ECONOMETRICS

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.

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

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

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

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

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

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

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ii

. . . . . . . . . . . . . . . . . . . . . 11. . . . . . . . . . . . . . . . . .7 Hypothesis Testing: The Distance Statistic 9. .8 Conditional Moment Restrictions . . . .11Model Selection . . . . 9. . . . . . . . . . .13 One-Sided Tests . . . . . . . . . . .4 Estimation . . 12. . . . . . . . . . . . 12 Univariate Time Series 12. . . .4 Testing . . . . . . . . . . 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. . . . . . . . .1 Overidentified Linear Model . . . . . . . . . . . . . . . . . . . . . . . 11 Endogeneity 11. . . . . . . . . . . 12. . . . . . . . . . . . . . . . . . Percentile Confidence Intervals . . . . . . . . . . . . . . . . . . . . . . .11 8. . . . . . . . . . . . . . . . . . . . . . . . . . iii . . . . . . . . . . . . . . . . . . . . . . . . 10. . . . . . . . 12. . . . . . . . . . . . . . . . . . 11. 11. . . . . . . . . . . . . . . . . . . .5 Stationarity of AR(k) . . . . . . . . . . . . . . 9.3 Stationarity of AR(1) Process . . . . . . . .1 Stationarity and Ergodicity . . . . . . . . . . . . . . .2 GMM Estimator .9 Bootstrap GMM Inference . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .8. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 Empirical Likelihood 10. . . . . . . . . . . .7 Asymptotic Distribution . . . . . . . . . . . . . . . . .3 Distribution of GMM Estimator . . . . . . . . . . . . . . . . . . . 11. . . . . . . . . . . . . . . . . . . . . . . . . .8 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .12Autoregressive Unit Roots . . . . . . . . . . . . . . . . . . . . . . . 9. . . . . . . . . . . . . . 12. . . . . . .12 8. . . . . . . . . . . . . . . .9 Trend Stationarity . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . . . 10. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. . . . . . . . . . . .6 Bekker Asymptotics . . Symmetric Two-Sided Tests . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9. . . . . . . . . . . . . . .10 8.2 Autoregressions . . .6 Estimation .2 Reduced Form . . . . . . . . . . . . . . . . . . . . . . . . . .5 Special Cases: IV and 2SLS 11. . . . . . .10 Exercises . . . . . . . 12. . . . .8 Bootstrap for Autoregressions . . 9. . . . . . . . . . .10Testing for Omitted Serial Correlation 12. 12. . . . . . .2 Asymptotic Distribution of EL Estimator 10. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .6 Over-Identification Test . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11. . . . . . . . .5 GMM: The General Case . . 11. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Instrumental Variables . . . . . . . . . .9 8. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4 Estimation of the Efficient Weight Matrix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9. . . . . . .7 Identification Failure . . . . . . . . . . . . 12. . . . . . . . . . . . . . . . . . . . . . . . .3 Overidentifying Restrictions . . . . . . . . . . . . . . . .5 Numerical Computation . . . . . 12. . . . . . . .4 Lag Operator . . . . . .1 Non-Parametric Likelihood . . . . . . . . . . . . . . . . . . . . . .3 Identification . Bootstrap Methods for Regression Models Exercises . . . . . . . . . . . . . . . . . . . . . . .

. . . . . . .4 Sample Selection . . . . . . . . . . . .4 Single Equation from a VAR . .3 Expectation . . . . . . . . . . . . . B. . . . . . . . . 13. . . . . . . . . . . . . . . . . . . . . . . 14. . . . . B Numerical Optimization B. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Foundations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Grid Search . . . . . . . . . . . . . . . . . . . . . . . . . . .9 Cointegrated VARs .7 Transformations . . .5 Multivariate Random Variables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157 15.2 Estimation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165 165 167 168 169 171 173 175 175 178 183 183 184 185 . . . . . . . . . . . . . A. . . . . . . . B. . . . . . . . . . . . . . . . . . . . 13. . . . . . . . . . . . . . . . . . . . . . . . . . . A. . . . . . . . . A. . . 13. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162 A Probability A. .8 Cointegration . .2 Count Data . . . . . . . . .2 Fixed Effects .2 Random Variables . . . . . . . . . . . . . . . . . . . . 160 16. . . . . . . . . 14. . . .2 Gradient Methods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Binary Choice . . . . . . . . . . . . . . . . . . . . . . . . . . .7 Granger Causality . . . . . .3 Restricted VARs . . . . .2 Asymptotic MSE for Kernel Estimates . . . . . . .1 Kernel Density Estimation . . . . . . . . . . . . . . . .5 Testing for Omitted Serial Correlation 13. . . . . . . . A. . . . . . . . . . . . . . . . . . . . . .1 Individual-Effects Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13. . . . . . . . . 157 15. . . iv . . . . 159 16 Nonparametrics 160 16.6 Conditional Distributions and Expectation . . . . . . . . . . . . . . . . . . . .3 Dynamic Panel Regression .9 Maximum Likelihood . . . . . . . 13. . . . . . . . . . . . . . . . . 14 Limited Dependent Variables 14. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A. . . . . . . . . . . . . . . . 145 145 146 146 147 147 148 148 149 149 151 151 153 153 154 . . . . . .8 Normal and Related Distributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 Panel Data 157 15. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3 Censored Data . . A. . . .3 Derivative-Free Methods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13. . . . . . . . . . . . . . . . . . . 14. . . . . . . . . . . . . . . . . . .6 Selection of Lag Length in an VAR . . . . . . . . . . . . . . . . . . . . . A. . . . . .13 Multivariate Time Series 13. . . . . . . . . .4 Common Distributions . . . . . A. . . . . . . . . . . . . . . . . . .1 Vector Autoregressions (VARs) . . . .

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

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

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

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

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

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

the Moore-Penrose generalized inverse A− exists and is unique. if there is no c 6= 0 such that Ac = 0.4 Inverse A k × k matrix A has full rank. For non-singular A and C. .3) The matrix A− is not necessarily unique. if A is an orthogonal matrix. . . The following fact about inverting partitioned matrices is sometimes useful. . (2. . . 0b 0b ak 1 ak 2 · · · a0 bk 1 a0 bk 2 . In this case there exists a unique matrix B such that AB = BA = Ik . If A − BD−1 C and D − CA−1 B are non-singular. a0 bk k ⎤ ⎥ ⎥ ⎥ ⎦ a0 bi i b0 ai i = = tr (BA) . then A−1 = A. some properties include AA−1 = A−1 A = Ik ¡ ¢−1 ¡ −1 ¢0 = A0 A Even if a matrix A does not possess an inverse. or is nonsingular.1) .3) plus the following three conditions A− AA− = A− AA− is symmetric A− A is symmetric For any matrix A. The Moore-Penrose generalized inverse A− satisfies (2.The can be seen since ⎢ ⎢ tr (AB) = tr ⎢ ⎣ = k X i=1 k X i=1 ⎡ a0 b1 a0 b2 · · · 1 1 a0 b1 a0 b2 · · · 2 2 . 2. (2. 7 Also.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. then # ¡ ¢−1 ¡ ¢−1 ∙ ¸−1 " A − BD−1 C A B − A − BD−1 C BD−1 ¡ ¡ ¢−1 ¢−1 = . This matrix is called the inverse of A and is denoted by A−1 . we can still define a generalized inverse A− as a matrix which satisfies AA− A = A. .

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

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

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

See Chapter 16. These are asymmetric (skewed) densities. Figure 3. This is used when the goal is to quantify the impact of one set of variables on another variable. We call xi alternatively the regressor. In the example presented in Figure 3. While it is easy to observe that the two densities are unequal. These are indicated in Figure 3.Chapter 3 Regression and Projection The most commonly applied econometric tool is regression. or the covariates. We list the elements of xi in the vector ⎞ ⎛ x1i ⎜ x2i ⎟ ⎟ ⎜ (3.1 by the arrows drawn to the x-axis. Take a closer look at the density functions displayed in Figure 3. The data are from the 2004 Current Population Survey 1 11 .1 displays the density1 of hourly wages for men and women. In this context we partition the observations into the pair (yi . These are conditional density functions — the density of hourly wages conditional on race.1.1 Conditional Mean To study how the distribution of yi varies with the variables xi in the population. education and experience. . We call yi the dependent variable. and that for women is $20. the conditioning variable. we can focus on f (y | x) .1. gender. which is a common feature of wage distributions.1) xi = ⎜ . An important summary measure is the conditional mean Z ∞ yf (y | x) dy. (3. and exists so long as E |yi | < ∞. m(x) can take any form. When a distribution is skewed. it is useful to have numerical measures of the difference. You can see that the right tail of then density is much thicker than the left tail. from the population of white non-military wage earners with a college degree and 10-15 years of potential work experience. xki 3.73. To illustrate. ⎠ ⎝ . The two density curves show the effect of gender on the distribution of wages. In this context it is often convenient These are nonparametric density estimates using a Gaussian kernel with the bandwidth selected by crossvalidation. the mean wage for men is $27. xi ) where yi is a scalar (real-valued) and xi is a vector. the conditional density of yi given xi . holding the other variables constant. the mean is not necessarily a good summary of the central tendency.22.2) m(x) = E (yi | xi = x) = −∞ In general. ⎟ .

12 . this yields the formula yi = m(xi ) + ei .2 shows the density of log hourly wages for the same population. 2 (3. degree in mean log hourly wages is 0. with mean log hourly wages drawn in with the arrows. wage regressions typically use log wages as a dependent variable rather than the level of wages. The main point to be learned from Figure 3. The difference in the log mean wage between men and women is 0.2) evaluated at the observed value of xi : ei = yi − m(xi ). To illustrate.D. By construction.Figure 3. 3.30. implying an average 36% difference in wage levels.3 is how the conditional expectation describes an important feature of the conditional distribution. and a Ph.3 displays a scatter plot2 of log wages against education levels.36.5. For this reason. the solid line displays the conditional expectation of log wages varying with education. the dashed line is a linear projection approximation which will be discussed in the Section 3. Figure 3.A.3) White non-military male wage earners with 10-15 years of potential work experience. Of particular interest to graduate students may be the observation that difference between a B.1: Wage Densities for White College Grads with 10-15 Years Work Experience to transform the data by taking the (natural) logarithm. This is a more robust measure of the typical wage gap between men and women than the difference in the untransformed wage means. Figure 3. When the distribution of the control variable is continuous. which implies a 30% average wage difference for this population. Assuming for simplicity that this is the true joint distribution. then comparisons become more complicated.2 Regression Equation The regression error ei is defined to be the difference between yi and its conditional mean (3. The conditional expectation function is close to linear. The comparison in Figure 3.1 is facilitated by the fact that the control variable (gender) is discrete.

3. by the definition of ei and the linearity of conditional expectations.2: Log Wage Densities Theorem 3. E (ei | xi ) = E ((yi − m(xi )) | xi ) = m(xi ) − m(xi ) = E (yi | xi ) − E (m(xi ) | xi ) = 0. 2. because no restrictions have been placed on the joint distribution of the data. A regression model imposes further restrictions on the joint distribution.Figure 3. 4.2. E (h(xi )ei ) = 0 for any function h (·) .1 Properties of the regression error ei 1. most typically. E(ei ) = 0. 13 . E(xi ei ) = 0. The remaining parts of the Theorem are left as an exercise. not a model. restrictions on the permissible class of regression functions m(x). are often stated jointly as the regression framework. These equations hold true by definition. It is important to understand that this is a framework. The equations yi = m(xi ) + ei E (ei | xi ) = 0. To show the first statement. E (ei | xi ) = 0.

i .1. subject to the restriction p that it is non-negative. A common measure of the dispersion is the conditional variance ¡ ¢ σ 2 (x) = V ar (yi | xi = x) = E e2 | xi = x . The expected squared error using this prediction function is E (yi − g(xi ))2 = E (ei + m(xi ) − g(xi ))2 = Ee2 + 2E (ei (m(xi ) − g(xi ))) + E (m(xi ) − g(xi ))2 i = Ee2 + E (m(xi ) − g(xi ))2 i ≥ Ee2 i where the second equality uses Theorem 3.3: Conditional Mean of Wages Given Education The conditional mean also has the property of being the the best predictor of yi . σ 2 (x) is a non-trivial function of x.3. and can take any form. In contrast. Thus the mean squared error is minimized by the conditional mean.4) E e2 | xi = σ 2 i 14 While the conditional mean is a good measure of the location of a conditional distribution. the conditional variance of yi is σ 2 = σ 2 (xi ). it does not provide information about the spread of the distribution.2. let g(x) be an arbitrary predictor of yi given xi = x.3 Conditional Variance Generally. when σ 2 (x) is a constant so that ¢ ¡ (3. Given the random variable xi .Figure 3. 3. in the sense of achieving the lowest mean squared error. In the general case i where σ 2 (x) depends on x we say that the error ei is heteroskedastic. To see this. The conditional standard deviation is its square root σ(x) = σ 2 (x). The right-hand-side is minimized by setting g(x) = m(x).

it is convenient to augment the regressor vector xi by listing the number “1” as an element. which we derive in this section.1) has been redefined as the k × 1 vector ⎛ ⎞ 1 ⎜ x2i ⎟ ⎜ ⎟ (3. The conditional standard deviation for men is 12. its functional form is typically unknown. ⎝ . 3. where x1i is the first element of the vector xi defined in (3. Equivalently. ⎟ β=⎝ . we can write it as m(x) = x0 β = β 1 + x2i β 2 + · · · + xki β k where ⎞ β1 ⎜ . it is more realistic to view the linear specification (3. Equation (3. xki When m(x) is linear in x. Instead.6) as an approximation.1 and that for women is 10.5 Best Linear Predictor While the conditional mean m(x) = E (yi | xi = x) is the best predictor of yi among all functions of xi .we say that the error ei is homoskedastic. Some textbooks inappropriately describe heteroskedasticity as the case where “the variance of ei varies across observation i”. Thus (3. ⎠ . So while men have higher average wages.5) xi = ⎜ . ⎠ . ⎟ .8) is called the linear regression model. As an example. An important special case is homoskedastic linear regression model yi = x0 β + ei i E (ei | xi ) = 0 ¢ ¡ E e2 | xi = σ 2 .7) is a k × 1 parameter vector. we assume that x1i = 1. 15 .3) is when the conditional mean function m(x) is linear in x (or linear in functions of x). and the linear assumption of the previous section is empirically unlikely to accurate. i (3. take the conditional wage densities displayed in Figure 3.1). they are also somewhat more dispersed. This concept is less helpful than defining heteroskedasticity as the dependence of the conditional variance on the observables xi .4 Linear Regression An important special case of (3. In this case (3.5. Notationally.3) can be writen as yi = x0 β + ei i E (ei | xi ) = 0. We call this the “constant” or “intercept”.1. βk ⎛ (3.8) (3.6) (3.9) 3.

otherwise they are distinct. 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 . i ∂β ¢¢−1 ¡ ¡ E (xi yi ) . Given the definition of β in (3.10) exists and is unique as long as the k ×k matrix E (xi x0 ) is invertible. written E (xi x0 ) > 0. xi contains an intercept. 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. we obtain a decomposition of yi into linear predictor and error yi = x0 β + ei . E (xi x0 ) is a mai E(x y trix and E (xi yi ) is a vector.1. there cannot i exist a non-zero vector α such that α0 xi = 0 identically. i 16 .12) This completes the derivation of the linear projection model. α0 E (xi x0 ) α = E (α0 xi )2 ≥ 0 so the matrix E (xi x0 ) is by construction i i positive semi-definite. alternative expressions such as E xixi ) or E (xi yi ) (E (xi x0 ))−1 i ( i 0i ) are incoherent and incorrect.5. E (x0 xi ) < ∞.1 1. It is invertible if and only if it is positive definite.10). 3. Observe i that for any non-zero α ∈ Rk .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 . x0 β is the best linear predictor for yi . We now summarize the assumptions necessary for its derivation and list the implications in Theorem 3. The vector (3. i i (3. by “best” we mean the predictor function with lowest mean squared error. Equivalently. Assumption 3.which is quadratic in β. i 4. In order for β to be uniquely defined.5. Therefore. Eyi < ∞. i (3. this situation must be excluded.10) It is worth taking the time to understand the notation involved in this expression. 2 2. This occurs when redundant variables are included in xi . The best linear predictor is obtained by selecting β to minimize S(β). As before. The error is i ei = yi − x0 β. α0 E (xi x0 ) α = E (α0 xi )2 > 0. i which requires that for all non-zero α. The first-order condition for minimization (from Section 2. Rewriting. E (xi x0 ) is invertible. i (3.

(3.9).1.3 ensure that the moments in (3.1.8)-(3.5.3 are called regularity conditions.1. Since from Theorem 3.4: Hourly Wage as a Function of Experience The conditions listed in Assumption 3.10) and (3. The finite variance Assumptions 3. Assumption 3. x0 β is the i projection of yi on xi since the error ei is orthogonal with xi .Theorem 3.1 Under Assumption 3.14) holds.5. 17 . Figure 3. the orthogonality restriction (3. E (xi ei ) = 0 and E (ei ) = 0.1. Assumption 3.1.14).1 is employed to guarantee that (3.5.5. (3.5.13) and 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 = 0.5. Let’s compare it with the linear regression model (3.11) are well defined.14) Proof.13) The two equations (3.2 and 3.11) and (3.1. By definition.5.4 guarantees that the solution β exits.1. However.4 is required to ensure that β is uniquely defined. For example. Then i i Exi e2 = Ex3 = 0 yet E (ei | xi ) = x2 6= 0.1.1.5. This means that the equation (3. Assumption 3.4 we know that the regression error has the property E (xi ei ) = 0.13) implies that xi and ei are uncorrelated.1.14) follows from (3.2.12) can be alternatively interpreted as a projection decomposition. the converse is not true as the projection error does not necessarily satisfy E (ei | xi ) = 0. i i i Since E (xi ei ) = 0 we say that xi and ei are orthogonal. Using the definitions (3.13) summarize the linear projection model. Since ei is mean zero by (3. Furthermore.5.10) are defined. suppose that for xi ∈ R that Ex3 = 0 and ei = x2 . Assumption 3.1 are weak.2 and 3. it follows that linear regression is a special case of the projection model.1. ¥ (3.12) and (3.5.5. Equation (3.

We have shown that under mild regularity conditions. No additional assumptions are required. This defect in linear projection can be partially corrected through a careful selection of regressors.3. we can augment the regressor vector xi to include both experience and experience2 . since the resulting function is quadratic in experience. xi ) we can define a linear projection equation (3. The linear equation (3.5.12) is defined by projection and the associated coefficient definition (3. Returning to the joint distribution displayed in Figure 3. In Figure 1. Most importantly.1 may be false.12) with the properties listed in Theorem 3. and are discussed in Chapter 11.4 we display as well this quadratic projection. These structural models require alternative estimation methods. Other than the redefinition of the regressor vector. and the straight dashed line is the linear projection. We illustrate the issue in Figure 3. In this case (3. 18 . In contrast. it is important to not misinterpret the generality of this statement. It over-predicts wages for young and old workers. in many economic models the parameter β may be defined within the model.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. Figure 3. In this example the linear projection is a close approximation to the conditional mean. there are no changes in our methods or analysis.10) may not hold and the implications of Theorem 3.5 for a 3 In the population of Caucasian non-military male wage earners with 12 years of education. In other cases the two may be quite different. However. In this case the linear projection is a poor approximation to the conditional mean. Figure 3. The solid line is the conditional mean. the dashed line is the linear projection of log wages on eduction. In the example just presented.1. and under-predicts for the rest.4 displays the relationship3 between mean log hourly wages and labor market experience.10). it misses the strong downturn in expected wages for those above 35 years work experience (equivalently. for those over 53 in age). In this example it is a much better approximation to the conditional mean than the linear projection. A projection of log wages on these two variables can be called a quadratic projection. for any pair (yi .

