = x2 6= 0. This means that the equation (3.10) are deﬁned. Figure 3. (3. Assumption 3. the converse is not true as the projection error does not necessarily satisfy E (ei | xi ) = 0. Assumption 3.5.14) follows from (3.5.5.3 ensure that the moments in (3.1.5.2.1.3 are called regularity conditions.12) and (3.14) Proof.13) implies that xi and ei are uncorrelated. E (xi ei ) = 0 and E (ei ) = 0.1.14).1.14) holds.13) summarize the linear projection model. Let’s compare it with the linear regression model (3.9).1 Under Assumption 3.1 is employed to guarantee that (3. (3. Equation (3.5. However.1. Assumption 3.10) ¡ ¡ ¢¢ E (xi ei ) = E xi yi − x0 β i ¡ ¢¡ ¡ ¢¢−1 E (xi yi ) = E (xi yi ) − E xi x0 E xi x0 i i = 0.1.5. Using the deﬁnitions (3.5.1. Since ei is mean zero by (3.5. the orthogonality restriction (3.12) can be alternatively interpreted as a projection decomposition.11) and (3. The ﬁnite variance Assumptions 3.11) are well deﬁned.

xi ) we can deﬁne a linear projection equation (3.3.10). 18 . In this example it is a much better approximation to the conditional mean than the linear projection. for those over 53 in age). In contrast. there are no changes in our methods or analysis.5. In Figure 1. However. In this case the linear projection is a poor approximation to the conditional mean. In this case (3.5: 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.5. the dashed line is the linear projection of log wages on eduction. It over-predicts wages for young and old workers.We have shown that under mild regularity conditions. Figure 3.10) may not hold and the implications of Theorem 3. and the straight dashed line is the linear projection. In the example just presented. we can augment the regressor vector xi to include both experience and experience2 . since the resulting function is quadratic in experience. in many economic models the parameter β may be deﬁned within the model. The solid line is the conditional mean. This defect in linear projection can be partially corrected through a careful selection of regressors. In this example the linear projection is a close approximation to the conditional mean. Figure 3.5 for a 3 In the population of Caucasian non-military male wage earners with 12 years of education. We illustrate the issue in Figure 3. and are discussed in Chapter 11.12) with the properties listed in Theorem 3. A projection of log wages on these two variables can be called a quadratic projection.4 displays the relationship3 between mean log hourly wages and labor market experience. and under-predicts for the rest.1. Most importantly. Other than the redeﬁnition of the regressor vector. it is important to not misinterpret the generality of this statement.12) is deﬁned by projection and the associated coeﬃcient deﬁnition (3. No additional assumptions are required. for any pair (yi . it misses the strong downturn in expected wages for those above 35 years work experience (equivalently. The linear equation (3.4 we display as well this quadratic projection. Returning to the joint distribution displayed in Figure 3. These structural models require alternative estimation methods.1 may be false. In other cases the two may be quite diﬀerent.

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

.6 Exercises 1. taking values only on the non-negative integers. 20 . then E(x2 ei ) = 0. Prove parts 2. 1. If yi = x0 β + ei . Suppose that yi is discrete-valued. Show that x y β 1 = σ xy /σ 2 and β 0 = µy − β 1 µx . σ = . 0 ≤ y ≤ 1. µx = Exi . If yi = xi β + ei . If yi = xi β + ei . m. Compute E(yi | xi = x) and V ar(yi | xi = x). xi ∈ R.. j! 0 j = 0.2.4 . then ei is independent of xi .1 . x 6. (x − µ)2 − σ 2 Show that Eg (X. Compute 2 the coeﬃcients of the linear projection yi = β 0 + β 1 xi + ei . If yi = x0 β + ei and E(xi ei ) = 0. y) = 3 x2 + y 2 on 0 ≤ x ≤ 1. Let X be a random variable with µ = EX and σ 2 = V ar(X). and the conditional distribution of yi given xi is Poisson: P (yi = k | xi = x) = e−x β (x0 β)j . True or False. and E(e2 | xi ) = 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 . e−λ λj j! . Compute the conditional mean m(x) = E (yi | xi = x) . xi ∈ R. E(Y 2 | X = x) and V ar(Y | X = x). a constant. E(ei | xi ) = 0. 2. Does this justify a linear regression model of the form yi = x0 β + εi ? i then EY = λ and V ar(Y ) = λ. i 10. i 11. True or False. and have the following joint probability distribution X=0 X=1 Y =0 . True or False. Let xi and yi have the joint density f (x. i 7. True or False. 3 and 4 of Theorem 3. µ. True or False. s) = 0 if and only if m = µ and s = σ 2 . If yi = x0 β + ei and E(ei | xi ) = 0. and E(ei | xi ) = 0. 9. then ei is i i independent of xi .1. then E(x2 ei ) = 0. σ 2 = V ar(yi ) and σ xy = Cov(xi . Suppose that Y and X only take the values 0 and 1. and E(xi ei ) = 0. .3. then E(ei | xi ) = 0. Are they diﬀerent? Hint: If P (Y = j) = 5. i 8. Deﬁne µ ¶ ¢ ¡ x−µ 2 g x. yi ). 2.2 Y =1 .3 Find E(Y | X = x). σ 2 = V ar(xi ). ¡ ¢ 4. 3.

2) can be written in the parametric 0 β)) = 0.8. we narrow the focus to the linear regression model.3) writes the projection coeﬃcient β as an explicit function of population moments E (xi yi ) and E (xi x0 ) .3) In Sections 4. Their moment estimators are the sample moments i ˆ E (xi yi ) = ¢ ¡ ˆ E xi x0 = i 1X xi yi n 1 n i=1 n X i=1 n xi x0 . (4.4) i i=1 i=1 ˆ Another way to derive β is as follows. 4.2) (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 . i n i=1 n 21 . but for most of the chapter we retain the broader focus on the projection model. The function g(β) can be estimated by form g(β) = E (xi (yi − xi g (β) = ˆ ¢ 1X ¡ xi yi − x0 β .1) (4.Chapter 4 Least Squares Estimation This chapter explores estimation and inference in the linear projection model yi = x0 β + ei i E (xi ei ) = 0 ¡ ¡ ¢¢−1 E (xi yi ) β = E xi x0 i (4.1 Estimation Equation (4. i It follows that the moment estimator of β replaces the population moments in (4. Observe that (4.7 and 4.

30 + 0.14 205. excluding military.14 14. Let yi be log wages and xi be an intercept and years of education. n X i=1 2 yi − 2β 0 n X i=1 xi yi + β 0 n X i=1 xi x0 β.95 xi yi = 42. with 10-15 years of potential work experience. Then µ ¶ n 1X 2. consider the data used to generate Figure 3. 40 0. An interpretation of the estimated equation is that each year of education is associated with an 11.83 µ We often write the estimated equation using the format \ log(W agei ) = 1.2 Least Squares There is another classic motivation for the estimator (4. i 22 . 30 = .3.95 42.83 ¶−1 µ ¶ .117 1 14.40 n i=1 1 n Thus ˆ β = n X i=1 xi x0 i = µ 1 14. 0. To illustrate.170 37.14 14.40 µ ¶µ ¶ 34.71 = −2.94 −2. This sample has 988 observations.ˆ This is a set of k equations which are linear in β. ¶ 2.7% increase in mean wages.4). These are white male wage earners from the March 2004 Current Population Survey.5) = n n 1X 1X ˆ xi yi − xi x0 β i n n i=1 i=1 whose solution is (4.14 205.37 µ ¶ 1. 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. 4. 40 2.4). 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 (4.117 Educationi .

Figure 4. which can cause confusion. i ˆ ˆ Note that yi = yi + ei . The error is unobservable. while the residual is a by-product of estimation. These two ˆ variables are frequently mislabeled. It is important to understand the distinction between the error ei and the residual ei .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 (4.4).1: Sum-of-Squared Errors Function As a by-product of OLS estimation.The Ordinary Least Squares (OLS) estimator is the value of β which minimizes Sn (β).1 displays an example sum—of-squared errors function Sn (β) for the case k = 2. we deﬁne the predicted value ˆ yi = x0 β ˆ i and the residual ˆ ei = yi − yi ˆ ˆ = yi − x0 β. 23 . Following convention we will call β the OLS estimator of β. Matrix calculus (see Appendix 2. the contour lines are ellipses. Since the function Sn (β) is a quadratic function of β. Figure 4. To visualize the sum-of-squared errors function. Figure 4.2 displays the contour lines of the same function — horizontal slices at equally spaced heights.

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

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

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

4.5

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

18) E (e | X) = ⎜ E (ei | X) ⎟ = ⎜ E (ei | xi ) ⎟ = 0.8)(3. the OLS estimator of β 2 and the OLS residuals e may be equivalently computed by either the OLS regression (4. . Regress Y on X1 . which you may have seen in an introductory econometrics course. or yi − y on x2i − x2 : ˆ β2 = Ã n X i=1 (x2i − x2 ) (x2i − x2 ) 0 !−1 Ã n X i=1 (x2i − x2 ) (yi − y) . The FWL theorem says that β 2 is the OLS estimate from a regression of ˜ ˜ Y on X2 . . obtain OLS estimates β 2 and residuals e. Regress X2 on X1 . ˆ which are “demeaned”. obtain residuals Y .7 Bias and Variance In this and the following section we consider the special case of the linear regression model (3. the primary use is theoretical. A common application of the FWL theorem. . Partition X = [X1 X2 ] where X1 = ι is a vector of ones. is the demeaning formula for regression. ! Thus the OLS estimator for the slope coeﬃcients is a regression with demeaned data.6.1 (Frisch-Waugh-Lovell). 4. . Regress Y on X2 . ˜ 2.13). ⎟ ⎜ ⎟ ⎜ (4. and X2 is the vector of observed regressors. ¡ ¢−1 0 ι. . 30 . ˆ ˜ ˜ ˆ 3. the FWL theorem can be used to speed computation. ⎠ ⎝ ⎠ ⎝ . .9). In some contexts. but in most cases there is little computational advantage to using the two-step algorithm. 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.14) or via the ˆ following algorithm: ˜ 1. In this case. Rather. observe that ⎞ ⎛ ⎞ ⎛ . . In this section we derive the small sample conditional mean and variance of the OLS estimator. By the independence of the observations and (3. obtain residuals X2 . In the model (4.Theorem 4. . .9). .

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 ) = 0.19) ˆ and thus the OLS estimator β is unbiased for β. ⎠ (4. and (4. σ2 n ⎞ We now calculate the ﬁnite sample bias of the method ¡ moments estimator σ 2 for σ 2 . 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. Then given (4. We have shown that which implies ³ ´ ˆ E β|X =β ³ ´ ˆ E β =β (4. the properties additional assumption of conditional homoskedasticity E ei i of projection matrices. . for any random vector Z deﬁne the covariance materix V ar(Z) = E (Z − EZ) (Z − EZ)0 = EZZ 0 − (EZ) (EZ)0 . . Next. the properties of conditional expectations. X 0 DX = X 0 Xσ 2 . .. From (4.8). .19) we see that ¶ µ³ ³ ´ ´³ ´0 ˆ ˆ ˆ V ar β | X = E β−β β−β |X = where The i’th diagonal element of D is ¡ ¢ D = E ee0 | X . and the trace operator observe that. and ³ ´ ¡ ¢−1 2 ˆ σ .. σ2 = ˆ ¢ 1 ¡ ¢ 1 0 1 1 1 ¡ e e = e0 M M e = e0 M e = tr e0 M e = tr M ee0 ˆˆ n n n n n 31 In the special case of the linear homoskedastic regression model.20) . σ 2 } = ⎜ .. . under the of ˆ ¢ 2 | x = σ 2 . 1 n .Using (4. σ 2 = σ 2 and we have the simplii ﬁcations D = In σ 2 . V ar β | X = X 0 X ⎟ ⎟ ⎟.. 0 0 ··· 0 0 . .18). ⎝ . .12).

says that the least-squares estimator is the best choice. In the homoskedastic linear regression model. or in the projection model. In this case. What is the best choice of A? The Gauss-Markov theorem. ˜ so β is unbiased if (and only if) A0 X = Ik . the best (minimumvariance) unbiased linear estimator is OLS. and thus can be written as ˜ β = A0 Y where A is an n × k function of X.Then ¢ ¡ E σ2 | X = ˆ ¢¤ 1 £ ¡ tr E M ee0 | X n ¡ ¢¤ 1 £ = tr M E ee0 | X n ¤ 1 £ tr M σ 2 = n n−k . ³ ´ ˜ E β | X = A0 Xβ. By a calculation similar to those of the previous section. 4. which we now present. As an alternative. however.8)¢ ¡ (3. It is important to remember. 32 .8 Gauss-Markov Theorem In this section we restrict attention to the homoskedastic linear regression model. known as the Gauss-Markov theorem. Now consider the class of estimators of β which are linear functions of i the vector Y. as it yields the smallest variance among all unbiased linear estimators. Thus since V ar (e | X) = In σ 2 under homoskedasticity.1 Gauss-Markov. Thus σ 2 is biased towards zero. The following result.8. 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. ˜ β L = A0 Y = A (Xβ + e) = β + Ae. It is not unbiased in the absence of homoskedasticity. ³ ´ ˜ V ar β | X = A0 V ar (e | X) A = A0 Aσ 2 .10). that this estimator is only unbiased in the special case of the homoskedastic linear regression model. The least-squares estimator is the special case obtained by setting A = X(X 0 X)−1 . the estimator ˆ 2 deﬁned (4.9) plus E e2 | xi = σ 2 . is a famous statement of the solution. = σ2 n the ﬁnal equality by (4. Theorem 4. we can write The “best” linear estimator is obtained by ﬁnding the matrix A for which this variance is the smallest in the positive deﬁnite sense. which is (3.

who established that in the projection model the OLS estimator has the smallest asymptotic meansquared error among feasible estimators. We discuss the intuition behind his result in this section. 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.. the class of potential estimators has been restricted to linear unbiased estimators.. 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. This latter restriction is particularly unsatisfactory. where 1 (·) is the indicator function. the deﬁnition (4. for ﬁnite r. Let A be any n×k function of X such that A0 X = Ik .. but we don’t know the probabilities. Note that X 0 C = 0. π r ) . As the data are multinomial. Not only has the class of models has been restricted to homoskedastic linear regressions.21) with the parameters ˆ π j replaced by the estimates π j : ⎞−1 ⎛ ⎞ ⎛ r r X X ˆ πj ξj ξ0 ⎠ ⎝ ˆ πj ξ j τ j ⎠ .9 Semiparametric Eﬃciency In the previous section we presented the Gauss-Markov theorem as a limited eﬃciency justiﬁcation for the least-squares estimator. the maximum likelihood estimator (MLE) is ¡ ¢ 1X 1 (yi = τ j ) 1 xi = ξ j πj = ˆ n i=1 n for j = 1. Suppose that the joint distribution of (yi . That is. xi ) is discrete. Set C = A − X (X 0 X)−1 .) In this discrete setting.. A broader justiﬁcation is provided in Chamberlain (1987). ¡ ¢ P yi = τ j . ˆ β mle = ⎝ j j=1 j=1 33 . The variance of the least-squares estimator is (X 0 X)−1 σ 2 and that of A0 Y is A0 Aσ 2 . ξ j ... Assume that the τ j and ξ j are known. .21) j j=1 j=1 Thus β is a function of (π 1 . . ¥ The Gauss-Markov theorem is an eﬃciency justiﬁcation for the least-squares estimator. but the π j are unknown.. and π j . r. (We know the values yi and xi can take. but it is quite limited in scope.5) as required. That is. 4. This property is called semiparametric eﬃciency.. It is suﬃcient to show that the diﬀerence A0 A − (X 0 X)−1 is positive semi-deﬁnite. π j is the percentage of the observations ˆ ˆ which fall in each category. and is a strong justiﬁcation for the least-squares estimator. j = 1.Proof.. The MLE β mle for β is then the analog of (4. . r for some constant vectors τ j . xi = ξ j = π j .3) can be rewritten as ⎞−1 ⎛ ⎞ ⎛ r r X X β=⎝ πj ξ j ξ 0 ⎠ ⎝ πj ξ j τ j ⎠ (4.

1.5. We can write the model as yi = x0 β 1 + x0 β 2 + ei 1i 2i E (xi ei ) = 0 where the parameter of interest is β 1 . (4.10) for the class of models satisfying Assumption 3.Substituting in the expressions for π j . if the data have a discrete distribution. He observes that the above argument holds for all multinomial distributions.22) 34 . 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 .4) is an asymptotically eﬃcient estimator for the parameter β deﬁned in (3. 1X xi x0 i n i=1 1X xi yi n i=1 n ˆ = β ols 4. Since this is a regular parametric model the MLE is asymptotically eﬃcient (see Appendix A. and thus so is the OLS estimator. Chamberlain (1987) extends this argument to the case of continuously-distributed data. ˆ r X j=1 πj ξ j ξ 0 ˆ j r n X1X ¡ ¢ = 1 (yi = τ j ) 1 xi = ξ j ξ j ξ 0 j n j=1 = 1 n 1 n i=1 n X X r i=1 j=1 n X i=1 ¡ ¢ 1 (yi = τ j ) 1 xi = ξ j xi x0 i = and r X j=1 xi x0 i πj ξ j τ j ˆ r n X1X ¡ ¢ = 1 (yi = τ j ) 1 xi = ξ j ξ j τ j n j=1 i=1 = r n ¡ ¢ 1 XX 1 (yi = τ j ) 1 xi = ξ j xi yi n = Thus ˆ β mle = Ã 1 n n i=1 j=1 n X i=1 xi yi !−1 Ã ! In other words.10 Omitted Variables xi = µ x1i x2i ¶ . and any continuous distribution can be arbitrarily well approximated by a multinomial distribution. He proves that generically the OLS estimator (4.9).

22). this is rarely a problem for applied econometric practice.11 Multicollinearity ˆ If rank(X 0 X) < k + 1. Typically. except in special cases.23) where is the coeﬃcient from a regression of x2i on x1i . the possibility of omitted variables bias should be acknowledged and discussed in the course of an empirical investigation. 4. Since the error is discovered quickly. or second. This happens when the columns of X are linearly dependent. When this happens. In general. log(p2 ) and log(p1 /p2 ). By construction. This is the situation when the X 0 X matrix is near singular. Typically there are limits. and the error as ui rather than ei . we regress yi on x1i only.23) is an estimate of γ 1 = β 1 + Γβ 2 rather than β 1 . then β is not deﬁned. when the columns of X are close to linearly dependent. the applied researcher quickly discovers the error as the statistical software will be unable to construct (X 0 X)−1 . because we have not said what it means for a matrix to be “near singular”. i. The more relevant issue is near multicollinearity.. Observe that γ 1 6= β 1 unless Γ = 0 or β 2 = 0.Now suppose that instead of estimating equation (4. This deﬁnition is not precise. 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. To see this. It is the consequence of omission of a relevant correlated variable. the general model will be free of the omitted variables problem. This is called strict multicollinearity. if X includes both the logs of two prices and the log of the relative prices.e. For example. there is some α such that Xα = 0.22) is zero. 35 . In this case. First. the coeﬃcient on x2i in (4. which is often called “multicollinearity” for brevity. Thus the short and long regressions have the same coeﬃcient on x1i only under one of two conditions. β 1 6= γ 1 .23) the short regression to emphasize the distinction. This is because the model being estimated is diﬀerent than (4. we calculate γ1 = ¡ ¡ ¢¢−1 E x1i x0 E (x1i yi ) 1i ¡ ¡ ¢¢−1 ¡ ¡ 0 ¢¢ 0 E x1i x1i β 1 + x0 β 2 + ei = E x1i x1i 2i ¢¢−1 ¡ ¢ ¡ ¡ E x1i x0 β 2 = β 1 + E x1i x0 1i 2i = β 1 + Γβ 2 ¢¢−1 ¡ ¢ ¡ ¡ E x1i x0 Γ = E x1i x0 1i 2i (4.22) the long regression and (4. Most commonly. log(p1 ). as many desired variables are not available in a given dataset. Goldberger (1991) calls (4. The diﬀerence Γβ 2 is known as omitted variable bias. 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 .22) by least-squares. To avoid omitted variables bias the standard advice is to include potentially relevant variables in the estimated model. this arises when sets of regressors are included which are identically related.

12 Inﬂuential Observations where X(−i) and Y(−i) are the data matrices omitting the i’th row.One implication of near singularity of matrices is that the numerical reliability of the calculations is reduced. We can see the eﬀect of collinearity on precision by observing that the asymptotic variance of a coeﬃcient ¡ ¢−1 approaches inﬁnity as ρ approaches 1.27) (4. A convenient alternative expression is ¡ ¢−1 ˆ ˆ xi ei ˆ (4. the worse the precision of the individual coeﬃcient estimates.−i = yi − x0 β (−i) = (1 − hi )−1 ei .25) below. the OLS estimator based on the sample excluding the i’th observation.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. 1] and sum to k. the change in the coeﬃcient estimate by deletion of the i’th observation depends critically on the magnitude of hi .26) As we can see. We derive expression (4. µ ¶−1 µ ¶ ³ ´ 2 σ2 1 ρ 1 −ρ ˆ|X = σ .24) β (−i) = X(−i) X(−i) is the i’th diagonal element of the projection matrix X (X 0 X)−1 X 0 . To investigate the possibility of inﬂuential observations. This equals ´−1 ³ 0 ˆ X(−i) Y(−i) (4. As a consequence. and 1 0 XX= n µ 1 ρ ρ 1 ¶ In this case The correlation ρ indexes collinearity. The hi take values in [0. = V ar β ρ 1 n n (1 − ρ2 ) −ρ 1 4. deﬁne the leave-one-out least-squares estimator of β. We can see this most simply in a homoskedastic linear regression model with two regressors yi = x1i β 1 + x2i β 2 + ei . it is statistically diﬃcult to disentangle the impact of β 1 from that of β 2 . since as ρ approaches 1 the matrix becomes singular. A more relevant implication of near multicollinearity is that individual coeﬃcient estimates will be imprecise. Thus the more “collinear” are the estimate σ 2 1 − ρ2 regressors. ˆ i A simple comparison yields that ˆ ei − ei. What is happening is that when the regressors are highly dependent.−i = (1 − hi )−1 hi ei . We can also deﬁne the leave-one-out residual ˆ ˆ ei. If the i’th observation 36 . that is. ˆ ˆ (4. In extreme cases it is possible that the reported calculations will be in error due to ﬂoating-point calculation diﬃculties. the precision of individual estimates are reduced.

27). ¢−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 .This implies has a large value of hi . The key is equation (2. Investigations into the presence of inﬂuential observations can plot the values of (4. 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 .4 which states that ¡ ¢ (A + BCD)−1 = A−1 − A−1 BC C + CDA−1 BC CDA−1 .25). which is considerably more informative than plots of the uncorrected residuals ei . ˆ We now derive equation (4.1) in Section 2.

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

ij i=1 j=1 (5.3) E |XY | ≤ (E |X|p )1/p (E |Y |q )1/q . 5.1) (5. If p > 1 and q > 1 and 1 p ⎞1/2 ⎛ m n XX ¡ 0 ¢1/2 |A| = tr A A =⎝ a2 ⎠ . ´1/2 ³ ´1/2 ³ E |Y |2 E |XY | ≤ E |X|2 Holder’s Inequality. If g(·) : R → R is convex. Cauchy-Schwarz Inequality. then its Euclidean norm is The following are an important set of inequalities which are used in asymptotic distribution theory. 41 . Triangle inequality |X + Y | ≤ |X| + |Y | . We list here some of the most critical deﬁnitions and inequalities. The Euclidean norm of an m × 1 vector a is Ã m !1/2 X ¡ 0 ¢1/2 = a2 .Chapter 5 Asymptotic Theory This chapter reviews the essential components of asymptotic theory. |a| = a a i i=1 If A is a m × n matrix. then (5.2) + 1 q = 1. then g(E(X)) ≤ E(g(X)). These approximations are bounded through the use of mathematical inequalities.1 Inequalities Asymptotic theory is based on a set of approximations. Jensen’s Inequality.

This is a probabilistic way of generalizing the mathematical deﬁnition of a limit. (E |X|p )1/p (E |Y |q )1/q ¥ µ ¶ ´ ³ U V 1 1 1/p 1/q ≤E + = + = 1.4) Proof of Jensen’s Inequality. For any strictly increasing function g(X) ≥ 0. as stated. Let U = |X|p /E |X|p and V = |Y |q /E |Y |q . =E U V p q p q Proof of Markov’s Inequality. then as n → ∞ n 1X Xn = Xi →p E(X). The WLLN shows that sample averages converge in probability to the population average. ¥ 5. Let a + bx be the tangent line to g(x) at x = EX. if for all δ > 0. Note EU = EV = 1. Applying expectations. n i=1 42 . Eg(X) ≥ a + bEX = g(EX).Markov’s Inequality. denoted Zn →p Z as n → ∞. Since g(x) is convex. If Xi ∈ Rk is iid and E |Xi | < ∞. p p p q which is (5. So for all x. tangent lines lie below it.1 Weak Law of Large Numbers (WLLN). 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 ) = + . ¥ Proof of Holder’s Inequality.3).2. (5.2 Weak Law of Large Numbers Let Zn ∈ Rk be a random vector. Set Y = g(X) and let f denote the density function of Y. P (g(X) > α) ≤ α−1 Eg(X). We say that Zn converges in probability to Z as n → ∞. n→∞ lim P (|Zn − Z| > δ) = 0. Then Z ∞ −1 P (Y > α) = α αf (y)dy Zα∞ ≤ α−1 yf (y)dy α Z ∞ ≤ α−1 yf (y)dy = α−1 E(Y ) −∞ the second-to-last inequality using the region of integration {y > α}. g(x) ≥ a + bx yet g(EX) = a + bEX since the curve is tangent at EX. Theorem 5.

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

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

If Zn →d Z as n → ∞ and g (·) is continuous. Ik ) distribution. then g(Zn ) →p g(c) as n → ∞.√ where λn → 0 lies on the line segment joining 0 and λ/ n.2 Continuous Mapping Theorem 2. √ Theorem 5. Σ) . for all ε > 0 we can ﬁnd a δ > 0 such that if |Zn − c| < δ then |g (Zn ) − g (c)| ≤ ε. 45 .4 Asymptotic Transformations Theorem 5. we see that as n → ∞. Since cλλ (λn ) → cλλ (0) = −Ik . Theorem 5. If Zn →p c as n → ∞ and g (·) is continuous at c. Stacking across elements of g. we ﬁnd jn ¢ ¡ √ √ 0 n (g (θn ) − g(θ0 )) = (gθ + an ) n (θn − θ0 ) →d gθ N (0.4. k ≤ m. Hence g(Zn ) →p g(c) as n → ∞. and g(θ) : Rm → Rk . Proof: Since g is continuous at c. Recall that A ⊂ B implies P (A) ≤ P (B). 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 . µ ¶ 1 Cn (λ) → exp − λ0 λ 2 the characteristic function of the N (0. where θ is m × 1 and Σ is m × m. Proof : By a vector Taylor series expansion.4. This is suﬃcient to establish the theorem. Thus P (|g (Zn ) − g (c)| ≤ ε) ≥ P (|Zn − c| < δ) → 1 as n → ∞ by the assumption that Zn →p c. for each element of g. gθ Σgθ .4. ¥ 5. It follows that ajn = gjθ (θ∗ ) − gjθ →p 0. gθ Σgθ where gθ (θ) = ∂ g(θ) ∂θ0 and gθ = gθ (θ0 ). then ¡ ¢ √ 0 n (g (θn ) − g(θ0 )) →d N 0.3 Delta Method: If n (θn − θ0 ) →d N (0. then g(Zn ) →d g(Z) as n → ∞. Σ) = N 0.1 Continuous Mapping Theorem 1 (CMT).

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

·) is continuous at (Q. 0) = Q−1 0 = 0 β−β =g n n i=1 i=1 ˆ which implies β →p β as stated.1).5. To characterize the sampling distribution more fully. using (6.1).1 and the WLLN (Theorem 5. (6. xi ei →p g (Q.1 Under Assumption 3.2.5.2. 0).2 Consistency ˆ As discussed in Section 6. (6. ¥ We can similarly show that the estimators σ 2 and s2 are consistent for σ 2 .4 implies that Q−1 exists and thus g(·. 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 .5.1. the OLS estimator β is has a statistical distribution which is unknown.3). n i=1 (6.1 by the fact that the sampling densities become more concentrated as n gets larger.4. Proof. β →p β as n → ∞. we can conclude ˆ that β →p β. xi ei = g i n n i=1 i=1 1X xi ei →p E (xi ei ) = 0.3) Ã where g(A. This is illustrated in Figure 6. A preliminary step in this approach is the demonstration that estimators are consistent — that they converge in probability to the true parameters as the sample size gets large.8) implies that ˆ β−β = Ã n X i=1 xi x0 i !−1 n X i=1 xi ei . Ã n ! n X 1X 0 1 ˆ xi xi . b) = A−1 b is a continuous function of A and b at all values of the arguments such that A−1 exist.From the ﬁgure we can see that the density functions are dispersed and highly non-normal. we will use the methods of asymptotic approximation. Assumption 3. Hence by the continuous mapping theorem (Theorem 5. and the continuous mapping theorem (Theorem 5. 6.1).1.2) i i n i=1 n From (6.1) imply that n ¡ ¢ 1X xi x0 →p E xi x0 = Q (6. Asymptotic (large sample) methods approximate sampling distributions based on the limiting experiment that the sample size n tends to inﬁnity. Assumption 3. ˆ Theorem 6. As the sample size increases the density becomes more concentrated about the population coeﬃcient.2). First.1) and ˆ We now deduce the consistency of β. (6. For a complete argument.1). ˆ 47 . Equation (4.4.1.

(6.3) and Theorem (6. σ 2 →p σ 2 and s2 →p σ 2 as n → ∞.1).2).1. (6.Theorem 6. ˆ n−k 6. ˆ Proof.1 guarantees that the elements of Ω are ﬁnite. since n/(n − k) → 1 as n → ∞. By the central limit theorem (Theorem 5. (6.3 Asymptotic Normality ˆ We now establish the asymptotic distribution of β after normalization. by the Cauchy-Schwarz inequality (5.2 Under Assumption 3. Thus σ 2 is consistent for σ 2 . ´1/2 ¡ ¯ ¯¢ ¯ ³ ¯ ¯2 ´1/2 ¡ ¯ 4 ¯¢1/2 ³ ¯ 1/2 E ¯xi x0 e2 ¯ ≤ E ¯xi x0 ¯ = E |xi |4 < ∞.5.2.5.3. (6. n 1 X √ xi ei →d N (0. Assumption 6.1).1 In addition to Assumption 3. i i Assumption 6.3. E ¯ei ¯ E ¯e4 ¯ i i i i (6.6) n i=1 48 . i Now deﬁne ¡ ¢ Ω = E xi x0 e2 . ˆ Finally.2).1. it follows that s2 = ¥ n σ 2 →p σ 2 . Ee4 < ∞ and E |xi |4 < ∞.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. Ω) .5) Thus xi ei is iid with mean zero and has covariance matrix Ω.3. Note that ˆ ei = yi − x0 β ˆ i i Thus and n ˆ = ei + x0 β − x0 β i i ³ ´ ˆ = ei − x0 β − β . To see this.2. We need a strengthening of the moment conditions.

but this is not a necessary condition. We say that ei is a Homoskedastic Projection Error when (6. is approximately normal when the sample size n is suﬃciently large. The trouble is that no matter how large is the sample size. e2 ) = 0.7) is true then V = V 0 .Then using (6. If α > 2 the 2 error εi has zero mean and variance α/(α − 2). after rescaling.8) Ω = E xi x0 E e2 = Qσ 2 i i V = Q−1 ΩQ−1 = Q−1 σ 2 ≡ V 0 (6. In this context the normalized least-squares slope estimator n α−2 β 2 − β 2 has α →d Q−1 N (0. for any ˆ ﬁxed n the sampling distribution of β can be arbitrarily far from the normal distribution. There is a special case where Ω and V simplify. This holds true for all joint distibutions of (yi . otherwise V 6= V 0 .2 we display the ﬁnite sample densities of the q ³ ˆ normalized estimator n α−2 β 2 − β 2 . |ε| ≥ 1. i i Condition (6. The expression V = Q−1 ΩQ−1 is called a sandwich form. as n → ∞ ´ √ ³ ˆ n β − β →d N (0. ´ √ ³ˆ As V is the variance of the asymptotic distribution of n β − β . How large should n be in order for the approximation to be useful? Unfortunately. However.9) In (6. V is often referred to as ˆ the asymptotic covariance matrix of β. xi ) which satisfy the conditions of Assumption 6.7) the asymptotic variance formulas simplify as ¡ ¢ ¡ ¢ (6.2). We call V 0 the homoskedastic covariance matrix. For α 49 .1.1.7) is true or false.3. however. The asymptotic distribution ´ Theorem 6. and (6. Q−1 ΩQ−1 .1 states that the sampling distribution of the least-squares estimator. Let yi = β 0 + β 1 xi + εi where xi is N (0. Ω) ¡ ¢ = N 0. ´ √ ³ ˆ n β−β = Ã 1X xi x0 i n i=1 n !−1 Ã Theorem 6. (6. Theorem 6.9) we deﬁne V 0 = Q−1 σ 2 whether (6.7) holds. when xi and ei are independent. 1) asymptotic distibution. for example. As α approaches 2. and εi is independent of xi with the Double Pareto density f (ε) = α |ε|−α−1 . 1).3.1 we have already seen a simple example where the least-squares estimate is quite asymmetric and non-normal even for reasonably large sample sizes.1 is commonly used to approximate the ﬁnite of √ ³ˆ sample distribution of n β − β . In Figure 6.3. 1 X √ xi ei n i=1 n ! the N (0. V ) where V = Q−1 ΩQ−1 . setting n = 100 and varying the parameter α. When (6.1). The approximation may be poor when n is small.6). We illustrate this problem using a simulation.3. the normal approximation is arbitrarily poor for some data distribution satisfying the assumptions.3. there is no simple answer to this reasonable question. its variance diverges q ³ ´ ˆ to inﬁnity. In´Figure 6. Under (6.7) Cov(xi x0 .1 Under Assumption 6.

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 (0.10) V 0 = Q−1 s2 .2 and 6. The lesson from Figures 6. As α diminishes the density changes signiﬁcantly. ˆ ˆ Since Q →p Q and s2 →p σ 2 (see (6.1) it is clear that V 0 →p V 0 .2: Density of Normalized OLS estimator α = 3.Figure 6. 1). We show the sampling distribution of n β 1 − β 1 setting n = 100. The estimator 2 2 in (6. The homoskedastic covariance matrix V 0 = Q−1 σ 2 is typically estimated by ˆ ˆ (6. concentrating most of the probability mass around zero. 6 and 8.0 the density is very close to the N (0. we need an estimate of Ω = E xi x0 e2 . Another example is shown in Figure 6. 1) asymptotic approximation is never guaranteed to be accurate. The MME estimator is i i 1X ˆ xi x0 e2 Ω= i ˆi n i=1 n (6. 4.3.11) 50 . 6.3 is that the N (0.10) without changing this result. for k = 1. 1) density. the sampling distribution becomes highly skewed and non-normal.2) and Theorem 6. As k increases. σ may also be substituted for s ˆ ¡ ¢ To estimate V = Q−1 ΩQ−1 .2.4 Let Covariance Matrix Estimation 1X ˆ xi x0 Q= i n i=1 n be the method of moments estimator for Q.

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

20 and µ ¶ ˆ = 0.83 ¶−1 = µ 7.199 2.14 14. p ˆ In this case the two estimates are quite similar. from which it follows that V →p V as n → ∞.6 Therefore the two covariance matrix estimates are µ ¶−1 µ ¶ 1 14.83 ¶−1 µ . just as any other estimator.2.83 −0.14 6. To illustrate.2/988 = .035 ¶ .020.12) i i n n n i=1 i=1 We now examine each sum on the right-hand-side of (6.3) so by the WLLN ³ ´ ³ ´3/4 ¡ ¯ ¯¢ 1/4 E |xi |3 |ei | ≤ E |xi |4 < ∞. (6.020) 6. but not under another set of assumptions. The standard errors for β 0 are 7. i i i i n i=1 Second.30 + 0.5 Consistency of the White Covariance Matrix Estimate 1X xi x0 e2 i ˆi n i=1 i=1 n ˆ ˆ We now show Ω →p Ω.98 −0.35/988 = .1) show that n ¡ ¢ 1X xi x0 e2 →p E xi x0 e2 = Ω. by Holder’s inequality (5.117 Educationi . E ¯e4 ¯ i ³ ´ 1X |xi |3 |ei | →p E |xi |3 |ei | .80 40.14 205.1. Ω 2. (6.480 ˆ0 = 0. and then the square roots. It is also important to understand that a particular standard error may be relevant under one set of model assumptions. Using (6.80 .6 ¶µ 1 14.5) and the WLLN (Theorem 5.14 205.085 p ˆ and that for β 1 is .80 40.493 −0.12) in turn. (. the standard method to calculate the standard errors is to ˆ ﬁrst calculate n−1 V .085) (.199 2.493 0. then take the diagonal elements. First.20 −0.14 14.used by an author when studying their work. we return to the log wage regression of Section 4. From a computational standpoint.14 205.80 2. We can write the estimated equation with standards errors using the format \ log(W agei ) = 1.20 = V 14. n n i=1 52 .039 and ˆ V = µ 1 14.4) 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 .480 . We calculate that s2 = 0.

n i=1 n ˆ ˆ Theorem 6. is deﬁned ˆ ˆ by replacing the OLS residual ei in (6.¯ ¯ ¯ ¯ˆ and thus since ¯β − β ¯ →p 0. Using this substitution. ¯ ¯n ¯ n i=1 so Together. 6. They also suggest that the scaling factor (n − 1)/n in (??) can be omitted.5. i=1 Third. Recall from Section 4. the jackknife estimator of the ˆ variance matrix for β is ˆ V ∗ = (n − 1) where n X³ ˆ β i=1 ¯ (−i) − β n ´³ ˆ β ¯ (−i) − β ´0 (6. Andrews’ proposed estimator is ˆ ˆ ˆ ˆ V ∗∗ = Q−1 Ω∗∗ Q−1 53 . From equation (3.−i = (1 − hi )−1 ei ˆ presented in (4.26).13) Using formula (4.25).12 the deﬁnition of β (−i) as the least-squares estimator with the i’th observation deleted.6 Alternative Covariance Matrix Estimators ˆ MacKinnon and White (1985) suggested a small-sample corrected version of V based on the jackˆ knife principle. you can show that 1 Xˆ ¯ β= β (−i) . MacKinnon and White (1985) present numerical (simulation) evidence i ˆ ˆ that V ∗ works better than V as an estimator of V . 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. Ω →p Ω and V →p V. ¯ ¯ ¯ ¯ ¯n ¯ n i=1 i=1 1X |xi |4 →p E |xi |4 .1 As n → ∞. Andrews (1991) suggested an similar estimator based on cross-validation. which. ¯ 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. these establish consistency. 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 0.14) 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 .13) of Efron (1982).11) with the leave-one-out estimator ei.