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

Let X be a random variable with µ = EX and σ 2 = V ar(X). j! 0 j = 0. Compute the conditional mean m(x) = E (yi | xi = x) .1. Does this justify a linear regression model of the form yi = x0 β + εi ? i then EY = λ and V ar(Y ) = λ. If yi = x0 β + ei and E(xi ei ) = 0. E(ei | xi ) = 0. ¡ ¢ 4. True or False. 20 . If yi = xi β + ei . µ. σ 2 = V ar(yi ) and σ xy = Cov(xi . i 10. Define µ ¶ ¢ ¡ x−µ 2 g x. m. 2. then ei is independent of xi . xi ∈ R. s) = 0 if and only if m = µ and s = σ 2 . True or False. Prove parts 2. σ = . Suppose that yi is discrete-valued. Let xi and yi have the joint density f (x. If yi = x0 β + ei and E(ei | xi ) = 0. and E(e2 | xi ) = σ 2 . 3 and 4 of Theorem 3.3 Find E(Y | X = x). Take the bivariate linear projection model yi = β 0 + β 1 xi + ei E (ei ) = 0 E (xi ei ) = 0 Define µy = Eyi .1 . taking values only on the non-negative integers. then E(x2 ei ) = 0. (x − µ)2 − σ 2 Show that Eg (X. i 11. If yi = x0 β + ei . True or False. then E(ei | xi ) = 0. 2. and the conditional distribution of yi given xi is Poisson: P (yi = k | xi = x) = e−x β (x0 β)j . xi ∈ R. e−λ λj j! . x 6. E(Y 2 | X = x) and V ar(Y | X = x). i 7.6 Exercises 1. Compute 2 the coefficients of the linear projection yi = β 0 + β 1 xi + ei . y) = 3 x2 + y 2 on 0 ≤ x ≤ 1.4 . Suppose that Y and X only take the values 0 and 1. yi ). 1. Are they different? Hint: If P (Y = j) = 5. 9. If yi = xi β + ei .. µx = Exi .. a constant. True or False. and E(xi ei ) = 0. and have the following joint probability distribution X=0 X=1 Y =0 .2 Y =1 . then E(x2 ei ) = 0. Compute E(yi | xi = x) and V ar(yi | xi = x).3. True or False. i 8.2. and E(ei | xi ) = 0. σ 2 = V ar(xi ). Show that x y β 1 = σ xy /σ 2 and β 0 = µy − β 1 µx . 0 ≤ y ≤ 1. then ei is i i independent of xi . 3. .

Their moment estimators are the sample moments i ˆ E (xi yi ) = ¢ ¡ ˆ E xi x0 = i 1X xi yi n 1 n i=1 n X i=1 n xi x0 .3) writes the projection coefficient β as an explicit function of population moments E (xi yi ) and E (xi x0 ) . but for most of the chapter we retain the broader focus on the projection model.8. The function g(β) can be estimated by form g(β) = E (xi (yi − xi g (β) = ˆ ¢ 1X ¡ xi yi − x0 β . (4.3) with the sample moments: ³ ¡ ¢´−1 ˆ ˆ ˆ β = E xi x0 E (xi yi ) i à n !−1 n 1X 1X 0 xi xi xi yi = n n i=1 i=1 à n !−1 n X X = xi x0 xi yi . 4. i n i=1 n 21 . we narrow the focus to the linear regression model.7 and 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. Observe that (4.2) (4. i It follows that the moment estimator of β replaces the population moments in (4.4) i i=1 i=1 ˆ Another way to derive β is as follows.1) (4.2) can be written in the parametric 0 β)) = 0.3) In Sections 4.1 Estimation Equation (4.

14 14. i 22 .7% increase in mean wages.3.83 ¶−1 µ ¶ .170 37.2 Least Squares There is another classic motivation for the estimator (4. The estimator β is the value which jointly sets these equations equal to zero: 0 = g (β) ˆ ˆ n ´ 1X ³ ˆ xi yi − x0 β = i n i=1 (4. These are white male wage earners from the March 2004 Current Population Survey. excluding military.4).117 Educationi . Define the sum-of-squared errors (SSE) function n X¡ ¢2 yi − x0 β Sn (β) = i i=1 = This is a quadratic function of β. An interpretation of the estimated equation is that each year of education is associated with an 11.14 205.37 µ ¶ 1.14 14.117 1 14. 30 = . Let yi be log wages and xi be an intercept and years of education. 0.30 + 0. 40 0.95 42. This sample has 988 observations. ¶ 2.40 µ ¶µ ¶ 34.5) = n n 1X 1X ˆ xi yi − xi x0 β i n n i=1 i=1 whose solution is (4. n X i=1 2 yi − 2β 0 n X i=1 xi yi + β 0 n X i=1 xi x0 β. 40 2.4). with 10-15 years of potential work experience.94 −2. 4.40 n i=1 1 n Thus ˆ β = n X i=1 xi x0 i = µ 1 14.71 = −2. Then µ ¶ n 1X 2. To illustrate. consider the data used to generate Figure 3.ˆ This is a set of k equations which are linear in β.14 205.83 µ We often write the estimated equation using the format \ log(W agei ) = 1.95 xi yi = 42.

The Ordinary Least Squares (OLS) estimator is the value of β which minimizes Sn (β). Figure 4. Since the function Sn (β) is a quadratic function of β. Figure 4. These two ˆ variables are frequently mislabeled.1: Sum-of-Squared Errors Function As a by-product of OLS estimation. Following convention we will call β the OLS estimator of β.1 displays an example sum—of-squared errors function Sn (β) for the case k = 2. The error is unobservable. i ˆ ˆ Note that yi = yi + ei . 23 . To visualize the sum-of-squared errors function.7) gives the first-order conditions for minimization: 0 = ∂ ˆ Sn (β) ∂β n n X X ˆ = −2 xi yi + 2 xi x0 β i i=1 i=1 ˆ whose solution is (4.2 displays the contour lines of the same function — horizontal slices at equally spaced heights. we define the predicted value ˆ yi = x0 β ˆ i and the residual ˆ ei = yi − yi ˆ ˆ = yi − x0 β.4). Figure 4. which can cause confusion. Matrix calculus (see Appendix 2. the contour lines are ellipses. while the residual is a by-product of estimation. It is important to understand the distinction between the error ei and the residual ei .

ˆ n−k 2 i=1 (4. and hold true for all linear regression estimates.7) A justification for the latter choice will be provided in Section 4. It measures the variation in the i “unexplained” part of the regression. ˆ σ = ˆ n 2 i=1 n (4.6) An alternative estimator uses the formula n 1 X 2 s = ei .2: Sum-of-Squared Error Function Contours Equation (4. These are algebraic results. 24 .5) implies that 1X xi ei = 0.Figure 4. Its method of moments estimator is the sample average 1X 2 ei . 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. ˆ n i=1 n Since xi contains a constant.7. one implication is that n 1X ei = 0. The error variance σ 2 = Ee2 is also a parameter of interest.

Instead. n−1 i=1 Theil’s estimator R is a ratio of adjusted variance estimators. it should be viewed as an estimator of the population parameter ρ2 = σ2 V ar (x0 β) i =1− 2 V ar(yi ) σy where σ 2 = V ar(yi ). σ 2 ) = − log 2πσ 2 − 2 2 2σ i=1 25 . 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. and distribution theory. Pn y2 ˆ σ2 ˆ R2 = Pn i=1 i 2 = 1 − 2 σy ˆ i=1 (yi − y) σ2 = ˆy 1X (yi − y)2 n i=1 n is the sample variance of yi .3 Normal Regression Model Another motivation for the least-squares estimator can be obtained from the normal regression model. σ 2 ).where A measure of the explained variation relative to the total variation is the coefficient of determination or R-squared. testing. where likelihood methods can be used for estimation. σ 2 ) maximize Ln (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 ). ˆ Plugging β into the log-likelihood we obtain n ¡ ¢ n 1 X 2 ˆ ei ˆ Ln (β. An alternative estimator of ρ2 proposed by Theil called “R-bar-squared” is y R =1− where σ2 = ˜y 2 n 2 s2 σ2 ˜y 1 X (yi − y)2 . The R2 is frequently mislabeled as a measure of “fit”. Hence the MLE for β equals the OLS estimator. Since Ln (β. 4. maximizing the likelihood is identical to minimizing Sn (β). σ 2 ) is a function of β only through the sum of squared errors Sn (β). This is a parametric model. This is the linear regression model with the additional assumption that the error ei is independent of xi and has the distribution N (0. The log-likelihood function for the normal regression model is à ¶! µ n X ¢2 1 1 ¡ 2 0 log exp − 2 yi − xi β Ln (β.

en ⎞ Observe that Y and e are n × 1 vectors.6). residual vector. σ 2 ) for the normal ˆ regression model are identical to the method of moment estimators. . n or equivalently Y = Xβ + e. ⎠ xi x0 = X 0 X i xi yi = X 0 Y. 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. = β+ XX 26 (4. and X is an n × k matrix.12) is a system of n equations. yn ⎟ ⎟ ⎟. σ 2 ) = − 2 + ¡ ¢2 e2 = 0.8) . including computation. ⎟. . We can stack these n equations together as y1 = x0 β + e1 1 y2 = x0 β + e2 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.Maximization with respect to σ 2 yields the first-order condition n X ∂ n 1 ˆ ˆ Ln (β. ⎠ ⎜ ⎜ e=⎜ ⎝ ⎟ ⎟ ⎟. yn = x0 β + en . 4. ⎝ ⎝ . For example n X i=1 For many purposes. . We define ⎛ ⎞ ⎛ y1 ⎜ ⎜ y2 ⎟ ⎜ ⎟ ⎜ X=⎜ Y = ⎜ . . n X i=1 Thus the estimator (4. x0 n ⎞ ⎛ e1 e2 . Thus the MLE (β. one for each observation. Sample sums can also be written in matrix notation. ⎠ . it is matrix notation.4 Model in Matrix Notation convenient to write the model and statistics in x0 1 x0 2 . ˆi 2 ∂σ 2 2ˆ σ 2 σ ˆ i=1 ˆ ˆ Solving for σ 2 yields the method of moments estimator (4.4). Due to this equivalence. The linear equation (3. . the ˆ OLS estimator β is frequently referred to as the Gaussian MLE. .

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

Regress Y on X1 . observe that ⎞ ⎛ ⎞ ⎛ . In some contexts. which you may have seen in an introductory econometrics course. In the model (4. Regress X2 on X1 .13). the primary use is theoretical. 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 .6. 30 .18) E (e | X) = ⎜ E (ei | X) ⎟ = ⎜ E (ei | xi ) ⎟ = 0. . In this section we derive the small sample conditional mean and variance of the OLS estimator. obtain residuals X2 .Theorem 4. . ¡ ¢−1 0 ι. ˜ 2. ˆ which are “demeaned”. and X2 is the vector of observed regressors. . 4. A common application of the FWL theorem. Rather. the OLS estimator of β 2 and the OLS residuals e may be equivalently computed by either the OLS regression (4. obtain OLS estimates β 2 and residuals e. Partition X = [X1 X2 ] where X1 = ι is a vector of ones.9).14) or via the ˆ following algorithm: ˜ 1. obtain residuals Y . but in most cases there is little computational advantage to using the two-step algorithm.9). . . the FWL theorem can be used to speed computation. Regress Y on X2 .1 (Frisch-Waugh-Lovell). . ˆ ˜ ˜ ˆ 3. 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.8)(3. By the independence of the observations and (3. ⎠ ⎝ ⎠ ⎝ . In this case. . ⎟ ⎜ ⎟ ⎜ (4. . ! Thus the OLS estimator for the slope coefficients is a regression with demeaned data. . . is the demeaning formula for regression.7 Bias and Variance In this and the following section we consider the special case of the linear regression model (3.

Then given (4.8). ⎝ . ⎠ (4.19) ˆ and thus the OLS estimator β is unbiased for β. . .. . ¡ 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. and ³ ´ ¡ ¢−1 2 ˆ σ . . for any random vector Z define the covariance materix V ar(Z) = E (Z − EZ) (Z − EZ)0 = EZZ 0 − (EZ) (EZ)0 . V ar β | X = X 0 X ⎟ ⎟ ⎟. σ2 = ˆ ¢ 1 ¡ ¢ 1 0 1 1 1 ¡ e e = e0 M M e = e0 M e = tr e0 M e = tr M ee0 ˆˆ n n n n n 31 In the special case of the linear homoskedastic regression model. X 0 DX = X 0 Xσ 2 . 0 0 ··· 0 0 . . . σ 2 } = ⎜ . 1 n . σ 2 = σ 2 and we have the simplii fications D = In σ 2 . and (4. . We have shown that which implies ³ ´ ˆ E β|X =β ³ ´ ˆ E β =β (4.12). and the trace operator observe that. .19) we see that ¶ µ³ ³ ´ ´³ ´0 ˆ ˆ ˆ V ar β | X = E β−β β−β |X = where The i’th diagonal element of D is ¡ ¢ D = E ee0 | X . σ2 n ⎞ We now calculate the finite sample bias of the method ¡ moments estimator σ 2 for σ 2 . Next.Using (4. we can calculate ³ ´ ³¡ ´ ¢−1 0 ˆ E β−β |X = E X 0X Xe|X ¢−1 0 ¡ X E (e | X) = X 0X = 0. Thus D is a diagonal matrix with i’th diagonal element σ 2 : i ⎛ 2 σ1 0 · · · ⎜ 0 σ2 · · · 2 ⎜ D = diag{σ 2 . the properties of conditional expectations.18)... the properties additional assumption of conditional homoskedasticity E ei i of projection matrices. under the of ˆ ¢ 2 | x = σ 2 . From (4.20) ..

32 .8 Gauss-Markov Theorem In this section we restrict attention to the homoskedastic linear regression model. the best (minimumvariance) unbiased linear estimator is OLS. the estimator ˆ 2 defined (4. = σ2 n the final equality by (4. or in the projection model.8)¢ ¡ (3. ˜ so β is unbiased if (and only if) A0 X = Ik . known as the Gauss-Markov theorem. It is not unbiased in the absence of homoskedasticity.Then ¢ ¡ E σ2 | X = ˆ ¢¤ 1 £ ¡ tr E M ee0 | X n ¡ ¢¤ 1 £ = tr M E ee0 | X n ¤ 1 £ tr M σ 2 = n n−k . In this case. The least-squares estimator is the special case obtained by setting A = X(X 0 X)−1 . 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. says that the least-squares estimator is the best choice. This is the justification for the common s ˆ preference of s2 over σ 2 in empirical practice. Now consider the class of estimators of β which are linear functions of i the vector Y. In the homoskedastic linear regression model. which is (3. which we now present. What is the best choice of A? The Gauss-Markov theorem. that this estimator is only unbiased in the special case of the homoskedastic linear regression model. Thus σ 2 is biased towards zero.1 Gauss-Markov. Theorem 4.7) is unbiased for σ 2 by this calculation. ³ ´ ˜ V ar β | X = A0 V ar (e | X) A = A0 Aσ 2 . 4.10). The following result. is a famous statement of the solution. Thus since V ar (e | X) = In σ 2 under homoskedasticity. It is important to remember.9) plus E e2 | xi = σ 2 .8. and thus can be written as ˜ β = A0 Y where A is an n × k function of X. As an alternative. By a calculation similar to those of the previous section. ³ ´ ˜ E β | X = A0 Xβ. ˜ β L = A0 Y = A (Xβ + e) = β + Ae. however. as it yields the smallest variance among all unbiased linear estimators.

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

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

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

that is. = V ar β ρ 1 n n (1 − ρ2 ) −ρ 1 4. As a consequence. We can also define the leave-one-out residual ˆ ˆ ei. If the i’th observation 36 . µ ¶−1 µ ¶ ³ ´ 2 σ2 1 ρ 1 −ρ ˆ|X = σ . ˆ i A simple comparison yields that ˆ ei − ei. 1] and sum to k. A more relevant implication of near multicollinearity is that individual coefficient estimates will be imprecise. The hi take values in [0.27) (4. We can see this most simply in a homoskedastic linear regression model with two regressors yi = x1i β 1 + x2i β 2 + ei . A convenient alternative expression is ¡ ¢−1 ˆ ˆ xi ei ˆ (4. define the leave-one-out least-squares estimator of β. This equals ´−1 ³ 0 ˆ X(−i) Y(−i) (4.24) β (−i) = X(−i) X(−i) is the i’th diagonal element of the projection matrix X (X 0 X)−1 X 0 . and 1 0 XX= n µ 1 ρ ρ 1 ¶ In this case The correlation ρ indexes collinearity. the worse the precision of the individual coefficient estimates.One implication of near singularity of matrices is that the numerical reliability of the calculations is reduced. In extreme cases it is possible that the reported calculations will be in error due to floating-point calculation difficulties. 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.12 Influential Observations where X(−i) and Y(−i) are the data matrices omitting the i’th row.−i = (1 − hi )−1 hi ei .25) below. We derive expression (4. What is happening is that when the regressors are highly dependent. We can see the effect of collinearity on precision by observing that the asymptotic variance of a coefficient ¡ ¢−1 approaches infinity as ρ approaches 1.26) As we can see. Thus the more “collinear” are the estimate σ 2 1 − ρ2 regressors. To investigate the possibility of influential observations.−i = yi − x0 β (−i) = (1 − hi )−1 ei . it is statistically difficult to disentangle the impact of β 1 from that of β 2 . the precision of individual estimates are reduced. the change in the coefficient estimate by deletion of the i’th observation depends critically on the magnitude of hi . ˆ ˆ (4. since as ρ approaches 1 the matrix becomes singular.

which is considerably more informative than plots of the uncorrected residuals ei . The key is equation (2. then this observation is a leverage point and has the potential to be an influential observation.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 .4 which states that ¡ ¢ (A + BCD)−1 = A−1 − A−1 BC C + CDA−1 BC CDA−1 .This implies has a large value of hi . ˆ We now derive equation (4.1) in Section 2. Investigations into the presence of influential observations can plot the values of (4. ˆ = β − (1 − hi )−1 X 0 X and thus ˆ β (−i) = 37 .25).

4.13

Exercises

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

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

Pn

i=1 g

¡ ¢ Xi , µ, σ 2 .

2. Consider the OLS regression of the n × 1 vector y on the n × k matrix X. Consider an alternative set of regressors Z = XC, where C is a k × k non-singular matrix. Thus, each column of Z is a mixture of some of the columns of X. Compare the OLS estimates and residuals from the regression of Y on X to the OLS estimates from the regression of Y on Z.
0ˆ 3. Let e be the OLS residual from a regression of Y on X = [X1 X2 ]. Find X2 e. ˆ

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

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

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

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

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

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

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

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

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

39

(f) (g) (h)

Pn

Pn

ˆˆ i=1 yi ei ˆ2 i=1 ei R2

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

40

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

For any strictly increasing function g(X) ≥ 0. g(x) ≥ a + bx yet g(EX) = a + bEX since the curve is tangent at EX.3).4) Proof of Jensen’s Inequality. tangent lines lie below it. ¥ Proof of Holder’s Inequality. If Xi ∈ Rk is iid and E |Xi | < ∞. p p p q which is (5.Markov’s Inequality. denoted Zn →p Z as n → ∞. Then Z ∞ −1 P (Y > α) = α αf (y)dy Zα∞ ≤ α−1 yf (y)dy α Z ∞ ≤ α−1 yf (y)dy = α−1 E(Y ) −∞ the second-to-last inequality using the region of integration {y > α}. So for all x. Let U = |X|p /E |X|p and V = |Y |q /E |Y |q . We say that Zn converges in probability to Z as n → ∞. then as n → ∞ n 1X Xn = Xi →p E(X). Theorem 5. Applying expectations. P (g(X) > α) ≤ α−1 Eg(X).1 Weak Law of Large Numbers (WLLN). The WLLN shows that sample averages converge in probability to the population average. as stated. Let a + bx be the tangent line to g(x) at x = EX. =E U V p q p q Proof of Markov’s Inequality. Set Y = g(X) and let f denote the density function of Y. (5. ¥ 5.2 Weak Law of Large Numbers Let Zn ∈ Rk be a random vector. n→∞ lim P (|Zn − Z| > δ) = 0.2. Since g(x) is convex. Note EU = EV = 1. if for all δ > 0. 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 ) = + . (E |X|p )1/p (E |Y |q )1/q ¥ µ ¶ ´ ³ U V 1 1 1/p 1/q ≤E + = + = 1. This is a probabilistic way of generalizing the mathematical definition of a limit. Eg(X) ≥ a + bEX = g(EX). n i=1 42 .