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

θ) β 6. we say that tn is an exactly pivotal statistic.16) ¥ Thus the asymptotic distribution of the t-ratio tn (θ) is the standard normal. 1) Proof. however. see Section X). Vθ ) √ Vθ = N (0. 1) →d ˆ−θ θ . and is therefore exactly free of unknowns. β 2 ). 55 . θ could be a single element of β). pivotal statistics are unavailable and so we must rely on asymptotically pivotal statistics. Since the standard normal distribution does not depend on the parameters. In special cases (such as the normal regression model. s(ˆ = n−1/2 H 0 V Hβ . that (so θ ˆ ˆ ˆ is. In general.1 tn (θ) →d N (0. the standard error for ˆ is the square root of n−1 Vθ . if R is a “selector matrix” R= so that if β = (β 1 . ˆ When q = 1q h(β) is real-valued). and θ = h(β) is some function of the parameter vector. µ I 0 ¶ ˆ the upper-left block of V . (For example. we say that tn (θ) is asymptotically pivotal. In this case. By (6. ˆ its estimate and s(ˆ its asymptotic θ θ) standard error. the statistic tn has an exact t distribution. s(ˆ θ) (6.8.15) tn (θ) = ˆ−θ θ s(ˆ θ) ´ √ ³ˆ n θ−θ q = ˆ Vθ N (0. A simple null and composite hypothesis takes the form H0 : θ = θ0 H1 : θ 6= θ0 where θ0 is some pre-speciﬁed value. Consider the studentized statistic tn (θ) = Theorem 6.8 t tests Let θ = h(β) : Rk → R be any parameter of interest.For example. then θ = R0 β = β 1 and ˆ Vθ = ¡ I 0 ¢ ˆ V µ I 0 ¶ ˆ = V11 .

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

and it is desired to test the joint restrictions simultaneously. We have the null and alternative H0 : θ = θ0 H1 : θ 6= θ0 . While there is no hard-and-fast guideline for choosing the coverage probability 1 − α.10 Wald Tests Sometimes θ = h(β) is a q × 1 vector. In this case the t-statistic approach does not work. ˆ + zα/2 s(ˆ . Thus values of θ within two standard errors of the estimated interval θ θ) θ θ) ˆ are considered “reasonable” candidates for the true value θ. = n h(β) − θ0 Hβ V Hβ 57 (6. However we often can calculate the asymptotic coverage probability limn→∞ P (θ ∈ Cn ).05. A good method for construction of a conﬁdence interval is the collection of parameter values which are not rejected by a statistical test. the most common professional choice isi95%. This corresponds to selecting the conﬁdence h i h ˆ ± 1.17) = ˆ − zα/2 s(ˆ θ and Cn is an asymptotic (1 − α)% conﬁdence interval. or α = . ˆ The natural estimate of θ is ˆ = h(β) and has asymptotic covariance matrix estimate θ ˆ0 ˆ ˆ ˆ Vθ = Hβ V Hβ where ∂ ˆ ˆ h(β). Hβ = ∂β The Wald statistic for H0 against H1 is ´0 ³ ´ ³ ˆ θ θ Wn = n ˆ − θ0 Vθ−1 ˆ − θ0 ´0 ³ ´−1 ³ ´ ³ ˆ ˆ ˆ0 ˆ ˆ h(β) − θ0 .18) . θ The interval has been constructed so that as n → ∞. We say that Cn has asymptotic (1 − α)% coverage for θ if P (θ ∈ Cn ) → 1 − α as n → ∞. ¢ ¡ ¢ ¡ P (θ ∈ Cn ) = P |tn (θ)| ≤ zα/2 → P |Z| ≤ zα/2 = 1 − α. and values of θ outside two standard θ errors of the estimated ˆ are considered unlikely or unreasonable candidates for the true value.96s(ˆ ≈ ˆ ± 2s(ˆ . The t-test of the previous setion rejects H0 : θ0 = θ if |tn (θ)| > zα/2 where tn (θ) is the t-statistic (6. θ θ) (6.16) and zα/2 is the upper α/2 quantile of the standard normal distribution.We typically cannot calculate the exact coverage probability P (θ ∈ Cn ). 6. 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).

025 .5. In this case.84 = z.15) showed that n ˆ − θ →d Z ∼ N (0. a chiq square random variable with q degrees of freedom. θ = β 2 . then the Wald statistic can be written in the form ¶ µ 2 ˆ σ − σ2 ˜ Wn = n (6. Also h(β) = a selector matrix. the test rejects at the α% level iﬀ pn < α.05) = 3. As before. q and pn is asymptotically U[0. An asymptotic Wald test rejects H0 in favor of H1 if Wn exceeds χ2 (α).10. Hβ (β) →p Hβ . then Wn →d χ2 . 1] under H0 . 6. We know that the Wald statistic takes the form 0 Wn = nˆ Vθ−1 ˆ θ ˆ θ ³ ´−1 ˆ ˆ0 ˆ β 2.1 Under H0 and Assumption 6. Vθ ). Thus Vθ = H 0 V Hβ →p H 0 V Hβ = Vθ > 0 if Hβ has full rank q.2. 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 . if rank(Hβ ) = q. so by the continuous mapping ˆ ˆ ˆ ˆ ˆ theorem. Furthermore.When h is a linear function of β. ˜˜ n ˜ e = Y − X1 β 1 . and there are q = k2 restrictions. For example.19) σ2 ˆ where σ2 = ˜ 1 0 e e. Wn = n R0 β − θ0 ´ √ ³ The delta method (6. Hβ (β) is a continuous function of β. = nβ 2 R0 V R R0 β is linear with R = µ 0 I ¶ ¢−1 ¡ ˆ ˆ ˆ .8. The asymptotic p-value for Wn is pn = p(Wn ). ˜ 58 ¡ 0 ¢−1 0 ˜ β 1 = X1 X1 X1 Y .1 showed θ ˆ that V →p V. χ2 (.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 .3. and Theorem 6. ˆ Wn = n θ θ q θ θ Theorem 6. then the Wald statistic takes the form ´0 ³ ´ ³ ´−1 ³ ˆ ˆ ˆ R0 V R R0 β − θ 0 . The null hypothesis is H0 : β 2 = 0. 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. h(β) = R0 β.1. where p(x) = P χ2 ≥ x is the tail q q probability function of the χ2 distribution. Hence β β by Theorem A. the upper-α quantile q 2 of the χ2 distribution.

19). This statistic is typically reported as an “F-statistic” which is deﬁned as ¡ 2 ¢ σ − σ 2 /k2 ˜ ˆ n − k Wn .19) the F form of the Wald statistic. Thus ¡ 0 ¢−1 R = X2 M1 X2 and ³ ¡ ´−1 ³ ¢−1 ´−1 ¡ 0 ¢ ˆ = σ −2 n−1 R0 X 0 X ˆ R = σ −2 n−1 X2 M1 X2 ˆ R0 V 0 R ³ ´−1 ˆ0 ˆ ˆ Wn = nβ 2 R0 V 0 R β2 = 0 ˆ ˆ0 β 2 (X2 M1 X2 ) β 2 . as the sum of squared errors is a typical output from statistical packages. still this formula often ﬁnds good use in reading applied papers. µ e0 e − e0 e ˜˜ ˆˆ e0 e ˆˆ ¶ =n µ σ2 − σ2 ˜ ˆ 2 σ ˆ ¶ . 59 . Now consider the residual regression of e on X2 = M1 X2 . X2 ). ˆ ¡ ¢−1 0 ˆ β = X 0X XY are from OLS of Y on X = (X1 . = F = n k2 σ 2 /(n − k) ˆ ¢−1 ¡ ˆ While it should be emphasized that equality (6. First. and σ2 = ˆ 1 0 e e. 2 σ ˆ To simplify this expression further. We now derive expression (6. since ˆ0 0 ˆ β 2 X2 M1 X2 β 2 = e0 e − e0 e. the residual is ˜ ˜ e = M1 Y. ˜ ˆ ˜ 2 β 2 + e and X 0 e = 0.are from OLS of Y on X1 . 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. Also.19) only holds if V 0 = σ 2 n−1 X 0 X ˆ . By the FWL theorem.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 . note that partitioned matrix inversion (2. ˜˜ ˆˆ ˆˆ σ 2 = n−1 e0 e ˆ we conclude that Wn = n as claimed. Because of this connection we call (6. The elegant feature about (6.19) is that it is directly computable from the standard output from two simple OLS regressions. ˆˆ n ˆ e = Y − X β. note that if we regress Y on X1 alone.

H 0 H) ∼ N (0. when an OLS regression is reported.3. This special F statistic is testing the hypothesis that all slope coeﬃcients (other than the intercept) are zero.12 Normal Regression Model As an alternative to asymptotic distribution theory. Since linear functions of normals are also normal. σ 2 ) can be be used to calculate a set of exact distribution results. This was a popular statistic in the early days of econometric reporting. Then (n − k) s2 σ2 1 0 ee ˆˆ σ2 1 0 e Me = σ2 ∙ ¸ 1 0 In−k 0 eH = H 0e 0 0 σ2 ∙ ¸ In−k 0 0 = u u 0 0 = ∼ χ2 . While there are special cases where this F statistic is useful. when sample sizes were very small and researchers wanted to know if there was “any explanatory power” to their regression. This is rarely an issue today. 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. In σ 2 . 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. Since uncorrelated normal variables are independent. introduced in Section 4. these cases are atypical. This is ¢ ¡ 2 ˆ σ y − σ 2 / (k − 1) ˜ F = . there is an exact distribution theory available for the normal linear regression model.4)) where H 0 H = In . including the estimated error variance 2. an “F statistic” is reported.where In many statistical packages. n−k 60 . The modelling assumption that the error ei is independent of xi and N (0. In particular. σ 2 /(n − k) ˆ σ2 = ˜y 1 (y − y)0 (y − y) n is the sample variance of yi . it follows ˆ that β is independent of any function of the OLS residuals. as sample sizes are typically suﬃciently large that this F statistic is highly “signiﬁcant”. equivalently the residual variance from an intercept-only model. 6. Let u = σ −1 H 0 e ∼ N (0. In ) . under the normality assumption the error vector e is independent of X and ¢ ¡ has distribution N 0.

β 2 ) and consider tests of the linear restriction H0 : β 2 = 0 H1 : β 2 6= 0 In the context of parametric models. The critical values are quite close if n − k ≥ 30. ˆ 2 2 2 ˜ ˜ The MLE of the model under the null hypothesis is (β 1 . with residual variance σ . 2 2 2 The LR statistic for H0 is ´ ³ ˆ ˆ ˆ ˜ ˜ LR = 2 Ln (β 1 . 0. The Gaussian log-likelihood at these estimates is ¡ ¢ n 1 ˆ ˆ ˆ σ Ln (β 1 . Theorem 6. σ2 ˆ 61 .1 shows that under the strong assumption of ˆ normality. (Unless the sample size is unreasonably small. β has an exact normal distribution and t has an exact t distribution. σ 2 ) discussed above. σ 2 ) = − log 2πˆ 2 − 2 e0 e ˆˆ 2 2ˆ σ ¡ ¢ n n n = − log σ 2 − 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.3. the notable distinction is between the N (0. We summarize these ﬁndings Theorem 6.12. so as a practical matter it does not matter which distribution is used. 0. 0. β 2 . σ ˆ ˆ βj − βj βj − βj N (0.8.1 we showed that in large samples.a chi-square distribution with n − k degrees of freedom. β and t are approximately normally distributed. σ 2 ) = − log σ − log (2π) − . if standard errors are calculated using the homoskedastic formula (6. The estimator under the alternative is the unrestricted estimator ˆ ˆ ˆ (β 1 . In contrast. which is twice the diﬀerence in the log-likelihood function evaluated under the null and alternative hypotheses. σ 2 ) − Ln (β 1 . The log-likelihood of this model is ¡ 2¢ n n n ˜ ˜ ˜ Ln (β 1 . As inference (conﬁdence intervals) are based on the t-ratio. σ 2 (X 0 X)−1 • (n−k)s2 σ2 ˆ β j −β j ˆ s(β ) j ∼ χ2 . σ 2 ).) Now let us partition β = (β 1 . β 2 .12.1 If ei is independent of xi and distributed N(0. n−k • ∼ tn−k ˆ In Theorem 6. β 2 .10) µ h i ¶ 2 (X 0 X)−1 N 0.10) then ´ ³ ˆ • β ∼ N 0. Furthermore. a good testing procedure is based on the likelihood ratio statistic. σ 2 ) where β 1 is the OLS estimate from ˜ 2 ˜ a regression of yi on x1i only.1 and Theorem 6. σ 2 ) ¡ ¢¢ ¡ ¡ ¢ ˆ = n log σ 2 − log σ 2 ˜ µ 2¶ σ ˜ = n log . and standard errors are calculated using the homoskedastic formula (6. 1) and tn−k distributions.

4 the Wald statistic Wn (s) as a function ˆ of s. features of this distribution can be calculated. This is an unfortunate feature of the Wald statistic. 6. we ﬁnd that the standard Wald test for H0 (s) is ´2 ³ s ˆ β −1 Wn (s) = n 2s−2 . To demonstrate this eﬀect. This is distressing since the choice of s seems arbitrary and irrelevant to the actual hypothesis. LR = n log 1 + 2 − 1 ' n σ ˆ σ2 ˆ the F statistic. Take the model yi = β + ei ei ∼ N (0. This produces random draws from the sampling distribution of interest. setting n/σ 2 = 10. as Wn (s) →d χ2 under H0 for 1 any s. 62 . one feature of importance is the Type I error of the test using the asymptotic 5% critical value 3. In the present context of the Wald statistic.8. 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. they can work quite poorly when the restrictions are nonlinear. σ 2 s2 β ˆ ˆ While the hypothesis β s = 1 is unaﬀected by the choice of s. It is easy to see that in each case there are values of s for which the line is for the case β test statistic is signiﬁcant relative to asymptotic critical values. The method uses random simulation to create an artiﬁcial dataset to apply the statistical tools of interest. while there are other values of s for which test test statistic is insigniﬁcant. σ2 ˆ Now notice that H0 is equivalent to the hypothesis H0 (s) : β s = 1 for any positive integer s. This can be seen by a simple example introduced by Lafontaine and White (1986).13 Problems with Tests of NonLinear Hypotheses While the t and Wald tests work well when the hypothesis is a linear restriction on β.84 — the probability of a false rejection. Letting h(β) = β s . The decreasing dashed ˆ = 1. σ 2 ) and consider the hypothesis H0 : β = 1.By a ﬁrst-order Taylor series approximation ¶ µ 2 ¶ µ σ ˜ σ2 ˜ − 1 = Wn .7. we have plotted in Figure 6. The increasing solid line is for the case β = 0. 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. Through repetition. the statistic Wn (s) varies with s. and noting Hβ = sβ s−1 . ˆ Let β and σ 2 be the sample mean and variance of yi .

For this particular example. this probability depends only on s. the Type I error probability improves towards 5% as the sample size n increases. The null hypothesis β s = 1 is true. so these probabilities are Type I error. There is. Rates above 20% are unexceptable. looking for tests for which rate rejection rates are close to 5%. however. Given the simplicity of the model. In Table 2. Type I error rates between 3% and 8% are considered reasonable.84.4: Wald Statistic as a function of s P (Wn (s) > 3.1 we report the results of a Monte Carlo simulation where we vary these three parameters.000 random samples.84 | β = 1) .1 you can also see the impact of variation in sample size. Any other choice of s leads to a test with unacceptable Type I error probabilities. and σ 2 . which is not surprising given the dependence of Wn (s) on s as shown in Figure 6.Figure 6. we compare the rates row by row. the only test which meets this criterion is the conventional Wn = Wn (1) test. and σ is varied among 1 and 3.1 reports the simulation estimate of the Type I error probability from 50.1 Type I error Probability of Asymptotic 5% Wn (s) Test 63 . In Table 4. The value of s is varied from 1 to 10. To interpret the table. Table 4. Each row of the table corresponds to a diﬀerent value of s — and thus corresponds to a particular choice of test statistic. Error rates avove 10% are considered excessive. no magic choice of n for which all tests perform uniformly well.4. remember that the ideal Type I error probability is 5% (.000 simulated Wald statistics Wn (s) which are larger than 3. Typically. Test performance deteriorates as s increases. and rarely fall outside of the 3%-8% range.05) with deviations indicating+ distortion. These probabilities are calculated as the percentage of the 50. n is varied among 20. Table 4. 100 and 500. The second through seventh columns contain the Type I error probabilities for diﬀerent combinations of n and σ. When comparing statistical procedures. In each case. n.

07 .10 .06 . deﬁne θ = β 1 /β 2 .34 .20 . β 1 .13 .05 .33 . ˆ ˆ ˆ ˆ ˆ Let β = (β 0 . so the hypothesis can be stated as H0 : θ = r.25 .16 Rejection frequencies from 50.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 . let V be an estimate of the ˆ asymptotic variance matrix for β and set ˆ = β 1 /β 2 .05 .08 .15 .06 . in other examples natural choices are not always obvious and the best choices may in fact appear counter-intuitive at ﬁrst.18 .24 .12 .23 .05 .20).06 .07 .06 .19 .28 .09 . Deﬁne θ ˆ ˆ ⎞ ⎛ 0 ⎟ ⎜ ⎟ ⎜ ⎜ 1 ⎟ ⎟ ⎜ ⎜ ˆ ⎟ ˆ H1 = ⎜ β 2 ⎟ ⎟ ⎜ ⎟ ⎜ ⎜ β ⎟ ˆ ⎠ ⎝ − 1 ˆ2 β2 ´ s(ˆ θ) −r .06 . 64 .07 .05 .05 .35 . In this case a t-statistic for H0 is t1n = ³ˆ β1 ˆ β2 where r is a known constant.12 .13 .06 .10 . This point can be illustrated through another example. Take the model yi = β 0 + x1i β 1 + x2i β 2 + ei E (xi ei ) = 0 and the hypothesis H0 : β1 =r β2 (6.000 simulated random samples In this example it is not surprising that the choice s = 1 yields the best test statistic.08 .25 . Other choices are arbitrary and would not be used in practice.05 .31 .15 .15 .11 .10 . While this is clear in this particular example.08 .22 .07 .20 .06 . An alternative statistic can be constructed through reformulating the null hypothesis as H0 : β 1 − rβ 2 = 0.26 .08 .22 .13 .17 .14 .15 .08 . β 2 ) be the least-squares estimates of (6.21 .07 .30 .20) ³ ´1/2 ˆ0 ˆ ˆ so that the standard error for ˆ is s(ˆ = n−1 H1 V H1 θ θ) .14 . Equivalently.06 .