Define the random vectors Wi = Xi 1 (|Xi | ≤ C) − E (Xi 1 (|Xi | ≤ C)) By the triangle inequality.4). (5. n i=1 0 where µ = EX and V = E (X − µ) (X − µ) . Set ε = δη/3. If Xi ∈ Rk is iid and E |Xi |2 < ∞. the fact that X n = W n + Z n . V ) . then as n→∞ n ¢ √ ¡ 1 X n Xn − µ = √ (Xi − µ) →d N (0. We have shown that for any δ > 0 and η > 0 then for all ¢ ¡¯ ¯ ¥ n ≥ 36C 2 /δ 2 η 2 .3. Fix δ and η.5).6) and (5. we can set E(X) = 0 (by recentering Xi on its expectation).6) By Jensen’s inequality (5. Theorem 5.7). denoted Zn →d Z. 43 . by Markov’s inequality (5. ≤ 2E |Xi | 1 (|Xi | > C) Zi = Xi 1 (|Xi | > C) − E (Xi 1 (|Xi | > C)) . where Z has distribution F (x) = P (Z ≤ x) . P ¯X n ¯ > δ ≤ η. ¯ ¯ ¯ ¯ ¯ ¯ ¢ E ¯X n ¯ ¡¯ ¯ E ¯W n ¯ + E ¯Z n ¯ 3ε ≤ ≤ = η. Pick C < ∞ large enough so that E (|X| 1 (|X| > C)) ≤ ε (5.1) and (5. ¯¢2 ¡ ¯ 2 ≤ EW n E ¯W n ¯ = EWi2 n 4C 2 ≤ n ≤ ε2 (5.5) (where 1 (·) is the indicator function) which is possible since E |X| < ∞. ≤ E |Xi | 1 (|Xi | > C) + |E (Xi 1 (|Xi | > C))| (5. ¯ ¯ E ¯Z n ¯ ≤ E |Zi | ≤ 2ε.7) the final inequality holding for n ≥ 4C 2 /ε2 = 36C 2 /δ 2 η 2 .1). Jensen’s inequality (5. 5. the triangle inequality. if for all x at which F (x) is continuous. We need to ¢show that for all δ > 0 and η > 0 there is some N < ∞ so that for all n ≥ N.1 Central Limit Theorem (CLT).3 Convergence in Distribution Let Zn be a random variable with distribution Fn (x) = P (Zn ≤ x) . Finally. ¡¯ ¯ P ¯X n ¯ > δ ≤ η. P ¯X n ¯ > δ ≤ δ δ δ the equality by the definition of ε. the fact that the Wi are iid and mean zero. as needed. Fn (x) → F (x) as n → ∞. We say that Zn converges in distribution to Z as n → ∞.Proof: Without loss of generality. and the bound |Wi | ≤ 2C.

By the properties of the exponential function. it is sufficient to consider the case µ = 0 and V = Ik . For ¡ ¢ λ ∈ Rk .Proof: Without loss of generality. 1 1 c(λ) = c(0) + cλ (0)0 λ + λ0 cλλ (λ∗ )λ = λ0 cλλ (λ∗ )λ 2 2 (5. the independence of the Xi . so when evaluated at λ = 0 c(0) = 0 cλ (0) = 0 cλλ (0) = −Ik .8) where λ∗ lies on the line segment joining 0 and λ. the definition of c(λ) and (5.8) ⎞ ⎛ nλ0 X 1 Xj ⎠ ln Cn (λ) = log E exp ⎝i √ n j=1 µ ¶ n Y 1 exp i √ λ0 Xj = log E n j=1 µ ¶ n Y 1 0 E exp i √ λ Xj = log n i=1 ¶ µ λ = nc √ n 1 0 λ cλλ (λn )λ = 2 44 . ∂λ∂λ cλ (λ) = cλλ (λ) = ∂ ∂ c(λ) = C(λ)−1 C(λ) ∂λ ∂λ ∂ ∂2 ∂2 −2 ∂ C(λ) 0 C(λ) c(λ) = C(λ)−1 0 0 C(λ) − C(λ) ∂λ ∂λ∂λ ∂λ∂λ ∂λ so when evaluated at λ = 0 Furthermore. let C(λ) = E exp iλ0 X denote the characteristic function of X and set c(λ) = ln C(λ). Then observe ¡ ¡ ¢¢ ∂ C(λ) = iE X exp iλ0 X ∂λ ¡ ¡ 0 ¢¢ ∂2 2 0 0 C(λ) = i E XX exp iλ X ∂λ∂λ C(0) = 1 ∂ C(0) = iE (X) = 0 ∂λ ¡ ¢ ∂2 0 0 C(0) = −E XX = −Ik . By a second-order Taylor series expansion of c(λ) about λ = 0. ¢ ¡ √ √ We now compute Cn (λ) = E exp iλ0 nX n the characteristic function of nX n .

3 Delta Method: If n (θn − θ0 ) →d N (0. This is sufficient to establish the theorem. we see that as n → ∞. and g(θ) : Rm → Rk . Ik ) distribution. for all ε > 0 we can find a δ > 0 such that if |Zn − c| < δ then |g (Zn ) − g (c)| ≤ ε.4.4. Hence g(Zn ) →p g(c) as n → ∞. then g(Zn ) →p g(c) as n → ∞. Stacking across elements of g. 45 . Thus P (|g (Zn ) − g (c)| ≤ ε) ≥ P (|Zn − c| < δ) → 1 as n → ∞ by the assumption that Zn →p c. k ≤ m. Σ) . where θ is m × 1 and Σ is m × m. gθ Σgθ where gθ (θ) = ∂ g(θ) ∂θ0 and gθ = gθ (θ0 ). Recall that A ⊂ B implies P (A) ≤ P (B). If Zn →p c as n → ∞ and g (·) is continuous at c. then g(Zn ) →d g(Z) as n → ∞. then ¡ ¢ √ 0 n (g (θn ) − g(θ0 )) →d N 0. we find jn ¢ ¡ √ √ 0 n (g (θn ) − g(θ0 )) = (gθ + an ) n (θn − θ0 ) →d gθ N (0. √ Theorem 5.√ where λn → 0 lies on the line segment joining 0 and λ/ n. It follows that ajn = gjθ (θ∗ ) − gjθ →p 0. Proof : By a vector Taylor series expansion. gj (θn ) = gj (θ0 ) + gjθ (θ∗ ) (θn − θ0 ) jn where θnj lies on the line segment between θn and θ0 and therefore converges in probability to θ0 .4 Asymptotic Transformations Theorem 5. If Zn →d Z as n → ∞ and g (·) is continuous.4. Since cλλ (λn ) → cλλ (0) = −Ik .2 Continuous Mapping Theorem 2. gθ Σgθ . Σ) = N 0.1 Continuous Mapping Theorem 1 (CMT). ¥ 5. µ ¶ 1 Cn (λ) → exp − λ0 λ 2 the characteristic function of the N (0. Theorem 5. for each element of g. Proof: Since g is continuous at c.

Chapter 6 Inference 6.1 Sampling Distribution The least-squares estimator is a random vector. its distribution is a complicated function of the joint distribution of (yi . the density function of β 2 was computed and plotted in Figure 6. Using ˆ simulation methods. xi ) and the sample size n. ˆ Figure 6.1: Sampling Density of β 2 To illustrate the possibilities in one example. n = 100 and n = 800.1 for sample sizes of n = 25. The verticle line marks the true value of the projection coefficient. let yi and xi be drawn from the joint density µ ¶ µ ¶ 1 1 1 2 2 exp − (ln y − ln x) exp − (ln x) f (x. and therefore has a sampling distribution. since it is a function of the random data. 46 . In general. y) = 2πxy 2 2 ˆ and let β 2 be the slope coefficient estimate computed on observations from this joint density.

For a complete argument. using (6.From the figure we can see that the density functions are dispersed and highly non-normal.1) imply that n ¡ ¢ 1X xi x0 →p E xi x0 = Q (6.4. ¥ We can similarly show that the estimators σ 2 and s2 are consistent for σ 2 . xi ei = g i n n i=1 i=1 1X xi ei →p E (xi ei ) = 0.8) implies that ˆ β−β = Ã n X i=1 xi x0 i !−1 n X i=1 xi ei . ·) is continuous at (Q. Assumption 3. 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.2 Consistency ˆ As discussed in Section 6. Proof.1. and the continuous mapping theorem (Theorem 5.1 by the fact that the sampling densities become more concentrated as n gets larger. To characterize the sampling distribution more fully. the OLS estimator β is has a statistical distribution which is unknown. First. (6. ˆ Theorem 6.1).2.2) i i n i=1 n From (6.4 implies that Q−1 exists and thus g(·. ˆ 47 . 0). b) = A−1 b is a continuous function of A and b at all values of the arguments such that A−1 exist. xi ei →p g (Q.1. (6.2.5. n i=1 (6.1). Asymptotic (large sample) methods approximate sampling distributions based on the limiting experiment that the sample size n tends to infinity.1) and ˆ We now deduce the consistency of β.1 and the WLLN (Theorem 5.1).1 Under Assumption 3. Assumption 3.5.2). Ã n ! n X 1X 0 1 ˆ xi xi . As the sample size increases the density becomes more concentrated about the population coefficient. This is illustrated in Figure 6. we will use the methods of asymptotic approximation.4. β →p β as n → ∞. we can conclude ˆ that β →p β.5.1). 6. Equation (4. (6.3). 0) = Q−1 0 = 0 β−β =g n n i=1 i=1 ˆ which implies β →p β as stated.1. Hence by the continuous mapping theorem (Theorem 5.3) Ã where g(A. we can write !−1 Ã n ! n 1X 1X 0 ˆ β−β = xi xi xi ei n n i=1 i=1 Ã n ! n X X 1 1 xi x0 .

2 Under Assumption 3. Thus σ 2 is consistent for σ 2 .1 guarantees that the elements of Ω are finite.Theorem 6. We need a strengthening of the moment conditions. ˆ Proof.3) and Theorem (6. since n/(n − k) → 1 as n → ∞.3. n 1 X √ xi ei →d N (0.2. by the Cauchy-Schwarz inequality (5.1). ´1/2 ¡ ¯ ¯¢ ¯ ³ ¯ ¯2 ´1/2 ¡ ¯ 4 ¯¢1/2 ³ ¯ 1/2 E ¯xi x0 e2 ¯ ≤ E ¯xi x0 ¯ = E |xi |4 < ∞. 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 . E ¯ei ¯ E ¯e4 ¯ i i i i (6. (6. (6.1). i Now define ¡ ¢ Ω = E xi x0 e2 . (6. ˆ Finally.3 Asymptotic Normality ˆ We now establish the asymptotic distribution of β after normalization.1.1 In addition to Assumption 3.2). To see this. σ 2 →p σ 2 and s2 →p σ 2 as n → ∞. Ee4 < ∞ and E |xi |4 < ∞.1.2. (6. Assumption 6. Ω) .5. it follows that s2 = ¥ n σ 2 →p σ 2 . i i Assumption 6.2).5) Thus xi ei is iid with mean zero and has covariance matrix Ω. ˆ n−k 6. By the central limit theorem (Theorem 5.3.5.4) ³ ´ ³ ´0 ³ ´ ˆ ˆ ˆ e2 = e2 − 2ei x0 β − β + β − β xi x0 β − β ˆi i i i σ2 = ˆ 1X 2 ei ˆ n i=1 i=1 →p σ 2 n 1X 2 = ei − 2 n à ! à n ! n ´ ³ ´0 1 X ³ ´ 1 X 0 ³ˆ 0 ˆ ˆ β−β + β−β β−β ei xi xi xi n n i=1 i=1 the last line using the WLLN.3.6) n i=1 48 .

1. Q−1 ΩQ−1 . Under (6. setting n = 100 and varying the parameter α. there is no simple answer to this reasonable question.2). In´Figure 6.3. 1).1 Under Assumption 6. but this is not a necessary condition. We say that ei is a Homoskedastic Projection Error when (6.1 states that the sampling distribution of the least-squares estimator. 1 X √ xi ei n i=1 n ! the N (0. ´ √ ³ˆ As V is the variance of the asymptotic distribution of n β − β . for any ˆ fixed n the sampling distribution of β can be arbitrarily far from the normal distribution. In this context the normalized least-squares slope estimator n α−2 β 2 − β 2 has α →d Q−1 N (0.3. As α approaches 2. We illustrate this problem using a simulation. 1) asymptotic distibution.7) holds. Let yi = β 0 + β 1 xi + εi where xi is N (0. This holds true for all joint distibutions of (yi . and (6. otherwise V 6= V 0 . is approximately normal when the sample size n is sufficiently large. The expression V = Q−1 ΩQ−1 is called a sandwich form. The asymptotic distribution ´ Theorem 6. V is often referred to as ˆ the asymptotic covariance matrix of β.6). xi ) which satisfy the conditions of Assumption 6.8) Ω = E xi x0 E e2 = Qσ 2 i i V = Q−1 ΩQ−1 = Q−1 σ 2 ≡ V 0 (6. i i Condition (6. e2 ) = 0. When (6. the normal approximation is arbitrarily poor for some data distribution satisfying the assumptions.9) In (6.1. V ) where V = Q−1 ΩQ−1 . If α > 2 the 2 error εi has zero mean and variance α/(α − 2). The approximation may be poor when n is small. We call V 0 the homoskedastic covariance matrix. Ω) ¡ ¢ = N 0. after rescaling. when xi and ei are independent.3.7) is true or false. ´ √ ³ ˆ n β−β = à 1X xi x0 i n i=1 n !−1 à Theorem 6. (6.7) the asymptotic variance formulas simplify as ¡ ¢ ¡ ¢ (6.7) Cov(xi x0 .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. however.7) is true then V = V 0 .3.2 we display the finite sample densities of the q ³ ˆ normalized estimator n α−2 β 2 − β 2 . for example. as n → ∞ ´ √ ³ ˆ n β − β →d N (0.1 is commonly used to approximate the finite of √ ³ˆ sample distribution of n β − β . The trouble is that no matter how large is the sample size.Then using (6. There is a special case where Ω and V simplify.3. |ε| ≥ 1. How large should n be in order for the approximation to be useful? Unfortunately. For α 49 . Theorem 6. However. In Figure 6. and εi is independent of xi with the Double Pareto density f (ε) = α |ε|−α−1 .1).9) we define V 0 = Q−1 σ 2 whether (6. its variance diverges q ³ ´ ˆ to infinity.

The estimator 2 2 in (6. The homoskedastic covariance matrix V 0 = Q−1 σ 2 is typically estimated by ˆ ˆ (6. As α diminishes the density changes significantly. We show the sampling distribution of n β 1 − β 1 setting n = 100. concentrating most of the probability mass around zero. ˆ ˆ Since Q →p Q and s2 →p σ 2 (see (6.3.2 and 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. we need an estimate of Ω = E xi x0 e2 .10) without changing this result. 1). Another example is shown in Figure 6. for k = 1.2) and Theorem 6. 6 and 8. the sampling distribution becomes highly skewed and non-normal. The MME estimator is i i 1X ˆ xi x0 e2 Ω= i ˆi n i=1 n (6. As k increases. The lesson from Figures 6. 4.0 the density is very close to the N (0. σ may also be substituted for s ˆ ¡ ¢ To estimate V = Q−1 ΩQ−1 .3 is that the N (0.2. 6. 1) density.10) V 0 = Q−1 s2 .11) 50 .2: Density of Normalized OLS estimator α = 3. 1) asymptotic approximation is never guaranteed to be accurate.Figure 6.4 Let Covariance Matrix Estimation 1X ˆ xi x0 Q= i n i=1 n be the method of moments estimator for Q.1) it is clear that V 0 →p V 0 .

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

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. (6.30 + 0.020) 6.20 and µ ¶ ˆ = 0.6 Therefore the two covariance matrix estimates are µ ¶−1 µ ¶ 1 14.2. but not under another set of assumptions. then take the diagonal elements. and then the square roots. Ω 2. First. by Holder’s inequality (5.used by an author when studying their work.80 40. the standard method to calculate the standard errors is to ˆ first calculate n−1 V .80 40.14 14.14 14.493 −0. We calculate that s2 = 0.020.480 ˆ0 = 0.4) ˆ Ω = = n n n ³ ´0 ³ ´0 ³ ´ 1X 2X 1X 0 2 0 ˆ ˆ ˆ xi xi ei − xi xi β − β xi ei + xi x0 β − β xi x0 β − β . From a computational standpoint.6 ¶µ 1 14.14 205.3) so by the WLLN ³ ´ ³ ´3/4 ¡ ¯ ¯¢ 1/4 E |xi |3 |ei | ≤ E |xi |4 < ∞.20 −0. we return to the log wage regression of Section 4. E ¯e4 ¯ i ³ ´ 1X |xi |3 |ei | →p E |xi |3 |ei | .14 6. Using (6. To illustrate.035 ¶ .039 and ˆ V = µ 1 14. p ˆ In this case the two estimates are quite similar.12) i i n n n i=1 i=1 We now examine each sum on the right-hand-side of (6.80 2.5) and the WLLN (Theorem 5.199 2. just as any other estimator.2/988 = .199 2.20 = V 14. It is also important to understand that a particular standard error may be relevant under one set of model assumptions.493 0. n n i=1 52 .14 205.98 −0. We can write the estimated equation with standards errors using the format \ log(W agei ) = 1.480 .14 205.085) (.085 p ˆ and that for β 1 is . from which it follows that V →p V as n → ∞.1) show that n ¡ ¢ 1X xi x0 e2 →p E xi x0 e2 = Ω. (.83 ¶−1 µ .117 Educationi .83 −0.83 ¶−1 = µ 7.1. The standard errors for β 0 are 7. (6.80 .12) in turn.35/988 = . i i i i n i=1 Second.

¯ ¯n ¯ n i=1 so Together.26). Recall from Section 4. ¯ n ¯ n ¯2 X ¯1 X ³ ´0 ³ ´¯ ¯ ¯ 0 ˆ ˆ ˆ − β ¯ ≤ ¯β − β ¯ 1 xi xi β − β xi xi β |xi |4 →p 0. 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 (6.12 the definition of β (−i) as the least-squares estimator with the i’th observation deleted.25). MacKinnon and White (1985) present numerical (simulation) evidence i ˆ ˆ that V ∗ works better than V as an estimator of V .11) with the leave-one-out estimator ei. ¯ ¯ ¯ ¯ ¯n ¯ n i=1 i=1 1X |xi |4 →p E |xi |4 . is defined ˆ ˆ by replacing the OLS residual ei in (6. these establish consistency. which. by the WLLN ¯ n ¯ à n ! ¯ 1X ¯1 X ¯ ¯ ³ ´0 ¯ ¯ ¯ ¯ˆ 3 0 ˆ xi xi β − β xi ei ¯ ≤ ¯β − β ¯ |xi | |ei | →p 0. i=1 Third. 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.−i = (1 − hi )−1 ei ˆ presented in (4.14) à 1X (1 − hi )−1 xi ei ˆ n i=1 n !à 1X (1 − hi )−1 xi ei ˆ n i=1 n !0 and hi = x0 (X 0 X)−1 xi . Ω →p Ω and V →p V. They also suggest that the scaling factor (n − 1)/n in (??) can be omitted. Andrews’ proposed estimator is ˆ ˆ ˆ ˆ V ∗∗ = Q−1 Ω∗∗ Q−1 53 .6 Alternative Covariance Matrix Estimators ˆ MacKinnon and White (1985) suggested a small-sample corrected version of V based on the jackˆ knife principle.13) of Efron (1982). Andrews (1991) suggested an similar estimator based on cross-validation. Using this substitution. 6.13) Using formula (4.¯ ¯ ¯ ¯ˆ and thus since ¯β − β ¯ →p 0. From equation (3. n i=1 n ˆ ˆ Theorem 6.5. you can show that 1 Xˆ ¯ β= β (−i) .1 As n → ∞.