However.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. . We let x1i and x2i be mutually independent N (0.05.645) are close to zero in most cases. .00 . −1 H V H ˆ 2 n 2 ⎞ 0 H2 = ⎝ 1 ⎠ . Ideally.10 .05 .09 . In contrast.06 .00 . and alternatives to asymptotic critical values should be considered.10 .05 . Table 4. ei be an independent N (0.06 .10 .00 .05 . if the hypothesis can be expressed as a linear restriction on the model parameters.05 .75 1.645) P (tn < −1.06 .00 . 1) variables. 6.645) and P (tn > 1.50 .05 β2 . the rejection rates for the linear t2n statistic are invariant to the value of β 2 . This leaves β 2 as a free parameter. then the “most linear” formulation should be selected.06 .2 is that the two t-ratios have dramatically diﬀerent sampling behavior.0 and n among 100 and 500.06 .12 .A t-statistic based on this formulation of the hypothesis is ´2 ³ ˆ 1 − rβ 2 ˆ β =³ ´1/2 .00 .00 . while the right tail probabilities P (t1n > 1.47 .7.25 . the rejection rates for the t1n statistic diverge greatly from this value.05 .06 .06 .645) greatly exceed 5%.26 . In this section we describe the method in more detail.00 .645) P (tn > 1. along with sample size n.05 .00 The one-sided Type I error probabilities P (tn < −1.07 .05 .2 Type I error Probability of Asymptotic 5% t-tests n = 100 n = 500 P (tn < −1. and 1.06 . We vary β 2 among .00 .645) are calculated from 50. The implication of Table 4.000 simulated samples. The common message from both examples is that Wald statistics are sensitive to the algebraic formulation of the null hypothesis. If no linear formulation is feasible. 65 .1. −r ⎛ t2n where To compare t1n and t2n we perform another simple Monte Carlo simulation.645) t1n t2n t1n t2n t1n t2n t1n t2n . It is also prudent to consider alternative tests to the Wald statistic.05 .15 . especially for small values of β 2 .28 . such as the GMM distance statistic which will be presented in Section 9. The results are presented in Table 4.06 . σ 2 ) draw with σ = 3. this formulation should be used. and are close to the ideal 5% rate for both sample sizes.25. .2. and normalize β 0 = 0 and β 1 = 1.00 .75.15 .02 .06 .50. In all cases.05 . The left tail probabilities P (t1n < −1. the entries in the table should be 0.645) P (tn > 1.

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

For example. The average (6. union member. . then B will have to be increased.96) . and dummy variable indicators for the following: married.Suppose we are interested in the ¯Type I error associated with an asymptotic 5% two-sided ¯ ¯ ¯ θ) θ t-test. We separately estimate equations for white and non-whites. Suppose we are interested in the 5% and 95% quantile of Tn = ˆ We then compute the 10% θ. female.21) is therefore an ³ ´ p ˆ unbiased estimator of P with standard error s P = P (1 − P ) /B.15 Estimating a Wage Equation We again return to our wage equation. if we are ³ ´ p √ ˆ assessing an asymptotic 5% test. Furthermore. the choice of B is often guided by the computational demands of the statistical procedure. such as the percentage estimate reported in (6. The typical purpose of a Monte Carlo simulation is to investigate the performance of a statistical procedure (estimator or test) in realistic settings. Often this is called the number of replications. 1000. if we set B = 999. female. For the dependent variable we use the natural log of wages. and therefore it is straightforward to calculate standard errors for any quantity of interest. and . Quite simply. In many cases. the performance will depend on n and F. where N = (B +1)α. 6. experience squared. Generally.003. A simple way to compute sample quantiles is to sort the sample {Tnb } from low to high. As discussed above. immigrant. and dummy variable indicators for the following: married. the researcher must select the number of experiments. For example.007. immigrant. then we can set s P = (. experience squared. then the 5% sample quantile is 50’th sorted value and the 95% sample quantile is the 950’th sorted value. For regressors we include years of education. Then qα is the N ’th number in this ordered sequence. union member. hispanic. In particular. We us the sample of wage earners from the March 2004 Current Population Survey. We now expand the sample all non-military wage earners.22/ B. and our regressors include years of education. B. a larger B results in more precise estimates of the features of interest of Gn . The random variable 1 (Tnb ≥ 1. excluding military.21) the percentage of the simulated t-ratios which exceed the asymptotic 5% critical value. Since the results of a Monte Carlo experiment are estimates computed from a random sample of size B. It is therefore convenient to pick B so that N is an integer. potential work experience.21). In practice. respectively. 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 ≥ 1.95) /B ' . As P is unknown. and non-white. an estimator or test may perform wonderfully for some values.96) . Hence the ³ ´ ˆ standard errors for B = 100. Again our dependent variable is the natural log of wages. If the standard error is too large to make a reliable inference. and 90% sample quantiles of the sample {Tnb }. but requires more computational time. for a selection of choices of n and F. this may ˆ be approximated by replacing P with P or with an hypothesized value. s P = .022. we included a dummy 67 . and poorly for others. It is therefore useful to conduct a variety of experiments. and estimate a multivariate regression.96) is iid Bernoulli. B b=1 (6. and 5000. are. equalling 1 with probability P = E1 (Tnb ≥ 1.05) (. so that coeﬃcients may be interpreted as semi-elasticities. The α% sample quantile is a number qα such that α% of the sample are less than qα . therefore. potential work experience. and hispanic.

variable for state of residence (including the District of Columbia.00002 .002 .010 Intercept Education Experience Experience2 Married Female Union Member Immigrant Hispanic Non-White σ ˆ Sample Size R2 One question is whether or not the state dummy variables are relevant. but not equal. Alternatively.102 −.4945. 2β 3 68 . excluding the coeﬃcients on the state dummy variables.48772 = 515. Table 4. Ignoring the other coeﬃcients.032 . The available sample is 18.101 .808 so the parameter estimates are quite precise and reported in Table 4.102 −.1 we ﬁnd the point estimate ˆ ˆ = − β 2 = 28. 50 Another interesting question which can be addressed from these estimates is the maximal impact of experience on mean wages.19) is ˜ µ ¶ µ ¶ σ2 ˆ .010 . 808 1 − .001 . θ ˆ 2β 3 β2 .69. 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.014 .070 .097 −. if β 2 > 0 and β 3 < 0 the solution is θ=− From Table 4. Using either statistic the hypothesis is easily rejected.027 .033 −.49452 σ ˜ Notice that the two statistics are close. Wn = n 1 − 2 = 18. The F form of the Wald statistic (6. Computing the Wald statistic (6. we ﬁnd Wn = 550.008 .013 . as the 1% critical value for the χ2 distribution is 76.34 ˆ s(β) .4877 18. this adds 50 regressors).00057 . reestimating the model with the 50 state dummies excluded.232 .18) that the state coeﬃcients are jointly zero.121 −.007 . the restricted standard deviation estimate is σ = .1.1 OLS Estimates of Linear Equation for Log(Wage) ˆ β 1.808 .

40. but it can be found numerically quite easily. Since tn (θ) is a non-linear function of θ.Using the Delta Method. 29. not testing a hypothesis. Our desired conﬁdence interval will be the set of parameter values θ which are not rejected by the hypothesis test. However. but the lower end is substantially lower. there is not a simple expression for this set.5].9. This is the set of θ such that |tn (θ)| ≤ 1. This set is [27.0.96. In the present context we are interested in forming a conﬁdence interval.5]. Notice that the upper end of the conﬁdence interval is the same as that from the delta method. implying a 95% conﬁdence θ) interval of [27. we found better Type I error rates by reformulating the hypothesis as a linear restriction. as the coverage probability of this conﬁdence interval is one minus the Type I error of the hypothesis test based on the t-test. so we have to go one step further. Instead. 69 . this is a poor choice. 29. we can calculate a standard error of s(ˆ = . In the previous section we discovered that such t-tests had very poor Type I error rates. 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 ).

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

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

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

2

is the homoskedasticity-formula standard error.

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

i=1 i=1

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

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

E (xi ei ) = 0

∗ yi = yi + ui

71

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

∗ E (yi ui ) = 0

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

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

• Qi • Di • Ci

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

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

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

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

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

73

in the linear regression model yi = x0 β + ei i E (ei | xi ) = 0. σ1 We now discuss this estimation problem.. The GLS estimator is sometimes called where D = diag{σ 1 i i n i i the Aitken estimator. where z1i is some q × 1 function of xi . the least-squares estimator is ineﬃcient. Often the functional form is kept simple for parsimony..2) E (ξ i | xi ) = 0. The theory of Chamberlain (1987) can be used to show that in this model the semiparametric eﬃciency bound is obtained by the Generalized Least Squares (GLS) estimator ¢−1 ¡ 0 −1 ¢ ¡ ˜ (7. 74 . Typically.. 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. Suppose that we model the conditional variance using the parametric form 0 σ 2 = α0 + z1i α1 i = α0 zi . The GLS estimator (7... σ 2 } and σ 2 = σ 2 (x ) = E e2 | x . we know that the least-squares estimator is semi-parametrically eﬃcient for the projection coeﬃcient.. However. σ 2 }. z1i are squares (and perhaps levels) of some (or all) elements of xi .1) infeasible since the matrix D is unknown. The error ξ i in this regression error ξ i is generally heteroskedastic and has the conditional variance ¡ ¢ V ar (ξ i | xi ) = V ar e2 | xi i ´ ³¡ ¢¢2 ¡ = E e2 − E e2 | xi | xi i i ¡ 4 ¢ ¡ ¡ 2 ¢¢2 = E ei | xi − E ei | xi . .Chapter 7 Additional Regression Topics 7.1 Generalized Least Squares In the projection model.1) XD Y β = X 0 D−1 X ¡ ¢ 2 . A ˆ ˆn feasible GLS (FGLS) estimator replaces the unknown D with an estimate D = diag{ˆ 2 . . Let η i = e2 .

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

Why then do we not exclusively estimate regression models by FGLS? This is a good question. Its asymptotic variance is not that given in Theorem 7.2) is correctly speciﬁed. then FGLS is asymptotically equivalent to GLS. FGLS estimation depends on speciﬁcation and estimation of the skedastic regression. This may be written as !−1 Ã n !Ã n !−1 Ã n 1 X −4 2 0 1 X −2 0 1 X −2 0 ˜ σ i xi xi ˜ σ i ei xi xi ˜ ˆ σ i xi xi ˜ V = n n n i=1 i=1 i=1 ³ ´−1 ³ ´³ ´−1 ˜ ˜ ˆ˜ ˜ X 0 D−1 DD−1 X X 0 D−1 X = n X 0 D−1 X ˜ which is consistent for V as n → ∞. This estimator V 0 is appropriate when the skedastic regression (7. Theorem 7. but the proof of this can be tricky. Instead..1. and was proposed by Cragg (Journal of Econometrics. ¢¢−1 ¡ ¡ . V ). It may be the case that α0 zi is only an approximation to the true conditional variance σ 2 = i ˜ E(e2 | xi ). ´´−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 . similar to the covariance matrix of the OLS estimator. There are three reasons.. i ˜ 0 is inconsistent for V . V n n i=1 . This is an estimator which is robust to misspeciﬁcation of the condie1 ˆn tional variance. FGLS is asymptotically superior to OLS. V ˜ An appropriate solution is to use a White-type estimator in place of V 0 . A trimming rule might make sense: σ 2 = max[˜ 2 . 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 ˜ = . In this case we interpret α0 zi as a linear projection of e2 on zi . e2 }. .1. β should perhaps be i i called a quasi-FGLS estimator of β. and thus where ´ √ ³ ˜ n β F GLS − β →d N (0. We just state the result without proof. Unless σ 2 = α0 zi .1. It is possible to show that if the skedastic regression is correctly speciﬁed.that there is a need to bound the estimated variances away from zero. σ 2 ] σi i for some σ 2 > 0. 1992).1.1 If the skedastic regression is correctly speciﬁed. V = E σ −2 xi x0 i i ˆ where D = diag{ˆ2 . Since the form of the skedastic regression is unknown. First. ´ √ ³ ˜ ˜ n β GLS − β F GLS →p 0.1. V = E α0 zi i i Examining the asymptotic distribution of Theorem 7. and it may be estimated with considerable 76 V takes a sandwich form√.. In the linear regression model.

In the linear regression model the conditional mean of yi given xi = x is 77 .2. Third.error. in which case ξ i is ˜ independent of xi and the asymptotic variance (7. It is consistent not only in the regression model. We may therefore test this hypothesis by the estimation (7. The point is that the eﬃciency gains from FGLS are built on the stronger assumption of a correct conditional mean. The asymptotic distribution (7.3) for α simpliﬁes to ¡ ¡ 0 ¢¢−1 ¡ 2 ¢ E ξi . the two tests coincide. And the FGLS probability limit will depend on the particular function selected for the skedastic regression. If i this simpliﬁcation is replaced by the standard formula (under independence of the error). then the OLS and FGLS estimators will converge in probability to diﬀerent limits. Second. This introduces an element of arbitrariness which is unsettling to empirical researchers.4). The GLS and FGLS estimators. and this requires trimming to solve. The main diﬀerences between popular “tests” is which transformations of xi enter zi .2 Testing for Heteroskedasticity ¢ ¡ The hypothesis of homoskedasticity is that E e2 | xi = σ 2 .7) under independence show that this test has an asymptotic chi-square distribution.7) Hence the standard test of H0 is a classic F (or Wald) test for exclusion of all regressors from the skedastic regression (7. This hypothesis does not imply that ξ i is independent of xi . the Wald test of H0 is asymptotically χ2 . on the other hand. but also under the assumptions of linear projection. require the assumption of a correct conditional mean. its squares. FGLS will do worse than OLS in practice.5) and the asymptotic variance (7. and the cost is a reduction of robustness to misspeciﬁcatio 7. and not a conditional mean. however. as they will be estimating two diﬀerent projections. BreuschPagan (1979) proposed what might appear to be ¡ distinct test.3 Forecast Intervals m(x) = E (yi | xi = x) = x0 β. 7. Motivated by the form of the asymptotic variance ˆ of the OLS estimator β.2). In this case. Vα = E zi zi (7. Theorem 7. or equivalently that i H0 : α1 = 0 in the regression (7. If the equation of interest is a linear projection.4) and constructing a Wald statistic. and all cross-products. OLS is a more robust estimator of the parameter vector. but the only diﬀerence is that they a ¢ allowed for general choice of zi . White (1980) proposed that the test for heteroskedasticity be based on setting zi to equal all non-redundant elements of xi . and replaced E ξ 2 with 2σ 4 which holds when ei is N(0. we impose the stronger hypothesis and test the hypothesis that ei is independent of xi .1 Under H0 and ei independent of xi . q Most tests for heteroskedasticity take this basic form. Typically. the estimated conditional variances may contain more noise than information about the true conditional variances. σ 2 ). individual estimated conditional variances may be negative.

which is a much more diﬃcult task. this has variance ³ ´³ ´0 ¡ ¢ ˆ ˆ Eˆ2 = E e2 | xi = x + x0 E β − β β − β x ei i = σ 2 (x) + n−1 x0 V x. We describe this setting as non-linear regression. 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. then the forecast standard error is s(x) = σ 2 (x) + n−1 x0 V x ˜ It would appear natural to conclude that an asymptotic 95% forecast interval for yi is i h ˆ s x0 β ± 2ˆ(x) . s 7. we see that m(x) = ˆ = x0 β and Hβ = x. In general.In some cases.g. A reasonable rule is the conditional mean m(x) as it is the mean-square-minimizing forecast. For a given value of xi = x. we may want to forecast (guess) yi out-of-sample.6). As the out-of-sample error ei is ˆ ˆ independent of the in-sample estimate β. the width of the conﬁdence set is dependent on x. If we have an estimate of the conditional variance function. the natural estimate of this variance is σ 2 + n−1 x0 V x. we want to estimate m(x) at a particular point x. A point forecast ˆ is the estimated conditional mean m(x) = x0 β. q 2 0 0 ˆ ˜ ˆ ˜ σ (x) = α z from (7. Given the diﬃculty. We would also like a measure of uncertainty for ˆ the forecast. s(x) ˆ But no such asymptotic approximation can be made. the validity of an asymptotic conﬁdence interval is based on the asymptotic normality of the studentized ratio. θ) = E (yi | xi = x) which is a non-linear function of the parameters θ. Notice that this is a (linear) ˆ ˆ θ function of β. σ 2 ). To get an accurate forecast interval. 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 .4 NonLinear Least Squares In some cases we might use a parametric regression function m(x. we need to estimate the conditional distribution of ei given xi = x. but this turns out to be incorrect. so p ˆ s(ˆ = n−1 x0 V x. In the present case. many applied forecasters focus h i ˆ on the simple approximate interval x0 β ± 2ˆ(x) . which is generally invalid. ¡ ¢ ˆ Assuming E e2 | xi = σ 2 . Notice that this is diﬀerent from the standard ˆ ˆ error for the conditional mean. so a standard ˆ i p ˆ error for the forecast is s(x) = σ 2 + n−1 x0 V x. Letting h(β) = x0 β and θ = h(β). e. ³ ´ ˆ ˆ The forecast error is ei = yi − m(x) = ei − x0 β − β . 78 .

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

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

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

Theorem 7. While a complete proof of Theorem 7. where V = and f (e | x) is the conditional density of ei given xi = x. V ).1) n X √ −1/2 n (g n (β 0 ) − g(β 0 )) = −n gi (β 0 ) →d N (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) . then f (0 | x) = f (0) and the asymptotic variance simpliﬁes V = (Exi x0 )−1 i 4f (0)2 (7.1 ´ √ ³ˆ n β − β 0 →d N (0. ∂ g(β) = ∂β 0 ¡ ¡ ¢¢ ∂ 0 0 Exi 1 − 2 · 1 yi ≤ xi β ∂β £ ¡ ¡ ¢ ¢¤ ∂ = −2 0 E xi E 1 ei ≤ x0 β − x0 β 0 | xi i i ∂β " Z 0 # xi β−x0 β 0 i ∂ = −2 0 E xi f (e | xi ) de ∂β −∞ £ ¢¤ ¡ = −2E xi x0 f x0 β − x0 β 0 | xi i i i £ 0 ¤ ∂ 0 g(β 0 ) = −2E xi xi f (0 | xi ) . then there are many innovations near to the median. Let g(β) = Eg (β). Pn −1 0 β)) .5. This can be done with kernel estimation techniques. First.10) is equivalent to g n (β) = 0. (7.1 is advanced.5.5. the conditional density of the error at its median. by a Taylor series expansion and the fact g(β 0 ) = 0 82 . ∂β ˆ g(β) ' ´ ³ ∂ ˆ g(β 0 ) β − β 0 . When f (0 | x) is large. and this improves estimation of the median. ˆ Proof of Theorem 7.11).3. In the special case where the error is independent of xi . we provide a sketch here for completeness.1: Since sgn (a) = 1 − 2 · 1 (a ≤ 0) . Exi x0 ) i i=1 since Egi (β 0 )gi (β 0 )0 = Exi x0 . We need where g n (β) = n i i=1 gi (β) and gi (β) = xi (1 − 2 · 1 (yi ≤ xi three preliminary result. Computation of standard error for LAD estimates typically is based on equation (7. by the central limit theorem (Theorm 5. See Chapter 16. Second using the law of iterated expectations and the chain rule of i diﬀerentiation. The main diﬃculty is the estimation of f (0). ∂β 0 so Third. the height of the error density at its median.11) This simpliﬁcation is similar to the simpliﬁcation of the asymptotic covariance of the OLS estimator under homoskedasticity.