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

1) Proof. In this case.15) tn (θ) = ˆ−θ θ s(ˆ θ) ´ √ ³ˆ n θ−θ q = ˆ Vθ N (0. ˆ When q = 1q h(β) is real-valued). we say that tn (θ) is asymptotically pivotal. By (6. (For example.For example. pivotal statistics are unavailable and so we must rely on asymptotically pivotal statistics.1 tn (θ) →d N (0. the statistic tn has an exact t distribution. In general. A simple null and composite hypothesis takes the form H0 : θ = θ0 H1 : θ 6= θ0 where θ0 is some pre-specified value. Since the standard normal distribution does not depend on the parameters. then θ = R0 β = β 1 and ˆ Vθ = ¡ I 0 ¢ ˆ V µ I 0 ¶ ˆ = V11 .16) ¥ Thus the asymptotic distribution of the t-ratio tn (θ) is the standard normal. In special cases (such as the normal regression model. and is therefore exactly free of unknowns. β 2 ). see Section X). s(ˆ = n−1/2 H 0 V Hβ . 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 . however.8. Vθ ) √ Vθ = N (0. s(ˆ θ) (6. µ I 0 ¶ ˆ the upper-left block of V . Consider the studentized statistic tn (θ) = Theorem 6. we say that tn is an exactly pivotal statistic. θ) β 6.8 t tests Let θ = h(β) : Rk → R be any parameter of interest. ˆ its estimate and s(ˆ its asymptotic θ θ) standard error. and θ = h(β) is some function of the parameter vector. 55 . that (so θ ˆ ˆ ˆ is. 1) →d ˆ−θ θ . θ could be a single element of β).

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

6. We say that Cn has asymptotic (1 − α)% coverage for θ if P (θ ∈ Cn ) → 1 − α as n → ∞. Hβ = ∂β The Wald statistic for H0 against H1 is ´0 ³ ´ ³ ˆ θ θ Wn = n ˆ − θ0 Vθ−1 ˆ − θ0 ´0 ³ ´−1 ³ ´ ³ ˆ ˆ ˆ0 ˆ ˆ h(β) − θ0 . However we often can calculate the asymptotic coverage probability limn→∞ P (θ ∈ Cn ). The t-test of the previous setion rejects H0 : θ0 = θ if |tn (θ)| > zα/2 where tn (θ) is the t-statistic (6. the most common professional choice isi95%.17) = ˆ − zα/2 s(ˆ θ and Cn is an asymptotic (1 − α)% confidence interval. or α = . and values of θ outside two standard θ errors of the estimated ˆ are considered unlikely or unreasonable candidates for the true value. This corresponds to selecting the confidence h i h ˆ ± 1. = n h(β) − θ0 Hβ V Hβ 57 (6. 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). 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. We have the null and alternative H0 : θ = θ0 H1 : θ 6= θ0 .10 Wald Tests Sometimes θ = h(β) is a q × 1 vector. In this case the t-statistic approach does not work. θ The interval has been constructed so that as n → ∞.We typically cannot calculate the exact coverage probability P (θ ∈ Cn ). ˆ + zα/2 s(ˆ .18) . A good method for construction of a confidence interval is the collection of parameter values which are not rejected by a statistical test. ¢ ¡ ¢ ¡ P (θ ∈ Cn ) = P |tn (θ)| ≤ zα/2 → P |Z| ≤ zα/2 = 1 − α. and it is desired to test the joint restrictions simultaneously. 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). While there is no hard-and-fast guideline for choosing the coverage probability 1 − α.96s(ˆ ≈ ˆ ± 2s(ˆ .16) and zα/2 is the upper α/2 quantile of the standard normal distribution.05. θ θ) (6.

An asymptotic Wald test rejects H0 in favor of H1 if Wn exceeds χ2 (α). 6.When h is a linear function of β. Hβ (β) is a continuous function of β.5. In this case. For example. Vθ ).84 = z. a chiq square random variable with q degrees of freedom. ˆ Wn = n θ θ q θ θ Theorem 6.2. Wn = n R0 β − θ0 ´ √ ³ The delta method (6. then Wn →d χ2 . Hβ (β) →p Hβ . Also h(β) = a selector matrix. 1] under H0 . and there are q = k2 restrictions. and Theorem 6. The asymptotic p-value for Wn is pn = p(Wn ). Furthermore. then the Wald statistic can be written in the form ¶ µ 2 ˆ σ − σ2 ˜ Wn = n (6. θ = β 2 .1 Under H0 and Assumption 6. where p(x) = P χ2 ≥ x is the tail q q probability function of the χ2 distribution.10. then the Wald statistic takes the form ´0 ³ ´ ³ ´−1 ³ ˆ ˆ ˆ R0 V R R0 β − θ 0 . We have established: ³ ´0 ³ ´ ˆ − θ0 V −1 ˆ − θ0 →d Z 0 V −1 Z = χ2 . the test rejects at the α% level iff pn < α. h(β) = R0 β. ˜˜ n ˜ e = Y − X1 β 1 .3. Thus Vθ = H 0 V Hβ →p H 0 V Hβ = Vθ > 0 if Hβ has full rank q. so by the continuous mapping ˆ ˆ ˆ ˆ ˆ theorem.8. if rank(Hβ ) = q. The Wald test fails to reject if Wn is q 1 ¡ ¢ less than χ2 (α).15) showed that n ˆ − θ →d Z ∼ N (0. 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. = nβ 2 R0 V R R0 β is linear with R = µ 0 I ¶ ¢−1 ¡ ˆ ˆ ˆ . q and pn is asymptotically U[0.025 . 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. As before.19) σ2 ˆ where σ2 = ˜ 1 0 e e. the upper-α quantile q 2 of the χ2 distribution.11 F Tests Y = X1 β 1 + X2 β 2 + e Take the linear model where X1 is n × k1 and X2 is n × k2 and k + 1 = k1 + k2 . Hence β β by Theorem A.1 showed θ ˆ that V →p V.1. The null hypothesis is H0 : β 2 = 0. χ2 (.05) = 3. ˜ 58 ¡ 0 ¢−1 0 ˜ β 1 = X1 X1 X1 Y .

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

Since linear functions of normals are also normal.3.4)) where H 0 H = In . 6. e ˆ M 0 σ2 M where M = I − X (X 0 X)−1 X 0 . This is ¢ ¡ 2 ˆ σ y − σ 2 / (k − 1) ˜ F = . The modelling assumption that the error ei is independent of xi and N (0. This is rarely an issue today. equivalently the residual variance from an intercept-only model. including the estimated error variance 2. an “F statistic” is reported. While there are special cases where this F statistic is useful. Since uncorrelated normal variables are independent. as sample sizes are typically sufficiently large that this F statistic is highly “significant”.12 Normal Regression Model As an alternative to asymptotic distribution theory.where In many statistical packages. under the normality assumption the error vector e is independent of X and ¢ ¡ has distribution N 0. n−k 60 . 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. when an OLS regression is reported. In particular. σ 2 /(n − k) ˆ σ2 = ˜y 1 (y − y)0 (y − y) n is the sample variance of yi . In ) . Let u = σ −1 H 0 e ∼ N (0. when sample sizes were very small and researchers wanted to know if there was “any explanatory power” to their regression. 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. 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 . it follows ˆ that β is independent of any function of the OLS residuals. introduced in Section 4. In σ 2 . there is an exact distribution theory available for the normal linear regression model. H 0 H) ∼ N (0. s The spectral decomposition of M yields ¸ ∙ In−k−1 0 H0 M =H 0 0 (see equation (2. This special F statistic is testing the hypothesis that all slope coefficients (other than the intercept) are zero. these cases are atypical.

The critical values are quite close if n − k ≥ 30. β 2 . Theorem 6. which is twice the difference in the log-likelihood function evaluated under the null and alternative hypotheses.1 and Theorem 6.10) then ´ ³ ˆ • β ∼ N 0. ˆ 2 2 2 ˜ ˜ The MLE of the model under the null hypothesis is (β 1 . The estimator under the alternative is the unrestricted estimator ˆ ˆ ˆ (β 1 . σ 2 ). As inference (confidence intervals) are based on the t-ratio. a good testing procedure is based on the likelihood ratio statistic. σ2 ˆ 61 . σ 2 ) ¡ ¢¢ ¡ ¡ ¢ ˆ = n log σ 2 − log σ 2 ˜ µ 2¶ σ ˜ = n log . In contrast.1 shows that under the strong assumption of ˆ normality.a chi-square distribution with n − k degrees of freedom. β 2 ) and consider tests of the linear restriction H0 : β 2 = 0 H1 : β 2 6= 0 In the context of parametric models.10) µ h i ¶ 2 (X 0 X)−1 N 0. and standard errors are calculated using the homoskedastic formula (6.8. 2 2 2 The LR statistic for H0 is ´ ³ ˆ ˆ ˆ ˜ ˜ LR = 2 Ln (β 1 . the notable distinction is between the N (0.1 If ei is independent of xi and distributed N(0. We summarize these findings Theorem 6. σ 2 ) where β 1 is the OLS estimate from ˜ 2 ˜ a regression of yi on x1i only. β 2 . σ ˆ ˆ βj − βj βj − βj N (0. with residual variance σ . σ 2 ) − Ln (β 1 . 0.1 we showed that in large samples.) Now let us partition β = (β 1 . 1) and tn−k distributions.12. Furthermore. 0. n−k • ∼ tn−k ˆ In Theorem 6. (Unless the sample size is unreasonably small. σ 2 (X 0 X)−1 • (n−k)s2 σ2 ˆ β j −β j ˆ s(β ) j ∼ χ2 . β has an exact normal distribution and t has an exact t distribution. σ 2 ) discussed above. σ 2 ) = − log σ − log (2π) − . β and t are approximately normally distributed.3. β 2 . The Gaussian log-likelihood at these estimates is ¡ ¢ n 1 ˆ ˆ ˆ σ Ln (β 1 . The log-likelihood of this model is ¡ 2¢ n n n ˜ ˜ ˜ Ln (β 1 . 0. if standard errors are calculated using the homoskedastic formula (6. so as a practical matter it does not matter which distribution is used. 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. σ 2 ) = − log 2πˆ 2 − 2 e0 e ˆˆ 2 2ˆ σ ¡ ¢ n n n = − log σ 2 − log (2π) − .12.

we have plotted in Figure 6. setting n/σ 2 = 10. σ 2 s2 β ˆ ˆ While the hypothesis β s = 1 is unaffected by the choice of s. This can be seen by a simple example introduced by Lafontaine and White (1986). This is an unfortunate feature of the Wald statistic. one feature of importance is the Type I error of the test using the asymptotic 5% critical value 3. 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.13 Problems with Tests of NonLinear Hypotheses While the t and Wald tests work well when the hypothesis is a linear restriction on β. 62 . as Wn (s) →d χ2 under H0 for 1 any s. 6. In the present context of the Wald statistic. This produces random draws from the sampling distribution of interest. Letting h(β) = β s . the statistic Wn (s) varies with s. The method uses random simulation to create an artificial dataset to apply the statistical tools of interest. and noting Hβ = sβ s−1 . ˆ Let β and σ 2 be the sample mean and variance of yi .84 — the probability of a false rejection. σ2 ˆ Now notice that H0 is equivalent to the hypothesis H0 (s) : β s = 1 for any positive integer s. To demonstrate this effect. Take the model yi = β + ei ei ∼ N (0. The decreasing dashed ˆ = 1. This is distressing since the choice of s seems arbitrary and irrelevant to the actual hypothesis. features of this distribution can be calculated. we find that the standard Wald test for H0 (s) is ´2 ³ s ˆ β −1 Wn (s) = n 2s−2 .4 the Wald statistic Wn (s) as a function ˆ of s. they can work quite poorly when the restrictions are nonlinear. σ 2 ) and consider the hypothesis H0 : β = 1. Our first-order asymptotic theory is not useful to help pick s. Through repetition. The increasing solid line is for the case β = 0.8.7. Then the standard Wald test for H0 is ˆ ³ ´2 ˆ β−1 Wn = n . LR = n log 1 + 2 − 1 ' n σ ˆ σ2 ˆ the F statistic.By a first-order Taylor series approximation ¶ µ 2 ¶ µ σ ˜ σ2 ˜ − 1 = Wn . while there are other values of s for which test test statistic is insignificant. 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 Type I error probability improves towards 5% as the sample size n increases. In Table 2.84 | β = 1) . so these probabilities are Type I error. n.000 random samples. These probabilities are calculated as the percentage of the 50.4. Test performance deteriorates as s increases. Given the simplicity of the model.1 you can also see the impact of variation in sample size. The second through seventh columns contain the Type I error probabilities for different combinations of n and σ. the only test which meets this criterion is the conventional Wn = Wn (1) test. Any other choice of s leads to a test with unacceptable Type I error probabilities.84.05) with deviations indicating+ distortion.1 Type I error Probability of Asymptotic 5% Wn (s) Test 63 .1 we report the results of a Monte Carlo simulation where we vary these three parameters. Table 4. and σ 2 . we compare the rates row by row. The value of s is varied from 1 to 10. When comparing statistical procedures. Rates above 20% are unexceptable. looking for tests for which rate rejection rates are close to 5%. this probability depends only on s.000 simulated Wald statistics Wn (s) which are larger than 3. In each case.Figure 6. and rarely fall outside of the 3%-8% range. Error rates avove 10% are considered excessive. however. and σ is varied among 1 and 3. n is varied among 20. no magic choice of n for which all tests perform uniformly well.4: Wald Statistic as a function of s P (Wn (s) > 3. which is not surprising given the dependence of Wn (s) on s as shown in Figure 6. Typically. 100 and 500. Type I error rates between 3% and 8% are considered reasonable. remember that the ideal Type I error probability is 5% (. To interpret the table. There is.1 reports the simulation estimate of the Type I error probability from 50. For this particular example. The null hypothesis β s = 1 is true. Table 4. Each row of the table corresponds to a different value of s — and thus corresponds to a particular choice of test statistic. In Table 4.

22 .10 .05 .20 .07 .12 . ˆ ˆ ˆ ˆ ˆ Let β = (β 0 .31 .09 .13 .06 .20).20 .15 . in other examples natural choices are not always obvious and the best choices may in fact appear counter-intuitive at first.20) ³ ´1/2 ˆ0 ˆ ˆ so that the standard error for ˆ is s(ˆ = n−1 H1 V H1 θ θ) .25 .06 .06 . While this is clear in this particular example.05 .34 .08 .08 .26 .08 . Equivalently. In this case a t-statistic for H0 is t1n = ³ˆ β1 ˆ β2 where r is a known constant.23 .05 . β 2 ) be the least-squares estimates of (6.08 .06 . This point can be illustrated through another example.15 .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 .16 Rejection frequencies from 50.12 . 64 .33 .05 .10 .15 . An alternative statistic can be constructed through reformulating the null hypothesis as H0 : β 1 − rβ 2 = 0.30 .07 .13 .15 . so the hypothesis can be stated as H0 : θ = r.10 .05 .35 . Define θ ˆ ˆ ⎞ ⎛ 0 ⎟ ⎜ ⎟ ⎜ ⎜ 1 ⎟ ⎟ ⎜ ⎜ ˆ ⎟ ˆ H1 = ⎜ β 2 ⎟ ⎟ ⎜ ⎟ ⎜ ⎜ β ⎟ ˆ ⎠ ⎝ − 1 ˆ2 β2 ´ s(ˆ θ) −r .06 .24 .18 .11 .06 .21 .14 .14 .25 .28 .08 .22 .13 . define θ = β 1 /β 2 . 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. Other choices are arbitrary and would not be used in practice.06 .05 .19 .07 . β 1 . let V be an estimate of the ˆ asymptotic variance matrix for β and set ˆ = β 1 /β 2 .06 .17 .000 simulated random samples In this example it is not surprising that the choice s = 1 yields the best test statistic.07 .07 .

06 .000 simulated samples. σ 2 ) draw with σ = 3. if the hypothesis can be expressed as a linear restriction on the model parameters.25.26 . . In contrast. If no linear formulation is feasible.28 . ei be an independent N (0. However.47 .25 .00 .05 . In this section we describe the method in more detail. the rejection rates for the linear t2n statistic are invariant to the value of β 2 .00 .06 .15 .A t-statistic based on this formulation of the hypothesis is ´2 ³ ˆ 1 − rβ 2 ˆ β =³ ´1/2 . the entries in the table should be 0.09 .05 . and normalize β 0 = 0 and β 1 = 1.645) and P (tn > 1.75. especially for small values of β 2 . Table 4. In all cases. We vary β 2 among . We let x1i and x2i be mutually independent N (0. The left tail probabilities P (t1n < −1. It is also prudent to consider alternative tests to the Wald statistic.0 and n among 100 and 500. such as the GMM distance statistic which will be presented in Section 9.1. Ideally.05 .06 .02 .645) t1n t2n t1n t2n t1n t2n t1n t2n . then the “most linear” formulation should be selected.00 The one-sided Type I error probabilities P (tn < −1. while the right tail probabilities P (t1n > 1.00 . The results are presented in Table 4.50.2.10 .50 . This leaves β 2 as a free parameter.15 .00 .645) P (tn > 1.645) greatly exceed 5%.7.05.06 .06 .00 . The implication of Table 4.06 .2 is that the two t-ratios have dramatically different sampling behavior.645) P (tn > 1.645) are calculated from 50. −r ⎛ t2n where To compare t1n and t2n we perform another simple Monte Carlo simulation.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. and are close to the ideal 5% rate for both sample sizes.10 .05 β2 . this formulation should be used. −1 H V H ˆ 2 n 2 ⎞ 0 H2 = ⎝ 1 ⎠ .00 . .645) are close to zero in most cases.12 .07 .05 . The common message from both examples is that Wald statistics are sensitive to the algebraic formulation of the null hypothesis. 1) variables.2 Type I error Probability of Asymptotic 5% t-tests n = 100 n = 500 P (tn < −1.06 . 65 .05 .05 . and 1. .06 .05 .10 .06 . 6.75 1.00 . the rejection rates for the t1n statistic diverge greatly from this value.645) P (tn < −1.06 .00 . along with sample size n.05 .05 . and alternatives to asymptotic critical values should be considered.00 .

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

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

Wn = n 1 − 2 = 18. The F form of the Wald statistic (6.18) that the state coefficients are jointly zero.033 −. excluding the coefficients on the state dummy variables.1 we find the point estimate ˆ ˆ = − β 2 = 28.00002 .007 .232 . we find Wn = 550.013 . 2β 3 68 .48772 = 515.49452 σ ˜ Notice that the two statistics are close.032 .808 . Using either statistic the hypothesis is easily rejected.00057 .808 so the parameter estimates are quite precise and reported in Table 4.014 .34 ˆ s(β) . the restricted standard deviation estimate is σ = .002 .101 . if β 2 > 0 and β 3 < 0 the solution is θ=− From Table 4.010 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.4945.121 −.070 .4877 18.008 .010 . Alternatively.69. 50 Another interesting question which can be addressed from these estimates is the maximal impact of experience on mean wages. reestimating the model with the 50 state dummies excluded. but not equal. Ignoring the other coefficients. this adds 50 regressors).102 −. Table 4.001 .variable for state of residence (including the District of Columbia. 808 1 − .1 OLS Estimates of Linear Equation for Log(Wage) ˆ β 1. Computing the Wald statistic (6.1.19) is ˜ µ ¶ µ ¶ σ2 ˆ . as the 1% critical value for the χ2 distribution is 76.102 −. The available sample is 18. 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. θ ˆ 2β 3 β2 .097 −.027 .