9) for the median to all quantiles. xi ) with conditional distribution function F (y | x) the conditional quantile function qτ (x) is Qτ (x) = inf {y : F (y | x) ≥ τ } . V ). However for computational convenience it is typical to assume that they are (approximately) linear in x (after suitable transformations).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. then F (Qτ (x) | x) = τ . when F (y | x) is continuous and strictly monotonic in y. 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. This linear speciﬁcation assumes that Qτ (x) = β 0 x where the coeﬃcients β τ τ vary across the quantiles τ . Again. θ where ρτ (q) is the piecewise linear function ½ −q (1 − τ ) q<0 ρτ (q) = qτ q≥0 = q (τ − 1 (q < 0)) .6 Quantile Regression The method of quantile regression has become quite popular in recent econometric practice. For ﬁxed τ .5. (7. The following alternative representation is useful. If the random variable U has τ ’th quantile Qτ . ¥ 7. Exi x0 ) →d i 2 = N (0.12) Qτ = argmin Eρτ (U − θ) . The quantile Qτ is the value such that τ (percent) of the mass of the distribution is less than Qτ . so you can think of the quantile as the inverse of the distribution function. For the random variables (yi .13) This generalizes representation (7. The median is the special case τ = . We then have the linear quantile regression model yi = x0 β τ + ei i 83 . the quantile regression function qτ (x) describes how the τ ’th quantile of the conditional distribution varies with the regressors. then (7. The third line follows from an asymptotic empirical process argument. then F (Qτ ) = τ . For τ ∈ [0. the quantile regression functions can take any shape. As functions of x.

the unconditional density of ei at 0.6. and form a Wald statistic i for γ = 0. and test their signiﬁcance using a Wald test. 7.where ei is the error deﬁned to be the diﬀerence between yi and its τ ’th conditional quantile x0 β τ . Thus. where and f (e | x) is the conditional density of ei given xi = x. and are widely available. since it has discontinuous derivatives.5.12). Furthermore. the τ ’th conditional quantile of ei is zero.1 n β τ − β τ →d N (0. conventional Newton-type optimization methods are inappropriate. Another popular approach is the RESET test proposed by Ramsey (1969). fast linear programming methods have been developed for this problem. 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.13).7 Testing for Omitted NonLinearity If the goal is to estimate the conditional expectation E (yi | xi ) . if the model yi = x0 β + ei has i been ﬁt by OLS. the asymptotic variance depends on the conditional density of the quantile regression error. When the error ei is independent of xi . 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. Vτ ). Fortunately. ¡ ¡ ¢¢−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. One simple test for neglected nonlinearity is to add nonlinear functions of the regressors to ˆ ˆ the regression. Since the quanitle regression criterion function Lτ (β) does not have an algebraic solution. ˆ Given the representation (7. ´ √ ³ˆ Theorem 7. then f (0 | xi ) = f (0) . n numerical methods are necessary for its minimization. otherwise its properties are unspeciﬁed without further restrictions. E xi xi f (0)2 A recent monograph on the details of quantile regression is Koenker (2005).1. i By construction. The null model is yi = x0 β + εi i 84 . A asymptotic distribution theory for the quantile regression estimator can be derived using similar arguments as those for the LAD estimator in Theorem 7. it is useful to have a general test of the adequacy of the speciﬁcation. and we have the simpliﬁcation Vτ = τ (1 − τ ) ¡ ¡ 0 ¢¢−1 .

yielding ˆ ˜ ˆ ˆ (β 1 . since Q12 Q−1 Q21 > 0.14) 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. m must be selected in advance. In this case i ¡ ¢−1 2 ˜ σ = Q−1 σ 2 . If Q12 = 0 (so the variables are orthogonal) then these two variance matrices equal. yi ˆm (7. However. Now let ˆ i ⎛ 2 ⎞ yi ˆ ⎜ . yielding predicted values yi = x0 β. Wn →d χ2 . Under which conditions is β 1 or β 1 superior? It is easy to see that both estimators are consistent for β 1 .8 Irrelevant Variables yi = x0 β 1 + x0 β 2 + ei 1i 2i E (xi ei ) = 0. small values such as m = 2. 1i 2i 2i 1i 22 . One estimator of β 1 is to regress 0 0 ˜ yi on x1i alone. 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. The comparison between the two estimators is straightforward when the error is conditionally ¢ ¡ homoskedastic E e2 | xi = σ 2 . 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 . β 1 = (X1 X1 )−1 (X1 Y ) . The RESET test appears to work well as a test of functional form against a wide range of smooth alternatives. Otherwise. Another is to regress yi on x1i and x2i jointly. 7. To see why this is the case. then 22 Q11 > Q11 − Q12 Q−1 Q21 . note that (7. or 4 seem to work best. and the two estimators have equal asymptotic eﬃciency. It is easy (although somewhat tedious) to show that under the null hypothesis. ⎠ . Then run the auxiliary regression ˆ 0 ˜ yi = x0 β + zi γ + ei ˜ ˜ i ˆ which is estimated by OLS. Typically. 3. In the model x2i is “irrelevant” if β 1 is the parameter of interest and β 2 = 0. and n→∞ say. lim nV ar( β 1 ) = Ex1i x0 1i 11 n→∞ say.be an (m − 1)-vector of powers of yi . ⎟ zi = ⎝ . and form the Wald statistic Wn for γ = 0.14) by OLS. β 2 ). To implement the test. they will (typically) have diﬀerence asymptotic variances. and consequently 22 ¡ ¢−1 2 σ . It is particularly powerful at detecting single-index models of the form yi = G(x0 β) + εi i where G(·) is a smooth “link” function.

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

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

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

x. the residuals e. 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 . else equals zero).. 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 . the mean absolute error (MAE) is E |yi − g(xi )| . For any predictor g(xi ) for y. E(e | X) = 0. In the homoskedastic regression model Y = Xβ + e with E(ei | xi ) = 0 and E(e2 | xi ) = σ 2 . Show that the function g(x) which minimizes the MAE is the conditional median M (x). i ˆ ˆ suppose β is the OLS estimate of β with covariance matrix V . (b) Find an estimate of the variance of this forecast. the estimates (β.. ˜ the residual vector is e = Y − X β. V . ji ˜ (a) In which contexts would β be a good estimator? ˜ (b) Using your intuition. Let θ satisfy Eg(Yi − θ) = 0. . ˆ ˆ n−k 6. and an estimate of σ 2 is ˆ s2 = 1 e0 Ω−1 e. σ 2 ). where xji is one of the xi . . Let σ 2 be the estimate of σ 2 . You wish to forecast an out-of-sample value of y given that ˆ ˆ ˆ ˆ X = x. based on a sample of size n. wn ) and wi = x−2 . X). Thus the available information is the sample (Y. Verify equation (7. Consider the Weighted Least Squares (WLS) estimator of β ¢−1 ¡ 0 ¢ ¡ ˜ X WY β = X 0W X where W = diag(w1 . ˆ (a) Find a point forecast of y. 2. V ar(e | X) = σ 2 Ω with Ω known. the GLS estimator is ¡ ¢−1 ¡ 0 −1 ¢ ˜ β = X 0 Ω−1 X XΩ Y . Deﬁne g(u) = τ − 1 (u < 0) where 1 (·) is the indicator function (takes the value 1 if the argument is true. 4. Let (yi . 5.12).. xi ) be a random sample with E(Y | X) = Xβ. Is θ a quantile of the distribution of Yi ? 3.7. (b) Prove that e = M1 e. and the out-of-sample value of the regressors. In a linear model Y = Xβ + e.10 Exercises 1.

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

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

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

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

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

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

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

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

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

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

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

Thus asymptotic critical values are taken from the Φ distribution. F ) ¶ µ 1 1 = Φ(x) + 1/2 g1 (x. From Theorem 8. F0 ) + O(n−3/2 ) = O(n−1 ). F ) + O(n−3/2 ) n n 2 = Φ(x) + g2 (x.10 Symmetric Two-Sided Tests If a random variable X has distribution function H(x) = P (X ≤ x). F ) + O(n−3/2 ). if Z ∼ N (0. and exact critical values are taken from the Gn (x. 8.1. F ) = Gn (x.The “derivative” ∂ ∂F g1 (x. as F is a function.5) where the simpliﬁcations are because g1 is even and g2 is odd. F ). Similarly.8. F0 ) = O(n−1 ). F ) is only heuristic. F ) + g2 (−x. then the random variable |X| has distribution function H(x) = H(x) − H(−x) since P (|X| ≤ x) = P (−x ≤ X ≤ x) = H(x) − H(−x). F ). We conclude that G∗ (x) − Gn (x. we can calculate that Gn (x. Hence the diﬀerence between the asymptotic distribution and the exact distribution is Φ(x) − Gn (x. This rate can be used to show that one-tailed bootstrap inference based on the tratio achieves a so-called asymptotic reﬁnement — the Type I error of the test converges at a faster rate than an analogous asymptotic test. F ) = Gn (x. Since Tn →d Z. 101 2 g2 (x. F ) − Gn (−x. = P (X ≤ x) − P (X ≤ −x) For example. n (8. F0 ) distribution. F ) − Gn (−x. n or ∗ P (Tn ≤ x) = P (Tn ≤ x) + O(n−1 ). A two-sided hypothesis test rejects H0 for large values of |Tn | . 1). F ) n n µ ¶ 1 1 − Φ(−x) + 1/2 g1 (−x. n . F ) + g2 (x. F0 ) = The order of the error is O(n−1 ). then |Z| has distribution function Φ(x) = Φ(x) − Φ(−x) = 2Φ(x) − 1. which is an improved rate of convergence over the asymptotic test (which converged at rate O(n−1/2 )). then |Tn | →d |Z| ∼ Φ. if Tn has exact distribution Gn (x. then |Tn | has the distribution function Gn (x.

Applying (8. Theorem 8. V ). Fn ) = Φ(x) + ∗ 2 g2 (x.Interestingly. Twosided tests will have more accurate size (Reported Type I error). and needs to be determined on a case-by-case basis. This is in contrast to the use of the asymptotic distribution. The diﬀerence is ³x´ ³x´ −Φ + O(n−1/2 ) G∗ (x) − Gn (x. F0 )) + O(n−3/2 ) n = O(n−3/2 ). whose error is O(n−1 ). the choice between symmetric and equal-tailed conﬁdence intervals is unclear. g1 . we ﬁnd Gn (x) = Gn (x. similar to a one-sided test.5) to the bootstrap distribution.8. Conﬁdence intervals based on the bootstrap can be asymmetric if based on one-sided tests (equal-tailed intervals) and can therefore be more informative and have smaller length than symmetric intervals. 8. F0 ) = ∗ 2 (g2 (x. n Thus the diﬀerence between the bootstrap and exact distributions is Gn (x) − Gn (x. F ) = Φ v √ where v = V .11 Percentile Conﬁdence Intervals ´ √ ³ To evaluate the coverage rate of the percentile interval. F0 ) = Φ n v ´ ˆ v ³x x (ˆ − v) + O(n−1/2 ) v = −φ v v ˆ ˆ = O(n−1/2 ) 102 . and g2 is continuous in F. and bootstrap tests have better rates of convergence than asymptotic tests. Therefore. Another way of writing this is ∗ P (|Tn | < x) = P (|Tn | < x) + O(n−3/2 ) so the error from using the bootstrap distribution (relative to the true unknown distribution) is O(n−3/2 ). Fn ) = Φ n v ˆ ˆ where V = V (Fn ) is the bootstrap estimate of V. A reader might get confused between the two simultaneous eﬀects. and for the bootstrap ³x´ + O(n−1/2 ). meaning that the errors in the two directions exactly cancel out. Thus a two-sided bootstrap test also achieves an asymptotic reﬁnement. The analysis shows that there may be a trade-oﬀ between one-sided and two-sided tests. Fn ) − g2 (x. We know that θ Tn →d N (0. is an even function. set Tn = n ˆ − θ0 . This is because the ﬁrst term in the asymptotic expansion.1 shows that a ﬁrst-order approximation ³x´ + O(n−1/2 ). Two-sided tests have better rates of convergence than the one-sided tests. as it depends on the unknown V. but one-sided tests might have more power against alternatives of interest. Fn ) + O(n−3/2 ). which is not pivotal. Gn (x. the asymptotic two-sided test has a better coverage rate than the asymptotic one-sided test. G∗ (x) = Gn (x. √ the last equality because Fn converges to F0 at rate n.

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

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

(c) With the given information. and thus reject H0 if ˆ ˆ > q ∗ (. (b) Report the 95% Alternative Percentile interval for θ. with variables listed in the ﬁle hprice1.95). Estimate a linear regression of price on the number of bedrooms. The ˆ are sorted. You replace c with qn (. θ respectively.95) denote the 5% θ) ∗ and 95% quantiles of Tn . you generate bootstrap samples. Calculate 95% conﬁdence intervals for the regression coeﬃcients using both the asymptotic normal approximation and the percentile-t bootstrap. lot size. ˆ = 1. Using the non-parametric bootstrap. can you report the 95% Percentile-t interval for θ? 7.95). Suppose that in an application. Let qn (. (a) Report the 95% Efron Percentile interval for θ. and the 2. Using the non-parametric ∗ bootstrap.Show that C exactly equals the Alternative percentile interval (not the percentile-t interval).5% quantiles of the ˆ are .dat contains data on house prices (sales).5% and 97.05) and qn (. and ˆ is calculated on each θ ∗ ∗ θ sample.2.3. ˆ − s(ˆ n (.95) denote the 95% quantile of Tn . You want to test H0 : θ = 0 against H1 : θ > 0.pdf.75 and 1. and deﬁne the bootstrap conﬁdence interval h i C = ˆ − s(ˆ n (. What is wrong with this procedure? Tn = θ/s(θ) n 6. The dataﬁle hprice1. The test for H0 is to reject if Tn = ˆ ˆ > c where c is picked so that Type I error is α. size of house. 105 . and the colonial dummy. θ θ) ∗ 1000 samples are generated from the bootstrap distribution. ∗ ∗ ∗ Let qn (.95). ∗ ∗ where s(ˆ is the standard error in the original data. θ θ)q ∗ θ θ)q ∗ θ/s(θ) 5.05) . calculate the estimates ˆ on these samples and θ then calculate ∗ ∗ ∗ θ θ Tn = ˆ /s(ˆ ).2 and s(ˆ = . You do this as follows.

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

then g n (β) = 0. i i . let Jn (β) = n · g n (β)0 Wn g n (β).1 ˆ 2Z 0 XWn X 0 Z β = 2Z 0 XWn X 0 Y While the estimator depends on Wn .3) The method of moments estimator for β is deﬁned as the parameter value which sets g n (β) = 0. then. Let and where gi = xi ei . the dependence is only up to scale. β GMM = Z 0 XWn X 0 Z 9. ˆ Deﬁnition 9.2 GMM Estimator n n ¢ 1¡ 0 ¢ 1X 1X ¡ 0 X Y − X 0 Zβ .2. Jn (β) = n · g n (β)0 g n (β) = n · |g n (β)|2 . ¡ ¢−1 0 ˆ Z XWn X 0 Y. gi (β) = xi yi − zi β = n n n i=1 i=1 Deﬁne the sample analog of (9. The GMM estimator minimizes Jn (β). For some × weight matrix Wn > 0. β GMM does not change. for if Wn is replaced ˆ by cWn for some c > 0. if Wn = I.1 β GMM = argmin Jn (β). β ˆ Note that if k = . but this is generally not possible when > k.2) g n (β) = (9.9. The ﬁrst order conditions for the GMM estimator are 0 = ∂ ˆ Jn (β) ∂β ∂ ˆ ˆ = 2 g n (β)0 Wn g n (β) ∂β ´ 1 1 ³ ˆ = −2 Z 0 XWn X 0 Y − Z β n n so which establishes the following. and the GMM estimator is the MME. the square of the Euclidean length. Proposition 9.3 Distribution of GMM Estimator ¡ 0¢ Q = E xi zi Assume that Wn →p W > 0. The idea of the generalized method of moments (GMM) is to deﬁne an estimator which sets g n (β) “close” to zero. For example. 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 . This is a non-negative measure of the “length” of the vector g n (β).2.

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

but can be numerically tricky to obtain in some cases. 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 . Here is a simple way to compute the eﬃcient GMM estimator. There is little point in using an ineﬃcient GMM estimator as it is easy to compute. these two estimators are asymptotically equivalent under the hypothesis of correct speciﬁcation.4) above. When constructing hypothesis tests. The estimator appears to have some better properties than traditional GMM. The criterion function is then Ã n !−1 1X ∗ 0 ∗ 0 gi (β)gi (β) g n (β).e. J(β) = n · g n (β) n i=1 In most cases. and GMM using Wn as the weight matrix is asymptotically eﬃcient. 0ˆ ˆ ˆ ˆ estimate β using this weight matrix. (9. First. under the alternative hypothesis the moment conditions are violated. ˆ An estimator of the asymptotic variance of β can be seen from the above formula. Since Egi = 0. However. Heaton and Yaron (1996).5 GMM: The General Case In its most general form. 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 . 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. set Wn = (X 0 X)−1 . and construct the residual ei = yi − zi β. GMM applies whenever an economic or statistical model implies the × 1 moment condition E (gi (β)) = 0.4) which uses the uncentered moment conditions.and deﬁne Wn = Ã Then Wn →p Ω−1 = W0 . 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. Alastair Hall (2000) has shown that the uncentered estimator is a poor choice. ∗ gi (β) = gi (β) − g n (β) 9. when we say “GMM”. and was introduced by L. we can let the weight matrix be considered as a function of β. so the uncentered estimator will contain an undesirable bias term and the power of the test will be adversely aﬀected. Then set gi = xi ei . Hansen. ˆ and let g be the associated n × matrix. There is an important alternative to the two-step GMM estimator just described. i. This is a current area of research in econometrics. A simple solution is to use the centered moment conditions to construct the weight matrix. 109 . Set ³ ¡ ¢−1 0 ´−1 ˆ ˆˆ XZ . Instead. we actually mean “eﬃcient GMM”. Egi 6= 0.

and if the weight matrix is asymptotically eﬃcient. 1 2 It is possible that β 2 = 0. Identiﬁcation requires l ≥ k = dim(β). n β − β →d N 0.1 (Sargan-Hansen). often the weight ˆ matrix Wn is updated. 9. The general theory of GMM estimation and testing was exposited by L. 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 . 110 . i i i i ∂β 1X 0 gi gi − g n g 0 ˆˆ n n i=1 n !−1 . G0 Ω−1 G . 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. β) = 0 holds. take the linear model yi = β 0 x1i + β 0 x2i + ei with E (x1i ei ) = 0 and E (x2i ei ) = 0.6. 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). ˆ J = J(β) →d χ2−k .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 .5. This estimator can be iterated if needed.Often. 1 it is possible that β 2 6= 0. and thus g n can be used to assess whether or not the hypothesis that Egi = 0 is true or not. For example. Note that g n →p Egi . Since the GMM estimator depends upon the ﬁrst-stage estimator. The GMM estimator minimizes J(β) = n · g n (β)0 Wn g n (β) where g n (β) = and Wn = Ã 1X gi (β) n i=1 n ˜ ˜ with gi = gi (β) constructed using a preliminary consistent estimator β. Theorem 9. However.1 Under general regularity conditions. this is all that is known. Thus the model — the overidentifying restrictions — are testable. and then β recomputed. ´ ³ ¡ ¢−1 ´ √ ³ˆ Theorem 9. and is thus a natural test statistic for H0 : Egi = 0. ˆˆ n is a quadratic form in g n . perhaps obtained by ﬁrst ˆ setting Wn = I. so that the linear equation may be written as yi = β 0 x1i + ei . where ³ ´−1 ∂ 0 ˆ ˆ ˆ ˆ Ω = (E (gi gi ))−1 and G = E ∂β 0 gi (β). Hansen (1982). Under the hypothesis of correct speciﬁcation. In this sense an 1i 1i exclusion restriction can be seen as an overidentifying restriction.

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

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

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

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

subject ˆ i ˆi i=1 to the restriction h(β) = 0. h(β)=0 The GMM test statistic (the distance statistic) of the hypothesis h(β) = 0 is ˜ D = Jn (β) = min Jn (β).5. h(β)=0 (9. λ = R0 Vn R (c) Show that if R0 β = r then ´ √ ³˜ n β − β →d N (0.6) (a) Show that you can rewrite Jn (β) in (9. 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 . In the linear model Y = Xβ + e with E(xi ei ) = 0. β) + ei E (zi ei ) = 0. The equation of interest is yi = g(xi .5) n 1 P ˆ where ei are the OLS residuals and Ωn = n n xi x0 e2 . Vn = X X i=1 ˜ and hence R0 β = r. The GMM estimator of β. l ≥ k. Deﬁne the Lagrangian L(β. xi . The observed data is (yi .6) equals the Wald statistic. the Generalized Method of Moments (GMM) criterion function for β is deﬁned as 1 ˆn (Y − Xβ)0 X Ω−1 X (Y − Xβ) (9.5) 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. the distance statistic D in (9. VR ) where ¡ ¢−1 0 R V. 6. zi is l × 1 and β is k × 1. 115 . zi ). Thus ˜ β = argmin Jn (β) R0 β−r Ã n ! ¡ 0 ¢−1 ¡ 0 ¢−1 X 0 2 ˆ XX xi xi ei ˆ . Show how to construct an eﬃcient GMM estimator for β. λ) = 1 Jn (β) + λ0 (R0 β − r) where λ is 2 s × 1. is deﬁned as Jn (β) = ˜ β = argmin Jn (β). VR = V − V R R0 V R (d) Show that in this setting.

. Take the linear model 0 yi = zi β + ei E (xi ei ) = 0. we can write Ω−1 = CC 0 and Ω = C 0−1 C −1 ³ ´0 ³ ´−1 ˆ ˆ ˆ C 0 ΩC (b) Jn = n C 0 g n (β) C 0 g n (β) ˆ (c) C 0 g n (β) = Dn C 0 g n (β 0 ) (d) Dn →p Il − R (R0 R)−1 R0 (e) n1/2 C 0 g n (β 0 ) →d N ∼ N (0. ˆ and consider the GMM estimator β of β. 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. 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 . 116 . Let ˆ ˆ ˆ Jn = ng n (β)0 Ω−1 g n (β) denote the test of overidentifying restrictions.

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

2) subject to the restrictions (10.where λ and µ are Lagrange multipliers. λ ¡ ¢ ln 1 + λ0 gi (β) . pi = ³ ˆ ˆ ˆ0 n 1 + λ gi β ˆ Ln = n X i=1 ln (ˆi ) . (10. λ. pn . probabilities 1 ³ ´´ . we ﬁnd µ = n and 1 ¢. λ(β)) = −n ln (n) − n X i=1 ˆ The EL estimate β is the value which maximizes Ln (β). This yields the (proﬁle) empirical log-likelihood function for β. Multiplying the ﬁrst equation by pi . summing over i. λ).7) 118 . (see section 6. . but must be obtained numerically (see section 6.5) This minimization problem is the dual of the constrained maximization problem. The Lagrangian for this maximization problem is Ã n ! n n X X X ln(pi ) − µ pi − 1 − nλ0 pi gi (β) L∗ (β... λ) = −n ln (n) − n X i=1 For given β. λ) is a convex function of 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. or equivalently minimizes its negative ˆ (10. µ) = n i=1 i=1 i=1 L∗ n with respect to pi . 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. p1 . Ln (β) = Rn (β. The solution cannot be obtained explicitly.. pi = ¡ n 1 + λ0 gi (β) Substituting into L∗ we ﬁnd n Rn (β. we also obtain the Lagrange multiplier λ = λ(β).5).3). λ) : λ(β) = argmin Rn (β. The solution (when it exists) is well deﬁned since Rn (β.4) (10.5) ˆ ˆ As a by-product of estimation. µ. p (10. and using the second and third equations. the Lagrange multiplier λ(β) minimizes Rn (β. pi gi (β) = 0.1) and (10.

β λ ∂ ³ ´. (β. β) = −xi zi .13) Premultiplying by G0 Ω−1 and using (10.11) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ ˆ 0 ' −g n − Gn β − β 0 + Ωn λ (10.11) 0 = ∂λ ˆ0 ˆ i=1 1 + λ gi β ³ ´0 ˆ n X Gi . i i Theorem 10. and n β − β 0 and nλ are asymptotically independent.12) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ 0 ' G0 λ − λ0 . i=1 i=1 i=1i Expanding (10. ˆ The asymptotic variance V for β is the same as for eﬃcient GMM.1 Under regularity conditions. V ) ¢−1 ¡ V = G0 Ω−1 G ¡ ¢−1 0 Vλ = Ω − G G0 Ω−1 G G G = EGi (β 0 ) ¡ ¢ Ω = E gi (β 0 ) gi (β 0 )0 (10. λ) = − (10.9) (10.8) and ¢ 0 0 For example. Thus the EL estimator is asymptotically eﬃcient. n (10.10) ¡ Ω−1 N (0.10).2. G = −E (xi zi ). g n = n n gi (β 0 ) and Ωn = n n g (β 0 ) gi (β 0 )0 . Gi (. λ) jointly solve ³ ´ ˆ n gi β X ∂ ³ ³ ´´ Rn (β.12) ∂β ˆ ˆ0 i=1 1 + λ gi β 1 P 1 P 1 P Let Gn = n n Gi (β 0 ) .13) yields n n Expanding (10. 0 = Rn (β. ´ √ ³ ˆ n β − β 0 →d √ ˆ nλ →d N (0.14) 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 .10. λ) = − (10.9) and (10.2 Deﬁne Asymptotic Distribution of EL Estimator Gi (β) = ∂ gi (β) ∂β 0 (10. in the linear model. ˆ ˆ Proof. and Ω = E xi x0 e2 . Vλ ) ´ √ ˆ √ ³ˆ where V and Vλ are deﬁned in (10.

V ) ˆ Solving (10. Ω) →d Ω−1 I − G G Ω G GΩ = Ω−1 N (0. Twice the diﬀerence between the unrestricted empirical likelihood −n log (n) and the maximized empirical likelihood for the model (10.3. tests are based on the diﬀerence in the log likelihood functions. it is an asymptotically eﬃcient estimator for β. and have the same interpretation. LRn = i=1 Theorem 10.ˆ Solving for β and using the WLLN and CLT yields ´ ¢−1 0 −1 √ ¡ √ ³ ˆ ' − G0 Ω−1 Gn n β − β0 Gn Ωn ng n n n ¡ 0 −1 ¢−1 0 −1 G Ω N (0. and (10. (10.1 If Eg(wi .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. This means that no consistent estimator for this class of models can have a lower asymptotic variance than V . Vλ ) Furthermore. 120 .14) for λ and using (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. ¥ Chamberlain (1987) showed that V is the semiparametric eﬃciency bound for β in the overidentiﬁed moment condition model. n ³ ´´ ´ √ ³ 1 X ³ ˆ ˆ √ g wi . The same statistic can be constructed for empirical likelihood.7) is n ³ ´´ ³ X ˆ ˆ0 (10. The overidentiﬁcation test is a very useful by-product of EL estimation. and it is advisable to report the statistic LRn whenever EL is the estimation method. Since the EL estimator achieves this bound. Ω) GΩ G →d = N (0. β 0 ) = 0 then LRn →d χ2−k . 10. since ³ ¡ ¢−1 0 ´ G0 I − Ω−1 G G0 Ω−1 G G =0 (10. First.16).16) ´ √ ˆ √ ³ˆ n β − β 0 and nλ are asymptotically uncorrelated and hence independent. Proof. by a Taylor expansion. They are asymptotically ﬁrst-order equivalent.3 Overidentifying Restrictions In a parametric likelihood context. The EL overidentiﬁcation test is similar to the GMM overidentiﬁcation test.15).17) 2 ln 1 + λ gi β .15) (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. where h : Rk → Ra .1 Under (10.4 Testing Egi (β) = 0 (10.18).ssc. The hypothesis of interest is h(β) = 0.prc 121 .edu/~bhansen/progs/elike.wisc. since ln(1 + x) ' x − x2 /2 for x small. the restricted EL estimator β is simply an EL estimator with − k + a overidenti˜ ˆ fying restrictions.18) and H0 : h(β) = 0.Second.4. Vλ )0 Ω−1 N (0.17) is not appropriate. This test statistic is a natural analog of the GMM distance statistic. 10. the simple overidentifying restrictions test (10. To test the hypothesis h(β) while maintaining (10.18) are assumed to hold and are not being challenged (at least for the test discussed in this section). LRn →d χ2 .18) Let the maintained model be where g is × 1 and β is k × 1. h(β)=0 ˜ Fundamentally. 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. Instead we use the diﬀerence in log-likelihoods: ³ ´ ˆ ˜ LRn = 2 Ln − Ln . By “maintained” we mean that the overidentfying restrictions contained in (10. 10. a The proof of this result is more challenging and is omitted.5 Numerical Computation Gauss code which implements the methods discussed below can be found at http://www. Vλ ) ¥ where the proof of the ﬁnal equality is left as an exercise. Theorem 10.

Eﬃcient convergence requires a good choice of steplength δ. λ) = − gi (β. The modiﬁed Newton method takes a quadratic approximation to Rn (β. λ)0 0 Rn (β. A complication is that λ must be constrained so that 0 ≤ pi ≤ 1 which holds if ¢ ¡ n 1 + λ0 gi (β) ≥ 1 122 (10. λ) G∗ (β. λ) = i The ﬁrst derivatives of (10. λ) = i ∂λ∂β 0 1 + λ0 gi (β) i=1 ⎞ ⎛ ¡ 0 ¢ ∂2 n 2 X 0 gi (β) λ ∂ ⎠ ⎝G∗ (β. λ) yielding the iteration rule λj+1 = λj − δ (Rλλ (β. 2. Deﬁne ∗ gi (β. δ 1 = 1 and δ 2 = 1. λp ) A quadratic function can be ﬁt exactly through these three points. The iteration (10. λj ) . λ) = − ∂β n X i=1 G∗ (β. λj ))−1 Rλ (β. Set δ 0 = 0. i Rββ = Inner Loop The so-called “inner loop” solves (10. set 2 λp = λj − δ p (Rλλ (β.4) are Rλ = Rβ = The second derivatives are Rλλ = Rλβ = ¡ Gi (β)0 λ 1 + λ0 gi (β) gi (β) ¢ 1 + λ0 gi (β) X ∂ ∗ Rn (β. The value of δ which minimizes this quadratic is ˆ = R2 + 3R0 − 4R1 . (10. The starting value λ1 can be set to the zero vector. λ) ∂λ i=1 n ∂ Rn (β. λ) . λ)0 − ∂β∂β Rn (β. λ)0 − Rn (β. One method uses the following quadratic approximation. λ) = ∂λ∂λ i=1 ¶ n 2 Xµ ∂ Gi (β) ∗ gi (β.4).19) is continued until the gradient Rλ (β.. δ 4R2 + 4R0 − 8R1 yielding the steplength to be plugged into (10.5) for given β. λj ) is smaller than some prespeciﬁed tolerance. For p = 0. λj )) Rp = Rn (β.Derivatives The numerical calculations depend on derivatives of the dual likelihood function (10.19). λ) = G∗ (β. 1. λ) G∗ (β.20) . λ) = i i ∂β∂β 0 1 + λ0 gi (β) i=1 n where δ > 0 is a scalar steplength (to be discussed next).19) X ∂2 ∗ ∗ gi (β. λ) gi (β. λj ))−1 Rλ (β.

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

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

1 Instrumental Variables 0 yi = zi β + ei Let the equation of interest be (11. so should be included in xi . Thus we make the partition ¶ µ k1 z1i (11.2) Any solution to the problem of endogeneity requires additional information which we call instruments. z1i is an instrumental variable for (11. In matrix notation.3) zi = z2i k2 where E(z1i ei ) = 0 yet E(z2i ei ) 6= 0.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 ¶ . β →p β ∗ .1). 11.1. This is called simultaneous equations bias. this can be written as Y = Zβ + e. and x2i are the excluded exogenous variables. (11. at least the intercept). In a typical set-up. By the above deﬁnition. That is x2i are variables which could be included in the equation for yi (in the sense 125 . We call (11.4) xi = x2i 2 where z1i = x1i are the included exogenous variables.1) if E (xi ei ) = 0.1) the structural equation. So we have the partition µ ¶ z1i k1 (11. which does not equal either β 1 or β 2 . Deﬁnition 11. We call z1i exogenous and z2i endogenous.1) where zi is k × 1. and assume that E(zi ei ) 6= 0 so there is endogeneity. some regressors in zi will be uncorrelated with ei (for example. ¶ 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 The × 1 random vector xi is an instrumental variable for (11.

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

11.2

Reduced Form

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

Substituting (11.6) into (11.2), we ﬁnd

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

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

11.3

Identiﬁcation

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

11.4

Estimation

0 yi = zi β + ei

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

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

11.5

Special Cases: IV and 2SLS

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

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

which again is the IV estimator.

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

then

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

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

11) (11.12).13) which is zero only when S21 = 0 (when Z is exogenous). 11. Z2 . u) E (ξ | X) = 0 ¢ ¡ E ξξ 0 | X = S As before. Z = [Z1 . PX Z2 ] = [Z1 . X2 ]. Z2 ] and X = [Z1 . we regress Y on Z1 and Z2 .6 Bekker Asymptotics Bekker (1994) used an alternative asymptotic framework to analyze the ﬁnite-sample bias in the 2SLS estimator. In our notation. ˆ since Z1 lies in the span of X.12) Z = XΓ + u ξ = (e. Then i h ˆ ˆ ˆ Z = Z1 . Recall. ¡ ¢−1 ¡ 0 ¢ ˆ β 2SLS = Z 0 PX Z Z PX Y . We now derive a similar result for 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 ) .11). Z2 = [PX Z1 . 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 . 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. Here we present a simpliﬁed version of one of his results. 129 . Using (11. First. the model is Y = Zβ + e (11.ˆ It is useful to scrutinize the projection Z. Thus in the second stage. PX Z2 ] h i ˆ = Z1 .

l .12) and this result. By the spectral decomposition of an idempotent matrix.7 Identiﬁcation Failure Recall the reduced form equation Z2 = X1 Γ12 + X2 Γ22 + u2 . ¢ 1 ¡ ¢ 1 ¡ ¢ 1 ¡ 0 E Z PX e = E Γ0 X 0 e + E u0 PX e = αS21 . except when S21 = 0 (when Z is exogenous). 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. 130 . The parameter β fails to be identiﬁed if Γ22 has deﬁcient rank.14) approaches that in (11. n and (11. Let q = H 0 ξS −1/2 which satisﬁes Eqq 0 = In and partition q = (q1 q2 ) where q1 is l × 1.Let PX = X (X 0 X)−1 X 0 . the bias in the 2SLS estimator will be large. 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 . 0). indicating that the bias in 2SLS approaches that of OLS as the number of instruments increases.14) In general this is non-zero. the expression in (11. Together µ µ ¶¶−1 µ ¶ ³ ´ 1 0 1 0 ˆ 2SLS − β E β Z PX Z Z PX e ≈ E E n n ¡ ¢−1 = α Γ0 QΓ + αS22 S21 . 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. It is also close to zero when α = 0.14) is the probability limit of β 2SLS − β 11. Bekker (1994) showed further that under the alternative asymptotic approximation that α is ﬁxed as n → ∞ (so that the number of instruments goes to inﬁnity proportionately with sample ˆ size) then the expression in (11. P = HΛH 0 0 0 where Λ = diag(Il . Indeed as α → 1.13).

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

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

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

pdf. Is zi = (xi i for estimation of β? x2 ) a valid instrumental variable i where income (Y ) and wage (W ) are determined outside the market. f atheduc (the education. using the instrument near4. I suggest that you use the 2SLS estimates as the ﬁrst-step to get the weight matrix. 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. (d) Re-estimate the model by eﬃcient GMM. (f) Discuss your ﬁndings.(b) Deﬁne the 2SLS estimator of β. (e) Calculate and report the J statistic for overidentiﬁcation. (b) Now treat Education as endogenous.. are the parameters identiﬁed? 8.dat is taken from David Card “Using Geographic Variation in College Proximity to Estimate the Return to Schooling” in Aspects of Labour Market Behavior (1995). listed in card. Report the estimates and standard errors. Estimate the model by 2SLS. Report estimates and standard errors. (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). in years. of the father) and motheduc (the education. in years. In this model. using zi as an instrument for xi . and the remaining variables as exogenous. Report estimates and standard errors. Does this diﬀer from 2SLS and/or OLS? 7. The data ﬁle card. of the mother). There are 2215 observations with 19 variables. Suppose that price and quantity are determined by the intersection of the linear demand and supply curves Demand : Supply : Q = a0 + a1 P + a2 Y + e1 Q = b0 + b1 P + b2 W + e2 ¡ ¢ (a) Show that E (xi ei ) = 0 and E x2 ei = 0. 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). (a) Estimate the model by OLS. a dummy indicating that the observation lives near a 4-year college. and South and Black are regional and racial dummy variables. and then calculate the GMM estimator from this weight matrix without further iteration. 134 .