5]. In the previous section we discovered that such t-tests had very poor Type I error rates. This is the set of θ such that |tn (θ)| ≤ 1. Since tn (θ) is a non-linear function of θ.9. we can calculate a standard error of s(ˆ = . This set is [27. 29. 29.Using the Delta Method. In the present context we are interested in forming a confidence interval. there is not a simple expression for this set.96. Instead. Notice that the upper end of the confidence interval is the same as that from the delta method. 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 ). but it can be found numerically quite easily. implying a 95% confidence θ) interval of [27.5]. not testing a hypothesis. but the lower end is substantially lower. 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. this is a poor choice.40. Our desired confidence interval will be the set of parameter values θ which are not rejected by the hypothesis test. 69 .0. However. so we have to go one step further.

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

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

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

is the homoskedasticity-formula standard error.

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

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

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

E (xi ei ) = 0
∗ yi = yi + ui

71

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

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

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

• Qi • Di • Ci

The flow variables are annual sums for 1987. The stock variables are beginning of year. (a) Estimate a linear regression of Ii on the other variables. Calculate appropriate standard errors. (b) Calculate asymptotic confidence intervals for the coefficients. (c) This regression is related to Tobin’s q theory of investment, which suggests that investment should be predicted solely by Qi . Thus the coefficient on Qi should be positive and the others should be zero. Test the joint hypothesis that the coefficients on Ci and Di are zero. Test the hypothesis that the coefficient on Qi is zero. Are the results consistent with the predictions of the theory?
2 (d) Now try a non-linear (quadratic) specification. Regress Ii on Qi , Ci , Di , Q2 , Ci2 , Di , i Qi Ci , Qi Di , Ci Di . Test the joint hypothesis that the six interaction and quadratic coefficients are zero.

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

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

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

73

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

5) ˆ Thus the fact that η i is replaced with η i is asymptotically irrelevant. ˜i Suppose that σ 2 > 0 for all i. σ 2 } σ1 ˜n and ³ ´−1 ˜ ˜ ˜ β = X 0 D−1 X X 0 D−1 Y. Vα ) (7. or FGLS. then the FGLS ˜i estimator is not well defined. ³ ´ ˆ ˆ ˆ = −2ei x0 β − β + (β − β)0 xi x0 (β − β) i i say. We may call (7. This is the feasible GLS. if σ 2 ≈ 0 for some i. We have shown that α is consistently estimated by a simple procedure. Vα ) α ¡ ¡ 0 ¢¢−1 ¡ 0 2 ¢ ¡ ¡ 0 ¢¢−1 E zi zi ξ i E zi zi . Note that n n n ´ 1X √ ³ √ −2 X 1 X ˆ ˆ ˆ √ zi φi = zi ei x0 n β − β + zi (β − β)0 xi x0 (β − β) n i i n n n i=1 i=1 i=1 →p 0 Let be from OLS regression of η i on zi .4) the skedastic regression. If σ 2 < 0 for some i.3) ˆ ˆ While ei is not observed. Furthermore. xi ).. which is typically undesirable. then the FGLS estimator will force ˜i the regression equation through the point (yi . Thus ˆ i i η − η i = e2 − e2 ˆ ˆi i = φi .. as it is estimating the conditional variance of the regression of yi on xi .Suppose ei (and thus η i ) were observed. we have the OLS residual ei = yi − x0 β = ei − x0 (β − β). This suggests 75 . and hence we can estimate 0 σ 2 = zi α by i ˜ (7. One typical problem with implementation of FGLS estimation is that in a linear regression ˜i specification. Then we could estimate α by OLS: ¢−1 0 ¡ Z η →p α α = Z 0Z ˆ and where √ n (ˆ − α) →d N (0.6) σ 2 = α0 zi . . Then set ˜i ˜ D = diag{˜ 2 . and will depend on the model (and estimation method) for the skedastic regression. there is no guarantee that σ 2 > 0 for all i.. Vα = E zi zi (7. estimator of β.4) ¡ ¢−1 −1/2 0 √ √ n (˜ − α) = n (ˆ − α) + n−1 Z 0 Z α α n Zφ →d N (0. Then ˆ ¢−1 0 ¡ Zη ˆ α = Z 0Z ˜ (7. Since there is not a unique specification for the conditional variance the FGLS estimator is not unique.

This may be written as !−1 à n !à n !−1 à n 1 X −4 2 0 1 X −2 0 1 X −2 0 ˜ σ i xi xi ˜ σ i ei xi xi ˜ ˆ σ i xi xi ˜ V = n n n i=1 i=1 i=1 ³ ´−1 ³ ´³ ´−1 ˜ ˜ ˆ˜ ˜ X 0 D−1 DD−1 X X 0 D−1 X = n X 0 D−1 X ˜ which is consistent for V as n → ∞. It is possible to show that if the skedastic regression is correctly specified. Its asymptotic variance is not that given in Theorem 7. V ). i ˜ 0 is inconsistent for V . . It may be the case that α0 zi is only an approximation to the true conditional variance σ 2 = i ˜ E(e2 | xi ). β should perhaps be i i called a quasi-FGLS estimator of β. This estimator V 0 is appropriate when the skedastic regression (7.. This is an estimator which is robust to misspecification of the condie1 ˆn tional variance. and it may be estimated with considerable 76 V takes a sandwich form√. FGLS estimation depends on specification and estimation of the skedastic regression. Instead. V n n i=1 . e2 }. A trimming rule might make sense: σ 2 = max[˜ 2 .2) is correctly specified.. FGLS is asymptotically superior to OLS. ¢¢−1 ¡ ¡ . V = E σ −2 xi x0 i i ˆ where D = diag{ˆ2 . We just state the result without proof. In the linear regression model. V ˜ An appropriate solution is to use a White-type estimator in place of V 0 . similar to the covariance matrix of the OLS estimator.1. ´ √ ³ ˜ ˜ n β GLS − β F GLS →p 0. σ 2 ] σi i for some σ 2 > 0..1 If the skedastic regression is correctly specified. V = E α0 zi i i Examining the asymptotic distribution of Theorem 7. and was proposed by Cragg (Journal of Econometrics. 1992). In this case we interpret α0 zi as a linear projection of e2 on zi . There are three reasons. and thus where ´ √ ³ ˜ n β F GLS − β →d N (0.1. but the proof of this can be tricky.1.that there is a need to bound the estimated variances away from zero. then FGLS is asymptotically equivalent to GLS. Since the form of the skedastic regression is unknown. Unless σ 2 = α0 zi . First. Theorem 7.1. ´´−1 ³ ³¡ ´´−1 ³ ³¡ ¢−1 ¢−2 2 0 ´´ ³ ³¡ 0 ¢−1 E α0 zi E α zi xi x0 σ i xi xi xi x0 . the natural estimator of the asympˆ totic variance of β is à n !−1 µ ¶−1 1 X −2 0 1 0 ˜ −1 ˜0 = XD X σ i xi xi ˜ = . Why then do we not exclusively estimate regression models by FGLS? This is a good question.1.

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

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

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

under H0 . θ0 ) + m0 (θ − θ0 ) . Suppose that m(xi . Hansen shows how to use simulation (similar to the bootstrap) to construct the asymptotic critical values (or p-values) in a given application. θ) ' (ei + m(xi . This means that under H0 . Furthermore. The asymptotic theory of such tests have been worked out by Andrews and Ploberger (1994) and B. Thus the NLLS 0 estimator ˆ has the same asymptotic distribution as the (infeasible) OLS regression of yi on mθi . tests of H0 do not have asymptotic normal or chi-square distributions. Thus we want to test H0 : β 2 = 0. 7. This renders the distribution theory presented in the previous section invalid. by a first-order Taylor series approximation. θ which is that stated in the theorem. θi Hence the sum of squared errors function is Sn (θ) = n X i=1 (yi − m(xi . In particular. 80 .For θ close to the true value θ0 . θ) ' m(xi . m(xi . ¥ Based on Theorem 7. but these are not the only measures of central tendency. an estimate of the asymptotic variance V is ˆ V = Ã 1X mθi m0 ˆ ˆ θi n i=1 n !−1 Ã 1X mθi m0 e2 ˆ ˆ θi ˆi n i=1 n !Ã 1X mθi m0 ˆ ˆ θi n i=1 n !−1 where mθi = mθ (xi . θi Thus ¡ ¢ yi − m(xi . 1 2 The model is linear when β 2 = 0. However. θ0 )) − m(xi . Hansen (1996). ˆ ˆ θ) ˆ θ).5 Least Absolute Deviations We stated that a conventional goal in econometrics is estimation of impact of variation in xi on the central tendency of yi .1. θ) = β 0 zi + β 0 xi (γ). Thus when the truth is that β 2 = 0.4. ˆ and ei = yi − m(xi . We have discussed projections and conditional means. the model is yi = β 0 zi + εi 1 and both β 2 and γ have dropped out. and this is often a useful hypothesis (sub-model) to consider. γ is not identified. 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 . An alternative good measure is the conditional median. θ0 ) + m0 (θ − θ0 ) θi = ei − m0 (θ − θ0 ) θi 0 = yi − m0 θ. the parameter estimates are not asymptotically normally distributed. Identification is often tricky in nonlinear regression models.

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

When f (0 | x) is large. V ).Theorem 7. Let g(β) = Eg (β). ¢¢−1 ¡ ¢¢−1 ¢¡ ¡ 1¡ ¡ 0 Exi x0 E xi x0 f (0 | xi ) E xi xi f (0 | xi ) i i 4 The variance of the asymptotic distribution inversely depends on f (0 | x) .1: Since sgn (a) = 1 − 2 · 1 (a ≤ 0) .11). This can be done with kernel estimation techniques. by the central limit theorem (Theorm 5. The main difficulty is the estimation of f (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 ) .5.1) n X √ −1/2 n (g n (β 0 ) − g(β 0 )) = −n gi (β 0 ) →d N (0.10) is equivalent to g n (β) = 0.3. ∂β 0 so Third. We need where g n (β) = n i i=1 gi (β) and gi (β) = xi (1 − 2 · 1 (yi ≤ xi three preliminary result. Pn −1 0 β)) . In the special case where the error is independent of xi . ˆ Proof of Theorem 7. (7. then there are many innovations near to the median. Second using the law of iterated expectations and the chain rule of i differentiation.1 ´ √ ³ˆ n β − β 0 →d N (0. where V = and f (e | x) is the conditional density of ei given xi = x.11) This simplification is similar to the simplification of the asymptotic covariance of the OLS estimator under homoskedasticity. Exi x0 ) i i=1 since Egi (β 0 )gi (β 0 )0 = Exi x0 . First. the conditional density of the error at its median. we provide a sketch here for completeness. ∂β ˆ g(β) ' ´ ³ ∂ ˆ g(β 0 ) β − β 0 . by a Taylor series expansion and the fact g(β 0 ) = 0 82 . and this improves estimation of the median.5.1 is advanced. While a complete proof of Theorem 7. the height of the error density at its median. then f (0 | x) = f (0) and the asymptotic variance simplifies V = (Exi x0 )−1 i 4f (0)2 (7. Computation of standard error for LAD estimates typically is based on equation (7.5. See Chapter 16.

If the random variable U has τ ’th quantile Qτ .13) This generalizes representation (7. Again. For τ ∈ [0.9) for the median to all quantiles. However for computational convenience it is typical to assume that they are (approximately) linear in x (after suitable transformations). then F (Qτ (x) | x) = τ . 1] the τ ’th quantile Qτ of a random variable with distribution function F (u) is defined as Qτ = inf {u : F (u) ≥ τ } When F (u) is continuous and strictly monotonic.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 (0.6 Quantile Regression The method of quantile regression has become quite popular in recent econometric practice. The third line follows from an asymptotic empirical process argument. V ). then (7.12) Qτ = argmin Eρτ (U − θ) .5. For fixed τ . (7. when F (y | x) is continuous and strictly monotonic in y. This linear specification assumes that Qτ (x) = β 0 x where the coefficients β τ τ vary across the quantiles τ . The median is the special case τ = . the quantile regression functions can take any shape. As functions of x. 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)) . so you can think of the quantile as the inverse of the distribution function. The quantile Qτ is the value such that τ (percent) of the mass of the distribution is less than Qτ . ¥ 7. The following alternative representation is useful. Exi x0 ) →d i 2 = N (0. xi ) with conditional distribution function F (y | x) the conditional quantile function qτ (x) is Qτ (x) = inf {y : F (y | x) ≥ τ } . the quantile regression function qτ (x) describes how the τ ’th quantile of the conditional distribution varies with the regressors. then F (Qτ ) = τ . For the random variables (yi . We then have the linear quantile regression model yi = x0 β τ + ei i 83 .

then f (0 | xi ) = f (0) . since it has discontinuous derivatives. and form a Wald statistic i for γ = 0. Fortunately.7 Testing for Omitted NonLinearity If the goal is to estimate the conditional expectation E (yi | xi ) . E xi xi f (0)2 A recent monograph on the details of quantile regression is Koenker (2005). ˆ Given the representation (7. Thus. 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 (7.13). ´ √ ³ˆ Theorem 7.1 n β τ − β τ →d N (0. Vτ ). it is useful to have a general test of the adequacy of the specification.1.12). n numerical methods are necessary for its minimization. fast linear programming methods have been developed for this problem.6. ¡ ¡ ¢¢−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. 7. The null model is yi = x0 β + εi i 84 . i By construction. the unconditional density of ei at 0. and test their significance using a Wald test. Furthermore. When the error ei is independent of xi . and are widely available. 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. where and f (e | x) is the conditional density of ei given xi = x. A asymptotic distribution theory for the quantile regression estimator can be derived using similar arguments as those for the LAD estimator in Theorem 7. conventional Newton-type optimization methods are inappropriate. otherwise its properties are unspecified without further restrictions. Since the quanitle regression criterion function Lτ (β) does not have an algebraic solution. Another popular approach is the RESET test proposed by Ramsey (1969). and we have the simplification Vτ = τ (1 − τ ) ¡ ¡ 0 ¢¢−1 . 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.where ei is the error defined to be the difference between yi and its τ ’th conditional quantile x0 β τ .5. One simple test for neglected nonlinearity is to add nonlinear functions of the regressors to ˆ ˆ the regression. the τ ’th conditional quantile of ei is zero.

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

We conclude that the inclusion of irrelevant variable reduces estimation efficiency if these variables are correlated with the relevant variables. σ2 ˜ lim nV ar( β 1 ) = 2 n→∞ σ x + µ2 while σ2 ˆ lim nV ar( β 1 )−1 = 2 . the question. and E (xi − µ)2 = σ 2 . To fix notation. Y = X1 β 1 + X2 β 2 + ε. estimate of β 1 from the unconstrained model. 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. respectively. where X1 is n × k1 and X2 is n × k2 . this result can be reversed when the error is conditionally heteroskedastic.9 Model Selection In earlier sections we discussed the costs and benefits of inclusion/exclusion of variables. as the larger problem can be written as a sequence of such comparisons.. . X2 ) = 0 Note that M1 ⊂ M2 . models 1 and 2 are estimated by OLS. xK ) enters the regression function E(yi | x1i = x1 . How does a researcher go about selecting an econometric specification. n→∞ σx ˜ When µ 6= 0. This is equivalent to the comparison of the two models M1 : M2 : Y = X1 β 1 + ε. However.. x2i = σ 2 . i A model selection procedure is a data-dependent rule which selects one of the two models. A model selection procedure is consistent if ´ ³ c → 1 P M = M1 | M1 ³ ´ c P M = M2 | M2 → 1 86 .˜ ˆ This means that β 1 has a lower asymptotic variance matrix than β 1 . “Which subset of (x1 . It is important that the model selection question be well-posed. In the absence of the homoskedasticity assumption. .7). To simplify some of ¢ statistical discussion. We c can write this as M. the question: “What is the right model for y?” is not well posed. and β 1 0 (The least-squares estimate with the intercept omitted. we will on ˆ1 ¡ occasion use the homoskedasticity assumption E e2 | x1i . we say that M2 is true if β 2 6= 0. xKi = xK )?” is well posed. take the model yi = β 0 + β 1 xi + ei and suppose that β 0 = 0. E (ε | X1 . For example.). We thus consider the question of the inclusion of X2 in the linear regression Y = X1 β 1 + X2 β 2 + ε.. In contrast. with residual vectors e1 and e2 . In many cases the problem of model selection can be reduced to the comparison of two nested models. etc. Let Exi = µ.. There are many possible desirable properties for a model selection procedure. x Then under (6. estimated ˆ ˆ ˆ2 the variances σ 2 and σ 2 .. E (ε | X1 .. ˆ For example.. 7. One useful property is consistency. X2 ) = 0. we see that β 1 has a lower asymptotic variance. Let β 1 be the ˜ be the estimate under the constraint β = 0. that it selects the true model with probability one if the sample is sufficiently large. To be concrete. when economic theory does not provide complete guidance? This is the question of model selection.

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

β K 6= 0.17). the models are M1 : β 1 6= 0. However. and 220 = 1. which are nested. There are two leading cases: ordered regressors and unordered. . a full-blown implementation of the BIC selection criterion would seem computationally prohibitive. one can show that thus LRn →p ∞. . 210 = 1024. E (εi | xi ) = 0 and the question is which subset of the coefficients are non-zero (equivalently. . 576. which can be a very large number.. β 2 = β 3 = · · · = β K = 0 M2 : β 1 6= 0.. The general problem is the model yi = β 1 x1i + β 2 x1i + · · · + β K xKi + εi . . For example. and then selects the model with the lowest AIC (7. In the latter case. Similarly for ˆ the BIC. a model consists of any possible subset of the regressors {x1i . MK : β 1 6= 0. selecting based on (7. 048. The methods extend readily to the issue of selection among multiple regressors. In the unordered case. β 3 = · · · = β K = 0 . We have discussed model selection between two models. stores the residual variance σ 2 for each model. β 2 6= 0.. Also under M2 . log(n) µ LRn > k2 | M2 log(n) ¶ ´ ³ c P M = M2 | M2 = P → 1. . which regressors enter the regression). β 2 6= 0.15).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. . 88 . The AIC selection criteria estimates the K models by OLS. and the AIC or BIC in principle can be implemented by estimating all possible subset models. xKi }. there are 2K such models. . In the ordered case.

In the homoskedastic regression model Y = Xβ + e with E(ei | xi ) = 0 and E(e2 | xi ) = σ 2 . the residuals e. Let (yi . (b) Prove that e = M1 e. ˆ ˆ n−k 6. (b) Find an estimate of the variance of this forecast. 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 . ji ˜ (a) In which contexts would β be a good estimator? ˜ (b) Using your intuition. the estimates (β. E(e | X) = 0. in which situations would you expect that β would perform better than OLS? 89 (a) Why is this a reasonable estimator for σ 2 ? ¡ ¢−1 0 −1 XΩ . σ 2 ).10 Exercises 1. V ar(e | X) = σ 2 Ω with Ω known. i ˆ ˆ suppose β is the OLS estimate of β with covariance matrix V . Define g(u) = τ − 1 (u < 0) where 1 (·) is the indicator function (takes the value 1 if the argument is true. In a linear model Y = Xβ + e. else equals zero). and the out-of-sample value of the regressors. based on a sample of size n. ˆ (a) Find a point forecast of y.7. Is θ a quantile of the distribution of Yi ? 3.. wn ) and wi = x−2 . xi ) be a random sample with E(Y | X) = Xβ. the mean absolute error (MAE) is E |yi − g(xi )| . the GLS estimator is ¡ ¢−1 ¡ 0 −1 ¢ ˜ β = X 0 Ω−1 X XΩ Y . Show that the function g(x) which minimizes the MAE is the conditional median M (x).. where xji is one of the xi . 4. .12). Consider the Weighted Least Squares (WLS) estimator of β ¢−1 ¡ 0 ¢ ¡ ˜ X WY β = X 0W X where W = diag(w1 . X). Thus the available information is the sample (Y. V . Verify equation (7.. 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. x. . and an estimate of σ 2 is ˆ s2 = 1 e0 Ω−1 e. 5. 2. Let θ satisfy Eg(Yi − θ) = 0. ˜ the residual vector is e = Y − X β. For any predictor g(xi ) for y.