The primary model for multivariate time series is vector autoregressions (VARs).) is a random variable.1. . There proofs are rather diﬃcult. Yt−1 .1 {Yt } is covariance (weakly) stationary if E(Yt ) = µ is independent of t.. however. and multivariate (yt ∈ Rm is vector-valued). 12. and use the subscript t to denote the individual observation..3 ρ(k) = γ(k)/γ(0) = Corr(Yt .4 (loose). T . γ(k) is called the autocovariance function.. then Xt is strictly stationary and ergodic. Deﬁnition 12.1.1. and Cov (Yt . Yt−k ) is the autocorrelation function. so classical assumptions are not valid...2 {Yt } is strictly stationary if the joint distribution of (Yt . t = 1. 135 .1 Stationarity and Ergodicity Deﬁnition 12. .. We can separate time series into two categories: univariate (yt ∈ R is scalar). we expect that Yt and Yt−1 are not independent.1. Yt−k ) = γ(k) is independent of t for all k.1. Deﬁnition 12. The following two theorems are essential to the analysis of stationary time series. A stationary time series is ergodic if γ(k) → 0 as k → ∞. The primary model for univariate time series is autoregressions (ARs).. Yt−k ) is independent of t for all k. Deﬁnition 12. Theorem 12.. To indicate the dependence on time. and T to denote the number of observations. Because of the sequential nature of time series.Chapter 12 Univariate Time Series A time series yt is a process observed in sequence over time. we adopt new notation. .1 If Yt is strictly stationary and ergodic and Xt = f (Yt .

ρ(k) →p ρ(k). ˆ 3. ˆ ˆ T t=1 γ (k) = ˆ The sample autocorrelation ρ(k) = ˆ γ (k) ˆ . ˆ 2. 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) . Thus an application of the Ergodic Theorem yields T 1X Yt Yt−k →p E(Yt Yt−k ). If Xt is strictly stationary and ergodic and E |Xt | < ∞. µ →p E(Yt ). T 1X Xt →p E(Xt ). and it has a ﬁnite mean by the assumption that EYt2 < ∞. ˆ ˆ γ ¥ 136 . ˆ Proof. γ (0) ˆ Theorem 12. Part (1) is a direct consequence of the Ergodic theorem. note that γ (k) = ˆ T 1X (Yt − µ) (Yt−k − µ) ˆ ˆ T t=1 = T T T 1X 1X 1X Yt Yt−k − Yt µ − ˆ Yt−k µ + µ2 . T t=1 Thus γ (k) →p E(Yt Yt−k ) − µ2 − µ2 + µ2 = E(Yt Yt−k ) − µ2 = γ(k). then as T → ∞. γ (k) →p γ(k).1 above. ˆ Part (3) follows by the continuous mapping theorem: ρ(k) = γ (k)/ˆ (0) →p γ(k)/γ(0) = ρ(k).Theorem 12.2 (Ergodic Theorem).3 If Yt is strictly stationary and ergodic and EYt2 < ∞. 1. For Part (2).1. ˆ ˆ T t=1 T t=1 T t=1 By Theorem 12.1.1. then as T → ∞. the sequence Yt Yt−k is strictly stationary and ergodic.

Y2 .. 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 . t By back-substitution. In fact.. Yt−2 . ∞ X = ρk et−k . E(Yt−k et ) = 0. should be a MDS. it is even more important in the time-series context... this series converges if the sequence ρk et−k gets small as k → ∞. or consumption growth rates.. The MDS property for the regression error plays the same role in a time-series regression as does the conditional mean-zero property for the regression error in a cross-section regression.1 et is a martingale diﬀerence sequence (MDS) if E (et | It−1 ) = 0. We consider the conditional expectation E (Yt | It−1 ) where It−1 = {Yt−1 . some versions of the life-cycle hypothesis imply that either changes in consumption. Deﬁnition 12.} are jointly random. Regression errors are naturally a MDS. .} is the past history of the series. For example. A mean-zero AR(1) is Assume that et is iid. then we have the autoregressive model Yt = α + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et E (et | It−1 ) = 0.. Y1 .. A useful property of a MDS is that et is uncorrelated with any function of the lagged information It−1 .. as it is diﬃcult to derive distribution theories without this property. we ﬁnd Yt = et + ρet−1 + ρ2 et−2 + .. . YT . Most asset pricing models imply that asset returns should be the sum of a constant plus a MDS.12. An autoregressive (AR) model speciﬁes that only a ﬁnite number of past lags matter: E (Yt | It−1 ) = E (Yt | Yt−1 . k=0 Loosely speaking. 137 .. Letting et = Yt − E (Yt | It−1 ) . Some time-series processes may be a MDS as a consequence of optimizing behavior. .. the series {... 12.2 Autoregressions In time-series.. E(et ) = 0 and Ee2 = σ 2 < ∞.3 Stationarity of AR(1) Process Yt = ρYt−1 + et . Thus for k > 0. This occurs when |ρ| < 1. The last property deﬁnes a special time-series process. .2.. Yt−k ) .

∞ X k=0 ρ2k V ar (et−k ) = 12. The AR(1) model can be written in the format Yt − ρYt−1 + et or (1 − ρL) Yt−1 = et . an AR(1) is stationary iﬀ |ρ| < 1.1. 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).Theorem 12. since ρ(z) = 0 when z = 1/ρ. Deﬁnition 12. except that the mean of Yt can be computed from the relationship EYt = α + ρEYt−1 . From Theorem 12. We say that the root of the polynomial is 1/ρ. The AR(k) model is Using the lag operator. 12.3. or ρ(L)Yt = et where ρ(L) = 1 − ρ1 L − ρ2 L2 − · · · − ρk Lk . we see that L2 Yt = LYt−1 = Yt−2 .3. Yt − ρ1 LYt − ρ2 L2 Yt − · · · − ρk Lk Yt = et .5 Stationarity of AR(k) Yt = ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et . We call ρ(L) the autoregressive polynomial of Yt . the above results are unchanged. 1 − ρ2 V ar(Yt ) = If the equation for Yt has an intercept. We call ρ(L) the autoregressive polynomial of Yt .4 Lag Operator An algebraic construct which is useful for the analysis of autoregressive models is the lag operator. We can compute the moments of Yt using the inﬁnite sum: EYt = ∞ X k=0 ρk E (et−k ) = 0 σ2 . and solving for EYt = EYt−1 we ﬁnd EYt = α/(1 − ρ).1 The lag operator L satisﬁes LYt = Yt−1 .1 If |ρ| < 1 then Yt is strictly stationary and ergodic. In general. Lk Yt = Yt−k . Deﬁning L2 = LL. 138 . The operator ρ(L) = (1 − ρL) is a polynomial in the operator L.4.

and hence Yt . One way of stating this is that “All roots lie outside the unit circle. which satisfy ρ(λj ) = 0.1. For an AR(k). β = X 0X (12. it is also strictly stationary and ergodic.1. . Thus T T 1X 1X xt et = ut →p E (ut ) = 0. t T t=1 T t=1 139 . Let |λ| denote the modulus of a complex number λ. since E (ut | It−1 ) = E (xt et | It−1 ) = xt E (et | It−1 ) = 0. t t T t=1 ¥ Combined with (12.1) Theorem 12. we see that Ã !−1 Ã ! T T 1X 1X ˆ β=β+ xt x0 xt et →p Q−1 0 = 0. Proof. Thus t by the Ergodic Theorem. We know that an AR(1) is stationary iﬀ the absolute value of the root of its autoregressive polynomial is larger than one.6 Let Estimation xt = β = ¡ 1 Yt−1 Yt−2 · · · α ρ1 ρ2 · · · yt = x0 β + et . This is a special case of non-stationarity.. T t=1 T t=1 ¢−1 0 ¡ ˆ X Y. so is xt x0 .1 The AR(k) is strictly stationary and ergodic if and only if |λj | > 1 for all j. Theorem 12. The Fundamental Theorem of Algebra says that any polynomial can be factored as ¢¡ ¢ ¡ ¢ ¡ ρ(z) = 1 − λ−1 z 1 − λ−1 z · · · 1 − λ−1 z 1 2 k 12.5.1. Note that ut is a MDS. By Theorem 12. we say that ρ(L).. The vector xt is strictly stationary and ergodic. λk are the complex roots of ρ(z).1. t Yt−k ¢0 ρk . it is helpful to deﬁne the process ut = xt et . “has a unit root”.1 If the AR(k) process Yt is strictly stationary and ergodic and EYt2 < ∞.1) and the continuous mapping theorem.where the λ1 . and by Theorem 12. T ¢ ¡ 1X xt x0 →p E xt x0 = Q. and is of great interest in applied time series.6.” If one of the roots equals 1. ¢0 Then the model can be written as The OLS estimator is ¡ ˆ To study β.. the requirement is that all roots are larger than one. then ˆ β →p β as T → ∞.

1 to see that T 1 X √ xt et →d N (0. This creates an iid bootstrap sample.2 If the AR(k) process Yt is strictly stationary and ergodic and EYt4 < ∞. ˆ 1. Simulate iid draws e∗ from the empirical distribution of the residuals {ˆ1 .12. ˆ 2.. Create the bootstrap series Yt∗ by the recursive formula ˆ ˆ ∗ ˆ ∗ ˆ ∗ Yt∗ = α + ρ1 Yt−1 + ρ2 Yt−2 + · · · + ρk Yt−k + e∗ . xt }. t t Theorem 12.. T 1 X √ ut →d N (0. Ω) .8 Bootstrap for Autoregressions In the non-parametric bootstrap. Divide the sample into T /m blocks of length m. Ω) . 140 ..7.. then as T → ∞. t This construction imposes homoskedasticity on the errors e∗ . as this imposes inappropriate independence. eT }.7. we constructed the bootstrap sample by randomly resampling from the data values {yt . Q−1 ΩQ−1 .. It also presumes that the AR(k) structure is the truth. ´ √ ³ ¡ ¢ ˆ T β − β →d N 0. t then as T → ∞. e ˆ 3. . which may be diﬀerent than the i properties of the actual ei . Brieﬂy. This is identical in form to the asymptotic distribution of OLS in cross-section regression.1 MDS CLT. Method 1: Model-Based (Parametric) Bootstrap. Y−k+2 . Clearly.. T t=1 where Ω = E(xt x0 e2 ).7 Asymptotic Distribution Theorem 12. Fix an initial condition (Y−k+1 . there are two popular methods to implement bootstrap resampling for time-series data. In particular. Estimate β and residuals et . . Y0 ). this cannot work in a time-series application. 12. i 4.7. T t=1 Since xt et is a MDS. the asymptotic covariance matrix is estimated just as in the cross-section case. we can apply Theorem 12. Method 2: Block Resampling 1. If ut is a strictly stationary and ergodic MDS and E(ut u0 ) = Ω < ∞. The implication is that asymptotic inference is the same.

The seasonal adjustment. 4. 141 . • You can estimate (12. and the way that the data are partitioned into blocks. But the long-run trend is also eliminated. The series ∆s Yt is clearly free of seasonality.9 Trend Stationarity Yt = µ0 + µ1 t + St St = ρ1 St−1 + ρ2 St−2 + · · · + ρk St−l + et . The reason why these two procedures are (essentially) the same is the Frisch-Waugh-Lovell theorem.2) (12. or the season-to-season change. • Use “seasonally adjusted” data. The seasonal factor is typically estimated by a two-sided weighted average of the data for that season in neighboring years. heteroskedasticity. ∆s Yt = Yt − Yt−s .3) replacing St with St .2)-(12. (12. and perhaps this was of relevance. 12..3) or Yt = α0 + α1 t + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et .3) sequentially by OLS. • Include dummy variables for each season. Thus the seasonally adjusted data is a “ﬁltered” series. If s is the number of seasons (typically s = 4 or s = 12). Resample complete blocks. ﬁrst estimate (12. draw T /m blocks.2). This procedure is sometimes called Detrending. The results may be sensitive to the block length. 5. get the ˆ ˆ residual St . This presumes that “seasonality” does not change over the sample.. however. This is a ﬂexible approach which can extract a wide range of seasonal factors. May not work well in small samples. For each simulated sample. • First apply a seasonal diﬀerencing operator. ρk ). and for modelmisspeciﬁcation. This allows for arbitrary stationary serial correlation. (12. Seasonal Eﬀects There are three popular methods to deal with seasonal data. also alters the time-series correlations of the data. • You can estimate (12. 3. 6.. and then perform regression (12.4) by OLS.4) There are two essentially equivalent ways to estimate the autoregressive parameters (ρ1 . Paste the blocks together to create the bootstrap time-series Yt∗ . .2. That is.

(A simple exclusion test).. AR(k) on this (uniﬁed) sample. Thus under H0 .5). (If you increase k. you need more initial conditions. this is the same as saying that under the alternative Yt is an AR(k+m).. if the null hypothesis is that Yt is an AR(k).. and then estimate the models AR(1). AR(2).g. to ﬁnd Yt − θYt−1 = α − θα + ρYt−1 − θρYt−1 + ut − θut−1 . An appropriate test of H0 against H1 is therefore a Wald test that the coeﬃcient on Yt−2 is zero. Yt is an AR(1). Another is to minimize the AIC or BIC information criterion.5) and lag the equation once: Yt−1 = α + ρYt−2 + ut−1 . . H0 may be expressed as the restriction that the coeﬃcient on Yt−2 is zero. One approach to model selection is to choose k based on a Wald tests.) This can induce strange behavior in the AIC.5) We are interested in the question if the error ut is serially correlated. let the null hypothesis be an AR(1): Yt = α + ρYt−1 + ut . An appropriate test is the Wald test of this restriction. 142 . We model this as an AR(1): ut = θut−1 + et with et a MDS. We want to test H0 against H1 . We then multiply this by θ and subtract from (12. and then reserve the ﬁrst k as initial conditions.6).6) 12. .. and the alternative is that the error is an AR(m).5) and (12.12.11 Model Selection What is the appropriate choice of k in practice? This is a problem of model selection. The hypothesis of no omitted serial correlation is H0 : θ = 0 H1 : θ 6= 0.10 Testing for Omitted Serial Correlation For simplicity. (12. and under H1 it is an AR(2). T where σ 2 (k) is the estimated residual variance from an AR(k) ˆ One ambiguity in deﬁning the AIC criterion is that the sample available for estimation changes as k changes.. The best remedy is to ﬁx a upper value k. and this is equivalent to the restriction that the coeﬃcients on Yt−k−1 .. or Yt = α(1 − θ) + (ρ + θ) Yt−1 − θρYt−2 + et = AR(2). we take (12. AIC(k) = log σ 2 (k) + ˆ 2k . Yt−k−m are jointly zero. In general. e. To combine (12. (12.

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

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

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

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

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

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

149 . Deﬁnition 13. the asymptotic distribution of the test is aﬀected by the presence of the time trend. For 0 < r < m. If r = m. Their justiﬁcation was Stock’s result that β is superˆ ˆ consistent under H1 . such that zt = β 0 Yt is I(0). and was articulated in detail by Engle and Granger (1987). 13. In other cases.8 Cointegration The idea of cointegration is due to Granger (1981). then β = (1 − 1)0 speciﬁes that the spread (the diﬀerence in returns) is stationary. it may be necessary to include a time trend in the estimated cointegrating regression.1 The m × 1 series Yt is cointegrated if Yt is I(1) yet there exists β. When the data have time trends.8. Thus H0 can be tested using a univariate ADF test on zt . The asymptotic distribution was worked out by Phillips and Ouliaris (1990). Furthermore ˆ this estimation is super-consistent: T (β 2 − β 2 ) →d Limit. Y2t ) and β = (β 1 β 2 ) and normalize β 1 = 1. Under H0 . of rank r. however. yet under H1 zt is I(0). so the ADF critical values are not appropriate. Yt is I(1) and cointegrated. m × r. β may not be known. from OLS of Y1t on Y2t . β = (1 − 1)0 . Then under H0 zt is I(1). The r vectors in β are called the cointegrating vectors. Often. but it is useful in the construction of alternative estimators and tests. Then β 2 = (Y20 Y2 )−1 Y2 Y1 →p β 2 . then Yt is I(0). so zt = β 0 Yt is known. If Yt is cointegrated with a single cointegrating vector (r = 1). it may be believed that β is known a priori. This is not. When β is unknown. We are often interested in testing the hypothesis of no cointegration: H0 : r = 0 H1 : r > 0. Engle and Granger (1987) suggested using an ADF test on the estimated ˆ0 ˆ residual zt = β Yt . Suppose that β is known. then it turns out that β can be consistently estimated by an OLS regression of one component of Yt on the others. If Y = (log(Consumption) log(Income))0 . as ﬁrst shown by Stock (1987). Hansen (1992). Whether or not the time trend is included. a good method to estimate β. In some cases. in general. then β = (1 − 1)0 speciﬁes that log(Consumption/Income) is stationary. if Yt is a pair of interest rates.13. Thus Yt = ˆ (Y1t . If the series Yt is not cointegrated. The asymptotic distribution was worked out in B. For example. then r = 0.9 Cointegrated VARs A(L)Yt = et A(L) = I − A1 L − A2 L2 − · · · − Ak Lk We can write a VAR as or alternatively as ∆Yt = ΠYt−1 + D(L)∆Yt−1 + et where Π = −A(1) = −I + A1 + A2 + · · · + Ak . β is not consistent.

9.Theorem 13. this is the MLE of the restricted parameters under the assumption that et is iid N (0. Thus cointegration imposes a restriction upon the parameters of a VAR. we typically just normalize one element to equal unity. Yt is cointegrated with m × r β if and only if rank(Π) = r and Π = αβ 0 where α is m × r. When r > 1. then estimation is done by “reduced rank regression”. These tests are constructed as likelihood ratio (LR) tests. 150 . 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 . this does not work. this can be estimated by OLS of ∆Yt on zt−1 and the lags of ∆Yt . Ω). 1991.1 (Granger Representation Theorem). it is simple to test for cointegration by testing the rank of Π. 1995). Equivalently. rank(α) = r. If β is known. When r = 1. which is least-squares subject to the stated restriction. and diﬀerent authors have adopted diﬀerent identiﬁcation schemes. In the context of a cointegrated VAR estimated by reduced rank regression. Their asymptotic distributions are non-standard. they are typically called the “Johansen Max and Trace” tests. One diﬃculty is that β is not identiﬁed without normalization. and are similar to the Dickey-Fuller distributions. As they were discovered by Johansen (1988. If β is unknown.

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

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

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

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

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

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

A panel may be balanced : {yit .. The goal is to eliminate ui from the estimator. 157 . t = ti . ti .. 15. xit } : For i = 1. OLS can be improved upon via a GLS technique.. n.. 15. xit } : t = 1. OLS of yit on xit is called pooled estimation.. . that eit is iid across individuals and time. In either event. There are several derivations of the estimator.1) If this condition fails. where the i subscript denotes the individual. This is often believed to be plausible if ui is an omitted variable. It is a strong assumption. OLS appears a poor estimation choice. .. and that eit is uncorrelated with xit ...Chapter 15 Panel Data A panel is a set of observations on individuals. and have arbitrary correlated with xi . . or unbalanced : {yit . that ui and eit are independent.1) is called the random eﬀects hypothesis. collected over time. The motivation is to allow ui to be arbitrary. Condition (15.1) fails if the individual-speciﬁc unobserved eﬀect ui is correlated with the observed explanatory variables xit . .. and most applied researchers try to avoid its use.. and thus achieve invariance.2 Fixed Eﬀects This is the most common technique for estimation of non-dynamic linear panel regressions. (15. n.. however. and the t subscript denotes time.1) is true.1 Individual-Eﬀects Model The standard panel data speciﬁcation is that there is an individual-speciﬁc eﬀect which enters linearly in the regression yit = x0 β + ui + eit . An observation is the pair {yit . i = 1. T .. xit }. then OLS is inconsistent. If (15. It is consistent if E (xit ui ) = 0 (15. it The typical maintained assumptions are that the individuals i are mutually independent.