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

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

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

in the Figure below.3.1). but the approximation appears to improve for the large n. Fn (y. In general.2) Fn (y.2. (8. the EDF is only a crude approximation to the CDF. ∗ P (yi ≤ y. 1) distribution. x)) →d N (0. x∗ ≤ x) = Fn (y. Notationally. 50. x) (1 − F (y. To see this. xi ≤ x) = E (1 (yi ≤ y) 1 (xi ≤ x)) . This is a population moment. x) →p F (y. i = 1. n. The EDF is a consistent estimator of the CDF. x) − F (y. xi ). x). 1 (yi ≤ y) 1 (xi ≤ x) is an iid random variable with expectation F (y. note that for any (y. x) = P (yi ≤ y.. To see the effect of sample size on the EDF.. √ n (Fn (y.. i 93 . The method of moments estimator is the corresponding sample moment: n 1X 1 (yi ≤ y) 1 (xi ≤ x) . Fn is by construction a step function. Fn is a nonparametric estimate of F. x∗ ) with the i distribution Fn . x) = n i=1 Figure 8. it is helpful to think of a random pair (yi . The random draws are from the N (0. the EDF step function gets uniformly close to the true CDF. x))) .1). F (y. x) . I have plotted the EDF and true CDF for three random samples of size n = 25. x) is called the empirical distribution function (EDF). For n = 25.1: Empirical Distribution Functions The EDF is a valid discrete probability distribution which puts probability mass 1/n at each ∗ pair (yi . x). as the sample size gets larger. Note that while F may be either discrete or continuous. and 100. Recall that F (y.2 The Empirical Distribution Function Fn (y. by the CLT (Theorem 5. Thus by the WLLN (Theorem 5. Furthermore. That is. x). .8. where 1(·) is the indicator function.

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

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

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

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

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

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

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

10 Symmetric Two-Sided Tests If a random variable X has distribution function H(x) = P (X ≤ x). Since Tn →d Z. F ) = Gn (x. F ) ¶ µ 1 1 = Φ(x) + 1/2 g1 (x. F ). n or ∗ P (Tn ≤ x) = P (Tn ≤ x) + O(n−1 ). 1). Similarly. F ) − Gn (−x. From Theorem 8. Hence the difference between the asymptotic distribution and the exact distribution is Φ(x) − Gn (x. F0 ) distribution. F ) is only heuristic. F ) + g2 (−x. A two-sided hypothesis test rejects H0 for large values of |Tn | . F ) = Gn (x. we can calculate that Gn (x. as F is a function. = P (X ≤ x) − P (X ≤ −x) For example. F ). F ) + g2 (x. Thus asymptotic critical values are taken from the Φ distribution. F0 ) = O(n−1 ). n .The “derivative” ∂ ∂F g1 (x. and exact critical values are taken from the Gn (x. if Tn has exact distribution Gn (x. F0 ) + O(n−3/2 ) = O(n−1 ). 8. 101 2 g2 (x.5) where the simplifications are because g1 is even and g2 is odd. if Z ∼ N (0.8. F ) + O(n−3/2 ) n n 2 = Φ(x) + g2 (x. which is an improved rate of convergence over the asymptotic test (which converged at rate O(n−1/2 )). then |Tn | →d |Z| ∼ Φ. then |Tn | has the distribution function Gn (x. then the random variable |X| has distribution function H(x) = H(x) − H(−x) since P (|X| ≤ x) = P (−x ≤ X ≤ x) = H(x) − H(−x). n (8. We conclude that G∗ (x) − Gn (x. F ) n n µ ¶ 1 1 − Φ(−x) + 1/2 g1 (−x. F ) − Gn (−x. then |Z| has distribution function Φ(x) = Φ(x) − Φ(−x) = 2Φ(x) − 1. F ) + O(n−3/2 ).1. F0 ) = The order of the error is O(n−1 ). 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.

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

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

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

05) . and the 2. lot size.95). ˆ = 1.2. and thus reject H0 if ˆ ˆ > q ∗ (. calculate the estimates ˆ on these samples and θ then calculate ∗ ∗ ∗ θ θ Tn = ˆ /s(ˆ ).2 and s(ˆ = . Suppose that in an application.95) denote the 95% quantile of Tn .pdf. with variables listed in the file hprice1. The ˆ are sorted. θ θ) ∗ 1000 samples are generated from the bootstrap distribution.95). You do this as follows.dat contains data on house prices (sales). ˆ − s(ˆ n (. Let qn (.05) and qn (. Using the non-parametric bootstrap. θ θ)q ∗ θ θ)q ∗ θ/s(θ) 5.95). What is wrong with this procedure? Tn = θ/s(θ) n 6. You want to test H0 : θ = 0 against H1 : θ > 0. ∗ ∗ where s(ˆ is the standard error in the original data.5% quantiles of the ˆ are . The test for H0 is to reject if Tn = ˆ ˆ > c where c is picked so that Type I error is α. You replace c with qn (. Estimate a linear regression of price on the number of bedrooms.75 and 1.95) denote the 5% θ) ∗ and 95% quantiles of Tn .5% and 97. Calculate 95% confidence intervals for the regression coefficients using both the asymptotic normal approximation and the percentile-t bootstrap.3. and define the bootstrap confidence interval h i C = ˆ − s(ˆ n (. Using the non-parametric ∗ bootstrap. θ respectively. (b) Report the 95% Alternative Percentile interval for θ. (a) Report the 95% Efron Percentile interval for θ.Show that C exactly equals the Alternative percentile interval (not the percentile-t interval). (c) With the given information. 105 . and ˆ is calculated on each θ ∗ ∗ θ sample. ∗ ∗ ∗ Let qn (. size of house. The datafile hprice1. can you report the 95% Percentile-t interval for θ? 7. you generate bootstrap samples. and the colonial dummy.

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

and the GMM estimator is the MME. β GMM = Z 0 XWn X 0 Z 9. the dependence is only up to scale.3) The method of moments estimator for β is defined as the parameter value which sets g n (β) = 0. let Jn (β) = n · g n (β)0 Wn g n (β). β GMM does not change. then g n (β) = 0. ¡ ¢−1 0 ˆ Z XWn X 0 Y. Proposition 9.1 β GMM = argmin Jn (β). ˆ Definition 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. but this is generally not possible when > k. For example. The idea of the generalized method of moments (GMM) is to define an estimator which sets g n (β) “close” to zero. i i . Let and where gi = xi ei .1 ˆ 2Z 0 XWn X 0 Z β = 2Z 0 XWn X 0 Y While the estimator depends on Wn . 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). gi (β) = xi yi − zi β = n n n i=1 i=1 Define the sample analog of (9. For some × weight matrix Wn > 0.2. then. for if Wn is replaced ˆ by cWn for some c > 0. β ˆ Note that if k = . The GMM estimator minimizes Jn (β). the square of the Euclidean length. Jn (β) = n · g n (β)0 g n (β) = n · |g n (β)|2 . if Wn = I.2.2 GMM Estimator n n ¢ 1¡ 0 ¢ 1X 1X ¡ 0 X Y − X 0 Zβ .2) g n (β) = (9.3 Distribution of GMM Estimator ¡ 0¢ Q = E xi zi Assume that Wn →p W > 0.

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. However. GMM estimators are asymptotically normal with “sandwich form” asymptotic variances. This yields the efficient GMM estimator: ¢−1 0 ¡ ˆ Z XΩ−1 X 0 Y.3. Q W ΩW Q Q0 W Q V = Q0 W Q Thus we have Theorem 9. Ω) . The proof is left as an exercise. n β − β →d N 0. without imposing additional assumptions.2 For the efficient GMM estimator. ˆ We have described the estimator β as “efficient GMM” if the optimal (variance minimizing) weight matrix is selected. we can define the residuals ei = yi −zi β and moment equations gi = xi ei = g(wi . ˆ we still call β the efficient GMM estimator. This results shows that in the linear model. 9.3. Chamberlain showed that in this context.4 Estimation of the Efficient Weight Matrix ˆ Given any weight matrix Wn > 0. as it has the same asymptotic distribution. n n We conclude: Theorem 9. where In general. V ) . Given any such first0ˆ ˆ ˆ ˆ step estimator. no estimator has greater asymptotic efficiency than the efficient linear GMM estimator. ˆ n i=1 gi = gi − g n . a better choice is Wn = (X 0 X)−1 . ˆ∗ ˆ 108 . the GMM estimator β is consistent yet inefficient. β = Z 0 XΩ−1 X 0 Z ´ ³ ¡ ¢−1 ´ √ ³ˆ . this is a semi-parametric problem. This is a weak concept of optimality. and this is all that is known. it is semiparametrically efficient. No estimator can do better (in this first-order asymptotic sense). This turns out to be W0 = Ω−1 . as the distribution of the data is unknown. For example. For any Wn →p W0 . ˆ Construct n 1X ˆ g n = g n (β) = gi . but it can be estimated consistently. as we are only considering alternative weight matrices Wn . we can set Wn = I .1 ´ √ ³ˆ n β − β →d N (0. it turns out that the GMM estimator is semiparametrically efficient.and µ µ ¶ ¶ 1 0 1 0 Z X Wn X e →d Q0 W N (0. If it is known that E (gi (β)) = 0. as shown by Gary Chamberlain (1987). In the linear model. W0 = Ω−1 is not known in practice. Q0 Ω−1 Q ¢−1 ¡ 0 ¢¡ ¢−1 ¡ . no semiparametric estimator (one which is consistent globally for the class of models considered) ¢−1 ¡ . β). The optimal weight matrix W0 is one which minimizes V. Since the GMM estimator has this can have a smaller asymptotic variance than G0 Ω−1 G asymptotic variance.

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

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

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

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

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

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

xi . 115 . h(β)=0 The GMM test statistic (the distance statistic) of the hypothesis h(β) = 0 is ˜ D = Jn (β) = min Jn (β). VR ) where ¡ ¢−1 0 R V. λ) = 1 Jn (β) + λ0 (R0 β − r) where λ is 2 s × 1. Define the Lagrangian L(β.6) equals the Wald statistic. zi is l × 1 and β is k × 1. In the linear model Y = Xβ + e with E(xi ei ) = 0. is defined as Jn (β) = ˜ β = argmin Jn (β).5. 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. Thus ˜ β = argmin Jn (β) R0 β−r à n ! ¡ 0 ¢−1 ¡ 0 ¢−1 X 0 2 ˆ XX xi xi ei ˆ . The GMM estimator of β.5) as ³ ´ ³ ´0 ˆ ˆ ˆ −1 β − β Jn (β) = β − β Vn where (b) Now focus on linear restrictions: h(β) = R0 β − r. λ = R0 Vn R (c) Show that if R0 β = r then ´ √ ³˜ n β − β →d N (0. Show how to construct an efficient GMM estimator for β. l ≥ k. the distance statistic D in (9.6) (a) Show that you can rewrite Jn (β) in (9. The observed data is (yi . 6. β) + ei E (zi ei ) = 0. subject ˆ i ˆi i=1 to the restriction h(β) = 0. h(β)=0 (9. VR = V − V R R0 V R (d) Show that in this setting.5) n 1 P ˆ where ei are the OLS residuals and Ωn = n n xi x0 e2 . zi ). The equation of interest is yi = g(xi . Vn = X X i=1 ˜ and hence R0 β = r. 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 .

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

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

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

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. ˆ The asymptotic variance V for β is the same as for efficient GMM.13) yields n n Expanding (10.11) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ ˆ 0 ' −g n − Gn β − β 0 + Ωn λ (10. β) = −xi zi .1 Under regularity conditions. in the linear model.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 .10.2.8) and ¢ 0 0 For example.9) (10.10) ¡ Ω−1 N (0.11) 0 = ∂λ ˆ0 ˆ i=1 1 + λ gi β ³ ´0 ˆ n X Gi .9) and (10. Gi (. i i Theorem 10. Vλ ) ´ √ ˆ √ ³ˆ where V and Vλ are defined in (10. ˆ ˆ Proof. 0 = Rn (β. β λ ∂ ³ ´.13) Premultiplying by G0 Ω−1 and using (10.2 Define Asymptotic Distribution of EL Estimator Gi (β) = ∂ gi (β) ∂β 0 (10. ´ √ ³ ˆ n β − β 0 →d √ ˆ nλ →d N (0. n (10. λ) jointly solve ³ ´ ˆ n gi β X ∂ ³ ³ ´´ Rn (β. Thus the EL estimator is asymptotically efficient. λ) = − (10. λ) = − (10. and Ω = E xi x0 e2 . (β. i=1 i=1 i=1i Expanding (10. G = −E (xi zi ). g n = n n gi (β 0 ) and Ωn = n n g (β 0 ) gi (β 0 )0 .12) ∂β ˆ ˆ0 i=1 1 + λ gi β 1 P 1 P 1 P Let Gn = n n Gi (β 0 ) .12) around β = β 0 and λ = λ0 = 0 yields ³ ´ ˆ 0 ' G0 λ − λ0 .10). and n β − β 0 and nλ are asymptotically independent.

They are asymptotically first-order equivalent.15). This means that no consistent estimator for this class of models can have a lower asymptotic variance than V .3 Overidentifying Restrictions In a parametric likelihood context. Vλ ) Furthermore. and have the same interpretation. 120 .16) ´ √ ˆ √ ³ˆ n β − β 0 and nλ are asymptotically uncorrelated and hence independent. LRn = i=1 Theorem 10.3. n ³ ´´ ´ √ ³ 1 X ³ ˆ ˆ √ g wi .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. Since the EL estimator achieves this bound. The EL overidentification test is similar to the GMM overidentification test.7) is n ³ ´´ ³ X ˆ ˆ0 (10.15) yields ³ ¡ ¢−1 0 −1 ´ √ √ ˆ nλ ' Ω−1 I − Gn G0 Ω−1 Gn Gn Ωn ng n n n n ³ ¡ 0 −1 ¢−1 0 −1 ´ N (0. ¥ Chamberlain (1987) showed that V is the semiparametric efficiency bound for β in the overidentified moment condition model. and it is advisable to report the statistic LRn whenever EL is the estimation method.17) 2 ln 1 + λ gi β . The same statistic can be constructed for empirical likelihood. Twice the difference between the unrestricted empirical likelihood −n log (n) and the maximized empirical likelihood for the model (10. β 0 ) = 0 then LRn →d χ2−k .14) for λ and using (10. since ³ ¡ ¢−1 0 ´ G0 I − Ω−1 G G0 Ω−1 G G =0 (10.1 If Eg(wi . V ) ˆ Solving (10.15) (10. The overidentification test is a very useful by-product of EL estimation. (10. it is an asymptotically efficient estimator for β. tests are based on the difference in the log likelihood functions. First. Ω) →d Ω−1 I − G G Ω G GΩ = Ω−1 N (0. and (10. Proof. Ω) GΩ G →d = N (0.16). by a Taylor expansion. β ' n g n + Gn β − β 0 n i=1 ³ ¡ ¢−1 0 −1 ´ √ Gn Ωn ng n ' I − Gn G0 Ω−1 Gn n n √ ˆ ' Ωn nλ. 10.

ssc. Instead we use the difference in log-likelihoods: ³ ´ ˆ ˜ LRn = 2 Ln − Ln . The restricted EL estimator and likelihood are the values which solve ˜ β = argmax Ln (β) h(β)=0 ˜ ˜ Ln = Ln (β) = max Ln (β).18). By “maintained” we mean that the overidentfying restrictions contained in (10. 10.4. This test statistic is a natural analog of the GMM distance statistic. The hypothesis of interest is h(β) = 0.wisc. the restricted EL estimator β is simply an EL estimator with − k + a overidenti˜ ˆ fying restrictions.edu/~bhansen/progs/elike.1 Under (10.Second. so there is no fundamental change in the distribution theory for β relative to β. a The proof of this result is more challenging and is omitted. Theorem 10. LRn →d χ2 . 10.5 Numerical Computation Gauss code which implements the methods discussed below can be found at http://www.17) is not appropriate. h(β)=0 ˜ Fundamentally.18) and H0 : h(β) = 0. the simple overidentifying restrictions test (10.4 Testing Egi (β) = 0 (10.prc 121 . Vλ )0 Ω−1 N (0. 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). Vλ ) ¥ where the proof of the final equality is left as an exercise. LRn = n X i=1 ˆ0 ' 2λ →d ˆ0 ˆ ' nλ Ωn λ = χ2−k n X i=1 ³ ´´ ³ ˆ ˆ0 2 ln 1 + λ gi β i=1 n ³ ´ X ³ ´ ³ ´0 ˆ − λ0 ˆ ˆ ˆ ˆ gi β gi β gi β λ N (0.18) Let the maintained model be where g is × 1 and β is k × 1. where h : Rk → Ra . since ln(1 + x) ' x − x2 /2 for x small.

δ 1 = 1 and δ 2 = 1. A complication is that λ must be constrained so that 0 ≤ pi ≤ 1 which holds if ¢ ¡ n 1 + λ0 gi (β) ≥ 1 122 (10. The value of δ which minimizes this quadratic is ˆ = R2 + 3R0 − 4R1 . λ) = i ∂λ∂β 0 1 + λ0 gi (β) i=1 ⎞ ⎛ ¡ 0 ¢ ∂2 n 2 X 0 gi (β) λ ∂ ⎠ ⎝G∗ (β.20) . λp ) A quadratic function can be fit exactly through these three points. λj ) is smaller than some prespecified tolerance. λ)0 − Rn (β. λ) = − gi (β.5) for given β. λ) = ∂λ∂λ i=1 ¶ n 2 Xµ ∂ Gi (β) ∗ gi (β.Derivatives The numerical calculations depend on derivatives of the dual likelihood function (10. λ)0 0 Rn (β. The modified Newton method takes a quadratic approximation to Rn (β.19). Efficient convergence requires a good choice of steplength δ. λ) ∂λ i=1 n ∂ Rn (β. 1. i Rββ = Inner Loop The so-called “inner loop” solves (10. λj )) Rp = Rn (β. δ 4R2 + 4R0 − 8R1 yielding the steplength to be plugged into (10. λj ))−1 Rλ (β. λ) . λ) = G∗ (β. λ) gi (β. λj ) . λ)0 − ∂β∂β Rn (β. Define ∗ gi (β.19) is continued until the gradient Rλ (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. Set δ 0 = 0.4). λ) yielding the iteration rule λj+1 = λj − δ (Rλλ (β.. One method uses the following quadratic approximation. set 2 λp = λj − δ p (Rλλ (β. (10. λ) = i i ∂β∂β 0 1 + λ0 gi (β) i=1 n where δ > 0 is a scalar steplength (to be discussed next). 2. λ) G∗ (β. λ) = i The first derivatives of (10. The starting value λ1 can be set to the zero vector. The iteration (10.19) X ∂2 ∗ ∗ gi (β. For p = 0. λ) = − ∂β n X i=1 G∗ (β. λj ))−1 Rλ (β. λ) G∗ (β.

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

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

(11. Thus we make the partition ¶ µ k1 z1i (11. so should be included in xi . That is x2i are variables which could be included in the equation for yi (in the sense 125 .3) zi = z2i k2 where E(z1i ei ) = 0 yet E(z2i ei ) 6= 0. and x2i are the excluded exogenous variables.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 ¶ . at least the intercept).1.2) Any solution to the problem of endogeneity requires additional information which we call instruments. which does not equal either β 1 or β 2 .1). β →p β ∗ . z1i is an instrumental variable for (11.4) xi = x2i 2 where z1i = x1i are the included exogenous variables.1) if E (xi ei ) = 0. By the above definition. and assume that E(zi ei ) 6= 0 so there is endogeneity. some regressors in zi will be uncorrelated with ei (for example. This is called simultaneous equations bias. 11. We call (11.1 Instrumental Variables 0 yi = zi β + ei Let the equation of interest be (11. In matrix notation.1 The × 1 random vector xi is an instrumental variable for (11. this can be written as Y = Zβ + e. Definition 11. We call z1i exogenous and z2i endogenous. So we have the partition µ ¶ z1i k1 (11. In a typical set-up.1) where zi is k × 1. ¶ µ ∙ β2 β1 1 −1 β 2 e1i + β 1 e2i (e1i − e2i ) ¸µ e1i e2i ¶ ˆ Hence if it is estimated by OLS.1) the structural equation.

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

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

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 . ¢ 1 ¡ ¢ 1 ¡ ¢ 1 ¡ 0 E Z PX e = E Γ0 X 0 e + E u0 PX e = αS21 . Indeed as α → 1. the expression in (11. indicating that the bias in 2SLS approaches that of OLS as the number of instruments increases. 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 (11.14) approaches that in (11. By the spectral decomposition of an idempotent matrix.14) is the probability limit of β 2SLS − β 11. The parameter β fails to be identified if Γ22 has deficient rank. 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 (11.7 Identification Failure Recall the reduced form equation Z2 = X1 Γ12 + X2 Γ22 + u2 . n and (11.Let PX = X (X 0 X)−1 X 0 . 130 . the bias in the 2SLS estimator will be large. l . It is also close to zero when α = 0.14) In general this is non-zero. Let q = H 0 ξS −1/2 which satisfies Eqq 0 = In and partition q = (q1 q2 ) where q1 is l × 1. 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.13). P = HΛH 0 0 0 where Λ = diag(Il . The consequences of identification failure for inference are quite severe. n n n ¢ ¡ ¡ ¢ ¢ ¢ 1 ¡ 0 1 ¡ E Z PX Z = Γ0 E xi x0 Γ + Γ0 E (xi ui ) + E ui x0 Γ + E u0 PX u i i n n = Γ0 QΓ + αS22 .12) and this result. 0).

and was examined by Phillips (1989) and Choi and Phillips (1992). but is weak. 131 . E x2 u2 i i n n i=1 i=1 n n (11. Then the model may be written as yi = zi β + ei zi = xi γ + ui and Γ22 = γ = E (xi zi ) /Ex2 . so E (zi xi ) = 0.16) ˆ β−β = 1 √ n 1 √ n Pn Pn i=1 xi ei i=1 xi zi →d N1 ∼ Cauchy.15) is unaffected. This result carries over to more general settings. but (11. Suppose this condition fails. meaning that inferences about parameters of interest can be misleading. E x2 e2 i i n i=1 n (11. Thus identification hinges on the existence of correlation between the excluded exogenous variable and the included endogenous variable. viz Γ22 = n−1/2 C. once again take the simple case k = l = 1.16) 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 . Qc + N2 ˆ As in the case of complete identification failure. The n−1/2 is picked because it provides just the right balancing to allow a rich distribution theory. To see the consequences. where C is a full rank matrix. Then by the CLT ¡ ¡ ¢¢ 1 X √ xi ei →d N1 ∼ N 0. We see that β is identified if and only if Γ22 = γ 6= 0. which occurs i when E (zi xi ) 6= 0. This occurs when Γ22 is full rank. Suppose that identification does not complete fail.15) therefore ¢¢ ¡ ¡ 1 X 1 X √ xi zi = √ xi ui →d N2 ∼ N 0. we find that β is inconsistent for β and the ˆ is non-normal. but small. Here. In addition.Take the simplest case where k = l = 1 (so there is no X1 ). the instrument xi is weak for zi if γ = n−1/2 c. as the Cauchy distribution does not have a finite mean. 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. N2 since the ratio of two normals is Cauchy. This is particularly nasty. Then (11.

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

8 Exercises yi = zi β + ei . The reduced form between the regressors zi and instruments xi takes the form zi = x0 Γ + ui i or Z = XΓ + u where zi is k × 1. Show that the GLS estimator of β can be written as an i IV estimator using some instrument xi . In the linear model 0 yi = zi β + ei E (ei | zi ) = 0 ¡ 2 ¢ suppose σ 2 = E ei | zi is known. at ˆˆ If X is indeed endogeneous. 1. 133 . in the sense that e ˜ ˜ least in large samples? 4. ˜ 0 e < e0 e. show that if rank(Γ) < k then β cannot be identified. u is n × k. and Γ is l × k. Take the linear model Y = Zβ + e. The parameter Γ is defined by the population moment condition ¡ ¢ E xi u0 = 0 i ˆ Show that the method of moments estimator for Γ is Γ = (X 0 X)−1 (X 0 Z) . Explain why this is true. 2.11. That is. Take the linear model yi = xi β + ei E (ei | xi ) = 0. X is n × l. Let β denote the IV estimator of β using as an instrument a dummy variable di (takes only the values 0 and 1). ˆ ˆ Let the OLS estimator for β be β and the OLS residual be e = Y − Z β. 6.) 3. Find a simple expression for the IV estimator in this context. ˆ ˜ ˜ Let the IV estimator for β using some instrument X be β and the IV residual be e = Y − Z β. xi is l × 1. l ≥ k. Consider the single equation model ˆ where yi and zi are both real-valued (1 × 1). Z is n × k. In the structural model Y = Zβ + e Z = XΓ + u with Γ l × k. we claim that β is identified (can be recovered from the reduced form) if rank(Γ) = k. 5. where xi and β are 1 × 1. will IV “fit” better than OLS. (Find an expression for xi .

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

.1 {Yt } is covariance (weakly) stationary if E(Yt ) = µ is independent of t.. and use the subscript t to denote the individual observation. then Xt is strictly stationary and ergodic. . T . Yt−k ) = γ(k) is independent of t for all k... To indicate the dependence on time. The following two theorems are essential to the analysis of stationary time series.. and multivariate (yt ∈ Rm is vector-valued). Because of the sequential nature of time series.) is a random variable. Definition 12. The primary model for univariate time series is autoregressions (ARs).Chapter 12 Univariate Time Series A time series yt is a process observed in sequence over time. 135 . t = 1. so classical assumptions are not valid.1. Theorem 12.1 If Yt is strictly stationary and ergodic and Xt = f (Yt . γ(k) is called the autocovariance function. 12. The primary model for multivariate time series is vector autoregressions (VARs). .4 (loose). Yt−k ) is independent of t for all k. There proofs are rather difficult. however.1 Stationarity and Ergodicity Definition 12. we adopt new notation. we expect that Yt and Yt−1 are not independent..3 ρ(k) = γ(k)/γ(0) = Corr(Yt .1. . Definition 12. and Cov (Yt . A stationary time series is ergodic if γ(k) → 0 as k → ∞. Definition 12.2 {Yt } is strictly stationary if the joint distribution of (Yt .1. Yt−1 .. Yt−k ) is the autocorrelation function.1.. We can separate time series into two categories: univariate (yt ∈ R is scalar). and T to denote the number of observations.1.

and it has a finite mean by the assumption that EYt2 < ∞. ˆ 2. ˆ ˆ γ ¥ 136 . γ (k) →p γ(k). then as T → ∞. T t=1 This allows us to consistently estimate parameters using time-series moments: The sample mean: T 1X µ= ˆ Yt T t=1 The sample autocovariance T 1X (Yt − µ) (Yt−k − µ) .1.1. γ (0) ˆ Theorem 12. the sequence Yt Yt−k is strictly stationary and ergodic. Thus an application of the Ergodic Theorem yields T 1X Yt Yt−k →p E(Yt Yt−k ).Theorem 12. T 1X Xt →p E(Xt ). For Part (2).1. note that γ (k) = ˆ T 1X (Yt − µ) (Yt−k − µ) ˆ ˆ T t=1 = T T T 1X 1X 1X Yt Yt−k − Yt µ − ˆ Yt−k µ + µ2 . 1. ˆ 3.1 above.2 (Ergodic Theorem). ˆ Proof. Part (1) is a direct consequence of the Ergodic theorem. then as T → ∞. ˆ ˆ T t=1 γ (k) = ˆ The sample autocorrelation ρ(k) = ˆ γ (k) ˆ .3 If Yt is strictly stationary and ergodic and EYt2 < ∞. µ →p E(Yt ). ˆ ˆ T t=1 T t=1 T t=1 By Theorem 12. T t=1 Thus γ (k) →p E(Yt Yt−k ) − µ2 − µ2 + µ2 = E(Yt Yt−k ) − µ2 = γ(k). If Xt is strictly stationary and ergodic and E |Xt | < ∞. ρ(k) →p ρ(k). ˆ Part (3) follows by the continuous mapping theorem: ρ(k) = γ (k)/ˆ (0) →p γ(k)/γ(0) = ρ(k).

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

We can compute the moments of Yt using the infinite sum: EYt = ∞ X k=0 ρk E (et−k ) = 0 σ2 . 1 − ρ2 V ar(Yt ) = If the equation for Yt has an intercept. or ρ(L)Yt = et where ρ(L) = 1 − ρ1 L − ρ2 L2 − · · · − ρk Lk . The AR(1) model can be written in the format Yt − ρYt−1 + et or (1 − ρL) Yt−1 = et . we see that L2 Yt = LYt−1 = Yt−2 . ∞ X k=0 ρ2k V ar (et−k ) = 12.4. The AR(k) model is Using the lag operator. except that the mean of Yt can be computed from the relationship EYt = α + ρEYt−1 . 138 . We call ρ(L) the autoregressive polynomial of Yt . since ρ(z) = 0 when z = 1/ρ. We call ρ(L) the autoregressive polynomial of Yt . In general. an AR(1) is stationary iff |ρ| < 1. 12. Definition 12. Yt − ρ1 LYt − ρ2 L2 Yt − · · · − ρk Lk Yt = et . 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). Lk Yt = Yt−k . Defining L2 = LL.Theorem 12.1 If |ρ| < 1 then Yt is strictly stationary and ergodic. the above results are unchanged.3. We say that the root of the polynomial is 1/ρ.3. and solving for EYt = EYt−1 we find EYt = α/(1 − ρ).5 Stationarity of AR(k) Yt = ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et . From Theorem 12.1 The lag operator L satisfies LYt = Yt−1 .4 Lag Operator An algebraic construct which is useful for the analysis of autoregressive models is the lag operator.1. The operator ρ(L) = (1 − ρL) is a polynomial in the operator L.

6. since E (ut | It−1 ) = E (xt et | It−1 ) = xt E (et | It−1 ) = 0. Thus T T 1X 1X xt et = ut →p E (ut ) = 0. . T ¢ ¡ 1X xt x0 →p E xt x0 = Q. We know that an AR(1) is stationary iff the absolute value of the root of its autoregressive polynomial is larger than one. and by Theorem 12. The vector xt is strictly stationary and ergodic.1 The AR(k) is strictly stationary and ergodic if and only if |λj | > 1 for all j. and hence Yt .1) and the continuous mapping theorem.” If one of the roots equals 1. it is helpful to define the process ut = xt et .6 Let Estimation xt = β = ¡ 1 Yt−1 Yt−2 · · · α ρ1 ρ2 · · · yt = x0 β + et . we say that ρ(L). This is a special case of non-stationarity. t t T t=1 ¥ Combined with (12.. t Yt−k ¢0 ρk . 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. One way of stating this is that “All roots lie outside the unit circle. By Theorem 12. Thus t by the Ergodic Theorem.1) Theorem 12. β = X 0X (12. Note that ut is a MDS. T t=1 T t=1 ¢−1 0 ¡ ˆ X Y.1. the requirement is that all roots are larger than one. which satisfy ρ(λj ) = 0.5. “has a unit root”. it is also strictly stationary and ergodic. Let |λ| denote the modulus of a complex number λ. For an AR(k). then ˆ β →p β as T → ∞.1. and is of great interest in applied time series. λk are the complex roots of ρ(z).1. Theorem 12. t T t=1 T t=1 139 . we see that à !−1 à ! T T 1X 1X ˆ β=β+ xt x0 xt et →p Q−1 0 = 0..where the λ1 . ¢0 Then the model can be written as The OLS estimator is ¡ ˆ To study β. Proof.1 If the AR(k) process Yt is strictly stationary and ergodic and EYt2 < ∞. so is xt x0 ..1.

. Divide the sample into T /m blocks of length m. ˆ 2. t t Theorem 12.8 Bootstrap for Autoregressions In the non-parametric bootstrap. Clearly. Y−k+2 .7.2 If the AR(k) process Yt is strictly stationary and ergodic and EYt4 < ∞.7. This is identical in form to the asymptotic distribution of OLS in cross-section regression. ´ √ ³ ¡ ¢ ˆ T β − β →d N 0. eT }. Ω) . Fix an initial condition (Y−k+1 . T t=1 Since xt et is a MDS.7 Asymptotic Distribution Theorem 12. t then as T → ∞.. e ˆ 3. we constructed the bootstrap sample by randomly resampling from the data values {yt . which may be different than the i properties of the actual ei . T t=1 where Ω = E(xt x0 e2 ). t This construction imposes homoskedasticity on the errors e∗ . .12. this cannot work in a time-series application.. This creates an iid bootstrap sample. If ut is a strictly stationary and ergodic MDS and E(ut u0 ) = Ω < ∞.1 to see that T 1 X √ xt et →d N (0. as this imposes inappropriate independence.7. The implication is that asymptotic inference is the same. i 4. It also presumes that the AR(k) structure is the truth. Briefly. T 1 X √ ut →d N (0. Ω) .. then as T → ∞. 12. Estimate β and residuals et .1 MDS CLT.. Method 2: Block Resampling 1. we can apply Theorem 12. ˆ 1. . In particular.. 140 . xt }. there are two popular methods to implement bootstrap resampling for time-series data. Method 1: Model-Based (Parametric) Bootstrap. 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∗ . the asymptotic covariance matrix is estimated just as in the cross-section case. Simulate iid draws e∗ from the empirical distribution of the residuals {ˆ1 . Y0 ). Q−1 ΩQ−1 .

• Include dummy variables for each season. 3. get the ˆ ˆ residual St . But the long-run trend is also eliminated.2. however.2). heteroskedasticity. That is. The seasonal adjustment.. Paste the blocks together to create the bootstrap time-series Yt∗ . Seasonal Effects There are three popular methods to deal with seasonal data. This is a flexible approach which can extract a wide range of seasonal factors. This procedure is sometimes called Detrending. draw T /m blocks. May not work well in small samples. . first estimate (12. • You can estimate (12. (12. Resample complete blocks.9 Trend Stationarity Yt = µ0 + µ1 t + St St = ρ1 St−1 + ρ2 St−2 + · · · + ρk St−l + et .2) (12. and perhaps this was of relevance. The seasonal factor is typically estimated by a two-sided weighted average of the data for that season in neighboring years.2)-(12. and the way that the data are partitioned into blocks. The series ∆s Yt is clearly free of seasonality.. • You can estimate (12. The results may be sensitive to the block length. If s is the number of seasons (typically s = 4 or s = 12). For each simulated sample. 141 . • Use “seasonally adjusted” data. and then perform regression (12. 6. ρk ). 5. 4.3) sequentially by OLS.4) There are two essentially equivalent ways to estimate the autoregressive parameters (ρ1 .3) replacing St with St . This allows for arbitrary stationary serial correlation. The reason why these two procedures are (essentially) the same is the Frisch-Waugh-Lovell theorem.3) or Yt = α0 + α1 t + ρ1 Yt−1 + ρ2 Yt−1 + · · · + ρk Yt−k + et .4) by OLS. This presumes that “seasonality” does not change over the sample. • First apply a seasonal differencing operator. 12. and for modelmisspecification. Thus the seasonally adjusted data is a “filtered” series. ∆s Yt = Yt − Yt−s .. or the season-to-season change. (12. also alters the time-series correlations of the data.

e. and the alternative is that the error is an AR(m). (A simple exclusion test). let the null hypothesis be an AR(1): Yt = α + ρYt−1 + ut .5) and (12.. AR(2).g.. you need more initial conditions. To combine (12.11 Model Selection What is the appropriate choice of k in practice? This is a problem of model selection. and this is equivalent to the restriction that the coefficients on Yt−k−1 .6) 12.12. if the null hypothesis is that Yt is an AR(k).5) We are interested in the question if the error ut is serially correlated. T where σ 2 (k) is the estimated residual variance from an AR(k) ˆ One ambiguity in defining the AIC criterion is that the sample available for estimation changes as k changes. to find Yt − θYt−1 = α − θα + ρYt−1 − θρYt−1 + ut − θut−1 .10 Testing for Omitted Serial Correlation For simplicity. 142 .5).) This can induce strange behavior in the AIC. or Yt = α(1 − θ) + (ρ + θ) Yt−1 − θρYt−2 + et = AR(2). . Thus under H0 . H0 may be expressed as the restriction that the coefficient on Yt−2 is zero..6). (12. Yt−k−m are jointly zero. An appropriate test of H0 against H1 is therefore a Wald test that the coefficient on Yt−2 is zero.5) and lag the equation once: Yt−1 = α + ρYt−2 + ut−1 . AR(k) on this (unified) sample. this is the same as saying that under the alternative Yt is an AR(k+m). We then multiply this by θ and subtract from (12. and then estimate the models AR(1).. We want to test H0 against H1 . and then reserve the first k as initial conditions. The best remedy is to fix a upper value k. In general. We model this as an AR(1): ut = θut−1 + et with et a MDS.. The hypothesis of no omitted serial correlation is H0 : θ = 0 H1 : θ 6= 0.. One approach to model selection is to choose k based on a Wald tests. Another is to minimize the AIC or BIC information criterion. we take (12. AIC(k) = log σ 2 (k) + ˆ 2k . . (If you increase k. An appropriate test is the Wald test of this restriction. Yt is an AR(1). (12. and under H1 it is an AR(2).

since ρ(1) = −α0 . Under H0 . and is called the Augmented Dickey-Fuller (ADF) test for a unit root. Thus ρ(1) = (1 − 1) − α0 − (1 − 1) − · · · − (1 − 1) = −α0 . However. Yt is non-stationary. the model for Yt is ∆Yt = µ + α1 ∆Yt−1 + · · · + αk−1 ∆Yt−(k−1) + et . 143 . and test statistics are asymptotically non-normal. but simply assert the main results. The DF parameterization is convenient because the parameter α0 summarizes the information about the unit root. Since α0 is the parameter of a linear regression.7) is (1 − L) − α0 L − α1 (L − L2 ) − · · · − αk−1 (Lk−1 − Lk ) But this must equal ρ(L). or I(d). So the natural alternative is H1 : α0 < 0.7). which is an AR(k-1) in the first-difference ∆Yt . An alternative asymptotic framework has been developed to deal with non-stationary data. It would seem natural to assess the significance of the ADF statistic using the normal table. under H0 . so conventional normal asymptotics are invalid. As we discussed before.12 Autoregressive Unit Roots The AR(k) model is ρ(L)Yt = µ + et ρ(L) = 1 − ρ1 L − · · · − ρk Lk . We do not have the time to develop this theory in detail. Yt is non-stationary. Yt has a unit root when ρ(1) = 0. the hypothesis of a unit root in Yt can be stated as H0 : α0 = 0. as the models are equivalent. A helpful way to write the equation is the so-called Dickey-Fuller reparameterization: ∆Yt = µ + α0 Yt−1 + α1 ∆Yt−1 + · · · + αk−1 ∆Yt−(k−1) + et . this is the most popular unit root test. Indeed. To see this. observe that the lag polynomial for the Yt computed from (12. Thus a time series with unit root is I(1). (12. Thus if Yt has a (single) unit root. or ρ1 + ρ2 + · · · + ρk = 1. Note that the model is stationary if α0 < 0. then Yt is “integrated of order d”. Hence. The ergodic theorem and MDS CLT do not apply. then ∆Yt is a stationary AR process. Because of this property. we say that if Yt is non-stationary but ∆d Yt is stationary. In this case.12. the natural test statistic is the t-statistic for H0 from OLS estimation of (12.7) These models are equivalent linear transformations of one another.