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

i ∗ yit = x∗0 β + e∗ . we ﬁnd y i = x0 β + ui + ei .3) A dynamic panel regression has a lagged dependent variable This is a model suitable for studying dynamic behavior of individual agents. there are more instruments available. the ﬁxed eﬀects estimator is inconsistent. Typically. it However. as yt−2 is uncorrelated with ∆eit . Taking ﬁrst-diﬀerences of (15. Thus values of yit−k . This is because the sample mean of yit−1 is correlated with that of eit . and the residual is the demean value ∗ yit = yit − yi . A simple application of GMM yields the parameter estimates and standard errors.3 Dynamic Panel Regression yit = αyit−1 + x0 β + ui + eit . ∗ ˆ The ﬁxed eﬀects estimator β is OLS of yit on x∗ . A more sophisticated GMM estimator recognizes that for time-periods later in the sample. Alternatively. are valid instruments. e So OLS on (15.4) . k ≥ 2. GMM using yt−2 and yt−3 as instruments (which is overidentiﬁed. as this enables the moments from the diﬀerent timeperiods to be stacked together to create a list of all the moment conditions. at least if T is held ﬁnite as n → ∞. 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 .4) will be inconsistent.4) by IV using yt−2 as an instrument for ∆yt−1 (which is just identiﬁed). if eit is iid. But if there are valid instruments. This is conveniently organized by the GMM principle. 159 (15. The standard approach to estimate a dynamic panel is to combine ﬁrst-diﬀerencing with IV or GMM. Another derivation of the estimator is to take the equation yit = x0 β + ui + eit .Since the regression of yit on di is a regression onto individual-speciﬁc dummies. 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. 15. the dependent variable and regressors in deviationit from-mean form. but loses a time-series observation). it (15. so the instrument list should be diﬀerent for each equation. Hence a valid estimator of α and β is to estimate (15.3) eliminates the individual-speciﬁc eﬀect: ∆yit = α∆yit−1 + ∆x0 β + ∆eit . the predicted value from these regressions is the individual speciﬁc mean y i . Unfortunately. two periods back. it it which is free of the individual-eﬀect ui . we use lags of the dependent variable. then IV or GMM can be used to estimate the equation.

Kh (u) = K h h be the kernel K rescaled by the bandwidth h. The kernel density estimator of f (x) is 1X ˆ f (x) = Kh (Xi − x) . The goal is to estimateP(x) from a random sample (X1 .Chapter 16 Nonparametrics 16. Let 1 ³u´ .. The ˆ ˆ EDF F i=1 dx standard nonparametric method to estimate f (x) is based on smoothing using a kernel. we can simply focus on the problem where x is a speciﬁc ﬁxed number. and then see how the method generalizes to estimating the entire function. While we are typically interested in estimating the entire function f (x).. The amount of smoothing is controlled by the bandwidth h > 0. .1 Kernel Density Estimation d Let X be a random variable with continuous distribution F (x) and density f (x) = dx F (x). |x| ≤ 1 0 |x| > 1 ¡ ¢2 1 − x2 . Three common choices for kernels include the Gaussian µ 2¶ x 1 K(x) = √ exp − 2 2π the Epanechnikov K(x) = and the Biweight or Quartic K(x) = 15 16 3 4 ¡ ¢ 1 − x2 . the choice between these three rarely makes a meaningful diﬀerence in the estimates. Deﬁnition 1 K(u) is a second-order kernel function if it is a symmetric zero-mean density function. |x| ≤ 1 0 |x| > 1 In practice. n i=1 n 160 .. 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.

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

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

A classic simple solution proposed by Silverman (1986)has come to be known as the reference bandwidth or Silverman’s Rule-of-Thumb. but not of n. We thus say that the optimal bandwidth is of order O(n−1/5 ). This choice for h gives an optimal rule when f (x) is ˆ normal. (16.Together. Equation (16. In practice. Together with the above table.1) is an asymptotic approximation to the MSE. we ﬁnd the reference rules for the three kernel functions introduced earlier. and there is a large and continuing literature on the subject. where φ is the N (0. 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 .06n−1/5 163 . the rule-of-thumb h can be quite ineﬃcient. σ 2 .2) but replaces R(f 00 ) with σ −5 R(φ00 ). but at a very slow rate. (16. and R(f 00 ). 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 + . Thus for the AMISE to decline with n. and gives a nearly optimal rule when f (x) is close to normal.2) This solution takes the form h0 = cn−1/5 where c is a function of K and f. That is. R∞ R∞ K σ 2 = −∞ x2 K (x) dx R(K) = −∞ K (x)2 dx K √ Gaussian 1 1/(2 π) Epanechnikov 1/5 1/5 Biweight 1/7 5/7 An obvious diﬃculty is that R(f 00 ) is unknown. 1) distribution and σ 2 is an estimate of σ 2 = V ar(X). ˆ It uses formula (16.2) depends on R(K). The asymptotically optimal choice given in (16. The ﬁrst two are determined by the kernel function. Gaussian Kernel: hrule = 1. but at a slower rate than n−1 . h must tend to zero. Their K values for the three functions introduced in the previous section are given here. the asymptotic mean-squared error (AMSE) for ﬁxed x is the sum of the approximate squared bias and approximate variance 1 f (x) R(K) . Note that this h declines to zero. we need h → 0 but nh → ∞.1) AM ISEh = AM SEh (x)dx = 4 nh R where R(f 00 ) = (f 00 (x))2 dx is the roughness of f 00 . We can calculate that √ R(φ00 ) = 3/ (8 π) . We deﬁne the asymptotically optimal bandwidth h0 as the value which minimizes this approximate MSE. Notice that the ﬁrst term (the squared bias) is increasing in h and the second term (the variance) is decreasing in nh. how should the bandwidth be selected? This is a diﬃcult problem. That is.

in which case the cross-validation rule can sometimes select very small bandwidths leading to dramatically undersmoothed estimates. This works by constructing an estimate of the MISE using leave-one-out estimators. as the optimal h for estimation of the roughness R(f 00 ) is quite diﬀerent than the optimal h for estimation of f (x). This is more treacherous than may ﬁrst appear. there are modern versions of this estimator work well.34n−1/5 Biweight (Quartic) Kernel: hrule = 2. 164 . The plug-in approach is to estimate R(f 00 ) in a ﬁrst step. but they are also known to converge very slowly to the optimal values. Fortunately there are remedies. I now discuss some of these choices. and then plug this estimate into the formula (16. There are other approaches. Another popular choice for selection of h is cross-validation. There are some desirable properties of cross-validation bandwidths. which are known as smoothed cross-validation which is a close cousin of the bootstrap. perhaps adjusted by visual inspection of the resulting estimate ˆ f (x).Epanechnikov Kernel: hrule = 2.78n−1/5 Unless you delve more deeply into kernel estimation methods the rule-of-thumb bandwidth is a good practical bandwidth choice. in particular the iterative method of Sheather and Jones (1991). They are also quite ill-behaved when the data has some discretization (as is common in economics). However. but implementation can be delicate.2).

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

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

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

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

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

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

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

An implication is that if X and Y are independent. however. σxσY (A. The correlation between X and Y is Corr(X. (A. is not true. The covariance between X and Y is Cov(X. y)dx. y) = g(x)h(y). y) = fX (x)fY (y). For example. Y ) = σ XY = E ((X − EX) (Y − EY )) = EXY − EXEY. 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 ) . If X and Y are independent. 172 . the marginal density of Y is fY (y) = Z ∞ f (x.5) if the expectations exist. if EX = 0 and EX 3 = 0. For example. then V ar (X + Y ) = V ar(X) + V ar(Y ). free of units of measurement. then MZ (λ) = E exp (λ (X + Y )) = E (exp (λX) exp (λY )) ¡ ¢ ¡ ¢ = E exp λ0 X E exp λ0 Y = MX (λ)MY (λ).6) The Cauchy-Schwarz Inequality implies that |ρXY | ≤ 1.5) is that if X and Y are independent and Z = X + Y. Y ). The reverse. if X and Y are independent then E(XY ) = EXEY. A useful fact is that V ar (X + Y ) = V ar(X) + V ar(Y ) + 2Cov(X.The correlation is a measure of linear dependence. Another implication of (A. Y ) = ρXY = σ XY . then σ XY = 0 and ρXY = 0. X and Y are independent if and only if there exist functions g(x) and h(y) such that f (x. −∞ The random variables X and Y are deﬁned to be independent if f (x. then Cov(X.Similarly. the variance of the sum is the sum of the variances. then Z Z E (g(X)h(Y )) = g(x)h(y)f (y. If X and Y are independent. X 2 ) = 0. Furthermore.

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

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

1]. Let Y = g(X) where g(x) : Rk → Rk is one-to-one. then g(X) ≤ Y if and only if X ≥ h(Y ).7 Transformations Suppose that X ∈ Rk with continuous distribution function FX (x) and density fX (x). A.10) d h(y).A. but its justiﬁcation requires deeper results from analysis. As one example. dy This is known as the change-of-variables formula. (A. 0 ≤ y ≤ ∞. J(y) = det ∂y 0 Consider the univariate case k = 1.10) shows that fY (y) = exp(−y). Here. g(x) = − ln(x) and h(y) = exp(−y) so the Jacobian is J(y) = − exp(y). Since fX (x) = 1 for 0 ≤ x ≤ 1 (A.∞). an exponential density. that for Y is [0. so the distribution function of Y is FY (y) = P (g(X) ≤ y) = FX (h(Y )) = P (X ≤ h(Y )) so the density of Y is fY (y) = d d FY (y) = fX (h(Y )) h(y). . then g(X) ≤ Y if and only if X ≤ h(Y ). The Jacobian is ¶ µ ∂ h(y) . dy dy If g(x) is a decreasing 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)| . This same formula (A.8 Normal and Related Distributions µ 2¶ 1 x . As the range of X is [0. 1] and Y = − ln(X). take the case X ∼ U [0. Let h(y) denote the inverse of g(x).10) holds for k > 1. φ(x) = √ exp − 2 2π 175 The standard normal density is −∞ < x < ∞. and invertible. diﬀerentiable. If g(x) is an increasing function.

For x ∈ Rk . f (x) = √ 2σ 2 2πσ which is the univariate normal density. we can also show that EX 2 = 1 and EX 4 = 3. and it is conventional to write X ∼ N (µ. Its mean and r variance are µ = r and σ 2 = 2r. then Σ = diag{σ 2 } is a diagonal matrix. y ≥ 0. Since it is symmetric about zero all odd moments are zero. −∞ < x < ∞. 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.1 Let X ∼ N (0. If X ∈ Rk is multivariate normal and the elements of X are mutually uncorrelated. It is conventional to write X ∼ N (0. where we used the fact that det (BΣB 0 )1/2 = det (Σ)1/2 det (B) . X has density Ã ! (x − µ)2 1 exp − . By iterated integration by parts. Q has the density f (y) = Γ 1 ¡r¢ 2 2r/2 yr/2−1 exp (−y/2) . Ir ) and set Q = X 0 X. This shows that linear transformations of normals are also normal. ¢ ¡ 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 . x ∈ Rk . q × q.11) and is known as the chi-square density with r degrees of freedom. then using the change-of-variables formula. q 176 . The mean and variance of the distribution are µ and σ 2 . If Z is standard normal and X = µ + σZ. and to denote the standard normal density function by φ(x) and its distribution function by Φ(x). denoted χ2 . Σ) and Y = a + BX with B an invertible matrix. respectively.8. A) with A > 0.2 If Z ∼ N(0. then they are mutually independent.8. Theorem A. The latter has no closed-form solution. the multivariate normal density is ¶ µ (x − µ)0 Σ−1 (x − µ) 1 . x ∈ Rk . Σ). exp − f (x) = k/2 1/2 2 (2π) det (Σ) The mean and covariance matrix of the distribution are µ and Σ. Theorem A. and it is conventional to write X ∼ N(µ. 1). then Z 0 A−1 Z ∼ χ2 . Another useful fact is that if X ∼ N (µ. This shows that if X is multivariate normal with uncorrelated elements. the density of Y is Ã ! (y − µY )0 Σ−1 (y − µY ) 1 Y exp − f (y) = . k/2 1/2 2 (2π) det (ΣY ) where µY = a+Bµ and ΣY = BΣB 0 .This density has all moments ﬁnite. σ 2 ). (A. then by the change-of-variables formula.

11). we see that the MGF of Z 2 is (1 − 2t)−1/2 .8.3 Let Z ∼ N (0. Then A−1 = C −10 C −1 and C −1 Z ∼ N (0. 1) and Q ∼ χ2 be independent. Thus the density of Z 2 is (A.1. ¡ ¢ √ using the change—of-variables s = x2 and the fact Γ 1 = π.2. Using the simple law of iterated expectations. 1).12) E exp (tQ) = 0 Γ (A. For Z ∼ N(0. From (A. (A. which we showed in (A.11) 2 with r = 1.8.3. The MGF for the density (A. C −1 CC 0 C −10 ) = N (0.11) is Z ∞ ¢ ¡ Γ r+1 2 f (x) = ´ r+1 ¡r¢ ³ √ 2 2 πrΓ 2 1 + x r (A. The fact that A > 0 means that we can write A = CC 0 where C is non-singular. tr has distribution 177 . 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 .13) is the MGF of the density (A.8.6) can be used to show that the MGF j=1 ¥ Proof of Theorem A. q Proof of Theorem A. Since we can write Q = P 2 X 0 X = r Zj where the Zj are independent N(0. which can be found by applying change-of-variables to the gamma function.13) = (1 − 2t)−r/2 R∞ where the second equality uses the fact that 0 y a−1 exp (−by) dy = b−a Γ(a). C −1 AC −10 ) = N (0. Iq ). 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.13). Set r Z .8. Proof of Theorem A.Theorem A.

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

179 . which maximizes the log-likelihood).3 Under regularity conditions. θ0 ) ln f (Yi . Theorem A.16) (A.9. If ˜ is an unbiased estimator of θ ∈ R. ˆ →p θ0 as n → ∞.16). The maximum likelihood estimator or MLE ˆ is the parameter value which maximizes θ the likelihood (equivalently.Deﬁne the Hessian H = −E and the outer product matrix Ω=E µ ∂2 ln f (Yi . the MLE θ Why do we believe that the MLE ˆ is estimating the parameter θ? Observe that when stanθ dardized.14) ¶ ∂ ∂ 0 ln f (Yi . we can see that it is an estimator of the maximizer θ of the right-hand-side. θ)¯ =0 ¯ ∂θ θ=θ0 H = Ω ≡ I0 (A. The ﬁrst-order condition for the latter problem is 0= ∂ ∂ L(θ) = E ln f (Yi . More typically.1 ¯ ¯ ∂ E ln f (Yi . θ) →p E ln f (Yi .17) is often called the information matrix equality.2 Cramer-Rao Lower Bound.9.9. then θ V ar(˜ ≥ (nI0 )−1 . θ0 ) ∂θ∂θ 0 (A. In fact. the log-likelihood is a sample average 1X 1 Ln (θ) = ln f (Yi . under conventional regularity conditions.15) Two important features of the likelihood are Theorem A. the restriction to unbiased estimators means that the theorem has little direct relevance for ﬁnite sample eﬃciency. θ Theorem A. cases are rare. However. we can ﬁnd an explicit expression for θ as a function of the data. n n i=1 n As the MLE ˆ maximizes the left-hand-side.17) The matrix I0 is called the information. ∂θ ∂θ (A. θ0 ) . θ) ∂θ ∂θ which holds at θ = θ0 by (A. We can write this as ˆ = argmax Ln (θ). but these ˆ must be found by numerical methods. I0 . θ θ∈Θ ˆ In some simple cases. and the equality (A. θ) The Cramer-Rao Theorem gives a lower bound for estimation. ˆ is consistent θ for this value. θ) ≡ L(θ). ´ ¡ −1 ¢ √ ³ˆ n θ − θ0 →d N 0.

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

θ0 ) ∂θ f (Yi . θ0 ) = ∂θ∂θ0 = Taking expectations yields (A.9. θ0 ) ∂θ ∂θ n i=1 which by Theorem (A. θ0 ) dy ¯ ¯ ¯ θ=θ0 f (y. y y θ(˜ y y y θS 1 = θ(˜ ∂θ ∂θ By the Cauchy-Schwarz inequality ¯ ³ ´¯2 ³ ´ ¯ ¯ θS θ 1 = ¯E ˜ ¯ ≤ V ar (S) V ar ˜ ³ ´ V ar ˜ ≥ θ 1 1 = . θ0 )0 . θ) f (y. θ) d˜ = ˜ y ) ∂ ln f (˜. ∂θ ¯θ=θ0 Z ! = 0. ∂2 ln f (Yi . θ) ¯θ=θ0 ¯ Z ¯ ∂ f (y. Proof of Theorem A.2.17). Since θ Z ˜ = ˜ y)f (˜.1) has mean zero and variance nH.9.9. θ) f (˜. To see (A. θ0 ) ln f (Yi . θ0 ) ∂ ∂θ f ∂ (Yi . Diﬀerentiating with respect to θ and evaluating at θ0 yields ˜ Z Z ³ ´ ˜ y ) ∂ f (˜. . (Yi .. θ0 ) (Yi . function of the data. yn ). θ) d˜ θ = Eθ θ(˜ y y where y = (y1 . V ar (S) nH so ¥ 181 . θ)¯ = ¯ ∂θ θ=θ0 = = = Similarly. Write the estimator ˜ = ˜ Y ) as a θ θ( ˜ ˜ is unbiased for any θ. θ0 ) ∂θ ∂θ ¥ ³ ´ X ∂ ∂ ˜ ln fn Y . S= ∂2 f ∂θ∂θ0 ∂2 f ∂θ∂θ0 ∂ ∂θ Z Ã ∂2 f ∂θ∂θ0 ¯ ¯ ln f (y. f (Yi . θ0 ) − f (Yi .Proof of Theorem A. θ) dy ¯ ∂θ f (y.. θ0 ) d˜ = E ˜ . θ0 = ln f (Yi . θ0 ) ∂ ∂ − ln f (Yi . θ0 ) ¯ ∂ f (y. θ) dy ¯ ¯ ∂θ θ=θ0 ¯ ∂ ¯ 1¯ = 0. we can show that E By direction computation.. θ0 ) f (Yi . ¯ ¯ ∂ E ln f (Yi . θ0 )2 (Yi . θ0 )0 f (Yi .16).1.

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

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

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

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

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