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

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

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

general. We see that an appropriate.5 Testing for Omitted Serial Correlation Consider the problem of testing for omitted serial correlation in equation (13. 1).1) yt = x0 β + et . j Often.3). Let et = ejt and β = aj . If valid. h¡ 1 Yt−1 · · · 0 Yt−k Zt−1 · · · 0 Zt−k ¢0 i . You may have heard of the Durbin-Watson test for omitted serial correlation.4 Single Equation from a VAR Yjt = a0 xt + et . Then yt = x0 β + et t et = θet−1 + ut E (ut | It−1 ) = 0. which once was very popular.2) may be estimated by iterated GLS. This can be done by a Wald test. 13. and is still routinely reported by conventional regression packages. Another interesting fact is that (13.1). This takes the form 0 and xt consists of lagged values of Yjt and the other Ylt s. Let yt = Yjt . t or yt = θyt−1 + x0 β + x0 γ + ut . direct estimation of (13. Then the single equation takes the form (13.13. under the restriction γ = −βθ. Otherwise it is invalid. xt−1 ) to the regression. it is convenient to re-define the variables. we are only interested in a single equation out of a VAR system. t t−1 (13.2) 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 . Suppose that et is an AR(1). and simple way to test for omitted serial correlation is to test the significance of extra lagged values of the dependent variable and regressors. The DW test is appropriate only when regression yt = x0 β + et is not dynamic (has no lagged values on the RHS). may be tested if desired. In this case.3) which is a valid regression model. and Zt be the other variables. Then the null and alternative are H0 : θ = 0 H1 : θ 6= 0. t and xt = This is just a conventional regression.2) is a special case of (13. with time series data. and is typically rejected empirically. (13. This restriction. (A simple version of this estimator is called Cochrane-Orcutt. So testing H0 versus H1 is equivalent to testing for the significance of adding (yt−1 . and subtract off the equation once lagged multiplied by θ.2) is uncommon in recent applications. 147 . which is called a common factor restriction.) Since the common factor restriction appears arbitrary. t and et is iid N (0. the model (13.

and the information set I2t is generated by both Yt and Zt . If it is found that Zt does not Granger-cause Yt . then we say that Zt Granger-causes Yt . In a linear VAR. the equation for Yt is 0 0 Yt = α + ρ1 Yt−1 + · · · + ρk Yt−k + Zt−1 γ 1 + · · · + Zt−k γ k + et . That is. lagged Zt does not help to forecast Yt . conditional on information in lagged Yt .. and et (k) is the OLS residual vector from the ˆ model with k lags.7 Granger Causality Partition the data vector into (Yt .. . Yt−1 . you may either use a testingbased approach (using. 148 . Yt−2 . This may be tested using an exclusion (Wald) test. that Zt may still be useful to explain other features of Yt . If Zt is some sort of forecast of the future. . such as the conditional variance. then we deduce that our time-series model of E (Yt | It−1 ) does not require the use of Zt . however. Yt−2 . This definition of causality was developed by Granger (1969) and Sims (1972). That is. This idea can be applied to blocks of variables. The hypothesis can be tested by using the appropriate multivariate Wald test.t−1 ) . Note. for example.. Zt does not Granger-cause Yt if and only if H0 : γ 1 = γ 2 = · · · = γ k = 0. Zt−2 . such as a futures price.. Zt .13.6 Selection of Lag Length in an VAR If you want a data-dependent rule to pick the lag length k in a VAR. the Wald statistic).) I2t = (Yt .t−1 ) = E (Yt | I2. We say that Zt does not Granger-cause Yt if E (Yt | I1. or an information criterion approach. Yt−1 . The latter has more information. Yt and/or Zt can be vectors. If this condition does not hold. . 13. Zt ). then Zt may help to forecast Yt even though it does not “cause” Yt . Define the two information sets I1t = (Yt . The reason why we call this “Granger Causality” rather than “causality” is because this is not a physical or structure definition of causality. 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. The log determinant is the criterion from the multivariate normal likelihood.) The information set I1t is generated only by the history of Yt . In this equation. Zt−1 .

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

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

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

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

}..” Also observe that the model implies that V ar (Yi | xi ) = λi = exp(x0 β). 14. This may be considered restrictive. i i i=1 ˆ The MLE is the value β which maximizes ln (β). Thus the model is that there is some latent process yi with unbounded support. the consumption level (purchases) in a particular period was zero. 2.3 Censored Data The idea of “censoring” is that some data above or below a threshold are mis-reported at the ∗ threshold. this motivates the label Poisson “regression.. In surveys. a typical approach is to employ Poisson regression. The first censored regression model was developed by Tobin (1958) to explain consumption of durable goods. This model (now called the Tobit) specifies that the latent (or ideal) value of consumption may be negative (the household 153 . any known value can substitute. k! = exp(x0 β). i so the model imposes the restriction that the conditional mean and variance of Yi are the same. He proposed the latent variable model ∗ yi = x0 β + ei i ei ∼ iid N (0.2 Count Data exp (−λi ) λk i . but we observe only ½ ∗ ∗ yi if yi ≥ 0 (14. i If Y = {0. . An example of a data collection censoring is top-coding of income.14. 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. 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 !) .. 1. 2.) The observed data yi therefore come from a mixed continuous/discrete distribution. Tobin observed that for many households. 0 if yi (This is written for the case of the threshold being zero.. This model specifies that P (Yi = k | xi ) = λi k = 0.1) yi = ∗ <0 . The censoring process may be explicit in data collection. σ 2 ) with the observed variable yi generated by the censoring equation (14. The conditional density is the Poisson with parameter λi . or it may be a by-product of economic constraints.1). 1. incomes above a threshold are typically reported at the threshold. The functional form for λi has been picked to ensure that λi > 0. Since E (Yi | xi ) = λi = exp(x0 β) i is the conditional mean. A generalization is the negative binomial. .

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

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

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

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

else Then note that and an n × 1 dummy vector with a “1” in the i0 th place.2) is a valid regression. un ui = d0 u. ⎟ u = ⎝ . Stacking the observations together: Y = Xβ + Du + e. so will have to be omitted. as the parameter space is too large. • Any regressor in xit which is constant over time for all individuals (e. ⎠ . so the intercept is typically omitted from xit . it will be collinear with di . OLS estimation of β proceeds by the FWL theorem. . i yit = x0 β + d0 u + eit . Observe that • This is generally consistent. . Computationally. let dij = and ⎧ ⎨ 1 ⎩ 0 ⎛ if i = j . which is quite large as typically n is very large. 158 .First.2) yields estimator (β. ˆ ˆ OLS on (15.2) ⎞ di1 ⎜ . you do not want to actually implement conventional OLS estimation. it i (15.g. • If xit contains an intercept. Let ⎛ ⎞ u1 ⎜ . ˆ β = ¢−1 ¡ 0 ¢ ¡ 0 X (1 − PD ) Y X (1 − PD ) X ¡ ¢−1 ¡ ∗0 ∗ ¢ = X ∗0 X ∗ X Y . Y ∗ = Y − D(D0 D)−1 D0 Y where X ∗ = X − D(D0 D)−1 D0 X. din Observe that E (eit | xit . • There are n + k regression parameters. ⎟ di = ⎝ . u).. Conventional inference applies. then by the FWL theorem. ⎠. with di as a regressor along with xi . di ) = 0. their gender) will be collinear with di . so (15.

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

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

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

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

The asymptotically optimal choice given in (16. how should the bandwidth be selected? This is a difficult problem. We define the asymptotically optimal bandwidth h0 as the value which minimizes this approximate MSE. Thus for the AMISE to decline with n. Gaussian Kernel: hrule = 1.1) AM ISEh = AM SEh (x)dx = 4 nh R where R(f 00 ) = (f 00 (x))2 dx is the roughness of f 00 . This choice for h gives an optimal rule when f (x) is ˆ normal. h must tend to zero. where φ is the N (0.Together. 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 + . 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 . Equation (16. A classic simple solution proposed by Silverman (1986)has come to be known as the reference bandwidth or Silverman’s Rule-of-Thumb. we find the reference rules for the three kernel functions introduced earlier. 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) . The first two are determined by the kernel function. we need h → 0 but nh → ∞. That is. That is.1) is an asymptotic approximation to the MSE. ˆ It uses formula (16. σ 2 . but not of n. 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. Their K values for the three functions introduced in the previous section are given here. and gives a nearly optimal rule when f (x) is close to normal. Notice that the first term (the squared bias) is increasing in h and the second term (the variance) is decreasing in nh. but at a slower rate than n−1 . The downside is that if the density is very far from normal.2) but replaces R(f 00 ) with σ −5 R(φ00 ).2) depends on R(K). In practice. the rule-of-thumb h can be quite inefficient. and there is a large and continuing literature on the subject.2) This solution takes the form h0 = cn−1/5 where c is a function of K and f. (16. Note that this h declines to zero. We can calculate that √ R(φ00 ) = 3/ (8 π) . Together with the above table. and R(f 00 ). (16.06n−1/5 163 . 1) distribution and σ 2 is an estimate of σ 2 = V ar(X). We thus say that the optimal bandwidth is of order O(n−1/5 ). but at a very slow rate.

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

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

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

a These expressions only make sense if F (x) is differentiable. ..2 Random Variables A random variable X is a function from a sample space S into the real line.3) is unavailable. . Instead... .. The probability function for X takes the form j = 1. of the sample space. these cases are unusualRand are typically ignored. F (x) is right-continuous We say that the random variable X is discrete if F (x) is a step function. and use lower case letters such as x for potential values and realized values. For any set B and any partition A1 ... the range of X consists of a countable set of real numbers τ 1 . (A. F (x) is nondecreasing in x 3.Theorem 2 (Bayes’ Rule). Pr where 0 ≤ π j ≤ 1 and j=1 π j = 1.. r (A. then for each i = 1. While there are examples of continuous random variables which do not possess a PDF. For a random variable X we define its cumulative distribution function (CDF) as F (x) = P (X ≤ x) . 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. This induces a new sample space — the real line — and a new probability function on the real line. we denote random variables by uppercase letters such as X.. limx→−∞ F (x) = 0 and limx→∞ F (x) = 1 2. ∞ A function f (x) is a PDF if and only if f (x) ≥ 0 for all x ∈ R and −∞ f (x)dx. In this case P (X = τ ) = 0 for all τ ∈ R so the representation (A. In the latter case. τ r .2) Sometimes we write this as FX (x) to denote that it is the CDF of X. . We say that the random variable X is continuous if F (x) is continuous in x. A2 . A function F (x) is a CDF if and only if the following three properties hold: 1... 167 . P (B | Ai ) P (Ai ) P (Ai | B) = P∞ j=1 P (B | Aj ) P (Aj ) A. Typically. 2.3) P (X = τ j ) = π j .

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

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

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

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

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

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

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

dy dy If g(x) is a decreasing function.10) shows that fY (y) = exp(−y).∞). φ(x) = √ exp − 2 2π 175 The standard normal density is −∞ < x < ∞. but its justification requires deeper results from analysis. As the range of X is [0. Here. J(y) = det ∂y 0 Consider the univariate case k = 1. . 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)| . then g(X) ≤ Y if and only if X ≤ h(Y ). an exponential density. A.10) holds for k > 1. (A. so the distribution function of Y is FY (y) = P (g(X) ≤ y) = FX (h(Y )) = P (X ≤ h(Y )) so the density of Y is fY (y) = d d FY (y) = fX (h(Y )) h(y).A. g(x) = − ln(x) and h(y) = exp(−y) so the Jacobian is J(y) = − exp(y). Let h(y) denote the inverse of g(x). This same formula (A. Let Y = g(X) where g(x) : Rk → Rk is one-to-one. The Jacobian is ¶ µ ∂ h(y) . take the case X ∼ U [0.10) d h(y).8 Normal and Related Distributions µ 2¶ 1 x . Since fX (x) = 1 for 0 ≤ x ≤ 1 (A. differentiable. dy This is known as the change-of-variables formula. If g(x) is an increasing function. and invertible. 1] and Y = − ln(X). 0 ≤ y ≤ ∞. 1]. then g(X) ≤ Y if and only if X ≥ h(Y ). As one example. that for Y is [0.7 Transformations Suppose that X ∈ Rk with continuous distribution function FX (x) and density fX (x).

Another useful fact is that if X ∼ N (µ. σ 2 ). and it is conventional to write X ∼ N(µ. then using the change-of-variables formula. and to denote the standard normal density function by φ(x) and its distribution function by Φ(x). Theorem A. then Σ = diag{σ 2 } is a diagonal matrix. −∞ < x < ∞. respectively. then Z 0 A−1 Z ∼ χ2 . Q has the density f (y) = Γ 1 ¡r¢ 2 2r/2 yr/2−1 exp (−y/2) . It is conventional to write X ∼ N (0.This density has all moments finite. the density of Y is à ! (y − µY )0 Σ−1 (y − µY ) 1 Y exp − f (y) = . exp − f (x) = k/2 1/2 2 (2π) det (Σ) The mean and covariance matrix of the distribution are µ and Σ. 1). By iterated integration by parts. q × q. This shows that linear transformations of normals are also normal. If X ∈ Rk is multivariate normal and the elements of X are mutually uncorrelated. The mean and variance of the distribution are µ and σ 2 . then they are mutually independent. (A. Ir ) and set Q = X 0 X. Σ) and Y = a + BX with B an invertible matrix. y ≥ 0. x ∈ Rk . then by the change-of-variables formula. In this case the density function can be written as j à à !! (x1 − µ1 )2 /σ 2 + · · · + (xk − µk )2 /σ 2 1 1 k f (x) = exp − 2 (2π)k/2 σ 1 · · · σ k à ¡ ¢2 ! k Y xj − µj 1 = exp − 2σ 2 (2π)1/2 σ j j j=1 which is the product of marginal univariate normal densities.11) and is known as the chi-square density with r degrees of freedom. ¢ ¡ 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 . k/2 1/2 2 (2π) det (ΣY ) where µY = a+Bµ and ΣY = BΣB 0 . Its mean and r variance are µ = r and σ 2 = 2r. Since it is symmetric about zero all odd moments are zero. This shows that if X is multivariate normal with uncorrelated elements. x ∈ Rk . The latter has no closed-form solution. the multivariate normal density is ¶ µ (x − µ)0 Σ−1 (x − µ) 1 . f (x) = √ 2σ 2 2πσ which is the univariate normal density. For x ∈ Rk . If Z is standard normal and X = µ + σZ. X has density à ! (x − µ)2 1 exp − . Σ).8. denoted χ2 . and it is conventional to write X ∼ N (µ. where we used the fact that det (BΣB 0 )1/2 = det (Σ)1/2 det (B) . q 176 . Theorem A.2 If Z ∼ N(0.8. A) with A > 0.1 Let X ∼ N (0. we can also show that EX 2 = 1 and EX 4 = 3.

C −1 CC 0 C −10 ) = N (0.11) 2 with r = 1.Theorem A.8. The fact that A > 0 means that we can write A = CC 0 where C is non-singular. Iq ).1. Proof of Theorem A. which we showed in (A. Set r Z .2. (A. tr has distribution 177 .13). Using the simple law of iterated expectations. tr = p Q/r The density of tr is and is known as the student’s t distribution with r degrees of freedom.11). q Proof of Theorem A.8. Thus the density of Z 2 is (A.8. 1). C −1 AC −10 ) = N (0. 1) and Q ∼ χ2 be independent.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).13) is the MGF of the density (A. ¡ ¢ √ using the change—of-variables s = x2 and the fact Γ 1 = π. which can be found by applying change-of-variables to the gamma function.3. we see that the MGF of Z 2 is (1 − 2t)−1/2 .6) can be used to show that the MGF j=1 ¥ Proof of Theorem A. Since we can write Q = P 2 X 0 X = r Zj where the Zj are independent N(0. 1) the distribution of Z 2 is ¡ ¢ √ P Z 2 ≤ y = 2P (0 ≤ Z ≤ y) µ 2¶ Z √y 1 x √ exp − dx = 2 2 2π 0 Z y ³ s´ 1 ¡1¢ = s−1/2 exp − ds 1/2 2 0 Γ 2 2 1 ¡r¢ 2 2r/2 y r/2−1 exp (ty) exp (−y/2) dy of Q is (1 − 2t)−r/2 .8. The MGF for the density (A. For Z ∼ N(0. Thus ¥ ¡ ¢0 ¡ ¢ Z 0 A−1 Z = Z 0 C −10 C −1 Z = C −1 Z C −1 Z ∼ χ2 . Then A−1 = C −10 C −1 and C −1 Z ∼ N (0.3 Let Z ∼ N (0. From (A.11) is Z ∞ ¢ ¡ Γ r+1 2 f (x) = ´ r+1 ¡r¢ ³ √ 2 2 πrΓ 2 1 + x r (A.12) E exp (tQ) = 0 Γ (A.

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

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

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

θ0 )2 (Yi . θ0 ) ln f (Yi . function of the data. θ0 ) ∂θ ∂θ ¥ ³ ´ X ∂ ∂ ˜ ln fn Y . Since θ Z ˜ = ˜ y)f (˜. θ0 )0 f (Yi ..1. Differentiating with respect to θ and evaluating at θ0 yields ˜ Z Z ³ ´ ˜ y ) ∂ f (˜. θ) ¯θ=θ0 ¯ Z ¯ ∂ f (y. ∂2 ln f (Yi . θ0 )0 .. . To see (A. ∂θ ¯θ=θ0 Z ! = 0. θ) f (y.9. θ0 ) ∂ ∂θ f ∂ (Yi . θ) d˜ θ = Eθ θ(˜ y y where y = (y1 . f (Yi . θ0 ) ∂θ f (Yi .1) has mean zero and variance nH. we can show that E By direction computation.9.16). θ) f (˜. (Yi . θ0 ) ∂θ ∂θ n i=1 which by Theorem (A. θ0 ) f (Yi . θ0 ) dy ¯ ¯ ¯ θ=θ0 f (y. yn ).17). θ) d˜ = ˜ y ) ∂ ln f (˜. θ0 = ln f (Yi . V ar (S) nH so ¥ 181 . S= ∂2 f ∂θ∂θ0 ∂2 f ∂θ∂θ0 ∂ ∂θ Z Ã ∂2 f ∂θ∂θ0 ¯ ¯ ln f (y. θ)¯ = ¯ ∂θ θ=θ0 = = = Similarly. θ0 ) = ∂θ∂θ0 = Taking expectations yields (A.Proof of Theorem A.. θ) dy ¯ ∂θ 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 = .9. θ0 ) d˜ = E ˜ . θ0 ) ¯ ∂ f (y. θ0 ) (Yi . θ) dy ¯ ¯ ∂θ θ=θ0 ¯ ∂ ¯ 1¯ = 0.2. θ0 ) − f (Yi . ¯ ¯ ∂ E ln f (Yi . θ0 ) ∂ ∂ − ln f (Yi . Write the estimator ˜ = ˜ Y ) as a θ θ( ˜ ˜ is unbiased for any θ. Proof of Theorem A.

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

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

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

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

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